(FORTUNE Magazine) – Back in the early '80s, a shoestring operation called MTV came up with the idea of a cable network that would play rock music videos 24 hours a day. Advertisers yawned. Cable system owners scoffed. Yet as we all know, MTV turned out to be hugely successful--thanks largely to the big record companies, which helped the network get off the ground by supplying free videos.

You may not remember this episode from the dawn of the cable era. But music industry executives do. And it makes them cringe. The way they see it, they should have extracted something in return for making MTV possible. Instead they got nothing.

That explains why today the Big Five record companies are singing the Who's "Won't Get Fooled Again" as they survey the digital-music scene. A lot of people think selling music on the Internet is the future of the industry. Nobody is sure how to make money at it, but the record companies are determined that if anybody succeeds, it'll be them this time. "We gave content for free to radio, free to MTV," grumbles Jay Samit, senior vice president for new media at EMI Recorded Music. "We're not going to do that again."

Thus, in recent months the Big Five have come out with a bewildering flurry of alliances and acquisitions linking the music makers to new-media technology companies. First came the announcement from Bertelsmann that it was entering into a partnership with Napster. More recently AOL Time Warner (parent of FORTUNE's publisher) joined forces with EMI and Bertelsmann--and software developer RealNetworks--to form an Internet music-distribution company called MusicNet. The service, expected to launch this summer, hopes to tap into AOL's 29 million subscribers. Then came the news that Sony and Vivendi Universal had teamed up with Yahoo to give life to their seemingly dormant online-music venture, Duet. And just a few weeks ago Vivendi announced that it was also buying MP3.com, the struggling Internet music pioneer, to provide another potential distribution channel for Duet.

It is impossible to know how all this will play out, but clearly these initiatives are an attempt by the music industry to keep interlopers away. Virtually everyone agrees that industry growth in the next several years will come mainly from online-music sales; according to one study, online-music revenues could hit $1.5 billion in the U.S. by 2004. Make no mistake: The big record companies want the lion's share of that money. So why is it, then, that even as the big boys have been erecting their fence, someone else has been quietly digging a tunnel under it? This business has a service that is far closer to reality than any of the recently announced music ventures by the major labels. What's more, the service is simple to use, consumer-friendly, and has access to music from all five of the major labels. Who is it? Are you sitting down? It's MTV.

In the modern history of the music industry, there have been three momentous shifts in the way money is made. The first was the rise of the long-playing record--and the concomitant decline of the 78-rpm single. As that change took place, consumers became accustomed to buying more expensive music compilations rather than singles. The second shift, which made the business even more profitable, was the introduction of the compact disk. Although CDs were no more costly to produce than vinyl, music companies charged substantially more for them, with very happy consequences for the bottom line. What's more, because it was a new technology, music lovers had to replace their entire record collections with CDs. As a result, worldwide music sales rose 40%, to $38.5 billion, over the past decade.

The third shift, of course, is the one that's going on now--the move from CDs to online music. First came MP3, a compression technology that made digital music possible. Then along came Napster, which allowed teenagers--and the rest of us--to share digitized songs with the entire world. For free! That unbeatable price made Napster a huge hit with its 80 million registered users. But price, or lack thereof, wasn't the only attraction. Napster gave users almost unlimited freedom to do what they wanted with their tunes. Limp Bizkit fans could download "Nooky" onto their portable MP3 players and take it to Daytona Beach for spring break. Albums? Who needed them? If you liked only two tracks from Jay-Z's The Dynasty Roc La Familia, you just downloaded those two songs and left the rest behind. Indeed, you could use Napster to burn your own CD of favorite tunes. Millions did just that, creating nothing less than a revolution for music lovers.

Of course, we all know what happened to Napster. It was a hugely successful copyright violator, and this past March, a federal court judge ordered it to remove copyrighted songs from its system. Napster has vowed to launch a paid service this summer, but to do that, it needs to be able to license songs from the big labels, and despite its alliance with Bertelsmann, it still doesn't have any such deals. From the perspective of the music industry, Napster is no longer a force to be reckoned with.

