Breakthrough Ideas (continued)
The European Standards War over GSM
The Eindhoven Study. In September 2000, three scientists, Bekkers, Duysters, and Verspagen, from the Eindhoven Center for Innovation Studies, used the concepts of intellectual property rights (IPR), strategic technology agreements, and market structure to analyze the landmark case of the origin of the GSM standard. In Europe, GSM represented the first case of a serious clash between IPR and a coalition’s standards. Filled with useful insights, their report focused on the standards setting process from the perspective of IPR, especially essential IPRs, without which products adhering to the standard cannot be manufactured. Although other resources like market position or tacit knowledge remain important, when multiple firms own essential IPRs, strategic technology alliances become crucial.
www-edocs.unimaas.nl
Using data from 1996 to estimate market shares of GSM base stations, switches, and mobile terminals, Ericsson, Nokia, Siemens, Motorola, and Alcatel, ranked from 1-5 respectively. This Big Five accounted for over 85% of sales in the $100 billion dollar GSM market. The authors clarified the roots of the Big Five’s emergent leadership.
As telecommunications began, the American Bell Telephone Company (later AT&T) owed its dominant position to the patent by Alexander Graham Bell. However, the importance of IPR declined after American Bell used its competitive advantage of long-distance service to consolidate the market. When it justified its monopoly status as necessary to ensure universal telephone coverage, it became a state-regulated monopoly. Internationally, telephone companies became state-owned. The state-owned or regulated monopolist network operators thereby reduced or eliminated significant competition between equipment suppliers through their monopoly of telecommunications. Although research continued by both manufacturers and operators, neither benefited much from protecting research results. A culture emerged in Europe where it was considered inappropriate to ask for licensing fees to use others R&D.
In the 1980’s this changed following telecommunication deregulation in the U.S., which increased competition. Increasing demand for international communication required interconnection standards. The growing necessity for data communication between computers required standard interfaces. Accelerating complexity associated with digital systems drove up R&D costs. Taken together, global competitive advance required new economies of scale that could only be met by achieving global standardization for the communication systems needed to conduct global businesses.
This worldwide pattern of deregulation, coupled with advances in telecommunication technology, strongly increased the value and significance of IPRs. Intellectual property rights protect expensive R&D investments designed to serve worldwide markets with standardized equipment, where compatibility standards require that interfaces be described in detail.
Most licenses of intellectual property rights are negotiated among manufacturers because network operators pass on all possible risks to them by inserting special clauses in their purchase contracts. As Paul Romer argued, a time-limited monopoly was required not only as payback for the innovation protected by IPR, but also as an incentive for new discontinuous leapfrogging innovations. Global markets required that IPR be fairly enforced around the world.
With encouragement from the Nordic countries and the Netherlands, the European Conference of Postal and Telecommunications Administrations (CEPT), an organization comprised of all incumbent telephone operators, took the initiative in creating a 2G European standard. To reduce manufacturers’ uncertainty, specifically their fear of competition from the Japanese, the fourteen CEPT member signed a 2G MOU that committed them to procure and deploy GSM networks, promising a large new 2G market to freshly excited manufacturers.
Hoping to give their national industries a head start, Germany and France subsidized the development of a suitable technology, which was developed by Alcatel. Soon after, Germany, France, and Italy signed an agreement to adopt an identical 2G digital standard. As the infighting progressed, however, the operators decided on a proposal submitted by Ericsson as the GSM standard. To prevent Germany and France from bolting, high-level diplomatic talks between governments secured commitments to German and French suppliers.
During the CEPT negotiations, the operators became more aware of the imminent danger of IPRs. Presumably, one reason for the rejection of the German-French proposal was that it was “too proprietary.” In 1988, under great pressure from the European Community, the GSM project was transferred to the newly established European Telecommunications Standards Institute (ETSI), which represented manufacturers as well as operators.
In 1988, fearing battles over IPR royalties and acting in concert, the operators wrote a draft RFP that required the manufacturers to give up their IPR claims and provide worldwide licenses for essential patents without any recompense. Motorola from the U.S. stood up against this attempted imposition. Subsequently, the provision eliminating IPR royalties was dropped. However, in a counter proposal, the operators asked the whole GSM community to sign and honor a declaration agreeing to license their IPR on a fair, reasonable, and non-discriminatory basis. Only the signers of this pledge would be eligible to participate in providing GSM handsets and infrastructure.
