Response to Postcomm’s initial proposals for the 2006 ... · 6 COVERAGE OVERVIEW 6.1 This section...

Response to Postcomm’s initial proposals for the 2006

price and service quality review

Detailed response

© Royal Mail 2005– Response to Postcomm’s initial proposals for the 2006 price and service quality review – of 108

TABLE OF CONTENTS

PART Page No.

C. Detailed commentary on Postcomm’s proposals and Royal Mail’s requirements

6. Coverage 3

7. Access 11

8. Structure: Price rebalancing 18

9. Structure: Non price terms and price rebalancing 27

10. Finance 36

11. Quality of service 60

12. Level 82

13. Management of risk 99


6 COVERAGE

OVERVIEW

6.1 This section sets out Royal Mail’s response on the coverage of the next price control for Royal Mail.

Postcomm’s proposals

Applying its competition based test, Postcomm proposes to remove Presstream products and Special Delivery (account) services from the next price control. In both cases Postcomm is satisfied that competition is developing to protect the interests of customers;

Postcomm proposes that new products introduced by Royal Mail during the present control (eg. Mailmedia, Mailsort 120 3, Special Delivery 9am, Packetsort Premium, Response Plus and Presstream Walksort) should not be subject to the next price control and that those introduced in next price control should not immediately be subject to price control;

Postcomm proposes a process for removing services from the price control that involves an application by 31 August in any year, a 28 day consultation and a decision by 31 January;

Postcomm proposes no changes to LC7 and LC11 regarding the publication and notification to Postcomm of prices.

Royal Mail’s response and what we require

Royal Mail agrees with Postcomm proposal to remove Presstream products and Special Delivery (account) services from the next price control and provides supplementary evidence to support this decision;

Royal Mail agrees with Postcomm’s proposal that new products introduced by Royal Mail during the present control should not be subject to the next price control and that those introduced in next price control should not be subject to price control;

Royal Mail proposes that the process for removing services from the price control involve a 3 month period and should be for an application made at any time of the year. Further it believes that the information requirements should be clarified and that confirmation of the decision to remove the services of Presstream and Special Delivery based on the evidence presented will provide further clarity on this subject;

Royal Mail believes that changes to LC7 are needed following Postcomm’s decision to fully open the market to competition. It proposes a number of changes relating to the publication and notification of prices. Royal Mail believes no change is necessary for LC11.


REMOVING SERVICES FROM THE CONTROL

6.2 Postcomm identified five criteria that it would use as the basis for its assessment of the development of competition: barriers to entry; scale and nature of competition; customer awareness and behaviour; behaviour of Royal Mail and other factors. Postcomm believes that, within the fifth criterion, it should consider, amongst other things: whether there are reasons, probably arising from consideration of the universal service, to maintain a price control even where competition is well developed; and the degree to which price control products “compete” with each other, because the possibility of substituting one Royal Mail product for another (price controlled) product may offer protection for some customers that is similar to that offered by external competition.

6.3 Royal Mail agrees that a test focused on assessing the nature of competition and its development is the most appropriate way to assess whether a specific segment is mature enough to enable the price controlled area to be ‘rolled back’. It welcomes the proposals put forward by Postcomm seeking to clarify this test.

6.4 Postcomm’s June 2005 document proposes to remove Special Delivery (account) 1 and Presstream from the coverage of the control. This was based on the evidence presented by Postcomm itself within its document and that presented by Frontier Economics in October 2004. In both cases Postcomm is satisfied that competition is developing to protect the interests of customers.

6.5 Royal Mail asked Oxera to report on the evidence and analysis presented by Frontier Economics and Postcomm, the regulatory precedence for removing services from the control by Oftel, in the case of BT, and its relevance for Royal Mail; a copy of its report is in Annex 1. The Executive summary states:

‘The evidence presented falls well short of the evidence and analysis undertaken by Ofcom (Oftel) for the removal of services. The need for fur her work and evidence appears to be recognised in Frontier Economics’ report, but has not been taken forward in Postcomm’s Initial Proposals, published in June 2005.

t

t r

tt

t f t

t t

r

t

The issue is not therefore that the proposed scope of the control is problematic, but rather that Postcomm has not applied its own process on the basis of the necessary evidence tosuppor its decision. As a ma ket liberalises, an incumbent firm needs to make significant adjustments to its business model if it is to make a successful transition to a competitive market. This transition is in the interest of the company, consumers and the regulator. A key element of the success of this process is the certain y around the regulatory framework. This is essential to both entrants and he incumbent. Without good evidence-based decision-making on the scope of the con rol, it is difficult or any marke participant to judge likely developments in pricing for a given product. This can hinder entry and investment by any participant.

In addition to considering the scope of the control, Frontier Economics’ report touches on issues related to the number of sub-con rols. As acknowledged by Frontier Economics, he categorisation of products is based on a significant degree of judgement and limited evidence. Furthermo e, although a set of three sequential criteria for establishing separate controls is considered, the two options considered in the final step are not based on clear objective guidelines tha would enable a choice to be made between the options. Other


1 Postcomm’s document refers to a distinction by payment method. Royal Mail is able to distinguish between account and non-account mail customers.

options could also have been considered, as there appea s to be no guiding principles for the choice other than simplification.’

r

t

t

– c tt

t t( r )

t t

– t

tt

–

t

– t t

t tt

t t t

tt

r

6.6 Royal Mail believes that the evidence presented by Postcomm and Frontier Economics is insufficient in itself to support the removal of Special Delivery and Presstream from the control. Further, it creates a degree of uncertainty as to the information required to justify the withdrawal of a service from the control that is unhelpful. These two points are addressed further below.

6.7 Royal Mail believes that Postcomm’s proposal to withdraw the services from the control is right. It therefore sets out further evidence to support Postcomm’s proposal and, in doing so, provides further clarity as to the information required to withdraw a service from the control. This evidence is summarised for the services of Presstream and Special Delivery in Annexes 2 and 3 respectively in reports prepared by Oxera.

6.8 On Presstream, the Executive summary of Oxera’s report concludes:

‘The evidence indicates tha the market in which Presstream competes includes postal and non-postal delivery of periodicals to readers.

Within this marke , the key evidence and findings are as given below.

There appear to be no signifi ant barriers to entry tha would prevent the development of effective competition for he delivery of periodicals to readers. Legal barriers are low. Royal Mail’s VAT s a us does not constitute a significant entry barrier since the majority of Presstream customers which account fo 87% of Presstream revenue can reclaim the VAT paid on postage costs. Economies of scale are not a significant barrier to entry. There is indicative evidence tha other operators would be able to replica e Royal Mail’s economies of scale for an end-to-end service. Furthermore, the available evidence indicates that competitors may benefit from similar economies of scope to Royal Mail.

Evidence shows tha publishers are aware of the different delivery channels (postal andnon-postal) of periodicals to readers. Furthermore, survey evidence indicates that the ‘Royal Mail’ brand for this product does not constitute a major barrier o the developmen of competition over the next few years.

There are other postal suppliers offering end-to-end magazine delivery, particularly in certain geographic areas. Publishers are trialling services with these other operators, indicating that customers may be willing to switch to rivals. This willingness to switch reflects the well-informed, sophisticated na ure of purchasers of these services.

Recen survey evidence indicates that a large proportion (75%) of Royal Mail’s cus omersin the publishing and consumer services sectors are likely to consider using another supplier. Further survey evidence shows that if pos al competi ors to Royal Mail were to offer a product a a lower price, Presstream would lose a large share of volume. This is consisten with the existing level of concentra ion in he magazine publishing sector, which suggests that buyer power is likely to be significant and switching costs low. Indeed, Presstream’s top ten publishing customers account for around one-third of to al Presstream volumes. This level of concentra ion of customers and the publishers’ likelihood to consider using alternative suppliers act as two significant constraints on Royal Mail’s pricing behaviou . ‘


6.9 On Special Delivery, the Executive Summary of Oxera’s report concludes:

The evidence indicates tha the relevan products competing with Special Delivery (Next Day) are other next-day PM secure, guaranteed deliveries for items weighing up to 10kg, sent by large and medium-sized business (account) customers.

t t

t

– ( tt t

tt t t t

– t f

t

– t

t t t)

t tt

t t

– t

t

Within this compe itive playing field, the key evidence and findings are as given below.

Royal Mail Special Delivery Next Day) appears price-constrained by compe ition, not by the regula ory price con rol, since Royal Mail has not increased the price for Special Delivery (Next Day) up to the maximum allowed under the price con rol. Indeed, analysis of recen con racts lost to compe itors shows that the la ter are able to match, and even undercut, Royal Mail on large contracts. Moreover, Royal Mail is losing business to rivals on price and service criteria, with around 40% of business lost because of price and 20% because of service in the last two years.

Survey evidence shows tha business customers are typically aware of a wide range of alternatives to Special Delivery, and that around 15% o businesses switch express carrier each year, indicating a significant degree of switching and awareness among customers of alternative suppliers. Further evidence shows that Special Delivery inland users employ, on average, 2.3 different carriers for their express dispa ches, indicating that Royal Mail is typically employed as part of a pool of suppliers.

Barriers to en ry do not appear to have prevented the development of effective competition for next-day secure deliveries. In fact, other operators have a share of the PM marke (up o 10kg) that is equal o, or higher than, Royal Mail’s 8.4% share. Although the largest operators focus on business-to-business (B2B deliveries,several other opera ors have major opera ions in business-to-consumer (B2C) deliveries. In general, these compe itors seem to benefit from economies of scope by using the same network to deliver to residential and business addresses. Royal Mail’s economies of scale and scope held by Royal Mail do not therefore seem to have prevented compe itors from becoming es ablished competitors to Special Delivery (Next Day).

Survey evidence shows tha one in two Special Delivery regular customers uses the Post Office counter. This indicates that, if the price of the account product were to rise, businesses could switch at he margin between Special Delivery on account and Special Delivery via meter or the Post Office. Thus, the regulated price of Special Delivery (non-account) is likely to serve as a ceiling for Special Delivery (account) if the latter is removed from the price control.

6.10 In summary, Royal Mail agrees that these products are in competitive markets and should be removed from the price controlled area.

THE TREATMENT OF NEW SERVICES

6.11 Postcomm proposes that new products introduced by Royal Mail during the next price control will not be subject to price control.

6.12 The regulatory precedence of the treatment of new services within Oftel is that new services introduced during the period of the control remain outside of the control. This principle has been applied for Royal Mail’s current control. Postcomm’s document is consistent with the continuation of this approach.


6.13 Royal Mail has applied guidelines as to what constitutes a new service as distinct from a minor variant of an existing service and explained this in its December 2004 document. This is consistent with minor variants of an existing controlled service being a close substitute and therefore in a similar market to the existing controlled service, and consequently price controlled. Postcomm’s June 2005 document is consistent with the continuation of this approach.

PROCESS FOR AN APPLICATION TO REMOVE A SERVICE

6.14 Royal Mail understands Postcomm’s intent to develop a process for removing products from price control as the market becomes increasingly competitive. Postcomm’s process for an application to remove a service from the control is based on receipt of an application by 31 August, a subsequent consultation paper and consultation period of 28 days and decision by 31 January for implementation in April.

6.15 Royal Mail does not believe that this adequately recognises the existing licence requirement to publish prices and submit external auditor’s report, setting out the expected under/over-recovery for the subsequent year, by 31 December for April implementation. This means that the prices for April will have to comply with the licence even if a decision, subsequent to their publication, is made to remove them from the control. Hence, any change to the prices or non-price terms arising from the decision to remove the service would have to be made after the April prices were implemented. Therefore it is incorrect to imply that a 31 January decision by Postcomm could result in an implementation in April. A minimum three-month period would be required to implement such a change.

6.16 Royal Mail does not believe the 31 August and 31 January dates are necessary as the April deadline is artificial and impractical. Instead, Royal Mail believes Postcomm’s June 2005 document sets out a proposal in which it will make a decision on application to remove a service 5 months after that application is made, and that this could be generalised to apply at any time of the year. Royal Mail believes the 5 months should be shortened to 3 months as its competitors have no time constraints at all ad the period should therefore be kept as short as possible. The 3 months would comprise of 1 month to draft and publish a consultation paper, 1 month of consultation and 1 month to draft and publish a final decision document.

6.17 Royal Mail also notes that Postcomm seeks to include:

‘a provision to reject an application from Royal Mail without consultation when insufficient information had been provided by Royal Mail to justify the application’. (3.62).

Instead of such a general statement, Royal Mail believes that it would be appropriate for Postcomm to provide some indication of the information and analysis that would be sufficient. Royal Mail believes that this may readily be done through recognition of the evidence presented in Oxera’s reports for Special Delivery (account) and Presstream.

6.18 In addition, it would be appropriate for Postcomm to clarify how the calculation of the C-factor would be affected by the removal of a service from the control.


CONSULTATION OF LC7 AND 11

6.19 Postcomm’s document proposes no changes to either Licence Conditions 7 and 11 (LC7 and LC11), but seeks comment on whether

a) the current requirement in LC7 for Royal Mail to publish pricing information should be more limited;

b) the current requirement in LC11 for services not included in LC19 to be referred to the OFT in the event of a formal complaint against Royal Mail of anti-competitive behaviour should be continued.

Licence Condition 7

6.20 The European Directive states:

‘Member States shall take steps to ensure that users are regularly given sufficiently detailed and up-to-date information by the universal service provider(s) regardingthe particular features of the universal services offered, with special reference tothe gene al conditions of access to these services as well as to prices and qualitystandard levels. This information shall be published in an appropriate manner’. (first paragraph of Article 6).

r

6.21 Royal Mail is content to fulfil the requirements of the European Directive regarding the universal services. However, the current LC7 goes well beyond this requirement to publish general conditions of access, prices and quality of service levels for all services that are price controlled, not only those that form part of the universal service obligation. Royal Mail believes that this requires change following Postcomm’s decision to fully open the market to competition.

6.22 Royal Mail believes that LC7 should not be applicable to services for large customers in respect of tenders and e-auctions. This is consistent with Ofcom published statement on large business pricing on 27th May2 where Ofcom stated that it would allow players with market power to have flexibility over pricing for large businesses even in markets where they have significant market power (SMP), if competitors are able to replicate the retail products by buying suitable wholesale products. Ofcom indicated that in the case of telecoms replicable services currently do not exist because of the differences in the provisioning process and technical aspects of service delivery. However, in the postal sector replicable services are available through the downstream access offering. In light of this, ex ante remedies for SMP should be applied more flexibly in the large business postal market to facilitate the growth of competition, even before SMP is eroded. This could include the non publication and non notification of prices (and Royal Mail to be able to depart from published prices) in respect of bids for tenders and e-auctions for the provision of services to large businesses.

6.23 In addition, Royal Mail believes it is reasonable, to clarify areas of ambiguity, protect commercial confidentiality or prevent imposition of unreasonable timing constraints necessary for Royal Mail to compete, for the following changes to be made to LC7:

2 http://www.ofcom.org.uk/consult/condocs/pricing_business_customers/ofcom_statement/section4/#content


• the phrase "postal services" to be changed to "universal services”;

• explicit reference to the fact that LC7 and the undertaking do not apply to bespoke solutions (to remove this ambiguity);

• reference to the fact that publication (certainly) and notification (preferably) need not apply to non-standard products and solutions if publication would "undermine a competitive process" - this would eliminate the current problem that publication of some responses to tender are technically required in advance of the tender closure date, for example;

• Royal Mail should not be obliged to publish details of commercial arrangements which directly involve a third party;

• where necessary and appropriate, a split between the requirements for notification and publication - this would formalise our current way of working with TMIs, for example.

Licence Condition 11

6.24 Royal Mail also believes that for services that are not under LC19, any formal complaint against Royal Mail of anti-competitive behaviour should continue to be referred to the OFT. This again ensures that it is treated the same as any other providers – for to not do so would again be discriminatory.

OTHER ISSUES ON COVERAGE

6.25 Royal Mail has received a copy of the financial model used by Postcomm to establish the RPI-X factors published within its document. Other aspects of the modelling are discussed elsewhere in this response (see, for example, Sections 9 and 12). Regarding coverage, Royal Mail has identified several inconsistencies between its stated coverage for the control and the coverage used to derive the X-factor. These include:

• The model includes Special Delivery (account) within the price control area when Postcomm proposes that it be removed from the control;

• The model includes Surface Mail Inbound, Aerogrammes (pre-paid), Large unofficial redirections, Bespoke Packetsort 1C and Large Customer Mail Order Returns 2C in the price controlled area when they are currently excluded from the price controlled area and there is no proposal to increase the coverage of the control in this way within Postcomm’s document;

• The model excludes 1C and 2C non-revenue generating services, Flatsort 8 Flat rate 1C, Freepost Name, Keepsafe social 2 months, Mailsort 3 1400 Compensation though these are currently included in the price controlled area and there is no proposal to decrease the coverage of the control in this way within Postcomm’s document.

6.26 In addition, price-controlled miscellaneous services are currently subject to separate individual price caps of RPI-1. In the model, they are grouped together with other services as part of the overall single basket - and as part of Basket 4 in the multiple basket case. This distorts the X calculation (as these services can for instance have revenues but no


volumes attached to them). These should have been modelled in a manner consistent with proposed draft licence (separate price caps).


7 ACCESS

OVERVIEW

7.1 This section sets out Royal Mail’s response on the regulation of access for the next price control for Royal Mail.


Postcomm proposes to bring downstream access products within the price control (licence condition 19 (LC19));

Postcomm’s initial preference is to control the headroom between Access 1400, Access 700, Access 120 (letters), Access 120 (flats and packets), Access 120 (CBC and OCR) and the corresponding retail products.

Postcomm proposes to set the initial ‘margin’ and subsequent margins to reflect projected efficiencies for the access products;

Postcomm proposes that the headroom available for each access product should be geographically uniform so long as the corresponding bulk mail product is also priced on a geographically uniform basis;

Postcomm proposes that the current quality of service target in the downstream access agreements of 95% next day delivery and a compensation regime similar to the business compensation scheme for retail customers should remain in place for the benchmarked products


Royal Mail believes that Postcomm has not established the case for including access services within LC19 and the price control: - there is no basis on non price terms for transferring access services from

LC9 to LC19 per se. If the price regulation of access products was transferred into LC19, the non-price terms would remain regulated under the current ex-post test of LC19(1);

- access contracts have been agreed to the mutual satisfaction of entrants with currently 9 companies taking advantage of access to the Royal Mail network.

- an effective market is operating here between willing parties already and therefore there is no need for regulation in the next price control period.

If nevertheless access services were transferred into LC19, Royal Mail believes the level of access price should be regulated with access products included in the single basket (along with end-to-end services) and applying an appropriate margin discount on the related end-to-end service.

Royal Mail believes that it is feasible to set the cap for the basic access price for contracts with a national geographic posting profile that currently exist by reference to a percentage discount on an existing and corresponding end-to-end service that has geographically uniform prices in the UK.

The appropriate level of the margin should be based on the most recent year’s prevailing level of discount in the market, given that there is significant take up of access at these levels;


Zonally priced access products should continue to be offered and they should be included in the single basket and price regulated such that the weighted average of the zonal access prices for a particular product is not greater than the access price for access product using Royal Mail’s national geographic posting profile, where the weightings should be those of the national geographic posting profile.

Royal Mail believes the current arrangements are already sufficient to ensure downstream access customers are properly treated and that this will be reinforced by the introduction of dedicated quality of service measurement.

GOVERNANCE

7.2 In Section 3 of Postcomm’s document it states, in the context of coverage and end-to-end services:

‘Postcomm proposes to keep out of the next price con rol new products tha have been launched by Royal Mail during the current control.’ 3.51

t t

7.3 Postcomm proposes to retain outside of the control all new end-to-end products that were introduced in the current control period. Access is a new product introduced within the existing control period. On this basis it would be consistent to retain access outside of the control.

7.4 One of the main reasons to retain new products outside of the control is the need to have the scope to adjust the non-price terms within a contract as the product establishes itself. Under the current arrangement, this can be done if all those on the same contract agree to the change or a contract relating to a new service is offered.

7.5 In December 2004, Royal Mail expressed the view that it expected to develop an Access Code. In practice, the arrangements for access have continued to develop with some details of contracts changing and Royal Mail offering zonal access pricing contracts. These contracts involved changes to the non-price terms. Consequently, Royal Mail believes it is premature to develop an Access Code while the service is still developing and customers are identifying their requirements. Royal Mail does not believe that an Access Code that could restrict the ability of Royal Mail to meet customer requests for access terms is in the interests of its customers. Consequently, it does not envisage developing an Access Code at this stage.

7.6 In Section 4 of Postcomm’s document it proposes ‘bringing access service into the price control’ (4.53). It also states:

‘The ex ante regulation of access products can also help to protect existing and new operators and all customers from poten ial anti-competitive behaviour by Royal Mail in relation o he price and non price terms of access offerings’ (4.20).

tt t

7.7 The above statement in 4.20 implies that Postcomm proposes to remove the existing LC9 and transfer the regulation of access services to LC19, which is currently restricted to end-to-end services. While Postcomm has published a draft LC19 it has not published LC9, and therefore this is not confirmed.


7.8 The statement also refers to the transfer being made on the grounds of ex-ante regulation of both price and non price terms. Further, Postcomm’s document states that, in relation to LC19:

‘Under the current control Royal Mail is required to seek Pos comm’s approval for all changesto non-price terms of price controlled products if the changes might have an adverse effect on customers’ interests. Prior to approving any changes proposed by Royal Mail, Postcommmust consult Postwatch and may consult customer and other interested parties. The mos significant example of such changes during the curren control was Royal Mail’s appli ation to change the terms and conditions of its Standard Parcel and Special Delivery products in 2003.’ (6.50)

t

t

t c

t

t

tc

r t t t (

7.9 However, this statement is incorrect. LC19(1) states:

‘...and any question as to whether the terms o her than price on which the Regulated Services were offered and provided are more or less beneficial to users on one date as compared with another shall be decided by determina ion by Postcomm’.

7.10 LC19(1) applies ex post regulation to non price terms which currently enables a customer to seek a determination after a change to the non price terms is made that it regards as detrimental to it. In the cases of Standard Parcel and Special Delivery, Royal Mail elected to approach Postcomm for prior approval, but this is not a requirement of the current licence.

7.11 Further, the price terms are covered by formulae in LC19 requiring any under or over recovery to be returned to the customer ex post - and therefore again is not ex ante.

7.12 Though there are some ex ante components of regulation (relating to the need for advanced approval for changes in structure and exceeding maximum limits on price changes) the main components for the current regulation of price and non price terms under LC19 are ex post. Hence, under the current licence, a change to the non price terms could be referred to an ex post determination whether under LC9 or LC19. The transfer of the access services into LC19 would bring no effective change, under the current licence, in terms of the determination route over changes to non price terms.

7.13 Postcomm’s document (in Section 6.51) not only appears to assume that LC19(1) is ex ante when it is ex post but also it proceeds to propose change for LC19(1) to an ex ante approval process for the non price terms with Postwatch’s involvement. Postcomm’s document states:

‘An alterna ive approach would be to give Postwatch a stronger role in the [ex ante] process for considering such changes [to non pri e terms]. Given Postwatch’s different statutory duties, and in particular its focus only on customers’ interests rather than also considering other stakeholders, (e.g. othe opera ors), Postcomm does not believe that i could leave theissue solely to Postwa ch.’ 6.54)

7.14 The alternative approach proposed by Postcomm relates solely to end-to-end services and recognises that Postwatch’s role is for customers rather than “other operators”. Given that access services involve both customers and other operators it would be inappropriate for Postwatch to undertake a review of access non price terms. Royal Mail notes that Postcomm agrees with this position in paragraph 4.53 of its document.

7.15 In conclusion, Royal Mail raises the potential benefit of clarifying LC19(1) to establish what may be regarded as non material changes to the non price terms. Postcomm’s proposal


does not see a route forward on this specific point. Royal Mail believes that Postcomm should still clarify materiality within LC19(1) and the existing LC19(1) should remain unchanged. If LC19(1) remains unchanged then ‘bringing access products under the control [of LC19]’ will have no effect of the regulation of the non price terms. Whether under LC19 or LC9, changes to the non price terms that are not acceptable to customers or operators can be raised in an application and this is then subject to a determination by Postcomm.

7.16 There is no basis on non price terms for transferring access services from LC9 to LC19 per se. If the price regulation of access products was transferred into LC19, the non-price terms would remain regulated under the current ex-post test of LC19(1).

REGULATING ACCESS PRICES

The structure

7.17 Postcomm’s statement in paragraph 4.20 also refers to the regulation of price as a basis for ‘bringing access into the price control’ (4.53). In addition, Postcomm’s document expresses concern regarding a marginal reduction in the margin discount between end-to-end and access services and proposes alternatives for regulating the price of access.

7.18 Royal Mail confirms again (as it did in its December 2004 response) that access prices are restricted within the contracts, by a maximum cap of RPI-1, consistent with the average movement under the current price control for end-to-end services and equivalent to the level of the caps for the Miscellaneous Services. Under this arrangement it is possible for the marginal discount between access and the related end-to-end service to increase, decrease or stay the same.

7.19 The existing price regulation for access is a variant of Option 2 within Postcomm’s Option 2 (4.22) of a separate basket for access services but with individual price caps (though regulated under LC9 and under contract rather than LC19). Postcomm’s document refers to two other options: Option 1 in which the minimum margins between access and related end-to-end services are set and Option 3 in which activities within Royal Mail are separated to allow the same access charges to be applied to Royal Mail’s end-to-end services in addition to customers and operators.

7.20 Postcomm’s document proposes Option 1. Royal Mail believes that there are at least two variants of Option 1 and it is unclear from its consultation document which one is envisaged by Postcomm. Firstly, access products could be included in a single basket within LC19 and the minimum margin discount between the end-to-end and related access products set appropriately. Secondly, access products could be included in a separate basket either in LC19 or LC9 and the minimum margin discount between the end-to-end and related access products set appropriately. In the first variant, if access prices were to fall over time the contribution to fixed network costs within their original price could be recovered through the prices of other products. In the second variant, if access prices were to fall over time the contribution to fixed network costs within their original price could not be recovered through the prices of other products.

