Securing the Universal Postal Service

Summary

The postal sector is essential to the UK economy

1.1 The postal sector is essential to the UK economy and society. In 2010, 16bn letters were delivered to 28.2m addresses. Royal Mail was responsible for delivering over 99% of these. The postal sector supports a diverse range of economic activity. Nearly all businesses in the UK use post in one form or another, for delivering and receiving goods, invoicing or paying bills, marketing and communicating with customers and suppliers, publications, bills, statements, etc. While residential consumers receive more mail than they send, it is clear that they still place a high value on the postal service.

1.2 Total spending on postal services in the UK in 2010 exceeded 6bn, but direct consumer spending on post is very low. Average weekly household direct spending in 2009 was only 40p - around 0.1% of household income. By comparison, weekly expenditure on other utilities such as telephone services, electricity and gas, at 10.80p, 10.20p and 9.70p respectively, were each over 20 times the level of spend on post.

1.3 Underpinning the postal service we are all used to is a universal service obligation (USO), which requires Royal Mail to provide for the delivery and collection of letters six days a week (and other postal packets five days a week), and that prices must be affordable and uniform throughout the UK. Royal Mail is also required to ensure that 93% of First Class arrives next day, and 98.5% of Second Class within three days of posting. Royal Mail has largely met these service standards in recent years.

1.4 The obligations that apply to Royal Mail in respect of the universal service exceed those that apply in most other countries in Europe. For example, Royal Mail is required to deliver post 6 days a week, whereas the EU requirement is only 5 days a week. This has inevitably had an impact on the costs of providing the universal service. Despite this, prices for postal services - in particular first and second class mail delivery - have until recently been amongst the lowest in Europe.

1.5 The UK postal sector is the largest in Europe, but it has also seen the steepest decline in volumes. The volume of mail in the UK has fallen by 25% since 2006, as consumers have moved away from traditional mail and towards digital means of communication.

1.6 Furthermore, in the same period there have been substantial changes in product mix, with customers tending to move away from higher value traditional products (first and second class mail) and towards lower value services such as bulk mail (post sent in high volume typically by major business customers).

There is a very real risk to the universal service

1.7 These forces have placed great strains on the industry and on viability of the universal service. Threats to the viability of the universal service are present today and are likely to remain for some years to come.

1.8 In the near term, the provision of the universal service is threatened by Royal Mail's immediate financial position. The part of Royal Mail responsible for delivering the universal service made a loss of 120m ^(-1-) in 2010-2011 on a cost base of 7bn. Royal Mail's negative operating cash gap has widened, and it reported an outflow on its mail activities of over 600m in 2010-11, in part due to its contribution towards the 300m annual costs of servicing its pension deficit and the cash cost of its modernisation programme. Since Royal Mail's current price control was imposed in 2006, its cumulative cash performance has been around 3bn worse than was expected by the regulator at that time.

1.9 Beyond the immediate challenge, it is likely that the market will continue to face uncertainty and challenge. Mail volumes, in particular, are expected to continue to decline worldwide, with letter volumes possibly declining by between 25% and 40% over the next five years ^(-2-) .

1.10 The risks to the universal service are therefore considerable. As volumes have dropped, Royal Mail's average unit costs have increased. Unless Royal Mail can deliver efficiency gains that exceed the effect of volume decline, it will have to rely on increasing prices, which in turn is likely to suppress demand, further increasing unit costs, and putting further upward pressure on prices.

1.11 To date, although Royal Mail reduced employee numbers by around 20,000 to 155,000 between 2007 and 2011 ^(-3-) , it has not been able to cut costs to keep pace with falling volumes. Royal Mail has spent about 2bn on a combination of redundancy and capital expenditure (i.e. new technology, sortation equipment) as part of its modernisation programme, and further investment is required. Royal Mail must convert capital expenditure and cost savings into real efficiency improvements.

1.12 The risks of efficiency savings not being achieved, or not being achieved sufficiently quickly, are significant. With no improvement in efficiency, declining volumes will translate into higher prices, which would only serve to lock the postal sector and the universal service into an inexorable spiral of decline.

The regulatory context

1.13 The challenges facing the universal service were recognised in the 2008 Hooper report: Modernise or Decline ^(-4-) . This concluded that, given the context, the status quo was untenable. In 2010 Hooper produced an updated report: Saving the Royal Mail's Universal Service in a Digital Age ^(-5-), which recognised the worsening of Royal Mail's financial position in the interim, and reaffirmed the following policy recommendations:

• That the Royal Mail needed to be opened up to private investment;
  
• Addressing the pension deficit by moving it to the Treasury;
  
• That responsibility for regulating post should be transferred to Ofcom.