Yet the forces Napster unleashed have become, if anything, even more powerful--and no matter how much they'd like to, the record companies cannot avoid them. For instance, the popularity of sharing major-label music online--and the fact that this ability has been abruptly taken away--has made it a potent political issue. Last July, Senate Judiciary Committee Chairman Orrin Hatch, himself a songwriter, held hearings in which he pressed the record companies to offer a legal alternative to Napster. Hovering over the proceedings was an implied threat: If the companies didn't act, Congress could take matters into its own hands by forcing the labels to license their songs to any company willing to pay a licensing fee.

To music executives the thought of compulsory licensing is anathema. After all, isn't mighty Microsoft talking about getting into the online music business? If the music industry had to give its songs to anyone who wanted them, it would lose control of the distribution.

Not surprisingly, by the time Hatch held his second online-music hearing two months ago, the major labels had their response: They would indeed be providing a legal alternative to Napster, in the form of two online services, MusicNet and Duet. The problem is that unlike Napster, the services have business models designed to help the companies, not their consumers.

Take, for instance, the way people are expected to pay for the two services. They both plan to institute subscription fees. That means that instead of purchasing the occasional album, consumers will write a monthly check and download a big selection of music in return. For an industry that has lived and died by hits, the appeal is obvious: It means a steady revenue stream.

But what's in it for music lovers? The closer you look at the two services, the more you're apt to conclude: not much. First of all, when you subscribe, you're not actually buying music but merely renting it. Because the Big Five are worried that consumers will write one monthly check, download a year's supply of music, and cancel their subscription, they're using a technology that will cause the music to vaporize if people stop subscribing. Industry executives see this plan as completely reasonable: "It's the same as cable television," insists David Brotherton, a RealNetworks spokesman. "If you pay your cable television bill, you can watch The Sopranos. If you don't pay your bill, you can't watch The Sopranos." But as any consumer knows, a song is not like a TV show. People want to own their music, to take it places, to listen to their favorites years from now, to share music with their friends. None of that is possible with MusicNet or Duet.

And that's not all. Subscribers to the two services will be able to listen to music only at their PC or laptop--no CD burning or downloading to MP3 players allowed. (Music executives say they hope to be able to offer that freedom--eventually.) In fact, Duet customers initially won't even be able to download songs to their hard drives; they'll have access only to streaming (i.e., radio-like) music.

Then there is the question of selection. At the moment each of the two services will only be able to offer music owned by the labels in their respective partnerships: EMI, Bertelsmann, and AOL Time Warner in the case of MusicNet, and Sony and Vivendi Universal in the case of Duet. But as AOL CEO Barry Schuler points out, "For music services to work, you have to have everything." After all, most music fans have no idea that Eminem, for example, records for Interscope, which is owned by Vivendi. So what will MusicNet tell his fans who log on and can't find "The Real Slim Shady"?

The executives at the Big Five say that they hope to cross- license one another's music before the two services launch this summer. But that brings its own set of headaches. For one thing, many in the industry fear that if the five majors license their content to MusicNet, AOL Time Warner, which is MusicNet's primary distributor through America Online, will wind up as the gatekeeper for music on the Internet. More important, if the Big Five dance too close, the U.S. Justice Department might decide to launch an antitrust investigation. That could lead to further cries for compulsory licensing.

If cross-licensing problems don't stall the launch of the two services, there is one other big obstacle. The music industry's decision to go the subscription route has brought it into serious conflict with the National Music Publishers' Association, whose 800 members control the publishing rights to most songs in the U.S. The association's licensing affiliate collects a royalty of 7.5 cents for every track sold on a compact disk. Edward Murphy, the association's president, says his constituents want a better deal if their work is sold on a subscription basis. He complains that the music companies low-balled his members when they introduced the CD. Now it's payback time. If MusicNet and Duet start up without settling the issue, litigation is virtually guaranteed. "You could launch the service," says Steven Marks, senior vice president of business affairs for the Recording Industry Association of America. "The problem is, you are launching a service without knowing how much it's going to cost." No wonder MusicNet and Duet have yet to announce specific launch dates.

