Postcomm proposes tighter price and service targets for Royal Mail

Postcomm today (1 June 2005) published initial proposals for regulating Royal Mail’s prices and quality of service that will enable customers to benefit from a more efficient Royal Mail as a fully competitive mail market develops.

The proposals:
• Freeze Royal Mail’s average domestic prices from 2006-2010
• Introduce service quality targets more suited to customers’ needs, and
• Create the conditions that will enable new operators to establish themselves successfully in the mail market.

Nigel Stapleton, chairman of Postcomm said: “These proposals offer customers a better deal and secure the universal service. The revised price caps are challenging but achievable as Royal Mail’s prepares for the full opening of the market in 2006”.

“Royal Mail still has over 99% of the letters market, but even limited competition so far in the marketplace has made the company more efficient and more customer-focused. The UK mail market is dynamic and growing. These proposals build on the momentum already generated by competition.

“Our proposals seek to strike an appropriate balance between Royal Mail’s regulatory freedom in a newly liberalised market and the interests of mail customers and rival postal operators. This is good news for domestic customers, who would benefit from a freeze on Royal Mail’s average prices and stronger incentives on the company to improve its quality of service.”

Postcomm’s proposal is that the revised controls would operate for four years, from April 2006 until March 2010.

The proposals – which are out for consultation for three months – follow a thorough review by Postcomm of the costs to Royal Mail of providing its regulated activities, including the universal service. They also take account of Royal Mail’s need to:

• make pension fund deficit contributions,
• invest in new capital equipment and
• finance its operations.

The structure of the control allows Royal Mail the freedom to make a regulatory profit of about £285m a year, although it could improve on this figure by increasing its efficiency or growing its volumes above the levels projected in the control. Royal Mail has done this before. “It has very significantly outperformed our last price control and is in good financial health”, Mr Stapleton said.

“Royal Mail says it’s ready for full competition and if it continues to improve its efficiency, this price control will enable the company to earn attractive returns for its shareholder, and at the same time pay down progressively its £4.5 billion pension deficit,” he added.

PRICE CONTROL DETAILS

Efficiency and revenue
• A comprehensive assessment of Royal Mail’s costs carried out by Postcomm suggests it can achieve efficiency savings of between 2.75% and 3.25% per year. Assuming 3% it should be able to achieve the proposed price caps.

• The proposals create a framework to increase investment in the universal service network. This will be achieved by establishing a “Regulatory Asset Base” to include all new efficient investment – Postcomm will ensure it earns a reasonable return. The initial regulatory asset base – based mainly on Royal Mail’s property and capital equipment – is calculated at £2.2 billion. Using this as a basis, Postcomm has allowed the company a regulated profit each year of about £285m. This is not a fixed amount. Royal Mail can earn more profits by efficient investment in new capital equipment, by outperforming the price control in terms of efficiency and by continuing to grow its mail volumes.

• Royal Mail is under-invested compared with some European operators and the proposals provide strong incentives for the company to increase its capital investment, such as by automated sorting of mail.

• Postcomm is proposing two price caps: for a ‘captive tariff basket’ of products, mainly used by the general public who have no alternative to using Royal Mail, and for a ‘non-captive tariff basket’ of products which are principally used by business customers, who are more able to use alternative operators. The proposed price cap for the captive basket – which would include first and second class stamps — would be RPI minus 3% per year. The proposed price cap for the non-captive basket of products is RPI minus 2% per year. Assuming annual inflation of 2.5%, this effectively freezes average prices. However Royal Mail will be able to increase prices of individual items by up to 4%, above the average price control, providing it reduces other items by the same amount to stay within its pricing average.

• If Royal Mail applied this 4% rule to public stamp prices, assuming an RPI of 2.5%, the maximum this formula would allow a first class stamp to rise would be from 30p now to 34p in 2009/10.The maximum increase for the second class stamp price would be from 21p now to 23p in 2009/10.

Service standards
• Postcomm has overhauled the existing service targets to make them more suited to customers’ requirements. At present Royal Mail has 16 service targets. Postcomm is proposing to rationalise these to produce a new list of ten service standards. As before, six of the targets will be public first and second class, bulk mail first and second class, public Special Delivery and postcode areas. To these Postcomm is proposing to add four new standards, relating to:

o correct delivery (mis-delivery is responsible for a significant number of complaints to Postwatch, the consumer body). We will consult on what the level of target should be;
o proportion of mail collected each working day – target 99%;
o proportion of mail delivered each working day – target 99%;
o proportion of outgoing mail going to European destinations that is delivered within three days – target 85%.

• Royal Mail already has to pay compensation to business and private customers if it misses its service targets. In the financial year ended April 2004, the company refunded more than £40 million to business customers. Another incentive is the so-called “C” factor in the price control which limits Royal Mail’s allowed revenue in the following year if it misses its service targets for non-bulk mail. Postcomm is proposing to increase the C factor more than five-fold from 0.9% of revenue for the relevant products to 5%. Taken together, these measures could cost Royal Mail as much as £280m if it missed all performance targets by 5% or more.
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Pension deficit
Sufficient money is allowed for funding the present pension deficit over the four year period. Postcomm proposes to allow Royal Mail a sum of money in the price control sufficient to fund its pension deficit contributions, calculated on annual contributions over a 20 year period. This will ensure that its financial health — and ability to provide the universal service — is safeguarded and it remains able to finance its other licensed activities.

Regulation of access
Postcomm proposes to regulate some of the prices that Royal Mail is charging for delivering mail from competitors over ‘the last mile,’ the so-called access price. At present access prices are outside the scope of the price control.

Royal Mail has a monopoly in providing access services every day on a national basis and Postcomm is concerned that without regulation there is a risk that this route to market will not develop sufficiently to stimulate competition and innovation.

Already operators are concerned over “margin squeeze” (the difference between what they pay Royal Mail to deliver their mail and the price they charge the customer). Royal Mail has reduced the margins of some of its products since access was introduced.

Any control is likely to be based on a minimum differential between access products and their equivalent retail tariffs. Further work will be needed before drawing any firm conclusions. Postcomm hopes to publish access proposals with its final price control proposal in November this year.

Notes

The market for large users, such as banks and direct mailers, was opened to competition in January 2003. Royal Mail retains over 99% of the market. The rest of the mail market will be fully open to competition from 1 January 2006.

The regulatory profit of £285m relates to accounting earnings before interest and tax. In cash terms, Royal Mail is expected to achieve cashflows before interest and tax of £265m per annum. Both figures are in nominal terms and relate only to Royal Mail’s regulated activities.

Today’s document, 'Review of Royal Mail’s Price and Service Quality Regulation from 2006 – Initial Proposals,' is published on Postcomm’s website www.psc.gov.uk. Printed copies will be available shortly from Postcomm at 6 Hercules Road, London SE1 7DB. Responses are requested by 1 September 2005. Postcomm will listen carefully to the views of interested parties such as Royal Mail, Postwatch, customers and operators. Postcomm will also have regard to the outcome of the government’s review of postal services, as foreshadowed in the Labour party manifesto.

JOIN THE DEBATE

Postcomm's price control proposals will be debated for the first time at Postcomm's London Forum on Wednesday 8 June. Speakers will include Sarah Chambers, chief executive of Postcomm, Adam Crozier, chief executive of Royal Mail, Bart Stromphorst, managing director of Sandd BV, the Netherlands and Kevin Trever of BSkyB. Industry representatives and large mail customers are welcome to attend. To pre-register for this free event contact Jessica Collett at [email protected].