1.14 The new Postal Services Act 2011 ("the Act") has set out the basis for these changes to be effected. The Act transfers regulatory responsibility from Postcomm to Ofcom, and also provides the legal framework for the government's intention to remove Royal Mail's historic pension deficit and to privatise Royal Mail.

Ofcom's duties under the Act

1.15 The Act gives us a primary duty to carry out our functions in relation to post in a way that we consider will secure the provision of a universal postal service. In discharging our duties in relation to the universal service, the Act also requires us to have regard to the need for the provision of a universal postal service:

• to be financially sustainable, including the need for a reasonable commercial rate of return for any universal service provider; and
  
• to become efficient within a reasonable time, and then to remain so.

1.16 The Act requires Ofcom to designate an operator as universal service provider. Ofcom provisionally designated Royal Mail as universal service provider on 1 October 2011, and it is expected to remain so for the foreseeable future.

1.17 Ofcom's principal duty under the Communications Act 2003 (the 2003 Act) is to further the interests of citizens and consumers, where appropriate by promoting competition. This duty, together with our general duties under the 2003 Act, also applies when we carry out our functions in relation to post. The 2011 Act also provides that in the case of a conflict between our duty to secure the provision of a universal postal service, and our general duties under the 2003 Act, our duty to the universal postal service takes precedence.

The regulatory challenge

1.18 In this context, fulfilling the primary duty of safeguarding the universal service implies:

• providing Royal Mail with the opportunity to return the universal service to sustainability - Royal Mail is the only company at present capable of delivering the universal service in the UK: unless it can be made financially viable, the universal service is at risk in the near term; and
  
• providing strong incentives to improve efficiency and innovation to counteract the longer-term threat to the universal service - unless it is able to improve efficiency, to cover costs Royal Mail would be forced to rely solely on price increases, which could lead to a spiral of decline.

1.19 In addressing this challenge, it needs to be recognised that the circumstances facing the sector at present are exceptional in a number of respects. Most fundamentally, Royal Mail, despite its market position, is currently unable to cover its costs. This forced it last year to return to the regulator to apply for further price increases over and above those agreed in the last price control, and it has recently contemplated a further application for price increases next year.

1.20 Not only is the market in a state of long-term decline, it is also characterised by great uncertainty. When the last price control was set in 2006, the extent of volume decline was foreseen neither by the regulator nor by Royal Mail. Moreover, the longer-term role of post in the overall communications market, and, in particular, the extent to which post will continue to be relied upon as a means of communication competing with electronic substitutes has yet to become clear.

Traditional approach to regulation has failed

1.21 There is widespread recognition that the approach to regulation adopted in the past, has failed in the face of the particular circumstances affecting this sector.

1.22 To date, the approach adopted has been based on price controls - similar to those used in most other utility sectors. In normal circumstances this approach is an effective means of preventing private operators from earning excessive profits, thereby providing incentives for firms to reduce costs, while at the same time protecting consumers from excessive prices. It is an approach that is widely used by regulators, including Ofcom, to regulate private operators with significant market power.

1.23 The recent experience of postal regulation, however, has demonstrated all the weaknesses of price controls with none of the benefits. In a highly uncertain market, price controls have removed the flexibility that would allow Royal Mail to adjust to changes in demand, while at the same time Royal Mail has been unable to improve efficiency, either at the rate expected by the regulator when the price control was set, or at the rate set by its own internal targets at the time.

1.24 Furthermore, price controls on Royal Mail have served less and less to protect customers from price rises. Since 2006 Royal Mail's financial position has led it to apply to the regulator for price rises over and above those consistent with the regulatory formula. In November 2010 Royal Mail applied to Postcomm for additional flexibility to increase prices, resulting in price rises averaging 12% for 2011-12. In the light of its primary duty towards the universal service, Postcomm granted these applications.

1.25 We therefore consider that price controls in this sector have failed in recent years. The reasons for this are clear. First, in a highly uncertain market environment, where the level and pattern of demand is so unclear, it is not feasible to expect to predict accurately whether a given price trajectory is sufficient to allow the universal service to be financed. If the price control that is set turns out to be to be too tight, it will not allow for the universal service to be financed. If, on the other hand, it is set too loosely, it will provide little protection and inadequate efficiency incentives.

