Written evidence submitted by Richard Hooper (USO 06)

1. Introduction and Summary

I submit this short paper to the BIS Committee wearing two hats – as the author of the three reports in 2008 and 2010 to the Labour and Coalition Governments on the future of the postal services sector in general and on Royal Mail in particular[1].

I am also currently an independent adviser to the CEO of Royal Mail on the matter of “cherry picking”.

This paper looks at the issues surrounding access and end to end competition in relation to their impact on the Universal Service Obligation (USO) – specifically the threat of cherry picking. 

Royal Mail wishes to persuade Ofcom to bring forward its review of end to end competition currently due to begin at the end of 2015 and link it to Ofcom’s planned Access Pricing Policy Review.  Royal Mail has a strong case. The USO’s financial sustainability will be put at risk if the review is left until the end of 2015, given the length of reviews and the likely complexity of solutions.  Ofcom’s primary statutory duty in postal regulation is not competition but the sustainability of the USO.

By 2017 Whistl (formerly TNT) plans to deliver, three days a week, to 42.5% of addresses in the UK covering only 8% of the landmass.  Whistl after four months of direct delivery has 14% market share in Manchester for example.  Royal Mail is required to deliver to 29 million addresses in 100% of the landmass on six days a week – the USO. Royal Mail is required by Ofcom, the postal regulator, to take all the letters Whistl does not wish to deliver and deliver them to other more-expensive-to-deliver parts of the country. This is cherry picking. In the period 2008-2010, when I was doing my three reports, there was one matter on which all political parties in both Houses of Parliament agreed every time it was raised – cherry picking cannot be allowed to hurt the viability of the much-loved universal service.

2. What is the universal service obligation (USO)?

“Post matters. It is important to the productivity of the economy and for social cohesion. Maintaining the universal service is at the heart of this review.”

The challenges and opportunities facing UK postal services Page 5

“The universal postal service is important.  The ability to deliver items to all 28 million business and residential addresses in the UK is part of our economic and social glue. But the universal service is under threat.” Modernise or decline, Page 6

The Royal Mail’s Universal Service Obligation (USO) is a public good, a national public service, just as the BBC and the NHS are.  The BBC is funded by the licence fee, the NHS by taxation, the Royal Mail’s USO is funded by commercial revenues in an increasingly competitive market. Part of that market – letters – is in long term volume decline.

I think it is helpful to define the USO as a network which is set up to collect six days a week letters and parcels from 115,000 postboxes, 12,500 post offices and thousands of small and medium-sized businesses across the UK, the so-called “first mile”. These letters and parcels  are taken to a mail centre for first sorting in the evening (outward mail centre), then overnight transportation to another mail centre (inward mail centre) for morning sorting, then to delivery offices for six days a week delivery to 29m addresses – the so-called “last mile”.  Mail centres all perform both outward and inward functions.  Alternative carriers who compete with the Royal Mail have no regulated obligations as regards quality and reach of service. UK Mail, for example, collects, sorts and transports upstream bulk business mail to the Royal Mail’s inward mail centres for downstream delivery by Royal Mail (“DSA” - downstream access).  UK Mail does no direct delivery, contracting with the Royal Mail to do it all. By contrast Whistl today (owned by the Dutch postal operator with investment expected from Lloyds Development Capital) does direct delivery in London, Liverpool and Manchester. Whistl then hands over all its other letters to Royal Mail. Royal Mail is required by regulation to take those other letters and deliver them.  Access to the Royal Mail’s downstream delivery is mandated with margin squeeze[2] price controls overseen by the regulator.

The USO is also defined by Ofcom as that set of products which are inside the USO, for example parcels up to 20kg.  It is better in my view to look at the USO as a total network embracing “first mile” and “last mile” with a strong element of fixed costs irrespective of volume.  Your postman or postwoman has to deliver to your house or flat or business six days a week whether he or she has one letter for you or twenty.

As a result of the digital age, for example texts and email, the letters market is contracting 4-6% per year.  As a result of the digital age, for example e-fulfilment, the parcels market is growing but subject to intense competitive pressures on Royal Mail from big companies such as Amazon.

3. What is cherry picking and why does it undermine the USO?

“Competition in the postal sector is asymmetric. While the obligation to provide a universal service rests with one company, Royal Mail, alternative carriers have no restrictions on their business models. As a result, some forms of competition can be inefficient and undesirable. “Cherry picking” has been used to describe a situation in which competitors take advantage of Royal Mail’s universal service constraint in a way to which Royal Mail is unable to respond….The theory of an unsustainable spiral. A spiral could occur, in theory, because of the misalignment of costs and pricing caused by a uniform pricing constraint, making it attractive for competitors to enter where this misalignment is most pronounced. The risk of this spiral occurring in practice depends on:

• The extent to which costs vary according to routes within the network
• The ease by which entrants can gain market share
• The extent to which this fuels an increase in Royal Mail’s unit costs; and
• Whether an increase in price leads to further losses in volume”

Modernise or decline, Page 96

“The more likely strategy for a competitor in the physical mail market is selective entry, cherry-picking the most profitable parts of the market, notably delivery in dense urban areas.  If successful, this undermines the cross-subsidies which are at the heart of the universal service’s viability because of the uniform single price within the UK.”

Saving the Royal Mail’s universal postal service in the digital age, Page 28

The USO’s financial viability is built on cross-subsidies from higher volume cheaper to deliver areas of the UK to lower volume more expensive to deliver areas of the UK.  Cherry picking happens when an alternative carrier such as Whistl direct delivers to the higher volume, cheaper to deliver areas and requires Royal Mail to take the rest of their letters to the lower volume, more expensive to deliver areas.

4. Diagnosis then solutions

When I did my report for the Labour Government in 2008, Prime Minister Gordon Brown suggested that it would be sensible to split the reports into diagnosis and solution. This ensures that people really understand, and ideally agree, what the problem is rather than attention going straight to agreeing or disagreeing with proposed solutions. It is crucially important that Ofcom gets on with the diagnosis rather than waiting for the planned date of December 2015.  If they conclude that cherry picking by Whistl will not undermine the financial viability of the USO, then there is no need to implement solutions, and nothing will have been lost, no unnecessary risks taken. 

But I believe that the evidence put forward in June 2014 by Royal Mail[3] strongly demonstrates that Whistl’s plans are already beginning to undermine the financial viability of the USO. By 2017, based on Whistl’s publicly stated plans of delivering to 42.5% of all 29m UK addresses in just over 8% of the landmass of the UK, the financial viability of the USO will be damaged strongly and possibly irrevocably. 14% market share of direct delivery in Manchester after four months is the fact that needs to be borne in mind rather than the 1% national market share – the whole point is that a cherry picker like Whistl is never going to compete nationally. If Whistl did, there would be no cherry picking!

A major reason for asking Ofcom today to bring forward its review of end to end competition is that if Ofcom agrees that cherry picking is endangering the USO, there are no easy magic bullet solutions.  Some solutions may require primary legislation for example. I believe that fundamental root and branch changes in regulation, changes to access pricing and policy, and changes to obligations on competing carriers will all be required.  That will take time.

5. Conclusion

If Ofcom starts its review in December 2015, it will take at least a year given due process, and in my view it could be longer given the fact that there are no easy solutions. By then TNT could be delivering to 42.5% of all 29m UK addresses with a cost structure that only has to deal with just over 8% of the landmass. The risks of Ofcom getting this wrong are high – the erosion of the USO, the country’s “social and economic glue.”

Richard Hooper CBE

21 October 2014