Viable Future Model for Internet by AT Kearney


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Viable Future Model for Internet by AT Kearney

  1. 1. A Viable Future Modelfor the InternetInvestment, innovation and more efficient use of the Internetfor the benefit of all sectors of the value chain
  2. 2. CONTENTSExecutive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42. Overview of the Internet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2.1. Description of the Value Chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 2.2. Structure of the Internet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63. Pressures on the Internet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 3.1. Performance Pressure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 3.2. Economic Pressure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 3.2.1. Structural Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 3.2.2. Investment Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . 15 3.2.3 Ongoing Traffic Growth in Existing Fixed Networks . . . . . . . . . . . 15 3.2.4 Ongoing Traffic Growth in Existing Mobile Networks . . . . . . . . . . 18 3.2.5 The Case for Fibre . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 3.2.6 Profitability of Investment in New Network Capacity . . . . . . . . . . 21 3.3. Policy Pressure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 3.4. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244. Alternate Commercial Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 4.1. Modification of Retail Pricing Schemes . . . . . . . . . . . . . . . . . . . . . 25 4.2. Traffic Dependent Charges for All Traffic . . . . . . . . . . . . . . . . . . . . . 29 4.3. Enhanced Quality Services over the Public Internet . . . . . . . . . . . . . . 34 4.4. Enhanced Quality Services Based on Bilateral Agreements. . . . . . . . . . 37 4.5. Summary Evaluation of Options . . . . . . . . . . . . . . . . . . . . . . . . . . 405. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43Appendix (Report Methodology) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
  3. 3. Executive Summary 100 percent, all underpinned by new, more capa- ble devices and new high-bandwidth servicesThe Internet is playing an increasingly important unleashed by a fresh wave of innovation. Aboverole in the lives of people around the globe and all, video content is having a dramatic effect onmore than ever underpins a significant portion of Internet usage. Yet the Internet risks becoming aeconomic activity. Within its short lifespan it has victim of its own success as this video traffic, muchalready delivered huge economic and social benefits of it free to the end user, threatens to swamp avail-in the form of reduced transaction costs, increased able network capacity and cause unacceptablecompetition and lower prices for many goods and levels of congestion for users of all while offering greater access to information Technology can again provide part of theand a whole new means of communication, educa- solution, both in terms of higher capacity net-tion, information, commerce, political debate and works and greater use of traffic management tech-entertainment. Yet this report makes clear that for niques including compression and caching. Thisgrowth to continue, the next few years must see a will not be sufficient because of two cumulativerealignment of who captures the value and who effects. First of all, there are limited economicfunds investment in the Internet value chain. incentives for Online Service (or “Over the Top”) Given its economic and social importance, it Providers to use network bandwidth no surprise that the Internet has a political Secondly, the investment case for such solutions isdimension. Most governments and regulatory currently weak, because of a structural disconnectauthorities see wider Internet access as something in the Internet value be encouraged and promoted; some are consid- As this report explains in some detail, thoseering subsidising services that would not be com- who benefit from higher traffic volumes are thosemercially viable to ensure that 100 percent of their who generate traffic (typically content sites) andpopulation has access. Debate has also extended those who consume it (typically end users). Thoseinto the question of what constitutes a “level play- who have to build and operate the networksing field” for competition and the right model to required to carry these traffic volumes earn almostgovern consumer and property rights. There is a no revenue from the former group and are oftenwidespread expectation among policy makers and locked into flat rate price schemes with the latterthe wider public that the Internet will continue to group, continually decreasing because of retailfunction well and support future growth. That competition. Economists often refer to such “two-expectation will be disappointed without signifi- sided markets” in terms of virtuous cycles, wherecantly higher levels of investment; however, such each side pays enough for the entire market toinvestments will not materialise without changes grow to everyone’s benefit. Because of the discon-in the economic model. nect between sources of revenue and sources of Recent traffic growth figures and mid-term cost in the Internet today, however, this two-sidedforecasts for future growth are impressive but raise market is simply squeezing value out, undermin-serious challenges regarding the viability of the ing future investment and the associated benefitscurrent Internet model in the future. Internet traf- of growth and innovation.fic delivered via fixed networks is growing at 35 If networks were upgraded to address thepercent p.a. and via mobile networks at more than forecast capacity needs to 2014 with no new price A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 1
  4. 4. signals or increase in revenues, we forecast that wholesale level, which would constitute an network operators would see their returns on cap- increase over current transit pricing but still rep- ital decline by 3 percentage points to around 9 per- resent a tiny fraction of the market price for cent and potentially as low as 7 percent. This is far legitimate high-bandwidth content below their cost of capital under any normal sce- • Enhanced quality services over the public nario and incidentally far below the returns enjoyed internet: Deploy widespread, standards-based by the Online Service Providers that are creating differential quality of service, with commit- demand and generating high-traffic volumes. ments of higher performance charged at a pre- Maintaining current levels of returns in the mium to Online Service Providers that need telecommunications networks (or “Connectivity” and request this; revenues cascade down the sector) while investing to maintain current net- value chain, reimbursing those who invest to work performance in Europe would require enable higher service levels additional revenue of €28 billion per annum by • Enhanced quality services based on bilateral 2014 to justify the necessary investments in fixed agreements: Ensure further evolution of the and mobile networks. This is about 10 percent market (as has already started) via a series of of the total telecommunications market today. bilateral