1.26 Moreover, an RPI-X approach to constraining prices and incentivising efficiency carries with it a major issue of credibility, given Royal Mail's current financial circumstances and our primary duty in relation to the universal service. If, in the near term, Royal Mail found itself unable to become profitable under the terms of a price control, it would have to return to the regulator to request further price rises. In assessing this, although we would press Royal Mail to increase efficiency rather than raise prices, we would also need to carry out our functions in a way that we consider will secure the provision of a universal service. This means that there are serious weaknesses associated with a price control formula in providing credible incentives to Royal Mail to become efficient in the near term.

1.27 A price control also reduces the flexibility of Royal Mail to adapt to unexpected changes in the market and its operating environment. We have examined the possibility of designing a price control which would allow for potential changes in the market, e.g. using adjustment mechanisms and re-openers. However, such approaches are unlikely to be able to predict or to resolve all potential circumstances and are also likely to reduce the incentive properties of any price control. Indeed, the more sophisticated we attempt to make a price control, the more potential there is for unintended consequences.

1.28 Universal service and access products make up about 60% of Royal Mail's total letter revenues. Therefore any difference between the assumptions made at the time of setting a price control and actual outturns in the market would inevitably have a very significant effect on Royal Mail's financial profitability and the viability of the universal service.

1.29 In summary, if Ofcom were to set a price control in relation to Royal Mail in the current circumstances:

• Prices would still need to rise in order to restore the universal service to viability in the near term.
  
• The risk of regulatory error is very high given the exceptional nature of the circumstances of the postal market. In determining the appropriate level of price rises, we would need to take a view now, not just of the current pattern of demand, but the pattern of demand throughout the life of the price control period. Ofcom would, in setting the level of control, in effect need to second-guess the market and the future commercial judgement of the company now and in the longer term, during a period of considerable change and uncertainty.
  
• It is highly likely that Royal Mail would apply for further price rises before the end of the price control, and quite possibly on more than one occasion.
  
• The efficiency incentives on Royal Mail would be weak. If, under a price control, Royal Mail finds itself in financial difficulties, it will, as recently demonstrated, approach the regulator to reopen the control. Awareness of this possibility substantially weakens the efficiency properties of a price control approach.

Ofcom's proposals

1.30 Overall, in light of Ofcom's duty to secure the provision of a universal service and in the current circumstances with the market facing such uncertainty and Royal Mail in its present financial situation, we believe that there are considerable risks in pursuing a traditional price control-based approach. We therefore propose to provide Royal Mail with more freedom in relation to the pricing of most products and services, and do not propose to impose a traditional price control on Royal Mail.

1.31 Providing more commercial freedom to Royal Mail in the current context may provide a more effective means of addressing the regulatory challenge. First, it allows Royal Mail the freedom to choose the most appropriate way to raise revenues to address the financial situation facing the universal service. In this uncertain time, when the position of post in relation to electronic substitutes is unclear, Royal Mail is in a better position to determine the impact of price rises of different products on overall demand and, hence, revenues.

1.32 Greater freedom also provides a more effective route to incentivising efficiency gains. The government's policy is to privatise Royal Mail, and it is necessary, therefore, to establish a regulatory regime that recognises the incentives facing a private operator.

1.33 To undertake the considerable challenge of improving Royal Mail's efficiency and committing expenditure to modernisation, an investor would need to be confident that it could recoup the benefits of doing so. For this to be the case there needs to be confidence that there will be a sufficient period of regulatory stability in which to both deliver and benefit from greater efficiency.

1.34 We consequently need a regulatory settlement that lasts for a sufficient period of time to provide a stable environment within which to address the efficiency challenge. The very real benefits to consumers reside in the short term with a sustainable universal service, and in the longer term with the prospect of not only a sustainable universal service, but also in sharing the efficiency benefits delivered by more effective incentives.

1.35 There are, however, also significant risks with giving Royal Mail commercial freedom. Most obvious is the risk that Royal Mail uses this as a means of shying away from the efficiency challenge in favour of simply increasing prices.

1.36 If the new regulatory framework did not lead to increased efficiency, it would have failed one of its fundamental goals. A reliance on price rises alone would reduce demand further, exacerbating the risk of the sector falling into an inescapable spiral of decline. There is also the related risk that Royal Mail raises prices to such a degree as to begin to raise affordability issues for vulnerable consumers.

1.37 These risks are significant and imply that commercial freedom cannot be provided without appropriate safeguards. With the right safeguards in place, however, we believe the risks are manageable - and taken together present a package that is the most suitable for the current circumstances.

