And just this week, two more announcements highlighted the tremendous activity in this space:
What does all this mean? It means that each of the leading Internet companies believe that they can position themselves to succeed in the online advertising space -- through the free market, and without government intervention. These companies believe that there are many ways to compete in this business.
Google, Microsoft, AOL, Yahoo, and others are developing different combinations of capabilities in an effort to provide the most compelling offering to advertisers, publishers, and customers. For example, Microsoft’s purchase of aQuantive will eventually result in it owning an ad serving business that competes with DoubleClick, and will also make Microsoft one of the largest interactive advertising agencies in the U.S. In DoubleClick, Google is acquiring a technology that delivers and measures the performance of display ads – a technology that is critical if we are to compete in display advertising.
Beyond the different approaches that companies are taking, more capital infusion into the online ad business also means that more entrepreneurs will enter it, too. In fact, we have noticed that several startups in the online advertising space have received venture funding since April. More entrepreneurs, more market participants, and more capital are combining to create more competition and innovation.
Brian McAndrews, the President and CEO of aQuantive (which, as noted above, has been purchased by Microsoft) recently said about online advertising: "We're in the first or second inning of a long game here. There's no monopoly on innovation. I don't think you're going to see two or three big players and then game over. There will continue to be a broad range of companies." We couldn’t agree more.
In recent days, and especially following Eric Schmidt's July 20 letter to FCC Chairman Kevin Martin, many people have asked us a straightforward question: why don't you just attempt to win the spectrum bidding outright, and then implement an open wholesaling business model yourself? Or, as AT&T has put it, "put up or shut up."
That question makes a lot of sense, especially for those most familiar with the ordinary marketplace structures they see on eBay, or Home Shopping Network, or at Target. In those everyday cases, the buyers and sellers collectively determine what is the fair market value for something, based on what willing participants on both sides agree should be the price. The free market is the optimal market.
But an FCC spectrum auction is a very different animal. Unlike in most commercial transactions, participants in an FCC auction operate in an artificially defined market. Initially, the spectrum comes sliced and diced in predetermined packages of varying bandwidth, geography, and duration. Those discrete slices tend to be compatible with what regulators perceive to be the prevailing services and technologies of the moment, such as centralized voice communications.
Further, given the sizable investments involved, only well-capitalized corporations can afford to bid at auctions. Ordinary citizens or entrepreneurs with novel ideas don't even show up. Even so, players still come to the table with unique assets, and in some cases disparate business models. For the upcoming 700 MHz auction in particular, the issue boils down to the different incentives at work between the existing national wireless carriers -- the incumbents -- and those companies seeking to enter the market for the first time -- potential new entrants.
As we have seriously considered entering the 700 MHz auction, we have been consulting with auction experts and game theorists to help us better understand the dynamics of a typical spectrum auction. What they have been telling us is that in a head-to-head bidding war between an incumbent wireless carrier and a potential new entrant, the incumbent almost invariably will prevail. Why? The answer involves two key economic factors: what we call the "incumbent blocking premium" and the "incumbent dilution discount."
Incumbent blocking premium
A significant economic factor that comes into play in an auction environment is the incentive and ability of one of the players to thwart the designs of the other. In the context of an FCC spectrum auction, there are at least three pertinent elements.
First, incumbent wireless carriers come to the auction with a vast array of existing assets, including thousands of radio towers, tens of thousands of miles of communications "backhaul" networks, and millions of customers, along with numerous retail outlets and tons of advertising. And perhaps most important of all, incumbents already own lots of spectrum -- much of which the FCC gave away for free some years ago, rather than sold at auction. By contrast, a true new entrant has none of these assets. Thus, to an incumbent, purchasing another wireless license is just an incremental investment, one made that much less costly given the existing, readily-available business inputs. To a new entrant, facing the daunting challenges of actually building and operating a network for the first time, the investment is less certain.
Second, the incumbent has the added benefit of operating in a less than fully competitive environment. Some use the term "monopoly rents" to describe the situation where a company enjoys revenues and profits that exceed what normally would be the case in a robustly competitive environment. Potential new entrants do not enjoy the same advantage.
Third, and perhaps most important, the incumbents have every incentive to preserve and protect their existing business model. Given their investment in all the necessary business inputs, and the relatively high prices and low bandwidth characteristics of their existing service offerings, the incumbents must prevent the entry of potential competitors to the market. In a spectrum auction, this means paying whatever it takes to block new entry. Not surprisingly, economists call this a "blocking premium."
As the diagram below shows, these three elements together mean that an incumbent will almost always be in a position to outbid a potential new entrant, simply by bidding above and beyond the fair market price. Unlike in a healthy auction situation, the final price would be higher than otherwise would be commercially reasonable.
The second significant economic factor that comes into play in any auction environment is related to the number of players who actually show up to participate in the bidding. Again, in a normal commercial environment, market prices are shaped by the number of willing buyers, from just a few to potentially millions. However, an FCC spectrum auction presents a comparatively artificial scenario.
