THE PRICE ISN'T RIGHT ON THE INTERNET MCI, AT&T, SPRINT, AND THE OTHER BIG CARRIERS OF INTERNET TRAFFIC WANT TO CHANGE THE WAY YOU PAY TO SURF. THEIR ACTIONS COULD RESHAPE THE INTERNET.
By J. WILLIAM GURLEY AND MICHAEL H. MARTIN

(FORTUNE Magazine) – In early December, when America Online began offering customers unlimited use of its service for $19.95 a month, it seemed as if cheap Internet access had finally become universal. Now just about anyone with a PC and modem can count on being able to dial in, via AOL or an Internet access provider, and pay only a low flat rate.

But in reality, AOL's move may have been flat-rate pricing's last hurrah. This is less rocket science than Econ 101: Offer unrestricted use of a valuable, limited resource, and overcrowding is inevitable. Runaway growth in traffic now threatens to clog the Net--newspapers in late December ran accounts of E-mail messages lost and connections dropped, of frustrated users who encountered busy signals when trying to dial in and who would hog circuits once they'd made a connection. The problems may get worse: Under the pounding of the traffic, the delicate fabric of business arrangements that makes the Internet possible shows signs of unraveling.

The Net today depends on the cooperation of thousands of service providers. To varying degrees, they're all slaves of the flat rate, from telecom giants like AT&T and MCI, and major online players like AOL and UUNet, down to hundreds of regional and local companies. For the ordinary Net user, here's how the system typically works: Your Internet service provider (ISP) buys the right to a certain amount of access to the phone system from a major telco. The provider then sets out to make money by signing up customers--lots of them. Typically, an ISP will enroll ten to 30 times more customers than its leased lines can accommodate at one time. That works--as long as most customers don't spend a lot of time online.

But when usage soars, the whole arrangement can melt down. That's what's happening now, as more and more people log on for longer and longer sessions. To keep customers happy, the ISP has no choice but to acquire more bandwidth, which means that its costs go up and it needs to charge a higher flat rate to break even. But then customers who connect for just a few hours a month begin to feel ripped off--why should they pay the same amount as a Net hog who is online all the time? The ISP has a simple choice: Either find a way to charge heavier users more or stick to flat-rate pricing and risk seeing those occasional users flee. Netcom, a San Jose provider, has chosen the former route: Next year it will phase out "all you can eat" pricing for consumers and concentrate on serving business customers who pay more for quality service.

Flat-rate pricing has wreaked havoc on the electronic frontier. In the words of MCI Internet guru Vinton Cerf: "The hill is overgrazed, there's no more grass, and the sheep die." Some phone companies say that soaring Internet traffic threatens to gridlock the U.S. phone system. Pacific Bell claims that during peak usage, one in six business calls does not get through. The switches in local phone company offices were not designed to handle today's typical Internet sessions, which can last ten times as long as the average phone call. And the situation will only deteriorate: Users of popular "broadcast"-style data services like Pointcast often leave their computers connected 24 hours a day--for the price of a single local call.

It should come as no surprise that a scheme as cockamamie as flat-rate pricing is an anomaly for which we can thank the government. Under FCC regulation, long-distance carriers like Sprint and AT&T pay the Baby Bells "access fees" between 3 and 4 cents per minute to deliver long-distance voice calls to local customers. But because of a regulatory exemption, the Baby Bells collect absolutely zilch when the same local lines are used to relay data.

According to FCC Chairman Reed Hundt, "We expect to provide alternatives to prolonging the present moribund access system." Several changes to existing rules are being considered, any of which would doom low flat-rate pricing. The FCC might decide to impose the same access charges on data that it imposes on voice calls. That could raise charges for Internet access $2 an hour, which would be a shocking change to Netheads accustomed to shelling out less than $20 a month. Or the FCC could lower or even eliminate access charges. This would cause the price of long distance to drop, boosting traffic and putting even more strain on local exchanges. The Baby Bells might have little choice but to rein in demand with metered pricing of all local calls. An FCC ruling on access charges is expected this spring.

The big companies that operate the Internet backbone (including Sprint, MCI, ANS, Netcom, PSINet, UUNet, and others) aren't waiting for the FCC. They're making moves to drive the industry toward usage-based pricing. But in doing so, they're likely to change the very nature of the Internet.

Today even the smallest Internet provider has some connection to at least one public data hub--switching centers scattered across the country that were created with federal money. It's data democracy in action. The public hubs are where all providers, small and large alike, hand off their traffic--E-mail, video streams, and so on. Most users don't know about the hubs, but they're crucial, a guarantee that no matter how small your Internet service provider, your E-mail can reach anyone else on the Internet.

Like airlines that agree to honor each other's tickets, Internet providers have a kind of gentleman's agreement to relay each other's data, at least as far as a hub. But this arrangement puts a heavy burden on the larger companies--the infrastructure that they've built up must carry the traffic of thousands of local providers that connect only at a few hubs. It's as if United and ValuJet agreed to carry each other's passengers, regardless of the fact that United serves many more cities than ValuJet. As passengers poured into its system via ValuJet, United's costs would go up, and it would have a harder and harder time serving its own customers.

This informal "peering" arrangement, as the nerds call it, worked fine when the Internet was still the preserve of academics and engineers. But it wasn't meant to handle a national craze. Sprint, MCI, and AT&T have quietly tackled the traffic problem by establishing hundreds of private links between networks that circumvent the public hubs. They say they're merely trying to reduce the hubs' congestion, but some smaller providers fear there is an oligopoly in the making. Having built enough private links, the big guys might abandon the public hubs altogether. MCI's Cerf acknowledges: "If the amount of connectivity at a given public peering point declined to negligible...we might consider disconnection."

Such a move would threaten the existence of small local providers, whose customers would no longer have access to the full Internet. Take a look at the prospectus for Digex, a Maryland provider that recently went public. Among the risks cited: "There is no assurance that other national ISPs will maintain peering relationships with the company." In fact, the number of Internet service providers will almost certainly drop precipitously in the next two years. The survivors will be big players like AT&T, MCI, and Sprint, and smaller providers that have close relationships with them.

What does this mean for the people who pay the bills? Companies that use the Internet heavily will pay higher prices; in return, they'll get better service. The more traffic an ISP carries on its own wires, the more it can do to prevent lost connections and misplaced packets of data. To their favored customers, MCI, Sprint, and others will begin to offer quality-of-service guarantees. "We are expecting to see some price differentiation," says Cerf. "For users of real-time services, if more capacity has to be assigned to service the requirement, we would expect the price to reflect this difference." Translation: You'll pay for what you get.

Those of us who are used to dialing up from home whenever we want for as long as we want probably have another 18 months or so before flat-rate pricing as we know it comes to an end. Meanwhile, consumers addicted to the current all-you-can-eat model can expect more busy signals, more dropped calls, and more time waiting.

Eventually we'll probably end up paying by the minute for every kind of call: long distance, local, and data. Of course, in the volatile world of the Internet, new models could emerge. The Baby Bells might make flat-rate Internet access available to customers who purchase a bundle of services that might also include local, long distance, and cellular. And there are, of course, many corporations that would like you to stay online so that you can see their ads and possibly order their products. Maybe they'll offer to subsidize your Internet access--they'll help you keep your low fixed rate if you'll agree to receive on your screen a barrage of advertising they think will interest you. It's a far, far cry from the cherished vision of the Internet as a public network involving the free exchange of ideas--in fact, it's very close to another medium called TV.