commercial arrangements operating in Considering the backdrop of declining revenues parallel to the current Internet model and from traditional services (especially voice) and addressing the needs of high-bandwidth users, intense competitive and regulatory pressure, rais- freeing up capacity for others ing additional revenue of this order of magnitude For each of these options, charging models will be a challenge. Our analysis, detailed in Section could relate to total traffic (a certain price per giga- 3 and the Appendix, considers only the incremen- byte), to certain types of traffic (based on quality of tal investment needed to maintain current perfor- service needs), or to certain types of providers mance levels in fixed and mobile networks as traffic (based on their business model and willingness to levels rise. There is a separate discussion for the pay). The structure and level of such charges would longer term about the deployment of fibre to the evolve under regular competitive forces to reach home (FTTH), which would enable new, even market equilibrium as in other two-sided markets. higher bandwidth services. Although, of course, Section 4 of this report demonstrates that no the value chain will also need to provide a sustain- single solution can solve all the structural issues. able revenue base for this investment. Instead we expect the right answer for the industry There are a number of possible options for to be a hybrid of these different options. Each new models that may rectify the problems option has its own merits but it is too early to dic- described and ensure adequate capacity increase tate which should succeed and which, if any, should to sustain the correct functioning of the Internet be discarded now. We therefore consider it impor- to the benefit of all: tant that policy makers not restrict the process of • Modification of retail pricing schemes: Increase innovation and competition by which a more end user prices, with a likely expansion of vol- viable commercial model for the Internet emerges. ume-dependent pricing to impact heavy users In our evaluation of the options outlined, we • Traffic dependent wholesale charges: Introduce have considered the impact on the wider ecosys- a reasonable traffic conveyance charge at the tem, on those businesses and individuals who use2 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney
  5. 5. the global reach of the Internet every day to find this report helps shift the attention. Some recenta market or a community. The only negative debate on Internet policy has not been helpfulimpact identified would be for those who offer in this regard: for instance, a misguided belief thatextensive volumes of free video with no legitimate the Internet—or even fundamental principles ofcommercial model—often, though of course not free speech and free enterprise—would suffer fromalways, pirated content. In our opinion, it is not the introduction of more balanced and rationalworth choking the Internet for this. We have also considered theimplications for competition andthe correct policy response to eachoption. On balance, A.T. Kearney For Internet growth to continue,would argue that all participants inthe Internet value chain should con- we must see a realignment oftinue to have the flexibility and free- who captures value and whodom to devise and test new businessmodels in the market. Imposing any funds investment in the Internetspecific option, or forbidding one ormore, risks preventing the Internet value chain.ecosystem from finding efficientsolutions to the current structuralproblems and therefore hinderingcustomers from enjoying high quality, innovative charging and traffic management principles. Theservices. Existing general competition law should opposite is true: without clearer economic incen-be sufficient to deal with any potential anti-com- tives, congestion will choke off innovation andpetitive behaviour that may arise if players with usage. It is promising that recent consultation exer-significant market power in any sector of the cises and policy statements in the European UnionInternet value chain attempt to abuse that power have shown an appreciation of this point, butin changing economic terms to achieve an unfair the policy discussions are still at an early stage.advantage. In conclusion, this report does not call for new leg- The future model of the Internet is an area of islative prescriptions, regulatory interventions orlegitimate policy interest for a range of social and taxpayer subsidies to address the immediate pres-economic matters. Our research suggests that so far sures. Instead, we recommend that policy makerstoo little attention has been paid in the policy be supportive of commercial initiatives contribut-debate to the core issue described here: how to fund ing to investment, innovation and more efficientthe required investment while a structural discon- use of the Internet for the benefit of all sectors ofnect distorts investment incentives. We hope that the economy. A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 3
  6. 6. 1. Introduction especially with regard to incentives and price sig- nals to enable more efficient use of available net- This report analyses an important component of work capacity and stimulate further innovation in the Internet value chain, the commercial model the delivery of end-user services. underpinning network infrastructure and the rela- It is important to note that this paper has tionship between Online Service Providers (some- been produced independently and does not neces- times known as over-the-top “OTT” players) and sarily represent the views of any of the sponsoring Connectivity Providers (primarily telecoms com- companies. The paper is intended to inform ongo- panies but also some firms that specialise in ing public debate and neither the four operators Content Delivery Networks). A.T. Kearney has nor A.T. Kearney can be held responsible for any previously1 analysed each segment of the value other use that might be made of it. The analysis is chain and considered the different economics and based on a transparent methodology as well as returns of each segment. Our research demon- public information sources which are summarised strates that the primary beneficiary is the end-con- in an appendix for those who wish to review the sumer while the players within each segment of analysis as part of their own deliberations on this the value chain have had very different experi- important topic. ences in terms of growth and shareholder returns. In this report, we seek to address five key The leading Online Service Providers and User questions, Interface manufacturers (hardware and software) • What are the current pressures affecting Internet have captured significant value while Connectivity Connectivity—on technical performance, eco- Providers and Content Rights owners have seen nomics and policy constraints? fewer benefits and even, in some parts of the • How do these pressures impact the key stake- media industry, value destruction. holders, such as end users, Online Service At the heart of these differences is the dis- Providers and Connectivity Providers? connect between traffic (as a key driver of the • How should the current commercial model cost base) and revenues. All forecasts point to a evolve to align incentives and to ensure that the continued rapid growth of traffic, not matched Internet continues to develop in a sustainable by revenue growth. Given this context, four Euro- and efficient manner? pean telecommunications companies—Deutsche • How can the value chain accommodate the Telekom, France Telecom, Telecom Italia and forecast rise in video usage (i.e., over-the-top Telefónica—commissioned A.T. Kearney to con- video streaming) and the demand for new high- duct an assessment of the viability of the current speed access services? model of Internet connectivity in terms of perfor- • What are the public policy implications in mance, economics and policy. We also assessed Europe and globally of changing the model or the investments needed to support expected traf- leaving the status quo intact, especially with fic growth and considered broad options on how regard to the current debate around Net the current commercial model may need to evolve, Neutrality? 1 A.T. Kearney, Internet Value Chain Economics, 20104 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney
