Royal Mail regulatory submission on Direct ... - Royal Mail Group

1 downloads 222 Views 1MB Size Report
Royal Mail's response: growing our parcels business and improving .... Mail provides in its capacity as the Universal Se
Royal Mail plc Direct Delivery: A Threat to the Universal Postal Service Regulatory Submission to Ofcom June 2014

Public Version Confidential information which has been redacted from this document is indicated by: []

© Copyright Royal Mail Group Ltd 2014. Royal Mail and the Cruciform are registered trademarks of Royal Mail Group Ltd. All rights reserved. Royal Mail Group Ltd, registered in England and Wales, number 4138203, registered office: 100 Victoria Embankment, London, EC4Y 0HQ.

Contents Executive Summary ............................................................................................................................................. i 1.

The UK postal system: benefits of the USO and nature of access competition ..............................1

2.

The challenge of declining letters traffic.............................................................................................. 10

3.

Royal Mail’s response: growing our parcels business and improving efficiency .......................... 16

4.

Direct delivery: a threat to the Universal Postal Service .................................................................. 26

5.

Risks to the financial sustainability of the Universal Service ........................................................... 40

6.

Options for Ofcom intervention ............................................................................................................. 43

7.

Ofcom’s response to the Universal Service financing challenge ..................................................... 51

8.

Conclusion: Summary of case for regulatory action ......................................................................... 58

© Copyright Royal Mail Group Ltd 2014. Royal Mail Group Ltd, registered in England and Wales, number 4138203, registered office: 100 Victoria Embankment, London, EC4Y 0HQ.

Executive Summary Direct delivery is threatening the economics of the Universal Service Structural decline in letter volumes means the Universal Service obligation (USO) is already challenged: The Universal Service offers every UK resident and business a uniform price and high quality of service. It is a service that Royal Mail is proud to deliver. Royal Mail is managing a structural decline in the addressed letter market of around 4-6% per annum. This means that the challenges of sustaining the USO are already significant. Our strategy aims to manage this through driving further efficiency improvements, focusing on customer needs and becoming a successful parcels business. This will itself be challenging given the increasingly competitive nature of the parcels market. The further pressure on the finances of the USO from direct delivery requires a regulatory response. The Universal Service is a regulatory construct: It enshrines an approach to the provision of postal services that is defined by legislation and therefore operates outside of normal competitive market dynamics. The fundamental economics of the Universal Service require a series of ‘cross-subsidies’ to support it. This requires Royal Mail to employ revenues generated from one area (geographic or product) to fund the costs of other areas. These mutually reinforcing cross-subsidies are unwound as direct delivery increases. We believe this should be reflected in Ofcom’s thinking. Direct delivery entry undermines the USO which consumers value and wish to see preserved in its current form. It does not deliver the benefits usually associated with competition: Direct delivery is in reality not level playing field competition that brings benefits to consumers. Rather it is ‘cherry picking’ arbitrage across three dimensions: 

 

Where: TNT Post UK Ltd (TNT Post) aims, by 2017, to deliver to c.42% of UK addresses. It believes it can achieve this by serving c.8.5% of the UK's geographical area. All of the areas TNT Post is delivering in are amongst the cheapest ‘costs to serve’1 for a new entrant. When: TNT Post provides an ‘every-other-day’ service. Royal Mail must abide by the USO: six day delivery and collection service for letters (five for parcels). What: TNT Post is only delivering mail originating from business customers, much of which is machine-sequenced. This type of mail is valuable for the USO provider. It is easier to handle, provides dependable volumes and a good financial contribution. The mandatory access regime means we must handle any item TNT Post does not wish to deliver itself.

Direct delivery could undermine our ability to finance the USO: Direct delivery entails cherry picking urban areas, easier-to-handle mail and offering a less frequent service. This removes from Royal Mail revenues that are currently deployed to support the costs of the USO. It puts at risk the current system of funding the USO. With our proposed access price changes suspended whilst

1

Source : Royal Mail data analysis of unit cost, driven by a combination of population density and mail density i

Ofcom carries out an investigation into a complaint by TNT Post, our commercial responses are constrained. On the other hand, direct delivery operators are free to continue their roll out. TNT Post’s recent expansion to Liverpool, North West London and Harrow so far in 2014 demonstrates this. A structural imbalance favours direct delivery entrants: The Universal Service requirements and our commitment to high quality of service standards mean that costs in delivery are high and relatively fixed. Royal Mail must set prices that reflect the costs of delivering the USO. In particular, this means our prices have to cover the costs of delivering six days a week across the country. Our analysis is that the ability to offer an ‘every-other-day’ service confers a cost benefit of around 40% to a direct delivery operator compared with providing a six-day delivery network2. Further cost advantages flow from delivering only in certain parts of the country and only certain types of mail. These cost advantages allow direct delivery entrants to set lower prices. It is difficult for Royal Mail to match this. Therefore, it would be expected that direct delivery entrants will be able to increase their market share significantly over time. There is no natural ceiling to direct delivery entrants’ growth of volume shares in the areas which they choose to enter. We can respond to direct delivery through limited cost reductions in delivery, linked to reduction in workload, but these are constrained by our obligations under the USO. The threat to the USO is not offset by the existence of a VAT differential: The services which Royal Mail provides in its capacity as the Universal Service Provider are exempt from VAT. This is required by EU law, which mandates the exemption from VAT of such services. The aim of the VAT exemption is to offer such postal services at a reduced cost. Customers who are unable to reclaim VAT, such as financial institutions, benefit from this cost reduction. However, direct delivery entrants have sufficient cost advantages by reason of the fact that they are not subject to the Universal Service obligation such that they are able to win business from Royal Mail’s customers despite the VAT exemption. The absence of the USO means entrants can offer cheaper prices for delivery than Royal Mail. Our analysis shows that entrants are winning direct delivery business in the banking sector. Costs of direct delivery entry are low for access operators: Direct delivery entrants can commence operations in urban areas without major capital investment. They need to lease premises and employ and train staff. But they do not have the large up-front costs that apply in other sectors. As an entrant expands its network, its customer base grows and its marginal costs reduce. Conversely, Royal Mail’s marginal costs increase as entry occurs. Royal Mail must:

2



comply with the USO, delivering to the same high service specifications in all markets including those where entry has occurred;



continue to deliver to the rest of the country; and



do so with less volume and revenue to fund the costs of the Universal Service network.

Source: Internal Royal Mail analysis ii

The impact from the roll out of direct delivery on the finances of the USO will be very significant. As TNT Post enters new urban areas, the profit pool available to the Universal Service Provider reduces quickly. The impact of the revenue loss from direct delivery on profits is intensified by Royal Mail’s high levels of operational gearing due to the fixed costs of the USO. Entrants can choose which items they wish to deliver and which they can require Royal Mail to deliver. They will likely keep the easier to deliver items and leave others for Royal Mail. Royal Mail has to cope with volume risk but also with managing the more expensive items. The risk of the USO becoming economically unviable is real and growing. The previous regulatory framework created an access mail market that means direct delivery is a greater threat in the UK than in other EU countries: No other EU country has experienced the degree of mandated and price controlled access as the UK. This has created a market where competitors to Royal Mail handle c.70% of addressed letters posted by large businesses. Direct delivery entrants with existing access businesses have direct customer relationships with many mailers and can readily switch mail volumes into their own direct delivery network. This creates a platform for rapid expansion of direct delivery and further erosion of the revenues needed to sustain the Universal Service. We estimate that over 50% of TNT Post’s upstream traffic is currently being converted to their direct delivery operation in areas where they operate3. This will increase as it establishes its position and is then able to win entirely new business. Our analysis suggests that [] by volume of the UK addressed inland letter market is contestable. The growth of direct delivery competition may not be smooth and predictable. The letters traffic posted by businesses is concentrated in relatively few corporate hands. Decisions made by a few large business customers following TNT Post’s entry may have significant consequences. The UK’s economic geography makes the USO challenging to sustain: Within the EU, the Universal Service obligation in the UK is particularly susceptible to harm from direct delivery entry. The UK has the highest concentration of large dense urban areas which are attractive to cherry-picking direct delivery. 15% of the population lives in very high density areas comprising just 1% of the landmass. On the other hand, the UK also has large parts of the country that are deeply rural and costly to serve. 15% of the population lives in lower density areas, comprising c.63% of the landmass4. The combination of mandated access and direct delivery, when added to structural decline in addressed letter volumes and the UK’s economic geography, creates real risk for the financial sustainability of the Universal Service. Comparisons with direct delivery penetration in other countries are of limited relevance to the UK. Direct delivery can grow quickly as entrants exploit arbitrage opportunities: We estimate that TNT Post is quickly achieving local market shares of [] in areas where it operates. The incentives for an entrant are to grow its business to much higher local and national market shares as it exploits

3 4

Ipsos MORI survey of direct delivery areas conducted on behalf of Royal Mail EU NUTS 3 data, Eurostat iii

economies of scale and scope and provides a lesser service than Royal Mail is required to by its USO. The speed of roll out could be faster than the regulator anticipates, as was the case with access competition a decade ago. TNT Post’s business model generates rapid growth at low risk. The Universal Service Provider’s ability to respond on price, frequency and product offering is constrained: For example, if a direct delivery entrant offers a lower price to a large company to entice it to move from using Royal Mail (access services) to the entrant’s own delivery network, Royal Mail cannot selectively match that price in order to keep those volumes within Royal Mail’s network and help to support the costs of delivering the Universal Service. Royal Mail already faces strong efficiency incentives. Direct delivery works counter to these: Competition from e-substitution, combined with the disciplines of being a public company, means that we face strong efficiency incentives already. We are targeting productivity improvements of 23% per annum over the medium term. Where costs can be taken out, we have made savings and will continue to do so. We have removed more than 50,000 jobs from the UK business5 since 2003. Our Management Reorganisation Programme will deliver significant reductions in management staff. Through tight cost control we have reduced non-people costs in UKPIL6 by 3% over the last year. Direct delivery provides no additional spur to efficiency. The tightly defined nature of the USO means reduced volumes tend to lead to lower productivity, and duplication of networks can represent economic waste. Whilst some cost reduction is possible as a response to volume decline, the Universal Service means that Royal Mail postmen and women must still walk the same streets, six days a week, just delivering fewer items. Reducing volumes have a direct negative impact on our revenues, but reduce only marginally our call rate, meaning that we continue to incur outdoor delivery costs at similar levels. The balance of risk is clearly in favour of an early review: Ofcom’s primary duty is to sustain the USO. Unfettered direct delivery could create a situation where the ‘one price goes anywhere’ Universal Service can no longer be supported from cross-subsidy within Royal Mail’s Designated Universal Service Provider system. Once this ability to cross-subsidise is lost, it will be irreversible. It is likely to be far more difficult for a regulator to unwind a situation once direct delivery is established than to set an appropriate framework now which safeguards the Universal Service. There are high risks to the Universal Service, and to customers who rely on it, of Ofcom not bringing forward the review it is already committed to undertake by end 2015. The risks of doing so are self-evidently low. In any event, as explained below, the threshold adopted by Ofcom for undertaking a review has been satisfied. Process considerations can make it hard to act quickly: Ofcom is monitoring the market and believes it could intervene quickly if needed. However, like most regulators, it is constrained by process requirements. Effective interventions may take some time to implement. Ofcom could find that a tipping point is reached - the USO has become unviable - before effective actions could be

5 6

Excluding Post Office Limited UKPIL means the UK Parcels, International and Letters division of Royal Mail Group, including Parcelforce Worldwide iv

implemented. The risk to the financial sustainability of the Universal Service is such that Ofcom should act now. Indeed, a prudent regulatory approach requires that Ofcom consider: 

the level of direct delivery competition which is consistent with the sustainability of the Universal Service;



the point at which conditions should be placed on direct delivery in order to secure the provision of the Universal Service, which is Ofcom’s highest priority statutory objective; and



the most effective forms of intervention.

Ofcom’s own thresholds for a review of direct delivery and intervention to address the threat have been passed: Based on our estimates of the impact of TNT Post UK’s publicly-stated plans, this could reduce Royal Mail revenue by over £200 million in 2017-187. Our analysis of the underlying economics and structure of the UK postal market, set out in this submission, supports our strong belief that TNT Post is incentivised to grow faster than its publicly-stated plans, absent regulatory intervention. Royal Mail has analysed a number of scenarios which show TNT Post growing its direct delivery operations faster than its publicly-stated plans suggest. Absent intervention from Ofcom, our analysis indicates that our ability to reach a 5-10% EBIT8 margin for Royal Mail’s Reported Business sustainably in the future would be undermined. Importantly, the impact of direct delivery competition on the financial sustainability of the universal service stems from structural factors, such as the existence of a highly competitive access market and the particular economic geography of the UK. Royal Mail is limited in its ability to mitigate the impact of direct delivery by reducing costs due to the high level of fixed costs associated with the USO. Our proposed access price changes are suspended and in any case would only partially address the problem. Moreover, we are already targeting challenging efficiency levels and pursuing different ways to grow the business. In light of the above, it is clear that the thresholds cited by Ofcom in its Guidance for both a review of the need for intervention (paragraph 3.26, Guidance) and indeed for intervention have been met. For example, the evidence supplied by Royal Mail demonstrates that TNT Post is incentivised to grow faster than its publicly-stated plans (Guidance at 3.26, bullet 2), such that Ofcom must now undertake a review.

7

Based on: TNT Post UK's stated ambition of c.42% delivery point coverage in 2017; expected addressed inland letter market volumes of approximately 11 billion items in 2017-18, using Royal Mail's forecast range of a 4-6% per annum decline in addressed letter market volumes; our estimate that TNT Post UK achieves a 20 per cent local market share in areas where it operates in 2017-18; and an annual RPI increase in our Average Unit Revenue per Downstream Access item. 8 EBIT: earnings before interest and tax, after transformation costs v

Direct delivery competition has developed significantly since Ofcom last substantively reviewed the position. Its success in establishing itself as a direct delivery operator is now apparent, with an estimated local market share of [] in areas where it operates. Royal Mail’s analysis demonstrates that, absent regulatory intervention, TNT Post will likely achieve its plans. On this basis, as to Ofcom’s threshold for intervention, it is clear that absent regulatory intervention, our ability to reach a 5-10% EBIT margin in the Reported Business sustainably in the future would be undermined (Guidance, paragraph 5.13). Under its Guidance, and its primary duty, Ofcom should now review the market and take action. Urgent action is needed: We believe a full review of direct delivery and its impact on the USO is needed, in addition to Ofcom’s current review of access pricing policy (announced April 2014). Royal Mail calls upon Ofcom: 

to undertake a full review of direct delivery as a matter of urgency; and, simultaneously,



to determine quickly the regulatory changes needed to protect the Universal Service.

Given the evidence and analysis to hand, and because effective interventions may take time to implement, for Ofcom not to take action would be inconsistent with its Guidance and primary duty under the Postal Services Act 2011 (PSA 2011).

vi

1.

The UK postal system: benefits of the USO and nature of access competition Summary 

The Universal Service brings significant benefits to individuals and businesses across the UK. Its wider social benefits have been recognised by Parliament and by Ofcom.



In the UK, the regulatory approach taken under the implementation of the first Postal Services Directive strongly favoured access-based competition. The regulatory regime adopted by Postcomm under the Postal Services Act 2000 (PSA 2000) resulted in the UK being the only country in the EU that mandated access and guaranteed a margin for competitors to the Universal Service Provider.



This feature of the postal services market makes the UK particularly susceptible to direct delivery.



The business context for the PSA 2000 was growing postal volumes. Regulation was focused on encouraging competition. From 2005, the UK postal services market changed profoundly as letter volumes declined. Yet the regulatory framework for access remained broadly unchanged. By 2007-08, access volumes at 4.1 billion items were 60% higher than the 2.6 billion that the regulator had projected in 2005.



The changing competitive context, and the structural decline in letter volumes, was recognised in the PSA 2011. The Act affirms the clear primary duty of the regulator to secure the provision of a financially sustainable Universal Service.



