Memorandum by Royal Mail

Introduction and Summary

1. Royal Mail welcomes the establishment of the Committee and the decision to conduct its inquiry into aspects of the operation of major UK Economic Regulators including the Postal Services Commission ( “Postcomm ”). This brief submission is made in response to the Committee’s Call for Evidence and concentrates on the regulation of the postal industry as determined by the Postal Services Act 2000 (PSA 2000) which gave Postcomm its statutory powers.

2. The principal areas within this submission which we consider merit attention by the Committee include the following:

• the nature of the UK postal market

• how it differs from other utility markets which are often used as exemplars of regulation

• the requirements of PSA 2000 - notably the primacy placed on the regulator, when exercising its functions, to ensure the provision of the Universal Service Obligation (USO)

• the consequent need for the regulator to create a sustainable balance between the USO and competitive developments

• and, given these requirements, the necessity for the regulator to be transparent, accountable and to assess the cost, benefits and impacts of the actions it takes

3. We trust that this evidence will assist the committee in the particular areas it has identified as being central to its inquiry. We would be pleased to provide further information or clarification as required by the Committee.

The UK Postal Market

4. The UK market for postal services has been fully liberalised since January 2006. Postcomm has licensed 20 operators to operate within this market including Royal Mail. These range from very large global companies such as DHL Global Mail UK Ltd (a subsidiary of Deutsche Post, the German postal operator) and TNT Post UK Ltd (a subsidiary of TPG NV, the Dutch Postal Operator) to small, localised operators such as Racer Consultancy Management Services Ltd or Royale Research Ltd, trading as CMS.

5. The Royal Mail licence alone contains a requirement for provision of universal postal service in the United Kingdom. This requires • a number of defined products to be provided at a uniform and affordable public tariff throughout the UK (these products include the expected ‘social

/domestic’ products such as first / second class stamped mail – but also include products that are only purchased large bulk mailers such as Mailsort) • at least one delivery to every delivery point (address) in the UK, 6 days a week; • one collection 6 days a week from defined access points (typically postboxes and post offices); and • a prescribed geographical spread and density of these postal access points

6. To meet the USO, Royal Mail currently provides a capability for uniformly priced items (for example a 32p first class letter) to be posted into the system at any one of 130,000 collection points (postboxes and post offices) for transmission and delivery to any one of 27 million addresses across the UK. This means maintaining a system that has the capability for moving physical items over 3 million million potential different routings every day. Royal Mail handles 80 million letters a day and utilises 70,000 delivery staff.

Economics of Royal Mail and the Postal Industry

7. The mails industry derives most of its revenue from large businesses who post mail in bulk. Most costs relate to the collection and delivery infrastructure which services addresses throughout the UK and the most substantial cost in this infrastructure is human resource.

• Businesses post 87% of all letters, Households post 13% (of which 7% is social mail such as birthday cards and personal letters) • The top 10 business posters account for 16% of all mail, the top 50 account for 31%, the top 100 account for 39%, the top 500 account for 54% • 60% of Royal Mails volume moves from Businesses to Domestic addresses, 27% is Business to Business, 10% Domestic to Domestic, 3% Domestic to Business. • 27 million households post 2.6bn letters a year, but receive 14 billion • The average household spends 50p per week on postage costs • The postal market in the UK between 2000 – 2004 showed 1- 2% annual growth. This flattened with 2005/6 inland letter volumes declining by 1.1% in 2005/6 and future forecasts project decline. (Above data all sourced from Postcomm Strategy Review Consultation Document August 2006) • The Royal Mail cost of operations for the Universal Service was £5.65bn in 2005-6. People costs represented 68.6% of this figure. (source Royal Mail Group Regulatory Financial Statements 2005-6)

8. The above information demonstrates why postal economics are particularly vulnerable to the postal procurement decisions of a relatively small number of large mailers. It also demonstrates that the mail recipients at 27 million addresses do not fund the service provision – but they do have significant interest in it, which is enshrined within the USO requirements.