  7. 7. 2. Overview of the Internet ogy segment has seen significant growth in inno- vative service offerings such as cloud computing,2.1. Description of the Value Chain content distribution, bespoke and targeted adver-A.T. Kearney has previously analysed the Internet tising etc. Within the Connectivity segment, theValue Chain in which we presented a framework market is extremely competitive, reflected in thedivided into five discrete segments, shown in continued increase in access speeds and decreasingfigure 1. charges. At the same time the diversity of devices Throughout the (relatively short) lifespan of that can be used to access the Internet has grownthe Internet, there have been rapid and ongoing significantly, allowing users to be connected forchanges in every segment of the value chain. longer and access a greater diversity of servicesContent Rights owners continue to experiment from ever more places.with commercial models that protect and extend Our research reveals that the imbalancethe value of their content. Online Services con- between traffic volumes and revenues also createstinue to evolve from the initial free-for-all of the significant differences in returns on capitaldotcom boom, with powerful players having employed for industry players. For example, lead-emerged in many areas, including search, social ing telecom operators generate returns aroundnetworking and e-retailing. The enabling technol- 12 percent (partly due to regulated pricing andFigure 1Overview of the Internet value chain ILLUSTRATIVE Content rights Online services Enabling Connectivity User interface technology services Media rights owners Communications Support technology Core network Applications • Video Skype Vonage • Web-hosting • Software • Web-design/development • Media players • Audio AT&T NTT Hotmail Facebook • Content management • Internet browsers • Books British France NTT/Verio Rackspace Telecom Telecom • Gaming General/vertical content Limelight Akamai McAfee Real- • Adult content Group Networks Yahoo! Wikipedia • Editorial content Symantec Firefox Financial Billing and payments Times Interchange • Online billing and TimeWarner EMI payment system Level 3 XO Search Communications Communications Harper providers Blizzard Collins Google Baidu PayPal First Data User BBC Devices Bing Chase Google Retail Internet Paymentech Checkout access • PCs • Smart phones Entertainment Advertising • Game consoles YouTube Xbox Live • Online ad agencies AT&T Vodafone • Other internet access User-generated hardware content • Online ad networks/ France Tiscali iTunes exchanges Telecom • Operating systems • Text • Voice • Third party ad servers Deutsche Telecom Telekom Italia Dell Nintendo • Images • Video Transactions • Ratings/analytics services NTT Telefónica WPP Razorfish Microsoft Apple eBay Amazon Double Nielsen Nokia Expedia Boursorama ClickSource: A.T. Kearney analysis A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 5
  8. 8. high capital intensity) while other key seg- translated into growth in revenues. We argue that ments such as search, gaming, gambling, and there is a fundamental structural problem with e-Commerce deliver returns of more than 20 per- the current commercial model of Internet cent and some segments even 30 percent or more. Connectivity and how it is paid for. Our research also demonstrates that revenues for consumer Online Services are growing more than 2.2. Structure of the Internet twice as fast as Internet access provision. Of the The Internet is an interconnected “network-of- five main segments, Connectivity and Content networks” based on open standards and protocols. Rights players do not appear to have benefited It originated as a U.S. military network that grew from the growth of the Internet to the extent that into an academic network linking universities the other segments have. Their market capitalisa- around the world. It took off as a broader service tion is the same now as it was five years ago and with the invention of the browser and hyper-text Figure 2 makes clear that this is not simply a fea- linking to provide an easy to use interface. The ture of the 2008/2009 economic downturn. interconnections allow networks to pass traffic There are many possible reasons for this dis- among each other on a “best-effort” basis, that is parity but, as we explore in this report, the growth to say there are no guarantees of how the traffic of the Internet and consequent growth in traffic will be treated or whether it will even reach its ulti- carried by Connectivity Providers is not being mate destination. Each participant pays for its Figure 2 Evolution of market capitalisation by value chain market (base 100 in 2004) 500 User interface5 400 Online services2 300 Enabling technology/ services3 200 100 Connectivity4 Content rights1 0 2004 2005 2006 2007 2008 2009 2010 Notes: Average for Disney, NewsCorp, Time Warner ,Warner Music Group, Vivendi and Electronic Arts 1 Sources: Bloomberg, A.T. Kearney analysis 2 Average for Amazon, Google, Yahoo!, eBay, Baidu, Expedia and Partygaming 3 Average for Akamai, CyberAgent, Google, Valueclick, Verisign and WPP 4 Average for AT&T, Vodafone, NTT, British Telecom, Deutsche Telecom and France Telecom 5 Average for Microsoft, Apple, Dell, Acer, Nokia and McAfee6 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney
