TV: Special Report - The pay-TV potential

Broadcasters are keeping their options open when it comes to funding models, Jeremy Lee says.

With the switch-off of the analogue signal due to begin in less than two years time, terrestrial TV broadcasters have been forced to re-evaluate their digital strategies.

While the switch-over process is not due to be completed until 2012, the future landscape is a difficult one to predict. Some of the broadcasters are therefore hedging their bets as to which digital platform will become the most powerful and the most profitable.

Andy Duncan, the chief executive of Channel 4, made an early and bold move by making its pay-TV channel E4 free-to-air. You might think that this move was out of nostalgic loyalty to the Freeview platform that he helped to found, but in fact the move had two purposes.

First, it assuaged the regulators of Channel 4's public-service broadcasting commitment at a time when future funding is very much on the agenda. Second, it made commercial sense - its audience would be bigger in Freeview homes than on pay-TV.

Channel 4 has, therefore, seen the potential - at least in the short to medium term - that the larger audiences could mean to its advertising revenue compared with the continued decline in the carriage money it gleaned from subscriptions.

Elsewhere, other broadcasters are reviewing their plans - but in the other direction. For a variety of reasons that have been well publicised, the future of the advertising-funded TV model is under threat and, with pay-TV already bigger than the £3.4 billion TV advertising revenue, pay could be an important part of the mix.

RTL, the owner of five, has made no secret that it would be interested in buying the Flextech pay-TV channels that currently belong to Telewest - and it joins a longlist of hopeful bidders, which includes Hallmark and Viacom, for the Flextech portfolio.

Flextech is certainly an attractive prospect - it runs channels on all of the digital platforms with a mixture of pay and free-to-air and its audiences could benefit from some cross-promotion.

ITV has also begun to make noises in the pay-TV area. Heeding the advice of Barry Cox, the chairman of SwitchCo (who said that the move by the traditional broadcasters to switching off the analogue signal was like "turkeys voting for Christmas"), it has hired Jeff Henry, the former chief executive of the Hallmark Channel, to head a new consumer division tasked with finding new revenue streams away from advertising.

While part of his job is looking at secondary revenue from telephony and competitions, it is no secret that he is also looking at the potential of launching an ITV-branded pay-TV channel.

Henry has the necessary experience to do this. As well as his time at Hallmark, he was also the chief executive of the now-defunct Granada Sky Broadcasting venture and is used to running pay-TV outfits. But ITV will have to find some pretty compelling content to make it worth viewers forking out for another pay channel.

One suggestion is that it could launch a high-definition TV channel that would only be available to subscribers. No-one at ITV would comment on the speculation, other than to make the rather bland statement: "A central plank of ITV's strategy is to develop new revenue streams. Jeff Henry joined ITV earlier this year ago to head up the consumer division and is naturally exploring all the options."

In April, ITV began to show its hand with the £134 million purchase of the Freeview channel operator SDN. The acquisition gives ITV control over a digital multiplex that currently broadcasts ten digital channels but also offers the possibility of future capacity as digital transmission is compressed.

So, some three years after the collapse of ITV Digital, ITV once again becomes the holder of a portfolio of channels including UKTV Gold, QVC and Cartoon Network offering it an additional revenue stream. But, more importantly, it also raises the spectre of a possible ITV Digital 2 - Freeview with a pay element.

The argument that the advertising revenues broadcasters currently rely on will be put under greater pressure as it becomes more thinly spread is a compelling one.

Even Channel 4, which is also launching More4 as a free-to-air offering, realises that pay-TV is likely to continue to play an important part of its funding model. But TV delivered via broadband (internet protocol TV) and mobile streaming look more likely to be the new revenue streams.

For those broadcasters that depend on pay-TV, the strategy seems to be about protecting their position.

Pay-TV, of course, powers Sky, with advertising revenue accounting for less than 10 per cent of the company's total revenues. The bulk of the remainder comes from subscriptions.

Sky long ago realised Freeview is a threat to its model and has embarked on an extensive - and expensive - marketing campaign to encourage consumers to take up pay-TV.

A dramatic repackaging of its entry-level subscription packages, the introduction of new technologies such as HDTV and Sky+ and a re-ordering of its electronic programme guide have also been lined up to accelerate growth of its platform.

Sky is confident that its hugely expensive "What do you want to watch?" campaign will encourage new and existing digital TV subscribers, and especially Freeview homes, to upgrade in some form or other to Sky Digital. There is a lot riding on it - not least the reputation of its chief executive, James Murdoch, who has a target of ten million subscribers by 2010.

The crux of the campaign is the variety and uniqueness of the different programmes that are available on Sky. And, peculiarly, this has increased the company's dependence on the channels that it carries.

According to the broadcast consultant David Cuff, the days when Sky could screw down carriage deals and squeeze the broadcasters until the pips squeaked look long gone.

Premium content - and a point of differentiation - are now crucial to Sky's offering in attracting and converting digital customers. It needs the likes of Discovery Networks, under the stewardship of its vice-president of ad sales and distribution, Jon Wildman, to maintain its edge over the rather drabber free-to-air offerings that can be accessed with a £40 Freeview box.

As the sands shift between pay-TV and free-to-air, broadcasters are forced to predict an uncertain future.