Message to ministers: Future of Royal Mail requires judgment of Solomon

Royal Mail's letters business is a conundrum. A state-owned organisation operating in a free market. Charged with making profits but obliged to offer a universal service delivering to 27m addresses six days a week. The competition wants to dig deep into its market share and for a year has had the freedom to do so. Top management wants to open up the share capital to the workforce – a proposal that leaves the government facing a judgment that would stretch Solomon.

Yesterday regulator Postcomm delivered its verdict on the first year of liberalisation of the 80m letters-a-day market which has pitted the 350-year-old monopoly against almost 20 challengers. The conclusion? So far, so good – but it's not going to get easier. Price sensitivity, alternatives such as email and the need for innovation mean tough times for the industry as a whole, while Royal Mail also faces the need to adapt and invest.

According to Postcomm the introduction of full-scale competition has given postal service users greater choice and lower costs and has spurred Royal Mail into dramatically improving its service.

Advantages

"Full competition is off to an encouraging start in 2006 with 18 new operators now in the market," Postcomm chairman Nigel Stapleton said. "Many large mailers in the private and public sector have switched to new operators who they have found to be reliable and sensitive to their specific needs. Everybody has benefited because, in response to competition, Royal Mail has delivered record service levels."

In 2005, ahead of the full opening of the market, Royal Mail delivered 785,000 letters on behalf of the competition under deals allowing private companies to collect mail, sort it and hand it to Royal Mail for delivery. This year, according to Royal Mail, the total will be above 2bn. Despite the arrival of competition, Royal Mail's market share is still 96%, according to Postcomm. It does have tremendous advantages, not least its economies of scale and VAT exemption, which have meant that rival end-to-end services (from pickup to delivery without a Royal Mail hand in sight) have yet to get off the ground.
That disguises where the real battle is – the business market. According to Royal Mail 10 customers account for 20% of the total market; 100 for 40%. Not surprisingly it is where Royal Mail rivals are concentrating. Mr Stapleton said: "It is imperative Royal Mail continues to modernise and reshape its business in order to succeed in a competitive market and to maintain a strong universal service customers value."

It is a view shared by Royal Mail. "Competition changes everything," says Alex Batchelor, Royal Mail's marketing director. "Our people are rising to the challenge by delivering to customers in 2006 the best quality of service on record – but we are going to have to work increasingly hard to compete successfully in a very tightly regulated environment. It is crucial that we modernise Royal Mail to become more efficient, use better and more technology, and be even more customer-focused."

The company reckons it needs to invest about GBP2bn in modernising its sorting operations. Postcomm has agreed that Royal Mail can increase stamp prices to help fund the investment and tackle its GBP5bn pension fund deficit.
The government has also agreed in principle to allow Royal Mail to transfer GBP850m into a special account which will give it more time to reduce the deficit. It has agreed a GBP900m loan for investment – on commercial terms. Trade and industry secretary Alistair Darling has yet to decide whether to allow Royal Mail to open up the company's capital structure to permit workers to receive shares.

Deft touch

Royal Mail's top management insists giving shares to staff is an essential incentive if it is to win workers' backing for the modernisation programme. The Communication Workers Union sees it as backdoor privatisation and a breach of Labour Party election pledges. This month Mr Darling promised a decision "soon". It will require a deft touch if he is to avoid undermining management plans without alienating the union and some of his party's backbench MPs.

Nor is competition likely to slacken. Nick Wells, chief executive of TNT Post, one of Royal Mail's leading rivals, said yesterday: "2006 saw one of the biggest changes in the history of the UK mail service with full deregulation. Businesses are experiencing the benefits of competition with improved customer service at better value. We are investing heavily in our infrastructure to ensure we continue to deliver the most competitive and modern postal service for all the operators in the UK."

TNT Post plans to continue lobbying the government to provide what it describes as a level playing field for participants in the postal market – with one area of concern being Royal Mail's preferential treatment over VAT. Another tricky decision for the shareholder.