  9. 9. own equipment and connection to the network little, if any, of their payments flow down to otherand these charges include a small component to Connectivity Providers in the chain.compensate those who connect the main Internet For the rest of this report, we adopt network-exchanges.2 End-users pay an Internet access centric terminology in line with figure 3 to illus-charge, typically bundled with their telephony or trate the key players within the relevant parts ofTV subscription, to be connected to the Internet. the Internet value chain.Most Online Service Providers pay a fee to their In this framework the Internet acts as aConnectivity Provider(s) to be connected to the communications platform, primarily connectingInternet, which is generally based on the band- Online Service Providers, who want access to thewidth they require, while the largest ones act as if largest population of potential customers, to endthey were Connectivity Providers in their own users who want access to the widest selection ofright and connect to others via peering agree- services. In performing this function the Internetments. In both cases these charges are generally flat has been outstandingly successful, rapidly castingfees, not linked with usage and they form a very aside early “competitors” such as Compuserve,small part of their total expenditure/cost structure. which were offering a similar service within aIn effect, Online Service Providers are paying to “walled garden” of fewer users.connect their services to the network but are not In microeconomics, this phenomenon ispaying for downstream service delivery, particu- known as a two-sided market—referring to anylarly to Retail Connectivity Providers since very economic platform that brings together twoFigure 3Internet network infrastructure ILLUSTRATIVE Content rights Online services Enabling Connectivity User interface technology services Connectivity providers Retail connectivity provider Online service Internet RAN provider Enterprise core Aggregation End connectivity and users provider backhaul Yahoo! Last mile Amazon AT&T Level 3 Communications NTT Verizon Vodafone Telefonica Virgin Google Mobile Deutsche France 02 YouTube Sprint Telecom Telecom 3 British Telecom Telecom ItaliaSource: A.T. Kearney analysis2 A simple analogy would be the cover charge in a restaurant, which does not pay for the food, drink or service to be consumed. A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 7
  10. 10. distinct user groups and where each group exhib- two sides. This balance accounts for the relative its demand economies of scale. In the context of value derived by each side and understands that the Internet, Connectivity Providers offer the increasing the charges to one side may actually be infrastructure services required to connect two beneficial to those bearing the increase because it user groups, namely Online Service Providers and enables more users on the other side to join, end users. The economic concept of two-sided increasing the total value enjoyed by all. However, markets achieving optimal pricing structures is if the pricing balance does not reflect appropriate well established. A good, non-technical example price signals between the two sides of the market, to illustrate this is the trade-fair— the organiser charges exhibitors for stand space and also charges attend- ees who visit. The value of the fair to an exhibitor is related to the number Revenues for consumer online of attendees and so exhibitors may expect to pay more to avoid the need services are growing more than for high entry fees. However if exhibitor charges are set too high, twice as fast as Internet access. some may withdraw and the attrac- tion of the fair to potential attendees declines, which in turn decreases the value of the fair to other exhibitors. The organiser the model may not be efficient in the long term will seek to maximise revenues, taking into since all participants in the market are subject to account limited floor space and number of visitors the normal rational economic behaviours and that can be accommodated, but always with an need to make a reasonable return. This is an eye to the new congress hall in the neighbouring important consideration when looking at the eco- town, which is keen to attract more trade fairs. nomics of the Internet value chain, as will be All successful providers of two-sided market explained further. services must find a pricing balance between the8 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney
  11. 11. 3. Pressures on the Internet exponential growth, both in fixed and mobile at a compound average growth rate of 35 percentThree major sources of pressure face the Internet: and 107 percent respectively (see figure 4).technical performance, economics and policies. This strong growth is driven by:These pressures are becoming more evident as the • Increasing availability of new servicesInternet grows to be the critical public infrastruc- with high-bandwidth requirements, includingture that underpins a wide range of other impor- Internet-TV based services such as Catch-uptant activities such as entertainment, supply chain TV, radio/music streaming services, applicationmanagement, banking and even healthcare and and content download services, richer contenteducation. The technical robustness of the as part of social networking sites (audio/ video)Internet is closely tied to the sustainability of the and cloud computing for business services deliv-underlying commercial model and therefore both ery (e.g. SaaS)are vital to support the growth of current and • Increasing penetration of multimedia devices future economic activity. such as smartphones, set-top boxes, media gateways, Internet connected TVs, connected3.1. Performance Pressure gaming consoles, enabling new types of high-Forecasts of Internet traffic in Europe over the bandwidth usagenext five years continue to be characterised by • Changing usage patterns supported by flat rateFigure 4Europe total Internet traffic projection1Fixed2 Mobile3(PB/month) 14,611 (PB/month) 1,217 26% YoY: +35% 11,192 YoY: +107% 28% 764 8,409 6,137 31% 33% 74% 399 4,426 3,236 72% 37% 39% 69% 185 67% 63% 77 61% 32 2009 2010 2011 2012 2013 2014 2009 2010 2011 2012 2013 2014 Other applications Video applications Mobile data and Internet trafficNotes: 1Data included for Western, Central and Eastern Europe, for Consumer and Business users 2 Video applications include gaming, file-sharing, video over the internet (i.e. internet video to PC/TV). Other applications include VoIP, business traffic across internet, video communication, web and data 3 Mobile data traffic includes handset-based data traffic, such as text messaging, multimedia messaging, and handset, video services. Mobile Internet traffic is generated by wireless cards for portable computers and handset-based mobile Internet usageSources: Cisco Visual Networking Index, A.T. Kearney analysis A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 9
  12. 12. offers and innovation in services and devices, all Cisco, the average broadband connection gen- of which encourage users to spend a greater por- erates 14.9 GB of Internet traffic per month in tion of their day using the Internet (always on, October 2010, up from 11.4 GB per month in always reachable) to access richer content the previous year, an increase of 31 percent.3 In A good illustration of these trends is the pop- the past, traffic growth was driven primarily by ular iPhone device, whose users spend almost the rapid increase in the number of customers. double the time on data intensive applications as • Internet traffic accounts for an increasing other mobile data users, as shown in figure 5. proportion of total communications traffic Although the Internet growth has been rapid and now has a major impact on the increase in since its inception, there are some fundamental total traffic carried by telecom network opera- trends that increase the urgency for change in tors. In the past Internet traffic used to be miti- network service delivery in the near future. gated by lower volume growth rates of traditional Compared to past traffic growth, the Internet services