7.21 Royal Mail asked academic experts who have undertaken significant research into access pricing to review Postcomm’s three options and to advise on the most appropriate price regulation for access, were it to be price controlled. Professors Helmuth Cremer and


Philippe De Donder were asked to provide their view of the subject given their extensive experience of access pricing, but without requiring a formal academic paper at this stage. A copy of their paper is in Annex 4.

7.22 The academics’ advice considers none of the three options to be optimal but of the three options their initial assessment is that Option 1 for the price regulation of access products with end-to-end services in a single basket is probably the least unsatisfactory. With regard to favouring Option 1, the paper states:

“This is in particular because of the practical cost allocation issues implied by the other options which arise from ‘… a number of (essentially unsolvable) cost allocation issues when more than one baske is used‘.

”t

However, they pose a number of questions which remain to be addressed by the regulatory framework and conclude that it may be better for Postcomm to leave options open at this stage so that the regulatory regime can respond to results from further analysis as well as development of the market.

7.23 In conclusion, if access products were to be transferred into LC19, Royal Mail’s initial view is that the appropriate structure of regulation would be under Option 1 with access products in the same single basket as other end-to-end services with the marginal difference between the access and related end-to-end service prices being set appropriately. In this context, retention of access services outside of LC19 or in a separate basket within LC19 would increase Royal Mail’s risks of not recovering the fixed network costs associated with its access service. However, Royal Mail stresses that if Postcomm were to move to bring access into the price control much further work is necessary to evaluate the implications of the precise form of such a step.

The coverage

7.24 Postcomm’s initial preference is to set a price cap on Access 1400, Access 700, Access 120 (letters), Access 120 (flats and packets), Access 120 (CBC and OCR).

7.25 Royal Mail believes that it is feasible to set the cap for the basic access price for contracts with a national geographic posting profile by reference to a percentage discount on a corresponding end-to-end service that has geographically uniform prices in the UK. This may also be extended to:

• a situation in which the end-to-end and access prices reflect ‘pricing in proportion’.

• access services with a national geographic posting profile that have not currently been requested or offered but for which there is an existing and corresponding end-to end service that has geographically uniform prices in the UK.

7.26 Royal Mail believes that this could include Access 1400, Access 700, Access 120 (letters), Access 120 (flats and packets), Access 120 (CBC and OCR) and Acess Walksort (letters, flats, packets).

The level of margin

7.27 Postcomm proposes to set the initial ‘margin’ and subsequent margins to reflect projected efficiencies for the access products.


7.28 Royal Mail observes that take up of access is at a significantly greater rate than that assumed in Postcomm’s document. This is very strong evidence that the existing margin between end-to-end and access services is sufficient for entry through access. Consequently, Royal Mail believes that, if access were to be price controlled, it should reflect current margins and should be set as a minimum as proposed by Postcomm.

Zonal access prices

7.29 Postcomm’s document states:

‘Prior to deciding its final proposals it will be necessary for Postcomm to establish a process by which a margin for zonal prices should be calculated. It is proposing that the margin available for each access product should be based on zonal differences for so long as the equivalent bulk mail produc is priced on a geographically uniform basis’ (4.45 t )

It also states:

‘Equally, Postcomm would welcome views from interested parties who believe these measures go too far’. (4.47)

7.30 Royal Mail believes that Postcomm’s proposals, as outlined in paragraph 4.45 of its document, do ‘go too far’. Postcomm’s document recognises that Royal Mail already offers zonally priced access products and also has some customers on these terms. Royal Mail believes that it is neither in these customers’ interests nor the interests of other customers (who may move to such arrangements in the future) to obstruct the availability of zonally priced access products or require them to be withdrawn. Yet, Postcomm’s proposals would do precisely this by obstructing zonally priced access products if Royal Mail does not offer the related zonally priced end-to-end product and by obstructing the introduction of zonally priced end-to-end products until the conclusion of a lengthy review by Postcomm.

7.31 Royal Mail believes that it would be discriminatory to only offer its zonally priced products to those already on a contract and not to other customers. Consequently, Royal Mail believes that Postcomm’s proposals would require the withdrawal of zonally priced access products from the start of the next control until such time as Postcomm allows the relevant end-to-end product to be zonally priced. Royal Mail believes this is unacceptable given its existing offerings and customers.

7.32 Postcomm’s proposals seek to offer some comfort that the review period could be less than that required for ‘pricing in proportion’. Royal Mail believes that this provides no guarantee or reassurance that for existing or potential customers of the zonally priced access products that these products would be retained as an offering within the next price control. Royal Mail also believes this is unacceptable given its existing offerings and customers.

7.33 Royal Mail believes that zonally priced access products should continue to be offered. Further it believes that these prices can be capped by ensuring that the weighted average zonal access prices, weighted by the national geographic posting profile, do not exceed the corresponding access prices offered for that national geographic posting profile.


QUALITY OF SERVICE FOR ACCESS PRODUCTS

7.34 Postcomm’s document states:

‘Postcomm proposes tha the curren quality of service target in the downstream access agreements of 95% nex day delivery and a compensation regime similar to the business compensation scheme for retail customers should remain in place for the benchmarked products. The compensation scheme is based on 0.1% expenditure of the access seeker fo every 0.1% of Royal Mail’s failure to mee the Mailsort 1 licence target.’ (4.49)

t tt

rt

7.35 Royal Mail‘s contracts with downstream access customers already include agreed levels of quality of service and compensation arrangements comparable to those in the bulk mail compensation scheme set out by Postcomm. It is therefore unclear to Royal Mail how Postcomm believes Royal Mail can “undermine the price control by reducing the quality of service” and why it believes further regulation is necessary. Postcomm has not provided any further details about how it would intend to implement such a scheme.

7.36 Given the evolving nature of contract changes and additions to service variants in the access arena, it is probable that future customers might require a contract without targetry or compensation, or indeed make proposals to increase existing contractual delivery aims.

7.37 In response to requests from some existing contract holders, Royal Mail’s intention is to trial measurement of downstream access mail making use of the RFID technology currently being introduced during the second half of 2005/6. If the trials confirm that robust and cost-effective measures are possible, actual measurement of the products can be introduced to replace the proxy measure where customers prefer this. The cost of such measurement would be recovered as part of the product price. It would also enable end-to-end measurement of the service given to the posting customer if the downstream access customer chose to pay for this.

7.38 Royal Mail therefore believes the current arrangements are already sufficient to ensure downstream access customers are properly treated and that this will be reinforced by the introduction of dedicated Quality of Service measurement. Royal Mail believes Postcomm’s proposals are unnecessary and burdensome, and would restrict customers’, operators’ and Royal Mail’s flexibility in an unwarranted way.

OTHER ISSUES ON ACCESS

7.39 As with retail prices, Postcomm is proposing that Royal Mail is required to publish its intended price changes for the benchmark products by 31 December prior to the prices being effective from the following April. Royal Mail believes that this can be achieved with access under LC9 or LC19.


8 STRUCTURE: PRICE REBALANCING

OVERVIEW

8.1 This section sets out Royal Mail’s response on the structure of the next price control for Royal Mail and in particular relating to price rebalancing.


Postcomm is proposing to introduce two tariff baskets – captive and non-captive – although its financial proposals are based on four (additionally, access and Miscellaneous services);

It proposes to continue with the structure of control for Miscellaneous services and introduce access into the control;

Postcomm proposes to allocate costs between the baskets using equi-proportional mark-ups;

Postcomm proposes to limit the degree of maximum price rebalancing to RPI-X+4


Royal Mail believes a single basket should be applied to price controlled services, with secondary caps; this follows the precedence of the first 12 years of regulating retail prices by Oftel;

Royal Mail believes that economic theory does not support the use of EPMU and application of multiple baskets as the basis for cost allocation and pricing rules for setting the price control for Royal Mail in a competitive market;

It believes that economic theory and regulatory precedence do not support the use of multiple baskets in the price control for Royal Mail before significant price rebalancing has been completed for prices to become more cost reflective; significantly greater rebalancing that RPI-X+4 was allowed for 12 years by Oftel;

Royal Mail believes that expected developments of the costing system and Postcomm’s proposed prices for the basic weight step prices of First and Second Class public stamps would mean that Royal Mail will continue to have prices well adrift from the costs in its costing system in 2009/10, four years after full market opening;

Royal Mail proposes to limit the degree of maximum price rebalancing to RPI-X+8.5.

TARIFF BASKETS

8.2 Postcomm proposes to have separate price controls for products serving “captive” and “non-captive” customers. Postcomm proposes the following composition for these baskets:

• “Captive Basket” ‘Basket A’ will include: 1st Class Public Tariff (Stamped, metered and PPI), 2nd Class Stamped, Standard Parcel, Response Services (1st and 2nd Class), Airmail (Europe and World Zone 1 and 2), Surface Mail;


• “Non-Captive Basket” ‘Basket B’ will include: 2nd Class Meter and PPI, Cleanmail (1st and 2nd class), Mailsort 120 (1st and 2nd class), Mailsort 700 (1st, 2nd and 3rd class), Mailsort 1400 (1st, 2nd and 3rd class) and Flatsort 1400 3, Packetpost (1st and 2nd class) and Packetsort 8 (1st and 2nd class), Walksort (1st and 2nd Class).

8.3 In addition, Postcomm’s document proposes two further groupings of products for Miscellaneous Services and downstream access services.

8.4 Royal Mail does not support the cost allocation and pricing rules used for Postcomm’s 2005 document, the application of its multiple baskets or the limited extent of price rebalancing.

8.5 It believes that the structure of the next price control should remain a single basket for price controlled services with increased rebalancing consistent with the development of, and costs expected from, ‘class costing’. It believes this is consistent with both economic theory and regulatory precedent. This is discussed in more detail in this Section and accompanying Annexes.

MOVING AWAY FROM EQUI-PROPORTIONAL MARK-UPS

Regulatory precedence of the application of equi-proportional mark-ups

8.6 Postcomm’s June 2005 document states that:

‘Postcomm’s approach to cost attribution is to set prices on the basis of the avoidable costs ofproviding a product, plus a proportiona e share of the fixed costs attributable to operational activities used by the produ t, plus an ‘equi-proportional mark up’ (EPMU) of joint cos s and profi . This approach was first established when considering UK Mail’s reque t for a determina ion for a downstream access price. The approach has been further developed andapplied as part of the work on Size Based Pricing and for the work Postcomm has undertaken to establish a Code of Practice for Common Operational P ocedures. Postcomm believes this approach is consistent with that suggested by the European Postal Directive. Also, the EPMU method has been adop ed by other regulators in pricing determinations.’ (6.20).

t

c tt s

t

r

t

t t t t t t

t

t rt tr

tt

8.7 Neither this document, nor any preceding document from Postcomm, sets out the regulatory precedence for the application of equi-proportional mark-ups in setting prices. Royal Mail asked Oxera to report on Postcomm’s approach to this subject; a copy of its report is included in Annex 5. The Executive Summary of its report states:

‘Postcomm has stated ha i believes equi-proportional mark-up (EPMU) o be he most appropria e approach to allocate joint and overheads. According to the regulator, this approach has been adopted by other regulators in pricing determinations and has been accepted by the Competition Commission.

However, these regula ory decisions should be analysed against the background and contextof previous cases, and in particular, the specific characteristics of the mobile telephony industry. From the review of these regula ory precedents, this repo argues tha EPMU would be an acceptable approach if the costs to be recovered th ough the mark-up were small, and if demand elasticities for the services in question were similar. For the postal services sector, it is the case both that costs to be recovered through the mark-up are significant, and that demand elasticities differ between products. This suggests tha an EPMU approach to allocate these costs is in principle less appropria e. Therefore, the regulatory precedents mentioned by Postcomm cannot be seen as providing the necessary


and sufficient suppor to adop an EPMU approach in the curren Royal Mail price control review’ (page i).

t t t

t t

t

t

t tt t

8.8 Postcomm’s statements that it has ‘established’ the application of EPMU in the postal sector by reference to regulatory precedence are overstated and unfounded.

8.9 Regulatory precedence does not support this use of EPMU as the basis for cost allocation and pricing rules for setting the price control for Royal Mail.

8.10 Further, Oxera’s report was also presented as part of Royal Mail’s response to the consultation on ‘pricing in proportion’ proposals3. In its decision document, Postcomm states that:

‘Postcomm is not persuaded by Royal Mail’s objections to the use of EPMU for the allocation of common costs across products and customers. The paper presented by Royal Mail argues tha EPMU should only be used where it genera es broadly the same distribution of costs as Ramsey pricing. As noted above, an EPMU approach is supportable on its own merits. Moreover, Postcomm does not believe that precedent in the telecoms sector suppor s Royal Mail’s premise. Nor does it believe that, when considered on a comparable basis, the cost and demand characteristics in the telecoms sector are as different from those in the postal sector as Royal Mail implies’ (paragraph 3.23).

8.11 Furthermore, Postcomm states that:

‘Postcomm is satisfied that its general approach is robust and consisten with the Postal Services Act 2000, Royal Mail’s licence and Postcomm’s duties. Furthermore, Postcomm is satisfied tha an EPMU approach to the allocation of overheads is appropria e and consisten with regula ory best practice’ (paragraph 3.24).

8.12 It is the case that in a context where the proportion of un-attributable costs to be

recovered is small and/or the demand elasticities do not differ significantly between products then the use of EPMU would be reasonable. However, where the size of un-attributable costs is significant, EPMU could introduce significant distortions to the market. In such context, it is difficult to believe that EPMU would be supportable on its own merits, as Postcomm claims.

8.13 Contrary to what Postcomm believe to be the case, the precedent in the telecoms sector does support Royal Mail’s premise. The case of the mobile telephony sector contained in the report is directly related to the examples of the regulatory precedents that Postcomm has used to support its decision to adopt EPMU (Postcomm 2005, paragraph 4.20). These precedents demonstrate that it is important to take into account the context of the sector in which the regulatory decisions are taken. In the mobile telephony case, given the limited size of the costs to be recovered through a mark-up, EPMU was likely to create modest distortions. Where this condition does not hold, it is unclear what position the regulator would adopt.

8.14 Furthermore, Postcomm appears to believe that the cost and demand characteristics in the telecoms sector are not that different from those in the postal sector, hence implying that the precedents in the telecoms sector would support Postcomm’s adoption of EPMU. This is an unsubstantiated and surprising statement, first, because there are clear differences in the costs and demand characteristics of both industries, which have been


3 Postcomm ‘Royal Mail’s proposals for Pricing in Proportion – A Decision Document’, August 2005.

extensively addressed in the economics literature, and, second, because a central consideration of the relevance of EPMU or alternative demand-based approach is the size of the costs to be recovered through a mark-up.

Application of equi-proportionate mark-ups to the Postal Sector

8.15 A paper4 at the 13th Conference of Postal and Delivery Economics in Antwerp (June 2005), to be published in the proceedings of the Conference, analysed the application of alternative cost allocation and pricing rule in a two product model of the postal sector. An update of this earlier paper is on Royal Mail’s website and a copy is in Annex 6. In its conclusion it states:

‘Our model has incorporated two products for the USP although these can also be viewed as representing two groups of products. This facilitates considera ion as to whether a singlecontrol or basket should apply as unde GPC or whether the two product should be placed and controlled in two separa e baskets. If the two products are price controlled separa ely then this requires a division of the fixed, network cos between the two ba ke s so producing a particular set of prices. This cost allocation rule not only affects he degree of price rebalancing between baske s but also the average level of allowed prices, the overall level of welfa e and the financial viability of the USP. The greater is the degree of competition, the more likely it is that any cost allocation rule, such as EPMU, will lie outside the range of p ices at which the USP breaks even.

t r s

t tt s t

tt

r

r

t r

t t t

tt t

t t t

Where, as in our model, the fixed cost is common to both products, the interdependence ofprices between the price controls on the two products is a key building block of the overallprice con rol. This interdependence between different g oups of products is unavoidable, particularly where entry is likely to be significant, as the overall requirement is for the two products jointly to recover he fixed cos . This requirement may be inadequa ely addressed by arbitrary cost allocation rules, like EPMU, if the degree of competition assumed in settingthe price con rol is understated for in such cases the USP may be loss-making and ultima ely unsustainable. In this situation cost allocation rules that are consisten with GPC and price con rol struc ures that facilitate the rebalancing of prices are necessary to enablethe USP to remain financially viable in the presence of compe ition provided a price solutionexists.’

8.16 The paper explains that the EPMU cost allocation and pricing rule may not be sufficient to enable a universal service provider (USP) to be financially viable in the presence of competition. Further, it concludes that a single basket is preferable to two baskets on account of the lower average level of allowed prices, the higher overall level of welfare and the strengthened financial viability of the USP.

8.17 Economic theory does not support the use of EPMU and application of multiple baskets as the basis for cost allocation and pricing rules for setting the price control for Royal Mail in a competitive market.


4 ‘Pricing and Welfare Implications of Alternative Approaches to Setting Price Controls in the Postal Sector’ De Donder, Philippe, Cremer H., Dudley P., Rodriguez F, June 2005, 13th Conference of Postal and Delivery Economics. Updated draft on Royal Mail’s website. A version of this paper will be published in 2006, in the book of conference papers edited by Michael A Crew and Paul R Kleindorfer.

REGULATORY PRECEDENCE SUPPORTS A SINGLE BASKET

8.18 Postcomm’s June 2005 document makes no reference to the regulatory precedence of applying two baskets within the price control. There is a reference in Frontier Economics’ report5 to the approach applied to BT by Oftel in 1996 and Postcomm’s document refers to the Frontier Economics’ report. Royal Mail asked Oxera to report on the regulatory precedence of this case and its relevance for Royal Mail; a copy of its report is in Annex 7. The report states:

‘’On the basis of the review of the regula ory precedents in the fixed telephony marke , several observations can be made with regard to the extent of tariff rebalancing before full market opening, and the length of time over which rebalancing took place be ore separate baskets were imposed.

t t

f

– t tt

t t

t

– – t

tt

t f

– t

– r t

tt

–

–

BT was able to undertake, and under ook, a significant degree of re ail price rebalancing in the period immedia ely after privatisation and the introduction of regulation, and prior to the opening of the marke to compe ition, which took place after the duopoly review. From an economic standpoint tariff rebalancing should be completed at the outset of the market liberalisation process, with the purpose of providing appropriate signals to competitors about their likely returns from long-term compe ition.

BT was able to conduct, and conducted, retail price rebalancing within a single tariff basket for the period 1984 97 (over 12 years) such that i s retail prices were significantly more cost-reflec ive prior to the emergence of competition, which in most part took place after 1997. Oftel only gradually increased i s regulatory control over BT during this period. This is also consistent with economic theory, which suggests thathere are bene its from a gradual rebalancing over time in circumstances where dramatic price increases are not feasible.

BT’s network charges reflected their (accounting) cost of provision a the time that Oftel introduced the different interconnection sub-caps.’

8.19 And further, with regard to the relevance for Royal Mail:

‘These observations may be contrasted with the regulation of the UK postal sector to date, and Postcomm’s proposed approach for the next price control in its June document.

For BT, the maximum increase in prices of local peak calls was 17.3% in real terms (equivalent to around RPI – X + 8.5) in the first three years of the first p ice con rol; incontrast, Royal Mail’s first price control allowed no rebalancing, while i s second price control permi ted a maximum of RPI – X + 2.5.

Oftel has never applied a two-basket approach for BT’s retail prices. It eventually moved to a re-weighted single basket in 1997 after a period of significant tariff rebalancing. For the regulation of BT’s network charges, separate tariff baskets were introduced only after the respective charges were broadly reflective of their costs of provision. In contrast, Postcomm proposes to apply two baskets before prices are more cost-reflective and after only three years of limited price rebalancing.

Economic literature shows that non-cost-reflective tariffs may be one of the most powerful sources of regulatory-induced problems with competition, by creating undesirable patterns of entry—too much entry in artificially profitable markets, and too


5 ‘The Scope of the Control’, Frontier Economics, October 2004.

little entry in loss-making markets. This link between the need to reduce cross-subsidies and liberalisation was acknowledged by the telecoms regulator.’

8.20 The Executive Summary concludes:

‘I is not evident that Postcomm’s p oposal for the implementation of a two-baske tariff structure is in line with regulatory pre edent in the telecoms sector. This precedent suggests that it is important to ake into account the interactions between regulation and liberalisa ion, to avoid exposing Royal Mail to poten ially underestima e levels of risk, and also to avoid jeopardising market development.’

t r tc

tt t t

tt

t

t

8.21 The paper summarises the theoretical basis for rebalancing prices prior to competitive entry within Economics literature and confirms its application for the case of BT within a single basket from 1984 to 1997. During this period BT was also able to apply significant retail price rebalancing (with a maximum limit or secondary cap on domestic rental charges of between RPI-X+6.5 and RPI-X+9.5). After 1997, a single re-weighted basket was applied with no secondary caps. Further, even for network access, where separate baskets were introduced, their introduction only occurred in 1997, 12 years into regulation and after the introduction of economic (LRIC) pricing.

8.22 Economic theory and regulatory precedence supports the use of a single basket for the price control of Royal Mail with the scope for significant rebalancing to become more cost reflective.

THE DEVELOPMENT OF ROYAL MAIL’S COSTING SYSTEM

8.23 The papers (referred to above) set out the inadequacy of the EPMU allocation for Royal Mail and the economic analysis that supports an alternative cost and pricing rule to EPMU that is potentially nearer to the economic welfare maximising Ramsey pricing. They also support the regulatory precedence for significant price rebalancing of between RPI-X+6.5 and RPI-X+9.5 for domestic rental charges.

8.24 For BT, Oftel reviewed its costs and prices through the period 1984 to 1997. During this period the costs and prices developed; for example, the LRIC models were developed by BT for the purposes of costing and pricing from 1997 onwards.

8.25 Postcomm has also reviewed Royal Mail’s costing system and this is welcomed by Royal Mail. Postcomm’s consultant, Brockley Consulting, has reviewed Royal Mail’s costing system (2003/04) during its consultation on ‘pricing in proportion’. In the Annex to its April 2005 consultation paper, it states:

‘I have been asked by Postcomm to repor on the reliability of Royal Mail’s Fully allocated Cost data for the purposes of Postcomm's assessment of the cos reflectivity of Royal Mail’sSize Based Pricing.

In September 2004 Pos comm commissioned me [Brockley Consulting] to undertake a wideranging review of Royal Mail’s approach to costing and the cost data resulting from its applica ion of the approach. My review covers its use of relevance to a broad range of issues facing Postcomm, including SBP [Size Based Pricing]’ (A5.1)

8.26 The report gives a general level of acceptance of the Royal Mail’s costing system (identifying only relatively minor changes to it) and a general level of acceptance of improvement and development over recent years. For example, it states:


‘In principle, Royal Mail’s cos ing system is sophistica ed enough to produce robust results. Moreover, i is clear that Royal Mail has put considerable effor into attempting to make thesystem as robust as possible, particularly in the last couple of years’ (A5.21),

t t t t

t

t t

and, in Footnote 1 of Annex 5, it confirmed that Postcomm was content to use Royal Mail’s FACs as the basis for calculating the reference prices and its EPMU approach.

8.27 Postcomm’s June 2005 document also gives its approval for the use of Royal Mail’s costing system to inform the price control review and states:

“For the purposes of this price con rol review, Postcomm believes the current costing system represents a sufficiently robust basis for apportioning revenues between non-regulated products, separate control and downstream access products” (6.21).

8.28 Postcomm’s June 2005 document goes on to propose price rises over the period to 2009/10 as follows:

‘For the public tariff, basic weigh step prices this hreshold would permit a 1p increase each year in the price control for first class stamps from 30p to 34p. For second class stamps could rise from 21p today to 23p’ (6.38)

8.29 In the 2004/05 costing system, the average Fully Allocated Cost (FACs) for a public tariff first class item is 36p and for the average second class item is 29p. These costs relate to all formats, weightsteps and methods of payment. Assuming a margin of 8% the basic weight step stamped prices reflecting these costs are close to these average costs due to the weight of volume at the basic weight step price, and are 37p and 30p respectively. Once these have been adjusted for inflation (2.5%) and efficiency (1.5%), the corresponding figures for the basic weight step stamped prices in 2009/10 would be 39p and 32p respectively. Consequently, Postcomm’s proposed prices would be below Royal Mail’s view of what FAC-based average prices would be like if the existing costing system were to operate in 2009/10.

8.30 However, Royal Mail and Postcomm (together with its consultant) have met and discussed some developments and improvements that could be made to the existing costing system. This is in line with the regulatory precedence in telecommunications where BT’s costing system developed over the period to 1997 to facilitate the implementation of LRIC. While further consideration needs to be given to such changes for Royal Mail, other changes are relatively straight forward to implement more imminently.

