Postcomm proposes modest stamp rises to secure financing of the universal servics

POSTAL SERVICES COMMISSION News Release (35/05) issued by the Government News Network on 7 December 2005

Postcomm, the independent regulator for postal services, today proposed a price control for Royal Mail that will allow modest increases in stamp prices to enable the company to modernise its operations, secure its universal service, serve its customers better and help plug its £4bn pension fund deficit.

Postcomm's final price and service quality proposals for 2006-10, published today, will:

* Safeguard the one-price-goes-anywhere universal service

* Provide an unprecedented £1.2 billion for Royal Mail to invest in modernising its network

* Allow Royal Mail an average of £320m a year towards reducing the £4bn deficit in its pension fund

* Require Royal Mail to increase its efficiency by at least 3% per year.

The customers' contribution towards funding these initiatives will require an increase in stamp prices. Royal Mail will be able to raise first class stamp prices next year from 30p to 32p. By 2010 these prices will be capped to a maximum of 36p.

Royal Mail has indicated that it accepts the price caps proposed and its responsibility to finance its business within these constraints.

Postcomm chairman Nigel Stapleton said: “This is a fair deal for customers, Royal Mail and new entrants to the competitive market. After five months of intensive consultation we have made three major changes to our initial proposals, allowing Royal Mail more money for pensions, more for investment and protection against risk if mail volumes or its pension assets alter significantly. Our proposals challenge Royal Mail to push harder for greater efficiency and to bring about a radical transformation in its letters business.

“The rises in stamp prices are substantially less than Royal Mail wanted and a little more than we planned. But without a contribution from customers, Royal Mail's weak financial position, brought on by its large pension deficit, would have put its ability to provide the universal service at risk.

“The long period of uncertainty about how Royal Mail is to be funded and how to deal with its pension deficit have been damaging. We hope, therefore, that these proposals can serve as the catalyst to enable these issues to be addressed quickly so that Royal Mail can focus on delivering better standards of service, greater innovation and higher efficiency.”

Royal Mail told Postcomm it needed first class stamp prices to rise to 39p by 2010. Postcomm's initial proposals published on 1 June, suggested 34p. The increase in these final proposals take account of new information provided by Royal Mail on the threat posed by its pension deficit, revised volume forecasts and the value added by its investment programme.

The control provides a 'safety net' for the universal postal service, which Royal Mail is required to provide, when the market will be fully open to competition for the first time. If mail volumes (and therefore Royal Mail's revenue) fall significantly short of forecast or the pension deficit increases for reasons outside the management's control, there will be an automatic adjustment to the price control.

The control also strengthens the protection for customers and new operators against any anti-competitive behaviour by Royal Mail. It includes a new provision, which prevents Royal Mail from squeezing the margins between the access price operators pay Royal Mail to deliver the mail over the 'last mile' and Royal Mail's retail price.

The standards of service that Royal Mail must provide have been simplified to align them more closely with what customers need. There will be stronger financial incentives for Royal Mail to meet its service standards.

NOTES FOR EDITORS

The price control in more detail

Price caps

Price caps in the control allow Royal Mail a one-off price increase on its regulated letters business of 6.2% (inflation plus a little over 3%) in the first year of the control, from 1 April 2006, to allow the pension deficit to be paid down more quickly. Royal Mail requested an initial price increase rather than a gradual increase over the four-year period. From the end of the first year, if inflation stays at around 2.5%, there will be no further increase in Royal Mail's average prices, although the price of the lowest weight step stamp is likely to rise.

There are two price caps. Products that are mainly used by the general public – who at present have no alternative to using Royal Mail – will be regulated in a 'captive tariff basket.' Products used by businesses – who are more likely to have a choice of operator – will be regulated in a 'non-captive tariff basket.'

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The price cap for the captive tariff basket will be a 6.2% increase in year one followed by prices pegged to RPI minus 1.5% per year until 2010. For the non-captive tariff basket the cap is 6.2% in year one and RPI minus 3.5% per year until 2010.