Competition within the UK Postal Market

9. Competitive entry in the UK mails industry has developed along the lines implied by these revenue and cost economics with entrants targeting the large revenue corporate mailers and using access to the Royal Mail infrastructure for final delivery.

10. Access competition - Under its licence arrangements, Royal Mail is obliged to provide access to parts of its network (notably the delivery capability to 27 million addresses) to other mail companies at a standard rate (subject to price control by Postcomm). Competition has thereby developed through entrant mail companies contracting with the large business posters (such as BT, DWP and British Gas) to switch postings away from Royal Mail. They then use the access arrangements for onward delivery. This form of access mail has grown exponentially in the past year and much faster than originally predicted within regulatory forecasts. In 2004/5 there were 100,000 letters delivered via this process, in 2005/6 that grew to 1.2 billion and the expectation is that will have doubled in 2006/7 to around 2.5 billion.

11. ‘End to end’ competition - the postal operator collects, transmits and delivers the mail itself without reference to the Royal Mail system. The basic economics of the industry would suggest that entrants focus on access mail arrangements to provide a UK wide service offer to the large bulk mailers and then perhaps move to establish delivery operations in selected low delivery cost urban areas (such as city centres). They would do this where localised delivery arrangements could be arranged at lower than the regulated ‘access’ price from Royal Mail but would utilise the access arrangements with Royal Mail to deliver everywhere else. At present end to end activity in the UK is at a low level and is often concentrated in large city centres, but it is expected to grow in such areas.

12. There appears to have been little appetite from other mail companies to date to seek to provide mailing services for small / social mailers or to provide delivery services across the UK. As outlined above, the revenue potential is much lower than in the bulk mail market and is much more costly to service (as posters are more dispersed and are each posting very small volumes). For example Royal Mail makes a significant loss on first and second class stamped mail.

Regulation in the UK Postal Market – Competition and the USO

13. It is clear from the description of the industry in paragraphs [4] – [6] that a tension exists within any postal regulatory system from the interplay between the maintenance and viability of the USO and the development of competition. Parliament recognised this in passing PSA 2000 and gave a clear steer on handling the tension by giving primacy to the USO - requiring the regulator to

exercise its functions in the manner best calculated to ensure the provision of the universal service.

14. The risk is that the asymmetry between revenue and cost structures in postal economics creates cross subsidies between business mail and social mail and between corporate/bulk mail revenues and the USO collection / delivery infrastructure. Competition will concentrate on bulk mailer revenues (given low barriers to industry entry due to the regulated access arrangements). As revenues are concentrated in a few large bulk mailers, substantial revenue can shift away from Royal Mail quickly as particular contracts switch to competitors. Any potential final safety net provided for the USO through the regulated access charge is undermined by competitors setting up their own delivery in low cost areas but still utilising Royal Mail for high cost delivery areas. The risk is that a tipping point is reached whereupon Royal Mail finances that underpin the provision of the USO are threatened.

15. The development of competition and the maintenance of the USO are therefore linked issues in the postal industry. The USO acts as the basic building block. Ironically if it falls, given that it is the platform for competition through access, the competitors are also likely to be unsustainable in the market. The hierarchy of duties for regulation in the industry, as enshrined in the PSA 2000, recognises these fundamentals in stating the primacy of ensuring the provision of the universal service.

16. For background reference, and in order to understand the very latest financial situation of Royal Mail within this fast changing industry, at Annex 1 we associate a copy of the interim report for the half year up to 24 September 2006 together with the summary press release that was issued on its publication on 8 February 2007. These show the increasing tensions in the crucial balance between the need to fund the one-price-goes-anywhere Universal Service and the development of competition: • Royal Mail’s operating profits have fallen by 86% to just £22m in the first half of 2006-07 • Competitive activity has intensified and it is now clear that rivals will in 2006-07 handle some £2.5 billion letters – around 1 in every eight posted in the UK • The Universal Service is now - for the first time – showing an underlying loss • Overall mail volumes are falling – after around a quarter century of growth – and there seems no prospect of Royal Mail relying on volume growth to generate new profits and revenue to sustain the Universal Service • Unlike in telecommunication which had double digit growth as the market was liberalised, competition and competitors have not, to date, generated any additional, new, volumes or revenues. The current position is unsustainable.