8.31 Royal Mail asked Oxera to report on the appropriateness of class costing and the principles involved; its report is included in Annex 8. The Executive Summary of this report states:

‘This report finds that, a a high level, the principles underpinning class costing has many of the characteristics of certain types of (long-run) incremental cos (LRIC) methodologies. In particular, both Royal Mail’s class costing p oposals and many incremental cost methodologies address this kind of coun erfactual: if this particular service or product did not have o be provided, wha costs would be saved? The advantage of determining costs on this basis has been frequently acknowledged by academics, as well as the Competi ion Commission and many UK economic regulators. There a e also precedents for costing methodologies following these principles in the postal sector: the cos ing approach used by the Uni ed S a es Postal Se vice (USPS) and the precedent established by he European Commission in the Deu sche Post case. The advantages o costing me hodologies based on these principles are tha they are mo e cost-reflective and, as such, they more closely

tt

rt

t t t

rt

t t t r tt f tt r


represent the costs that would prevail in a competitive market than those emerging using an FAC approach. It has also been acknowledged tha prices based on LRIC assessments are more likely to encourage efficient entry.

t

tt

tr

t

t t

Oxera understands tha Royal Mail is planning to develop further its class costing proposals beyond the limited application currently wi hin the ABC model. These proposals involve what might be called ‘ad hoc’ adjustments, in that they are not linked to Royal Mail’s existing models (although they do take account of outputs from the models). As Royal Mail undertakes these changes, Oxera has identified ways in which these changes could be made so as to preserve/enhance the LRIC-type properties of Royal Mail’s class costing proposals. These are outlined below. If these principles are reflected in the development of these ad hoc adjustments, which can be implemented relatively quickly, then it is considered tha the adjustments a e likely to provide directionally more accurate estimates of the costs that should be attributed across the service groups. In reaching this conclusion, atten ion has been given to the relatively ad hoc ways in which (long-run) incremental costs have been estima ed in other con exts, most particularly in the European Commission findings onDeutsche Post.’

8.32 Royal Mail expects to implement ‘class costing’ by 2008/09 (and for subsequent years) such that the FAC costs incorporate more elements of ‘class costing’. Further examples of the changes arising from class costing and preliminary estimates of the likely impact of implementing class costing have been estimated using an additional ad hoc analytical approach. Applying this approach to the costing system data for 2004/05, the FAC of the average public tariff first class item would increase from 36p to about 44p and the FAC of the average public tariff second class stamped item would decrease from 29p to about 26p (see Annex 9). Royal Mail notes that with these costs, Royal Mail would be making substantial losses on its existing stamped prices. It is envisaged that further work in this area may take place before Postcomm’s final Price Control proposals are published in November 2005.

8.33 Royal Mail believes the equivalent FAC-based basic weight step stamp prices (adjusted for margin, inflation, efficiency) in 2009/10 would be 45p and 30p for first and second class respectively. Postcomm’s proposed prices for the basic weight step prices of first and second class stamped public tariff would mean that Royal Mail would continue to have prices well adrift from the costs in its costing system in 2009/10, four years after full market opening.

8.34 Further, in its evaluation of the P0 and X value for the control in Section 13, Royal Mail has assumed the basic weight step price for first class stamped mail to be 39p from April 2009. This represents a significant compromise since, at 39p (and 41p in 2010/11), the business would not be able to generate a commercial return for its shareholder (after pension deficit funding) consistent with its investment in the business, and would expose the business to very significant competitive risks since price rebalancing would be severely restricted.

8.35 Royal Mail believes that such a price level is consistent with the existing costing system (and Royal Mail’s projections of efficiency and inflation) and is further supported by the ‘class costing’ approach. Indeed the preliminary estimates of the development of class costing from the ad hoc analysis suggest that FAC based prices would be significantly higher. Royal Mail believes that in the light of these and other considerations significant scope to rebalance prices should be given within the single basket. Indeed Royal Mail


believes this should more generally follow the precedent in Oftel, where prices were rebalanced under a secondary cap of RPI-X+8.5% in the initial years (See Annex 7).

OTHER ISSUES RELATING TO STRUCTURE

8.36 Postcomm is proposing that Royal Mail should only be allowed to rebalance between immediately successive years and not indefinitely over the length of the control, as at present. Royal Mail believes that adding in a two-year rolling threshold rather than retain the existing arrangement adds unnecessary complexity and restraints to the control.

8.37 The majority of Royal Mail’s traffic is priced according to the Standard Tariff, first and second class. Royal Mail can only price these services in increments of a penny. The price control must recognise this pricing constraint and endeavour to alleviate it by allowing pricing subcaps to be cumulative during the life of the control and allowing unused headroom extant at the cessation of the second price control to be rolled forward into the commencement of the third price control period (as was done at the cessation of the first price control and commencement of the second price control period).

CONCLUSIONS

8.38 This response has referred to several papers in the Annex that have reviewed subjects related to the structure of the control. These papers show that Postcomm’s proposals for the structure of the control are not supported either by economic theory or regulatory precedence. Further, Postcomm’s proposals are out of line with both the current costing system and development of costs in the costing system for 2009/10 including ‘class costing’.

8.39 Royal Mail believes that the structure of the next price control should remain a single basket for the controlled services with increased rebalancing consistent with the development and costs expected from ‘class costing’. It believes that the rebalancing limit should be set at RPI-X+8.5%, in line with the rebalancing of BT’s domestic rental charges in the initial years after 1984. Royal Mail believes that this is consistent with both economic theory and regulatory precedent.

8.40 In addition, it believes that adding in a two-year rolling threshold rather than retain the existing arrangement adds to the complexity and restraints to the control unnecessarily.


9 STRUCTURE: NON PRICE TERMS AND PRICE RESTRUCTURING

OVERVIEW

9.1 This section sets out Royal Mail’s response on the structure of the next price control for Royal Mail relating to Postcomm’s proposals to change the regulation of changes to non-price terms and geographical de-averaging of pricing.


Postcomm has separately set out proposals for the definition of the universal service, which are related to issues in the price control review document, in which it proposes to retain some bulk services under the universal service obligation;

Postcomm proposes a change to the current ex-post regulation of non-price terms in LC19(1) to ex-ante regulation in which Royal Mail would need to seek prior approval from Postwatch;

Postcomm proposes to retain the existing criteria [currently in 19(12-13) for assessing Royal Mail’s applications for changes in pricing structure, but proposes to tighten this so that Royal Mail would need to make an application to introduce zonal end-to-end prices irrespective of whether the proposed prices met the requirements of the primary and secondary controls limits;

Postcomm proposes to process the application of a pricing structure changes within 12 months of receipt of it. In the absence of a decision after a further 3 months Royal Mail could proceed to implement the change. If in Postcomm’s view insufficient information has been provided by Royal Mail, Postcomm could reject the application within 3 months of receipt.


Royal Mail believes that the retention of bulk mail services and indeed any business products within the universal service definition will affect the scope to introduce zonal pricing for those services and distort the market; this is contrary to economic theory that supports the development of stable market conditions for entrants;

Royal Mail believes the proposed changes to LC19(1) do not clarify when non-price terms are material and would add further layers of regulation. The current LC19(1) should not be altered;

Royal Mail believes that the proposed changes to LC19(12-13) for de-averaged zonal pricing would also add further layers of regulation that are unnecessary because the structure of the zones is already established through access pricing and the level of the price changes is already adequately addressed. It would be more appropriate for Royal Mail to be required to make a statement ahead of implementation confirming the structure and prices and setting out the communication plan, and for the latter to follow the guidelines of the case for ‘pricing in proportion’;


Royal Mail welcomes Postcomm’s commitment to review an application within 12 months of receipt but believes that guidelines on the required level of information needs to be developed to avoid Royal Mail making a series of applications on the same subject.

9.2 Royal Mail also believes that it is appropriate to await the final proposals and draft licence modifications for the price control and quality of service review before accepting or rejecting the licence modifications proposed in the separate document for the universal service.

PROPOSED CHANGES TO DEFINE THE UNIVERSAL SERVICE

Postcomm’s request for a response

9.3 Postcomm has separately set out proposals for the definition of the universal service, which are related to issues in the price control review document, in which it proposes to retain some bulk mail and business services under the universal service obligation. In contrast Royal Mail’s vision for the market is one in which it is able to charge geographically non uniform (non universal) retail prices for most of its services, with only stamped mail for public tariff services under the universal service obligation.

9.4 In a separate document6 to its Price Control Review and Quality of Service document, Postcomm sets out its proposal for the bulk mail products of Cleanmail and Mailsort 1400 (first and second class) to remain under the universal service obligation, thereby requiring these services to retain a geographically uniform price. Postcomm’s separate document proposes draft licence modifications to put this into effect. It also states:

‘Postcomm looks to Royal Mail to indicate by 1 September 2005 whether it is willing to accept the modifications or not. If Royal Mail is willing to accept the licence modification then Postcomm will give final notice with a view to modifying the licence on 1 April 2006. Ifnot, the universal service can be left on the same broad basis as it currently applies or Postcomm could refer the ma er to the Compe ition Commission.’ (S.16)

tt t

9.5 Though this statement is made within a separate document, Postcomm’s document sets the same date for response as that for its price control document and makes frequent reference to its proposed changes to the price control. For example, Postcomm’s separate document refers to the proposed amendment to LC19(12-13) for zonal pricing which is discussed in detail later in this section of Royal Mail’s response. It also recognises that the proposed licence amendment for the universal service will come into effect from 1 April 2006, which is the same date that it proposes for amending the current price control. Hence the licence modifications for the universal service and price control are linked within Postcomm’s document. For this reason Royal Mail believes that it is appropriate to await the final proposals and draft licence modifications for the price control and quality of service review before accepting or rejecting the licence modifications proposed in the separate document for the universal service.


6 2005,‘The universal service for Bulk Mailers” Postcomm (30 June).

The market distortion of Postcomm’s proposals

9.6 The universal service involves ‘everyday, everywhere’ collection and delivery service and forms the bedrock of Royal Mail’s operation. The requirement to collect and deliver every working day to every address substantially drives the cost of our national network. For example, if Royal Mail was not required to deliver every day then we could materially reduce our costs of delivery by clustering walks in certain (primarily non-urban) areas on selected days of the week, so saving on the fixed cost of the postman’s walk. If Royal Mail was not required to deliver to the home or premises Royal Mail could deliver to clusters of roadside boxes as many other countries do.

9.7 Similarly, the requirement to price mail at a uniform geographic price creates a distortion in the competitive market. Royal Mail’s delivery costs per letter are much lower in dense urban areas than in non-dense rural areas as discussed in Annex 10. In consequence any uniform tariff results in a cross subsidy in the recover of costs between urban recipients and rural recipients, encouraging excessive entry in urban delivery and too little entry in rural areas.

9.8 Postcomm appears to agree that the definition of the universal service should only include products that are widely available:

“a service available to everyone — with no restrictions on who may access the service, subject only to the payment of the ‘affordable tariff’”7

t ct t

t ”

t t t

r t t tt

t

and suggests that competitive products should lie outside the definition of the universal service:

“Once competition has developed…it might be appropria e to review the universal servi e obligation with a view to narrowing i to provide (as curren ly seems to be the case for parcels, for example) a more basic level of service leaving it to the competitive market to provide customers with a choice of services, including services provided by Royal Mail outside i s universal service obligation. 8

9.9 Further, Postcomm’s document states:

‘Postcomm agrees with Royal Mail tha there may be a distortion in the market if some products are provided a a uniform geographic price and others are not. However, in he absence of a wide ange of alternative offers from other opera ors, Pos comm is keen o ensure tha all bulk mail customers have the safeguard of being able to use a universal service product tha is priced on a geographically uniform basis.’ (3.4)

9.10 However, Postcomm appears not to have undertaken any analysis of the ‘dis-benefit’ and ‘benefit’, Royal Mail believes that Postcomm’s expressed keenness for the proposed bulk services to be under the universal service obligation is unsupported.

9.11 Royal Mail believes that:

a) the ‘dis-benefit’ of retaining Cleanmail and Mailsort 1400 (first and second class) services under the universal service can be measured by the reduction in scope

7 Postcomm’s consultation document on universal postal service, April 2003, paragraph 2.26.


8 Postcomm’s consultation document on universal postal service, April 2003, paragraph 3.16.

for more cost reflective zonal pricing on bulk mail and business services and the associated market distortions;

b) the ‘benefit’ of retaining Cleanmail and Mailsort 1400 (first and second class) services can be measured from expected reduction in bulk mail sent to rural customers arising from the introduction of zonal pricing.

It believes such an assessment should be undertaken and form part of Postcomm’s final proposal document alongside its proposed licence modifications.

9.12 The impact of retaining Mailsort 2 1400 within the universal service is a case in point. This product does not meet Postcomm’s stated criteria of being “a service available to everyone”. It is not available to all users as it has a minimum posting requirement of 4,000 items. Less than 2% of Royal Mail customers could meet the volume requirements necessary to use this product. Mailsort 2 1400 requires a high degree of pre-sortation which inevitably limits the scope of its potential customer base even further. In addition, Mailsort 2 1400 is in a highly competitive area, with Royal Mail projecting a 20% market share loss to downstream access by the year end.

9.13 Furthermore, leaving Mailsort 2 1400 inside the USO effectively rules out zonal pricing on any Mailsort 2 service, including the 120 and 700 selections that Postcomm has “removed” from the USO. This is because any zonal city discounts on 120 or 700 would suck in large scale volumes of urban 1400 mail, while rural surcharges on 120 or 700 would not be sustainable in the market as users would simply switch into the geographically uniform 1400 service. In other words, the fact that Mailsort 2 120, 700 and 1400 are substitutable for each other means that it is not possible to sustain both uniform and de-averaged pricing structures simultaneously in the market place. Users can simply arbitrage between products using lower, de-averaged prices in high density areas and the uniform price in low density areas.

9.14 Postcomm’s decision on the definition of the USO will effectively block any zonal pricing of Mailsort 2 and potentially, by extension, block any zonal pricing of access if the pricing regimes for retail and wholesale products are linked in the way Postcomm implies. This will perpetuate prices being out of line with costs and promote inefficient entry. Similarly Postcomm’s decision to retain full tariff account mail in the USO will block cost reflective delivery zone pricing and subsidise urban cherry picking by DHL, DX and others. Overall, Postcomm’s definition of the USO is unreasonably broad and is inconsistent with Postcomm’s own stated principles of cost reflective pricing to encourage efficient entry into the market.

Royal Mail’s alternative universal service definition

9.15 Royal Mail believes that the definition of the universal service should be focused upon the core social offer – namely individual unsorted stamped mail – which is unlikely to be attractive to competition in the short to medium term.9 Products that are likely to be competitive should be removed from the universal service definition in order to minimise distortions in the competitive marketplace. In particular this implies that all bulk mail


9 In addition there is a USO requirement to provide a registered and insured product.

should be immediately removed from the definition of the universal service as it is already exposed to significant competition:

Mailsort 2 – the core 2 to 3 day bulk offering used primarily for statements – is already migrating rapidly to downstream access through third party intermediaries such as Business Post, DHL and TNT. By year end 2005/06 we expect to have lost 20% of Mailsort 2 to downstream access (approximately a billion items) after only two years of competition.

Mailsort 3 – the slow speed 7 day bulk offer used primarily for direct mail – is highly vulnerable to competitors setting up their own end-to-end networks and delivering only 2 or 3 days a week so substantially reducing their cost structure relative to our USO-driven delivery costs. This is essentially the model that Citymail have adopted in Sweden where they hold at least a 25% share of their addressable market (bulk presorted mail to 3 major cities). Postcomm shares our view on the vulnerability of Mailsort 3 to bypass competition: “Royal Mail will losesignificant volumes of third class mail…most third class mail lost to competitors will be provided by competing end-to-end networks and not by u e of Royal Mail’s downstream access products.”10

s

r

9.16 Removing bulk products from the universal service definition is also entirely consistent with developments overseas, for example in the Netherlands and Sweden.

PROPOSED CHANGES TO LC19(1)

9.17 Royal Mail believes that a vibrant competitive market benefits postal customers by providing choice and encouraging innovation by all players. However, it is critical that entry occurs based on efficient economic signals, and not simply to exploit misalignments between prices and costs created by historical and universal service constraints. Regulation should support a framework that allows market players to innovate and so respond to customer needs for new products and to rebalance prices towards costs

9.18 From the perspective of a price control, innovation means having the opportunity to evolve products and services that are within the control both in price and non price terms. In practical terms this means that the industry needs a framework to cover the following innovations:

Development of replacement services: Royal Mail fully accepts that the ability to evolve standard products should not be seen as an opportunity to evade a price control. In developing a service that is effectively a replacement of an existing service, we would want the existing service to be removed from the control and the new service to take its place. This process must be clear, quick and simple.

Removal of a replaced se vice: In developing a product that is a direct substitute of an existing service, we would expect a high percentage of customers to migrate to the new service and the old service to be withdrawn. Royal Mail acknowledges that for the service to be withdrawn, the new service should pass a substitution


10 Postcomm’s initial proposals on price control, June 2005, Appendix 3.55.

test that must be clearly defined. This test however must acknowledge that the new service may not necessarily be better in all respects and for all customers.

Cessation: Royal Mail believes that there should be scope to withdraw minor variants of existing services to facilitate the development of Royal Mail’s new product portfolio.

Introduction of new products: The framework should allow Royal Mail to introduce new products with appropriate commercial freedom and without the automatic prospect of price or quality regulation – such as downstream access and Mailmedia.

9.19 LC19(1) places a constraint on Royal Mail to continue to provide the same services as at the outset of the price control. Changes can be made to services if they are to the benefit of customers and changes that are considered to be detrimental by customers can be referred, through an application, to Postcomm for a determination. Royal Mail has sought clarification as to what constitutes a material detrimental effect on a customer to clarify the scope for change within LC19(1), but Postcomm has declined to provide such clarification.

9.20 Instead, Postcomm proposes a change to the current ex-post regulation of non-price terms in LC19(1) to ex-ante regulation in which Royal Mail would need to seek prior approval from Postwatch. Postcomm’s document states that, in relation to Licence Condition 19:

‘Under the current control Royal Mail is required to seek Postcomm's approval for all changesto non-price terms of price controlled products if the changes might have an adverse effect on customers’ interests. Prior to approving any changes proposed by Royal Mail, Postcommmust consult Postwatch and may consult customer and other interested parties. The mos significant example of such changes during the curren control was Royal Mail’s appli ation to change the terms and conditions of its Standard Parcel and Special Delivery products in 2003.’ (6.50)

t

t c

t t

9.21 However, this statement is incorrect. Licence Condition 19(1) states:

‘and any question as to whether the terms other than price on which the Regulated Services were offered and provided are more or less beneficial to users on one da e as compared wi hanother shall be decided by determination by Postcomm’.

9.22 Licence condition 19(1) applies ex post regulation to non price terms which currently enables a customer to seek a determination after a change to the non price terms is made that it regards as detrimental to it. In the cases of Standard Parcel and Special Delivery, Royal Mail elected to approach Postcomm to prior approval, but this was not a requirement of the current licence.

9.23 Further, the price terms are covered by formulae in LC19 requiring any under or over recovery to be returned to the customer ex post - and therefore again is not ex ante.

9.24 Though there are some ex ante components of regulation (relating to the need for advanced approval for changes in structure and exceeding maximum limits on price changes) the main components for the current regulation of price and non price terms under Licence Condition 19 are ex post.


9.25 Postcomm’s document (in Section 6.51) not only appears to assume that LC19(1) is ex ante when it is ex post but also it proceeds to propose changes for LC19(1) to an ex ante approval process for the non price terms with Postwatch’s involvement. Postcomm’s document states:

‘An alterna ive approach would be to give Postwatch a s ronger role in the [ex ante] process for considering such changes [to non price terms]. Given Pos watch’s different statutory duties, an in particular its focus only on customers’ interests rather than also considering other stakeholders, (e.g. other opera ors), Postcomm does not believe that it could leave the issue solely to Postwatch.’ (6.54)

t tt

t

t( t t

( )

tt

t

9.26 In conclusion, Royal Mail has raised the potential benefit of clarifying LC19(1) to establish what may be regarded as non material changes to the non price terms. Postcomm’s proposal does not address this specific point, particularly in respect of the withdrawal and replacement of existing services, and Royal Mail believes this should be done to clarify the scope for innovation during the next price control. Further LC19(1) should remain an ex post condition on which Royal Mail clearly retains the option to seek advance approval of any non price terms.

PROPOSED CHANGES TO LC19(12-13)

9.27 Postcomm proposes to retain the existing criteria currently in 19(12-13) for assessing Royal Mail’s applications for changes in pricing structure, but proposes to extend this so that Royal Mail would need to make an application to introduce zonal end-to-end prices irrespective of whether the proposed prices met the requirements of the primary and secondary control limits

9.28 Postcomm’s Market Opening Document (September 2004) states that the removal of services from the universal service obligation (USO) “gives Royal Mail more pricing flexibility than was previously the case” (S.22). In Royal Mail’s response of December 2004, Royal Mail stated:

‘This is only true if Royal Mail can proceed to introduce such pricing flexibility following the removal of the product from the USO. In practice, Royal Mail may not be able to proceed because of other restrictions within the licence (notably the restric ion on the changes to non price terms in Licence Condition 19 1) and Pos comm’s process of applica ions for changes to pricing structures in Licence Condition 19 12 ). Changes to the licence would be needed in this regard to achieve Postcomm’s objective and “gives Royal Mail more pricing flexibility”’.

9.29 In contrast to this position, Postcomm proposes to increase the regulation of moves to zonal pricing, thereby further reducing the scope to price more flexibly. Postcomm’s document states:

‘Postcomm is also proposing to extend the coverage of the provisions of paragraphs 12 and13 of Condition 19 of the licence. This extension will require Royal Mail [ o] obtain Postcomm’s prior approval for the introduction of geographically de-averaged re ail prices for price con rolled products’ (6.49)

9.30 Postcomm’s justification for the proposed change is that:


‘Postcomm has a duty to protect customers, including potentially disadvantaged cus omers, such as rural customers, and the duty to promote competition’ (6.49) 11.

t

tt t

f

9.31 Postcomm also notes that:

‘Products that are part of Postcomm’s proposed definition of the universal service could not have geographically de-averaged prices’ (6.49)

9.32 In response Royal Mail notes that its customers are charged for sending rather than receiving mail. Zonal pricing would increase the postal charges for mail sent to rural areas, not mail sent from rural areas.

9.33 In addition, to the extent that increasing the charges of mail sent to rural areas disadvantaged rural customers, this can be addressed through retention of the uniform tariff under the universal service obligation. However, when a service is removed by Postcomm from the obligation, it is accepting that Royal Mail should have the scope to implement zonal pricing.

9.34 The remaining questions are then ones of (a) the structure; (b) cost reflectivity; (c) the level of pricing and (d) the communication. For zonal pricing:

a) the structure is already established through the access service, given that these elements form a substantive component of the end-to-end service;

b) the improvement in cost reflectivity from zonal pricing is generally recognised. For ‘pricing in proportion’ Postcomm considered factors that were outside of the costing system in its review of costs by size. Royal Mail has presented at a conference and provided a paper to Postcomm setting out its approach to establishing zonally priced access prices, and the same approach equally applies to the end-to-end service. For completeness this paper is included in Annex 10.

c) the level of pricing is constrained firstly by the maximum price thresholds and secondly by the requirement for Royal Mail to submit an application in the event of the thresholds being exceeded. Postcomm’s document recognises this in stating:

‘Appendix 1 [of Postcomm’s document] sets out the cri eria Royal Mail has to satisfy under Condition 19 of i s licence to make changes to i s pricing structure for price controlled services. Whilst these criteria cover changes in the pricing structure, such as SBP, they do not require Royal Mail to seek approval for the sub-division of existing products, such as the introduction of channel pricing and zonal pricing. In these circumstances the rebalancing threshold acts to limit the opportunity or price increases when sub-dividing products’ (6.42)

d) the communication required for the introduction of ‘pricing in proportion’ provides a precedent and guideline for future changes to the pricing structure.

9.35 Royal Mail believes that, instead of Postcomm’s proposed approach, it would be more appropriate and sufficient for the licence to include a requirement for Royal Mail to issue a statement ahead of proposed implementation of zonal pricing that

a) reminds customers of the zonal pricing structure;


11 It is noted that this does not refer to Postcomm’s primary duty to ensure the provision of the universal service.

b) provides prices showing that they comply with the maximum thresholds; and

c) includes a communication plan that is consistent and proportionate with that of ‘pricing in proportion’ (given that zonal pricing will only involve some business services).

9.36 In addition, and aside from zonal pricing, Royal Mail believes it should not need to submit an application under the equivalent of the existing licence condition 19(12-13) for continuation and extension of pricing structures that already exist including speed, weight, channel, volume, machineability, sortation and booking. Further Royal Mail believes that it should not be required to make an application under Licence Condition 19 (12-13) for services outside the universal service, as these are considered to be within a competitive environment in which the universal service obligation should not hold.

OTHER ISSUES ON STRUCTURE

9.37 Royal Mail has received a copy of the financial model used by Postcomm to establish the X factors published within its document. Other aspects of the modelling are discussed elsewhere in this response (see, for example, Sections 7 and 12). Regarding structure, the draft licence modification appears to retain the application of RPI-X to allowed average prices that are in some way disaggregated to address product mix but this has not been modelled within Postcomm’s financial model. Consequently, Postcomm does not have a consistent definition of the allowed average prices to which the RPI-X formula would apply. Therefore the results of its modelling and its proposal are unclear in this critically important area and this will need to be addressed in Postcomm’s final decision document.

9.38 Since the publication of Postcomm’s documents on the price control and service quality review and the universal service, Postcomm has also published its proposed decision document for the implementation of ‘pricing in proportion’ in August 2006. If the next price control commences on 1 April, this would imply that the change to the new structure will take place within the next price control period. Postcomm’s document on pricing in proportion sets out a draft licence modification to calculate the allowed revenue with the change to ‘pricing in proportion’.

9.39 Royal Mail believes that the proposed formula may significantly distort the calculation of the allowed revenue and that there are several practical issues to overcome to adequately define the volumes within the year before and after the change. Royal Mail has already raised these concerns, and others, to Postcomm. Royal Mail expects that these will need to be resolved in amendments to the draft licence modification. Hence it believes a final decision on licence modifications for pricing in proportion should be made at the same time as those arising from the price and service quality review and universal service review.


10 FINANCE

OVERVIEW

10.1 This section sets out Royal Mail’s response on the financial framework for the next price control for Royal Mail, and in particular the regulatory capital value (RCV)12 and WACC. Other issues relating to the financeability are included in Section 12.