Motorola agreed, with some exceptions. Simply put, this arrangement, after subsequent cross licensing by principal vendors, meant that no potential competitors, who were not party to this Musketeers’ Oath, “GSM for One, GSM for All,” whether from Europe or abroad, could supply GSM equipment.
According to Bekker et al (2000, p. 10-11),
“On the supply side, virtually all equipment was supplied by the companies that took part in the cross licensing scheme: Ericsson, Nokia, Siemens, Alcatel, and Motorola . . .. For suppliers, the participation in cross-licenses turns out to be essential to obtain a strong market position. First of all, companies who do not succeed in securing all the necessary licenses simply cannot make market products . . .. Secondly, those firms that do succeed in getting all the necessary licenses could be forced to pay a premium price for them. Sometimes IPR holders are only prepared to sell a full bundle of patents that in fact only contains a few essential ones. Our own research has indicated that the cumulative fee paid for GSM handset licenses is very high, and that was recently confirmed by the actor director of ETNO (European public Telecommunications Network Operator’s association), who revealed that royalty fees make up to 29% of the costs of the GSM handsets. Such prices make competing very difficult for companies that are not participating in cross-license fees.”
Also, in footnote 3 (p. 7), the authors stated:
“The standards laid down at ETSI, including GSM, are formally voluntary. Nevertheless, there are a number of reasons why European network operators have virtually no choice but to use GSM for mobile telephony networks. For example, national licenses for building such networks often refer to the GSM standard. Also, virtually all frequency bands that are allocated by the ITU for mobile telephony applications in Europe are exclusively reserved for GSM networks. Furthermore, GSM is the only second-generation standard for which Common Technical Regulations (CTR) are available, greatly facilitating the procedures for bringing products on the market.”
GSM as De Facto Proprietary. Thus, I contend that GSM became a de facto proprietary standard. The Europeans had already unified their individual national and corporate interests within socialist governments before they formed a European Union to help them compete with the U.S. and Japan. With GSM, competition is restricted or essentially denied through political means: trade war by another name.
Moreover, European governments required that the 900 and 1800 MHz bands of spectrum be reserved for GSM only. (Now they similarly require that the 1900 and 2100 MHz bands of spectrum be reserved for UMTS only.) The European governments allocated their 2G spectrums to operators at very cheap prices with the proviso that the operators provide universal coverage. The European vision was the GSM was to become a universal technical and organizational standard. To ignite its growth, European government shut down analog, except in remote near-artic regions. When Europeans joined the club, they were guaranteed roaming across this worldwide standard. If you were not admitted to the club, which was controlled by the grand alliance of the Big Five, ETSI, and the EU, you were locked-out of the market and its profits. Thus, the European coalition transformed the GSM standard into a de facto proprietary standard when GSM became a required standard that locked in European operators but locked-out all suppliers who were not in the Big Five.
Both the lock-in and lock-out resulted from a confluence of forces: the fear of foreign competition; the desire to gain a regional advantage that could be extended globally; persisting allegiances within nations between regulators, operators, and OEMs; the ITU assignments and national regulations that bands of spectrum must only be used for GSM; the political processes used to evolve the GSM standards; the codification of GSM-only standards into CTRs; the Musketeer’s Oath tied to becoming exclusive suppliers; the bundling of patents; the high combined royalty rate; the lack of single point of negotiation for licenses; the cross-licensing among the Big Five; and, the control by ETSI over who satisfactorily met the standards.
After these actions, the reality is that the Europeans owned GSM because securing a GSM license was an arduous, even impossible, task, requiring negotiating with many individual companies, who taken together charge up to 29% royalties on the manufacturer’s bill of sales. And, they owned GSM as a politically derived strategy to extend European mobile telecommunications dominance around the world.