Mandated access and the ‘headroom’ control created an environment where the majority of upstream volumes have moved from Royal Mail to access competitors. By 2013-14, addressed letter access volumes passing through the Royal Mail Core Network comprised c.7.1 billion items or more than 50% (by volume) of all addressed letters handled by Royal Mail. In no other EU country is more than c.25% of upstream letters volumes accounted for by access competitors.



Existing upstream volumes enable a direct delivery entrant quickly to build a local business in dense urban areas and so realise the arbitrage opportunity presented by the USO. They act as a bridgehead. The UK’s access regime accentuates – and accelerates - the threat to the Universal Service represented by direct delivery.

1

1.1.

The benefits to consumers of the Universal Service

Royal Mail’s customers value the important Universal Service which we are proud to deliver. Our customers, wherever they are in the UK, benefit from our commitment to a high quality collection and delivery service on which they can rely. In March 2013, Ofcom confirmed that the Universal Service was affordable for consumers, met the needs of individuals and business users, and is highly valued by them: “Universal postal services are affordable for almost all residential customers, including low

income and other vulnerable consumers, at current prices and prices to take effect in April 2013.”9 “Universal postal services are affordable for UK businesses, including small and medium businesses.”10 “We have concluded that the postal market is currently meeting the reasonable needs of

users and is highly valued by residential users and businesses across the UK. Therefore, we have decided not to change the scope of the Universal Service.”11 Ofcom surveys show that people recognise a wider social benefit from the Universal Service, for instance in supporting rural communities and to some extent in supporting the elderly. This was reflected in the different patterns of usage among households, with post being more important than average to users aged 65+, disabled and housebound users, and those in rural and offshore areas.12 Royal Mail’s national network helps small and large businesses find new customers as well as delivering to their existing ones. It is a particularly crucial lifeline for many rural communities and businesses.13 Independent surveys of Royal Mail’s customers demonstrate strong support for the service delivered, clearly and consistently over many years. In recognition of the wider societal benefits of the Universal Service, Royal Mail, as Universal Service Provider, is granted VAT exemption status on certain services. The public policy rationale is that this allows the provision of the Universal Service at a reduced price to the benefit of users. The European VAT exemption for postal services14 falls within the category “Exemptions for Certain Activities in the Public interest” in EU VAT legislation.

9

Ofcom, The affordability of universal postal services (19 March 2013), para. 1.8 (ibid) para. 1.9. 11 Ofcom, Review of postal users’ needs: an assessment of the reasonable needs of users in relation to the market for the provision of postal services in the United Kingdom (27 March, 2013), para. 1.3. 12 (ibid) para. 5.10 13 Ipsos MORI research - Postal User Needs Qualitative Research MC: MCMR/003 August 2012 14 Article 132.1(a) of Council Directive 2006/112/EC (known as the VAT Directive), since October 2006 10

2

1.2.

Impact of the Universal Service Obligation on postal network economics

The obligation on Royal Mail to provide the Universal Service requires the business to maintain an inherently high cost network infrastructure. Royal Mail must be capable of delivering to 29 million addresses, and collecting mail from around 115,000 post boxes and 11,500 Post Offices six days a week. It must do so to a high common service standard for a uniform price. The costs of providing this service are not uniform, and are largely fixed – deriving from the requirement to serve every address six days per week. Urban areas have high delivery point densities and higher numbers of items per address. This makes the unit cost of delivery lower in these areas, whereas the revenue generated per address tends to be higher than average. In providing the same service to all addresses, Royal Mail must therefore utilise revenues derived from urban areas to offset the higher unit costs and lower revenues from more rural areas. Overall, Royal Mail is seeking to generate a reasonable commercial rate of return on all the costs of providing the Universal Service. Direct delivery entry targets precisely those areas of higher revenue and lower costs, as well as targeting easier to handle mail and operating at a three days per week frequency. Our analysis illustrates that offering an every other day service confers a cost benefit of around 40% to a direct delivery entrant compared with operating a six-day delivery network. Further cost advantages flow from delivering only certain types of mail and only in certain parts of the country. Direct delivery reduces the revenues available to support the Universal Service and increases Royal Mail’s unit costs in urban areas. It therefore creates a clear threat to the finances of the Universal Service.

1.3.

Consequences of the USO for Royal Mail’s costs

Royal Mail can scale some processing parts of its business better to match projected lower mail volumes and workload more effectively. But that is much less true of the ‘first mile’ and ‘last mile’ of Royal Mail’s collection and delivery network. While traffic falling within the Universal Service represents a minority of Royal Mail’s revenue (c.33% in 2012-1315), its requirements define the majority of the cost base. This creates a high degree of operational gearing for Royal Mail because so much of its cost base is relatively inflexible to changes in volume. []. Aspects of the UK postal service place specific costs on Royal Mail compared with many other European postal operators. For example, our delivery staff usually walk up to individual front doors rather than leave post at communal collection points for flats or streets. We are committed to this delivery approach which we think benefits consumers. However, such an approach creates a higher cost structure, and leads to a greater level of increase in unit costs when volumes are declining.

15

Royal Mail regulatory accounts for 2012-13 3

Figure 1.1: Implications of the Universal Service requirements for Royal Mail’s business USO Requirement

What this means

Deliver letters Monday to Saturday (excluding bank holidays) to every address in the UK (and parcels every weekday)

A delivery person has to be able to visit each street and village road in every area of the UK six days a week, even if the volume of mail falls substantially. Mail volumes cannot be accumulated to make fewer deliveries per week of more items per address point.

Provide a parcel delivery service (up to 20kg)

The ability to deliver both letters and parcels to all areas of the country on every weekday.

Maintain a network of access points (for posting by users) at a prescribed density. Make at least one collection of letters every Monday to Saturday (and weekdays for parcels)

The servicing of a given network of collection points six days a week regardless of how few letters are in each post-box.

Meet high quality of service targets: delivery of at least 93% of 1st class mail by the next working day and 98.5% of 2nd class mail within three working days

Contributes to the high fixed costs of the USO, because of the need for timely delivery on a consistent basis throughout the UK and across the whole year. Royal Mail faces regulatory sanctions if it fails to meet the high quality standards.

Provide services at an affordable, uniform tariff

Inability to charge more for expensive-to-serve areas. So revenues raised in lower cost-to-serve urban areas must be offset against the higher cost of rural areas. Constraints on simply increasing prices across the board as prices must remain affordable to all UK households and businesses.

The resources needed to fulfil the outdoor delivery part of the USO are relatively invariant to changes in mail volumes. This results in significant economies of scale as volumes increase, and economies of scope between letters and parcels. Conversely, when volumes fall, either overall or in one product (such as letters), Royal Mail suffers from the reverse effect.

1.4.

Obligations under the EU Postal Services Directives and UK legalisation

1.4.1. EU legislative framework European legislation is clear on the Universal Service objectives, although it leaves the Member States to decide how best to achieve them. EU legislation “mandates” the primacy of maintaining a financially sustainable Universal Service, and specifies certain minimum requirements. Safeguarding the Universal Service is therefore a fundamental feature of the EU’s postal legislation, sitting alongside the aim of liberalisation of the postal market. Directive 2008/6 recognises that “greater competition and choice means that Member States should be given flexibility to determine the most efficient and appropriate mechanism to guarantee the availability of the Universal Service” (emphasis added).

4

The Postal Services Directive leaves it to Member States to design the postal services system which best suits their national requirements. In the UK, as explained below, a regulatory approach was historically taken which favoured access competition.This means the UK is the only country that has mandated access in such a way that it has driven over 50% of all addressed letters, and c.70% of the volume of addressed letters posted by large businesses, to operators other than the Universal Service provider.

1.4.2. UK legislation In the UK, the Postal Services Act 2000 (PSA 2000) conferred on Postcomm a range of duties and powers, including a duty “to ensure provision of a universal postal service” (section 3), and other duties, subject to this duty, “to further the interests of users of postal services, wherever appropriate by promoting effective competition between postal operators” (s.5(1)) and, subject to s.3 and s.5(1), “to promote efficiency and economy on the part of postal operators”. The changing competitive context and the structural decline in letter volumes, was recognised in the Postal Services Act 2011 (PSA 2011).16 The PSA 2011, which transferred regulatory responsibility to Ofcom, sets out clearly the regulator’s primary duty: “to carry out its functions in relation to postal services in a way that it considers will secure the provision of a universal postal service”. Ofcom must have regard to the need for the provision of the Universal Service to be efficient and financially sustainable. This includes a reasonable commercial rate of return for the Universal Service provider. The PSA 2011 clearly delimits the scope of Ofcom’s general duties under the Communications Act 2003 (CA03). In the event of a conflict between the duty to secure the Universal Service under the PSA 2011 and the general duties set out in CA03, the legislation is very clear. The sustainability of the Universal Service must take precedence.

1.4.3. The previous regulatory framework favoured access competition Under the PSA 2000 regime, Postcomm decided to favour the development of access competition. The economic context for this regulatory approach was a backdrop of growing postal volumes. Within this relatively benign environment regulation was focused on promoting competition. From 2005, the UK postal services market changed profoundly as letter volumes started to decline. Yet the regulatory framework for access remained broadly unchanged. By 2007-08, access volumes at 4.1 billion items were 60% higher than the 2.6 billion that the regulator had projected in 2005 (Figure 1.2). In 2006 price regulation was introduced on mandated access, as a safeguard against the risk of ‘margin squeeze’ by Royal Mail on access competitors. Royal Mail had to ensure that there was sufficient ‘headroom’ between the access price and Royal Mail’s equivalent bulk mail service. The headroom was set on the basis of the prices that were in force at the time, at a level some way above Royal Mail’s upstream costs, and so promoted access competition.

16

Postal Services Act 2011 S.29 5

The UK has the most developed access market in Europe, in large part due to the encouragement given to it by the previous regulator and the historic restraints placed on Royal Mail in competing with access competitors. Even if access competitors had upstream costs higher than Royal Mail’s own costs, they would still have been able to flourish safe in the knowledge that Royal Mail was constrained in its ability to respond on price by virtue of the access headroom regime. This system allowed operators to gain volume quickly and to develop customer relationships. Predictions of the pace of growth of access competition were also significantly underestimated (Figure 1.2).

Figure 1.2 Projections from 2005 of access mail volumes17 7,000

Millions of items

6,000 5,000 4,000

Postcomm Access Forecast

3,000

Actual Access Volumes

2,000 1,000 0 2005/6

2006/7

2007/8

2008/9

2009/10

The 2008 Hooper report for Government concluded that while access competition had brought some benefits to consumers in the form of keener prices (if not greater innovation), the regulatory regime for access was not sustainable and needed reform18. In particular, Hooper recommended that the regulator review the relationship between the regulated access headroom margin and Royal Mail’s costs, the incentives that regulation provided Royal Mail for efficiency, and the need for improved cost transparency. In 2010, the headroom price control was moderated, including a reduction in both the services covered and the actual headroom, so that the control was set by reference to a basket of prices.

17

Source: Postcomm, Royal Mail Price and Service Quality Review Final Proposals for Consultation, December 2005, Table 9.4, and Royal Mail data for Actual Access Volumes 18 Hooper Report: Modernise or decline - Policies to maintain the universal postal service in the United Kingdom - An independent review of the UK postal services sector, 2008, paragraphs 196-202 6

1.4.4. Access competition is different in the UK compared with the rest of Europe. It has a significant financial impact on Royal Mail In 2012, there was a loosening of the access regime. Royal Mail is now only mandated to deliver access for D+2 (and later)19 mail delivered by the access competitor at the Inward Mail Centre. The formal headroom price control was removed, leaving the margin squeeze test on Royal Mail’s access pricing, which is more akin to competition law. Overall, however, Royal Mail is still required to provide access and is subject to regulatory oversight and potential constraints arising from this. The combination of declining letter volumes and increasing access volumes has had a significant impact on Royal Mail’s overall letter traffic. Royal Mail’s share has dropped from 94% of upstream volume in 2006 to c.44% in 2013-14. The UK stands in marked contrast to most other European states20. In no other EU country is more than c.25% of upstream letters volumes accounted for by access competitors. In Germany, access competitors are estimated to handle c.11%-12% of volume. In France, the level is estimated to be c.25%. For all other EU states, no precise figures are available but the market share of access competitors is understood to be significantly lower than 50% of business mail, and no more than 25% of all mail.

Figure 1.3: Downstream Access and mandated access are different in the UK21

19

D+2 (and later) refers to the delivery speed of mail items, which are delivered to the recipient two days or later after posting into the Royal Mail network. 20 EU postal operators do not publish information on access volumes. The information here has been sourced through National Regulatory Authorities’ annual reports, interviews with EU posts, and Royal Mail analysis of operators’ annual reports. 21 Source: Royal Mail 7

By 2013-14, access accounted for c.53% of all addressed letter volume. When Royal Mail loses a customer to an access competitor, the impact on revenue per letter is a loss of typically around 4p depending on product, with Royal Mail retaining the Downstream Access (DSA) price of typically around 20p. When a customer is lost to an end to end operator all revenue is lost. Moreover, the collection and upstream processing of mail offers greater scope for cost responsiveness, scaling resources to projected volumes, than is open to Royal Mail in the downstream processing and ‘last mile’ delivery of items.

1.4.5. The structure of the UK access market facilitates direct delivery The previous regulatory regime and the continued price controlled mandating of DSA for D+2 (and later) services at Royal Mail’s Inward Mail Centre exacerbates the potential for cherry picking on several levels: 

Entry into local markets: Mandated DSA permits operators to enter the delivery market at a local level whilst still offering a national service to its customers. Operators can use Downstream Access to Royal Mail’s network for delivery of items in areas which they do not serve thereby enabling entrants to target the most profitable areas.



Targeted delivery within areas: Operators can choose to deliver to only those delivery points which are cost effective for them. []. This demonstrates the selectiveness with which an entrant can operate within the current regulatory structure.



Tailored to core rather than peak volumes: A direct delivery operator does not need to maintain the capacity to deliver all of the mail all of the time from its upstream operation into its local delivery areas. It need not carry costly excess capacity to handle periods of peak demand as it can hand excess traffic to Royal Mail to deliver through DSA. This enables an entrant closely to match its capacity to forecast volume. However, this in turn passes volume variability risk, and associated costs, to Royal Mail.

Significantly, access volumes constitute a bridgehead to direct delivery. They enable an entrant quickly to build a local business in dense urban areas and realise the arbitrage opportunity presented by the USO. Access operators have their ‘hands’ on the mail, which they can simply divert into their own downstream delivery networks to the extent that it has been profitable to develop them in a particular area (and to the extent it is not profitable for the operator to deliver to a particular area, the operator can force Royal Mail to do it for them, under the mandated access service). The UK’s historic approach to regulation, which has promoted access competition, therefore accentuates the threat to the Universal Service represented by direct delivery. Further analysis is provided in chapter 4.

8

Conclusions 

The Universal Service matters for consumers and businesses across the UK. This is recognised in the PSA 2011 and in Ofcom’s own studies.



The way in which access has been mandated in the UK has resulted in competitors holding over 50% of all letters and c.70% of the volume of addressed letters posted by large businesses. Nowhere else in the EU comes close to this level of access competition.



The UK is particularly susceptible to direct delivery competition as access volumes act as a bridgehead to direct delivery.



The combination of high access volumes and direct delivery significantly increases the vulnerability of the Universal Service.

9

2.

The challenge of declining letters traffic Summary 

Letters in total accounted for 59% of UKPIL revenue in 2013-14. They are vital to sustain the Universal Service.



UK total inland letter volumes have been declining, driven by e-substitution and low underlying GDP growth.



Addressed letter volumes are forecast to continue to decline by around 4-6% p.a. in the medium term.



Less mail is being delivered to each address. Volumes per household have declined by around 40% since 2004-05. They currently stand at a level last seen in the mid-1980s.



Business mail is greatly at risk from e-substitution. These letters are easier to process and valuable to Royal Mail.



This structural decline creates a particularly challenging environment for Royal Mail and for the finances of the Universal Service

2.1.

