What has been the experience of giving more commercial freedom?

Marina Gibbs, Competition Policy Director 10th December 2019

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM Agenda

• Overview of evolution of UK regulation & current regulatory framework

• Market and competition landscape

• Consumer outcomes

• The USO business and Ofcom’s approach to measuring sustainability

• Performance of the USO business and recent strategy

• Ofcom’s work programme in post

Jean Downey (Head of Digital and Creative Services) and Verity Pillinger-Cork (Digital Manager)

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 2 Overview of how postal regulation has evolved

Second Directive 2002/39/EC Third Directive 2008/6/EC – – continues trend towards full liberalisation of markets (in liberalisation 2011/2013)

Postal Access Hooper Report Postal Services TNT Post (now Royal Mail Ofcom Ofcom Services Act competition published – Act 2011 – ) begins shares (70%) announces concludes 2000 – begins, then “Modernise or general end-to-end traded on the review of review of licensing proceeds to Decline”, updated authorisation delivery trials in Stock postal postal regime grow 2010 regime replaces West London Exchange regulation regulation introduced significantly licensing

2000 2003 2005 2006 2008 2011 2012 October January June March 2013 2014 2015 2017 Postcomm is Business mail Market Ofcom gains New Ofcom opens Whistl set up removed liberalisation responsibility regulatory Competition withdraws from the for regulating framework Act from end-to- reserved area the postal investigation end market sector Into RM’s access prices

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 3 Ofcom’s regulatory framework since 2012

• Freedom to set the significant majority of prices

Greater commercial & • Flexibility to better meet the needs of customers, through non-price operational freedom for changes to universal services and more operational flexibility Royal Mail12 • Ability to negotiate terms and conditions with non-universal service customers

• Retained the high quality of service standards and requirements to provide a First and Second Class service of the previous universal High quality standards postal service

BUT subject to key safeguards….

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 4 Key safeguards

• Monitoring Royal Mail’s performance with the power to re-intervene if necessary to ensure: Monitoring – Quality of universal services is maintained – Royal Mail becomes more efficient over time – improved profits not to come entirely from price rises

• Ensuring a basic, affordable universal service is available to all: – A 65p cap for 2C letters (with CPI inflation increase each year) – current 2C safeguard cap price is 61p and a basket cap for large letters and small packets up to 2kg

• Letters competition: – Mandated access for operators to inward mail centres Access competition – Ex-ante margin squeeze test

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 5 Our 2017 review concluded that current regime should remain in place until 2022

• 2012 approach to regulation should remain in place until 2022: – not appropriate to impose retail or wholesale price controls (other than 2C safeguard caps for affordability reasons) – shareholder discipline more likely to be effective in securing an efficient and financially sustainable universal postal service than the imposition of additional regulation

• Consumers’ interests regarding parcels are best served by competition, but given Royal Mail’s high revenue and volume shares for single piece and light-weight bulk parcels, we would: – protect consumers by retaining the safeguard cap on Second Class single piece parcel prices – retain the current position on standard universal service parcels, i.e. that tracking is not included – review Royal Mail’s regulatory accounting rules and develop cost models to ensure Royal Mail does not unfairly leverage its strong position in letters

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 6 There is very limited end to end access competition in the UK market…

• Whistl began to extend delivery coverage to major cities in 2012 before exiting the market in 2015 • Its exit followed a change to access pricing announced by Royal Mail in Jan 2014 that would have meant access operators who did not use Royal Mail for virtually all deliveries (such as end to end competitors) would pay higher prices • Ofcom subsequently opened an investigation and found that Royal Mail’s conduct infringed competition law and imposed a £50m fine • Ofcom’s decision was upheld in full by the Competition Appeal Tribunal (CAT). Royal Mail is currently seeking permission to appeal the CAT’s decision • In contrast, access operators account for the majority of all letter volumes (>60%)

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 7 …while the parcels market is significantly more competitive

Overview of competition in the parcels market Strong and dynamic e-commerce market

• Significant number of parcels players active in the • E-commerce sites reach: 94% of UK internet users UK market, including many international • Shop online: 70% of UK internet users - More than companies (Amazon, DHL, UPS…) half (54%) of all internet users claimed to do more • Royal Mail share of addressable UK parcels market of their shopping online ‘these days’. 51% in volume and 40% in revenue terms (1) • However Royal Mail is particularly strong in the • Top two retail sites, Amazon and eBay, reached single piece small packets segment (up to 2 kgs) 79% and 68% of the UK online audience aged 13+ with a 80-90% share of volumes and revenues (2) respectively.