Effectiveness of Regulation by Postcomm

17. The effectiveness of Postcomm as a regulator can only be measured by how well it is able to discharge its functions in the Act. Those functions were based on clear awareness of the USO / Competition dilemma – and Postcomm have, throughout its existence, sought to determine what it has seen as an appropriate balance. The way in which Royal Mail has been regulated has been the result of how Postcomm has judged that balance.

18. Postcomm has sought to push hard to promote competition in the market place by, for example, setting its liberalisation timetable in advance of taking a view on what products are required within the USO. It has combined an access approach to stimulate competition with strong regulatory controls on Royal Mail pricing and new product development designed to constrain approaches that can be taken by the incumbent operator to address the competition.

19. The combination of heavy regulation on Royal Mail, plus promotion of competition in an industry characterised by the USO / Competition dilemma, places great power and responsibility in the hands of the regulator. Its judgement on the balance to be struck, and the industry environment created as a result of that judgement, has very far reaching effects. This leads to requirements for accountability and transparency. There are several areas where this is important:

(a) A clear, detailed and properly prioritised forward agenda of Postcomm activity must be provided in its draft business plan to allow the industry to plan resources and activities accordingly and avoid any sense of unstructured, scattergun or micro-management regulatory intervention.

(b) In a complex and fast moving market it is vital that operators know where they stand on regulatory issues quickly. Lengthy investigations and decision making processes undermine the operator’s future plans and stifle innovation within the market place.

(c) Postcomm's discharge of its functions, and the careful balances it must maintain, inevitably require significant information requests upon Royal Mail. To be effective, information requests need to be clear, reasonable and targeted at the outset, with sufficient detail setting out the rationale for the request and with proportionate and reasonable timeframes for responses.

(d) Whilst Postcomm has a Code of Practice governing the discharge of its functions, it doesn’t cover the constitution and decision making framework within Postcomm. A collegiate body of Commissioners has been established. However, with the level of regulation adopted there has been some inevitable delegation of decision making authority to supporting Postcomm staff. Transparency and clarity on such matters of delegated authority are important given the extent of Postcomm’s intervention in the postal industry as it seeks to judge its balance of USO and competition issues. Technical and regulatory expertise together with knowledge of the industry (including its labour intensive, geographical

and economic features which differ from the fixed capital infrastructure of other regulated sectors) need to be clearly utilised in accordance with the “Principles of Good Regulation’ as identified by the Better Regulation Task Force Report 2001.

(e) Regulatory Impact Assessments and proper cost benefit analyses are important in this industry given the careful judgements that need to be established – particularly with respect to the USO. The postal industry increasingly operates on knife edge economics, yet has a wide social significance to virtually everyone in the country (and indeed environmental significance given the emissions involved in serving collection points and delivery points). Regulatory Impact Assessments together with cost / benefit analyses should be an effective tool in maintaining transparency and ensuring sufficient focus on these wider issues.

(f) In handling the USO / Competition balance, Postcomm has rightly emphasised the role that can be played by Royal Mail improving efficiency and growing revenues through innovation and market penetration. This is a challenge that Royal Mail embraces but the impacts of the changing environment and Postcomm’s own regulatory approach to Royal Mail do act as constraints. As set out in paragraph [7] the overall market is now flat to declining. Despite bulk mail contracts being price sensitive and highly competitive, Royal Mail is in a position where 90% of its prices are subject to regulatory control. This restricts its ability to set prices based on costs allowing new entrants to undercut and win the lucrative bulk mail contracts. New initiatives from Royal Mail are subject to lengthy regulatory assessment. Postcomm has also introduced consultations that could lead to further increase in USO costs just at the time when the revenues from bulk corporate mailers are reducing. Efficiency savings have been effectively undertaken within Royal Mail, but are subject to the constraints of the need to meet regulated standards and maintain the USO with its required human infrastructure. The USO / Competition dilemma for the regulator cannot be sidestepped by simply invoking efficiency activity in Royal Mail.