such as voice. today is characterised by the following: • Rise in mobile Internet traffic is unprece- • Increase in video applications is driving an dented as the long-awaited adoption of mobile increase in usage per customer. According to data has been explosive. Moreover, in the past, Internet traffic was based on many-to-many traffic flows, which were Figure 5 evenly distributed and fairly symmetrical across Changing usage patterns, average vs. iPhone networks. The connectivity requirements for users (2009) Internet services were homogenous as the services were largely limited to web browsing, e-mail and file-sharing, all of which were delay-tolerant and Time spent on application or service resistant to variation in network performance. By Other 3% 3% contrast, the current Internet is rapidly becoming 3% Double the Internet 2% 3% 9% time spent a “few-to-many” content distribution platform, as Games 4% on data- Music 8% intensive shown by the fact that fewer sites account for an 15% applications ever increasing percentage of total traffic. Google, E-mail 10% SMS Voice call 11% for example, is ranked 3rd in overall global traffic carried (mainly due to its YouTube service) behind 14% Level 3 and Global Crossing and generates more 70% traffic than the rest of the Tier 1 players such as Sprint and Cogent.4 As a result, Connectivity 45% Providers today are facing asymmetrical traffic with highly heterogeneous traffic flows with dif- ferent performance requirements. The asymmetry Average user iPhone user in the exchange of traffic between Connectivity Sources: Apple; Mobile Internet Report Key Themes Final, 2009 December, Morgan Stanley; A.T. Kearney analysis Providers and Online Service Providers can reach 1:10 and in some cases even 1:20.5 At the same 3 Cisco Visual Networking Index: Usage, October 25, 2010. 4 Based on analysis of anonymous ASN (Autonomous System Number) data in the ATLAS Internet Observatory 2009 Report by Arbor Networks.10 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney
  13. 13. time, newer services such as video streaming or file-sharing traffic, which is more resilient to con-unmanaged VoIP are more sensitive to network gestion, effectively crowds-out the more inter-performance than web browsing or file sharing active and real-time services that are likely to beand require dedicated resources that the best- the basis of the new more innovative services. Ineffort approach may not be able to deliver during the long-run, Online Service Providers will be lesstimes of congestion. inclined to invest and launch more advanced If traffic continues to grow as shown in Figure services if they question their ability to offer a4, particularly with regard to greater use of video high-quality user experience. Yet they need theseapplications, but operators do not have the busi- advanced services ultimately to generate revenueness case to invest at a similar rate in new capacity, and to launch new services such as telemedicine,the result will be increasing network congestion at which could have great social and economic ben-peak times. Voice network congestion manifests efits, but which rely on high quality connectivity.itself in the form of blocked calls, but for the In economic terms, this illustrates that carryingInternet the effect is less abrupt, a more progres- any traffic not only brings utility, but also hassive degradation of the customer experience. If implied opportunity costs.congestion occurs in a localised area, one of the It is important to repeat that within the best-great attributes of the Internet is its ability to route effort delivery model no allowance is made todayaround such bottlenecks. However, as traffic for different types of traffic and so applicationsgrows at an aggregate level everywhere more wide- with specific requirements (round-trip delay, jitterspread congestion will occur within operator net- and error-rates, for example) must be treated inworks, resulting in: the same way as applications that are less sensitive• Traditional services (e-mail, web-browsing, file to congestion. When network capacity is abun- downloading) will become progressively slower, dant relative to traffic, this works fine but in the although still function future, a mechanism to use limited capacity more• E-commerce services will become less predict- efficiently will be needed to deliver adequate able and reliable and therefore less appealing to service in a predictable way. end users Traffic management techniques are increas-• Interactive services such as online gaming, VoIP ingly being used to tackle network congestion at calls and web-conferencing will stop working peak-hours. Such techniques are used to maximise effectively, with poor quality or periodic inter- the use of the “constrained” available capacity and ruptions making them increasingly unusable network resources and to use specific actions to• Any sort of streaming service will become unus- limit the impact of the congestion on end users. able at peak times due to frequent interruptions There are two basic approaches. The first is user- Such service degradations are clearly frustrat- based, where operators allocate the availableing for end users but also affect Online Service bandwidth equitably and when necessary limitProviders who almost certainly lose revenues throughput of heavy users to prevent them fromthrough lost sales or lost users and the associated negatively impacting the service of others.loss of advertising revenue. The technical char- Alternatively, operators can manage traffic basedacteristics of different traffic types means that on traffic type and minimise delays in applications5 Based on operator interviews. A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 11
  14. 14. that are more prone to delays by rate-limiting, or is the need to continue to enable innovation. The slowing traffic that is more delay-tolerant while Internet has been a great source of innovation, continuing to ensure that such services work effec- leading to new business models and the creation tively, albeit taking slightly longer. In both cases, of large companies that did not exist 20 years ago, the application of appropriate network manage- while revolutionising the way many services are ment practices can lead to a “win-win” situation delivered to end users. Key attributes contributing where Connectivity Providers optimize network to this include: resources and all customers continue to benefit • Open standards allow both users and service from an effective service. Without traffic manage- providers to connect and interact seamlessly ment the risk is that all users suffer from a reduced • Ease of use allows anyone with a suitable device quality of service. While these tactical measures to connect to the network and be able to access help alleviate some of the main causes of congestion the full range of content and services they are only really short-term measures that delay • A level playing field minimises barriers to entry rather than solve the problem. If nothing changes and initial costs for start-ups, enabling small an ever-increasing intensity of traffic management companies with a good idea to be up and run- will be needed to help manage congestion. ning much sooner and more economically Technical improvements that improve