Postcomm’s Proposals

Postcomm proposes to assess financeability by reference to ability of Royal Mail to retain a positive cash flow against single downside risks that it defines regarding volumes, efficiency, pensions and quality of service;

Postcomm proposes an intangible asset value of zero for the opening RCV on 1 April 2006

Postcomm proposes a level of cash in the opening RCV of zero; Postcomm proposes that leased assets are not capitalised on the assumption

that is makes no difference to the calculations of allowed revenue; Postcomm proposes the rolling forward the RCV at inflation and deducting

disposals at the carrying value in the regulated asset base Postcomm proposes to consider whether overspend on capex would be

included in the RCV at a future date and proposes to require Royal Mail to report capex annually;

Include an allowance of £261m each year for pension deficit costs for the regulated activities, as outlined in table 8.12 of Postcomm’s document

Postcomm proposes to allocate costs for the purposes of setting allowed revenues using an equi-proportional mark-up approach;

Postcomm proposes a real, pre-tax WACC of 8%, based on a range from 6% to 10 % and indicates that Royal Mail has not made a convincing case for its use of beta, gearing and risk premium.


Royal Mail believes that regulatory precedent does not support the way in which Postcomm has assessed financeability. This should be based on financial ratios for a number of scenarios and combinations of downside risks on the central case;

Royal Mail estimates the intangible value to be at least £1.2bn. It provides four approaches to support this which also can be checked against the implicit value formed from the top-down approach (assuming that leased assets are capitalised);

Royal Mail estimates the efficient working capital in the opening RCV to be £274m based on BT’s definition of working capital;

Royal Mail believes that it is appropriate for leased assets to be capitalised for the purposes of the price control calculations and explains why it does affect Postcomm’s calculation of allowed revenue;


12 Referred to as the Regulatory Asset Base (RAB) in Royal Mail’s December 2004 response and in some Annexes.

Royal Mail believes an allowance for pension deficit costs for regulated activities should permit funding over 12 years and include costs of latest mortality assumptions;

Royal Mail agrees with Postcomm’s approach for rolling forward the RCV at inflation and deducting disposals at the carry value in the regulated asset base;

Royal Mail believes that clarification of Postcomm’s approach to the treatment of capex overspend is necessary as part of Postcomm’s final proposals in the light of Postcomm’s proposals to significantly reduce the allowance on capex sought by Royal Mail. This would also help clarify the information requirements

Royal Mail believes that cost allocation approach proposed by Postcomm is likely to be reasonable approximation for the separation the price controlled and non price controlled services within the Letters business. But it is not likely to be reasonable for the allocation of costs between products within the price controlled area because of the move to class costing; and, further, is neither necessary nor consistent with regulatory precedent (see Section 9).

Royal Mail believes the real, pre-tax WACC is at least 10%.

FINANCEABLITY

10.2 Postcomm’s document sets out its approach to testing the financeablity of the proposed price control in Section 8 of its report. It states that:

‘As part of i s statutory duties Pos comm needs to be satisfied tha its price control proposals will allow Royal Mail sufficient revenue to provide the universal service and finance i s licensed activities – referred to as its regulated activities.’ (8.117)

t t t

t

t tr t

t

and

‘Other regula ors have similar duties. They have sought o fulfil this duty by assessing whether their price control p oposals would be consisten with the companies maintaining an investment grade credit rating from credit organisations S andard and Poor’s or Moody’s’ (8.118)

10.3 Having stated the approach that is widely used by other UK regulators for assessing the financial viability of the business, Postcomm’s document does not propose or proceed to apply this approach. Thereby its proposals are outside of regulatory precedence elsewhere in the UK. Further, in doing so, Royal Mail believes that Postcomm is also out of line with its own objective of seeking to treat Royal Mail as an independent, commercial business.

10.4 Postcomm’s document supports this move from regulatory precedence by reference to Royal Mail not having been assessed by a credit rating agency and having limited debt. On the first point, Royal Mail believes that Postcomm could have sought advice from a credit rating agency and, further, that the appropriate credit rating could be deduced from comparison of the ratings used by other UK regulators to set the control. On the second point, paragraph A4.28 Postcomm’s document has applied a gearing of 20-40% to derive an estimate of the WACC. While Royal Mail believes that the gearing should be 20% (if the pensions is treated as pass-though), it is inconsistent of Postcomm to claim on the one hand that there is limited debt and on the other to apply a gearing of 20-40%.


10.5 Royal Mail believes that Postcomm should assess the financeablity of its business consistent with the approach used by other UK regulators and summarised in its own document in paragraphs 8.117-8.118. Royal Mail believes that Postcomm’s final proposals should set out the results of such tests.

10.6 To assist further in this consideration, the specific indicators, as used by Ofwat and Ofgem at their most recent reviews, and in conjunction with the credit rating agencies, are provided in the Table 10.1. In applying these tests, regulators have not simply taken the existing balance sheet position of the companies. Instead, the tests have been based on a notional balance sheet, consistent with the gearing assumption used in the WACC calculation. This ensures that companies are not incentivised to take an aggressive gearing position, as they would be if the approach was based on actual gearing levels, where highly geared companies would be more likely to be allowed returns in excess of their cost of capital. Further it is noted that these are a minimum set of requirements.

Table 10.1 Financeability indicators and thresholds considered by Ofwat and Ofgem

Indicator Ofwat Ofgem

Cash interest cover (FFO:gross interest) 3x 3x

Adjusted cash interest cover (FFO less capital charges:gross interest)

1.6x n/a

Adjusted cash interest cover (FFO less capital maintenance expenditure: gross interest)

2x n/a

FFO:debt Greater than 13% n/a

Retained cash flow:debt Greater than 7% Greater than 9%

Gearing (net debt:RCV) Below 65% Below 65%

Current cost dividend cover At least one, over the medium term n/a Notes: FFO, funds from operation. Ofgem ‘concluded that for standalone distribution companies … weaker test ratios than those shown above could still be consistent with ratings comfortably within investment grade.’ Source: Ofgem and Ofwat 2004 final determinations.

REGULATORY ASSET BASE

10.7 Postcomm’s document proposes an the opening value for MEAV/ CCA value on the basis of tangible assets valued at £2,203m on 1 April 2006. Postcomm’s document refers to a report by Martin Cave in support of its inclusion of the tangible asset value only within the opening RCV. Royal Mail asked for and received a copy of this report. Professor Martin Cave states the summary of his report13 undertaken for Postcomm:

‘Where regulators undertaking price con rol in monopoly sectors can concern themselves principally with maintaining investmen incentives, in compe itive sec ors a RCV is used to set prices whi h also crea e entry signals. Allowing a regulated firm o recover its costs

tt t t

c t t


13 2005, ‘The Royal Mail’s Regulatory Asset Base’, Martin Cave, March.

based on the current cost accounting valuation of its assets is most likely to create efficient signals of this type, as it gives entrants a realistic target o beat’.

t

t t t

t t tt

t tt t

t rt

t

tr

t

t

t tt

t tt

t tt t

tt

10.8 Royal Mail agrees that a primary requirement of regulators in sectors that are opened up to competition is to maintain investments and send appropriate price signals. However, Royal Mail does not agree that this leads one to a current cost accounting valuation of tangible assets alone. Entrants will, in addition to their investment in tangible assets, also need to invest in intangibles. Intangibles are not just brand but are also the accumulation of strategic position, tacit knowledge (e.g. by postal operatives of delivery walk sequence), reputation, organisation structure, software, learning, product development, customer relationships.

10.9 Royal Mail asked Professor Colin Mayer of Oxford University to comment on Professor Martin Cave’s paper. His paper, which is included in Annex 11, states that:

‘Where barriers to entry exist hen Royal Mail’s valua ion can exceed the curren cost of itsassets. Barriers to entry arise where new firms cannot replicate either the demand or costcondi ions of the incumbent. In the case of the Royal Mail there are several fac ors tha may contribu e to a market or cost advantage of the incumbent. First, the Royal Mail has areputational advantage in he market and has created a na ional network of customers. Second, i has established the physical infrastructure required o provide a national mail service. Third, it has the knowledge and managerial skills to organize the service.

An entrant will have to build a customer base, acquire the infrastruc ure and acqui e the knowledge and skills to manage a mail system. In addition o the current cost of Royal Mail’s physical assets, an entrant will therefore incur marketing costs in attracting customers, purchase costs of acquiring and installing assets, and learning and implementation costs in establishing the managerial skills. There will furthermore be a delay before the entrant has created a viable customer base and efficient modes of deliveryof services. These upfront costs and delays create barriers to entry tha allow the Royal Mail to earn returns that are in excess of normal returns on the current cost value of i s physical assets without encou aging entry into the industry.

To promote entry, charges will have to be set at a level that reflects the entry costs of newfirms coming into the indus ry which will be in excess of a normal return on Royal Mail’s existing assets. The difference between the value tha is required to encourage entry and the current cost of Royal Mail’s physical assets is what I will term the intangible value of Royal Mail.’

and further

‘In principle therefore the approach tha the Royal Mail has taken to the determina ion of its valuation combining bottom-up with top-down estimates is appropriate. It will be impor ant to establish whe her these approaches have in practice been correc ly implemented. Such an assessment should in particular critically evaluate the determina ion of current cost valuations, i.e. whe her efficient configura ions of assets and modern technologies have been considered or appropria e adjustments o existing valuations been made, the assessment of the additional cos s incurred by entrants and the identification of compara ors for determining brand values. The consistency of the results emerging from the different approaches will provide an indication of the reliability of the estimates of Royal Mail’s valuation ‘

10.10 Royal Mail notes that Postcomm’s documents on market opening and competition make frequent reference to the presence of barriers to entry. Thereby Postcomm has implicitly


accepted the presence of a primary reason for there to be an intangible value for Royal Mail.

10.11 Having confirmed the principle for including an intangible value within the opening RCV, Royal Mail proceeds to set out several different approaches for the valuation of the combined tangible and intangible value. These do not strictly follow an MEAV approach in which the configuration of the network is assumed to be optimally designed given the complexity of undertaking such analysis for the postal sector. Nevertheless, the different approaches closely approximate many of the features of such an analysis. Further, Royal Mail believes that the initial position should be such to encourage entry and that it is therefore better to include an intangible valuation than to exclude it altogether or understate it.

10.12 The approaches that have been applied yield broadly consistent valuations of the intangibles of at least £1.2bn and an opening RCV of around £5bn for the Letters business (including the capitalisation of the leased assets). These are discussed further below.

Top down approach

10.13 Postcomm received Royal Mail’s “top down” estimate of the RCV in January 2005. On this subject, In its document, Postcomm states:

‘Postcomm does not believe tha Royal Mail’s “top-down” approach to estimating an opening regula ed asset base is appropria e. It is unclear to Postcomm why the value of TPG or Deutsche Post, even a derived value for their letter’s businesses, should be similarto the value of Royal Mail. TPG and Deutsche Post opera e in countries with differen regulatory and political regimes, their business models are significantly different from Royal Mail’s, (e.g. substan ially more automated network, as discussed in LECG’s efficiency review report), and the level of compe ition tha they face is different form Royal Mail). There arelikely to be other significant differences between TPG and Deutsche Pos and Royal Mail. Itis unlikely, therefore that any value of Royal Mail derived from the value of these companies would have particular merit’ (7.43).

tt t

t t

tt t

t

10.14 This statement is misleading as:

a) Royal Mail’s calculations used several independent broker reports (not commissioned by Royal Mail) on the value of TPG and DPWN’s letters businesses; that is, it does not apply any Group level valuation;

b) Royal Mail’s calculations took account of differences in the asset values and thereby the degree of automation.

10.15 Royal Mail expects Postcomm’s mis-understandings to be rectified by receipt of the broker’s reports (not commissioned by Royal Mail) and further review of its original submission.

10.16 Royal Mail’s original submission stated the rationale for using the market valuations of the Letter businesses of TPG and DPWN was based on them being publicly quoted companies and meeting the universal service obligation in their respective countries. Further, these are potential competitors to Royal Mail in the UK market.


10.17 Royal Mail recognises that the regulatory and political regime may be different between the countries. However, a result in which the enterprise value exceeds the tangible value should not be a surprise as it occurs for many businesses in low capital intensive businesses owing to the presence of intangible value (see Annex 14).

10.18 Moreover, such considerations do not necessarily bias the estimates that Royal Mail has derived. Postcomm has fully opened up the UK postal market in January 2006, ahead of that in the Netherlands and Germany. Postcomm’s price control proposals expose Royal Mail to the downside risk arising from its market opening decision and an opening RCV that would be lower than the equivalent of some of its main competitors. Royal Mail believes that the proposed price control leaves it over exposed financially, as discussed in Section 13. This is further substantiated below in the context of the intangible valuation for the ‘bottom-up’ approach. In conclusion, just as with the top-down analysis for efficiency, the top-down approach provides an appropriate and valid cross-check on the opening RCV. This approach is supported by Professor Colin Mayer (see Annex 11)

Intangible value

10.19 In its January 2005 submission to Postcomm, Royal Mail summarised an approach to estimating the intangible value that was based on a ‘royalty rate’ approach. This assesses what a third party would be willing to pay Royal Mail for the use of the Royal Mail brand which in this case would be an estimate of the ‘cost of entry’ for entrants to attain market share. Typically the approach applies royalty rates to the future revenue stream, adjusted for standing of the Royal Mail brand within other competing brands, and discounted to form a present value. A rule of thumb is used to ensure that reasonable and appropriate royalty rates are used. While this standard approach is also included in the consultants’ report, it involves a degree of circularity in that it depends on the future level of revenue which Postcomm for which seeking to set an allowed revenue. Consequently, the report provides an equivalent result in the context of the intangible value for the RCV and is included in Annex 12.

10.20 Postcomm’s document makes several comments on an estimate of the intangible value.

(a) It highlights the reference to “rules of thumb” and questions whether the approach is robust. Royal Mail believes that Postcomm has misinterpreted the approach and the application of the “rule of thumb” and this is consistent with its misrepresentation of the approach in its paragraph 7.67 which may be contrasted with the preceding paragraph above.

(b) It refers generally to some capitalised industries and some supply businesses as not having intangible value. Royal Mail believes the capitalised industries are largely irrelevant because they are not subject to competition. However, electricity supply businesses are less capital intensive and are subject to competition and therefore may be of greater relevance. In this regard, Rothschild has advised Royal Mail that between 1998 and 2002 there were nine trade sales of electricity retail business from which is possible to deduce the intangible value in seven cases, for which the enterprise value significantly exceeded the net asset value to imply a significant intangible value.

(c) It questions whether entrants would invest in intangibles and in particular brand “given that most of the mail volume is concentrated amongst large business


customers” (7.68). In this regard Postcomm is inconsistent. Postcomm has stated in a separate published document that

"Royal Mail's brand value [...] is significant across a wide range o customers and postal users. This has been borne out by Pos comm's market research. Royal Mail's brand benefits from having a universal coverage. A further brand benefit might be derived from Royal Mail's universal network of pillar boxes and post offices, which might con ribute to promoting Royal Mail and i s products. Oftel found that public telephone boxes offered a similar benefit o British Telecom"14.

ft

t tt

t

t

tt

t rt

t t t t

tt

This is also implicit in the volume projections used to set the price control.

10.21 Royal Mail believes that Postcomm has no valid grounds for its assumption that the intangible value of its business is zero - the conclusion it makes in paragraph 7.70 of its document. Royal Mail maintains the view that the intangible value is significant and positive. Further it maintains the view that the ‘royalty rate’ is a valid approach for estimating the intangible value.

10.22 As evidence in support of its original submission, Royal Mail has undertaken two further pieces of analysis. In the first approach it assesses the ‘cost of entry’ measured by the discount on Royal Mail prices necessary for entrants to attain market shares; this uses information of the UK postal sector from the switching functions obtained from customer surveys and applied within Royal Mail’s Entry Pricing Model. In the second approach it assesses the ‘cost of entry’ measured by the benefit to Royal Mail’s cash position of retaining market share; this uses information of the size of the transferable market from the UK postal sector together an estimate of the overall long-run cost elasticity for Royal Mail. Indeed these approaches are consistent with the statement in Postcomm’s document that:

‘To the extent that brand value is useful to Royal Mail then it enables it to re ain more customers in a competitive market than would otherwise be the case’ (7.68).

10.23 The Executive Summary of the report, setting out these two approaches, is included in Annex 13, concludes:

‘The paper supports an intangible value of at least £1.3bn (and po entially as much as £2.6bn15) within the RCV based on the ‘cost of entry’ measured by the discount on Royal Mail prices necessary for entrants to a ain market shares.

It also suppor s an intangible value of more than £1.3bn within the RCV (if not add essed elsewhere wi hin the price control) as a means of ensuring the financial viability of the universal service provider in the presence of compe itive ‘by pass’ entry cap uring more than about 20% of the market share, based on he ‘cost of entry’ measured by the benefit oRoyal Mail’s cash position of retaining marke share. The adverse effect of the financial viability of in particular ‘bypass’, but also potentially ‘access’ if the access prices are not se

14 Postcomm, Competitive Market Review proposals, September 2004, para 4.76.


15 This figure marginally reduced to £2.3bn with the EPM phasing of the transfer from start to end switching functions.

at the appropriate level, has been well documented in the Economics literature of the postal secto ’.16 r

tt t r

10.24 Royal Mail has also prepared a report looking at the intangible costs associated with a ‘green-field’ replication of Royal Mail’s Letter business. This considers the costs of IT, training, advertising and hiring that an entrant would need to incur to replicate Royal Mail (i.e. investment it would need to make in intangible assets). It identifies costs of at least £3.6bn. Further details are included in Annex 4.

10.25 While Postcomm’s document shows that it has undertaken no analysis (up to June 2005) on this subject and is prepared on that basis to assume a zero value. Royal Mail has presented four approaches that estimate the intangible value to be at least £1.2bn and which also align with the implicit value assumed from the top-down approach (having capitalised leased assets):

a) the ’royalty rate’ approach assesses what a third party would be willing to pay Royal Mail for the use of the Royal Mail brand which in this case would be an estimate of the ‘cost of entry’ for entrants to attain market share; its estimate is £1.2bn.

b) the ‘entrant’s pricing’’ approach assesses the ‘cost of entry’ measures by the discount on Royal Mail prices necessary for entrants to attain market shares; its estimate is at least £1.3bn.

c) the ‘cost of entry’ measured by the benefit to Royal Mail’s cash position of retaining market share; its estimate is £2.6bn.

d) the ‘greenfield’ approach assesses the ‘cost of entry’ measured by the expenditure required by entrants to attain Royal Mail’s position in terms of IT systems, training, advertising and hiring that comprise the intangible value; it is estimated to be at least £3.6bn.

10.26 In summary, Royal Mail believes that the intangible value for the RCV should be at least £1.2bn. Further, the analysis identifies a risk to the financial viability of Royal Mail arising from loss of mail to entrants which needs to be addressed either through a higher intangible value in the RCV or elsewhere within the setting of the price control; this is discussed further in Section 13.

Working capital

10.27 Postcomm proposes to include no cash within the opening RCV. Postcomm’s document states:

‘Postcomm does not propose to include cash within the regulated asset base for several reasons. First there is no regula ory precedent to support this approach. Second, movemen s of cash would need to be incorporated into the regula ory asset roll fo ward, which would create unnecessary complexity. Third, only an efficient level of cash required for funding working capital should be included. Surplus cash should be excluded from the asset base. Assessing the appropriate level of working capital is likely to be difficult and


16 See, for example, 2005, De Donder P, Cremer H, Rodriguez F, ‘Access Pricing and the Uniform Tariff in the Postal Sector’ in ‘Competitive Transformation of the Postal and Delivery Sector’ edited by M.A Crew and P.R. Kleindorfer, Boston, MA: Kluwer Academics Publishers.

subjective. Last, excluding cash will not affect the marke value of the company or the level of regula ed prices” (7.63

tt )

r

10.28 Royal Mail has developed its view of cash and working capital and in line with LECG’s comments more towards working capital. Royal Mail believes it is standard accounting practice to include working capital (or net current assets) as an asset on the balance sheet and, therefore, to the extent that opening RCV has reflected the assets on the balance sheet, they will have directly or indirectly included such an element. In most cases, a direct mapping of the opening RCV to the accounting book value was not undertaken because the opening RCV was based on a market valuation rather than accounting book value per se. In cases where regulators have made reference to the accounting book value this has (as LECG make clear) included such assets. Consequently, it is not contrary to regulatory precedent to include this within the RCV within a ‘bottom-up’ approach that tries to assess what the value of the assets on the balance sheet would look like on a market valuation.

10.29 Further, Royal Mail believes that point made in the last sentence of paragraph 7.63 of its document is incorrect. In the ‘bottom-up’ approach the working capital held on the balance sheet affects the opening RCV and thereby the level of allowed profit and allowed revenue.

10.30 In its review of Royal Mail’s initial submission, LECG states the difference between Royal Mail’s definition of capital employed and BT’s definition, where the latter is defined as: ‘mean total assets less current liabilities, excluding corporate taxes, dividends payable, capitalised goodwill, provisions other than those for deferred taxation. LECG also state that ‘…it would be inapp opriate to include cash but to exclude other working capital balances.’

10.31 In light of these comments, Royal Mail has reviewed its submission with regard to the inclusion of cash and other working capital balances. In order to reach consistency with the way BT has defined its asset base, and hence to include all working capital balances, it is necessary to add the net current asset position (current assets less current liabilities) to Royal Mail’s assessment of its (revalued) tangible and intangible assets. This will result in Royal Mail’s asset base being equal to total assets less current liabilities and, as such, by accounting identities, this will reflect the level of long term financing (equity plus long term creditors) that will be required by a new entrant.

10.32 The net current asset position of Royal Mail Group (ie excluding POL and GLS) is, according to the most recent 2004/05 accounts, £1912m.17 However, Royal Mail recognises that this would not appropriately reflect the net current asset position of the letters business. In particular, it would appear necessary to make three adjustments: ’

(a) Within debtors receivable beyond one year, there is an entry in the accounts of £835m to reflect pension prepayments. However, consistent with its arguments developed elsewhere in its submission, and reflecting its belief that Postcomm should provide for full remuneration of its pension deficit over an appropriate period within the opex allowance, Royal Mail would suggest that all pension


17 It is noted that in this year’s regulated accounts, a balance sheet for neither of the Letters business nor the regulated business has been calculated.

related issues are removed from the consideration of the balance sheet. Royal Mail therefore proposes to remove this entry.

(b) Within the total current asset investments of £1056m, £800m are ring-fenced as

part of the mails reserve for future use by POL, and should therefore be excluded from the consideration of the working capital position of the Letters business.

(c) Consistent with the approach taken by BT, as suggested by LECG, Royal Mail

propose to not include corporation tax payable.

10.33 The result of these adjustments, as shown in Table 10.2, is that the net current asset position of Royal Mail is adjusted downwards from £1912m to £274m in 2003/04 prices.

Table 10.2: Derivation of the working capital position for the Letters business from the balance sheet.

Category Includes As found in Royal Mail Group plc accounts

Revised entry

Debtors receivable within one year

Trade debtors, amounts owed by subsidiaries, loan to associate, other prepayments

£919m £919m Current assets

Receivable beyond one year

Pension prepayment, amounts owed by subsidiaries, other.

£1458m £623m

Investments Gilt edged securities, short term deposits, other deposits

£1056 £256m

Current liabilities

Creditors – amount falling due within one year

Loans, trade creditors and accruals, advanced customer payments, amounts due to subsidiaries, corporation tax, other taxation and social security, other creditors

(£1548m) (£1524m)

Net working capital position

£274m

10.34 Finally, Royal Mail would note that one of the further objections stated by Postcomm for not including working capital, that it would require detailed year on year modelling of the fluctuations in the entries, need not be a concern. Royal Mail would point to the precedent established by the Competition Commission in the context of BAA. It stated that:

With regard o the future, BAA said that, in order for the RCV roll forward to be clear and unambiguous, it would be preferable fo change in working capital to be excluded. We agree, and have excluded changes in working capital from the RCV roll-forward18

t r

Royal Mail supports this approach in the roll forward of its own RCV.


18 Competition Commission (2002) BAA plc, November.

Capitalising leased assets

10.35 Postcomm proposes not to include leased assets within the opening RCV. Postcomm’s document states:

‘Postcomm is not persuaded tha including leased asse s within the regulated asse base would be app opriate for a number of reasons. First, SSAP 21, an accounting standard under UK GAAP, s a es that opera ing leases should no be capitalised on the face of the balance sheet. Second, the capitalisa ion of leased assets for regula ory purposes will create an inconsistency with how leased are trea ed within the sta utory and managemen accounts. This will make monitoring and reconciling information at subsequent price controls more difficult. Third, Postcomm is unaware of any regulatory precedent that wouldsuppor this approach. Fourth, it can be shown ha the policy is purely cosme ic and doesnot impact future prices because the lease payments would othe wise be treated as opera ing expendi ure. Last, including leases in the regulated asset base does not increasethe profi abili y of the business or increase the return to equity shareholders, as an elementof total allowed profits will relate to finance charges payable to lease holders.’ (7.61)

t t tr

t t t tt t

t t t

t t t t

rt t

t t

10.36 Royal Mail responds to these five points below:

a) the SSAP21, UK GAAP and accounting standards are not a constraint on the establishment of the appropriate opening RCV, which is primarily an economic value used to determine the appropriate level of allowed revenue for Royal Mail in a market open to entrants. Indeed, Postcomm includes within the RCV non capitalised assets of under £2500 which, under accounting policies, are not included in the accounts;

b) the capitalisation of all leased assets would place all similar assets within a single category for the setting of the price control, rather than two categories (leased and owned) between which the assets could transfer; a single category would reduce confusion;

c) the question of whether assets should be capitalised or not is addressed by all regulators in assessing the RCV. It may or may not have arisen at the time of setting the opening RCV – in most cases the RCV reflects a market value. There is no inherent reason why it should not be addressed in the opening RCV;

d) there are two reasons why this is not purely cosmetic and does impact future prices and allowed revenue:

Postcomm estimates the WACC for the business to be 8%. However the leased assets are capitalised at a discount rate of 8.5%. Under Postcomm’s proposals, this would make the future prices and allowed revenue lower with the capitalisation of the leased assets. Conversely, with a WACC of 10% this would make the future prices and allowed revenue higher with the capitalisation of the leased assets;

Postcomm’s proposals reduce the base year opex by an RUOE of 3%p.a. If leased costs are in the opex base this implies a reduction in leased costs of 3% p.a. which does not apply if the leased assets are capitalised.

e) For the two reasons stated in (d) Royal Mail believes that the capitalisation of leased assets will increase the profitability of the business and increase the return to the shareholder within the calculations for setting the price control.