Royal Mail’s mailbag

Royal Mail’s mailbag is made up of the six categories set out below (with weighting by volume22). The revenue composition is somewhat different. This is mainly due to the higher average unit revenue of parcels significantly increasing the revenue share of this category23. 

Business mail []: bank statements, bills and invoices, government communications, and other business correspondence. This is the segment of mail that is most at threat from esubstitution. Moreover, as explained in chapter 4, business mail, being mail which is often posted in bulk and which can use a later than D+1 delivery24, is also most at threat from being diverted into the network of a downstream competitor – bulk mail is predominantly handled by access operators;



Marketing mail []: addressed and unaddressed advertising mail;



Publishing mail []: magazines, journals and newsletters;



Social mail []: cards and other social correspondence;

22

Source: Royal Mail, 2013-14 data Percentages may not add to 100% due to rounding 24 D+1 Delivery refers to a 1st Class delivery service where items are delivered 1 day after being handed to Royal Mail 23

10



Parcels []: sent by businesses and consumers; and



Other []: international and other letters products.

Letters share of total volume has declined and parcels increased. However, letters still account for the majority of UKPIL’s revenues (59%). It is trends in letters that are setting the key financial challenge for Royal Mail and the Universal Service.

2.2.

Letters: declining volumes

In 2013-14, Royal Mail handled approximately 13.3 billion addressed letters and 3.1 billion unaddressed letters. UK total addressed inland letter volumes declined by c.6% p.a. between 2008 and 2014. These declines are expected to continue, albeit at a slower rate. Addressed letter volumes are projected to fall at c. 4-6% p.a. in the medium term. There are three broad categories of letter services: 

End to end: The collection, transporting, sorting and delivery of letters by a single postal operator (referred to as direct delivery in this submission).



Network access: Royal Mail is required to provide customers and other postal operators with access to its core network at the Inward Mail Centre. This allows third parties to collect, transport and sort letters (the upstream activities) before handing them over into the Royal Mail for final delivery to end-recipients (the downstream activities). Royal Mail’s key competitors in the upstream market are TNT Post, UK Mail and Secured Mail.



International: Royal Mail has relationships with postal administrations around the world to facilitate the import and export of letters to and from the UK.

2.2.1. Decoupling of economic growth and Royal Mail postal volumes Until the early 2000s, Royal Mail’s postal volumes tended to rise and fall broadly in line with changes in the UK economy. Since around 2002-03, this simple relationship has decoupled. Changes in mail volumes are now less directly related to patterns of GDP growth (Figure 2.1).

Figure 2.1: [] The main structural factor causing this decoupling is the substitution of paper-based for electronic communication i.e. e-substitution. The combined effects of low GDP growth and increasing esubstitution have significantly reduced letter volumes over the past decade. Business mail is at high risk of e-substitution, which is likely to erode further this significant revenue stream for Royal Mail. Many companies are taking active steps to migrate customers onto email, web and SMS as the default means of communication.

11

2.2.2. Declining volumes and an increasing number of households puts pressure on delivery costs The effect of the decline in letter volumes is exacerbated by the rise in household numbers. Together, these factors raise unit delivery costs. The number of UK households increased by 11% in the last decade. This is projected to continue to increase by around 1% p.a., and in turn tends to increase the number of delivery points at a similar rate. Less mail is being delivered to each address. Traffic volumes per household have declined by around 40% since 2004-05 and currently stand at a level last seen in the mid-1980s (Figure 2.2). This combination of more households and lower volumes puts further pressure on the costrevenue equation for Royal Mail.

Figure 2.2: [] 2.3.

Projections of future postal volumes

In 2013, as part of its prospectus for the sale of shares, Royal Mail projected postal market trends in the UK. Addressed letter volumes were projected to decline by approximately 4-6% per year over the medium term. PwC published an independent view on the outlook for UK mail volumes up to 202325. This assessment reached the following conclusions: 

Letters: PwC expect the decline of letter volumes to continue but at a slower rate over the projection period. The main driver of mail declines has been electronic substitution of paper communication. As time goes on, the remaining base becomes more skewed towards ‘paperloyal’ consumers and those being sent higher value communications. PwC expect demographic changes and technology evolution to have a less prominent impact on this segment. A return to GDP growth as the recession ends is likely to increase overall communication volumes, partially offsetting the declining share of letters in overall communication, particularly for Direct Mail. PwC expect the overall UK inland mail volumes to continue to decline albeit more slowly than we have seen historically: 5% p.a. decline 2013-18 and 4% p.a. decline 2018-23.



Parcels: PwC expect declines in letter volumes will also continue to be partially offset by robust growth of parcels traffic, driven by specific categories of online shopping PwC projected parcels volumes to increase at 3% per annum increase in the period 2013-18, 2% per annum in the later period 2018-23.



Overall: Despite the slowing rate of decline in overall mail, these projections imply a significant reduction from current levels of paper communication by 2023, as well as a substantial change in mix (we believe parcels will double their share of the mail bag to c.21%)

25

PwC Strategy & Economics: The outlook for UK mail volumes to 2023. 11 October 2013. 12

2.3.1. Impact of changing volumes on composition of Royal Mail revenues In 2013-14, letters accounted for 59% (£4.6bn) of UKPIL revenue26. Letter revenue has been largely unchanged in nominal terms since 2010-11. Recent declines in letter volume have been offset by above inflation price increases (

Figure 2.3 2.3). These have been necessary to make up for the pricing constraints placed upon Royal Mail by the previous regulatory regime.

Figure 2.3: Composition of Royal Mail UKPIL revenues

Revenue £ million

5,000 4,000 3,000 Parcels

2,000

Letters

1,000 2010/11

* adjusted 52 week basis Source: Royal Mail

2011/12

2012/13*

2013/14

Financial year

Despite these price increases, Royal Mail still compares favourably with other European postal operators. Both First and Second class Stamp prices are below the European average. Royal Mail also offers the option for a next day and three day delivery service. Many other European countries – including Germany, Netherlands, Spain, Austria, Ireland and Belgium - do not have a lower priced, later than next day delivery option. Royal Mail does not plan – or indeed believe there is scope within the market – to increase prices significantly. We expect future price increases for letters to be broadly in line with retail price inflation. As volume continues to decline, letters revenue contribution to the total of UKPIL revenue is expected to fall. Over time, the composition of Royal Mail’s delivered mail has also shifted, which has tended to dilute revenue. ‘Downtrading’ within the letters portfolio has worked to reduce the average unit revenue achieved for letters, as business customers have over time moved traffic from stamped mail to metered mail and to pre-sorted bulk and access mail. First Class and Second Class unsorted traffic27 each now account for [] of total addressed inland mail volumes. Lower value

26 27

Including Other and unaddressed Mainly Stamp, Meter, USO account and unsorted business letters traffic 13

bulk and access traffic now account for [] of mail volumes28. Letters posted by large businesses and access mail are particularly susceptible to downstream delivery competition. Upstream operators have control of the relationships with customers who post this type of mail and can divert it into their downstream delivery operations, where profitable to do so. These long run trends are likely to continue.

Conclusions

28



E-substitution combined with growing household numbers (and inflation) has increased the underlying unit costs for Royal Mail in meeting the Universal Service obligation over the past decade. The speed and intensity of change in individual and business communications has created a challenging market for us.



Mail volumes have declined significantly since 2005. This trend will continue. All that is at issue is the speed of decline. This is a fundamental structural pressure on the USO.



The USO imposes constraints on Royal Mail’s network, which creates a high degree of operational gearing and tends to increase unit costs as volumes fall.



The UK mailbag has a high proportion of business mail. This type of mail – much of which is already handled upstream by access competitors – is particularly susceptible to esubstitution and direct delivery competition.

Source: Royal Mail, data for 2013-14 14

15

3. Royal Mail’s response: growing our parcels business and improving efficiency Summary

29



Royal Mail’s strategy is to be a successful parcels business. We aim to offset the decline in letters with growth in parcels and increases in efficiency.



Growing our parcels business is challenging given the intensity of competition, the impact of new business models and technological innovation.



Our business plan targets productivity gains of 2-3% per annum in collections, processing and delivery in the coming years.



We have recently signed an important new agreement with our trade unions which will provide the framework to drive efficiency savings.



Royal Mail has undertaken a major transformation programme since 2007-08, following a long period of underinvestment. Our transformation programme is delivering greater productivity and operational flexibility: o

We have reduced the number of our Mail Centres by 42% since 2007-08;

o

We have modernised 94% of our Delivery Office estate;

o

Royal Mail will employ fewer people in future - we have already initiated a major Management Reorganisation Programme.



We have reduced costs in central functions (including via our 2010 and 2014 management reorganisations). We have delivered a 3% reduction in non-people costs in UKPIL in 201314.



NERA’s recent report for Ofcom recognises that the USO limits the extent to which Royal Mail can take costs out of delivery functions29. OXERA’s analysis shows that the productivity levels targeted by Royal Mail are challenging yet plausible.



Direct delivery does not contribute to the already strong incentives on Royal Mail to seek greater efficiency across its business. Lower workload in Royal Mail’s delivery network, combined with a constrained ability to reduce hours, tends to reduce productivity.

http://stakeholders.ofcom.org.uk/binaries/post/postal-efficiency/nera.pdf 16

3.1.

Parcels: Royal Mail’s strategy

UKPIL delivered 1.1bn parcels in 2013-14 through both its core mail delivery network (over 90%) and Parcelforce Worldwide (less than 10%). Parcels accounted for £3.2bn of revenue, some 41% of the total UKPIL revenues. The scale and configuration of Royal Mail’s core network enables low cost foot delivery of small business-to-consumer (B2C) parcels. It is difficult for business-tobusiness (B2B) competitors to adapt their networks for the B2C segment in the UK. Furthermore, the core network is well suited to serving SMEs across the whole country. Royal Mail has a clear vision to be recognised as the best delivery company in the UK. We aim to capitalise on growth in online retailing to grow our parcels businesses. Our transformation programme in our UK network is adapting our capability to accommodate the change in traffic mix from letters to parcels. We are also looking to innovate to meet customer needs. For example, we recently opened up our network at weekends to process parcels for large customers and will be trialling Sunday parcel deliveries and Sunday opening at Delivery Offices. As the market leader, Royal Mail is well positioned in the parcels market in terms of both revenue and volumes. However, competition is tough and intensifying. Maintaining and growing our share of parcel revenues within the market will be challenging.

3.1.1. Technological change Over recent years, e-retailing has driven parcel volume increases in the UK. Competition is intense and capacity is increasing. We are focused on maintaining our leading position by becoming increasingly flexible and efficient, and offering additional service features and options. While our volumes are driven largely by growth in e-commerce, we do not benefit from growth in all areas of e-retailing. For example, we do not operate in all online segments and are under-represented in some areas, such clothing and shoes. We are now focusing on faster growing market segments. We are increasing the proportion of items we can carry cost-effectively on foot, enabled by trolleys.

[]

3.1.2. Intensely competitive market in parcels While competition has long been a key feature of the UK parcels market, new entry has occurred and existing players have expanded. Innovation is a key feature of the market, both in changing how parcels are delivered and changing the scope of what is delivered. Retailers and e-retailers continue to develop in-house Click & Collect and returns services. Third party Click & Collect continues to grow. Amazon’s expanding own-delivery network has added capacity equivalent to a new operator. Demand is being aggregated by major online market-places, such as Amazon. Specialist e-commerce delivery platforms, such as Metapack, are also growing in influence. They connect online retailers with a wide range of carrier networks in the UK and internationally. Competitor delivery companies are increasingly able to offer added-value customer services through technology, such as electronic notification of delivery which is being offered by more express carriers. They are also innovating in their pricing, such as myHermes response to Royal Mail’s own pricing size-based pricing for consumers and SMEs introduced in April 2013. DPD and 17

Hermes have announced that they will each commence Sunday deliveries, and Yodel has launched a courier collection service for online traders. Competitors, such as DPD and Hermes, are also putting in place additional capacity.30 Royal Mail is working hard to maintain its position in an increasingly competitive parcels market. We are also focusing on improving our efficiency and productivity.

3.2.

Improving efficiency

Royal Mail’s core operations have undergone a major transformation – one of the biggest industrial transformations in the UK in recent history. This has improved the effectiveness of Royal Mail. We are better equipped to handle the number of parcels being sent through the core network and can deliver both parcels and letters more efficiently. A summary of the key metrics of Royal Mail’s transformation programme is set out in Figure 3.1. Among the major achievements delivered are a reduction of 42% in the number of Mail Centres and an increase in the proportion of letters sequenced for delivery to over 80%.

Figure 3.1: Royal Mail Transformation Programme key metrics (selected)31 2007-08

First Class Retail Quality of Service32

2008-09

2009-10

2010-11

2011-12

2012-13

2013-14

92.8%

93.0%

93.4%

92.6%

92.8%

92.5%

93.2%

Number of Mail Centres

69

68

64

59

57

48

40

New, Refurbished & Upgraded Machines

40

215

374

669

904

995

998

Letters Sequenced to Delivery Point

1%

1%

8%

34%

75%

79%

81%

Delivery Offices Undergoing Modernisation

-

-

1

110

408

860

1277

World Class Mail Sites Launched – Mail Centres

-

4%

19%

41%

79%

100%

100%

WCM Sites Launched – Delivery Offices

-

0%

0%

5%

14%

40%

98%

Between 2006-07 and the end of 2012-13, the Group invested a total of £2,795 million in the Transformation Programme. As a result, on the basis of post implementation reviews of completed projects, the Group estimates that it now bears approximately £0.5 billion less cost per year than it would otherwise have done.

30

Source: Royal Mail, Full Year 2013-14 Results presentation, 22 May 2014 Source: Royal Mail 32 Adjusted for force majeure 31

18

During the last four financial years, the Transformation Programme has delivered annual productivity improvements of 4.4%, 3.2%, 1.7% and 1.7% in 2010-11 through to 2013-14. Productivity growth has been due to improvements in mail processing, mail delivery and a reduction in headcount (Figure 3.2). The slowing rate of improvement has been caused primarily by the decline in workload over the period and our inability to reduce hours at a faster rate.

Figure 3.2: Trajectory of productivity and employment 146

5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%

thousands employed

144 142 140 138 136 134 132 130 2011

2012 2013 financial year ending

Productivity improvement YOY (%) Operations People Employed

2014

3.2.1. Mail processing Royal Mail has responded to the decline in workload by undertaking a radical transformation of its Mail Centre estate. Figure 3.3 below documents the Mail Centre closure programme. UKPIL now has 40 operational Mail Centres. Between 2008-09 financial year and 2013-14, 33 Mail Centres have been closed (and 4 new modernised Mail Centres opened). Of the closed Mail Centres, a number are kept within the business to facilitate further property estate consolidation, for example providing the opportunity to rationalise smaller local Delivery Offices into a single site.

19

Figure 3.3: Mail centre transformation

In addition to reducing the number of Mail Centres, Royal Mail has modernised its remaining Mail Centres. As of 31 March 2014, 998 new, refurbished or upgraded machines had been installed into the Mail Centres and Delivery Office network. These reduce the level of manual sortation required and enable automatic sortation of letters to match the delivery sequence, so improving productivity.

3.2.2. Delivery Office and Logistics modernisation Royal Mail has an estate of approximately 1,400 Delivery Offices. They are a key part of the core infrastructure required for the USO. As at March 2014 94% of Royal Mail’s Delivery Offices have completed or commenced modernisation. Delivery modernisation focuses on adapting delivery to serve the changing postal market more effectively. This is achieved through automated walk sequencing, deployment of new delivery methods including trolleys and vans, improved office layouts and equipment for manual preparation, and extended delivery spans. Productivity is further improved by better matching resource to variations in workload. Royal Mail has also modernised its logistics function. Double-decker trailers and shared delivery vans have been introduced. We centralised procurement, management and maintenance of the vehicle fleet and optimised the vehicle replacement cycle and servicing network.