the than if they had to establish a more traditional capacity and efficiency of the infrastructure and business enable operators to squeeze better performance It is important that these principles are main- from the network are continually being devel- tained and protected in the future. However, as oped. For example, compression algorithms allow the range of services delivered over the Internet traffic to be transmitted more efficiently and continues to grow and diversify, it is also impor- improved application design can minimise the tant that the network itself evolves and innovates volume of signalling traffic, which can be a partic- to support both new services and existing services ular problem in mobile networks. However, few better. The Connectivity segment is therefore incentives are concurrently in place to encourage under pressure to streamline the delivery of online Online Service Providers to adopt these techni- services and offer new services such as cloud com- cal improvements. The performance of network puting, content distribution, bespoke and tar- equipment develops similar to Moore’s law for geted advertising, to name a few. computer processors, enabling faster switching of Although the enabling technology plat- data in high-end equipment but also improving forms may be less visible to end users, consider- the cost effectiveness of mid-range equipment, able innovation has already occurred within the thus delivering greater throughput at similar price Connectivity segment. The speed and ubiquity of points. These incremental improvements, signifi- Internet access (fixed, mobile, Wi-Fi) grows cant though they are in the short term, can only relentlessly while access costs have fallen steadily offset a portion of the forecast growth in traffic. in this highly competitive market. It will become What is needed is the right set of economic incen- more important that the underlying network tives for a permanent and continual stream of infrastructure is able to support more advanced incremental improvements. services—for example, HD and 3-D television A further dimension of performance pressure streaming, telemedicine, full screen online gaming,12 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney
  15. 15. and B2B services such as telepresence videocon- 3.2. Economic Pressureferencing—that will contribute to further innova- 3.2.1. Structural Problem. A fundamental struc-tion and economic growth. This is a question of tural problem exists in terms of who pays for theboth the pure capacity to handle the traffic and of necessary infrastructure required to sustain thethe technology used to optimise the delivery of Internet because pricing on both sides of theservices when today’s best-effort protocols are no market is disconnected from network usage. Aslonger sufficient. mentioned earlier, in the vast majority of cases, Pressures on the Internet will only increase as end users of fixed connections pay a flat monthlytraffic continues to grow. The congestion prob- fee for as much usage as they need, while mobilelems will not only diminish customer experience users typically choose a tiered usage level. Onlinebut also limit innovation as Online Service Service Providers pay for their access speed to beProviders find it more difficult to reach customers connected to the Internet, or alternatively connectand their business models fail to fully exploit their directly through transit and peering agreements atpotential. The limitations of the current model a much lower unit cost (sometimes zero). In fact,could ultimately hinder future innovation of new on a per-user basis, traffic per customer is expectedservices for business, entertainment and some to continue to grow, while the average price for acritical applications for public services such as fixed broadband connection (both standalone ande-Health. This will have spill-over effects not only in bundles with other services) is expected to con-in the Internet ecosystem but also in the economy tinue declining. (Between 2007 and 2009 theas a whole. price of the average fixed standalone broadbandFigure 6Price signals in the current Internet model Online service provider End user Traffic Traffic Very weak price No price signal signal linked with linked with traffic traffic generation generation Internet access Current traffic charge delivery charge Time TimeSource: A.T. Kearney analysis A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 13
  16. 16. connection declined by 44 percent.6) The result is In fact the misalignment of costs and traffic could that operators are faced with an insatiable increase actually be an incentive to induce more traffic in traffic, which causes a rising cost base that since their business models and revenues are is completely disconnected from revenues. On driven by number of visitors/eyeballs (for instance, mobile networks, due to the scarcity of spectrum advertising based). Furthermore, at times of con- resource, the trend is moving toward capped data gestion, a lack of appropriate price signals, com- tariffs, for example, a fixed price for 1GB per bined with the current best effort delivery month and a higher price for 3GB, which at least approach, incurs opportunity costs not only to the begins to restore some linkage (albeit weak) Connectivity Providers but also to the overall between usage and price. value chain if high volume but low value traffic As illustrated in Figure 6 on page 13, the crowds out high value/important traffic. absence of price signals means end users and The result of this misalignment between rev- Online Service Providers have no incentive to enue and costs means that when a Connectivity manage demand or to optimise the traffic they Provider is considering new capacity investments, send or receive; this problem is likely to be exacer- the return on this investment (that is, the addi- bated by the capacity demands of video-intensive tional revenues that may follow) is far from clear. applications. Online Service Providers have little Moreover, under the current model, any new incentive to limit traffic because they are only capacity built will not resolve the congestion issue paying for the relatively low backbone network but merely delay it as new capacity is rapidly filled costs and are not paying for access network costs. by additional traffic as there are no price signals Figure 7 New network investments Capacity upgrades Technology upgrades Increasing capacity Deployment of new technologies of existing networks in order to deliver new services Fibre roll-out Fixed networks Deployment of Fibre to Cabinet and Home Incremental capacity upgrades to deliver high-speed access speeds to core and backhaul networks and services (30-100Mbps) Mobile networks LTE Upgrade existing and deploy new sites New radio access technology to enable (with associated backhaul) higher speed mobile access services In addition to new services, the higher spectral efficiency of LTE means it will also be a more efficient Source: A.T. Kearney analysis means of increasing mobile network capacity 6 Europe’s Digital Competitiveness Report - Volume 1: i2010 — Annual Information Society Report 2009 Benchmarking- i2010: Trends and main achievements, European Commissions.14 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney
  17. 17. and hence incentives for the users to change their capacity upgrades, and LTE deployment we usedbehaviour. This is becoming a pressing issue the multi-step approach summarised in figure 8.because, after years where demand often lagged For the fibre roll-out we estimated deploymentsupply, the industry—and particularly the mobile costs of rolling out fibre according to the EUsegment—is now facing the challenge of manag- Commission’s 2020 target. A larger public policying serious capacity constraints for the first time. and commercial strategy debate is taking place onFixing these problems and developing the right the wide-scale deployment of fibre to the home;pricing signals to promote efficient use of the it is not the intent of this paper to tackle all ofInternet will require new pricing and commercial these questions.models. 3.2.3. Ongoing Traffic Growth in Existing 3.2.2. Investment Requirements. To under- Fixed Networks. Fixed access networks (last mile)stand the economic sustainability of the current have sufficient capacity for today’s usage, andInternet model, we carried out analysis to estimate therefore traffic increases require mainly invest-the level of capital expenditure (“capex” or invest- ment in aggregation and core network capacity.ment in ongoing infrastructure expansion) needed With much of the traffic growth being driven byto support the forecast traffic growth and assumed video, substituting file-sharing traffic to somethat opex (operating expenses) increases propor- extent, capacity or bandwidth requirements maytionately. The investment requirements are broken actually outpace the growth in total traffic since itdown between ongoing infrastructure expansion, is likely to result in more simultaneous usagewhich is purely traffic driven, and the technology versus the more distributed nature of file-sharingupgrades, specifically fibre and LTE, which will traffic. Figure 9 on page 16 shows the estimateddeliver new services and faster access speeds. We traffic growth to 2014, highlighting the incre-have also split the assessment between fixed-net- mental capacity required each and mobile networks due to the different The impact of such rapid growth can beinvestment profiles (see figure 7). clearly seen—in 2014 alone, the incremental In the following section we model the growth in traffic is greater than total traffic inexpected costs of each of these investments and 2009. Or in absolute terms, capacity equivalent tothe potential additional revenue needed to make the entire Internet today will need to be added inthese investments viable. For fixed and mobile just one year. We modeled the expected cost ofFigure 8Capex and revenue modeling approach Model the capex Map capex required Estimate additional Traffic and bandwidth required to increase with actual capex revenues required forecast network capacity in line forecast to identify to fund capex with forecast portion above trendline above trendlineSource: A.T. Kearney analysis A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 15
  18. 18. Figure 9 European fixed Internet traffic growth1 (PB/month) Incremental traffic 14,611 Previous year traffic Historical Projected 3,419 11,192 YoY: +35% 2,783 8,409 1,711 6,137 11,192 4,426 1,190 8,409 3,236 1,190 6,137 2,276 960 4,426 824 1,232 1,044 3,236 409 2,276 824 1,232 2006A 2007A 2008A 2009A 2010 2011 2012 2013 2014 Note: 1Data included for Western, Central and Eastern Europe, for Consumer and Business users Source: Cisco VNI Figure 10 Estimated capex required to fund incremental capacity for European fixed internet networks (€ million) 8,250 7,898 Additional capex required 7,590 Capex trendline 6,721 Cumulative 3,013 2,352 2,661 €9.8Bn 1,484 5,516 5,501 5,219 5,238 263 4,390 5,238 5,238 5,238 5,238 5,238 2006A 2007A 2008A 2009A 2010 2011 2012 2013 2014 Notes: 1Using an average capex per PB/month from 2008 -2009 and applying a 15% cost improvement p.a. Sources: Oppenheimer, A.T. Kearney analysis thereafter. No new technology considered and quality of services maintained at current level 2 Assuming 20% of total capex is dedicated to Internet related investments16 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney
  19. 19. Summary of findings: Ongoing traffic growth in existing fixed networks Expected traffic increase (2010-2014) 11,375 PB/month (35% CAGR) Expected total capex to convey it (2010-2014) €36 billion Total capex trendline at current levels (2010-2014) €26 billion Total incremental capex (2010-2014) €10 billion Estimated additional annual revenues required in 2014 €9 billionSource: A.T. Kearney analysisbuilding this capacity, based on an estimated ing for a return to capex funding at pre-crisishistoric 20 percent of operator capex being used levels, we estimate that around €9.8 billion addi-for Internet capacity investments (see Appendix on tional spending will be needed between 2010 andpage 45). The results are shown in figure 10. 2014, with €3 billion alone in 2014, to meet the Figure 10 shows the total capex required to forecast traffic demand. Importantly, this is not ameet the forecast traffic growth and highlights the one-off impact but an ongoing requirement thatportion that is above the expected capex plans of is likely to keep growing beyond 2014.the industry. As shown, capex decreased in 2009 Calculating the revenues or contributioncompared with previous years in response to the margin needed to justify this additional invest-economic crisis and is also reflected in the lower ment is a challenge and one could adopt differentpace of growth in Internet traffic in 2009 shown methodological approaches. Additional operatingin figure 9, where traffic grew by less in absolute costs are implied by such investment (mainte-terms than the previous year (960 PB/month vs. nance fees and power, for example) and there is1,044 PB/month in 2008). Investment in Internet also the question of how to treat common costsrelated infrastructure is recovering to 2008 levels for sales, marketing, customer service. For thisfrom 2010 onward according to investor relations report, we took our 2009 estimate of fixed capexstatements and industry analysts. relative to revenue for Internet Connectivity of In line with the rapid traffic growth expected, 34 percent7 and assumed that this (very high level)the total capex required rises constantly to 2014 should not grow even higher. On this basis, addi-(and beyond), even allowing for 15 percent year- tional revenues of around €9 billion per yearon-year improvement in the cost/performance of would be needed by 2014.the equipment deployed. However, during this This increase is obviously significantly aboveperiod, fixed operators are generally expected to current levels but it is important to view it in theachieve flat revenues and, based on that expecta- context of other changes. Past investment wastion, are forecasting flat capex spending plans. As driven in part by traffic growth underpinned bya result the capex required is likely to be only increasing penetration and take-up of services thatpartly funded by current capex plans. Even allow- had a matching revenues uplift. Future traffic7 In developed markets, the overall average industry capex vs. sales ratio is about 10 percent including both fixed and mobile as well as voice and data. 34 percent presents a very high capex intensity and is only sustainable for Connectivity Providers if there is matching revenue growth. A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 17
