International Think-Tank on Innovation and Competition
The Economics of Standard Setting Organizations
by F. Etro and E. Tarantino
November 20th, 2010
The new draft of the Guidelines on the applicability of Article 101 of the Treaty on the Functioning of the European Union to horizontal co-operation agreement (to be finalized by the end of 2010) set-up the legal framework to analyze different agreements between firms that can be exempt from the application of Art. 101 against collusive agreements. Besides R&D, production, purchasing and commercialization agreements, a crucial category analyzed in the Guidelines is given by standardization agreements, which are aimed at defining technical and quality requirements with which certain products or processes may comply. The role of these agreements is quite important in the private sector because of their impact on the innovative activity of high-tech firms (think of the crucial role of standards in ICT) and in the public sector for public procurement (think of the debate on the European Interoperability Framework, currently under discussion at the EU level to set common rules on the procurement of e-Government services by public authorities). The draft Guidelines acknowledge the importance of Standard Setting Organizations (SSOs) in promoting innovation, competition, technology adoption and interoperability, however they also stress that the discussions among competitors in SSOs may result in anticompetitive practices.
Representatives of firms participating in SSOs repeatedly meet to reach consensus on the technical requirements that define a standard. In the ICT sector, such meetings are necessary to outline these requirements and often to select the best technologies to include in the standard, and they contribute to promote and reward R&D investment, address interoperability concerns, and to create further opportunity for new innovation and competing implementations. Almost every standard supporting the ICT industry includes patented technology that is technically necessary in order to implement the standard. The selection of the most efficient and effective standards and the incentive to continue to invest in R&D are therefore important considerations with regard to standardization agreements.
During or after determining the composition of a standard, bilateral negotiations take place between the holders of patents that are essential to the standard and implementers of the standard. Consensus is sometimes reached only after several years of technical committee work. In the meanwhile firms may start the production phase by following the indications emerging from the evolving drafts and discussions at the technical committee meetings. This implies that patent holders have a strong bargaining position at the negotiation stage and in extreme cases there can be the risk of the so-called hold-up: investment by others is limited ex ante because it could be exploited by the patent holders ex post.
The thousands of ICT standards approved by standards-setting organizations (SSOs) in the ICT industry include the Wi-Fi protocol (or IEEE 802.11n standard), the ADSL and the SDRAM technologies. Although the number of successful and non-controversial ICT standards is very large, there are some standardization efforts that have resulted in litigation. For example, there are several antitrust cases with allegations that aggressive competitive tensions influenced the process of ICT standards’ definition (FTC v. Rambus, FTC v. N-Data, EC v. Rambus and EC v. Qualcomm). As acknowledged by the Guidelines, these tensions arise from the conflicting interests driving firms with different business models, with companies slotting in along a spectrum going from pure innovators to pure manufacturers, with many falling somewhere in-between the two poles.
Pure innovators raise most of their revenue from the technology market; they are interested in having their patented technologies included in a new standard and in gaining the associated licensing revenue. Product manufacturers in SSOs are often vertically integrated; they join certification bodies to achieve coordination among industry participants and have a clear interest in paying low rates for standard’s technologies. While they often hold patents essential to the implementation of the standard, they may decide to monetize their patents through their products and they need to have those patents respected. Services providers often want standardized technology available as a loss leader that they can give away to provide their services and up-sell to proprietary offerings.
The different incentives that characterize the licensing stage can alter the outcome of the standardization activity. While most ICT standards are developed and implemented without controversy or concerns, on rare occasions there can be inefficient outcomes. This happens, for example, when integrated manufacturers sign cross-licensing contracts and exclude from a standard the technology of a pure innovator even though its inclusion would increase social welfare. Exclusion can arise because, from the point of view of manufacturers, cross-licensing preserves product-market and licensing rents, while contracting with pure developers is efficient from the technological point of view but leads to rents’ dissipation because of hold-up. This creates a bias in favor of cross-licensing that is welfare detrimental when the pure developer’s input is very efficient.
The normative implication is that standard setting consortia should adopt a policy of early licensing commitments for the essential patents to fix the hold-up problem and let integrated companies design the standard more efficiently. These commitments should not be anchored to vague definitions of fair, reasonable and non-discriminatory (Frand) terms, which do not reflect the nature of existing SSOs and contradict the same nature of the IPRs (which deliver market power by definition). The market should be allowed to set whatever licensing terms arise out of the early negotiations.
However, so far a policy of early-licensing commitment has received only timid support from SSOs, mainly because of firms' fear of antitrust authorities' intervention. The Guidelines seem to support the employment of an ex-ante licensing policy by SSOs when they state that “if standard-setting organizations provide for ex ante disclosures of most restrictive licensing terms, this will not lead to a restriction of competition within Article 101(1)” (# 287). However, they also specify that “[p]rior to the adoption of the standard, agreements by IPR holders on the licensing terms they will disclose also constitute restrictions of competition by object within the meaning of Article 101(1)” (#267). The difference between the two expressions, and in particular between “licensing terms” and “most restrictive licensing terms” (emphasis added), is small but substantial and calls for an interpretative effort that clearly introduces uncertainty on the enforcement of the law by the Commission.
The ambiguity of the Guidelines generates two risks. First, the potential beneficial effects of ex-ante disclosure of licensing terms would likely not be realized because of SSOs’ member firms fear of being punished for anticompetitive coordinated practices. Finally, and this is a general problem of the part of the draft Guidelines concerning SSOs, a dangerous bias against proprietary technologies could implicitly emerge even if it is clear that this would be highly detrimental to innovation and technological progress in ICT sectors and to efficient decisions in public procurement.