10.37 Royal Mail therefore believes that it is appropriate to capitalise leased assets into the opening RCV to avoid potential errors in the calculations and ensure that the profitability of the business is correctly determined. The capitalisation could be reported to Postcomm on an annual basis.

10.38 It is therefore necessary to consider what value should be ascribed to the leased assets to be added to the RCV. With regard to the leasehold property, Royal Mail continues to believe that the previous value as calculated by Atisreal remains appropriate, reflecting, as it does, Royal Mail’s belief that its future lease cost obligations are likely to remain constant in real terms into perpetuity. It is noted that because of Royal Mail’s proposed regulatory treatment of these assets, its cash requirement over the next price control period will be lower than if these assets were depreciated.

10.39 In terms of leased vehicles, Royal Mail has made a number of small adjustments to ensure that the derivation and roll-forward of the RCV remain consistent with Royal Mail’s future policy of purchasing rather than leasing vehicles and, in particular, the fact that Royal Mail plans to lease no new vehicles after the end of 2004/05 and that by end 2008/09 the book value of the fleet of leased vehicles is projected to be nil. This has involved extending the assumption on the UEL of these vehicles from 4 to 5 years. Given the changes in lease payments resulting from the decision to purchase vehicles, and the fact that Royal Mail has re-assessed the ‘base’ value of its leasing costs from £64m to £48m, to preserve the principle of neutrality, assuming a capitalisation rate of 8.5%, the book value of the leased assets has been revised downwards to £140m.

Rolling forward the bottom up RCV to 2006

10.40 Postcomm’s document and proposals assume an opening RCV in 2004 based on an existing use valuation of assets undertaken by Atisreal, on behalf of Royal Mail, and amended by LECG as reported in its document ‘Response to Royal Mail’s submission on the Regulatory Asset Base’ (June 2005). Postcomm’s document rolls this opening value forward to 2006, depreciating the assets according to its view of the asset lives, adding capex and subtracting disposals at the carrying value in the RCV.

10.41 Royal Mail has reviewed the assumptions on asset lives and the amendments made to its original submission. Royal Mail's notes the CCA value has been depreciated through assumed remaining lives so that the allowed revenue has a CCA depreciation allowance. It observes:

(a) As regards the capitalised leases from Royal Mail Property Holdings to Royal Mail Letters for property and land held by Royal Mail Property Holdings, LECG adjusted the December 2004 value submitted by RM to a March 2004 value, in part by adjusting for movements in the relevant index between these two dates and in part to deduct the capex that Royal Mail projected to undertake between these two dates19. Royal Mail accepts the first of these adjustments. However, as far as Royal Mail can ascertain LECG has deducted the capex between these two dates but not added back the depreciation between these dates. It is likely to be broadly the case that depreciation is


19 Assuming that 75% of the annual capex projected for this year would take place between April and December,

equal to capex at any one point in time, so Royal Mail proposes that this adjustment not be made.

(b) A distinction should be drawn between buildings, which should be assumed to depreciate, and land, which should be assumed not to. Royal Mail considers that c£500m20 is an appropriate assessment of the value of its land and therefore proposes to remove this amount from the value of the capitalised leases from Royal Mail Property Holdings to Royal Mail Letters for property and land held by Royal Mail Property Holdings and that this should be assumed to not depreciate. Royal Mail notes that this will reduce the revenue requirement of the business over the next price control period.

(c) Royal Mail continues to believe that there should be no difference, in principle, between the treatment of its (previously) non-capitalised assets and its other assets, and that therefore it is appropriate to index these assets. Following the approach in the water industry, where there is a presumption that asset values will rise in line with RPI, with only periodic adjustments to reflect any differences from this presumption, Royal Mail believes that indexing these assets on the basis of RPI remains appropriate. Furthermore, Royal Mail believes that it is peculiar that Postcomm/LECG are content for the non-capitalised assets to increase by RPI from 2004/05 onwards, as part of the overall RCV roll forward, but not to adopt a similar approach before 2004/05. As a result, Royal Mail continues to believe that a value for its non-capitalised assets of £235m remains appropriate.

(d) LECG’s model commences depreciation of the RCV from 2004 thereby applying CCA depreciation in 2004/05 and 2005/06 with the current price control. Postcomm’s decision document (February 2003) 21 refers to a line which provides only an HCA depreciation allowance within the allowed revenue of the current price control. Royal Mail has not adjusted for this for the modelling results presented in this paper, but believes such an adjustment should be considered by Postcomm in its final calculations.

Rolling forward the RCV after 2006

10.42 There are two aspects to the rolling forward other RCV after 2006 that are raised in Postcomm’s document (a) the treatment of disposals and (b) the treatment of capex.

10.43 On disposals, Postcomm’s initial proposals have been developed on the basis of rolling forward at inflation and deducting disposals at the carrying value in the regulated asset base. Postcomm’s document states:

‘Postcomm’s initial proposals have been developed on the basis of deducting disposals at the carrying value in the regulated asset base’ (7.79)

10.44 Royal Mail believes that this is the right approach to apply to disposals. The value of property within the RCV is based on existing use. The value at the time of sale may differ from the value of existing use and reflect an alternative use value. Given that property is

20 This is a provisional estimate used for the purposes of this response.


21 2003,Table 7.17 of ‘Second Price Control, Quality of Service Targets and Compensation – Final Proposals Document and Technical Annexes (February).

included in the opening RCV at existing-use value, the existing-use value should be subtracted from the RCV when a disposal occurs. The difference between alternative use and existing use within the RCV can be referred to as ‘disposal proceeds’.

10.45 Royal Mail believes that disposal proceeds should be retained by the business (and be available to the shareholder) so that the RCV continues to reflect costs that would be incurred by entrants while also incentivising Royal Mail to develop its assets in the same way as other commercial companies. This is also broadly consistent with the outcome of BT’s approach to disposals on its ‘Detailed Valuation Methodology’, BT which states that:

‘General Purpose Land and Buildings are valued on an existing use basis where occupied by BT for business purposes and on an open marke basis, where held for strategic, investmen , development and trading purposes or where surplus to current and future requirements.’

tt

tt

t

t

10.46 On capex, Postcomm’s document states:

‘Postcomm currently believes that it would be appropriate for i to consider whether the actual capital expenditure was not inefficiently incurred before confirming tha it would be added to the regulated asse base.’ (7.85)

and

‘..Postcomm will develop draft principles to define operating and capital expenditure, consisten with the definitions used in setting the regulated asset base value discussed above ... The revised licence condition would require Royal Mail to report cost information annually consistent with these definitions’ (7.84)

10.47 Royal Mail believes that it is not appropriate to assess ex-post the extent to which an investment has subsequently been required to meet customer needs. The assessment should be undertaken ex ante on the basis of the evidence available at that time. Otherwise Royal Mail would be exposed to significant asymmetric risk: it the investment was subsequently not (fully) demanded by customers then Royal Mail would earn a return less than its cost of capital on that investment, whereas if the investment was subsequently demanded by customers the maximum return would continue to be based on the WACC. As such the truncation of upside returns with no corresponding downside truncation would mean that the average expected rate of return on any investment not funded at the time of prices are set would be less then the cost of capital, establishing a significant disincentive to invest.

10.48 In the event that Royal Mail overspent on the allowed capex used to set the control, Royal Mail believes that it would be reasonable to assess whether, at the time that the decision to make the investment was undertaken, the investment was projected to deliver benefits to the customer. This is different from Postcomm’s stated position that the NPV of the business case was positive, as such a criterion suggests that customers are only interested in investments that lower costs, and not other investments that may bring alternative benefits to customers.

10.49 In addition, in the event that the additional capex was then included in the RCV, Royal Mail believes that this should be done complete with rolled up financing costs between the time of the investment and the opening RCV for the next control to create appropriate incentives to continue with the investment within the price control period.


10.50 Further, if Postcomm wishes to assess whether the investment was executed efficiently, Royal Mail believes that only the proportion considered to represent the ‘overspend’ should be disallowed from the amount that is rolled up into the asset base, rather than the total expenditure.

10.51 In the event that Royal Mail underspent, Royal Mail believes that any underspend should be adjusted only after 5 years to create appropriate incentives for executing investments efficiently. This approach is an approach that has not been implemented simply in the water sector by Ofwat. The bulk of UK regulated sectors have introduced, or plan to introduce similar mechanisms.

10.52 In addition, Royal Mail believes that if it achieves its quality of service targets satisfactorily and underspends on capex, it should be presumed that the underspend represents efficiency savings. If quality of service targets are not achieved satisfactorily and there is underspend, then it may be necessary to establish whether the underspend had contributed to the failure to satisfactorily meet a particular quality target.

10.53 Further, if any capex is deferred it may be necessary to establish the reasons for the deferral and whether these are in the interests of customers.

10.54 On capex monitoring, Postcomm’s document states:

‘..Postcomm will develop draft principles to define operating and capital expenditure, consisten with the definitions used in setting the regulated asset base value discussed above ... The revised licence condition would require Royal Mail to report cost information annually consistent with these definitions’ (7.84)

t

10.55 Royal Mail believes that clarification of Postcomm’s approach to the treatment of capex overspend and underspend is necessary as part of Postcomm’s final proposals. This would clarify both the investment risk for Royal Mail over the period and the information requirements for capex monitoring which should be focused on such issues and, Royal Mail believes, the principles outlined above.

Apportioning the value of regulated asset base between price controlled products.

10.56 Postcomm has effectively apportioned the value of the regulated asset base on an equi-proportional basis to the attributable costs for each product. Postcomm indicates it would probably be more appropriate to attribute the regulated asset base according to how the products within each price control basket use different assets (e.g. access products do not use upstream assets). This would help to ensure that the separate baskets reflect as well as reasonably possible the costs incurred for providing the products in the baskets. However, Postcomm does not have information about this at the current time. Postcomm considers its approach of apportioning the regulated asset base a reasonable proxy, given the available information.

10.57 Royal Mail does not support the application of separate baskets proposed by Postcomm and further does not accept that equi-proportional mark-ups is a valid approach for allocating costs to individual products for the purposes of pricing. Royal Mail set out its position in Section 9. Royal Mail believes that the approach is likely to be a reasonable approximation for the separation the price controlled and non price controlled services within the Letters business. However, a move to class costing, as explained in Section 9, would imply significantly different cost allocations between products within the price


controlled area. Further, the application of the two baskets within the price controlled area, which drives Postcomm’s requirement for a means of allocating cost between products, is neither necessary nor consistent with regulatory precedent.

Conclusions

10.58 Royal Mail’s opening RCV position for its Letters’ business is as stated in Table 11.3. The opening RCV in 2006/07, including capitalised leased assets, is £4.6bn in 2005/06 prices, using the ‘bottom-up” approach. The change in the value to that submitted in January primarily arises from a reduction in the assumed working capital and the assumption that the depreciation allowed for in the last control equated to CCA and not the HCA stated in Postcomm’s decision document in 200322.

Table 10.3 Royal Mail's assessment of its opening RCV for the Letters business in

2005/06 prices

Component Value (£m)

Capitalised leases from Royal Mail Property Holdings to Royal Mail Letters for property held by Royal Mail Property Holdings23

442.3

Capitalised leases from Royal Mail Property Holdings to Royal Mail Letters for land held by Royal Mail Property Holdings

525.3

Leasehold property (Short and Long) 739.4

Property Fit Out 734.2

Vehicles 187.7

Plant and Machinery 254.6

Leased vehicles 44.1

Fixtures and equipment 5.9

Other 213.5

Net current assets 280.9

Intangible Values 1200

Total 4628.0

WEIGHTED AVERAGE COST OF CAPITAL

10.59 Postcomm’s initial calculation adopts a pre-tax real WACC of 8%. This provides a forecast profit allowance for Royal Mail’s regulated activities of about £285m on average per

22 2003,Table 7.17 of ‘Second Price Control, Quality of Service Targets and Compensation – Final Proposals Document and Technical Annexes (February).


23 The values of property and land were estimated by Royal Mail’s external valuers. The split between land and property is a provisional estimate used for the purposes of this response (see para. 10.41).

year 4 (though this is not the core allowed profit, as measured by RCVxWACC, which is c£170m). Postcomm’s document states

‘For i s initial proposals Poscomm has used a pre-tax real cost of capital of 8%. Based on an opening RCV o £2.203bn, and Pos comm’s assump ions on how the RCV should roll forwa d, this results in a profit allowance of around £285m on ave age in each yea of the price con rol. This is equivalent to a cash profi of £265m on average in each year of the price control.’ (A4.46)

tf t t

r r rt t

t t

tt t

10.60 Postcomm’s document agrees with Royal Mail’s estimate of the parameter values for the weighted average cost of capital (WACC) other than in respect of the level of gearing, equity beta and equity premium.

10.61 Postcomm subsequently provided a May 2005 report undertaken by James Dow (Professor of London Business School) on its behalf, which commented on aspects of the cost of capital. This does not raise any substantive issues on Royal Mail’s original submission in three areas of gearing, equity beta and equity premium. Further, it supports the principle that operational leverage affects the asset and equity beta, thereby indicating the need for the regulator to take this into consideration and contradicting Postcomm’s statements that there is no operational leverage.

10.62 Royal Mail believes that Postcomm has significantly underestimated the WACC and believes its calculations should reflect a higher risk premium, less gearing than projected by Postcomm and a higher equity beta. These are discussed further below.

Gearing

10.63 Postcomm has used a gearing range of 20-40% in developing its preliminary WACC range (A4.28). It raises the issue of the pension deficit, pointing out that it will be treated as debt under FRS 17 and by debt-rating agencies, suggesting therefore a gearing ratio of 200% might be considered, reducing the WACC still further (A4.30)

10.64 As a matter of principle Royal Mail believes that the pension deficit should be fully funded as pass-through cash operating expenditure (see Section 13). This is consistent with regulatory precedent. In such a scenario, it does not contribute to the capital of the business or provide the capacity to fund it and so the pension deficit would not affect the gearing level and WACC estimate. The target gearing should then be set consistent with that for market operators like TPG and DPWN, which Royal Mail believes to be about 20%.

10.65 However, this would not be the appropriate level of gearing if pensions was not treated as a passthrough, which is the case in Postcomm’s proposals document. Postcomm’s document states that:

‘…pensions contributions by their nature are volatile and to an extent can be considered to beoutside of managemen con rol.’ (8.90)

and

‘Postcomm does not believe it would be appropria e for Royal Mail to be allowed to pass through pension defici costs or have an automatic re-opening mechanism for pension deficicosts’ (8.91).

10.66 Postcomm’s proposals do not address the risks for the volatility of pension costs that it acknowledges exist and, to a significant extent are outside of management control and


therefore do not ensure that the pension costs are included in the cash operating expenditure. This potentially constrains the ability of Royal Mail to finance its activities and limits its additional capacity to raise debt given its existing lending covenants with the effect of placing downward pressure on the gearing level. Further, a gearing of zero may not be sufficient to satisfy the financial ratios, in which case a further mark-up on the WACC may be required (see also Section 13).

10.67 Royal Mail concludes that the target gearing assumed for the WACC estimate should be 20%, as previously submitted, if pensions are passthough. In the event that pensions are not passthrough the gearing level would fall and, even at zero, may not be sufficient to satisfy the financial ratios; in such a case a further mark-up on the WACC may be required (see also Section 13).

Equity beta

10.68 In its January 2005 submission on the cost of capital, Royal Mail focused on the fact that the nature of its business meant that its profits, and hence the returns to its shareholder, were very sensitive to relatively small changes in volumes. This was due to the fixed nature of many of its costs, which needed to be covered regardless of revenues, and the fact that its proposed asset base, and hence profit allowance which could act to absorb a cost shock, was a relatively small percentage of the operating costs of the company. In other words, it was argued that Royal Mail’s equity beta needed to reflect the operational leverage of the company24.

10.69 In response, Postcomm’s June 2005 document states, regarding the equity beta, that:

‘Postcomm believes tha Royal Mail has not made an effective case for its beta to be higher than other regulated industries. Royal Mail argues that is more sensitive to fluctua ions in volumes than other utilities because i has a relatively high opera ing leverage (i.e. ration offixed costs to revenues). Postcomm is no certain, on the evidence presented to da e, tha Royal Mail does have a significant high operating leverage. Even if it does, and this leverage does make Royal Mail more sensitive to fluctuations in volume, Postcomm is not convinced that his risk is systematic’ (A4.42).

t t

t t t t t

t

10.70 Royal Mail believes that its equity beta is about 1.3. Royal Mail believes that references to the levels of equity betas that other UK regulators have used, without taking account of such factors as gearing and operational gearing, are inappropriate. Further finance theory supports the user of a higher beta due to the higher operational leverage of the business, and this use is confirmed by Ofcom and in many common finance text books. Royal Mail develops this in further detail below, including the issues of the economic theory and regulatory precedence for its application of operational leverage and its treatment of this as a systematic risk in determining the asset beta (and, with gearing, the equity beta).

10.71 First, as well as the reference to the Office of Rail Regulation (ORR) decision in Royal Mail’s original submission, the ORR had a further opportunity to consider these arguments in the more recent interim review of Network Rail’s access charges. It made the following statements:


24 See also the annex to ‘Volume Risk I: Forecast errors – for the UK inland mails business of Consignia, June 2003’.

‘The main reason for the difference in the return allowed by the Regulator in October 2000and the returns set by regulators in other industries was the fact tha a given change in Railtrack’s costs and revenues has historically had a much larger impact on profits than in other regula ed industries … One way of measuring this sensitivity is to compare the amount of money tha a company spends annually on operating, maintaining and renewing the network with the value of that company’s RAB. Railtrack’s annual expenditure amounted to approxima ely 50% of the value of the RAB, while in Network Rail’s case the figure is between 20% and 30%. While the level of operational gearing may have diminished, and continues to diminish further, Network Rail’s profits will still remain more sensitive to changes to costs and revenues than is the case for other regulated companies, where the equivalent ratio is typically between 15% and 20% … the Regula o takes the view that Network Rail’s exposure to cost risk has changed little since the October 2000 access charges review.’ 25

t

tt

t

t r

tt t t t

–t

t t t

t

10.72 The equivalent to the 50% for Railtrack, 20–30% for Network Rail and 15–20% for ‘other regulated companies’ referred to in the above quotation is approximately 120% on the basis of Royal Mail’s submission and as high as 220% using Postcomm’s proposed values (in the first year of the next control period).

10.73 Corroborating this approach entirely, although using a slightly different metric, is the decision made by the Civil Aviation Authority (CAA) in its recent determination on National Air Traffic Services (NATS):

‘the CAA considers that users have paid insufficient attention to NERL’s high opera ional gearing and the fact tha he business’s capital bases and profi s remain small relative o annual turnover. By way of comparison, the return on the RCV represents only around 1015% of NERL’s revenues, as against 30-40% for a typical water or electrici y distribution business. This means tha the actual re urns tha the shareholders receive are more sensitive than most transport and utility companies to unexpected cost shocks, including those driven by systemic risks such as wage infla ion. In these circumstances, NERL’s beta is likely to be higher than that of comparator companies in the transport and utility sectors’ 26

10.74 Again, the comparisons with Royal Mail are marked. Using exactly the same metric as considered by the CAA, the return on the regulatory capital value (RCV) (otherwise

referred to as the regulatory asset base (RAB))27 as a percentage of total revenues, Royal Mail’s ratio in the first year of the next price control would be as low as 3.1%, based on Postcomm’s June 2005 proposals.

10.75 Finally, Ofcom has also considered the issue of the determinants of the equity beta in a recent consultation paper. This paper is particularly important in the context of Postcomm’s critique, as Ofcom is keen to stress that it is only systematic risk that should be rewarded in the cost of equity calculation. In this context, it is interesting to note that Ofcom states, with reference to a well established textbook on corporate finance

theory,28 that:

25 ORR (2003), ‘Access Charges Review 2003: Final Conclusions’. 26 CAA (2005) NATS Price Control Review 2006–2010 CAA’s Firm Proposals, May 27 £2.2 billion multiplied by an 8% pre-tax real cost of capital gives £178m as the return on the RAB.


28 Brealey and Myers (2000) Principles of Corporate Finance, Sixth Edition.

‘The magnitude of an equity beta is de ermined by the extent to which… additional units o output have an impact on the firm’s prof ts—this w l tend to be higher isthe proportion of the firm’s costs that are fixed’.29

tf i il

10.76 This was precisely the issue that was considered by the second metric in Royal Mail’s original submission, where it was demonstrated that, as a proportion of revenues, Royal Mail’s fixed costs were between one and a half and three times greater than that of a range of UK regulated company comparators.

10.77 Furthermore, the Ofcom document referred to above is also interesting in that along with operating leverage, it suggested, again citing Brealey and Myers, that the other principal driver of the equity beta of a company is the extent to which ‘demand for the relevant product(s) is correlated with market returns, ie aggregate demand.’ Furthermore, in terms of measuring this exposure when direct evidence on betas is not available (as is the case with Royal Mail), the paper suggested that the income elasticity of demand for the product or service is likely to be a very useful indication, with the higher the income elasticity of demand, the higher the appropriate equity beta value will be. Indeed, evidence on this parameter forms an important plank of its evidence when it suggests that the equity beta measure for some of BT’s products should be lowered.

10.78 A similar approach can also be used to assess the riskiness of provision of postal services by Royal Mail, relative to the risk of supplying those products and services provided by other UK regulated companies. This can provide further evidence, in addition to the arguments on operational leverage, as to whether Postcomm is correct to assess its equity beta as similar to that of other UK regulated companies. A summary of such evidence includes:

Nankervis, Carslake and Rodriguez estimated in 1999 that the long-run income

elasticity of demand for total UK inland letters is exactly 1.30

Unitary elasticities for total UK traffic in relation to economic activity were also found by Nankervis et al in an updated piece of research in 2002, with estimates between 1.35 and 1.43 for first-class mail and 0.75 and 0.95 for pre-sort.31

Florens, Marcy and Toledano estimated that in France, the income elasticity for total traffic is 0.75, rising to 1.12 for letters and 3.72 for non-urgent mail.32

10.79 In comparison with this, the income elasticities of demand for products supplied by most UK regulated companies are significantly lower. For instance, in a meta study examining

143 different papers on the elasticities of residential demand for water, Dalhuisen et al33

29 Ofcom (2005), ‘Ofcom’s Approach to Risk in the Assessment of the Cost of Capital’, January. 30 Nankervis, J., Carslake, I. And Rodriguez, F. (1999), ‘How Important have Price and Quality of Service been to Mail

Volume Growth?’, in Crew, M. and Kleindorfer, P. eds, Emerging Competition in Postal and Delivery Services, Boston, MA. Kluwer Academic Publishers

31 Nankervis, J, Richard, S., Soteri, S. and Rodriguez, F. (2002), ‘Disaggregated Letter Traffic Demand in the UK’, in Crew, M. amd Kleindorfer, P. eds, Pricing, Productivity, Regulation and Strategy, Boston, MA. Kluwer Academic Publishers

32 Florens, J-P, Marcy, S. and Toledano (2002), ‘Mail Demand in the Long and Short Term’, in Crew and Kleindorfer, op. cit.


33 Dalhuisen, J., Florax, R. de Groot, H. and Nijkamp, P. (2001), ‘Price and Income Elasticities of Residential Water Demand’, Tinbergen Institute Discussion Paper.

found an average income elasticity of demand of 0.43, while Liu34 ascertained that the income elasticity of demand for electricity varies between 0.06 and 0.3 for domestic consumers and 0.3 and 1.04 for industrial consumers. Finally, in the context that Ofcom estimate BT’s equity beta to be 1.1, it is noteworthy that the broad consensus on the

income elasticity of demand for calls is in the region of 0.4–0.635, while demand for access was even lower at c. 0.1.

10.80 It can be seen that, according to this measure—and as would accord with intuition—the demand for Royal Mail’s products is much more likely to be exposed to fluctuations in the business cycle, than the products of other UK regulated companies with which Postcomm compares Royal Mail. Indeed, this would appear to be corroborated by Postcomm in its Initial Proposals document when it recognises that ‘mail volumes tend to correspond with the level of economic activity.’

10.81 In conclusion, Postcomm’s approach to examining the equity beta does not take account of economic theory and regulatory precedence. Postcomm’s document reference to other UK regulators within its document are inappropriate, as it does not take into account the very significant differences that exist between Royal Mail and these other companies that affect its exposure to systematic risk. In particular, Ofcom, citing the leading textbook on corporate finance, identifies two key factors that are likely to determine a company’s equity beta: its operational gearing and the sensitivity of the demand for the company’s products to changes in aggregate demand.

10.82 We have examined (or in the case of operational leverage, re-examined) both issues and concluded that there is significant evidence that on both of these measures, Royal Mail is an outlier relative to the bulk of UK regulated companies, and hence would require an equity beta substantially in excess of the 0.7 to 0.9, which Postcomm claims takes into account the decisions made by other UK regulators. Indeed, the previously identified an asset beta of at least 1.0 and equity beta of at least 1.3 would, taking into account the evidence above, continue to be appropriate.