Given the existence of the incumbent blocking premium, as described above, it is often the case that there are no new potential entrants to bid against an incumbent. Why should a new player even bother to bid, or bid aggressively, if the incumbent inevitably will prevail? Where there may be only two incumbents -- or even one -- left to bid for a license, obviously the resulting price will not reflect the fair market value that otherwise would have been reached. The dilution of competitive bidders means the final price will be lower than otherwise would be the case. Recent studies have confirmed that this is a pervasive aspect of the FCC auction environment.
Un-skewing the spectrum auction
When looking at the combined impact of the incumbent blocking premium and the incumbent dilution discount, it's easy to see how FCC auction results become skewed.
Ironically enough, it is Google that has been accused of attempting to skew the auction structure, by our recommendation that the licenses be conditioned on certain "open platforms" requirements. Of course, as we have explained it is the current auction system that skews the results away from potential new entrants and in favor of existing incumbents.
Our position is simple enough. FCC Chairman Kevin Martin and the other commissioners have argued persuasively that we need a real third pipe broadband competitor in this country. They also believe that the upcoming 700 MHz auction is the best way to get there. All we are saying is that, based on what we know, new broadband competition will emerge from the upcoming auction only if the FCC's rules allow it to happen. For Google, and other potential new entrants, the prevailing imbalance can be corrected most effectively by introducing license conditions based on open platforms.
While Google embraces the kinds of openness and innovation that are the hallmark of the Internet, the incumbents apparently prefer their existing business models. That of course is their prerogative. However, open platforms -- specifically, open applications, open devices, open wholesale services, and open network access -- together make the spectrum more valuable to Google, or any other potential bidder seeking to create innovative, higher-speed, lower-priced offerings.
That is why Google has indicated that it is willing to spend a minimum of $4.6 billion in the auction, which is the FCC's reserve price for the particular spectrum block in question. At the same time, incumbents are unable to leverage anti-competitive blocking in this scenario. Regardless of who wins the bidding, however, the end result is an auction that yields a fair market price, with the added bonus of a new broadband network that is open to all comers. The American people get full value for their spectrum, plus open broadband platforms -- and even the possibility of a real third pipe competitor. Not a bad deal overall.
Citizens should have a right to privacy online. And governments have an obligation to keep their citizens safe. Finding the right balance between privacy and security is a delicate balancing act. Europe’s recent experience with data retention holds interesting lessons for everyone concerned with this balance.
In the aftermath of the Madrid bombings in 2004, the European Council adopted a Declaration on Combating Terrorism, which stated the need for rules on the retention of communications traffic data by European service providers for the first time. In some European countries, the ability to monitor communications was perceived as a practical priority in helping law enforcement agencies prevent and investigate terrorist acts. In April of 2004, the UK, Sweden, Ireland and France put forward a proposal for a Framework Decision calling for the retention of a wide variety of data for between 12 and 36 months.
However, for some politicians, the idea of adopting wide-ranging measures, requiring providers of telecommunications and Internet services to retain details of calls and electronic communications for periods of time beyond their pure operational needs, was not entirely justified. Indeed, for a while European privacy rights appeared to have the upper hand and the European Union institutions seemed to listen to the objections of the European Parliament’s Committee on Civil Liberties, Justice and Home Affairs.
According to the calculations of this group of European Members of Parliament, if all the traffic data covered by the proposal did indeed have to be stored, the network of a large Internet provider would accumulate up to 40,000 terabytes – the equivalent of four million kilometers worth of paper files -- or about 10 stacks of files each reaching from Earth to the moon. But others pointed out that even the slowest terrorist would figure out that he could simply avoid his communications being traced by using a non-European service provider. Nonetheless, the political pressure continued, and the European Commission went on to propose a directive on data retention in September 2005.
The rest is history… and now law. Although the European Parliament’s Committee on Civil Liberties, Justice and Home Affairs succeeded at introducing some amendments aimed at softening the effect of the proposal, an unprecedented data retention directive was adopted by the European Council on 15 March 2006. This directive imposes retention obligations between six months and two years in relation to accessible data generated or processed as a consequence of a communication or a communication service.
On paper, the aim behind the directive is simple and proper: to harmonise data retention rules across the EU and to ensure that the necessary information is available for the purpose of the investigation, detection and prosecution of serious crime. Unfortunately, the simplicity pretty much ends there. For a start, using the words “directive” and “harmonisation” in the same sentence is often an oxymoron, especially when a directive is cobbled together as a compromise between conflicting ideological positions.
On a practical level, the likelihood of seeing a consistent implementation of the rules across the EU is effectively zero. The timing of the implementation – due by September 15, 2007 – will certainly vary. 16 of the 27 EU Member States have already declared that they will delay the implementation of data retention of Internet traffic data for an additional period of 18 months, as permitted by the directive. The compulsory retention period for each type of data will also vary from country to county (e.g. Germany has proposed 6 months, the UK 12 months, and the Netherlands 18 months). The interpretation of other key elements, such as “serious crime," “competent national authorities,” or “electronic communications services” will be different across jurisdictions too.