What does an excessive combined royalty of up to 29%-of-manufacturer’s-sale-price do to potential GSM competitors’ costs and margins? Indirectly, the process of seeking multiple licenses for GSM certainly delayed and discouraged competition. When added to the expensive royalty itself, if it does not legally block entry, it eliminates any financial rewards for unwanted competitors. More directly, after obtaining licenses from all parties, you still may be delayed or kept out completely because your products continually fail to meet ETSI (now called 3GPP) standards. Although frequently presumed to be a non-proprietary standard, GSM is in fact proprietary to the Big Five, who by their exclusive cross-licensing in a grand alliance control not only the law-and-regulation encrusted GSM standard but also the pragmatics of who can play in their European oligopoly game.
Similar European tactics were intended to do the same for UMTS. Ironically, in May 2002, after claiming to hold 25% of the essential UMTS patents, is it surprising that Nokia suggested a 5% cap on all UMTS royalties? Although quickly rejected, this proposal was intended to reduce Qualcomm’s proportion of royalties, which remained a firmly contracted percentage of the manufacturer’s wholesale price of a handset. Given the turning of the tides, what is to prevent Europe from now reaping the added costs and reduced margins in 3G that they sowed for non-Big-Five GSM suppliers in the 2G? If they can succeed in gaining agreement among themselves in 3GPP on what essential patents for UMTS are worth, which will not be easy, then any additional royalties would be on top of Qualcomm’s royalty for essential spread spectrum patents. This further raises costs that might be passed along to already unenthusiastic consumers. These additional UMTS royalties raise costs and reduce margins for Europe’s already financially troubled operators. Worse yet, they want to charge royalties for “intellectual property” that makes their UMTS system less efficient, cynically defeating the principle of just rewards for R&D in order to promote a failed effort at European hegemony.
Motorola’s Role in the Battle over GSM. The resulting historical outcome is not a simple result of an European conspiracy to restrain trade, but also a complex product of Europe’s legitimate desire to remain competitive with the U.S. and Asia and the corporate actions of companies seeking legitimate competitive advantage that interacted with path dependence, given how the specific battles unfolded during the establishment of the GSM standard. Bekkers et al tell more of the story, including the central importance of Motorola, a U.S. company, in generating the outcome that I described as a “proprietary GSM standard.”
Bekkers et al identified 140 essential IPRs in GSM, with Motorola holding 27, Nokia with 19, 14 for Alcatel, and Phillips with 13. Not only did Motorola have R&D and manufacturing capabilities in Europe, but more importantly, in the U. S., Motorola had to fight hard against AT&T and Intel as significant rivals in business landscapes where Motorola was not the leader. When the GSM standard was adopted in 1987, Motorola held essential pre-standard IPRs derived from 1G patents. Moreover, Motorola aggressively pursued new patents in GSM during the standard-setting process. Then, after the standard was set, Motorola used its patent position to cross license technology and to cement relationships that ensured its own future in GSM.
As the Europeans gradually recovered from a “Gentleman’s Agreement” mentality of generosity with intellectual property, Motorola used its licenses, first, to prevent GSM from being adopted in regions of the world where it had competing interests, and second, to create specific license conditions that either gave it access to other firm’s technology or dictated the structure of GSM suppliers. Thus, within the framework of European regulations mandating GSM for Europe, Motorola preserved its place at the GSM table at the expense of all competitors who were not central to meeting its needs in the market place.
Having leaned its hard lessons in America, Motorola taught the Europeans the hard lesson of the strategic value of IPRs. Thus, Motorola was a key player in the cross licensing strategy that locked in the Big Five and locked out competitors.
The market dominance of Nokia, Motorola, and Alcatel is consistent with their strong IPR positions. Phillips held early patents, but made a corporate decision to exit the GSM market. Siemens entered the GSM market late, but it held important patents in switching that Motorola needed.
With only four essential patents acquired through acquisition, Ericsson’s weak patent position appears to be an exception to the general rule that IPRs are strategically linked to market share. However, Ericsson had three countervailing competitive advantages: (a) its head start in GSM technology based on its winning proposal; (b) during the pre-standard period, it opened entry for GSM into many international markets; and (c) it was a smart net worker that was strategically central to the GSM value web as a gatekeeper of information and opportunity. As we shall see, this did not keep Ericsson from claiming that it held “essential CDMA patents” in the 3G standards war. |