3.2.3. Impact of transformation The impact of the transformation programme is shown by the progressive reduction in staffing across different parts of the business. Those areas most amenable to rationalisation have shown

20

most progress, while the rate of reduction in Delivery Office staffing has been below the average for Royal Mail operations. Mail Centres have delivered productivity improvements of [] since 2007-08, through rationalisation of centres and staff reductions. Royal Mail has also been able to achieve productivity gains here in indoor delivery processing, by reorganising and streamlining the activities within each Mail Centre. Delivery operations, by contrast, have achieved [] productivity improvement over the same period, having recovered from falling productivity in the recession of 2008-2009. This reflects the relatively fixed cost nature of these parts of the pipeline due to the USO requirements around delivery.

Figure 3.4: [] []

Figure 3.5: [] 3.3.

NERA’s report on efficiency

Ofcom recently commissioned a report from NERA on measuring postal efficiency33. Its key conclusions are set out below.

Measuring Postal Efficiency – NERA report for Ofcom 

There are significant differences between post and other regulated industries. These include declining demand, the form and extent of competition and the high labour intensity of the postal industry. These are important features to take into account when assessing efficiency.



There are economies of scale and density in providing mail services. This means that unit costs typically fall when volumes increase and rise when volumes fall. This is also the case even if underlying efficiency is unchanged. The combination of scale economies and falling volumes could lead to increases in Royal Mail’s unit costs, offsetting the impact of efficiency improvements.



Postal costs are less responsive to volumes when demand is falling than when it is rising at least in the short term. These cost asymmetries affect how efficiency performance in post might be compared with other regulated industries.

Royal Mail’s business is labour intensive. The degree of labour intensity also increases the influence of trade unions. This could make it more difficult to implement efficiency improvements

33

NERA Economic Consulting, Approaches to measuring the efficiency of postal operators, January 2014 21

that require changes to working practices or reductions in staffing levels (especially if falling volumes are already reducing labour inputs).

3.4.

On-going restructuring

Since 2003, more than 50,000 people have left UKPIL34. 12,000 people have left since 2010. A Central Restructuring Programme was initiated in August 2010 to reduce the number of people performing roles outside of direct operations, deliver staff cost savings and centralise support functions. This resulted in more efficient structures and greater individual accountability. []. In spring 2012, Royal Mail restructured its operations and modernised its management structure to support and improve the focus of operational management. The reorganisation reduced the number of management posts and thereby costs. The hierarchy was reduced by removing two layers of management, and is now slimmer than the vast majority of organisations benchmarked by PwC35. We announced on 25 March 2014 a further set of measures to enhance efficiency across the business, through a Management Reorganisation Programme. The changes entail a reduction of approximately 1,600 roles, with around 300 new or enhanced roles created. The vast majority of employees affected will be in the Group’s operational and head office managerial population. The programme is expected to deliver annualised cost savings of around £50 million, of which approximately £25 million will be realised in 2014-15. Royal Mail has one of the largest defined benefit (DB) pension schemes in the UK (the RMPP) which represents a significant on-going cost to the business. The costs of such schemes have been increasing throughout the last decade. Along with many UK corporates, Royal Mail has significantly reformed the scheme in order to contain its costs. The main items of reform include the closure of the scheme to new members (2008), the switch of future service from ‘final salary’ to ‘career average’ (2008) and the increase in the future service normal retirement age to 65 (2010). Since 2008 new entrants have been enrolled in the RM Defined Contribution Plan, a significantly more efficient scheme for the company with costs currently c.10% of pensionable pay (including additional National Insurance Contributions and life assurance costs) as opposed to c.17% for the defined benefit scheme (RMPP). Royal Mail further reformed its defined benefit pension scheme in 2013, with future pensionable pay increases capped at the lower of RPI or 5% (except for certain promotional increases). This crystallised a surplus in the scheme, enabling the Company to agree with the scheme Trustee that it could reduce its on-going cash funding to a level significantly lower than that which would otherwise have been required. This action facilitated the continuation of the scheme at least until the Company’s next pension review in March 2018.

34 35

Measured on a like for like basis, excluding Post Office Limited PwC, Measuring Postal Efficiency – report for Royal Mail, 2013 22

3.5.

A new industrial relations framework

In 2013, Royal Mail management and unions jointly created a new, legally binding, innovative industrial relations framework36. It is designed to provide a platform for industrial stability and a more flexible labour model. The new agreement represents a joint commitment to improve industrial relations and to create a can-do culture. Royal Mail and the Communication Workers Union (CWU) have committed to an Agenda for Growth, building partnership and participation across the company. Both parties are working together to develop and implement business strategies, respond to competitive challenges and develop new approaches to improve efficiency. The framework sets out a new approach to resolving issues at a faster pace and without disruption. The agreement, believed to be the first of its kind in the UK, includes legally binding terms covering industrial stability and employee protections. The framework included a pay deal involving pay increases totalling around 9% over three years which is broadly in line with forecast RPI. It is consistent with longer term pay trends and with shorter term pay pressures that are likely to accompany sharp falls in UK unemployment. A number of independent forecasters37 are currently forecasting UK average earnings to increase broadly in line with RPI.

3.6.

Future operational productivity plans and projections

Royal Mail is already doing everything it can on cost reduction and productivity improvement and aims to do more in future. We target annual improvements in productivity of around 2-3% across collections, processing and delivery. This reflects much higher projected levels of productivity improvement in those parts of the business (such as Mail Centre processing) with greater flexibility to respond to changes in the market, offset by lower levels of productivity improvement in the delivery network where costs are more fixed. Near term objectives for the business include:

36 37



Focus on productivity: use summer resourcing to create additional flexibility, further tightening the controls around variable hours and minimising use of casuals in delivery, introducing a programme dedicated to closing the gap in the high impacting delivery units;



Raising processing productivity and reducing performance variability across units; and



Improving customers’ experience of delivery and quality of service: including increasing first time delivery, improving the Enquiry Office experience and implementing weekend service enhancements.

Source: Royal Mail Regulatory News Service announcements 9 December 2013 and 5 February 2014 For example, Office of Budget Responsibility, Experia, Oxford Economic Forecasting 23

Medium term objectives include: 

Re-engineering the end-to-end pipeline processes: removing unnecessary work, simplifying indoor delivery preparation and maximising the value of automation;



Designing and implementing production control and supply-chain visibility solutions; and



Reviewing flexible resource models.

3.7.

[]

3.8.

Incentives on Royal Mail towards greater efficiency

The scale of the structural change to the mail and parcels markets means that we face a powerful incentive to improve efficiency. This incentive is greater than faced by most UK companies which benefit from market demand rising in line with economic growth. That market pressure is now allied with two important developments. First, Royal Mail faces the disciplines of being a public company, following the privatisation of the company. Second, there is now a potentially more balanced regulatory framework encouraging Royal Mail’s efficiency programme. Royal Mail considers that the balance of market and regulatory factors now is such as to provide a clear imperative towards increased efficiency. From a regulatory perspective, the 2012 changes have provided greater commercial freedom. As Ofcom itself said, detailed price controls did not provide credible incentives to efficiency. The revised regime, considerable market pressures and the need to deliver value for shareholders now do this, subject to regulatory review in line with Ofcom’s duty to ensure an efficient and financially sustainable Universal Service. Direct delivery does not add to these efficiency incentives. Rather, as explained later in this submission, it detracts from them and tends to reduce productivity. Royal Mail considers that Ofcom needs now to consider the risk that direct delivery may undermine some of the positive incentives from the revised regime, especially in the light of the announcement of a policy review of access pricing.

24

Conclusions 

Structural decline in letters requires Royal Mail to seek to take advantage of the opportunities in the growing parcels market and to increase its efficiency substantially.



Parcels growth is challenging given the intense and recently increased competition in the parcels market.



Royal Mail is continuing to focus on driving efficiency improvements across the business. It has undertaken a major transformation programme since 2007-08, after a long period of underinvestment.



Where costs can be tailored to volume or processes reorganised, there have been substantial improvements.



As recognised in the recent NERA report for Ofcom, the difficulty in removing costs in response to declines in mail volumes and associated workloads tends to raise unit costs for a Universal Service provider.



There is a relative high proportion of fixed costs in the final mile delivery network, where the structure of costs is driven by the requirements of the Universal Service and there is a relative insensitivity to volumes.



Royal Mail has strong incentives to improve efficiency and to innovate without direct delivery, which does not provide an additional spur.

25

4. Direct delivery: a threat to the Universal Postal Service Summary

38



There are long term factors in the UK which make the Universal Service in the UK particularly susceptible to the threat posed by direct delivery.



The UK has an uneven population distribution. Over 50% of all addressed letters are delivered within just c.10 % of UK landmass. At the same time, the UK has a significant portion of costly-to-serve rural areas: 15% of the UK population live in lower density areas equating to c.63% of total landmass.



Other major European countries do not generally provide the same opportunity for urban cherry picking coupled with such a significant portion of low density, more costly to serve rural areas. Dense urban areas are also rich in mail volumes. Mail volumes per household are over 1.5 times higher in parts of London compared with the national average.38



Royal Mail is responding to direct delivery as far as possible. However, the nature of outdoor delivery means that the opportunities to reduce costs are constrained.



The current access regime allows competitors to continue to hand mail items to Royal Mail for final mile delivery in any area it chooses, including low density, low volume areas.



Today TNT Post is estimated to handle [] of total inland mail upstream and to have c.5,000 direct customer relationships. Its direct delivery business model does not face regulatory constraints: it is free to determine its delivery frequency, coverage, and the type of mail items it delivers. This is cherry picking arbitrage.



Royal Mail’s analysis suggests that the majority of letter volumes are contestable by TNT Post. TNT Post can readily move letters it handles upstream as an access operator into its own direct delivery network, where it is profitable for it to do so.



As TNT Post expands its urban network it will benefit from economies of scale and scope. The reverse is true for Royal Mail, which must still meet all the costs of the USO.



In line with Ofcom’s guidance, in January 2014, Royal Mail used its commercial freedoms to mitigate the impact of direct delivery. Contractual clauses mean these proposed changes are now suspended pending the conclusion of Ofcom’s investigation into a complaint from TNT Post.

Royal Mail analysis 26

4.1.

The UK’s economic geography

The UK’s particularly uneven population distribution makes the USO more susceptible to cherry picking of mail in revenue-rich urban areas with both high delivery point density, and high mail volumes. England has a high population density (411/km2), and is home to 84% of the UK’s 63.7m population. However, the UK average population density is significantly lower (263/km2), since Scotland and other predominantly rural regions are sparsely populated. Scotland has 5.3m people, 8.3% of the UK population, living in 32.2% per cent of UK landmass, with a density of 68/km2 (77% below UK average). Moreover, within Scotland there is significant variation between the major cities and the rest of the country. The UK population centres on several high density corridors, one running from the south coast through London, into the Midlands and to North West England, and another in Scotland between Edinburgh and Glasgow. This concentration of high population in a relatively compact geography is closely reflected in TNT Post’s proposed network coverage (Figure 4.1).

Figure 4.1: TNT Post’s published roll out plan39

39

Slide presented by TNT Post at Market Force conference in September 2013 27

4.2.

Comparing the UK with European counterparts

The UK’s particular susceptibility to geographic cherry picking can be best demonstrated by comparing the UK’s population density to its European counterparts. No other major European country provides the same level of opportunity for urban cherry picking coupled with such a significant portion of low density, more costly to serve rural areas. Analysis of Eurostat data highlights the UK’s distinctive position40. While inter-country comparisons can be complicated by the area boundaries used by different countries, the general direction is clear; the UK has more densely populated areas than other European countries. Fifteen of the top twenty-five most densely populated NUTS level 3 areas are in the UK. Five of these are within London, with Inner London being one of the most densely populated areas in Europe, to which only Paris compares. Beyond London, the UK has a significant number of very high density areas, more so than any other European country (Figure 4.2). No other European country has as great a concentration of such high density urban areas in close proximity41.

Figure 4.2: Number of high population density areas by country Population Density per Square Km 4001+ 3001-4000 2001-3000 1001-2000

UK

Germany Sweden Netherlands

France

Spain

Other

8 14 9 12

2 2 19 52

-

1 5

4 -

-

3 2 8 8

Total

43

75

0

6

4

-

21

Total Nuts 3 regions

139

412

21

40

96

57

426

as %age of total

31%

18%

0%

15%

4%

0%

5%

40

Analysis in this section based on Eurostat NUTS Level 3 data. Generally, these refer to counties or groups of unitary authorities. Analysis between countries and regions is not always on a like-for-like basis due to the differences in size and number of administrative zones in different countries. 41 While Germany has more in total, they have significantly more areas (400) than the UK (140). They therefore make up a smaller portion of the total. 28

Figure 4.3: Population density of the UK and selected other countries42

42

Data: NSIs, Eurostat; Designer and cartography: Nordrigio (Johanna Roto); Published 2013 29

A feature of the UK’s population distribution is that it has both areas of high population density as well as areas of low population density. Much of Scotland and mid-Wales have population densities below 25/km2. These areas account for 25% of total UK landmass. The Scottish Highlands and Islands’ density of only 8/km2 is comparable only to northern Sweden43. However, Sweden has far fewer inhabited islands with the majority of the population grouped in accessible coastal towns.

4.3.

European case studies

In Sweden, direct delivery competitors deliver to over 50% of the addresses44. Their operations are centred in the southern regions around the cities of Stockholm, Malmo and Gothenburg. The underlying density characteristics of Sweden resemble those in the UK. The south is more densely populated while the north is large and sparsely populated. Indeed, the sheer scale of the northern region should imply that there is a greater cost associated with rural leading to a more uneven distribution of cost between urban and rural in Sweden than the UK. However, final delivery operations in Sweden (and access arrangements) are very different to the UK. Delivery to a mail box is the norm as opposed to delivery to the door. More importantly, only 70% of mailboxes are at or close to people’s homes with many significantly further away45. This will have a particularly prominent effect in rural areas as it reduces the area each delivery must cover. It also allows the opportunity to cluster post boxes and deliver multiple addresses items at once. This reduces the disparity in cost between urban and rural. The Netherlands, like the UK, is densely populated (404/km2). However, unlike the UK there are few significant rural areas. This implies a more even distribution of the USO revenue and cost base and so reduces the variation between geographic areas and the resulting potential for geographic arbitrage. While Germany’s population density is relatively comparable to the UK’s at 233/km2, its population is more evenly distributed. 27% of the UK’s landmass has a population density below the minimum density in Germany. This means there is potentially less need for the Universal Service to rely on urban mail volumes to support rural services in the Universal Service network in Germany. Relative to other European countries, the UK has higher per household mail volumes. UK households receive 583 items on average per year. This is 30% greater than Germany’s 450 items, 28% higher than Sweden’s 456 and 16% higher than the Netherlands’ 501. This further increases the risk to the USO since these are particularly concentrated in dense urban areas. For instance, mail volumes per household are over 1.5 times higher in parts of London compared with the national average46. This puts at risk the revenues from high density areas that are essential for support of the Universal Service network in less densely populated areas.

43

In terms of major European countries Swedish Post and Telecom Authority (PTS), Service and competition, 2013 45 Swedish Post and Telecom Authority (PTS), The Swedish population’s use of postal services, 2014 46 United Nations Economic Database, IPC, Royal Mail analysis 44

30

4.4.

The UK’s susceptibility to direct delivery

In summary, as shown in Figure 4.4, all other major European countries have to varying degrees a more even distribution of population than the UK. Most have populations less concentrated in high density urban areas and, therefore, present less opportunity for cherry picking. The UK also has a greater cost burden than many other countries from serving those in less densely populated areas – a greater share of its landmass is deeply rural. The impact of this has also to be assessed in the context of the different delivery arrangements applying in different countries. The UK’s delivery to each door will increase the cost of serving dispersed rural areas relative to arrangements which require less delivery to the door and/or greater aggregation of neighbourhood mail. This combination of geographical factors places more pressure on Royal Mail as the Universal Service Provider to gain sufficient revenues in revenue-rich urban areas to fund the rural network. Unfettered direct delivery competition thus risks undermining more quickly in the UK than other European countries the inherent cross subsidy underpinning the provision of the Universal Service.