Sources: (1) Royal Mail Journey 2024 presentation, Slide 68, 2017 numbers, Source: Ofcom Online 2019 report excludes Amazon Logistics and same day parcels (2) Ofcom review of the second class safeguard cap, January 2019

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 8 2018/19 saw an acceleration of letter revenue and volumes decline….

Addressed letters volumes (millions) Addressed Letters Revenues (millions)

Source: Operator returns, Ofcom estimates Note: Revenues are in real terms Source: Royal Mail Regulatory Financial Statements, operator returns to Ofcom, Ofcom estimates.

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 9 …while parcel volumes grew by 10%

Total measured parcels volumes and revenues Domestic parcel volumes and revenues by (including international) speed of delivery: 2017-18 and 2018-19

Note: Revenues are in real terms Note: Revenues are in real terms Source: Operator returns to Ofcom/Ofcom estimates. Source: Operator returns to Ofcom/Ofcom estimates.

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 10 Residential customer satisfaction remains high…

NET Satisfied Overall Satisfaction postal services(QG6) 2018/1 39% 47% 10% 2%1% 1% 86% 9

2017/1 39% 48% 9% 2%1%1% 87% 8

Overall Satisfaction with Royal Mail(QG5) 2018/ 38% 11% 3%1% 19 46% … 84%

2017/ 39% 47% 10% 3%1% 18 86%

Satisfaction with postal services for Value For Money of sending post (QG2) 2018/ 31% 45% 15% 6% 2%1% 19 76%

2017/ 32% 45% 14% 5% 1% 18 2% 77%

Very satisfied Fairly satisfied Neither Fairly dissatisfied Very dissatisfied Don’t know

Source: Ofcom Residential Postal Tracker Q3 2018 – Q2 2019 (5,956), Q3 2017-Q2 2018(5,779)

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 11 …as does SME satisfaction

Source: Ofcom Business Postal Tracker

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 12 The Reported Business is the part of the Royal Mail group we look at to assess USO sustainability Overview of Royal Mail Group

Reported business: Revenues Royal Mail Group £7.1bn USO packets and parcels, Non USO 2018/19 Revenues £10.5bn packets and parcels. REGULATED Parcelforce: Revenues £0.5bn Express parcel and business in UK mainly for businesses. UNREGULATED

GLS: Revenues £2.9bn International parcel delivery and logistics. Most profitable part of business UNREGULATED

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 13 We use EBIT margin as a first order test to assess sustainability

Reported Business EBITDA

• Use of 5-10% as an indicative range was first introduced in 2012, and has been subject to ongoing consideration • While the upper end may be associated with potentially excessive levels of return, at the lower end we look at additional financial health metrics: – credit rating – funds from operations (FFO) / net debt – net debt / EBITDA – EBITDA / interest

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 14 Margins at UKPIL fell in 18/19 but parcels showed strong revenue growth

Overview of UKPIL financial performance in 18/19 2018/18 UKPIL performance

• 18/19 EBIT margin outturn for UKPIL (i.e. 18/19 17/18 Change Reported Business plus Parcelforce) almost halved Total revenues 7,595 7,615 Flat relative to 17/18 (£m) Operating 7,263 7,112 2% • This was driven by a 2.4% increase in costs on flat costs (£m) revenues: Transformation 133 113 17.7% – parcels revenue grew 7% costs (£m) – addressed letters revenue fell by 8% EBIT margin 199 390 (48%) • Despite weaker performance, the financial health (£m) of the Group remains strong: EBIT margin % 2.6% 5.1% – investment grade credit rating Note: equivalent metrics for the Reported Business have not been – successful bond issue of £550m in October published yet – key financial threshold tests comfortably Source: Royal Mail Capital Markets Day presentation exceeded

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 15 Royal Mail has announced a new strategy that aims to transform it into a parcels’ led business Strategy overview Key network changes anticipated

• In May Royal Mail announced a new 5 year strategy • Creation of “overlay network” of 3 large parcel hubs

• Overall vision is to “turn around and grow the UK • Creating 7k dedicated parcel routes for urgent and business” by transforming the parcels network to larger parcels enhance its e-commerce proposition… • Reducing combined letters & parcels routes from 60k • …with the aim of parcels revenue growth outstripping to 50k letters revenue decline… • …while also targeting 15-18% productivity • Increasing parcels automation from ~12% to >80% by improvements to 2023/24… 2023/24 • …returning to ~5% EBIT margins at Group level by2023/24

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 16 Implications for Ofcom’s work programme

• We are currently undertaking preparatory work to help inform our 2022 review of the future regulatory framework for post

• Key work packages include: – development of bottom-up cost model of Royal Mail’s network – efficiency review – review of postal user needs

• …while we continue our monitoring programme and expect to publish our annual monitoring report shortly

PROMOTING CHOICE • SECURING STANDARDS • PREVENTING HARM 17