Within each basket Royal Mail will be able to increase prices of individual items by up to 3% above the average price control, providing it reduces other items by the same amount. It cannot rebalance prices between baskets. It is this 3% rule that will allow Royal Mail to raise public stamp prices.

Efficiency and revenue

A comprehensive assessment of Royal Mail's costs carried out by Postcomm and its advisers suggests it can achieve efficiency savings of between 2.75% and 3.25% per year.

The proposals establish a “regulatory asset base” to include all new efficient investment, which Postcomm will ensure earns a reasonable return. The initial regulatory asset base – based mainly on Royal Mail's property and capital equipment – is calculated at £2.3 billion. Using this figure, and assuming the 3% per annum efficiency savings, Postcomm has allowed the company an average annual profit on its regulated activities, before pension deficit contributions, interest and tax, of around £650 million (10% operating margin). Pension deficit payments will average around £320 million per year. Royal Mail can earn greater profits by efficient investment in new capital equipment, by outperforming the price control in terms of efficiency and by growing its mail volumes – as it has under the current control.

Royal Mail's pension deficit.

The size of Royal Mail's pension deficit can change significantly because a large proportion of the pension fund is invested in equities and the fund's value does, therefore, fluctuate with the stock market.

Postcomm's pension calculations are for the deficit that applies to the part of Royal Mail's business that Postcomm regulates – the letters business – which makes up around 80% of Royal Mail Group's activities. For this, Postcomm has allowed an average of around £320 million per year.

Based on the expected performance of the equity market, it is estimated that the deficit is most likely to be paid off in about eight to 10 years. However, on very prudent assumptions of returns on assets, with contributions at this level it could take 17 years to repay the deficit.

Service standards

At the moment Royal Mail has 16 service targets. Postcomm is proposing to rationalise these to produce a new list of 12 service standards. As before, eight of the targets will be public first and second class, bulk mail first and second class, bulk mail third class, public Special Delivery, Standard Parcels and postcode areas. To these Postcomm is proposing to add four new standards, relating to:

* correct delivery (mis-delivery is responsible for a significant number of complaints to Postwatch, the consumer body). Postcomm will consult on what the level of target should be

* proportion of mail collections completed each working day – target 99%

* proportion of mail deliveries completed each working day – target 99%

* 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 £280 million if it missed all performance targets by 5% or more.

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.

Already operators are concerned over “margin squeeze” where Royal Mail has reduced the margins of some of its products since access was introduced.

The control is based on retaining the current differentials between access products and their equivalent retail tariffs. Royal Mail, other operators and customers can apply for these differentials to be amended after 2 years of the price control.

What happens next

These proposals are subject to a three-month consultation, during which we will discuss with Royal Mail and others the details of the licence modifications required to implement them. Should Royal Mail refuse to accept the licence modifications, Postcomm will seek a reference to the Competition Commission. In this event, the current price control will continue until the Competition Commission's decision.

Today's document: 2006 Royal Mail Price and Service Quality Review: Final Proposals, is published on Postcomm's website http://www.psc.gov.uk. Printed copies will be available shortly from Postcomm at Hercules House, 6 Hercules Road, London SE1 7DB.

A pre-recorded MP3 interview with Sarah Chambers, Postcomm's chief executive, is available to download from the GNN website, http://www.gnn.gov.uk from 0001 hours, 7 December 2005.

Postcomm regulates Royal Mail's prices and service quality in the letters market.

In the UK postal market:

* Over 80 million items are delivered each day six days a week to more than 27 million addresses

* The market for large mailers (more than 4000 items in a single posting) was opened in 2003

* Postcomm has licensed 14 companies to compete with Royal Mail

* Royal Mail is by far the biggest operator with more than 97% of the market

* Royal Mail made a profit from operations of £452 million on its regulated activities last year (excluding exceptionals and pension deficit payments)

The letters market will be open to full competition on 1 January 2006.