  20. 20. growth is more driven by an increase in traffic per works. The forecasts for this are so high in fact customer which, with the current pricing struc- that we have modelled a constrained growth sce- tures, does not drive much incremental revenue. nario, which is lower than that forecast by Cisco In addition, the compounding nature of the expo- VNI, with a constant annual growth in capacity. nential growth rates means that in absolute terms Such a constraint could either come through the challenge and cost of continually increasing greater efficiency of applications (for example, capacity is becoming even more expensive. To more compression), traffic “offloading” (whereby date operators have generally used broadband the mobile network tries to use Wi-Fi networks or subscriptions as an “add-on” to traditional services femtocells as much as possible) or the unsatisfac- and so could cross-subsidise to some extent and tory outcome of congestion driving users to divert use the service as a tool to retain customers their usage to fixed networks even when mobile who generated higher-margin voice revenues. access might be more convenient. Nevertheless, Increasingly, however, as Internet connectivity this still results in traffic growing 16 fold in the service is becoming the core product that repre- five years between 2009 and 2014, an effective sents a greater proportion of an operator’s total compound annual growth rate of 74 percent (see revenue, it needs to be self-sustaining. Future figure 11). investments in Internet infrastructure need to be To separate the effect of traffic growth from justified by the returns on that investment. new services, we have assumed the demand is met 3.2.4. Ongoing Traffic Growth in Existing using the current 3G networks. Figure 12 shows Mobile Networks. The increase in traffic in that the investment required to support our con- mobile networks is even greater than in fixed net- strained traffic growth scenario is estimated to be Figure 11 European mobile Internet traffic growth1 (PB/month) Below Cisco projections2 Incremental traffic 509 Previous year traffic Historical Projected 108 401 YoY: +74% 108 293 108 185 401 108 293 77 185 2 32 45 77 1 3 11 11 11 21 1 32 2006A 2007A 2008A 2009A 2010 2011 2012 2013 2014 Notes: Data included for Western, Central and Eastern Europe, for Consumer and Business users 1 Sources: Cisco VNI, Oppenheimer, A.T. Kearney analysis 2 Constrained scenario with the mobile growth remaining at the 2011 level18 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney
  21. 21. €95 billion over five years. Comparing this to the which is likely to reduce the need to build new celltrendline capex based on 3.5 percent annual growth sites (because of LTE’s higher spectral efficiency)above historic levels shows that the resulting total and therefore increase capital efficiency.capex for 2011 to 2014 is around €31 billion To evaluate this, we modelled a scenario inabove trend. (See appendix for full methodology) which LTE technology is used to carry 13 percent As in the discussion of fixed capex, this is an of mobile data traffic by 2014 and the technologyongoing requirement rather than a one-off invest- is deployed progressively from 2012 onward. Thement. Maintaining today’s 25 percent ratio of resulting capex requirement is shown in figure 13mobile capex to mobile data revenues would on page 20.imply additional annual revenues of around €28 We estimate the total capex required for thebillion in 2014. This level is so much higher combined 3G and LTE investment is €86 billionthan for fixed—although the mix of traffic is still between 2010 and 2014 inclusive (note that thisheavily skewed to fixed (which includes Wi-Fi)— is lower than the total capex in the pure 3G sce-due to the need to build additional radio access nario noted earlier due to the higher capacity ofnetwork capacity and upgrade core and back- LTE sites and greater use of existing towers). Thehaul layers; the fixed scenario assumed adequate exact timing of LTE investments is still to becapacity in the access network for the near term. determined but spreading the total investment In reality, if the forecast traffic growth materi- over the period shows that by 2014 around €4.6alizes, operators are expected to carry a sizeable billion additional capex above the expected trend-part of these traffic increases over LTE networks, line will be required. Using the same 25 percentFigure 12Estimated capex required to fund incremental capacity for mobile networks, 3G only option(€ million) 20,822 20,822 20,822 20,822 Additional capex required Historical Projected Capex trendline Cumulative 7,930 7,479 7,012 €30.8Bn 8,366 13,345 12,574 12,627 12,034 10,759 13,343 13,810 12,891 12,456 2006A 2007A 2008A 2009A 2010 2011 2012 2013 2014Notes: 1The 2006-2010 data capex was derived from Oppenheimer’s historical and projected total mobile Sources: Oppenheimer, A.T. Kearney analysis capex from 2006-2011 by applying the ratio of Network Growth capex over total capex (70%) 2 Baseline capex from 2012-2014 was extrapolated using the 2006-2011 CAGR of 3.5% A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney 19
  22. 22. Figure 13 Estimated capex required to fund incremental capacity for mobile networks — hybrid option (€ million) Additional capex required Historical Projected 18,440 18,440 18,440 18,440 Capex trendline Cumulative 5,548 5,097 4,630 €21Bn 5,984 13,345 12,574 12,627 12,034 10,759 13,343 13,810 12,891 12,456 2006A 2007A 2008A 2009A 2010 2011 2012 2013 2014 Notes: 1The 2006-2010 data capex was derived from Oppenheimer’s historical and projected total mobile Sources: Oppenheimer, A.T. Kearney analysis capex from 2006-2011 by applying the ratio of Network Growth capex over total capex (70%) 2 Baseline capex from 2012-2014 was extrapolated using the 2006-2011 CAGR of 3.5% ratio of mobile capex to mobile data revenues while users upgrade to LTE-enabled devices. implies additional revenues of €18.5 billion per During this time it will still be necessary to also year in 2014, considerably less than the €28 bil- invest in 3G. As a result, a capex spike will likely lion that would be needed to support the same occur as operators invest in LTE launches; over capacity using 3G technology alone. time this evens out. In the long-run, LTE is a more cost effective Beyond 2014, it remains to be seen what means of delivering the extra capacity required. effect new services LTE offers will have in the However, upfront investments are required to market and specifically in increased mobile traffic. build a national network and a lag time exists If LTEs higher access speeds prove popular then Summary of findings: Ongoing traffic growth in mobile networks hybrid option Expected traffic increase (2010-2014) 477 PB/month (74% CAGR) Expected total capex to convey it (2010-2014) €86 billion Total capex trendline at current levels (2010-2014) €65 billion Total incremental capex (2010-2014) €21 billion Estimated additional annual revenues required in 2014 €19 billion Source: A.T. Kearney analysis20 A VIABLE FUTURE MODEL FOR THE INTERNET | A.T. Kearney