Written evidence submitted by Royal Mail plc

1.     Key Points

1.1      Royal Mail is pleased to participate in the Committee’s inquiry into competition in the postal sector and the Universal Service Obligation (USO) including letters and parcels. This inquiry comes at a vital time. Cherry picking direct delivery is threatening the economics of the Universal Service. Without urgent intervention from Ofcom, there is a clear and growing threat to the finances of the Universal Service. A tipping point could be reached. The Universal Service could become unviable before effective changes can be implemented.

1.2      We have said that the revenue impact on Royal Mail of Whistl (formerly TNT Post UK) achieving its previous publicly-stated plans would be over £200m in 2017. Due to the fixed costs of the Universal Service, this revenue impact represents a grave threat, especially as it is likely that interventions will take many years to implement.

1.3      Royal Mail has a business strategy to address the twin challenges of structural decline in letters and a fiercely competitive parcels market. We are a more efficient organisation. We are reducing costs year on year and maintaining and improving a very high quality of service. We are also investing in modernising our business. Achieving our strategy is already challenging. The additional pressure from direct delivery undermines the economics of the Universal Service. This cannot be addressed through any business strategy – it requires a regulatory response.

1.4      Ofcom has said that it could intervene quickly if needed. However, even to undertake a review of direct delivery could take a year or more. Any subsequent interventions could take many years to design, implement and take effect. A compensation fund could take at least 3-4 years to put in place, and be of doubtful value thereafter. Meanwhile, direct delivery operators would be free to continue their roll out. The finances of the Universal Service would be further undermined.

1.5      We believe solutions that rely on revenue contributions from other industry players are unlikely to work. The structural decline in letters volumes, taken with the additional costs involved in network duplication, means there is insufficient profit within the sector to meet the costs to the Universal Service from direct delivery. Seeking to recreate the cross subsidies that direct delivery has unwound is therefore unlikely to succeed. Neither do we favour Government-funded solutions based on taxpayer support. Again, these could take many years to put in place.

1.6      It is better to intervene at an early stage before the Universal Service has been undermined. Once a direct delivery operator has established operations and employed people, it would be very hard for this to be reversed. Indeed, we know of no major example where a regulator has closed down large-scale operations once they are established.

1.7      We therefore propose:

-          comprehensive and urgent measures to address the threat to the financial sustainability of the Universal Service from direct delivery, and;

-          the introduction and implementation of a wider sustainability framework that will underpin the Universal Service for the future at both the UK and EU level. This requires fresh and radical thinking about how the Universal Service can be safeguarded.

The Universal Service: precious, but fragile and under increasing threat

1.8      Royal Mail is proud to deliver the Universal Service. We help to make commerce and social interaction happen across the UK by connecting customers, companies and communities. In a recent survey of the general public, 89% of respondents said that they value the current six day service, a core feature of the Universal Service[1]. Our operation also benefits the UK economy; it is estimated we made the seventh largest contribution to the UK economy of all UK corporations in 2013-14, with a total economic impact of more than £10.9 billion[2]. We employ 148,000 people in the UK and, on average, one in every 200 people working in the UK works for Royal Mail. The jobs provided by Royal Mail are spread across the UK, often in areas of deprivation where employment opportunities are fewer. These high-quality jobs are under threat from direct delivery.

1.9      The Universal Service is precious. But, it is also fragile and is becoming more so. The ongoing structural decline in letters volumes (c.4-6% each year) means that sustaining the Universal Service was a significant challenge prior to the arrival of direct delivery. Parcels should not be seen as a “white knight”. While there is indeed some growth in parcels, competition in the UK is fierce and growing.

Market forces – if left unchecked – will undermine the Universal Service

1.10 The delivery and maintenance of the Universal Service is a cherished public policy objective. It is a public good whose costs are met by its users. This approach has served the UK well. It brings benefits to consumers and taxpayers. If the market were left to its own devices, it would focus only on areas where volumes and profits were high, particularly in the light of the decline in letters and the growth of electronic communications. A six-days-a-week service, to all 29 million addresses in the UK at a uniform price – which Parliament has determined is an essential service – can only be achieved through a legislative and regulatory framework that is actively supportive of the Universal Service. Market forces – if left unchecked - will naturally work to undermine the Universal Service.

1.11 Ofcom’s 2012 Regulatory Framework was a significant step forward, removing many parts of the failed Postcomm regime. However, it did not address the direct delivery problem. And it did not include a comprehensive sustainability framework for the Universal Service to underpin the primary objective outlined in the Postal Services Act 2011, namely, to secure a financially sustainable Universal Service in the United Kingdom. There is an urgent need for a fresh approach. Regulation should be tailored to the unique circumstances of the postal market, where a public good (the Universal Service) cannot solely be delivered by the market. In fact, the normal dynamics of the market – if unchecked - will exploit the arbitrage opportunities in the high density, low cost to serve, urban areas. This effectively removes the traffic needed to finance the whole network, including the high cost rural areas. Regulatory approaches should seek to safeguard the Universal Service against these financially undermining arbitrage opportunities, not promote them.