(g) In August 2006, Postcomm issued a consultation on a strategy review document looking at the postal market 2010 and beyond. Royal Mail welcomes this review which opens the debate on important issues around the future of the postal industry at a time of rapid change. This strategy review process remains underway but it does offer an opportunity for Postcomm to reshape the regulatory framework for the industry. The right regulatory strategy – with fair prices, a viable and modern universal service, a competitive business market, and an integrated Royal Mail – will deliver profound benefits to customers.

Comparisons with other Industries

20. In many ways the postal industry differs from the utility industries that are often used as a model for regulation

and liberalisation. The infrastructure is not a hard wired ‘sunk cost’ of cables or pipes from which future revenue streams can be derived against planned maintenance costs. Instead it is comprised of large numbers of people who need to be managed, motivated and funded (including pension issues) on an ongoing basis.

21. The postal marketplace is no longer growing – as was, for example, the case when Telecoms was in a comparable regulatory situation where its market had double digit growth. Rather it is flat to declining with significant risk of e-substitution. The social / household consumers for whom the regulator holds a clear remit are not prime payers of the service as is the case in most utilities.

22. Postcomm does not have concurrent powers under s.60 of the Competition Act 1998 to apply either Chapter I or II prohibition nor to apply Articles 81 and 82 of the Treaty. This limits the obligation on it, in implementing its fair-trade condition, to demonstrate that there is an effect on trade arising out of any alleged infringement. Finally PSA 2000 places a clear requirement on the primacy of the USO in the approach to regulation in the industry. This differs, for example, from the Utilities Act 2000 where competition has the prime emphasis.

23. Against this backdrop the postal market has been opened up to full competition at different pace than most other industries. For example in electricity, market liberalisation followed a clear three stage process that took place over 8 years.

Conclusion

24. The task facing Postcomm is a difficult one although it is a clear one as laid down in the Postal Services Act 2000. It bears a heavy responsibility and is accountable for judging the right balance between the USO and competition, ensuring that competition is not emphasised at the expense of the USO. There have been benefits from the introduction of competition for large posters and in terms of assisting the development of commercial and customer focus mindsets within Royal Mail. These benefits should be built upon in the future.

25. However, the primary function for Postcomm is ensuring the provision of the universal postal service and this must be its prime measure of effectiveness. The key issues Postcomm should consider are: • There has been to much emphasis on competition at the expense of the universal service • The particular economics of the postal industry mean that viability of the USO can tip quickly as change accumulates. • The market has moved both differently from original forecasts (such as overall volume decline replacing growth) and more rapidly than originally expected (such as accelerating growth in access mail). • Large global players have moved quickly into the market to compete for bulk mail

• Royal Mail’s competitive response in these crucial revenue generating markets has been hamstrung by heavy regulatory controls including constraints on its ability to price on a cost reflective basis. • The same constraints hamper the ability of Royal Mail to underpin the finances of the USO. This leads to the very real risk that the pace and trajectory followed to date - fast on competition, slower on USO finance protection – if extrapolated forward, and left unchecked, can, and is likely to, lead to market failure.:

26. There are steps that can still mitigate such developments: • The USO should be re-focused specifically on stamped mail rather than including bulk business products • The removal of cross-subsidies to create transparency for business customers and to ensure that competition is sustainable • Full retail deregulation of business products as competition has now replaced the need for regulatory constraints. • Speedier regulatory processes that remove restrictions on Royal Mail and allow us to compete through innovation and the development of new products and services that are increasingly being demanded by our customers.