Equity risk premium (ERP)

10.83 Regarding the equity risk premium, Postcomm’s June 2005 document states:

‘Postcomm at this stage considers that a reasonable range is 3.5-5.0% and has used these estima es to set the preliminary range for Royal Mail’s WACC’ (A4.35) t

10.84 Royal Mail believes that the ERP should be higher, at 4% to 5%. This is supported by further evidence from other regulators U.K., e.g. Ofwat, ORR, Ofgem, Ofcom and CAA as well as regulators in other markets e.g. Commission for Energy regulation, Commission (Ireland) for Aviation all of whom use a higher ERP. In addition, the table used by Postcomm is incorrect and Royal Mail submits corrections to it demonstrating a higher ERP. Further Royal Mail believes that Postcomm has not appropriately taken into account the risk on its estimate of ERP. This risk is asymmetric which is why regulators such as

34 Liu, G. (2004), ‘Estimating Energy Demand Elasticities for OECD Countries A Dynamic Panel Data Approach’, Discussion Paper No. 373, Statistics, Norway.


35 Taylor reports a study by Bell Canada which suggested income elasticities of demand for calls of between 0.47 and 0.64 (Taylor, L., 1993, Telecommunications Demand in Theory and Practice, Kluwer), while Larson, Lehaman and Weisman also reported in the same book give an elasticity for calls with respect to income of 0.5.

Ofcom tend to err on marginally higher risk premia where there is uncertainty in order to ensure fulfilment of their obligations to promote competition — Royal Mail believes that this regulatory precedent applies to Postcomm also. This is developed further below.

10.85 Postcomm’s stated range of 3.5–5.0% for the ERP seems to be too low given both recent regulatory evidence on the ranges adopted by other regulators, and also the trend that, within a particular range, regulators tend to choose a WACC value consistent with an ERP towards the top end of any identified range. In light of these factors, a range for the ERP of between 4% and 5% would be more reflective of the practice adopted by other regulators and hence more appropriate to apply to Royal Mail.

10.86 Postcomm presents a summary of regulator’s estimates of the ERP between 2000 and 2004. However, the lower end of the range adopted by Ofwat has been reported incorrectly and Postcomm may also have underestimated the ERP assumed by Ofgem, which suggests that Postcomm’s reported range for the ERP may be biased downwards. Table 10.4 presents an updated version of Postcomm’s summary of estimates of the ERPs adopted by other regulators.

Table 10.4 Regulatory precedent—revised estimates of the equity risk premium

Regulatory decision Equity risk premium estimate (%)

Ofwat (2004) 4.0 – 5.0

ORR (2000) 4.0

Ofgem (November 2004) Aggregate post-tax cost of equity of 7.5%, implying an ERP of 5.0% with Postcomm’s 2.5% decision on the risk free rate.

Ofcom (January 2005) 4.0 – 5.0

CAA (November 2004) 3.5 – 5.0 Sources: 1 Ofwat (2004), ‘Future Water and Sewerage Charges 2005–10: Final Determinations’, December.2 ORR (2000), ‘Railtrack Access Charges’. 3 Ofgem, (2004), ‘Electricity Distribution Price Control Review, 2005–10, Final Proposals’, November. 4 Ofcom (2005), op cit. 5 CAA (2005), op cit.

10.87 Postcomm is incorrect to state that Ofwat’s range for the ERP, as set out in its final determinations, was 3.5–5.0%. Instead, Ofwat actually used a range for the ERP of 4.0–5.0% in calculating the allowed return. It was Ofwat’s advisers who had suggested a range of 3.5–5.0%, and even within this range, it was recognised that ‘the very top end of this range …[was] … more appropriate.’ Postcomm also failed to take account of the fact that Ofgem’s decision on the cost of equity changed substantially between March 2004, where the range reported by Postcomm is correct, and the final decision reached in November. In this final decision document, Ofgem did not estimate a range for the cost of equity but instead provided a point estimate for the aggregate post-tax cost of equity of 7.5%. As a result of this approach, individual estimates of the ERP and the risk-free rate were not provided by Ofgem. However, to achieve this outcome, given a risk-free rate assumption of 2.5%, as used by both Postcomm and Royal Mail, the ERP estimate would need to be 5%.

10.88 Further evidence to support a higher range is provided by consideration of other regulators. Postcomm is correct to note that the ERP estimates assumed by the ORR in


2000 and Oftel (now Ofcom) in 2001 were 4.0% and 5.0% respectively. While, it is the case that Ofcom has recently consulted on revising its ERP estimate downwards from its previous policy of using 5.0%. However, even here, it is significant that the range on values for which it asked for responses is between 4.0% and 5.0% and has recently concluded 4.5%.

10.89 Postcomm could also take into account some recent overseas regulatory evidence. The Commission for Energy Regulation (CER) has its based WACC calculations on an ERP of 5.3% for electricity generation in 2004. The CER’s determinations in 2001 (for the Electricity Supply Board), 2003 (for BGE), and 2004 (‘best new entrant’ for electricity

generation) on the ERP were 5.4%, 5%, and 5.3%, respectively.36 Precedent by the Commission for Aviation Regulation for Aer Rianta in 2001 suggests that the ERP could

be as high as 6% 37. Given the available regulatory evidence, this implies that it would be more appropriate for Postcomm to uplift the lower end of the range for the ERP to 4.0%.

10.90 Furthermore, even within this revised range of 4.0–5.0%, there would be strong regulatory precedent (as noted by Postcomm), as well as public-interest benefits, in using a value towards the top end of this range. For instance, Ofcom has traditionally used estimates for the ERP towards the higher end of the possible range as it considers that downside risk associated with taking too low a value for the ERP (discouraging discretionary investment) is more detrimental to the public interest than taking too high a value (leading to higher prices to customers) and has recently applied 4.5%. This precedence has been followed by Ofwat, where in its final determination, a value towards the top end of the 4–5% range for the ERP was selected. Although point estimates for each of the individual parameters, consistent with the real post-tax WACC of 5.1%, were not provided, this choice of a point estimate for the overall WACC is consistent with an ERP towards the top end of the range (ie, close to 5.0%).

10.91 In conclusion, there is a strong body of evidence to suggest that a range for the equity risk premium of 4–5% is more appropriate than Postcomm’s current proposal of 3.5–5%. Furthermore, within the actual point estimate of the WACC that this would result in, the bulk of regulatory evidence suggests using a value consistent with the top end of this range. Unless Postcomm increases the lower end of the ERP, this is likely to undermine future investment incentives, which ultimately would have detrimental impacts upon the customer.

Conclusion

10.92 In summary, in its submissions to Postcomm, Royal Mail has estimated a range of 10-12% for its pre-tax weighted average cost of capital for its Letters business as illustrated in Table 10.5. The value of 10%, at the lower end of the spectrum, is used in its assessment of the P0 and X values in Sections 12 and 13.

36 CER (2004), 'Best New Entrant Price 2005, Decision and Response Paper', CER/04/320, p. 5; CER (2001), 'Distribution Price Review Proposals', July, CER 01/86, p. 89; and CER (2003), 'Commission's Decision on Transmission Use of System Revenue Requirement and Tariff Structure, 1 October 2003–30 September 2007', July, CER/03/172, p.6.


37 Kearney, C. and Hutson, E. (2001), 'Aer Rianta's Cost of Capital, Appendix VI to CP8', Dublin City University, August, p. 155.

Table 10.5 Royal Mail’s central estimate of the real pre-tax Weighted Average Cost of Capital Estimate for its Letters business

Low High Risk free rate 2.50 2.50 Debt premium 0.50 0.50 Cost of debt 3.00 3.00 Equity risk premium 4.50 5.00 Asset beta 1.00 1.20 Equity beta 1.25 1.50 Post tax cost of equity 8.13 10.00 Tax wedge 1.43 1.43 Pre-tax cost of equity 11.6 14.3 Gearing 0.2 0.2 WACC 9.9 12.0


11 QUALITY OF SERVICE

OVERVIEW

11.1 This section sets out Royal Mail’s response on the quality service of the next price control for Royal Mail. It makes several critical points:


Royal Mail is currently obliged to use all reasonable endeavours to meet the scheduled standards. To prove a breach of the licence if the standards are not met Postcomm must prove that Royal Mail has not used all reasonable endeavours. Postcomm proposes to reverse the burden of proof by obliging Royal Mail to use all reasonable endeavours to provide services to the highest possible level having regard to all the circumstances. If Royal Mail fails to meet the standards by more than a margin (determined by Postcomm), Postcomm will presume that Royal Mail has not used all reasonable endeavours unless it can prove otherwise;

Postcomm proposes to remove transit time standards from 1 April 2006 for Presstream and Special Delivery (account);

Postcomm proposes to remove the ‘tail of mail’ transit time targets and the intra postcode area targets;

Postcomm proposes to retain a standard for ‘the transit time of first class mail ultimately delivered in each post code area’;

Postcomm proposes to combine transit time standards for the remaining targeted products;

Postcomm proposes to retain the present target levels for the transit time standards;

Postcomm proposes that the EU standard for 85% of first class intra-European cross-border mail to be delivered with 3 days of posting be included as a new transit time standard in the Licence and C factor;

Postcomm proposes including new standards for ‘misdelivery’, USO collection and USO delivery in Licence and the ‘C-factor’ calculations from April 2006 onwards;

Postcomm proposes additional Licence reporting requirements for collection and delivery times;

Postcomm proposes to increase the level of financial exposure for failure of service targets to £280m (i.e. c.160% of RCVxWACC) with no exclusion for industrial action;

Postcomm proposes that it should determine loss and damage compensation levels and arrangements for all Royal Mail products.


Royal Mail believes Postcomm’s proposed changes to the current duty to use all reasonable endeavours fundamentally increase the risk to Royal Mail as it would reverse the burden of proof to one in which Royal Mail is guilty until proven innocent and in addition expose Royal Mail to undefined and


unspecified penalties during a price control period where it requires regulatory certainty. Instead Royal Mail proposes to replace the current pass/fail targets with ranges of performances and with the use of all reasonable endeavours retained on the current basis;

Royal Mail agrees in principle that, once a product is removed from the control, it should not be subject to service targets;

Royal Mail agrees with the removal of the tail of mail and intra postcode area targets;

Royal Mail does not object in principle to products being grouped to form weighted targets, but believes the weights must be based on volumes. Royal Mail has proposed revisions to some of the groupings;

Royal Mail believes that the present target levels for postcode floors and response services are unachievably high and should be lowered;

Royal Mail questions the need for an additional Licence target on outbound international mail as there is already a requirement to meet the EU Directive target and performance is consistently well above the target level. Royal Mail believes that the introduction of an additional Licence requirement in an open competitive market, for the sake of principle rather than to address any identified issues, is therefore disproportionate and it cannot accept such a target;

Royal Mail is prepared to accept a revised package of standards based on performance ranges, with industrial action included as part of force majeure. This package would include annual national targets for USO collection (deferred until 2007/08) and USO delivery, together with measurement and publication of annual national misdelivery figures, subject to agreement on the measurement method and appropriate target levels and funding of the measurement;

Royal Mail will not accept a target for misdelivery; Royal Mail believes Postcomm has not thought through the implications or

application of its proposals for reporting collection and delivery times and that it has drafted unacceptable proposals that are disproportionate, incompatible with its efficiency assumptions under the price control and impracticable to implement;

Royal Mail believes the level of exposure and absence of any upside for outperformance to be outwith regulatory precedent, and particularly so for a developing competitive market. It proposes an alternative approach more in keeping with precedence;

Royal Mail believes the proposed changes for loss and damage compensation are disproportionate and reduce the certainty that Royal Mail should have over its next price control period. Royal Mail can not agree to such Licence changes.

11.2 Royal Mail notes that it has commented in more detail on a number of issues in its response to Postcomm's 2006 Price and Service Quality Review Supplementary Paper 2 Issues Regarding Quality of Service, which includes a proposed draft Licence Condition 4 (LC4). The response should be read in conjunction with this Section.


PRINCIPLES

Coverage

11.3 Postcomm believes that products outside the price control should not be subject to quality regulation whilst products within the price control should be, to prevent Royal Mail from reducing costs through reductions in quality of service. However not all products need an individual target or the same type of financial incentive or enforcement.

11.4 Royal Mail believes that only USO products should be subject to formal Licence targetry and that other price controlled products can be regulated by other means, such as publication of results and appropriate compensation regimes. However Royal Mail is willing to consider the continuation of Licence targets for price controlled products provided that this is part of an appropriate quality regime. Such a regime is described later in this Section. Royal Mail notes that in order for Postcomm to apply its principle it will be necessary to align the product lists in LC4 with those in LC19. Royal Mail believes that this may impact upon measurement and compensation regimes.

Level of targets

11.5 Postcomm believes that without good evidence otherwise the new target levels should match the 2005/6 Licence targets, as these have been signed up to by Royal Mail, are valued by customers and should be funded under the price control.

11.6 Royal Mail believes that Postcomm has not taken a good opportunity to reconsider whether the 2005/6 target levels are actually appropriate, particularly in the context of a more competitive market. Royal Mail notes that the European Directive only requires a “postal service of good quality”38 and that other countries have responded to this by setting relatively low minimum levels of performance (e.g. 80% next day in Germany, 85% next day in Sweden). Royal Mail’s Licence targets for second and third class products in particular are set at a very high level, such that it would be possible for Royal Mail to fail its second class stamped and metered target and still have a world class performance for those services. However Royal Mail recognises some of the difficulties Postcomm faces in adjusting the targets, particularly in terms of public perception and the difficulties of quantifying appropriate cost changes. Royal Mail is therefore prepared to consider targets based on the 2005/06 levels for the majority of new targets provided, again, that this is part of an appropriate quality regime.

Financial Incentives

11.7 Postcomm believes that direct compensation schemes and C factor adjustments are the best forms of protection for users and that enforcement and fines should only be used as a last resort to deal with severe performance failings. Postcomm’s aim is that compensation, C factor and competition should provide a strong enough incentive to achieve targets.


38 Directive 97/67/EC Article 16

11.8 Royal Mail does not disagree with the sequence of financial incentives. Under Royal Mail’s existing licence it is strongly incentivised to achieve but not exceed its targets under the existing regime. In addition Royal Mail believes that if the regime is properly constructed it should remove the need for intensive scrutiny by Postcomm unless and until performance moves into the enforcement area. However Royal Mail believes that the regime proposed by Postcomm goes beyond what is required to incentivise it to perform well and fails to consider the potential effects fully.

11.9 In addition, Royal Mail believes that Postcomm’s proposals for the financial level of exposure for quality of service failure are at odds with regulatory precedent. Royal Mail believes that the financial exposure for failure of service targets should take account of the impact of reduced quality of service on its volumes and the level of expected cash flow before interest, tax and dividends (i.e. WACCx RCV). Further, Royal Mail also believes that Postcomm’s proposals for the financial level of exposure for quality of service underperformance to lead to an adverse financial impact and quality of service outperformance to lead to no financial reward is at odds with regulatory precedent. These principles are discussed further in Section 13 and Annex 15, with the detailed regime discussed in this Section and Annex 17.

DESIGN OF THE OVERALL FRAMEWORK

11.10 Postcomm’s document (9.21 to 9.28) proposes changes to the regulatory framework for quality. These changes are reflected in its draft LC4 proposals. Royal Mail is currently obliged to use all reasonable endeavours to meet the scheduled standards. To prove a breach of the licence if the standards are not met Postcomm must prove that Royal Mail has not used all reasonable endeavours. The proposed changes have the effect of "codifying" what constitutes reasonable endeavours and reverses the current burden of proof. The amended LC4 would require Royal Mail to use all reasonable endeavours to provide the scheduled services "to the highest level possible having regard to all the circumstances." If Royal Mail meets or exceeds39 the relevant service standard it is deemed to have used all reasonable endeavours and if it does not it is presumed not to have done so. Royal Mail would be able to supply evidence in rebuttal of the presumption that it was in breach but Postcomm would have no obligation to demonstrate that Royal Mail was in breach of LC4 in order to fine Royal Mail.

11.11 This regime is not acceptable to Royal Mail, particularly in the light of the lengthy and cumbersome processes it has been put through to get Postcomm’s agreement on areas such as force majeure allowances for the bulk compensation scheme. This is not the light touch regulatory regime Royal Mail expects to operate under in a competitive environment. It is further exacerbated by Postcomm’s proposals for automatic penalties of c.160% of allowed profit (as measured by the RCV x WACC) and full exposure on industrial action.

11.12 Royal Mail believes that the proposed modification is not proportionate in circumstances where attainment of the standards is not mechanistic but dependent on many conditions, some of which are within, and some outside, Royal Mail’s control. Royal


39 Royal Mail notes that paragraph 2.7 of the Supplementary paper states "in the event that actual performance exceeds the scheduled standard for a scheduled service, the Licensee is presumed to have met its obligation to use all reasonable endeavours as required". Royal Mail presumes this is an error.

Mail’s failure to meet a required standard is therefore a matter over which it is necessary for a regulator to exercise discretion. It is possible to imagine a circumstance where all the factors that cause Royal Mail to breach its licence are outside its reasonable control (for example a strike at air traffic control or a natural disaster) – but even so Royal Mail would be presumed to have breached its licence. Royal Mail would have to rebut this presumption. The use of ‘all reasonable endeavours’ (as previously drafted) allowed Postcomm to take into account any factors that may have affected the service, and for Royal Mail to challenge Postcomm if it felt that discretion had not been properly exercised.

11.13 Moreover Royal Mail notes that the draft LC4 does not set a margin below which fines may be considered but simply states “by more than such margin as Postcomm may direct". Royal Mail needs regulatory certainty during the price control on both the size of the margin and the period for which it is fixed incorporated explicitly into its draft Licence modification, so that they cannot be changed without its consent. The concept that Royal Mail would be exposed to the uncertainty of Postcomm’s unilateral Direction in such a key area of its Licence is unacceptable. Royal Mail can have no certainty that Postcomm would actually set the margin at the 5% proposed for the minimum standard - indeed there would be nothing to stop Postcomm setting a margin of 0% if it so chose, or changing it during the price control period.

11.14 Under Postcomm’s proposals, if Royal Mail’s performance fell to a level (unspecified) that is below the minimum standard proposed by Postcomm, Postcomm would consider Royal Mail to be guilty until proven innocent. If its performance fell below the minimum standard but not by as much as the unspecified level, there would be no provision in the draft Licence modification as to whether Royal Mail would be penalised over and above any C factor or compensation penalties – presumably this too would be at Postcomm’s discretion and subject to the unspecified “exceptional circumstances” referred to in paragraph 9.25. It is difficult to see how Postcomm expects this regime to provide Royal Mail with the “greater certainty over the likely financial consequences” it seeks to achieve in paragraph 9.21 of its document. It is also difficult to see why Postcomm expects that Royal Mail should accept such draft Licence modification changes in place of the existing system. Royal Mail does not accept such changes and believes the current system of reasonable endeavours should remain.

11.15 Royal Mail’s preferred system, one Postwatch supported during discussions but which Postcomm has effectively ignored in redrafting LC4, is for ranges of performances instead of simple pass-fail targets, to be built explicitly into its Licence. Royal Mail has proposed four bands of performance for each target, set out in Table 11.1. These could be linked, where appropriate, to a financial penalty/reward regime.


Table 11.1: Royal Mail’s proposals for four bands of quality of service performance

Band Reward/penalty (where appropriate)

Excellent Rewarded by additional revenue under the C factor

Good No penalty or reward incurred

Needs improving Revenue withheld under the C factor or bulk compensation paid

Unacceptable Fines considered in addition to any penalties (but still subject to reasonable endeavours on the current basis).

11.16 A similar system is currently used for quality regulation in the water industry40 and is used to set explicit performance levels below which investigation and enforcement action may be appropriate.

POSTCOMM PROPOSALS FOR TRANSIT TIME STANDARDS

11.17 Postcomm proposes to retain transit time (end to end) targets for products within the price control, grouping some of these into combined targets. It proposes to remove transit time targets for tail of mail and intra postcode area performance and to exchange the posted postcode area performance for delivered performance. It proposes to restrict Special Delivery targetry to items posted at Post Offices®.

11.18 Royal Mail agrees that it is appropriate for targets to remain on transit time measures. Transit time (the proportion of mail items delivered by a specified day after posting) is a major consideration for customers and robust independent measures are in place to capture this information. Article 16 of the European Directive also requires transit time measurement and reporting.

Combined targets

11.19 Postcomm has proposed (9.51) combined targets for groups of products: second class stamped and metered and standard parcels, first class bulk mail and second/third class bulk mail (Royal Mail notes that the stamped and metered first class “group” is already a Licence target measured by a single survey). Royal Mail does not object to the principle of combined targets. However there may be issues around the construction and use of these targets in a performance regime. Postcomm has advised Royal Mail that where the existing end-to-end targets have been combined the proposed target level has been based on the existing targets and the relative volumes of the products. For example, Postcomm considers the combined target of 98.5% for second class stamped and metered mail and standard parcels to be reasonable even though the existing standard parcel target is only 90%, because parcel volumes are very small in comparison to second class stamped and metered volumes. It follows therefore that combined


40 See for example Table 19 of “Levels of Service in England and Wales 2003-04” report, published by Ofwat

performance for a group of products must be based on the proportion of items meeting the service specification.

11.20 Royal Mail notes that bulk mail customers are already paid compensation in proportion to revenue and that Postcomm proposes to continue this and to use revenue to weight up the contribution of the transit time service standards used in the C factor. However Postcomm has also told Royal Mail and Postwatch that it is considering combining transit time performance for groups of products on the basis of revenue rather than volume. This equates to targeting Royal Mail on the basis of the proportion of revenue meeting the service specification for the product grouping. For the avoidance of all doubt Royal Mail considers that a transit time performance based on anything other than the proportion of mail items meeting the target level would be completely unacceptable. Any alternative definition would constitute a change to the way Royal Mail’s performance is measured, which would be intensely confusing for both customers and employees alike. Moreover it would actually be a breach of the CEN standards Royal Mail is required to adhere to, which explicitly require that “the overall transit time quality of service result is to be expressed as percentage of mail delivered within J+n days end to end according to the EC postal directive”41. Therefore any transit time performance for groups of products would need to be combined on the basis of mail volume. Otherwise combined targets are misleading and unhelpful and not to be preferred to separate targets.

11.21 Postcomm’s document proposes that any compensation due is calculated on the combined performance of all products in a group, and is paid to customers using those products in proportion to the revenue spent on those products. If product performances within the group are widely different then this could have the effect of paying compensation to customers of a product within the group that has performed well and conversely, of not paying compensation to customers of a product that has performed badly. However, this is an inevitable consequence of a combined target. Problems may also arise if there are disparities in performance within the group and the volume mix within the group changes. A number of the proposed groupings are vulnerable to this effect. For the Bulk 2 standard, Mailsort 3, has a very different service specification to the rest. For the second class stamped &metered/parcel combination parcels have a much lower target than stamped and metered mail. . Royal Mail therefore believes that a separate target should be retained for standard parcels and for Mailsort 3.

Target levels

11.22 Royal Mail’s performance has stabilised since the completion of its major operational changes in 2003/04 and the first quarter of 2004/05, and over the past twelve months has run at or close to target levels for most products. The first quarter of 2005/06 has seen some very good performances for most products.

11.23 As stated in paragraph 11.6, Royal Mail is prepared to consider annual42 targets based on the 2005/06 target levels for the majority of new targets. However Royal Mail believes the current target levels are set unachievably high for postcode floor targets and response services targets and should be reduced before considering new targets.

41 See for example Section 1 of BS EN 13850:2002.


42 Excluding the Christmas period as currently defined in Royal Mail’s Licence

11.24 Royal Mail has already explained to Postcomm and Postwatch that the First and Second Class Response Services product as currently specified with manual counting and billing of items is not capable of achieving the 2004/5 or 2005/6 levels set in its Licence. Royal Mail has developed and deployed a new Response Services Plus product in 2004/05 and customers are continuing to migrate to the new product, which Postcomm proposes to keep outside the price control (see Section 6). This leaves a higher proportion of items requiring manual billing and counting for the existing products. Royal Mail believes that targets of 85% J+1 for first class and 95% J+3 for second class would be more appropriate for Response Services.

11.25 Royal Mail is prepared to consider a set of standards including a delivered rather than a posted floor target for postcode area performance of first class stamped and metered mail, for all postcode areas included in the existing posted floor target. However in order for such a target to be acceptable, the floor target must be realigned so that it is statistically compatible with an acceptable national target for first class stamped and metered mail. Currently the floor target is set too high in relation to the national target, so that it is unachievable without a higher level of national performance; this is not achievable with the current operation and is not funded under the price control. Postcomm’s document (9.43) states that it could be argued that it is not necessary for the two targets to be aligned as the postcode area target is intended to ensure that specific areas of the country do not receive a very poor performance. However, statistical theory is clear that if the floor target is set too high in relation to the national target then it will not be able to identify accurately only those postcode areas where real performance is a lot lower than national performance. Instead it will also capture postcode areas where real performance is on or close to the national average but which are subject to measurement error because the survey can never be totally accurate (and any increases in the accuracy of postcode level results would be extremely expensive). At best a considerable amount of time and effort may be spent investigating postcode areas whose underlying real performance is quite acceptable; at worst Royal Mail may be penalised or fined on the wrong basis. New target levels are proposed in paragraph 11.66 and these are statistically aligned with the national target levels for first class stamped and metered mail.43

Restricted and removed targets

11.26 Royal Mail agrees with the principle that the Special Delivery Next Day target should only apply to those Special Delivery items within the price control, which Postcomm proposes should be those posted at a Post Office® rather than on account. However it is unlikely to be possible to distinguish between these items in compiling the Special Delivery performance results, therefore the reported results will continue to be based on all items. Additional delay compensation under the retail scheme could probably be restricted to items posted over the counter.

