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Deal with the devil: why Netflix broke its own rules on net neutrality

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By agreeing to pay Comcast, Reed Hastings set a painful precedent

Netflix CEO Reed Hastings published an impassioned blog post last week criticizing internet service providers like Comcast and Verizon for asking his company to pay interconnection fees in order to ensure that their data reaches customers with speed and quality. "Some big ISPs are extracting a toll because they can — they effectively control access to millions of consumers." he wrote. This toll, says Hastings, violates Netflix’s definition of true and total net neutrality.

So why did Netflix agree, just one month earlier, to pay Comcast and violate its own stated principles? According to Hastings, "Netflix believes strong net neutrality is critical, but in the near term we will in cases pay the toll to the powerful ISPs to protect our consumer experience." That is certainly part of the truth. Given Comcast’s massive size, Netflix could no longer afford to have so many customers suffering poor service.

"Some big ISPs are extracting a toll because they can."

But informed speculation would suggest there is also a more opportunistic strategy at play here. Netflix had been negotiating with the major American ISPs for two years over these fees. What if the deal happened now because Comcast, under intense regulatory scrutiny over its proposed merger with Time Warner, finally came to the table with terms Netflix could agree to? Is it possible Hastings saw the chance to strike a deal with the devil, abandoning his own stated principles to capture a bargain at a moment of maximum leverage?

Who pays for these pipes?

To understand the Netflix–Comcast deal, we need to back up and explain the way traffic moves around the internet. Big internet companies like Google, Microsoft, Facebook, and Netflix have traditionally relied on a three-party system for delivering that data to its final destination. Because they don't own any physical pipes themselves, they pay a middleman — a company like Cogent or Level 3 — to transmit their data to an ISP, which then takes it the last mile into customers’ living rooms. Comcast and companies like Cogent have what’s known as a peering arrangement: they agree to share an equal amount of data back and forth across their networks instead of paying one another to transport it.

Netflix traffic overwhelmed the peering arrangement

The problem was that Netflix had become enormous, sending over one-third of all US internet traffic during prime-time viewing hours. This was overwhelming the peering arrangement, causing congestion in the places where Cogent and Level3 connected to Comcast's network. Netflix service to customers was suffering as a result. Someone needed to pay to upgrade the infrastructure. (You can find a deeper dive into the situation at StreamingMedia.)

The recent post by Hastings and similar ones from Cogent and Level 3 argue that the ISPs should be responsible for the cost of upgrading their networks so that data gets to customers at the speed and quality promised. Comcast and other ISPs like AT&T, which fired back in a blog post of its own last week, want Netflix or Cogent to pay for upgrades to its network that would allow it to handle the extra volume. "As we all know, there is no free lunch, and there’s also no cost-free delivery of streaming movies," wrote AT&T’s Jim Cicconi. "Mr. Hastings’ arrogant proposition is that everyone else should pay but Netflix. That may be a nice deal if he can get it. But it’s not how the internet, or telecommunication for that matter, has ever worked."

"There is no free lunch."

Netflix proposed that, instead of paying for new interconnections, it could reduce congestion by working with ISPs through a program it created called Open Connect, which would place Netflix hardware directly in the data centers of big ISPs to ease the load on their networks. Netflix offered to pay the cost of installing and maintaining this hardware, but while Open Connect had some success in Europe and with smaller American ISPs like Cablevision, the big three — Comcast, Verizon, and AT&T — declined to participate, and asked to be paid for the privilege of giving Netflix a new interconnection instead.

A moment of weakness

So what changed? After nearly two years of stalled negotiations, Comcast and Netflix finally reached a deal one month ago, less than two weeks after Comcast announced its intent to buy Time Warner Cable. Perhaps the two events had nothing to do with one another, but it seems more likely that Netflix was finally able to extract terms from Comcast it found favorable enough to agree to.

The price tag certainly backs this up. Wedbush Securities estimates Netflix is paying between $25 million and $50 million a year to Comcast, and industry analysts like Frost and Sullivan’s Dan Rayburn think the cost to Netflix could be as low as $12 million a year. That estimate is supported by the fact that Netflix has not filed any notice with the SEC altering its guidance for this quarter’s financial performance: if it was suddenly doling out a big new chunk of change to Comcast, Netflix would be legally obligated to let its shareholders and the public know.

Netflix saw its chance to lock in a killer deal

While it has not been publicly disclosed, Netflix didn’t just get a good price, it also got a long-term commitment that helps to future-proof the arrangement. Sources familiar with the deal tell The Verge that it locks in attractive pricing for a number of years and leaves room for significant expansion, as Netflix projects its US subscriber base could grow from the roughly 30 million today to between 60 and 90 million customers within the next decade.

The aftermath and path ahead

If Netflix got such a good deal, why is it now publicly bashing Comcast and the very bargain it struck? First, Netflix hasn’t done a deal with the nation’s two other biggest ISPs, Verizon and AT&T. Immediately after the Comcast deal was made public, both of those companies told the press they expected to strike a similar payment agreement with Netflix in the near future.

But Netflix doesn’t have the kind of leverage over these companies it likely had with Comcast, and so the parties are likely no closer to an agreement than they have been for the past two years since Netflix launched Open Connect. Hastings’ blog post is sending a clear signal that, while Netflix did see a bargain it could accept with Comcast, it isn’t going to settle up with Verizon or AT&T any time soon — at least not at the price they’ve been asking.

Netflix also knows that in the future the leverage it has over Comcast may not be so strong. When that current deal expires, the "tolls" extracted for interconnectivity could get much steeper. And so Hastings is trying to push for legal and legislative changes that would allow the FCC, under the auspices of net neutrality, to eliminate these costs for Netflix altogether.

Hastings took a gamble

Hastings took a gamble. By agreeing to pay Comcast, he may have set a painful precedent. The Netflix deal allowed the ISPs to claim that fees for interconnection are good business. "To me this shows you don't necessarily need a lot of regulation in a dynamic market here," Verizon CEO Lowell McAdam told CNBC. "By doing these commercial deals we'll get good investments and good returns for both parties." A new report this morning shows that Comcast is pushing ahead with this model, conducting talks with Apple about providing a "fast lane" for data to its new TV service that would avoid internet "congestion."

But it’s hard to blame Hastings for seizing his opportunity to strike a deal with Comcast while the getting was good. After a recent circuit court decision gutted what remained of net neutrality’s existing legal standing, and with Comcast poised to swallow up major markets like New York City with the Time Warner Cable deal, he saw the writing on the wall. The arrangement with Comcast provides Netflix much-needed breathing room as the battlefield is set for a much bigger showdown over the scope and power of net neutrality in America.