The UK is uniquely at risk from direct delivery

1.12 Direct delivery removes the mutually reinforcing cross-subsidies (between dense and sparsely populated communities) which underpin the economics of the “one price goes anywhere” Universal Service. It syphons off vital revenues from the Universal Service and leaves the vast majority of the very considerable costs in the hands of the Universal Service Provider. Our postmen and women must still walk the same streets, six days a week, even though the amount of mail they are delivering is sharply reduced and revenues essential to pay for the universal service are lost.

1.13 The effective removal of these cross-subsidies that support the Universal Service would be particularly felt in many parts of the UK. The Universal Service is a lifeline for consumers and businesses in Scotland, Wales, Northern Ireland and many rural parts of England. It helps connect these communities with the rest of the UK and overseas. And it provides stable and valuable employment in these localities.

1.14 The previous regulatory framework gold-plated the European directive. Mandatory access to Royal Mail’s network created an opening for new entrants into the mail business and the regulatory price control guaranteed them a profit. That mandated access regime accelerated the loss of mail from Royal Mail’s network, and led to Royal Mail losing £800m in cash terms on downstream access services in the five years to 2011-12[3]. A very large mandated downstream access mail[4] market has now been created. This means direct delivery is a greater threat here than in any other EU country. Access operators like Whistl already handle c.70% of business mail and over 50% of all letters. Whistl also has direct customer relationships with many mailers. Whistl is actively and rapidly switching mail volumes into its own direct delivery operations in selected urban areas. At the same time, it is leaving any items it does not wish to handle for Royal Mail to deliver. We estimate that over 50% of Whistl’s existing business is converted to direct delivery in areas where they operate.

1.15 The UK’s economic geography makes the Universal Service challenging to sustain. It also creates an attractive environment for cherry picking. In the EU, the UK has the highest concentration of large, dense urban areas. These are very attractive to a cherry-picking strategy: the densest 15% of the population live in just 1% of UK landmass. Conversely, the UK has a significant proportion of costly-to-serve rural areas: just 15% of the population live in low density areas equating to 63% of the total UK landmass[5].

1.16 Direct delivery is not, therefore, level playing field competition. It is cherry picking arbitrage that both exploits the Universal Service and puts its future at risk. The main beneficiaries are the direct delivery operators (and potentially their corporate customers), not the end-consumer. There is a damaging asymmetry between Royal Mail and direct delivery operators. Royal Mail must meet all its Universal Service obligations including its regulatory requirement for a high quality of service. Our costs are therefore higher and relatively fixed. By contrast, a direct delivery operator can choose when, where, and what it delivers. These cost advantages can easily be exploited to set lower prices and, as a result, extract revenues available to support the costs of the Universal Service.

1.17 Royal Mail receives no direct financial support from Government for providing the Universal Service, unlike postal operators in some other EU countries. In Italy, an industry compensation fund operated from 1999 until 2011. It was then suspended as revenues available were insufficient. It failed in part as it only required contributions from operators who were delivering Universal Service mail. But the main competitors to Poste Italiane – as in the UK – chose not to handle such mail. They instead focused on easier-to-handle business mail. Even if contributions had been more broadly based, it is unlikely that industry profits would have been sufficient to meet the costs of the Universal Service. The Italian government now gives direct financial support to Poste Italiane. Our preference is for options that maintain the current system of financing the Universal Service, rather than government or industry-funded solutions. One example is Belgium, where a national law was passed in 2010 to avoid the risk of direct delivery undermining the Universal Service.

2.     The threat to the Universal Service

2.1      Parliament passed the Postal Services Act in 2011. The sustainability of the Universal Service is the Act’s overriding objective. It gave Ofcom its primary duty: “to secure the provision of a Universal Postal Service”. Post is the only sector that Ofcom regulates where its primary duty is securing a Universal Service. Its duties elsewhere tend to focus more on “promotion of competition”.

The growing threat to the Universal Service from direct delivery

2.2      Direct delivery has grown quickly since 2012. Whistl currently operates direct delivery services covering around two million postal addresses. Whistl’s publicly-stated plans demonstrate that it intends to reach over 42% of delivery points but only covering 8.5% of the landmass. This is classic cherry picking. Urban locations and machine-readable business mail items are intrinsically easier to deliver, and less costly, than the generality of mail. Royal Mail is left to deliver to the rest of the country but with less and less revenue available to support the costs of doing so.

