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This Is the Secret to AT&T’s Merger With Time Warner

House Judiciary Cmte Holds Hearing On AT&T T-Mobile MergerHouse Judiciary Cmte Holds Hearing On AT&T T-Mobile Merger
Chairman, CEO and president of AT&T Randall Stephenson testifies during a hearing before the Intellectual Property, Competition and the Internet Subcommittee of the House Judiciary Committee.Alex Wong—Getty Images

As Randall Stephenson continues the campaign to sell his proposed $100 billion purchase of Time Warner, the AT&T CEO has gone to great lengths to say he has no plans to bestow TV shows and other content from Time Warner with preferential treatment on AT&T’s network.

“We are not talking about changing how the content is made available to other people or customers or distributors,” the AT&T chief executive said in a recent interview with CNBC, arguing that the Federal Communications Commission should not be concerned about any potential anti-competitive aspects of the merger. “It’s a pure vertical integration.”

And yet, just hours after the acquisition was originally announced, that statement was already outdated—and arguably even untrue—after AT&T announced its new all-digital DirecTV Now service.

The new service provides access to more than 100 channels from a variety of different providers—including Time Warner—and it will only cost $35 a month. That’s significantly less than competitors like SlingTV.

But AT&T customers get an even better deal because watching the new service won’t count against their mobile data usage, no matter how much they consume.

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This is the real secret to how AT&T plans to make the Time Warner acquisition work, and it’s called “zero rating.” That’s when a carrier allows its customers to stream content (which it either owns or licenses), but charges everyone else for the same privilege.

One of the most common questions raised since the merger was announced was how the telecom company was going to make money from Time Warner’s content business. Restricting access to that content by providing it only to AT&T users wouldn’t make any sense. But with zero rating, AT&T (T) can theoretically have its content cake and eat it too.

AT&T isn’t the only carrier that uses zero rating to give its customers preferential access to certain kinds of content. Almost all the major telecom companies do it, and some cable providers, including Comcast (CMCSA).

For example, Verizon (VZ) customers who watch videos on the company’s Go90 streaming service don’t use up any of their data, and neither do those who watch Verizon’s NFL mobile offering, which it pays the NFL $1 billion a year for the rights to stream on mobile devices.

And T-Mobile (TMUS) also uses zero rating to allow its customers to watch video from partners it has signed deals with as part of its BingeOn plan, without consuming any data. (But T-Mobile doesn’t charge partners for being part of the program.)

But doesn’t this violate the principle of “net neutrality,” which is supposed to require the owners of pipes—like telecom companies, cable and satellite providers, and Internet service companies—to treat all data the same and not give preferential treatment to any service?

The short answer is yes, it certainly seems to do so. But the Federal Communications Commission hasn’t ruled on these kinds of programs yet, despite repeated complaints from technology companies such as Mozilla and groups like the Electronic Frontier Foundation. The FCC says it is conducting an “informal policy review” of the practice.

Defenders of zero rating argue that it doesn’t disadvantage anyone—it simply requires those who want their services to be part of the program, which usually involves paying a fee. And it provides a clear benefit for customers, they say.

AT&T gets around the idea of net neutrality or zero rating in its description of the new DirecTV Now service, saying “the data required to stream it onto your mobile device is incorporated into the price of the content.” But if that’s true, how can DirecTV Now be almost 50% cheaper than similar services from non-carriers?

At a Wall Street Journal conference, Stephenson pooh-poohed the idea that the FCC or anyone else needs to protect the over-the-top streaming market, remarking, “Netflix is probably going to be okay.”

AT&T to buy Time Warner for more than $80 billion. Watch:

But the point of net neutrality rules isn’t necessarily to protect Netflix (NFLX) because it has billions of dollars that it can spend paying T-Mobile or Comcast the fees required to be part of zero rating. It may not like having to do so (and it has fought bitterly with Comcast over the practice in the past), but at least it has the means to pay if it wants to.

The real victim of policies like zero rating will be the up-and-coming services or potential Netflix and DirectTV killers that won’t get past first base because they can’t afford the fees.

Policies like zero rating could allow telecom companies and cable providers to cement their control over the content that flows through their pipes, and thus capture and retain users who might otherwise move to competing providers, or cut the cord completely.

AT&T users may sign up for the new DirecTV Now service in droves because they can essentially watch unlimited amounts of it for nothing. And that may benefit those users, and it may help AT&T justify the $100 billion it is spending to acquire Time Warner (TWX). But it’s not at all clear that consumers as a whole or the digital economy will benefit.

And if and when the FCC decides to do something about zero rating, it could make it a lot more difficult for AT&T to justify its massive acquisition.