Verizon's refund is just the start of a shakeup in wireless

Verizon just confessed to overcharging 15 million wireless customers. It's a tiny part of a much bigger problem for the wireless giant.

Verizon Wireless padded the bills of 15 million customers with unnecessary charges, the company admitted in a terse statement released on Sunday afternoon.  Verizon (VZ), which clearly hoped to bury the matter quickly, wouldn't specify either the average or the total amount of the overcharges. It simply said that most were small, a few dollars per customer, and promised full refunds.  Total overcharges could run as high as $90 million.

It's easy to assume the worst -- that Verizon's overcharges were a too-convenient "mistake."  The wireless industry has a long history of rounding bills in its own favor. (A 61-second cellphone call typically counts as two minute of use, for example.) Verizon is also under intense pressure to boost revenue from data, as opposed to traditional phone calls, which is just what the recent overcharges happened to do.

At the heart of the issue lies the ticklish question of how to charge for wireless data. Right now most cellular customers who use data services pay for a bucket of monthly phone minutes and an unlimited amount of data usage. The customers Verizon overcharged, however, pay for data per download, at a rate of $2 per megabyte.

That's exactly how most people will pay in the future. Just two weeks ago Verizon CEO Ivan Seidenberg announced that the company would be moving away from all-you-can-eat data plans to systems in which people pay by the megabit. AT&T (T) made a similar announcement. It's all part of a tectonic shift in the wireless market.   Today Verizon and other companies make most of their money charging customers by the minute, not the megabit.

Like AT&T and its other competitors, Verizon desperately needs people to pay more for data service to continue a three-decade-long run of growth.  Last quarter, Verizon's wireless data revenue shot up $900 million from the year before—a fortunate thing, since otherwise a decline in its core wireless calling market would have dragged down Verizon's overall wireless revenue by $200 million.

In the long term, charging by the bit makes it easier to pad customer bills by sneaking extra megabits onto them. It also makes fundamental economic sense. Modern wireless systems, like the Long-Term Evolution one Verizon is beginning to install, treat all wireless communication the same, breaking everything into bits that are handled in an identical fashion. (Older, less efficient digital systems have a special system for handling voice calls.)

Selling bits will ultimately expose the fact that wireless customers are being overcharged for all sorts of wireless services—including the old-fashioned phone calls and text messages that still form the core of Verizon's business. Right now phone calls and text messages, neither of which take too many bits to transmit, bring in a wildly disproportionate number of dollars per megabit compared with data applications.

Text messages are an especially egregious example. After the Big Four carriers all raised rates in lockstep a few years ago, the Senate launched an antitrust investigation. Somehow texting prices kept going up even as the already negligible cost of sending a text fell ever lower.

Radical changes in costs have happened elsewhere in telecom to brutal effect—just ask Seidenberg. When he came on as Verizon's chief executive, the company's core business was local phone service. Since then companies like Skype, Vonage (VG), and Google (GOOG) have found ways to disguise phone calls as data and send them over the Internet, often for free, a process called going "over the top."

The same thing, Seidenberg noted two weeks ago, is happening to the cable companies.  Fast web connections are letting video disguised as Internet data stream to laptops, Netflix-enabled DVD players, Apple's new Apple TV, and other gizmos. "Over-the-top is going to be a big issue for cable," he recently said in comments noted by MediaMemo.  "I think cable has some life left in its model, but that it is going to get disintermediated over the next several years."

What, then, about wireless?  What happens as wireless customers start going over-the-top, paying by the megabit?  Won't wireless companies be made into dumb pipes too?

Verizon and its competitors have built their businesses around selling services, not bits. There's one price for phone service, another for text messaging, another for web access. Yet wireless customers increasingly don't want to buy a service -- they want to buy bits. That's the great trend in telecom: consumers demanding raw digital communication capacity that they control.

The recent overcharging brouhaha is likely to be one of many stumbles as Verizon migrates its 92 million–customer business toward billing by the bit. The ultimate outcome, however, will be to weaken the industry's ability to overcharge for services like talk and text. Compared with that, the $60 million to $90 million Verizon overcharged for unused megabits barely registers.

You could get angry at the folks at Verizon for messing up their new by-the-bit billing system. But it might make more sense to pity them for having to go through the brutal transition in the first place.