Should a college student downloading a movie with BitTorrent pay his ISP more than a senior citizen trading emails with a grandchild, as phone companies argue? At its simplest, that’s what the current fight over Net neutrality in the United States comes down to.

Networks want to impose a pay-per-use system based on a tiered formula that would prioritize traffic, and increase charges to third-party companies (which, in effect, would pass the extra charges on to their customers) for using line capacity that consumers have already paid for.Proponents of Net neutrality essentially want the status quo—to pay the same monthly bill whether the line is used a lot or a little for whatever purpose.

In August 2005, against a backdrop of protest from at least a dozen consumer advocacy groups, the U.S. Federal Communications Commission ruled that phone companies should be as free to run their networks as the cable companies—bar competing services from using their lines, or charge them what they liked for the privilege. The decision effectively returned control of the networks underlying the Internet back to the telcos—and only strengthened monopoly practice, in the eyes of one critic.

“I would allow the telcos to run their networks any way they pleased if we had real competition, but we don’t,” says Bill Woodcock, research director of Packet Clearing House, a San Francisco-based Internet research institute. “What we have are protected oligopolies. People are forced to be their customers, so I support Net neutrality until we see real competition in the U.S.”

Targeting the Moneymakers

The ruling may have hit the ISPs initially, but the objects of the telcos’ ire are really Google, Skype, Vonage, and others generating massive traffic. They’ve earned immense amounts of money by hugely increasing traffic but have not, at least in the view of the telcos, helped make the requisite network investment to support it. And so the carriers propose a multi-tiered broadband network, one still toll-free, but also a paid tier requiring Google, Skype, and others to contribute to the upkeep of the network.

The neutrality side argues that this is double-dipping, essentially charging consumers for the use of bandwidth and then charging applications providers for using what’s already been paid for. In any event, there are now at least four bills in the U.S. House of Representatives and Senate that address Net neutrality. Two of them—the Network Neutrality Act of 2006 and the Internet Freedom and Nondiscrimination Act of 2006—focus on Net neutrality.

New rules could end up mandating network neutrality—though a Forrester Research analyst, for one, doesn’t see that happening—or offer some kind of accommodation to phone companies and allow them to charge Internet tolls in certain circumstances.

Accommodating the telcos, neutrality proponents warn, could overturn businesses, shift investment flows, and slow innovation across every conceivable sphere. Undoubtedly, analysts will develop formulas for determining how e-commerce could ebb and flow with different charge systems, just as economists can pinpoint the impact of a gasoline price increase on economic activity. But one thing is certain right now: Venture capitalists have billions riding on the outcome.

It’s easy to see why the telcos and network owners want to do something about increasing revenues; while more and more outriders use their lines to make a killing selling goods and services, traditional long-distance revenue has shrunk to nothing. And cheaper wireless services have cut into traditional voice and data revenue—or cannibalized it in cases where telcos own the wireless service. Both AT&T and Verizon have seen their margins on traditional wireline services disappear while their wireless operations continue to post pre-tax margins in excess of 40 percent.

“Opinions on Net neutrality are split among VCs,” says Khaled Nasr, a partner at Menlo Park, California-based InterWest Partners. “The industry as a whole invested pretty heavily on the infrastructure side, but these are older investments,” Mr. Nasr says. “Much of the new spending is on Internet applications and related fields.”

VCs have their hand in every piece of the pie, from startups that can ill afford to pay Internet tolls to telecom carriers seeking compensation for the billions of dollars they spent building today’s Internet network—and did they ever spend.

Indeed, the overbuilding story is a vivid example of the kind of devastation public policy choices can bring. With deregulation introduced when former U.S. President Bill Clinton signed the Telecommunications Act of 1996, companies spent $500 billion installing fiber and wireless networks. “So much long-distance capacity was added in North America, for example, that no more than 2 percent is currently being used,” noted a Brookings Institution report in December 2002. When the industry reached bottom that year, it lost an estimated $2 trillion in market cap, according to Brookings, and half a million jobs.

Business has begun to turn around for some telecom carriers, as they reap revenue from broadband and mobile. Carl Stjernfeldt, a partner with Battery Ventures who opposes neutrality, argues that companies like Vonage and Google, which generate billions of packets of data on the Internet, will just have to figure out a business model that “does not assume transport is free,” as he puts it. “Nothing in life is free,” he says. “If you want to watch a Google video in high-definition, you pay more for it.”

Nothing in life is free, unless you’re a phone company, communications iconoclast David Isenberg would counter. “As if the telephone companies aren’t subsidized by billions and billions and billions of dollars’ worth of resources,” roars Mr. Isenberg, a one-time veteran of AT&T Labs. “They use the public rights of way at an incredibly beneficial rate—sometimes free, sometimes really cheap.” Why should the public subsidize telco shareholders, he asks.

In Mr. Isenberg’s book, phone companies complaining about subsidizing other businesses brings high definition to the aphorism about the pot calling the kettle black. “And we’re the example of the free market?!”

Discrimination Threat

Don’t get him started. “The reason I pay Verizon 30 bucks a month is so I can get to places like Google in the first place,” Mr. Isenberg says. “No, I do not pay them 30 bucks a month so I can get access to the businesses they want me to have access to—I pay them 30 bucks a month so I can get access to the businesses I want to get access to.”

No, Mr. Isenberg doesn’t like the drift of this one bit, citing the toll road analogy. “There is not one rate for GM cars and an other rate for Japanese cars,” he says. “But that is the threat—the threat of deliberate discrimination, more than just extra cost.”

David Weiden, a partner with Khosla Ventures, another Menlo Park-based firm, says he absolutely supports Net neutrality. “I would go so far as to say that not supporting it is both shortsighted and un-American.” he says. Mr. Weiden argues that telcos and cable companies should stick with building better networks, and charging premium rates for better service—and build revenue there instead of getting into the toll business.

Network owners aren’t above giving the neutrality side a good bash. “For the sake of argument, let’s say that ‘neutrality’ is the right principle,” Comcast vice president and public policy counsel Joseph Waz told the Broadband Policy Summit in Washington last month. “If it’s ‘right’ at the network layer, how can it not be right at the other layers of the Internet?”

Mr. Waz then cited several examples, such as Google and Yahoo giving prominence to paid search results, as hardly neutral. “If these companies tell us that we must put the principle of ‘neutrality’ above everything else, which of them will be the first to volunteer to have their business regulated?”

He also rejected the notion that all innovation occurs at the edge where all the application and content creators hang out—and that “all policy decisions must yield to preserving the interests of those at the edge.” Dismissing this as so much twaddle, Mr. Waz said networks had to “innovate constantly” to improve security, manage bandwidth better, and so on.

“Many have called for the U.S. government to mandate ‘network neutrality’ that will ensure all Internet traffic is delivered equally, consumer choice is upheld, and Internet innovation is not stalled. But it won’t happen in the next three to five years,” noted Forrester analyst Maribel D. Lopez in a recent report. But when rich content starts taxing networks, look for the FCC to take a more hands-on approach, she says. “In the meantime, operators should err on the side of limited prioritization and content owners should build priority delivery into carriage agreements.”

Of course, it would be unwise to assume the Net neutrality camp will hang together forever. Some big players, who could absorb the costs, might conceivably welcome the idea of a new charge system washing their peskier, poorer competitors over the side. Stuff happens.