11.27 Royal Mail agrees that it is appropriate to remove the transit time tail targets and intra postcode area transit time floor targets to concentrate on performance against specification and delivered postcode area performance, which are of greater importance


43 Clearly if Postcomm accepts these new levels and the principles on which they have been derived Royal Mail would not expect to be subject to enforcement on 2005/6 posted performance for postcode areas with performance above the equivalent levels for posted performance.

to customers. Royal Mail also agrees that with Presstream products removed from the price control they should no longer be subject to quality regulation.

POSTCOMM PROPOSALS FOR NEW STANDARDS

International mail

11.28 In line with its principle that all price-controlled products and services should be included in the quality of service regime, Postcomm has proposed that Royal Mail should have a target for outward international mail based on the EU standard of 85% J+3 end to end performance for mail within the European community. Postcomm has told Royal Mail that it would use overall UK outbound performance as measured by the UNEX survey run by IPC (International Postal Corporation) to assess Royal Mail's performance against this target.

11.29 All EU universal service providers are targeted under the EU Directive to achieve 85% J+3 for priority cross-border mail. This requirement is reflected in Royal Mail's existing Licence. However its inclusion as a specific Licence service standard would make it subject to enforcement action, fines and penalties if performance were to fall below this level. As measured by UNEX, UK outbound mail performance is currently at 90.8% J+3 cumulative for the calendar year 2005 to date. This level of performance is not untypical.

11.30 Royal Mail notes that Postcomm proposes to apply this performance standard in relation to all revenue from outward mail flows including airmail outside the EC and surface mail. In other words Royal Mail could be penalised on products whose performance is not actually being measured.

11.31 Royal Mail agrees that if an international target were necessary then the 85% J+3 target set by the EU Directive would be the obvious candidate. It is already a target and it is independently and reliably measured, although performance is reported for the calendar year rather than the twelve months ending 31 March. However Royal Mail's main concern about this target in the context of its use within a penalty regime is that its achievement is not fully within Royal Mail's control. If as Postcomm proposes there are to be no exemptions for industrial action or other force majeure events then Royal Mail could face penalties or fines on the basis of industrial action, bad weather or emergencies in another country. Royal Mail is aware that some elements of force majeure may be removed from the UNEX results, including third party industrial action, but only upon application from the affected operator in line with rigorous procedures and rules. Moreover the impact of the accession countries on intra-community performance levels is as yet an unknown quantity. Postcomm has told Royal Mail that the relatively low level of the target (which is actually higher than the domestic target for next day delivery in some countries) should provide sufficient cushion for such eventualities and that it would also take them into account in assessing any fines (but not penalties) that Royal Mail might become liable to pay. Royal Mail considers this to be unacceptable.

11.32 Royal Mail questions the need for an additional Licence target on outbound international mail. There is already a requirement to meet the EU Directive target and performance is consistently well above the target level. Other postal and transport operators also


influence performance. International mail is a highly contested market with a large number of competitors. Consumers can already choose between different suppliers based on service and price. Royal Mail believes that the introduction of an additional Licence requirement in an open competitive market, for the sake of principle rather than to address any identified issues, is therefore disproportionate and unnecessary. Royal Mail cannot accept a Licence target for international outbound mail.

Delivery USO

11.33 Postcomm proposes to include a standard for the percentage of delivery routes completed each day in the Licence and C factor calculations. As a universal service provider Royal Mail is already required to make a daily delivery to all addresses each working day, apart from a tiny fraction of very inaccessible or unsafe locations. However its inclusion as a specific Licence service standard would make it subject to enforcement action, fines and penalties if performance were to fall below the level set.

11.34 Royal Mail has already offered Postwatch a target on annual national performance for the proportion of delivery routes completed, subject to agreement on the measurement method and appropriate levels. Royal Mail is prepared to renew this offer, again subject to agreement on the measurement method and appropriate levels, but only as part of a revised set of standards with the banding system described in 11.15 and with force majeure (including industrial action) excluded from reported performance.

11.35 Royal Mail has had in place for a number of years a system for managerial recording failures to complete delivery routes, which is used on an exception reporting basis for discussion of persistent problems with Postcomm and Postwatch. Failures are rare and are usually due to staff sickness, operational difficulties, industrial action or other force majeure events, such as severe weather. An independent report on measurement methods shared with Postcomm and Postwatch44 has recommended that any formal regulatory reporting should continue to be based on this system, although it also concludes that there is no practical way of independently checking the results of the system. Any future service standard would only be accepted by Royal Mail on the basis of such self-measurement methods, as there is currently no practicable alternative. This would require an amendment to Postcomm's draft Licence modification in respect of this standard, as the measurement cannot be independent or audited.

11.36 Postcomm’s document (9.58) states that it is considering a level of performance of at least 99.0%, but that it would expect Royal Mail to achieve a performance much closer to 100% because it is obliged to make daily deliveries to all but a handful of excepted addresses that are unsafe or very difficult to access. However this figure can be considerably lowered in the case of extensive industrial action or other force majeure event, such as severe weather or an emergency. For each day of a national strike or widespread severe weather, Royal Mail’s annual national performance would fall by 0.3%, as in these circumstances contingency arrangements to make delivery would not be possible. Failures due to industrial action and other force majeure events are separately identified in the exception reports to Postcomm. Royal Mail can only accept targets that do not expose it to large automatic penalties and fines in the event of major industrial action and other force majeure events. The levels proposed in paragraph


44 “Evaluation of 'Other' Postal Quality Measures - Delivery USO”, Kantar November 2004

11.66 below are derived from the self-reporting system are put forward on the basis that the effects of force majeure, including major industrial action, are excluded from the reported figures.

11.37 Targets for delivery USO other than for annual national performance are not acceptable to Royal Mail, as this simply increases the number of targets towards previous levels. It has already agreed in principle to a postcode area transit time target for delivered mail and this will also reflect widespread delivery failures at postcode area level. Moreover if Royal Mail is to accept automatic penalties for failure to meet a delivery USO target it is not then acceptable for Royal Mail to also be required to continue detailed reporting with intervention from Postcomm and Postwatch whilst performance remains above the levels at which enforcement would be considered.

Collection USO

11.38 Postcomm proposes to include a standard for the percentage of collection points served each day in the Licence and C factor calculations. As a universal service provider Royal Mail is already required to make a daily collection from all access points each working day, apart from a tiny fraction of very inaccessible or unsafe locations. However its inclusion as a specific Licence service standard would make it subject to enforcement action, fines and penalties if performance were to fall below the level set.

11.39 Royal Mail has already offered Postwatch a target on annual national performance on the proportion for post boxes and Post Offices® receiving a daily collection, subject to agreement on the measurement method and appropriate levels. Royal Mail is prepared to renew this offer, again subject to agreement on the measurement method and appropriate levels, but only as part of a revised set of standards with the banding system described in 11.15 and with force majeure (including industrial action) excluded from reported performance.

11.40 Royal Mail has recently rolled out Access Bar Coding (ABC) to the majority of its collection points and intends to put in place a system for collating national results to replace the self-recording system which is currently used for discussion of persistent problems with Postcomm and Postwatch. Under ABC the postman must scan a barcode on the inside of each collection point; details of the collection are then automatically captured by the scanner. LECG has included this project as one of the initiatives to be funded by the price control45. An independent report on measurement methods shared with Postcomm and Postwatch46 has concluded that it would not be practical to carry out physical checks on boxes in respect of daily collection but that ABC data might be used to assess the proportion of collection points receiving a daily collection. This would be Royal Mail's preferred method of measuring performance against a target of this nature. Again this would require an amendment to Royal Mail's Licence in respect of this standard, as the measurement cannot be totally independent or audited.

11.41 Postcomm’s document (9.58) states that it is considering a level of performance of at least 99.0%, but that it would expect Royal Mail to achieve a performance much closer to 100% because it is obliged to make daily collections from all access points provided as

45 Future Efficient Costs of Royal Mail’s Regulated Mail Activities LECG August 2005 para 12.45.


46 “Evaluation of 'Other' Postal Quality Measures – Postbox Collections”, Kantar November 2004

part of the universal service. However, as for delivery, this figure can be considerably lowered in the case of extensive industrial action or other force majeure event, such as severe weather or an emergency. Again, for each day of a national strike or widespread severe weather, Royal Mail’s annual national performance will fall by 0.3%. Royal Mail can only accept targets that do not expose it to large automatic penalties and fines in the event of major industrial action and other force majeure events. Royal Mail will only agree levels on the basis that the effects of force majeure, including major industrial action, are excluded from the reported figures.

11.42 Analysis of information from Royal Mail’s transit time measurement suggests that the extent of collection failures from boxes and Post Offices® (USO failure or early collection) does not exceed 1.5%. However this estimate also includes other causes of transit time delay and therefore cannot be used as a measure of USO collection performance failure, which is likely to be much lower than this level. Royal Mail does not currently have a national measure of daily collection performance from the ABC system and it is not therefore in a position to discuss appropriate target levels until robust results from this system are in place. This is unlikely to be the case until 2006/07. Postcomm is required to ensure that Royal Mail has sufficient funding via its price control to achieve its targets, which cannot be assured without knowing the current levels of performance as measured using the proposed method. Therefore whilst Royal Mail is prepared, on the basis set out above, to accept an annual national target for the proportion of post boxes and Post Offices® receiving a daily collection it will not be in a position to accept target levels in time for this target to be introduced for 2006/07. The introduction of a target would need to be deferred until 2007/08.

11.43 As for delivery, targets for collection USO other than for annual national performance are not acceptable to Royal Mail. Similarly, detailed reporting to Postcomm and Postwatch should not continue if automatic penalties are accepted.

Misdelivery

11.44 In view of the importance that users attach to misdelivery, Postcomm proposes including a standard for this in the Licence and “C” factor calculations from April 2006 onwards. Misdelivery is also important as it is believed to be the major contributor to lost mail. A letter is misdelivered if the address on the letter is not the address to which it has been delivered, and in addition the addressee does not live at the address to which it has been delivered.

11.45 Royal Mail has previously offered to measure and publish annual national performance on misdelivery within the new framework of quality of service incentives. Royal Mail is prepared to renew this offer, subject to agreement on the measurement method and funding of the ongoing measurement costs in the price control, but only as part of a revised set of standards with the banding system described in 11.15 and with force majeure (including industrial action) excluded from reported performance. Royal Mail is not prepared to accept a target on misdelivery under the next price control, as there is currently no track record of performance monitoring and control to support consistent delivery of a given level of performance.

11.46 For the last four years Royal Mail has commissioned a panel survey to measure the proportion of misdelivered mail it is required to provide under LC8. This panel survey method is also used by other postal administrations to measure misdelivery. The survey


is run for a two-week period by an independent agency and its results are auditable, although not currently audited. The survey specification has been shared with Postcomm and Postwatch. Results from the survey suggest that 0.5% of mail is misdelivered but this is subject to quite wide confidence intervals of +0.21%, i.e. the underlying misdelivery rate is between 0.29% and 0.71% and there is a 1 in 20 chance that the underlying rate is outside this range. A more extensive and costly panellist diary survey would be needed to get a more accurate result (of the order of £0.5m pa to get an accuracy down to +0.08%). Royal Mail’s intention, subject to contracting a suitable supplier, is to run a more extensive survey from Autumn 2005 to March 2006 in order to provide additional information about misdelivery levels.

POSTCOMM PROPOSALS FOR MEASUREMENT AND REPORTING WITHOUT STANDARDS

Transit times for products within a group

11.47 Postcomm proposes in paragraph 9.52 that Royal Mail should be required to continue publishing separate performance information on all products within the combined targets. Royal Mail notes that Postcomm has not included this requirement in its draft Condition 4 proposals, and presumes this is an error.

11.48 Whilst separate surveys remain in place Royal Mail has no objection to continuing to measure and publish annual national performances for the existing Licence product groupings (Standard Parcels, Mailsort 1, 2 and 3, PPI 1 and 2 and Response Services 1 and 2), although not for any more detailed breakdown. There are no immediate plans to amalgamate any of the current surveys. However Royal Mail would object strongly to Postcomm publicly criticising or attempting to take action against it for a lower performance on one product in a group if the group as a whole is performing well, as this would be tantamount to retaining the existing targets and associated obligations.

Collection times

11.49 Postcomm proposes in paragraph S60 that Royal Mail is required to monitor and publish its performance for collection times, although this is not discussed in Chapter 9 of Postcomm’s document. It has further included a requirement in its draft LC4 proposals for Royal Mail to “record and publish on a quarterly basis the percentage of collections made each working day from all post office letter boxes at or after the advertised time of collection”47. Royal Mail presumes Postcomm means to refer to collections from post offices and letter boxes. It is also not clear whether Postcomm means Royal Mail to report against all collection times or only final collection times.

11.50 Royal Mail has previously offered to Postwatch to consider either an annual national target of its universal service obligation to collect daily from each post box and Post Office® or an annual national report of the proportion of collections made at or after the final collection time from such access points. In either case the feasibility of robust measurement and reporting using Royal Mail’s Access Bar Coding technology (as described above) would need to be confirmed and trialled. Royal Mail considers that a target relating to annual national USO collection performance would be a more appropriate focus and would be easier to measure reliably as it requires only


47 2006 Royal Mail Price and Service Quality Review Supplementary Paper 2 Appendix 1 paragraph 3

confirmation that a daily collection has taken place, rather than a precise indication of the collection time.

11.51 Royal Mail does not believe it is necessary for Royal Mail to be required to provide information on collection times under LC4 of its Licence in order for Postcomm to perform its regulatory function. Postcomm has general information gathering powers that could be used to require Royal Mail to provide information about early collections if a problem were to be demonstrated. It would be more appropriate to use these means, rather than insert a new clause in LC4. Furthermore, the proposed clause would be anomalous relative to the other standards in LC4, given that there is (currently) no sanction for breach of these standards. Postcomm’s proposals are not, therefore, the most appropriate way of obtaining such information. The draft paragraph also gives Postcomm the power to direct how the recording and reporting shall be done. This is not acceptable and is a further example of over-regulation.

11.52 Royal Mail also questions whether the proposals are proportionate. Postcomm has not identified either in the supplementary paper or the price control consultation document why it (as opposed to Postwatch) thinks there is a need to monitor collection time performance in this way. It is not in Royal Mail’s interests to collect earlier than the final advertised collection time, as this will cause transit time failures with the risk of penalties. If the problem is widespread then it should show up in Royal Mail’s analysis of its transit time performance and be dealt with as part of this. If it is not a widespread problem then it is of debatable general importance. In either case Royal Mail believes a Licence requirement to measure and report this information, in addition to a range of transit time targets and a target for USO collection completion, is excessive.

11.53 In its consideration of collection and delivery times Royal Mail is aware that Postcomm may be concerned about potential issues such as the impact of early collection times and late delivery times in rural areas. However it is not a requirement of Royal Mail’s USO for customers to be able to post a reply at their nearest post box the same day as they receive an item, neither can there be such a requirement on Royal Mail, particularly under the price control regime and market conditions proposed by Postcomm. Late deliveries and early collections are common in other countries, including countries favourably considered by Postcomm’s consultants, LECG, in benchmarking Royal Mail’s efficiency. Royal Mail’s current view is that it is preferable to retain a little-used post box with an earlier final collection time rather than to remove it altogether. Royal Mail would therefore not accept any future extension of its Licence obligations outside the USO to require final collections to be at a given time.

Delivery times

11.54 Postcomm’s document (9.36-9.37) correctly recognises that delivery by a given time is not a requirement of Royal Mail's USO, and that to oblige it to deliver by certain times will affect its cost structure. Postcomm nevertheless proposes that Royal Mail should be required to measure and report its performance against its stated delivery times, citing in support of this the value that some customers place on early delivery times. The manner in which the draft Condition 4 requires this measurement and reporting to be done is particularly onerous and impracticable. Finally Postcomm states that if Royal Mail misses its stated delivery times or changes them then it will consider a Licence modification to address this.


11.55 Paragraph 3 of the draft LC448 proposes a new obligation on the Licensee to measure and publish data illustrating the percentage of deliveries that occur by their stated delivery time. It requires Royal Mail both to set delivery times for all UK addresses; and notify Postcomm of changes on a monthly basis. Postcomm will direct the form of the monitoring and publication. This information is intended to allow Postcomm, Postwatch and other interested parties to monitor whether Royal Mail is meeting its public commitment for delivery and collection times.

11.56 Royal Mail does not believe it is necessary for Royal Mail to be required to provide information on delivery times under LC4 in order for Postcomm to perform its regulatory function. Postcomm has general information gathering powers that could be used to require Royal Mail to provide information about delivery times if a problem were to be demonstrated. It would be more appropriate to use these means, rather than insert a new clause in condition 4. Furthermore, the proposed clause would be anomalous relative to the other standards in condition 4, given that there is (currently) no sanction for breach of these standards. Postcomm’s proposals are not, therefore, the most appropriate way of obtaining such information. The draft paragraph also gives Postcomm the power to direct how the recording and reporting shall be done. This is not acceptable and is a further example of over-regulation.

11.57 Royal Mail also questions whether the proposals are a proportionate response to the problems Postcomm perceives with variable or late delivery times for some customers.

11.58 Royal Mail believes that Postcomm is unreasonable to expect delivery times to any given address to remain static on a daily basis. There will be natural and possibly quite substantial variation in daily delivery times due to factors beyond Royal Mail’s control, such as changes in the volume and mix of mail and local weather conditions.

11.59 Royal Mail considers that Postcomm's position on this issue is inconsistent with its stated beliefs about the universal service and its own efficiency analysis. Postcomm expects Royal Mail to optimise its delivery routes, which cannot be done effectively without changing individual delivery times. Postcomm compares Royal Mail unfavourably in terms of efficiency and quality with operators such as TPG and DPWN, who have much later delivery times than Royal Mail. These operators found that later delivery times were fundamental requirements for the successful introduction of initiatives such as sequence sorting and streamlining of mail centre operations (see for example paragraphs A14.5 and A14.23 of LECG's report49). Delivery times determine the cost structure not only for delivery but also for the mail centre and transport network upstream. Yet Postcomm expects Royal Mail to achieve high levels of efficiency and quality at much lower and more closely controlled prices with a much tighter delivery specification. The implication that Postcomm will at some time in the future extend Royal Mail's obligations outside the USO by seeking to restrict and control Royal Mail's delivery times is commercially unacceptable to Royal Mail.

11.60 In conclusion, Royal Mail believes Postcomm has not thought through the implications or application of its proposals. As a result it has drafted unacceptable proposals that are disproportionate, incompatible with its efficiency assumptions under the price control and impracticable to implement.

48 2006 Royal Mail Price and Service Quality Review Supplementary Paper 2 Appendix1 paragraph 3


49 Future Efficient Costs of Royal Mail’s Regulated Mail Activities LECG 2 August 2005

POTENTIAL STANDARDS REJECTED BY POSTCOMM

Redirections

11.61 Postcomm proposes not to introduce a regulatory standard for redirections, as it is not clear what additional benefits a standard would provide, since customers are offered voluntary compensation and Royal Mail already has incentives to maintain and improve the quality of its service. Postcomm would reconsider this position if there was a material change in the way in which the compensation scheme was operated (9.45).

11.62 Royal Mail agrees with Postcomm’s position. Performance is already scrutinised under Royal Mail’s Licence and individual compensation is available for valid complaints. Therefore there is no justification for an additional Licence target, which would also be very expensive to measure properly. Royal Mail would not accept such a target.

Post Office Queuing times

11.63 Postcomm proposes not to reintroduce a target for Post Office® queuing times as it considers that the reasons for dropping the target remain valid (9.44).

11.64 Royal Mail agrees with Postcomm’s position. In addition, a Licence target for queuing for postal products only is neither measurable nor meaningful nor appropriate in the context of the type of business undertaken at Post Offices®, and a target for queuing in general in Post Offices® is outside the remit of Postcomm and Postwatch.

ROYAL MAIL PROPOSED TARGETS

11.65 Royal Mail proposes that the present service standards regime be replaced by the set of banded standards shown in the table below, together with annual national measurement and publication of misdelivery performance. These standards are offered as a package to replace the existing standards.

11.66 All standards are annual excluding the Christmas period as currently defined and all except the PCA floor standard are national. All end to end standards are measured as percentage of items meeting this service specification – i.e. all combinations are on the basis of volume. USO delivery is defined as the percentage of delivery rounds fully completed during the year and USO collection is defined as the percentage of daily collections made from boxes and Post Offices® during the year on days when a collection was due (all daily collections made as a proportion of all daily collections due). All levels for all standards are offered on the basis that the reported results exclude major force majeure events (which includes industrial action). The Bulk 1 standard assumes an underlying performance of 85% J+1 for RS1 and the Bulk 2 standard assumes an underlying performance of 95% J+3 for RS2. Finally, the levels assume that there are no legislative changes, for example airport restrictions, that impact on Royal Mail’s ability to meet the standards.


Standards Standard Excellent

at or above Good

between

Needs improvement at or below

Unacceptablebelow

1C Stamped & Metered 93.0 J+1 94.0

1% above std92.0-94.0 92.0

1% below std 88.0

5% below std

2C Stamped & Metered 98.5 J+3 99.5

1% above std97.5-99.5 97.5

1% below std 93.5

5% below std

Standard Parcel 90.0 J+3 91.0

1% above std89.0-91.0 89.0

1% below std 85.0

5% below std

Special Delivery non-account

99.0 by guaranteed

time 100.0

1% above std

98.0-100.0 98.0

1% below std 94.0

5% below std

PCA floor target (1C S&M delivered) to be met by all PCAs except HS, KW, ZE 90 J+1

91 aligned national

89-91 89

aligned national 86

aligned national

USO delivery rounds completed 99.5

100.0 0.5% above std

99.0-100.0 99.0 0.5% below std

97.0 2.5% below std

USO collection To be agreed during 2006/7 for introduction in 2007/08

Bulk 1 (MS1, PPI1, RS1) 90.5 J+1 91.5

1% above std89.5-91.5 89.5

1% below std 85.5

5% below std

Bulk 2 (MS2, PPI2, RS2) 97.5 J+3 98.5

1% above std96.5-98.5 96.5

1% below std 92.5

5% below std

Mailsort 3 97.5 J+7 98.5

1% above std96.5-98.5 96.5

1% below std 92.5

5% below std

FINANCIAL PENALTIES

11.67 In addition to the changes to fines and reasonable endeavours Postcomm proposes in paragraphs 9.61 and 9.62 that Royal Mail should continue to pay up to 5% of revenue to bulk mail customers under the bulk mail compensation scheme and that the C factor penalty should be increased to cover 5% of revenues for social products.

11.68 Although some form of positive incentive was supported by Postwatch and by the findings of the MORI survey, Postcomm proposes in paragraph 9.65 that Royal Mail should not receive any reward for exceeding the target levels as this might encourage Royal Mail to “gold plate its services beyond the requirements of its customers”.

11.69 Postcomm also proposes that Royal Mail should continue to have to argue for mitigation in payments because of force majeure events, such as severe weather, and that it does not consider that any form of industrial action by Royal Mail or its agents should be taken into consideration. This is discussed further in Section 13.

11.70 Finally Postcomm proposes changes to Royal Mail’s Licence to reverse the burden of proof on reasonable endeavours, which potentially can apply to any performance falling


below the target level, and to give Postcomm control of loss and damage compensation for all Mail products.

11.71 Taken as a package, all these changes combine to expose Royal Mail to some £280m, not including downstream access compensation (at up to 5% of revenues), retail compensation payments (which are unlimited) or fines (which may be up to 10% of turnover). Royal Mail’s maximum automatic penalty for quality failures represents c. 160% or than one and a half years of its core allowed profit under the proposed regime. This is at odds with regulatory precedent, where the mid-range is 15% of core allowed profit as shown in Table 11.2 (alongside the degree of risk from competition). This is discussed further in Section 13 and Annex 15.

Table 11.2: Penalties as a percentage of allowed profit for regulated businesses

Sector Penalties as % allowed profit

Risk from competition

Electricity distribution (2005-10) 14 Low

Gas distribution (2002-07) 0 Low

BAA London airports (2003-08) 3 Low

Water (2005-10) 3 Low

NATS (2000-05) 15 Low

NATS (2006-10) 42 Low

BT 0 High

Postcomm proposals for Royal Mail 160 High

Source: Oxera (Annex 15)

11.72 Postcomm’s proposals are punitive and offer no upside for superior performance. Royal Mail does not believe that a regime of this severity is required to incentivise Royal Mail to maintain good standards of performance. . In an increasingly competitive market, in the event of underperformance, unhappy customers are able to move to competitors and do not need a regulator to intervene on their behalf. Under these proposals, which cover an inappropriately wide set of products, Royal Mail would lose both customers, as would be expected in a competitive market, and also face significant penalties. This represents a double jeopardy for the business, which may, in the worst case, threaten the financial viability of Royal Mail. The treatment of force majeure is also of particular concern since the operational efficiency targets Postcomm is considering would require Royal Mail to drive through its transformation without rewarding its people, making substantial quality of service penalties almost inevitable. Royal Mail believes that Postcomm’s continued refusal to consider major industrial action as force majeure is irrational in the context of a performance regime designed to prevent Royal Mail from reducing costs at the expense of quality (9.19).

11.73 The primary purpose of any Quality of Service regulation should be to protect the interests of customers. Customers need differing levels of protection depending on whether the product or service is open to free and efficient competition. Royal Mail


believes that Quality of Service regulation should be ‘light touch’ and limited in scope to those areas that are not likely to be subject to effective competition.

11.74 In competitive areas, if Royal Mail is not offering its customers a high quality of service in business areas that are subject to effective competition, then it will lose those customers to competitors who can provide that quality level at that price. Customers are able to choose a service provider that meets their own individual quality of service needs. In these business areas competition is the most effective policeman of service quality. Whilst it may be appropriate to retain standards with the possibility of fines and enforcement for such products during the next price control Royal Mail believes it is disproportionate to apply further penalties in the shape of bulk compensation or C factor to these products, particularly where standards and current performance levels are high.