2.3      This will undermine the Universal Service. Whistl has recently suggested it may achieve its 42% target in 2019, rather than 2017 as previously stated. This does not alter the existential nature of the threat to the Universal Service. Nor does it alter the fact that remedies can take many years to design, implement and take effect.

2.4      Direct delivery can grow quickly in the UK. The impact this has on the finances of the Universal Service are significant. The damage done to the financial sustainability of the Universal Service is most clearly seen and measured at a postcode level. In new direct delivery areas, Whistl’s local market share quickly reached around 14% as it switched mail into the new service. In our view it can comfortably exceed this share. Revenues needed to support the Universal Service are lost. The current and future impact in these local urban areas is the critical issue, not the current (c.1%) national market share.

Asymmetry between direct delivery operators and Royal Mail

2.5      Whistl’s business model stands in sharp contrast to that of Royal Mail. We must deliver letters six days a week, and parcels weighing up to 20kg five days a week, to all UK addresses. Whistl can achieve rapid growth by choosing:

-          Where it delivers: Operating only in the cheaper ‘cost to serve’ urban areas

-          When it delivers: Providing only an ‘every-other-day’ service

-          What it delivers: 

• Whistl only delivers mail originating from business customers, much of which can be machine-sequenced and is therefore less costly to process and deliver.
• The mandatory access regime allows Whistl to pass any items that it does not wish to deliver to Royal Mail.

2.6      Direct delivery entrants offer customers a lower level of service than Royal Mail. By providing this lesser service, they are able to undermine the Universal Service that we know consumers and businesses across the UK value so highly. They enjoy a 40% cost advantage from being able to offer only an every-other-day service compared to the costs of a six-day service. They also enjoy other cost advantages through not having to comply with regulatory standards and quality of service requirements.

2.7      Direct delivery competition also makes it harder for Royal Mail to run an efficient Universal Service network.  Whistl can decide day by day what it will deliver itself or give back to Royal Mail due to the mandated downstream access framework. This makes it harder for Royal Mail to plan an efficient network.

2.8      Whistl has cited Royal Mail’s ‘advantage’ as a result of the VAT exemption for services which we provide in our capacity as the Universal Service Provider. This is an exemption that flows from EU law to recognise the great obligation on Universal Service providers. VAT exemptions are enjoyed by other major postal operators, including Whistl’s parent company, Post NL. However, the 20% VAT exemption only applies to Royal Mail’s USO and downstream access services. It does not compensate for the larger cost advantage enjoyed by direct delivery entrants who can arbitrage the Universal Service. This is evidenced to Ofcom by the fact that customers, like large banks, have switched delivery to Whistl despite the VAT differential.

Table 1: Major differences in customer service standards

On-going efficiency improvements

2.9      Ongoing structural decline in letters has meant that Royal Mail has focused vigorously on efficiency improvements. We have a good track record on efficiency and cost reduction over recent years. Between 2006-07 and the end of 2012-13, Royal Mail Group invested a total of £2,795 million in the Transformation Programme. The Group estimates this generates annualised savings of c.£0.5 billion. More than 50,000 people have left the business since 2003.

2.10 We are targeting further efficiency improvements. But, these are needed just to cope with the structural decline in letters volumes. They cannot also cover the rapid losses that will result from direct delivery growth. At the same time, the costs of the Universal Service increase. Each year we expect around 150,000 additional delivery points as new homes are created, while letters volumes overall continue to decline.

3.     The urgent need for regulatory intervention on direct delivery

Direct Delivery

3.1      We have asked Ofcom to bring forward its review of direct delivery. Ofcom is constrained by process requirements, e.g. the slow progress on the Access Pricing Policy Review[6] and the current Competition Act investigation.  Carrying out a review to consider direct delivery could take at least a year. Designing and implementing effective interventions could take even longer. Most would take at least a further year to put in place, and could be challenged in the courts. Throughout this period, direct delivery operators can expand their operations significantly, with the Universal Service coming under progressively greater threat.

Commercial pricing freedom to safeguard the Universal Service

3.2      Under its Access Pricing Policy Review, Ofcom should confirm the freedoms from price controls and constraints that Royal Mail thought it had been granted under the 2012 Framework. This is essential to help support the Universal Service. In January 2014, Royal Mail sought to use its pricing freedoms to respond to the direct delivery threat, in line with Ofcom’s March 2013 guidance. Following a complaint by Whistl, Ofcom decided to investigate these new zonal pricing proposals for downstream access. They are suspended while the investigation continues. The limited support they would have provided to the Universal Service finances is, as a result, also suspended.

3.3      It should be noted, however, that pricing responses can only ever offer a partial mitigation of the direct delivery threat, because of the high fixed cost nature of the Universal Service. 