Figure 4.4: European economic geography summary47

% of landmass covered by population living in lowest 15% of population density

70%

High cost-toserve rural areas

Sweden Portugal

60%

UK Revenue-rich urban areas

Spain 50% Greece 40%

Netherlands Italy

30%

Belgium Germany

France

Austria

Poland

Romania Bulgaria

Hungary

20% 10% -% 0

1,000

2,000

3,000

4,000

5,000

6,000

Average density of population living in top15% of population density (persons/ km2)

The UK’s greater susceptibility than most European countries to geographic cherry picking would have implied over time a threat to the USO in any case. However, this threat has been materially hastened and supercharged by the UK’s unique position in relation to the access market, as discussed in chapter 1. This enables direct delivery entrants to estimate accurately the volume

47

We have used a top 15% metric to illustrate the point. At a 10% metric, the results are distorted by the unique position of Paris within France. At a 20% metric, the results are broadly similar to those presented above. 31

potential of an area prior to entry, and then to build local market share upon entry very quickly. These factors combine to reduce both the risk and cost of entry while at the same time undermining the revenues in high density areas that are essential for support of the Universal Service network in less densely populated areas.

4.5.

Why direct delivery is an arbitrage of the USO, not fair competition

In a normal market, a business can compete to offer products or services that are more attractive to customers or which can be produced at a lower price. Other businesses in such a market will have the same basic opportunities available to them as their rivals and can seek to respond through innovations, improved production techniques, better quality or lower price. However, the postal services market is fundamentally influenced and shaped by the Universal Service Obligation. Royal Mail must, by law, fulfil its Universal Service obligations. This means it must have the capacity to deliver to every UK address, six days a week. This necessitates a particular network structure with an inherently high proportion of fixed costs. Direct delivery entails duplication of parts of this network, which therefore increases the total costs attached to the delivery of mail across the UK. When a direct delivery entrant targets only certain urban areas, delivering only selected mail types, and offering only a three days a week service it will inevitably have a lower cost base than if operating a six days a week service to every address in the UK. A direct delivery entrant can theoretically deliver the same volume of mail in three days as Royal Mail can deliver in six. This confers advantages as an entrant can maximise economies of scale by consolidating items across days. We estimate that the three day a week service confers a cost benefit of around 40% relative to operating a six-day delivery network. This means an entrant will have opportunities to price at a level below Royal Mail – regardless of how efficient Royal Mail becomes – because of the inherently higher costs attached to delivering the Universal Service. This does not represent fair competition. It is an arbitrage of the terms of the Universal Service. It also brings no obvious advantages for those receiving mail in terms of service or innovation – in fact it puts the ability to finance the Universal Service at risk. In the UK, the access regime enables direct delivery operators to offer their customers national coverage without having to incur the costs of delivering to the whole country. They can price to win business safe in the knowledge that Royal Mail must accept mail for delivery to areas they do not wish to serve. So a direct delivery operator is in fact arbitraging the very service that enables its business model to work and to offer the national coverage its business customers require. Similarly, customers of a direct delivery operator are effectively ‘free riding’ on the USO. They can secure a short-term cost advantage by switching to a direct delivery operator without taking into account the long-term consequences for the finances of the Universal Service on which they continue to rely for delivery in areas their chosen operator does not itself cover. In a normal market, arbitrage opportunities are usually short-lived as the market adjusts. In the postal services market, the USO means that this correction cannot take effect.

32

4.5.1. Structural imbalance and consequences for price competition Royal Mail’s cost base – as described above – will tend to be higher than a direct delivery operator that can choose where it enters, what to deliver and how often. Royal Mail’s prices must be set to cover the costs of delivering the USO. A direct delivery operator has the ability to price much lower if it can exploit its large cost advantages on frequency and location. This means it will likely see its market shares grow over time as it exploits this price advantage. As a result, there is no natural ceiling to the growth of direct delivery entrants’ market shares. It also means there is no level playing field for competition, and no efficiency response available to Royal Mail that can address the structural imbalance created. This dynamic is explored further below.

4.6.

TNT Post’s Business Model

Today we estimate that TNT Post handles over [] of total inland mail upstream and has c.5,000 direct customer relationships48. We understand that TNT Post has the contractual flexibility to determine the delivery method for the majority of its customers49. Over half of this upstream volume is already delivered through its direct delivery network in areas where TNT Post operates. TNT Post’s stated plan is to deliver to c.42% of UK delivery points by covering only 8.5% of UK landmass by 201750. It is able to do this by: 

serving only the densest population centres - taking advantage of the UK’s particular economic geography;



delivering mail originating from business customers, derived from both TNT Post’s national access contracts as well as locally-generated mail from businesses (for example from local authorities); and



delivering a lower cost, lower frequency three delivery per week service51.

This is classic cherry picking. Such locations and mail items are intrinsically easier, and therefore less costly, to deliver than the generality of mail across the UK52. This business model stands in sharp contrast to that of Royal Mail. It must deliver letters six days a week, and parcels weighing up to 20kg five days a week to all UK addresses. This contrast lies at the heart of the threat to the USO.

48

Source: Witness Statement of Nigel Graham Polglass, TNT Post UK Ltd, R (on the application of) v HM Revenue and Customs & Ors [2012] EWHC 3380 (Admin) (10 December 2012), para 8 49 (ibid) para 9 50 Source: TNT Post presentation at Marketforce conference, October 2013 51 According to TNT Post statements to the market 52 Comprising uniform sized letters, thin, letterboxable, deliverable first time – no need to return to a caller’s office or reattempt delivery 33

The current regulatory regime supports TNT Post’s direct delivery operation. It provides TNT Post with the ability to freely hand any mail which is not profitable for TNT Post to deliver itself (for example because it has to be delivered to a less dense area) or mail which is difficult to deliver, e.g. parcels and large catalogues, to Royal Mail for delivery through DSA. The general dynamics of access competition mean that TNT Post can initially divert a significant volume of mail into its direct delivery service, and achieve near instant economies of scale upon entry. Royal Mail understands that TNT Post is currently converting over 50% of this into its own ‘last mile’ network. If this were to increase it would further enhance these scale economies.

[]

4.6.1. Progress of direct delivery to date From commencement of its West London operation in April 2012, we estimate that TNT Post has rapidly expanded its coverage to [] of UK addresses. It has also simultaneously grown its local market share of letter traffic in the areas which it covers [].

[]

4.6.2. [] Figure 4.5: [] 4.6.3. [] Economies of scale could also play a significant role as TNT Post extends its direct delivery operation. These reduce costs and enable it to offer low end-to-end prices. These then incentivise further senders to move into its delivery network. This creates a ‘virtuous circle’ (Figure 4.6).

34

Figure 4.6: Dynamics for new entrant in direct delivery

In summary, our analysis shows that [] of the addressed letters market by volume is contestable under TNT Post’s current business model. The structural imbalance in costs between one company required to meet a Universal Service obligation and another that is able to cherry pick will be reflected in an on-going price advantage. There is therefore no natural equilibrium that would see direct delivery’s share of letters traffic settle at a level that still allows the finances of the Universal Service to be protected.

4.7.

Impact of direct delivery on the UK Universal Service

Royal Mail has examined the likely impact of direct delivery on the UK Universal Service. We have looked at the underlying cost structure a new entrant would face in the UK, based on proven models of a classic postal delivery network, in which local Delivery Offices are sited across urban areas to match capacity requirements and local population density. The result is an estimated distribution of Delivery Offices for the new entrant. This aligns to observed TNT Post operations in London, Manchester and Liverpool. TNT Post’s publicly-stated ambition is that it intends deliver to c.42% of UK delivery points through covering 8.5% of UK landmass by 2017. Based on our estimates of the impact of TNT Post UK's publicly-stated plans, this could reduce Royal Mail revenue by over £200 million in 2017-18.53 4.7.1. Estimating the cost of delivery Our analysis shows that economies of scale result from increases in local market share because increasing volumes through each delivery unit up to its capacity reduces unit costs. An entrant is incentivised to expand to all areas which it can serve at a cost below the payments it would have otherwise had to make to Royal Mail for DSA services.

53

Royal Mail Group plc, Preliminary Results for year ended 30th March 2014, May 2014 35

Even at low levels of local market share within a given postcode sector (or Standard Selection Code)54, our analysis estimates that the marginal cost - with increasing scale economies - is always significantly less than the average unit cost (Figure 4.7). This is because: 

there are high levels of fixed cost associated with walking between delivery points;



there is a reducing probability of having to make an additional delivery point call as a result of the marginal item; and



the marginal costs associated with processing marginal items during indoor activities, both at the Mail Centre and delivery unit, will reduce slightly as volumes increase.

Figure 4.7: [] The substantial revenue concentration in city markets, driven by the number of delivery points per mile of delivery walk, further increases the attractiveness of urban areas to competitors. In the UK the first 10% of delivery mileage55 across the UK accounts for 26% of mail volumes, while the last 10% of route mileage covers only 2.4%. The estimated costs of delivery, for any given local market share, vary substantially across the country. Categorising the UK by degree of urbanisation, it is apparent that the high concentration of population in urban areas allows for relatively low cost entry across nearly half of the UK delivery market which is located in densely populated conurbations. 4.7.2. Estimating entrants’ ability to grow market share Having achieved a higher local market share with a broader range of customers in a given geographical footprint, a new entrant could then replicate its direct delivery service across further (slightly higher cost to serve) local areas. The resulting higher share means costs across all areas fall, making it profitable to enter more areas. Having established wider service coverage, a new entrant would then again be incentivised to win further volumes from Royal Mail by cutting prices to capture volume via exploiting economies of scale. This two-stage process (increase volumes in each area served, increase number of areas served) creates a strong virtuous circle for any new entrant to enter and grow in successive urban areas across the UK (Figure 4.8). This effect will eventually level out for two reasons:

54



there are rural areas of the country that are unlikely to ever be profitable (e.g. mid-Wales, the Outer Hebrides); and



there are segments of the mailbag that are unlikely to be able to use such a network (e.g. first class, SME/consumers due to an absence of public access in the form of pillar boxes), parcels senders and senders of returns/response services.

Each sector covers around 10,000 addresses. These units can then be aggregated up into Standard Selection Code – SSC – the combination of one or more postcode areas, e.g. HA, NW: Harrow and North West London. 55 With Standard Sorting Code areas ranked by mail volume per km 36

Figure 4.8: [] [] The current publicly-stated position of TNT Post is that it intends to achieve a geographic footprint of c.42% coverage of UK delivery points by 2017. TNT Post could however profitably expand share in local markets and then proceed up the ‘growth spiral’ to expand its direct delivery operations and market share in steps. This growth path is more consistent with the dynamics of the access market as described above and the scope this gives to move large volumes into direct delivery. TNT Post’s business plan is therefore likely to underestimate the level of direct delivery competition which is likely to emerge. A rational entrant would likely proceed rapidly up the growth curve.

4.8.

Royal Mail’s operational response to direct delivery competition

Royal Mail’s operational teams have responded to direct delivery entry in local areas by tailoring processes and staffing as far as possible to the reduced workload. When direct delivery rolls out in a new area (or as soon as it is expected that direct delivery will roll out), the local management responds to mitigate the impacts on workload.

[] Given the requirement on each Delivery Office to maintain full daily coverage of delivery to every address, it is not possible to match reductions in mail volumes arising from direct delivery competition with proportionate reductions in work hours. As a result, labour productivity has fallen in affected offices. In some comparator offices in the control groups, productivity has improved. Royal Mail can and is responding to direct delivery as far as possible. In line with our general approach to efficiency, we are seeking to draw learning and best practice from parts of our network to inform new approaches in other parts. Where we can take costs out in response to volume declines we do. However, the nature of outdoor delivery in the context of the USO means that the opportunities to reduce costs in the part of the business most negatively affected by direct delivery are constrained. However, while staff hours have been reduced in areas affected by direct delivery, productivity has been impacted because the USO constrains Royal Mail’s cost response. Looking ahead, Royal Mail will continue to reduce costs in response to volume reductions. However, the associated reduction in productivity is likely to grow over time as the share of direct delivery in local areas increases the extent to which the fixed costs of the Universal Service have to be spread over a diminishing volume of mail. The resulting financial pressures and risks to the economics of the Universal Service will increase.

4.9.

Royal Mail’s commercial response to direct delivery: Access pricing

In the context of the commercial threat to Royal Mail from direct delivery competition, Ofcom has indicated that it expects Royal Mail to use the commercial freedoms afforded under the current regulatory regime to mitigate the impact of increased competition and support the finances of the Universal Service. 37

Royal Mail planned to offer access customers a lower price (by 0.25p per item) for providing a two year volume forecast for a national mailing profile across 86 local geographical districts, reflecting the cost benefits Royal Mail can realise as a result of greater volume certainty. Royal Mail also proposed changes to its Zonal Access contracts, which do not require provision of a volume forecast or a national mailing profile, which changed the price differential between the four zones56 to ensure they are more reflective of relevant costs and market conditions. In setting the price for each zone, Royal Mail has had regard to its own underlying costs using accepted regulatory cost measures and its best estimate of entrants’ costs. Royal Mail’s access pricing proposals are part of a longer term programme to adjust access contracts so that they better reflect the structure, operation and costs of maintaining the Universal Service. Access customers’ future volume intentions, including their local geographic posting profile, are a key part of this.

4.10. Impact of Ofcom’s investigation In February 2014, Ofcom announced that it would commence an investigation into a complaint that Royal Mail’s proposed access price changes were harmful to TNT Post. We deny the allegations and will defend Royal Mail’s proposed price changes robustly during the investigation, while of course co-operating with Ofcom. The effect of clauses in Royal Mail’s access letters contract is that, once an investigation has been formally launched by Ofcom, the contested proposals are effectively suspended pending a decision. This suspension applies to any and all access customers, not only to the complainant. Ofcom has launched its investigation under Competition Act 1998 powers, rather than under its regulatory powers under the PSA 2011. In Royal Mail’s view, based on other competition law investigations in UK regulated markets, the practical result of this decision is likely to be an investigation which takes one to two years to conclude.

56

London, Urban, Suburban and Rural 38

Conclusions 

The UK has a significant number of high density areas, paired with significant areas of sparse population. This makes the UK particularly susceptible to cherry picking.



The business model adopted by TNT Post stands in sharp contrast to that of Royal Mail. TNT Post is free to determine its delivery frequency, delivery coverage as well as the type of mail items it delivers. This contrast lies at the heart of the threat to the USO.



Royal Mail’s analysis suggests that a large proportion of addressed letter volumes are contestable by TNT Post. It can therefore grow its upstream market share as a result of its direct delivery operation. This in turn increases the local market share it can achieve in its direct delivery networks and helps to generate a positive growth spiral. It is clear that TNT Post is incentivised to not only achieve its publicly-stated plans, but go beyond them.



The need to maintain the capacity to meet the USO means Royal Mail’s cost responses to direct delivery are constrained. As a result, productivity will tend to fall in areas affected by direct delivery.



Royal Mail has attempted to use the commercial freedoms afforded under the current regulatory regime to respond to the direct impact of increased competition and support the finances of the Universal Service. However, these proposed changes are now under investigation due to a complaint by TNT Post and are suspended pending a decision by Ofcom. Royal Mail has thus been unable to implement an effective commercial response. As noted in chapter 3, Royal Mail is already doing all it can to increase efficiency and drive innovation.

39

5. Risks to the financial sustainability of the Universal Service Summary 

The UK is particularly susceptible to cherry picking direct delivery competition as a result of its economic geography and the existing structure of the access market. The underlying economics create strong incentives for direct delivery entrants to grow their market share as quickly as possible. There is no natural limit which could provide comfort in considering the financial impact on the Universal Service.



When these factors are considered against the background of continuing structural decline in letter volumes, it is clear there are significant and increasing risks to the financial sustainability of the Universal Service from direct delivery.



Based on our estimates of the impact of TNT Post UK's publicly-stated plans, this could reduce Royal Mail revenue by over £200 million in 2017-18.



Our analysis indicates that the underlying economics of the UK postal market would create strong incentives and opportunities for TNT Post to achieve a wider roll-out and larger market share than its current publicly-stated plans suggest.