These uncertainties impact on the justification for any privacy intrusions. Is a country more democratic than its neighbour because of its shorter retention period? Or do the citizens of that country face a greater security risk for the same reason? If there is something about the data retention directive that can be called into question is its proportionality – not necessarily in terms of financial cost to service providers, but in terms of privacy and anonymity loss. And what will Internet companies do in practice, especially if they operate one data architecture that cannot vary from one country to another: apply the longest retention period, or the shortest, or some “average”?
The data retention directive is of course just part of the picture. Several other initiatives provide additional evidence of the fact that traditional concepts of Internet privacy are in turmoil. One example was a proposal by the German government to complement its anti-terrorism measures by prohibiting the use of anonymous email accounts, by mandating that service providers verify the identity of their account holders.
Thankfully, the German government has recently retracted this proposal. Nonetheless, the idea continues to appeal to many: to make sure that every single e-mail user can be tracked down to an identifiable individual, so that the police can locate the terrorist behind the e-mail with the bomb-making instructions attachment, to take the most blatant possible example. The issue once again is whether this threat to anonymity on the Internet will be effective in making the world a safer place. Or will it do nothing to catch your average technology-savvy terrorist while eroding yet another layer of Internet privacy?
So, against this background, what is Google doing? We have recently announced a new policy to anonymize our search server logs after 18 months (we’re the first in our industry to have taken this step). We’re trying to get the balance right too, between privacy and other goals (like security, fraud prevention, and search improvements). People want to be free as much as they want to be safe. That’s true online too.
As I’ve written before, Google has become increasingly involved in U.S. spectrum policy issues this year. One of our top public policy objectives is to expand the Internet's reach to more Americans. In part, that means creating new competition to challenge the existing broadband access duopoly (between cable and phone companies), by paving the way for consumers to gain meaningful alternatives via advanced wireless services.
Unfortunately, the wireless airwaves required to develop such a service traditionally have been allocated in a fragmented and inefficient manner. The federal government’s upcoming auction of spectrum in the 700 MHz bands (as part of the digital television transition) offers a tremendous, and probably unique, opportunity to promote competition and web-based innovation.
Earlier this year, Google and other members of the “Coalition for 4G in America” urged the Federal Communications Commission to adopt flexible rules that encourage competitive entry by new and innovative broadband companies. At the time, we stated that our advocacy in the 700 MHz proceeding did not necessarily signal our intention to participate in the auction itself, although no final decision had yet been made.
In comments we filed in late May, we stressed that new entrants face considerable hurdles when competing head-to-head with incumbent wireless carriers. We also noted that a proposal by Frontline Wireless to impose a wholesale/open access mandate on a certain spectrum block would ensure that the owner of that block at least would operate its wireless network in an open manner.
Over the last several weeks, we’ve been taking a closer look at whether and how Google might participate meaningfully in the auction. As part of that look, we've consulted with spectrum auction experts and conducted various game theory scenarios. Our analysis has confirmed that, under the originally proposed rules, the existing national wireless carriers are likely to prevail in the bidding process against a potential new entrant like Google. While we remain interested in the possibility of participating in the auction, it’s clear that the incumbent carriers have built-in advantages that will prove difficult to overcome (particularly the economic and operational barriers to entry for a company like ours, and the relatively greater value and usefulness that spectrum brings to existing carriers).
What would happen if one or some of the existing national wireless carriers win this valuable spectrum at auction? They would probably use it to protect their existing business models and thwart the entry of new competitors -- both understandable actions from a rational business perspective. Beyond the loss of a valuable public resource, however, that outcome would not bring us any closer to fostering much-needed competition in the broadband market, or providing innovative new web applications and service offerings.
Too much is at stake for the federal government to let that happen. Late yesterday, we filed a letter urging the FCC to take concrete steps to make sure that regardless of who wins the spectrum at auction, consumers’ interests are best served. We believe that the winning bidders should be required to adhere to enforceable rules that require the adoption of four types of "open" platforms:
We believe that adopting these four license conditions collectively will encourage prospective broadband companies to participate in the auction, and be able to bid successfully for the available spectrum. Not only are new entrants more likely to embrace an ethos of openness, but additional forms of competition will emerge from web-based entities, such as software applications providers, content providers, handset makers, and ISPs. And consumers ultimately will come out ahead in that rich and vibrant broadband environment.
In the meantime, there is now potentially positive news coming out of the FCC. Chairman Kevin Martin apparently is about to circulate proposed auction rules to his fellow commissioners, and we're hearing through the proverbial grapevine that his proposal includes several of the open platform conditions we have recommended. If these reports are accurate, we are most encouraged by this favorable development. Obviously we'll need to see the fine print, but such a proposal would represent a step forward for new, innovative entrants to the broadband market.
