Funding universal service obligations in the postal sector Prepared for La Poste, De Post-La Poste, Hellenic Post, Poste Italiane, P&T Luxembourg, Correos, Magyar Posta, Cyprus Post, Poczta Polska January 2007 Oxera i Draft for Comment: Strictly Confidential Oxera Consulting Ltd is registered in England No. 2589629. Registered office at Park Central, 40/41 Park End Street, Oxford OX1 1JD, UK. Although every effort has been made to ensure the accuracy of the material and the integrity of the analysis presented herein, the Company accepts no liability for any actions taken on the basis of its contents. Oxera Consulting Ltd is not licensed in the conduct of investment business as defined in the Financial Services and Markets Act 2000. Anyone considering a specific investment should consult their own broker or other investment adviser. The Company accepts no liability for any specific investment decision, which must be at the investor’s own risk. © Oxera, 2007. All rights reserved. Except for the quotation of short passages for the purposes of criticism or review, no part may be used or reproduced without permission. Executive summary Background to the study The European Commission intends to enable the European postal market to be fully open by January 1st 2009, as envisaged in the Postal Directive (2002/39/EC). In the Commission’s view, the confirmation of this date will: allow the benefits of greater competition to improve service levels, in terms of quality, prices and choice available to consumers and to unlock the growth and employment potential of the sector. (CEC 2006b) At the same time, the Commission considers it appropriate that universal service and the associated quality requirements set out in the Directive be maintained in full. Within this context, the issue of financing the universal service becomes critical. This has been acknowledged by the European Commission and in the study undertaken for the Commission by PricewaterhouseCoopers (PwC 2006), which shows that, in some Member States, full market opening is likely to have a significant impact on the universal service provider’s (USP) results. In addition, the Commission identifies a number of flanking measures that countries could adopt to safeguard the provision of universal service under financially viable conditions in a competitive market. These measures, which are ‘considered sufficient to make market opening possible’ (CEC 2006b), include, for example, increasing the commercial freedom of the USP, implementing a cost-based access charge regime, and modifying the scope of the universal service obligation (USO). In some markets, these flanking measures might reduce the burden of the USO such that further funding mechanisms would not be required; however, for many postal markets, such measures may be insufficient to finance the costs of providing universal service. The Commission has acknowledged the need for additional funding—indeed, it is currently proposing a set of alternative options to provide compensation. These include direct state subsidies, sector fees, compensation funds, or public tendering, although no formal analysis of the applicability of these mechanisms to the postal sector appears to have been undertaken. Variations of these alternatives have been implemented across a number of countries and sectors that are subject to universal service-type obligations. However, the fact that some funding mechanisms have worked well in other sectors does not necessarily mean that they could work equally well in the postal sector. Therefore, how the USO in the postal sector may be funded in a further liberalised market is still a challenging question that deserves further consideration. A number of attributes or criteria may influence the relevance of a mechanism to fund the USO, including whether the mechanism promotes efficiency, ensures fair competition, is proportional and transparent, and can be implemented in practice. While it is important to ensure that funding mechanisms are assessed against these criteria, the weight given to each is likely to vary across Member States, depending on the objectives and statutory duties of the regulatory authorities. Oxera i Funding universal service obligations in the postal sector Against this background, Oxera has been commissioned by a group of European postal operators to undertake a detailed assessment of several alternative mechanisms to fund the USO, placing emphasis on their applicability to the postal sector. The study begins by addressing issues surrounding how the USO may be preserved as further market liberalisation is introduced, including the measurement of the cost of the USO and its allocation. Although the focus of the study is on the funding mechanisms, the measurement of the cost of the USO is also considered, to the extent that it may have implications for the design and subsequent assessment of these mechanisms. Furthermore, the study clearly defines a set of criteria that may be relevant for the different regulatory authorities. These criteria are used to assess the generic funding mechanisms and ultimately to determine their applicability to the postal sector. The mechanisms examined are as follows: – reserved area; – compensation funds of various forms; – state funding; – pay-or-play; – access charge uplifts; and – competitive tendering. The assessment of each mechanism has been informed by a comprehensive academic literature review, as well as an extensive review of the experience with universal service-type obligations in the postal and other sectors (ie, energy, telecoms, and rail and air transport). The USO funding problem under liberalisation In a liberalised environment, governments and regulators may wish to preserve the USO— that is, to ensure that customers are able to access certain services on fair terms, irrespective of their geographical or other characteristics. This raises three fundamental questions regarding how, in practice, the USO may be preserved as the market is further liberalised: – how much does the USO cost? – who should provide the USO? – how should the USO be financed? Measuring the cost of the USO is a complex exercise in terms of both the theory behind the concept and the practicability of the methodologies available. Approaches that have been proposed and adopted in a number of sectors and countries have looked at the USO problem from different angles. Some have focused on the costs that an operator would avoid if it were not obliged by the USO to provide services to unprofitable routes/customers; others have focused on the forgone profits of the USP as a result of entry. Only under restricted circumstances would these methodologies provide a similar answer on what size of USO would need to be funded. Because different USO cost methodologies can yield significantly different results, they can have important implications for the design of USO funding mechanisms, especially for mechanisms that rely purely on financing the USO from contributions within the industry. Regardless of the methodology employed to measure the size of the USO cost, the fundamental objective of any funding mechanism is to restore the financial viability of the USP so that it can continue to provide the USO at current levels. This could be broadly interpreted as saying that, after taking into account the net subsidy from the funding mechanism and any flanking measures (including efficiency improvements that might have Oxera ii Funding universal service obligations in the postal sector been achieved by the incumbent), the USP’s financial position post-liberalisation should ensure the full financing of the USO. A related issue is the need to preserve the USO in the presence of legacy costs over which the USP has little or no room to manoeuvre. An example of legacy cost that is of particular relevance for a number of European postal sectors is the civil servant status of the USP’s employees, which may restrict the ability of the USP to respond to competitive pressures. While it may be possible, conceptually, to construct a hypothetical model of the costs of the USO in a world where the USP does not face such legacy costs, this would not be a relevant consideration for the purposes of estimating the required funding to cover USO costs. Rather, the appropriate costs would depend on the size of the efficient costs borne by the USP. In principle, costs that are not controllable due to external factors, such as the civil service obligations, cannot be deemed inefficient from the USP’s perspective. With regard to the second question—who should provide the USO?—in the presence of market liberalisation, a regulatory authority would need to define clearly two key aspects: – how to determine who should provide the USO and how it should be provided—should the USP be selected endogenously using a market mechanism, or determined exogenously by the regulator?; – who should/can provide the USO—the incumbent operator, entrants, or all operators? The answers will define which USO funding mechanism is relevant. Indeed, if the USP is selected using the market force mechanism, the incumbent or entrants, or both, could provide the USO. In this case, funding mechanisms, such as competitive tendering or ‘pay- or-play’, could become relevant to the analysis of how to finance the USO. Alternatively, if the regulatory authorities determine that the USO should be provided by the incumbent only, or shared between the incumbent and entrants, different funding mechanisms could become available, such as reserved area,