The scenarios we have analysed, to assess this likely impact of direct delivery, show that in the absence of intervention from Ofcom, Royal Mail’s ability to reach a 5-10% EBIT margin for the Reported Business sustainably in the future would be undermined.

5.1.

Risks to the financial sustainability of the USO

This submission has explained how the Universal Service obligation has profound implications for Royal Mail’s operations, costs, revenues and financial sustainability. Royal Mail is responding actively to the long term challenge of declining letters traffic by seeking to grow parcels revenue and consistently drive for greater efficiency. We have presented new data and analysis on the underlying susceptibility of the UK’s Universal Service to direct delivery competition, arising from the UK’s geography and the unique structure of its access market. We have also demonstrated how a new entrant can quickly and profitably scale up both its coverage of the UK’s revenue-rich urban areas and its share of letters delivered in these areas. This extracts revenues directly from Royal Mail, but leaves us with the bulk of the costs of the network needed to maintain the Universal Service.

40

5.2.

Assessing the potential financial impact on the USO

Royal Mail has assessed the potential financial impact of the development of direct delivery competition on the overall revenues of the Universal Service. This assessment assumes that Ofcom does not undertake an urgent review, starting in summer 2014, of the impact of direct delivery competition on the financial sustainability of the USO and move swiftly thereafter to implement effective remedial measures.

[] Based on our estimates of the impact of TNT Post UK's publicly-stated plans, this could reduce Royal Mail revenue by over £200 million in 2017-1857. [].

Figure 5.1: [] 5.3.

Assessing the potential financial impact on the USO []

Should TNT Post roll out either to more areas, or more quickly, or achieve greater local market share than its published plans suggest, then the impact on revenues and therefore on the Universal Service would further increase. Our analysis – and the fundamental economics of postal networks - create incentives and opportunities for direct delivery entrants. Absent intervention from Ofcom, our analysis indicates that our ability to reach a 5-10% EBIT margin for the Reported Business sustainably in the future would be undermined.

[]

Figure 5.2: [] []

Figure 5.3: [] Figure 5.4: [] Figure 5.5: [] Figure 5.6: [] Figure 5.7: [] Figure 5.8: [] []

Figure 5.9: []

57

Royal Mail plc, Preliminary Results for the year ended 30 March 2014 41

Conclusions 

Against the background of continuing general decline in mail volumes, there are now significant risks to the financial sustainability of the USO. These arise from the particular susceptibility of the UK to direct delivery, and the dynamics of the market, as evidenced in this submission.



Based on our estimates of the impact of TNT Post UK's publicly-stated plans, this could reduce Royal Mail Reported Business revenue by over £200 million in 2017-18.



Our analysis indicates that the underlying economics of the UK postal market would create strong incentives and opportunities for TNT Post to achieve a wider roll-out and larger market share than its publicly-stated plans. The scenarios we have analysed, to assess this likely impact of direct delivery, show that in the absence of intervention from Ofcom, Royal Mail’s ability to reach a 5-10% EBIT margin for the Reported Business sustainably in the future would be undermined.

42

6. Options for Ofcom intervention Summary 

Ofcom should intervene now to review the financial sustainability of the Universal Service in the face of the unfettered roll out of direct delivery. In our view, this would provide the evidential basis for subsequent and speedy action. Royal Mail has given initial consideration to what such action might entail.



Certain options for regulatory intervention will take significant time to develop and implement. Easier to implement conditions may not have sufficient positive impact. More effective measures would necessarily require more time to design, calibrate and implement.



The measure likely to be of sufficient effectiveness (whilst satisfying the requirements of proportionality and non-discrimination) would be to determine the level of direct delivery competition which is consistent with a financially sustainable Universal Service. This could be done within a framework for how the potential interaction between different competitors is managed within the pre-determined level, and would be implemented under s.42 PSA 2011, which provides a broad and flexible power.



The risks and costs of undertaking a review of direct delivery now are minimal. The risks of not doing so are very significant. Ofcom could be closing off certain of the regulatory tools which it currently has at its disposal were it to continue to defer analysis of possible regulatory interventions. As direct delivery becomes more established it will be harder for Ofcom to reverse its effects using conditions such as s.42 conditions which impose delivery frequency or geographic coverage requirements.

6.1.

Options for Ofcom Intervention

Ofcom has a number of options under the PSA 2011 for ensuring the protection of the Universal Service, including58:

58



reforming Access conditions;



imposing General Universal Service Conditions (GUSCs) under the powers conferred by s.42 PSA 2011; and



introducing a Compensation Fund.

Other options which are not legally available for many years, notably making a procurement determination to split the Universal Service between different operators (blocked until 2021 unless Royal Mail has agreed to the making of the determination), or potential reforms to the EU Postal Services Directive, are not discussed further here. 43

These three are clearly articulated on the face of the legislation and, in the case of access conditions, are an established part of the regulatory framework. Royal Mail has given initial consideration to the possible actions which might be effective to address the risk to the Universal Service whilst satisfying the requirements of proportionality, nondiscrimination and transparency with which a regulatory condition must comply. As explained below, the option which Royal Mail considers would best meet these criteria would be a s.42 condition, under which Ofcom sets a level of direct delivery competition which is consistent with the financial sustainability of the Universal Service. Direct delivery competition would be permitted in the market up to that level and the framework for competition within that level would be set by the condition. Ofcom itself considers the two key options for intervention are the imposition of a GUSC or the setting up of a Universal Service compensation fund59. The latter option is, as Ofcom recognises in its Guidance60, not immediately available. As such the key option which is immediately available to Ofcom is the use of a GUSC (although as Royal Mail sets out below, there is likely to be significant delay involved in establishing any such remedy, with the result that Ofcom must take action towards designing a remedy as soon as possible).

6.2.

Reforming access conditions

Ofcom could impose a general access condition on other direct delivery operators61. Or, conversely, it could ease Royal Mail’s own access conditions, as a means of assisting in the financing of the Universal Service. For example, Ofcom could determine that for companies with established direct delivery operations, Royal Mail was no longer mandated to provide access in the same way that it currently does. Either form of condition could be triggered by direct delivery competition reaching a particular level in a given postal delivery area. Reforming access conditions could potentially have an impact on Royal Mail’s volumes. As explained above, Royal Mail retains the downstream revenue from delivery where mail is handled by an upstream competitor but delivered by Royal Mail. Amending the access condition could potentially reduce the revenues which Royal Mail receives from such delivery. Royal Mail cannot envisage a form of amendment to the access conditions which would be sufficient to remedy the harm caused to the Universal Service from direct delivery competition.

59

Ofcom, End-to-end competition in the postal sector - Final guidance on Ofcom’s approach to assessing the impact on the universal postal service, March 2013, paragraph 6.12 60 Ofcom Guidance (ibid), paragraph 6.28 61 Under section 50 PSA 2011 44

6.3.

Imposing General Universal Service Conditions (GUSC)

Ofcom could impose a GUSC62. This option is not subject to explicit time limitations regarding its use. As Ofcom itself recognises in its Guidance, “there is a wide range of obligations that could potentially be imposed through a GUSC”63. Two of the classes of obligations considered as potential options by Ofcom in the Guidance64 were: 

GUSCs requiring coverage of peripheral rural areas; and



those requiring delivery on a minimum number of days per week.

They would seek to replicate to an extent for direct delivery operators the conditions under which Royal Mail as Universal Service provider has to operate. Such conditions would tend to divert available new entrants’ resources from profitable roll out and acquisition of market share in urban areas for a lower quality (less frequent) service. Royal Mail is concerned that these classes of GUSCs may damage the financial sustainability of the Universal Service even further. Ofcom recognised this as a potential risk in the Guidance65. Before the development of direct delivery competition, such GUSCs could have potentially protected the USO by deterring widespread entry of downstream competitors. However, once the operation of an entrant is in part established, such GUSCs may only serve to further undermine the Universal Service over a greater geographic area or by a more frequent delivery service. Such a remedy could therefore cause more volumes to switch to a direct delivery competitor. Royal Mail’s initial analysis is that these GUSCs would be unlikely to offer a fully effective remedy. The risks to USO finances would remain. Royal Mail has considered whether a different form of GUSC could be suitable as a remedy. The first such option which Royal Mail considered relates to Royal Mail’s previous arguments that regulatory Mail Integrity reporting should be applied consistently across the industry66. All customers of direct delivery operators are businesses with a commercial interest in understanding the quality of service for which they are contracting. This form of GUSC, while possibly welcome as a means of addressing information asymmetry, would therefore be very unlikely to counter fully the financial vulnerability of the Universal Service to direct delivery competition as customers tend to base decisions on price rather than quality. Indeed it might be considered such a condition is not “necessary” for securing the provision of the Universal Service within the meaning of s.42 PSA 2011.

62

Under section 42 PSA 2011 Ofcom Guidance (ibid), paragraph 6.21 64 Ofcom Guidance (ibid), paragraph 6.21 65 Ofcom Guidance (ibid), paragraph 6.54 66 Royal Mail, Response to Ofcom’s Review of: Mail Integrity and Common Operational Procedures, April 2013, paragraph 14 45 63

There would be no such objection to the second additional type of GUSC which Royal Mail has considered, which is explained in the next section.

6.4.

A GUSC to set a sustainable level of direct delivery competition

This option would aim to act directly on the level of direct delivery competition permitted. It would enable a degree of market entry consistent with maintaining the financial sustainability of the Universal Service. The rationale for this option is as follows. Given the UK’s economic geography, history of access regulation and letters market trends, there will always be a threat to the sustainability of the Universal Service by reason of direct delivery competition. Regulatory intervention should establish a threshold up to which a degree of direct delivery competition would be compatible with an efficiently delivered and financially sustainable USO. Section 42(2)(a) PSA 2011 gives Ofcom considerable discretion. It can impose whatever condition it considers “necessary for the purpose of securing that a Universal Service is provided in accordance with the standards set out in the universal postal service order”. This wide-ranging discretion in the legislation recognises the inherent tension of a Universal Service obligation that requires revenues from one part of the network to be used to meet the costs of another part of the network, and the pricing constraints that apply to the Universal Service provider. It is also consistent with the terms of the EU Postal Services Directive. The USO itself requires Royal Mail to price in a way that is not reflective of different marginal costs in different parts of its network. It also specifies particular service standards and geographic coverage requirements that do not apply to competitors. Ofcom is invited to determine the level of direct delivery competition it deems consistent with its objective to ensure provision of a financially sustainable Universal Service. This could be expressed in terms of national market share of mail volumes subject to direct delivery competition. Or it could be by reference to local market shares and geographic coverage of the UK. One example could be to consider the issue by reference to the market conditions within each SSC. It would be necessary also for Ofcom to determine a framework for the operation of competition beneath this level. This would be so that the interests of potential new entrants are balanced against those already in the market. For example, Ofcom could consider whether an auction for this declared capacity, perhaps on a franchise basis, would be appropriate. Such an approach would be likely to reduce the risk of long term harm to the financial sustainability of the Universal Service. The risk of regulatory error would, however, have to be carefully considered by Ofcom. Setting the threshold too high could still allow harm to occur to Universal Service financial sustainability. Wherever it were set, this threshold would still permit the arbitraging of the Universal Service and so some degree of detrimental financial impact would remain. The key question would be to set the threshold so as to allow Royal Mail the opportunity to achieve a 5-10% EBIT margin in its Reported Business sustainably in the future. The continued risk to the sustainability of the 46

Universal Service could be partly mitigated by ensuring that Royal Mail had the pricing freedom to enable it to compete with the permitted degree of direct delivery competition. Royal Mail recognises that there are significant implementation issues to be resolved. But this type of approach would at least have the merit of dealing directly with the core issue that confronts the viability of the Universal Service. This would be on the basis of full Ofcom analysis of the degree of direct delivery competition that would be consistent with the financial sustainability of the USO. This would be targeted action, in line with Ofcom’s Guidance67, and would be action which (as explained in this submission) is necessary to impose in connection with securing the provision of the Universal Service. Moreover, this would potentially create a more transparent regulatory environment, to the benefit of all operators. Royal Mail understands that Ofcom has previously suggested a timeframe of six to nine months for design and implementation. This looks highly optimistic in light of the issues GUSCs raise and their potential impact on private sector businesses. Accordingly, Ofcom must begin considering the use of these remedies at the earliest possible opportunity.

6.5.

Introducing a Compensation Fund

If, contrary to Royal Mail’s position, Ofcom decides to impose a GUSC which mandates a particular delivery frequency or geographic coverage, since such a GUSC would be likely only to partially address the underlying risk to the financial sustainability of the Universal Service (and may in fact create further harm to the Universal Service), Ofcom would need to consider whether a long-term solution would be to establish a compensation fund towards the cost of financing the Universal Service68. This route has been adopted by some other EU Member States. A few provide direct contributions from general tax revenues via State Aid69. Some others have established and operate a compensation fund to which all postal operators contribute. The majority of Member States have enacted the necessary enabling legislation (in line with EU Postal Services Directives). But they have not brought such a fund into operation. Before setting up a compensation fund, Ofcom would, under the legislation, be required to conduct a review to assess the financial burden of complying with the Universal Service obligations. Ofcom cannot conduct such a review before October 2016 unless directed to do so by the Secretary of State. Subject to the adoption of regulations setting out a different methodology, Ofcom would be required to assess the burden of the Universal Service by looking at the net cost of compliance. This is likely to be a complex exercise. There is no agreement at an EU or national level on how an assessment of the burden should be carried out.

67

Ofcom Guidance (ibid), paragraphs 6.47-48 Under section 46 PSA 2011 69 Such contributions are compatible with EU State Aid provisions provided the contributions are for the discharge of a public service obligation and the compensation does not exceed what is necessary to cover all or part of the costs incurred in delivering the public service obligations. 68

47

If, after having conducted a review of the financial burden of providing the Universal Service, Ofcom concluded that it would be unfair for Royal Mail to bear all or part of this burden, it would have to: 

submit recommendations to the Secretary of State;



outline what actions (if any) it considered should be undertaken. The recommended actions could include: o

setting up a fund;

o

a review of the scope of the Universal Service or nominating another postal operator to provide all or part of the Universal Service. In this case, Ofcom would not be able to split the Universal Service obligation until 2021 at the earliest, without the consent of Royal Mail.

The Secretary of State has ultimate responsibility for determining whether a compensation fund is appropriate in the circumstances. He or she is likely to be guided by the recommendations of Ofcom. Subject to Ministerial and then Parliamentary approval70, Ofcom would still have to design and implement the compensation fund scheme. Depending on how a compensation fund was structured, it may also require State Aid approval from the European Commission. This suggests that a fund, whilst it could be a longer term option, will not be the answer to the immediate direct delivery threat. Moreover, a fund would be seeking to recreate the cross subsidies that have supported the current system and that direct delivery would have been allowed to unwind. In Royal Mail’s view, it would be far better to deal with the problem now before it reaches that stage.

Setting up a fund The setting up of a fund could take up to five years. The process of implementation is likely to fall broadly within the following timescales: 

2½ years (October 2016) before a review of the financial burden can be conducted unless the Secretary of State directs that the process should start earlier;



12 months to conduct the review of the financial burden. This could potentially conclude that a narrowing of the scope of the Universal Service from its existing specifications would be part of the solution to maintain a financially sustainable USO;



18-24 months to implement a fund. This includes assessing the net cost of the resulting USO specification. This would likely be a contested finding subject to further audit, consultation and, ultimately, potential legal challenge. Ofcom’s Guidance71 recognises that there are issues in relation to the design of any such fund which may well be contentious

70

Parliamentary debate and scrutiny would be required as part of the affirmative resolution process in support of a Government decision to implement a fund. 71 Ofcom Guidance (ibid), paragraph 6.33 48

6.6.