1.38 Therefore we propose to grant Royal Mail commercial freedom for a period of seven years by not imposing a traditional price control, subject to safeguards in the following areas:

• effective monitoring of performance, including scope for re-regulation if the incentives to deliver greater efficiency are demonstrably failing;
  
• ensuring that a basic universal service is available to all and affordable by all;
  
• the discipline of competition and innovation.

Safeguard 1: Monitoring and the potential for reregulation

1.39 Although we propose to give Royal Mail commercial freedom, we will, at the same time, carefully monitor its performance to ensure that this is used in a way which accords with our regulatory objectives in respect of the universal service.

1.40 For the reasons set out above, under the proposed regulatory framework, we fully expect Royal Mail to be in a position to address the sustainability of the universal service. We expect the universal service to be restored to a sustainable position as a product of price rises, but also efficiency improvements.

1.41 In monitoring performance we will focus in particular on the following areas:

• quality of service targets - to ensure that the universal service continues to be provided at the level required and that the service that users receive is maintained to the required standard;
  
• Royal Mail's pricing and profitability - while Royal Mail needs to return to being profitable for the universal service to be sustained, if it is earning excess profits as a result of price rises, as opposed to efficiency gains, we will consider the case for re-intervention, to secure a financially sustainable, efficient and affordable universal service in the interests of consumers.

1.42 The Act enables us to require Royal Mail to provide us with information, and we propose to use these powers to monitor Royal Mail's performance. In this document we make specific proposals relating to the extent of financial reporting that we propose we should require of Royal Mail, and also in relation to the need for Royal Mail to provide separate accounts for different areas of its business.

Safeguard 2: Ensuring that a basic universal service product is available to all and affordable to all

1.43 In a period of such market uncertainty, and where there is upward pressure on prices, it is vital that there remains a basic universal service product that is accessible to all, especially the vulnerable.

1.44 While for the reasons set out above, we believe that sustaining the universal service requires substantial commercial freedom for Royal Mail, within this it is essential that the role of the universal service in society is preserved and that the price of a basic universal service is not allowed to rise above an affordable level.

1.45 Therefore we propose to set a safeguard cap for Second Class stamps.

1.46 We believe that the ceiling should be targeted at Second Class stamps as they are the most likely to be used by vulnerable customers; at the same time this would provide a safeguard to all users in the sense that it would act as a 'backstop' service to First Class stamp customers.

1.47 Our analysis also indicates that setting a ceiling on Second Class stamps at an appropriate level will not unduly constrain Royal Mail's pricing flexibility in relation to other products. In this sense, this approach will not cut across the wider benefits to be gained from pricing freedom.

1.48 In proposing this safeguard, we note, first, that UK stamp prices are currently within the range of EU prices, despite the fact that elements of the UK's universal service are more onerous than those in other countries. We also note that average household expenditure on post is generally very low, at 40p a week. Nonetheless, this figure is an average, not just across households, but also across the whole year, and is likely to vary significantly between different consumers and at different times of year.

1.49 We therefore propose a straightforward price ceiling on Second Class stamps set at an initial level, and then allowed to rise in line with the retail prices index.

1.50 The appropriate initial level for the ceiling is essentially a matter of judgement. Given its purpose, which relates to affordability of the service to vulnerable consumers, we do not propose to set the level directly in relation to the costs of the service. Rather, our concern is to ensure that the resultant service is affordable in particular to vulnerable consumers. We are proposing, for consultation, that the cap lies in the range of 45p-55p for a standard letter, and would value stakeholders' input and views on the impact of different levels within this range on different categories of consumers and whether there is still sufficient flexibility available to Royal Mail to ensure the universal service is sustainable.

1.51 In line with the need for a significant period of certainty, we propose that the safeguard provisions apply for a period of seven years. However we propose to leave open the possibility of reassessment in two years exclusively in relation to the safeguard cap. Such an assessment, if necessary, would consider relevant market conditions and/or affordability.

Safeguard 3: Competition within the mail market

1.52 Postal services inevitably face some degree of competition from other modes of communication. This has the potential to provide a real constraint on Royal Mail's ability to raise prices, although at present it is not possible to be certain about its strength.

1.53 The final safeguard we are proposing is consequently in relation to the overall competitive framework within the post market. Competition in principle brings substantial benefits, especially in terms of increasing pressure on Royal Mail to improve efficiency. The potential for Royal Mail to lose business as a result of competition is, however, also a potential risk to the universal service if it results in a position where Royal Mail, as the only operator capable at present of offering the universal service, cannot remain viable. Given our primary duty, the assessment of competition needs to balance these factors.