So what has MTV been doing while all this wrangling has been going on? Its first move was to get its hands on the music. A San Jose technology company called RioPort--in which MTV (and Microsoft) are investors--quietly signed deals with all the major labels to license and sell their music. RioPort then made the music available to MTV, a division of Viacom. Why were the record companies willing to give their music to RioPort and MTV? Stunningly, they did so in part because they felt it would help keep Congress at bay. "The MTV deal is just another way to get content out, because there's this threat of compulsory licensing hanging over the industry," says Andreas Schmidt, president of Bertelsmann's e-commerce group.

To keep the record companies happy, RioPort has developed a system that allows its music to be downloaded onto any "secure" portable player--but prevents it from being transferred to a friend's player. And it has figured out ways to accept music in a variety of technologies--the record companies all have their preferred, often incompatible formats--yet make those different formats almost indistinguishable to the consumer. (So far at least, Microsoft has refused to do likewise. For obvious reasons Microsoft would prefer to license songs itself and digitize them all in its Windows Media format.)

But none of this explains the real advantage MTV has in the online-music services competition. No, MTV's real brilliance is that it is offering a service that appears far more likely to appeal to consumers. For instance, rather than subscriptions, MTV will offer individual downloads ranging in price from as little as 99 cents a song to as much as $18.98 per album. MTV figures buyers will want lots of singles to make their own compilations. "My sense is that people are going to fill their shopping carts and check out when they've got enough music to have a satisfying listening experience," says Nicholas Butterworth, president and chief executive of MTVi, the network's Web division. "Pay-per-downloads are appealing to consumers because you can cherry-pick albums," agrees P.J. McNealy, a Gartner Group analyst. "Most people don't necessarily want the whole CD." That's one of the reasons music fans once flocked to Napster. Now MTV is giving them the same opportunity.

And unlike music subscriptions, pay-per-downloads are treated exactly like CD sales by existing copyright laws--hence no problem with the publishers' association. As a matter of fact, MTV is already selling EMI downloads on its Websites, which include MTV.com and VH-1.com, as RioPort irons out 11th-hour details with the four other big record companies.

So what do big music-company executives have to say about MTV's plan? They say pay-per-downloads are a waste of time. It was tried back before the court put a lid on Napster. "[Pay-per-downloads] were a major flop. They were a disaster," says Frank Sarfeld, a spokesman for Bertelsmann's e-commerce group. True, the experience was miserable for consumers. Each label delivered music in a different format, forcing consumers to set up multiple players on their computers. And let's not forget that Napster was giving the same stuff away for free. Even so, the consulting firm PWC estimates that people bought $8 million in digital albums and $8 million in digital singles in 2000 from e-tailers like TowerRecords.com.

So imagine if you actually did it right--if you set up a service that was easy to use, offered music from all five labels, and allowed consumers to pick and choose the songs they wanted. Sounds a lot like what MTV is trying to do, doesn't it? Of course, the service, which still needs to be tested, has to be a technological breeze. But think of what MTV has. Its Websites already attract six million visitors monthly. Throw in the network's unparalleled ability to market to the 12- to 24-year-old set, which spends more per capita on music than any other group, and, well, suddenly it appears as if the Big Five have a pretty formidable competitor.

It makes you wonder what music executives are smoking. They want to turn Napster fans into their customers, but they expect them to pay for a limited selection of music and listen to it only on their PCs. They snub Microsoft because they are afraid it will take over the distribution market but then hand the crown jewels to MTV, the most recognizable brand name in pop music. If you asked U2 fans if they'd go to MTV or Microsoft to get their music, what answer do you think they'd give?

Here's another thought: What happens in a year if MTV's service is in full swing and MusicNet and Duet still can't agree to share each other's catalogs? True, it's way too early to pick winners in this game. But it's not too early to see who is the odds-on favorite coming out of the gate.

FEEDBACK: dleonard@fortunemail.com