A new sustainability framework

3.4      There needs to be a shift in Ofcom’s focus to create a sustainability framework for the Universal Service. This should include conditions on direct delivery and confirmation that Royal Mail can use access pricing to partially mitigate the impact of direct delivery on the financial sustainability of the Universal Service. But, it should go beyond this to create a comprehensive, forward looking approach that safeguards the interests of consumers for the future. The sustainability framework should be based on a fundamental rethink of the current approach to regulation in post. The framework should explicitly recognise that market forces – if left unchecked – encourage cherry picking and threaten the Universal Service. It should create a level playing field for competition, and remove the opportunities for arbitrage. This would include minimum standards for all postal operators, including for Mails Integrity in letters and parcels, to increase consumer confidence in our industry.  It should also remove the constraints that prevent Royal Mail from competing for the traffic that is available.

4.     Raising the standard in parcels for consumers

4.1      The UK has one of the most developed e-retail markets in the world. The domestic parcels market is highly competitive. Royal Mail is the biggest player in the UK parcels market – handling over one billion items in 2013-14[7].  The Universal Service underpins parcel services for rural SMEs and consumers - other operators charge premiums for delivery to remote and rural parts of the UK, or decline to offer delivery to these areas.

4.2      The dynamic nature of the parcels market is benefiting customers. For example, Royal Mail:

-          is trialling Sunday parcel deliveries and Sunday opening at Delivery Offices;

-          has opened up its networks at weekends to process parcels for large customers;

-          has enabled Click and Collect at 10,500 Post Office Branches;

-          has invested in technology to increase the proportion of parcels that are tracked, and

-          is assessing options for automation of parcels sorting.

4.3      Royal Mail is focused on becoming more of a parcels business as part of its strategy to cope with the structural decline in letter volumes. However, the level of competition in the parcels market makes that challenging. Significant overcapacity is already present in the parcels market. Amazon Logistics, the new service Amazon has created to deliver its own parcels, has taken up most of the recent potential growth. Other operators have also increased capacity. New delivery options including locker delivery and ‘click and collect’ are enticing consumers away from traditional postal parcel delivery models.

Protecting consumers: raising the standard in parcels

4.4      A recent survey by Which?[8] suggests that 60 per cent of people shop online due to the convenience of having products delivered. Which? also found 26 per cent have experienced problems with delivery in the past 12 months. The main problems were: late delivery (17%), delivery failure (3%), and damaged items (2%).

4.5      The UK parcels market is unregulated. Ofcom’s Mails Integrity Code of Practice applies only to letters, not parcels. However, since Royal Mail uses the same network and staff to deliver both letters and parcels we apply these same requirements to all the items we deliver. This is not true for other operators. 

4.6      Royal Mail believes that the Mails Integrity Code of Practice should be extended to ensure the same basic standards apply to the whole parcels industry in order to protect all consumers.

4.7      Royal Mail believes that industry standards need to be improved and that this can be best achieved through either an industry-wide quality standard, and/or, regulation. We believe the current basic requirements would help to ensure the parcels industry delivers a better service for consumers.

Table 2: Proposed standards for the parcel industry

5.     Conclusions

5.1      Royal Mail asks the Select Committee to support its call for an urgent review by Ofcom of direct delivery, and to ask Government to undertake a wider review as to how a sustainability framework for the Universal Service can be put in place.

5.2      The risk of progressing the reviews is low. If Ofcom determines that the Universal Service will not be undermined by direct delivery then the only cost will have been to take forward the work at an earlier point than already planned.

5.3      By contrast, the risk of delay is significant. The failure to review this issue now and bring forward measures needed to protect the Universal Service would be a missed opportunity and risks creating a failure of regulation and public policy, potentially condemning the Universal Postal Service to the history books.

5.4      In summary, in the letters market, Royal Mail calls for:

-          Ofcom to commence immediately its planned review into direct delivery and quickly implement changes to support the Universal Service;

-          Ofcom to conclude its Access Pricing Policy Review and confirm that Royal Mail can use pricing to address partially the financial harm to the Universal Service caused by direct delivery, and;

-          Government and Parliament to consider amendments to the legislation to create a forward looking sustainability framework to secure the Universal Service for the future;

-          The European Commission to make sustainability of the Universal Service the prime objective for any future Postal Services Directive.

5.5      In the parcels market, Royal Mail proposes that:

-          Ofcom should advance its delayed consultation on the Mails Integrity Code of Practice. It should review the regulatory position to ensure a level playing field for all parcels operators and that appropriate consumer protection measures apply to all, and;

-          An industry standard for parcels be developed to increase customer confidence in the market. This could include:

- a rigorous vetting process for employees;

- proof of safe delivery to door or neighbour as standard;

- being a Living Wage employer;

- publishing clear compensation guidelines.

Annex 1: Comparison of postal markets in major EU countries