1.54 There are two main models of competition in post:

• Access competition - where a post operator receives mail from customers, and then accesses Royal Mail's network for the letter to be delivered to the final recipient.
  
• End-to-end competition - where a post operator not only receives the letter from the customer but then delivers it to the recipient, by-passing Royal Mail's network entirely.

1.55 Access competition is the predominant form of competition in the UK. Around 40% of mail volumes are currently carried by access providers (but delivered by Royal Mail). Access has brought benefits to the universal service in terms of;

• improved efficiency incentives to Royal Mail;
  
• reduced prices to customers;
  
• improving customer focus of services; and
  
• innovation in new products and services.

1.56 Furthermore, access appears to be critical as a platform for end-to-end competition, firstly in terms of allowing a rival operator to establish a customer base from which to begin to offer an end-to-end service and secondly, in order to maintain a national service to customers with a limited delivery network.

1.57 We therefore believe that it is important for access competition to remain in the future.

1.58 In terms of setting prices for access, however, it is clearly necessary that these allow Royal Mail to cover the costs of the network adequately. If they do not, then the universal service will be further undermined.

1.59 We therefore propose:

• imposing an access condition on Royal Mail to oblige it to grant access at inward mail centres;
  
• not to regulate the price of access, to enable Royal Mail to set prices in a way that covers the costs of the network; and
  
• ensuring, by means of a 'margin squeeze test', that the difference between the access price and retail price is kept at a level that allows efficient access competitors to compete effectively.

1.60 We note that under the Act, imposing an access condition also enables operators to bring disputes to Ofcom, relating to the terms of access.

1.61 End-to-end competition does not currently have a significant presence in the UK, although it is the predominant form of competition in other European countries, such as Germany and the Netherlands. We recognise that the potential benefits in terms of increased efficiency pressures are greater than those for associated with access. In particular, by providing a competing service to Royal Mail's delivery operations, it potentially provides powerful incentives on Royal Mail to reduce cost across the full length of the value chain.

1.62 On the other hand, however, end-to-end competition poses a potentially greater threat to the sustainability of the universal service by removing greater amounts of revenue from Royal Mail. While end-to-end competition is the main model of competition in other countries, and appears to coexist with a healthy universal service and an efficient incumbent operator, in the current circumstances, and in terms of Royal Mail's current financial position, we need to recognise the associated risk to the provision of the universal service.

1.63 Under the Act, the Secretary of State can direct us to impose a notification condition under section 41 of the Act to assess entry or expansion by rival postal operators offering a competing delivery service, and to assess this in terms of its overall impact on the provision of the universal service. On 3 October 2011 the Secretary of State issued such a direction to us, giving us six months to set this condition in place.

1.64 We propose to assess any actual or planned end-to-end competition notified to us on a case-by-case basis. We will do so in the light of the potential impact on the provision of the universal service, in order to decide whether it would be appropriate to impose further conditions on operators in order to secure provision of the universal service, in accordance with our primary duty under the Act. We plan to consult on the notification condition before the end of the year.

1.65 Lastly, in a competitive market it is important that there is also sufficient flexibility to allow Royal Mail, as well as its competitors, to innovate; to improve existing services or introduce new services that are beneficial to its customers and users. The previous licence-based regime ^(-6-) set constraints on Royal Mail, in terms of having to publicly notify the market of its intentions and to obtain regulatory agreement to changes in its regulated products.

1.66 While such a regime provides stability and clarity for customers, users and the market, it can represent a significant reduction in commercial freedom for Royal Mail in responding to a challenging market environment. We intend to consider this issue further and will be presenting proposals later in the year as part of a wider review of regulatory conditions, but our intention will be to simplify the obligations and wherever appropriate to consider the benefits of permitting greater commercial freedom for Royal Mail.

1.67 Ofcom invites responses to this consultation, to reach us by 5 January 2012. We anticipate issuing a final statement in February 2012.

Footnotes:

  1.- UK Letters, Parcels and International (UKLPI), previously Letters, Parcelforce, Corporate and Group Property

  2.- Figure cited in R.Hooper (2010) : Saving the Royal Mails Universal Service in a Digital Age, http://www.bis.gov.uk/assets/biscore/business-sectors/docs/s/10-1143-saving-royal-mail-universal-postal-service

  3.- Based on data from Royal Mails Statutory Accounts

  4.- http://www.bis.gov.uk/files/file49389.pdf

  5.- http://www.bis.gov.uk/assets/biscore/business-sectors/docs/s/10-1143-saving-royal-mail-universal-postal-service

  6.- Which applied under the Postal Services Act 2000