Narrowing the scope of the Universal Service

The Universal Service specification could be altered to reduce the cost burden on Royal Mail. This would have very significant repercussions for the quality of the delivery service currently provided by Royal Mail. It is not a move advocated by Royal Mail. Royal Mail continues – as it previously stated in 201272 - to support the provision of the currently defined Universal Service throughout the UK:

“Royal Mail believes that no major changes should be proposed to the scope of the Universal Service in the UK. Royal Mail is the designated provider of the universal postal service, committed to providing the high quality USO that the Government has set down. We are honoured to provide the Universal Service and have the strategic aim to become the best delivery company in the UK.” This conclusion was supported by Ofcom in its more recent review of user needs73. It found that the scope of the Universal Service was reasonable:

“We have concluded that the postal market is currently meeting the reasonable needs of users and is highly valued by residential users and businesses across the UK. Therefore, we have decided not to change the scope of the Universal Service”. The PSA 2011 requires Ofcom to review the extent to which the current minimum requirements reflects the reasonable needs of users before proposing any relaxation of the Universal Service specification. It is probable that any substantive change would require a significant amount of time to implement. Notwithstanding these timescales, the Government has indicated an unwillingness to revise the scope of the Universal Service during this Parliament. Indeed, Ofcom, in its Guidance does not even consider this as a potential remedial option.

72 73

Royal Mail, Response to Ofcom consultation on postal users’ needs, December 2012 Ofcom, Review of postal users’ needs, March 2013, para. 1.3 49

Conclusions 

Ofcom should intervene now, initially to review the financial sustainability of the Universal Service in the face of unfettered direct delivery. This would provide the evidential basis for suitable interventions, which should be considered in parallel. Royal Mail would respond formally to any Ofcom consultation on proposed measures.



There are no uncontroversial and readily specified options available to Ofcom for regulatory intervention to provide adequate protection for the long term financial sustainability of the Universal Service.



Given the risk to the financial sustainability of the Universal Service that is now apparent, Ofcom would be closing off future regulatory options and potentially increasing the ultimate cost of intervention were it to continue to defer the launch of a review of the market and of the options for intervention.



The clear focus for any review needs to be options which can be implemented speedily and which go to the heart of the issue. Some pre-determination – and management - of the level of direct delivery competition, consistent with a financially sustainable Universal Service, looks most likely to fit the bill. This would be action which is targeted, necessary and proportionate.

50

7. Ofcom’s response to the Universal Service financing challenge Summary 

Ofcom’s primary duty is to secure the provision of the Universal Service. However, even a consideration of Ofcom’s subsidiary duties does not necessarily support unfettered direct delivery competition. The key benefits of competition, namely increased efficiency and consumer benefits are not necessarily generated by such competition. In considering how best to protect the sustainability of the USO in the face of direct delivery competition, Ofcom should keep in mind regulatory best practice principles in respect of evidence, consistency and transparency.



A framework for direct delivery which is transparent to all players would give all players in the market greater certainty. Such transparency should be provided by the remedy which Ofcom adopts and also by Ofcom’s approach to this market going forward.



The first step should be a review of the level of direct delivery which is compatible with the existence of a financially sustainable Universal Service (which allows Royal Mail the opportunity to achieve a 5-10% EBIT margin in the Reported Business).

7.1.

Ofcom’s regulatory stance

This chapter sets out some general considerations that Royal Mail suggests Ofcom could take into account as it considers the issues relating to direct delivery and the protection of the Universal Service. Royal Mail acknowledges that Ofcom is actively monitoring developments in the UK postal services sector. This is an important first stage to inform Ofcom’s evolving assessment of the sector. However, as we set out in this chapter and elsewhere in this submission, we consider that there is now more than adequate evidence and a pressing need (given the risks to the financial sustainability of the Universal Service) for Ofcom to move beyond monitoring to a full review of direct delivery and consideration and implementation of interventions that would safeguard the Universal Service. Fundamentally, Royal Mail believes that Ofcom should reach a view about the degree of competition consistent with a financially sustainable Universal Service, and consider the best regulatory responses that would support this outcome. The provision of the Universal Service has clear primacy in UK and EU legislation. This stands ahead of other duties, including towards promoting competition.

51

In any event, these two objectives (Universal Service and competition) are not necessarily in tension with each other. In our view, the objectives of competition policy should be to provide greater economic and social benefits to consumers. These objectives include: greater economic efficiencies from the use of resources; lower prices for consumers; greater innovation; improving customer experience. In its Guidance74, Ofcom sets out how it considered that the potential benefits from competition (“the indirect effects” of direct delivery competition) could be price reduction and efficiency incentives. As explained in this submission, such benefits would not and have not materially emerged as a result of direct delivery competition. Accordingly when assessing regulatory risk (as Ofcom says it will do in its Guidance75), Ofcom must adopt an approach tipped in favour of protecting the sustainability of the Universal Service rather than favouring competitive downstream entry. Not only is that required by Ofcom’s overriding section 29 duty, but in any event, the benefits ordinarily associated with competition would not be generated (at least to any material extent) by widespread growth of direct delivery competition in the context of the UK postal services market. Royal Mail supports effective competition as it can raise the standard of the social benefit delivered by the Universal Service provider. However, the question is whether direct delivery which relies on cherry picking by geography, service frequency and products is likely to produce such benefits. In Royal Mail’s view, this form of competition will not produce the benefits usually associated with competition. Rather, through reducing economies of scale in a declining market it will raise Royal Mail’s unit costs, cutting across its efficiency efforts. As a result, an approach which allows the unfettered roll out of cherry picking direct delivery is currently at risk of undermining the USO in the UK.

7.2.

Regulatory best practice

In addition to its duty towards the Universal Service, Ofcom operates under a general duty to have regard to the principles of good regulatory practice, specified in the Communications Act 2003. This means acting in a transparent, accountable, proportionate, and consistent manner. Regulation should be targeted only at cases in which action is needed76. It must also have regard to those factors from a specified range which appear to Ofcom to be relevant to the circumstances. These include the desirability of promoting competition in relevant markets, and encouraging investment and innovation. Ofcom has clearly stated that any condition imposed on direct delivery competitors to Royal Mail would have to be properly justified, not unduly discriminatory, proportionate and transparent. Similar obligations apply to the arrangements that, through Ofcom’s Guidance, now effectively regulate Royal Mail.

74

Ofcom, End-to-end competition in the postal sector - Final guidance on Ofcom’s approach to assessing the impact on the universal postal service, March 2013, paragraph 3.14 and 4.12 75 Ofcom Guidance (ibid), paragraphs 6.52–6.54 76 Part 1, s.3 CA03 52

Royal Mail believes that the regulatory regime for the UK postal industry should be in line with Ofcom's general principles in respect of evidence, proportionality, transparency, consistency and accountability: 

Transparency and evidence: in a fast changing commercially competitive market, it is important for regulation to be soundly based on a fundamental understanding of UK postal services. This includes the extent to which it may be feasible or desirable for the market to support more than one final mile operator and considering whether, when and how to intervene.



Proportionality: the scale of regulatory interventions should match the importance of the consequences of action or inaction. The risk to the Universal Service is of such importance that it would be disproportionate not to take action, particularly action which amounts to no more than a review of the need for intervention, at the earliest opportunity.



Targeted action: In regulatory contexts where broader competition is assessed as meeting consumers’ needs, this principle encourages the regulator to do the minimum necessary. The situation is reversed in the postal sector. Developing direct delivery competition is undermining the finances of Royal Mail as the Universal Service provider. It is leading to the undermining of revenue streams in densely populated areas, so threatening the ‘one price goes anywhere’ service to the detriment of consumers. So the need for regulatory action is urgent.

Rail regulation The rail regulator has recently considered the treatment of open access competition on the rail network*. While the parallels with Ofcom’s duties towards the USO and with the economics of post are not precise, the exercise was indicative of how regulators might best approach the introduction of competition. The Office of Rail Regulation (ORR) had to weigh up its public interest duties and considerations of the impact of competition on existing operators. ORR conducted a prior assessment of the potential impact of open access competition and of the financial basis on which it should be permitted. That assessment considered the wider public interest in the public financing of the railways. It balanced that against ORR’s duty to promote competition, and the impacts of potential competition despite the relatively high barriers to entry. It also considered the effect on incumbent rail operators’ finances given the extent to which new open access services capture market share from existing franchise holders rather than generating new business. ORR has a duty to enable providers of rail services to plan their businesses but a framework of this sort is also consistent with regulatory best practice. ORR concluded** not to implement either of the market-opening options on which it consulted, so there will be no significant changes to the open access regime for the five-year price control period for Network Rail commencing April 2014. ORR has undertaken the sort of prior review of competition that Royal Mail is requesting that Ofcom undertake in the postal sector. Given the primacy of its duty towards the USO, the low 53

barriers to entry, and the negative impact on Royal Mail’s finances, the arguments for Ofcom taking a similarly prudent approach to ORR are compelling. * ORR, On-rail competition: Consultation on options for change in open access, June 2013 ** ORR, Final determination of Network Rail's outputs and funding for 2014-19, October 2013

7.3.

The context of the UK postal market

The particular position of the postal market was highlighted by Hooper, in his 2010 report. He explained that, due to the uncertainty provided by DSA and end-to-end competition, a risk-based approach should be taken to the protection of the Universal Service:

“Because the development of the mail market is inherently uncertain, we recommend that Ofcom should adopt a risk based approach to the protection of the Universal Service. This involves planning a regulatory response to a broad range of scenarios, from the rapid development of end-to-end competition, to a more limited increase in the number of companies providing upstream services. The regulator also needs to plan for the market to decline at various rates, now that the combination of cyclical and structural change is making mail volumes more difficult to predict”.77 In developing a regulatory regime grounded in the realities of UK postal services, we would encourage Ofcom to consider: 

the extent to which regulatory incentives over the past decade may have bolstered access competition unduly, effectively tilting the playing field against the Universal Service and Royal Mail; and



how the risks to consumers generally from a financially weakened Universal Service may be balanced against the benefits from lower prices to TNT Post’s direct delivery customers.

Ofcom may well address some of these issues as part of its investigation into Royal Mail’s access pricing proposals and its subsequently announced review of access pricing. We would encourage Ofcom to build on the analysis undertaken for these separate regulatory actions and to develop and articulate a more holistic assessment of the operation of the postal market overall and its impact on the Universal Service. This would create greater clarity for all postal operators and for other stakeholders.

77

Hooper Review, 2010, paragraph 175 54

Telecommunications economics and regulation There are profound and far-reaching differences in the cost structures of telecoms and post. They in turn affect the way in which the UK incumbents in each sector (BT and Royal Mail) have responded to competition and falling volumes and been regulated: 

Telecoms’ cost base is biased towards capital rather than labour, and thus offers through technological change inherently better efficiency prospects than in posts.



Telecoms’ sunk investments dilute exposure to the Universal Service obligation: BT’s ‘last mile’ access network is the capitalised result of 40+ years investment. Royal Mail’s network is sustained by current labour costs. BT’s USO costs are small relative to the whole business and are financed predominantly out of prior cash flows. This provides much greater insulation from entrants targeting the profitable customers that contribute to the costs of Universal Service.



Telecoms enjoy greater economies of scope than post. Upgrading the core network has enabled BT to offer new products and services, substituting for decline in basic fixed line voice calls. By contrast, Royal Mail is managing structural decline in letters.



Telecoms companies are much better able to internalise costs of the USO. The cost of delivering BT’s USO has been estimated by Ofcom (2006) to be approximately £57m £74m. This is offset by estimated £60m of associated advertising and brand benefits. The net impact on BT is considered by Ofcom to be negligible. For Royal Mail, the USO represents a much greater proportion of total costs.

So in fixed line telecoms, technology allows for a rapid reduction in the costs of providing the Universal Service. At the same time, it opens up new markets in which the incumbent can compete for new revenue streams. Growing competition is not then a substantial threat to the financial sustainability of the Universal Service obligation. In this case, neither the regulator nor Government need intervene. The regulator can safely mandate the progressive opening up of markets. This enables new entrants to move up a ‘ladder of competition’ and driving efficiency improvements by the incumbent provider. It can nevertheless continue to fund the Universal Service from its own revenues. This benign scenario does not hold in a postal market facing structural decline in letters volumes.

7.3.1.

Consistency of Ofcom’s approach to regulation

Well-designed regulation creates enduring incentives for the regulated company to improve service quality and efficiency to the benefit of consumers. We would encourage Ofcom to consider the wider incentive effects of its regulatory approach to direct delivery competition. We would encourage Ofcom to consider the incentive effects of its approach to assessing financial performance. While Ofcom suggests that any 'transient' under-performance against its financial metrics would not constitute a reason for intervention, such under-performance would be unlikely to be offset over time by countervailing sustainable over-performance. This is because any such 55

over-performance would constitute leeway under Ofcom's arrangements for further direct delivery competition, which in turn would further challenge Royal Mail’s ability to earn an appropriate financial return. (In any event, as we have explained in this submission, the low profitability which Royal Mail has demonstrated would be likely to occur, absent effective regulatory intervention, is not transient but is underpinned by long term or structural factors in the market which increase the susceptibility of the Universal Service in the UK to damage from direct delivery competition.) Finally, we would ask Ofcom to reassess the potential inconsistency between its treatment of access competition and direct delivery. Ofcom recognises that direct delivery competition can pose a threat to the Universal Service. Yet, in its March 2012 decision on access conditions, Ofcom noted, in support of its decision, the fact that access competition would facilitate direct delivery competition. In our view, Ofcom might usefully assess the tensions inherent within this regulatory stance: 

The existence of access competition, promoted by the previous Postcomm regime, sharpens considerably the threat to the Universal Service from direct delivery competition.



The UK's access regime is uniquely developed. Yet Ofcom has, to an extent, relied upon comparisons with direct delivery in countries with less penetrated access regimes.



Ofcom appeared in March 2012 to rely upon the likelihood that the most likely form of direct delivery competition would be regional. In fact, what TNT Post is planning is more akin to a sub-national service, albeit confined to more dense urban areas. The role that access can play in developing such a network is significant.

7.3.2.

Transparency about regulatory approach

Ofcom’s current approach might be characterised as ‘wait and see’. This means actively monitoring but allowing direct delivery competition to progress until there is evidence of likely financial harm. As explained in this submission, applying Ofcom’s own ‘wait and see’ approach, the time has now come for regulatory action. However, Royal Mail would like to take the opportunity to make a broader point that greater transparency about Ofcom’s regulatory approach would have assisted all players in the postal services market. Customers are being incentivised to change behaviour by the offer of direct delivery. They may well be offered advantageous local direct delivery deals but without the necessary clarity about what acceptance might mean for their wider and longer term interests in the Universal Service being maintained. Corporate decisions on switching away from Royal Mail to direct delivery competitors are being made on the basis that the current Universal Service continues as is. Yet, those very actions undermine its sustainability. More information about how Ofcom will approach this would underpin more informed decision-making by all customers of postal services. Transparency should be a key component of any remedy which Ofcom imposes. The UK postal market has been and remains a product of regulation. The commercial opportunities for all parties are effectively driven by regulatory rules. Ofcom has a special responsibility to manage the market so as to avoid creating uncertainty and delaying decisions which could lead to under investment and raise the cost of capital. Private capital is being

56

committed on all sides. Clearer regulatory ground rules would enable timely and efficient commercial investments. Setting the framework to sustain the financing of the Universal Service will take time. The legal processes could create significant delays before changes can be implemented. In the meantime, direct delivery can roll out further causing harm to the Universal Service. This process drag strengthens the case for improving transparency for all by initiating a review now.

Conclusions 

We encourage Ofcom to consider how far its regulatory framework is compatible with sustaining the USO in the face of direct delivery threats. In doing so, Ofcom should keep in mind its own best practice principles in respect of evidence, consistency and transparency.



The speed and irreversibility of change, and the time for any regulatory response to take effect, suggest that it would be prudent to act now, on the basis of an already strong evidence base, rather than delay. There is therefore a compelling case for Ofcom to review the market this year, in line with its own guidance on the factors which would trigger such a review, and to consider its intervention options.



We also encourage Ofcom to reassess the role that direct delivery can play in the postal sector. This assessment could consider how this is working within the market as well as the increasing substitution to digital means of communication. It could also assess how the consumer interest is best served given the importance attached to the USO. Finally, an assessment could be made of the existing pressures on Royal Mail to make significant efficiency gains, in response to structural changes and from its new private ownership.