Such adjustments in the regulatory trajectory, driven by recognition of how the market has moved, would serve the interests of both sustainable competition and, crucially, credible ongoing USO financing – and it remains the prime duty for Postcomm to exercise its functions in the manner best calculated to ensure the provision of the universal service.

15 February 2007

Annex 1 – Interim Half Year Results and associated news release

Royal Mail Group Royal Mail Unveils Financial Re-Organisation And Investment Plan 08/02/2007

Government Backs Group-Wide Modernisation

Royal Mail, operator of Britain’s state-owned mail service and the Post Office network, is today unveiling an ambitious investment plan to strengthen the group’s finances, improve competitiveness and reward its workforce.

The five-year programme, agreed by the Government, will re- position Royal Mail to compete more effectively with commercial rivals and address major funding challenges for the company.

Highlights of the programme include:

• Government agreement for a £1.2bn debt facility, on commercial terms, to modernise Royal Mail operations • Restructuring of the Post Office network, already approved by Government • £1bn investment in an escrow account to give security to the pension fund trustees, including £850m from company reserves and a further payment of £150m by Royal Mail • Royal Mail agreement in principle with the pension fund trustees to fund the pension deficit, currently standing at £6.6bn, over 17 years • Consultation on how best to safeguard an affordable final salary pension scheme for existing employees • Consultation on replacing the final salary scheme for newly recruited employees with a defined contributions scheme • Inaugural "phantom" share scheme to reward Royal Mail’s 190,000 employees, worth up to £5,300 per employee over five years - equivalent to a £1bn dividend distribution.

Alistair Darling, Secretary of State for Trade and Industry, said: "We fully support the business in delivering the programme of reform that it needs to undertake. We recognise that there are a number of difficult changes that need to be made to the way the company operates, including limiting the pension liability going forward, and fully support the business in making them. It is for the management and staff to make the changes necessary to give the company a sound platform on which to build for long-term success in a competitive market."

Allan Leighton, Royal Mail Chairman, said: "Continuing to transform our operations isn’t optional. We will do so while also rewarding our people for their efforts and allowing them to share in our continued transformation."

Adam Crozier, Royal Mail Chief Executive, said: "Our goal is to have a strong and healthy Royal Mail - providing better services than our rivals and with a real chance to compete in the open, competitive market place. We have been talking for some time about how we need to modernise this business to compete. Now we have the means to get on with it."

Financial Performance

Operations have already been transformed under the new management team at Royal Mail. As a result - and with the support of the group’s workforce - losses that were running at £1m a day four years ago have been transformed into a £355m operating profit last year.

However, the cost of servicing the pension fund has continued to be a major drain on the group’s financial performance. The servicing costs of the fund rose by £280m to £730m in 2006-07. As a result, interim profits at Royal Mail fell to £22m from £159m in the first six months of the 2006-07 financial year, in spite of a 1.4% increase in revenue to £4.4bn. Although the decline is in line with management expectations, the £730m annual cost of servicing the pension fund is threatening Royal Mail competitiveness.

Restructuring to Date

The modernisation programme follows significant action by

management and all employees to transform Royal Mail. Historic losses have been wiped out following the changes.

The improvements to date have led to: • Record quality of service • Improved productivity • Reduced absenteeism • Better industrial relations • Substantial increase in basic pay - 25% over the last four years - and "Share in Success" payments of around £1500 have played an important role in motivating the workforce.

Details of Royal Mail Modernisation

1. Competitive and Regulatory Environment

The sweeping modernisation of Royal Mail, one of Britain’s iconic companies, follows a major shift in the competitive environment for postal services, compounded by structural changes - in the internet age - in the way information is received and consumed.

As a result of these new market forces and stringent regulatory constraints: • Total volumes in the UK mail market fell by 2 per cent year on year in the first half of 2006-07 • Competitors are expected to handle some 2.5bn items of mail this year out of a total volume of 22bn handled by Royal Mail - currently Royal Mail loses around 2p on every one of these items • Operating losses at the Post Office have doubled to £4m a week following the loss of Government contracts to handle pensions and benefits business.