Ofcom’s review could usefully address head on the question inherent in the legislative framework for postal services: to what extent is the financial sustainability of the Universal Service consistent with unfettered growth of direct delivery competition? To the extent that there is an inconsistency, or a risk of such, then Ofcom’s statutory duties lead it clearly towards prioritising the former over the latter.

57

8. Conclusion: Summary of case for regulatory action Summary 

In Royal Mail’s view, the evidence now available and presented in this submission: o

satisfies Ofcom’s own criteria for initiating a review of the UK postal market to assess the impact of direct delivery on the financial sustainability of the Universal Service; and

o

provides sufficient grounds for Ofcom to conclude that its own higher threshold of evidence required to initiate regulatory action to protect the Universal Service has been met.



In particular, this submission demonstrates that Ofcom’s core test for assessing financial risk to the Universal Service is now met: Royal Mail has assessed the impact of TNT Post achieving its currently stated plans by 2017. Based on our estimates of the impact of TNT Post’s publicly-stated plans, this could reduce Royal Mail revenue by over £200 million in 2017-18.



Royal Mail has also set out evidence that, absent regulatory intervention, it is likely that these plans will likely be achieved, or exceeded.



We also set out that – absent regulatory intervention – Royal Mail’s ability to reach a 5-10% EBIT margin for the Reported Business sustainably in the future – a range that Ofcom has indicated is consistent with the need for Royal Mail to earn a reasonable commercial rate of return - would be undermined.

8.1.

Introduction

In this submission, Royal Mail sets out evidence and arguments relating to the impact of direct delivery on the Universal Service. The submission presents clear evidence against the criteria and thresholds that Ofcom has established for any regulatory intervention and shows that they are met. This chapter summarises Royal Mail’s case that the threshold for intervention has been reached, referencing back to the relevant sections in this submission where evidence and analysis is presented.

58

8.2.

Ofcom guidance

In March 2013, Ofcom published guidance on its approach to direct delivery competition (“the Guidance”78). By this Guidance, in combination with Ofcom’s previous statements, notably its July 2012 update on end-to-end competition in the postal market79, Ofcom has created a legitimate expectation that it will act consistently with its stated policy.80 Not to do so would be likely to be found unlawful. The Guidance establishes two measures which Ofcom envisages taking, once certain defined thresholds have been crossed. The first would be for Ofcom to start a review of the impact of endto-end (direct delivery) competition on the financial sustainability of the Universal Service. The second, arising from such a review, would be for Ofcom to take the regulatory action it deems necessary to protect the Universal Service.

8.3.

Review threshold

The circumstances in which Ofcom will commence a review of the need for intervention (“the Review Threshold”) are set out at paragraph 3.26 of Ofcom’s Guidance: 

There has to be prima facie a “potential material threat” to the provision of the Universal Service resulting from end-to-end competition.



The factors which are said to evidence such a threat include a “material increase” in the level of end-to-end competition and a “material change” in Ofcom’s assessment of the likely scale, timing or certainty of a competitor’s plans.

These comprise a comparatively low threshold. Royal Mail demonstrates below and in the rest of this submission that this has now been passed. [We reference in parentheses those sections of this submission where the relevant evidence and analysis is presented]:

“Material increase” in the level of end-to-end competition: 

78

In July 2012, when Ofcom issued its update on end-to-end competition, TNT Post had entered just one local urban market (West London). Since then, TNT Post has increased its presence in urban markets, now operating in much of London, and in Manchester and Liverpool. Our Ipsos Mori market research shows that TNT Post is achieving market shares of [] in areas where it operates. This is prima facie evidence of a “material increase” in the level of end-to-end (direct delivery) competition, as evidenced further in this submission [section 4.6.1].

Ofcom, End-to-end competition in the postal sector - Final guidance on Ofcom’s approach to assessing the impact on the universal postal service, March 2013 79 Ofcom, End-to-end competition in the postal sector - Ofcom’s assessment of the responses to the draft guidance on end-to-end competition, March 2013 80 A public body will act unlawfully where it departs, without cogent overriding justification, from the legitimate expectation of a substantive outcome or position (which will have been engendered by a previous act such as a promise or practice); Fordham, Judicial Review Handbook, 6th edn. at 54.2. 59



Moreover, not only is there an increase since Ofcom’s last assessment of the extent of end to end competition, but as presented in this submission it is likely that direct delivery will reach a level which goes beyond that foreshadowed in TNT Post’s stated plans.

“Material change” in Ofcom’s assessment of the likely scale, timing or certainty of a competitor’s plans

81



Scale of competition: TNT Post’s stated plans81 envisage it increasing its geographic coverage to c.42% of the UK’s addresses, encompassing some 8.5% of the UK landmass, by 2017. At this point, Royal Mail estimates that TNT Post could have secured c.20% local market share in those markets in which it provides a direct delivery service. Royal Mail’s analysis of the costs of market entry demonstrates the resulting ability of an entrant to price increasingly competitively to win greater local market share and to expand profitably across a wider area [section 4.7.2]. This indicates that the underlying dynamics of relative costs in the market would likely have the result that TNT Post would be incentivised to grow its local market share further. Royal Mail estimates that this could increase to [] by 2017-18, with TNT Post delivering to up to [] of addresses. This is prima facie a material change in the likely scale of a competitor’s plans.



Timing of competition: the increase in TNT Post’s local market share to [] (from our IPSOS Mori research) demonstrates that, in those urban areas where it provides a direct delivery service, it can very quickly secure a material market share. For example, following entry into Manchester in November 2013, TNT Post had secured [] local market share within three months. []. It also shows that a switch away from Royal Mail by a relatively few business customers would rapidly increase TNT Post’s local market share to [] [section 4.6]. This is prima facie evidence that the timing of competition is more rapid than previously envisaged by Ofcom.



Certainty of competition: In July 2012, when Ofcom issued its update, TNT Post’s market entry was still at the trial stage. In March 2013, when Ofcom issued its Guidance, TNT Post was still operating in only one city and its local market share there had risen to [] by July 2013. By May 2014, TNT Post was operating a now proven operational and commercial model in Manchester, Liverpool and large parts of London. Royal Mail has experienced the reality of reduced mail volumes (and associated higher unit costs) in those areas affected by direct delivery competition. Business customers of TNT Post have experienced the reality of TNT Post’s service in the areas covered. Other business customers of Royal Mail will have greater certainty about the price and service which TNT Post can now offer in competition with Royal Mail. In addition, in light of this emerging evidence, Royal Mail’s financial analysis points clearly to the likely future evolution of direct delivery competition, which is predicted to lead to wider coverage and higher local market shares. This would increase the adverse impact on Royal Mail revenues beyond that resulting from TNT Post’s currently stated plans [section 5.2 and section 5.3]. This is

TNT Post ’s Marketforce Conference Presentation, September 2013 60

evidence of greater certainty of the impact of competition than Ofcom has previously been able to assess.

“Potential material threat” to the provision of the Universal Service resulting from end-to-end competition: 

Efficiency: As part of its response to the continuing structural decline in mail volumes, Royal Mail has demonstrably improved further its own efficiency, in large part through the completion in 2014 of the majority of measures in its transformation programme. The initial phase of Royal Mail’s transformation is now largely complete [section 3.2]. Royal Mail has also demonstrated how, within the tight constraints of the Universal Service, it has responded to direct delivery competition by reducing costs to the limited degree possible in those urban areas affected by TNT Post market entry [section 4.8]. It is now clear that Royal Mail is significantly more efficient than in 2012 when Ofcom issued its update. We are taking measures to protect the financial sustainability of the Universal Service by improving efficiency further. However, the constraints of the USO mean that we cannot replace the revenues lost from direct delivery with cost reductions from improved efficiency which are in any case required to cope with the secular decline in mail volumes.



Commercial pricing: In its March 2013 Guidance, Ofcom indicated that it would wish to consider the potential for commercial pricing responses from Royal Mail before concluding whether the Universal Service might be under threat as a result of direct delivery competition. Royal Mail’s main commercial responses have been to propose changes to access prices, improve efficiency and to aim to grow revenue from the parcels market. It is now apparent, following the opening of Ofcom’s competition law investigation into Royal Mail’s proposed access price changes, that the first response will be held back for some time [section 4.9]. This increases the threat to the Universal Service. With regard to the third response, Royal Mail’s central commercial strategy is to transition to become a more parcels-oriented business [section 3.1]. However this, along with the second response of efficiency improvements, is required to help offset the continuing structural decline in letters volumes.



Risk to revenues: In light of newly emerging evidence about the impact of TNT Post’s roll out [section 4.6], and the latest evidence on efficiency, commercial pricing and parcels growth, Royal Mail has analysed a range of possible outcomes and the resulting impact on Royal Mail’s revenues. Based on our estimates of the impact of TNT Post UK's publiclystated plans, this could reduce Royal Mail revenue by over £200 million in 2017-18.

We have undertaken further analysis to consider a range of hypothetical alternative scenarios, in which the resolution of Ofcom’s investigation regarding Royal Mail’s proposed access price changes, is further delayed and/or TNT Post secures greater local market shares. This analysis shows that there are risks for the finances of the USO that Ofcom should consider, beyond the likely impact of TNT Post achieving their stated plans. On this basis, whilst Royal Mail’s proposed price changes remain suspended, and absent a regulatory response, our ability to reach the 5-10% EBIT margin for the Reported Business sustainably in the future would be undermined. 61

This submission presents new evidence on: 

Royal Mail’s efficiency response;



The impact of the suspension of our proposed access price changes; and



Our analysis of possible scenarios for the Reported Business EBIT margin.

Taken together these provide a clear case that the Universal Service faces a potential material threat. Given its primary duty under the PSA 2011, there is more than sufficient evidence for Ofcom to act now. In weighing its response, Ofcom needs to take account of the relative risks and costs of acting now as against not doing so. This is particularly the case where taking action now involves bringing forward a review that is planned for next year. Ofcom’s primary duty is very clear. The potential for irreversible harm to the financial sustainability of the Universal Service is also clear. In these circumstances conducting a review now would appear to be a proportionate, risk-based response to the evidence presented here.

8.4.

Action threshold

In its Guidance, Ofcom set out a four step process that it would undertake in order to inform its judgement as to whether it should take action to protect the financial sustainability of the Universal Service82. Ofcom describes the financial analysis as involving the following four steps:

82



Step one: Determine what the financial position of the Universal Service would be likely to be in the absence of end-to-end competition. This would allow us to understand Royal Mail’s expected profitability (of the Reported Business, which delivers the Universal Service) in the foreseeable future absent end-to-end competition.



Step two: Consider the expected direct impact of the loss of business on Royal Mail resulting from end-to-end competition. This would involve reviewing the current and potential activities of competitors and then looking at how this would impact Royal Mail’s forecast financial position (determined in step one).



Step three: Consider the impact of any potential subsequent commercial response(s) from Royal Mail, including improving efficiency. Increased competition might be expected to change Royal Mail’s behaviour in relation to its commercial strategy, and its ability to make efficiency savings. The financial analysis would need to be adjusted to take this into account.



Step four: Test whether the Universal Service is likely to be put at risk allowing for the uncertainties associated with projections.

Ofcom Guidance, March 2013, paragraph 4.3 62

In Royal Mail’s view, there is now sufficient evidence, presented in this submission, for Ofcom to conduct these four stages of its assessment, and thus proceed to take regulatory action to protect the financial sustainability of the Universal Service. Royal Mail’s key arguments and evidence on each step are set out below, with references to the sections of the submission where the relevant material is described.

Step one: Financial position of the Universal Service in the absence of end-to-end competition Royal Mail’s Reported Business is expected to generate an EBIT margin of [] for 2013-14. Royal Mail has analysed a case where TNT Post achieves its stated business plan aims. Based on our estimates of the impact of TNT Post UK's publicly-stated plans, this could reduce Royal Mail revenue by over £200 million in 2017-18. The impact of this scenario could be used by Ofcom to inform its first step of assessing the likely financial position of Royal Mail’s Universal Service business assuming an absence of end-to-end competition. Royal Mail recognises that Ofcom may wish to remove such assumptions as to end to end competition to avoid the risk of double counting when carrying out the review itself (as suggested in the Guidance at paragraph 4.6). Royal Mail can assist with that task.

Step two: expected direct impact on Royal Mail resulting from end-to-end competition As discussed above in relation to the review threshold, this submission sets out the evidence and analysis which demonstrate that TNT Post is likely to achieve or exceed its publicly-stated plans [section 4.6]. Absent regulatory intervention, the ability for Royal Mail to reach a 5-10% EBIT margin for the Reported Business sustainably in the future would be undermined [section 5.3].

Step three: impact of commercial response(s) from Royal Mail, including improving efficiency As discussed above under the review threshold, this submission sets out the evidence and analysis on three key commercial responses from Royal Mail – efficiency, parcels, and price reforms. First, it demonstrates the improvements in efficiency to date and the scope and ambition for further efficiency improvements in future; subject to the constraints of continuing to deliver the Universal Service [sections 3.2 to 3.5]. It also identifies that Royal Mail has responded by removing costs to the limited degree possible in those local Delivery Offices which have been directly affected by direct delivery competition, again within the limits imposed by the Universal Service obligation [section 4.8]. Second, this submission describes Royal Mail’s ambition to increase revenues and market share in the growing parcels market. This market is itself subject to fierce competition from other carriers within the market and increasingly diverse and innovative forms of competition from outside the market [section 3.1]. The submission demonstrates that potential growth of Royal Mail’s parcels revenue – alongside our efficiency improvements - is likely to be sufficient to offset the structural 63

decline in letters volumes in the UK as a whole. But parcels revenue growth is not likely to be sufficient to offset the potential additional loss of net revenues arising from direct delivery competition. Third, the submission explains the impact of Ofcom’s competition investigation into Royal Mail’s proposed access price reform, which in Royal Mail’s view is an appropriate commercial response to changing market circumstances, using its commercial freedoms. Royal Mail’s proposed price changes are now suspended83 until the conclusion of Ofcom’s investigation. This could permanently defer or delay their implementation for a long period [sections 0 and 4.10]. Our analysis shows that there is an adverse impact of these various delay scenarios on our ability to support the costs of the USO. This analysis shows that, under all outcomes where Royal Mail’s proposed price changes remain suspended, and absent regulatory intervention, our ability to reach 5-10% EBIT margin range that Ofcom has established for the Reported Business sustainably in the future would be undermined.

Step four: Test whether Universal Service likely to be put at risk allowing for uncertainties associated with projections Royal Mail’s analysis takes a comprehensive and structured approach to assessing the potential range of impacts from a wide variety of factors likely to affect the extent of direct delivery competition and Royal Mail’s ability to respond commercially to that competition. on Ofcom’s ‘fair bet’ principle84 , absent regulatory intervention, our ability to reach 5-10% EBIT margin range for the Reported Business sustainably in the future would be undermined.

83

As a result of clauses within Royal Mail’s access contracts, the existence of which is linked to the previous Postcomm access regime. 84 Ofcom Guidance, March 2013, paragraphs 5.23-5.27 64

Conclusions 

Ofcom’s Guidance establishes a series of thresholds for the regulator to pass before (i) initiating a review of the extent to which direct delivery competition may present a financial threat to the Universal Service, and then (ii) taking regulatory action to mitigate any such threat if identified via such a review.



This summary chapter illustrates how the evidence and analysis marshalled by Royal Mail in this submission provides more than sufficient material for Ofcom to pass the first, review, threshold and thus start such a review immediately.



The submission also contains evidence which would be sufficient to enable Ofcom to cross its own action threshold. Royal Mail anticipates presenting the material to Ofcom in fuller detail. We are confident that Ofcom would then conclude, based on a review of the available evidence, that its tests for undertaking action to protect the Universal Service would have been met.



As we have set out elsewhere, the threat to the Universal Service is sufficiently significant, and the complexities around potential interventions sufficiently great, that Ofcom needs to undertake its reviews of the market and potential regulatory involvement in parallel to avoid the further delay from a sequential process.

65