Royal Mail cannot compete on commercial terms because of the constraints on its pricing and flexibility imposed by the regulator. In this environment, it will be increasingly difficult to protect volumes and revenues. Royal Mail must respond to these significant market challenges and continued pressure on group finances by accelerating its modernisation programme to improve productivity and cut costs further.

2. Future Modernisation

The Government has agreed a financial package based on a new strategic plan for the next five years. The plan includes: • Commercial loans to invest about £1.2bn in Royal Mail to modernise the business - these loans need to be repaid out of productivity gains • £1bn injection to safeguard pensions and address the deficit - including £850m from company reserves and a further payment by Royal Mail of £150m • Separate funding agreed already for the Post Office network to restructure it over next five years • Return on the investment will require significant improvements in competitiveness - but will offer a substantial return to Government if plans succeed • Productivity will need to be addressed across the group • Employees will be rewarded for their contributions, in addition to pay, through an innovative phantom share scheme.

3. Phantom Share Scheme

Royal Mail and the Government, its shareholder, have agreed to set up a "phantom" share scheme for all employees. In its application, the scheme will be similar to that operated by the John Lewis Partnership, one of the UK’s leading retailers.

Under the terms of the scheme:

• 20 per cent of the value of Royal Mail today will be earmarked for employees • Shares will be distributed equally to every employee, from board members to frontline delivery staff • Up to £1bn could be distributed to employees if modernisation targets are reached • Shares will be distributed free, they will not be paid for • Employees holding shares will receive an annual profit share, based on Royal Mail’s performance • The profit share combined with the phantom shares themselves are expected to be worth up to £5,300 per employee over five years, depending on performance.

Allan Leighton, Chairman, said: "The task facing our people is daunting. That’s why we are particularly pleased that the shareholder has agreed to an employee incentive scheme similar to the one run by the John Lewis Partnership. It will underpin the commitment and engagement of our people who, we know, are capable of transforming this vital business on which the whole country depends."

4. Pension Scheme

Given the competitive situation and the pension deficit, Royal Mail is today announcing steps to tackle the issue. After careful consideration, the group management has agreed the following steps to protect the interests of existing employees and provide safeguards for newly recruited staff.

• Consultations will take place on ways to safeguard an affordable final salary scheme for all existing employees • Separate consultations will begin on replacing the final salary scheme for newly recruited employees with a defined contributions scheme • Consultations are expected to begin in April and continue for about six months • Any resulting changes will affect all employees from board members to frontline staff • Royal Mail has also reached an agreement in principle with the pension fund trustees to fund the pension deficit, currently standing at £6.6bn, over 17 years. Increased payments are already underway, reflecting the company’s commitment to its workforce • Under the new modernisation programme, £1bn will be held in escrow accounts to provide security for the pension fund trustees.

Adam Crozier, Chief Executive, said: "It is important we safeguard the future of the pension fund for our people, who regard having a final salary pension scheme as a key benefit of working for Royal Mail.

"But the £730m annual cost of servicing the pension fund clearly damages our competitiveness as we need to increase the price of our products and services to pay for it. Around 93 per cent of our mail volumes come from business customers and

they should not have to pay for the increased cost of our pensions - and if we ask them to do so more of them will simply go to the competition.

"So to ensure the problem does not get worse for the company or our pension fund members we will now begin a six month consultation on replacing the final salary pension scheme for new recruits with a defined contributions scheme, and on the best way to safeguard an affordable final salary scheme for our existing employees."

5. Management & Government Endorsement

Royal Mail management and Government ministers have agreed the plan following several months of detailed talks and proposals.

Today’s announcements provide clarity and confidence for the Government about the continued prospects of Royal Mail and the Post Office network.

Adam Crozier, Chief Executive, said: "These are enormous challenges but if Royal Mail is to compete and thrive, there is no alternative to change."

Ends

Issued by Royal Mail Group plc 148 Old Street LONDON EC1V 9HQ www.royalmailgroup.com