11.75 Quality of service regulation is, however, necessary in those business areas where Royal Mail is unlikely to face effective competition – essentially stamped mail. These areas are essentially stamped mail where customers are unlikely to be able to choose a service provider according to the quality of service on offer. Hence the service provider should agree acceptable levels of quality with the regulator and consumer body and these should be funded by the price control. As Royal Mail products use the same networks and performance is highly correlated, the regulation of quality for core products and services will also underpin quality levels for other products.

11.76 Where core products already have individual compensation in place for failure to meet the specification Royal Mail believes that this provides sufficient incentive to achieve a good standard of performance. Special Delivery Next Day has a refund of fee for failure to meet the guaranteed time and an additional payment for further failure under the retail compensation scheme. Royal Mail therefore believes it is disproportionate to apply additional penalties under the C factor for this product.

11.77 As a follow-up to the MORI survey Royal Mail commissioned Accent and Rand Europe to undertake a much more detailed study of willingness to pay for different levels of quality. The study considered transit times for ten Royal Mail products and the three non-transit time targets proposed by Postcomm (daily collections, delivery round completion and misdelivery). The study report forms Annex 16 to this response.

11.78 Significantly, while Postcomm’s document states that

‘Pos comm is not pe suaded tha cus omers are bette off to the same extent when performance exceeds targets. Therefore there is probably not an overall willingness to pay for outperformence’ (9.65)

t r t t r

the Accent study and analysis finds significant evidence to support an overall willingness to pay for outperformance.

11.79 Further, the findings of the study show that for transit times:

• In general social products have a higher value of delivered service than bulk products.

• Customers were willing to pay for service level improvements for some products.

• A symmetrical regime (penalty and reward) would be appropriate for all first class products, standard parcel and second class stamped mail.

• A penalty only regime would be appropriate for the other products examined.


• Customers were not interested in price changes for small changes in quality around the current levels. Generally there should be at least 1% leeway before penalty or reward is incurred. For Mailsort 3 a penalty should not be incurred until performance has fallen considerably below current levels to between 90% and 95%.

11.80 The findings for the other areas of performance were that:

• Correct delivery and daily collection were valued more highly by customers than delivery round completion.

• Customers were willing to pay for service level improvements. A symmetric regime (penalty and reward) is appropriate for all three aspects of performance

• The survey findings do not support any leeway before penalties are incurred.

11.81 Royal Mail believes quality of service regulation should be limited in scope to only those areas that are not likely to be subject to effective competition and should not be more punitive than in other regulated industries. Therefore Royal Mail believes that the level of exposure for poor performance should be considerably reduced to no more than 15% of core allowed profit, with the emphasis shifted to core USO products, and that there should be appropriate incentives for good performance. Royal Mail has set out its proposals in Annex 17 for an appropriate incentive regime based on the standards in 11.66 above.

OTHER ISSUES

Loss and Damage Compensation

11.82 Postcomm believes the importance that users attach to loss and damage is such that an operator working in a competitive market would face the possibility of losing market share if it was unable to meet customer expectations. It argues that this was shown in last year’s MORI survey in which more than half of all domestic and small business customers said that they would be willing to pay more for services should this lead to a reduction in the number of items that are lost. Therefore, in principle, Postcomm believes that incentives relating to loss and damage should be brought within the scope of the regulatory framework (9.31).

11.83 However, Postcomm acknowledges that measuring the incidence of loss and damage is far from straightforward. For loss, as few as between 0.01% (1 in 10,000) and 0.02% (1 in 5,000) of items are likely to be affected, and sampling methods used to measure loss are known to have an error rate of +/-0.5% or more. Damage is difficult to measure because it is partly subjective and also because it is often difficult to determine what caused the damage, e.g. a poorly wrapped package will be more likely to be damaged. Therefore, Postcomm does not consider it appropriate to set explicit loss and damage targets, but instead proposes to ensure that adequate redress is available to customers who experience loss and damage, through Royal Mail’s statutory schemes, made under section 89 of the Act (9.32). Postcomm’s proposed modifications form paragraph 24 of the draft LC4.50


50 2006 Royal Mail Price and Service Quality Review Supplementary Paper 2 Appendix 1.

11.84 Royal Mail notes with concern that the draft LC4 changes are considerably broader than the changes proposed in the price control consultation document (9.32 and 9.33). In particular as drafted the clause enables Postcomm to direct changes to existing section 89 schemes, and to direct the content of future contracts and section 89 schemes and future contracts in relation to compensation for loss of or damage to postal packets. This includes the process and maximum amount of compensation that may be paid. Postcomm can make changes to Royal Mail's liabilities at any time or frequency. Postcomm could therefore disregard the level of exposure that Royal Mail accepts as part of the price control negotiations at any time during the price control period directing new levels of compensation for damage and loss. In addition as drafted the list of examples in the paragraph is non-exclusive. Postcomm would therefore have a wide discretion over matters in relation to compensation for loss of and damage to postal packets, i.e. all Royal Mail products, whether included in the price control, or even in the reserved area. The wide power that is accorded to Postcomm in this proposal therefore reduces the certainty that Royal Mail should have over the next price control period, at a time when Royal Mail is being exposed to competition and in need of regulatory certainty.

11.85 Royal Mail acknowledges that loss and damage are issues of importance to customers, although the picture given by the MORI survey on loss (there were no conclusions in relation to damage) is mixed. For example large business customers generally were not willing to pay more to reduce levels of loss and did not regard loss levels of the order quoted by Postcomm in paragraph 9.32 as significant. Royal Mail is pleased that Postcomm has recognised the substantial issues with measurement and targetry of these aspects of performance, and agrees that suitable measurement of misdelivery might be helpful, as misdelivery is the largest estimated cause of mail loss. Royal Mail also agrees that redress for individual cases of loss and damage are best dealt with under Royal Mail's compensation schemes, although this must take into account that many of the issues Postcomm raises concerning loss and damage targetry also apply to individual compensation claims, making it very difficult to establish the validity of such claims. These issues are compounded in a multiple operator environment with the additional difficulty of establishing which operator lost or damaged an item

11.86 Royal Mail does not agree that its current schemes are deficient either in the levels of payment made or in the manner that they are operated. Royal Mail's loss and damage compensation schemes for ordinary postal items are among the most generous in the world with up to £30 payment for a lost or damaged item. Under the schemes, Royal Mail has the right to require evidence such as proof of posting and item value before making such payments. Royal Mail is well aware that Postwatch would prefer schemes automatically paying out large sums of money for claims of loss and damage to ordinary mail items on a “no quibble basis”51. Royal Mail regards such proposals as unreasonable, due to the disproportionately high flat rate levels of payment, the huge risk of widespread fraud and the potential financial exposure. Indeed, this was one of the main reasons why Royal Mail was unable to agree a compensation scheme with Postwatch in 2001.


51 For example, in its responses to Postcomm’s consultations on compensation published on Postcomm’s website on 2 December 2002 and 24 March 2003.

11.87 Royal Mail notes that Section 89 of the Postal Services Act does not provide for direction by Postcomm and believes that it would be more appropriate for such powers to be conferred by legislation rather than by licence. It also believes that this approach is disproportionate. The conclusion of any survey that loss and damage are issues of importance to customers does not mean that Royal Mail's current schemes are deficient, or that Postcomm should have the power to direct the content of such schemes. Royal Mail has received no criticisms from Postcomm about the levels or operation of its compensation schemes for loss and damage of ordinary items. Postcomm has been asked on a number of occasions over the past few years why it (as opposed to Postwatch) feels the schemes are deficient in respect of loss and damage compensation but it has not given any reasons or evidence of widespread problems to support the need for changes such as those it proposes. Royal Mail would of course take such evidence very seriously. The only criticism is from Postwatch, which has for a number of years criticised the Royal Mail scheme and recommended an alternative scheme that would entail high costs for Royal Mail and would be open to fraud. Given the wide discretion accorded to Postcomm under these proposals, Royal Mail believes that Postcomm should identify the problem that it solves and why it thinks the proposed power is proportionate.

11.88 In conclusion Royal Mail believes the proposed changes are disproportionate and reduce the certainty that Royal Mail should have over its next price control period. Royal Mail could not agree to such Licence changes, or indeed any changes that might lead to the introduction of compensation schemes for loss or damage along the lines of those proposed by Postwatch.

Measurement and audit

11.89 Postcomm proposes to review ownership of performance measurement and the audit of this measurement in its Consultation document on Condition 4. Postcomm has consulted on this issue in its 2006 Price and Service Quality Review Supplementary Paper 2 Issues Regarding Quality of Service.

11.90 Royal Mail’s view is that the surveys it commissions are fully independent and the results are robust. As professional auditors appointed by Postwatch independently audit the surveys, publication of an audit statement should resolve any issues of perception. Therefore commissioning of the surveys should remain with Royal Mail.

11.91 In addition to the publication of an audit statement the audit report should be shared with Royal Mail, Postcomm and Postwatch. The audit should be compliant with the relevant CEN standards and BSI1901:2002.

11.92 Royal Mail’s full views are set out in its response to the Supplementary Paper 2.


12 LEVEL

OVERVIEW

12.1 This section follows Royal Mail’s principles and approach to setting the price control, as set out in the previous sections of this response, and focuses on the level of some of the key parameters, where not previously expressed.


A 4 year control (2006/07 to 2009/10); A set of prices based on an assumption that efficiency will average a headline

3% p.a. over this period; Basic wages to rise at RPI (with any payments above this to be covered

directly e.g. by productivity schemes and share in success out of allowed profit);

The price controlled area broadly as currently, subject to Presstream and Special Delivery (account) being taken out of the control and downstream access products being included in the control;

A total offer for CAPEX, pension deficit, exceptionals (such as redundancy payments), one-off costs associated with initiatives which in total is below Royal Mail’s plan;

A RCV of £2.2bn for Royal Mail Letters and WACC of 8%, implying an allowed profit of about £180m p.a. (Postcomm refers to another average value of profit as £285m p.a.);

As presented explicitly in LECG’s model, a structure to the control which contains 4 baskets under an average revenue control;

The baskets are for the services of ‘captive’ (X=3), ‘non-captive’ (X=2), access (X=6.9) and miscellaneous (X=3) with the proposed X-values for each basket shown in brackets and a subcap of 4% on individual products in each basket.

This structure of the control is at odds with Postcomm’s discussion of its draft licence modification;

An assumption that Royal Mail should fund the deficit over 20 years from 2003/04.


Postcomm states that it has presented initial financial proposals it intends to change by moving to two (or three) baskets rather than the original four baskets. Additionally, Postcomm has not stated it wishes to change the current disaggregated tariff basket structure but its financial proposals are modelled with an average revenue control. Accordingly Royal Mail believes that Postcomm’s initial financial proposals are unclear and do not represent a coherent set of proposals;

Further, the allowed revenue in the proposal Postcomm has presented is unclear. The prices derived from the RPI-X formulae are different to those used to model the volumes to which they are applied so that if those prices were in fact set the outturn volumes and hence allowed revenue would be


different to that presented by Postcomm, prospectively by a very large amount;

Royal Mail believes that correcting these components of its initial proposals will lead Postcomm to produce a significantly revised set of proposals. As part of developing these Royal Mail sets out its requirements below;

a control of up to 5 years if the risks of the business are managed more appropriately (as discussed in this response);

a set of prices based on an assumption that efficiency will average a headline 1.5% p.a. over this period;

The price controlled area broadly as proposed by Postcomm with Presstream and Special Delivery (account) excluded (but with some additional amendments as discussed in Section 6), with the exception of access which Royal Mail believes should remain outside of the control;

a total offer for CAPEX, pension deficit, exceptionals (such as redundancy payments), one-off costs associated with initiatives which in total is set out in Royal Mail’s revised plan;

A RCV of around £5bn for Royal Mail Letters (including capitalised leased assets) and WACC of at least 10%;

As presented explicitly in Postcomm’s financial model, a structure to the control which contains a single basket for all price controlled services (with the exception of Miscellaneous Services);

Pricing that is more cost reflective than currently including the adoption of prices in proportion and zonal pricing for end-to-end products, the continuation of zonal access prices and further rebalancing requires sub-caps of RPI-X + 8.5%;

Royal Mail believes the P0 in the central case would be 8% to address the impact of the pension deficit and even out cashflows over the period and the X would be 0% such that prices rise by RPI to reflect the underlying improvements in efficiency of 1.5% against a background of declining end-to-end volumes and the cash flow requirements;

Royal Mail believes an allowance for pension deficit costs for regulated activities should permit funding over 12 years and include costs of the latest mortality assumptions.

VOLUMES AND PRICING

12.2 Postcomm has proposed adopting the market share projections developed by its consultants, Frontier Economics (Frontier), in conjunction with Postcomm for the price control. Royal Mail’s forecast of total market growth provided to Postcomm in January 2005 as part of the BPQ submission has been used to set the draft price control, but this is expected to be reviewed for the final price control.

12.3 Postcomm’s document explains Royal Mail’s approach to volume forecasting as a two stage process in which Royal Mail firstly forecasts the growth in mail volumes using an econometric model (the Inland Letter Traffic Model (ILTM)), with ‘overlays’ to take account of factors not contained within the historical data, and, secondly, forecasts the impact of volume transfer to entrants through a second model (the Entry Pricing Model (EPM)).

12.4 Postcomm’s proposals are based on volumes developed by Frontier using Royal Mail’s projection for overall volume growth and Postcomm’s CPMM model instead of the EPM.


Frontier reviews and criticises aspects of Royal Mail's projection for overall volume growth52 and these are set out in a report. Royal Mail has prepared a detailed response to Frontier on this area which is contained in the first part of Annex 18. It also invited Professor Jean-Pierre Florens to review the methodological issues raised by Frontier with regard to econometric modelling and his comments are contained in Annex 19.

12.5 The main area of difference with Frontier relates to the extent to which long-term projections should be based solely on an analysis of historical data using econometric techniques and to what extent other information should be incorporated in such projections to augment a purely historically based approach. Royal Mail agrees fully with Professor Florens conclusion that is it important to balance or weight the use of both types of information so that a long-term projection is not just an extrapolation of past trends, an assessment at odds with Frontier’s view. Royal Mail notes that Postcomm has adopted Royal Mail's projection for overall volume growth rather than changes in line with Frontier’s review.

12.6 Royal Mail estimates the effect of entry through end-to-end (bypass) services and access (downstream) services through the EPM. The EPM has developed over a number of years from a model that took account of end-to-end entry only at the time of the last price control review, to one that takes account of end-to-end entry, operator downstream access and customer downstream access. The model has been independently reviewed for Royal Mail by Oxera.

12.7 Frontier has reviewed the EPM and has developed a separate model, called the CPMM, which addresses the second stage of market entry. Many of the features of the CPMM are the similar to those in the EPM with the main distinction being that the CPMM considers entry without assessing entry within different geographical zones in a meaningful way. Frontier claims the CPMM to be superior to the EPM.

12.8 Royal Mail has provided a detailed response to this part of Frontier’s report in the second main part of Annex 18. It also invited Professors Helmuth Cremer and Philippe De Donder to review the methodological issues raised in Frontier’s commentary on the CPMM and their comments are contained in Annex 19. They contest the qualification of the CPMM as an economic model and consider its construct to be a development from the EPM in the wrong direction for the postal sector as, amongst other features, it does not address the fundamental issue of zonal entry under the geographically uniform price constraint of the universal service in a meaningful way.

12.9 As an operational model the CPMM depends on a number of key parameter values both with regard to modelling the extent of entry and also assumptions on the pace at which entry occurs in the market. The results of its model are sensitive to these assumptions but Frontier has not reported any tests on these sensitivities either by testing parameters individually or jointly though techniques such as Monte Carlo simulations. The reporting of sensitivities would improve the transparency of the CPMM and Royal Mail believes that the results of such exercises should be a key element and integral part of Postcomm’s management of volume risk (see Section 13).

12.10 Royal Mail notes that the access volumes used by Postcomm in its document and CPMM are understated relative to actual access volumes observed to date. Royal Mail expects


52 ‘Volume modelling for the price control’, Frontier Economics (June) 2005.

this to be corrected in Postcomm’s final proposal document. In addition, Royal Mail gave Postcomm indicative access costs for 2003/04 for its projections though there were no access volumes with which to confirm the access costs. Royal Mail has subsequently established the access volumes and costs for 2004/05 which it will provide to Postcomm and expects these to be used in its final proposals document.

12.11 Royal Mail notes that the prices calculated as part of the “X” values proposed by Postcomm for its four baskets are not consistent with the volumes assumed in its models. Postcomm has not tested and demonstrated a model that derives forecast prices and volumes that are consistent with one another and thereby ones that it could reasonably expect to see in the market over the price control period. This is important because Postcomm’s document suggests that its proposals for 34p for 1C and its four basket structure will deliver the revenues and cash flow without properly testing whether such an outcome is feasible within its own models. Royal Mail expects this to be corrected in the final decision document. In addition, Postcomm’s document does not apply or analyse the potential impact of pricing in proportion or zonal pricing.

12.12 Further, Postcomm’s modelling does not assume that access prices are set under its proposed structure (option 1). Instead the modelling assumes that RPI-X applies to an average price for access in the base year (Postcomm’s option 2) (see further below). Royal Mail expects this to be corrected in Postcomm’s final decision document.

12.13 Having corrected and adjusted for these factors and potentially updated to a 2004/05 base, Royal Mail’s two stage approach yields the volumes for the ‘regulated activities’ as defined by Postcomm to be the union of the universal service and price controlled services as set out in Table 12.1, which, for comparison also includes the figures in Table 8.4 of Postcomm’s document.

12.14 Royal Mail’s updated projections differ in two principal ways from those provided to Postcomm in January 2005 as part of Royal Mail’s BPQ submission. Projected total volumes are lower in earlier years (by between about 2% and 3%) because of an underperformance of volume growth from the end of 2004 to the summer of 2005 compared with the projection provided in January. This underperformance has affected Direct Mail and First Class volumes in particular. Consequently, total volumes are lower throughout. Secondly, the share of downstream access is higher. Volumes have been modelled under Postcomm’s option 1 for access as a percentage discount on a corresponding end-to-end product. Relative to the corresponding end-to-end service, access prices are lower than projected in January leading to a greater movement of Royal Mail end to end products to access. The volumes modelled are consistent with the level of prices used for Table 12.4.


Table 12.1 Volume Forecast for Royal Mail’s Regulated Activities from 2005/06 to 2009/10 (millions of items)

2005/06 2006/07 2007/08 2008/09 2009/10 Postcomm End to end 20,210 20,123 20,228 19,824 19,236 Access 305 472 740 1,002 1,413 Total 20,515 20,595 20,968 20,826 20,649 Source Frontier Economics Royal Mail End to end 19,161 16,836 15,868 14,413 13,379 Access 1,363 3,665 5.149 6,525 7,333 Total 20,523 20,501 21,017 20,938 20,712 Source: Royal Mail

OPEX AND CAPEX

Opex efficiency

12.15 Regarding efficiency, Postcomm’s document states:

‘LECG’s bo om-up” analysis of Royal Mail’s operating expendi ure derives a forecast of annual efficiency savings of between 2.6 and 4% in unit cost terms to 2010/11’ (8.66)

tt t

rtt

t

t t t rt r

) t

12.16 The range of 2.6% to 4.0% corresponds to the range of RUOE before one off costs in Tables 270 and 272 of LECG’s report and relates to the figures before correcting for volume and mix effects. This is addressed in LECG’s report which, subsequent to Tables 270 and 272, states:

‘The analysis carried out on a bottom-up basis therefore suppo s a projection of forward productivity growth, adjusted for volume and mix effec s, of between 1.4% and 2.6% in ROUE terms and be ween 1.4% and 2.5% on an RUOC basis’. (26.20)

12.17 This is further confirmed in Table 276 of LECG’s report which states the annual decrease in RUOE to be in the range of ‘1.2% to 2.6%’ for the ‘Bottom up review of RML’s Strategic Plan’.

12.18 LECG’s final projections of operating costs before one-off costs assume an RUOE of 3% in constant volumes and mix terms (26.44). Royal Mail observes that this is above the range of 1.2%-2.6% stated in Table 276 of LECG’s report for the ‘Bottom up review of RML’s Strategic Plan’. Royal Mail believes the RUOE of 3% in constant volumes and mix is 0.4-1.8% above LECG’s bottom-up analysis.

12.19 Postcomm’s document also refers to LECG’s internal benchmarking analysis for delivery offices and mail centres stating:

‘The conclusions suggested ha savings could amount to be ween £350 and £450m ove the period of the price control (equivalen to about 2.6 to 2.8% a year over a five yea period . These savings are based on assuming tha all Mail Centres and Delivery Offices reach the current performance level of the bottom performer in the current decile by 2010/11. The analysis does not assume any improvement in the performance of


benchmark Mail Centres and Delivery offices. The stated savings have been reduced by a factor of 20% to allow for errors in the underlying information.’(8.72)

12.20 Royal Mail asked Oxera to report on LECG’s analysis. Oxera’s reports were undertaken with the assistance of Professor Tom Weyman-Jones, Professor Andrew Chesher and Professor Emmanuel Thanassoulis. Their reports on the SFA and DEA approaches are included in Annexes to Royal Mail’s response to the LECG report.

12.21 Oxera’s report using the SFA approach concludes that the potential savings identified by the approach could be as low as £150m, but that a more conservative range would be £150m to £250m.

12.22 Royal Mail notes that this would be equivalent to a reduction on a cost base of about £2.7bn of between 1.1% and 1.9% over a five-year period. Royal Mail believes these results to be broadly consistent with the BPQ plan and ‘bottom-up’ review referred to above.

12.23 Though not referred to directly in Postcomm’s document, the LECG report also identifies savings for overheads in the range of £135m to £280m on a cost base of about £530m. Royal Mail asked Oxera to review the overhead analysis presented in LECG’s report and this identified several deficiencies in LECG’s approach and analysis that lead to LECG’s estimate of the potential savings to be overstated. Oxera’s report supports potential savings of about £31m, equivalent to about 1.2% over a five-year period.

12.24 Oxera’s reports on LECG’s analysis therefore identify savings on a cost base of £3.25bn of between 1.1% and 1.8% over a five-year period.

12.25 Postcomm’s document refers to further top-down analysis and states:

‘LECG estimate from its top-down analysis that on balance, real unit operating expenditure gains on a constant volume basis of between 3% and 4% a year could be assumed to be achievable over the forthcoming price control period’ (8.74)

12.26 More specifically, Postcomm’s document (Table 8.10) refers to estimates of the average RUOE from LECG’s report for:

a) Royal Mail’s historic performance at ‘2.9%’;

b) the average of other regulated companies at ‘3.0% to 4.0%’;

c) total factor productivity analysis at ‘above 2.6%’.

12.27 With the assistance of Oxera, Royal Mail has reviewed each in turn and found:

a) the historic average RUOEs achieved by Royal Mail since regulation is between 1.4% and 2.2%, as documented in Royal Mail’s response on the LECG report. This is broadly consistent with the range of 1.2%-2.6% stated in Table 276 of LECG’s report;

b) the range of 3.0% to 4.0% for other regulated companies appears to originate from Table 245 of LECG’s report which identifies the full range across sectors (that do not include the postal sector) to be between 0.0% and 5.7%. The range of 3.0% to 4.0% is formed by a selective presentation of data that is ultimately misleading and bears no specific relation to the postal sector;


c) total factor productivity analysis involves a degree of subjectivity, which is also recognised by LECG’s report. Nevertheless, Royal Mail has reviewed LECG’s total factor productivity analysis and, with some amendments and corrections, estimated the RUOE range to be about 0.4% to 2.7%.

12.28 In conclusion, LECG’s report does not support an RUOE of 3% from its own “bottom-up’ analysis and detailed top-down analysis. This figure is 0.4-1.8% above LECG’s ‘bottom up’ analysis which is not supported by detailed top-down analysis and therefore LECG relies on less sector specific and less detailed top-down analysis to support the 3% figure.

12.29 A summary of Royal Mail’s results are shown in Table 12.2. Royal Mail believes that the RUOE used for setting the control should be based on the top-down stochastic and deterministic frontier analysis and bottom-up analysis, with the less sector specific and less detailed top-down analysis and the historic performance used as a cross check on the results. Royal Mail believes that this supports an RUOE for the next price control of 1.5% and expects Postcomm’s final decision to take account of this evidence.

Table 12.2: Royal Mail’s estimates of RUOE based on the approaches used by LECG.

Approach Potential RUOE reduction (%)

Stochastic and deterministic frontier analysis and overhead analysis (on the partial cost base of £3.25bn) (Source:Oxera)

1.1-1.8

Historic range under regulation (Source Royal Mail) 1.4-2.2

Other regulated businesses (Source: LECG) 0.0-5.7

Total factor productivity (Source: Oxera/RM) 0.4-2.7

12.30 In addition to differences in the level of operating efficiency discussed above, Royal Mail also believes that Postcomm and LECG make unreasonable assumptions as to the speed with which savings can be made. Postcomm and LECG model cost reductions from volumes in the same year as the reduction in volumes. Royal Mail has explained to Postcomm and LECG that this does not occur within the postal sector and that there is a lag in extracting such costs. Royal Mail expects Postcomm’s final decision to include a lag for cost reduction arising from reductions in volume.

Capex

12.31 Postcomm’s document makes several references to a comment in LECG’s report stating that the allowed capex would be underspent in the current price control period. Postcomm’s reference is made in support of its decision to allow lower capex than Royal Mail has sought in its BPQ, even though both Postcomm and its consultant agree with the need for greater capex spend by Royal Mail than in the past. Indeed, Postcomm’s document follows the recommendations from LECG’s report for allowing Royal Mail annual capital expenditure (£189m) greater than the allowance under the current control (about £157m), but not at the levels proposed by Royal Mail in its January BPQ submission. This capex allowance included £369m of non-specific capex spend. LECG expected this level of capital expenditure to be sufficient to cover all reasonable replacement expenditure and allow a number of new projects to be carried out.


12.32 Royal Mail notes that Postcomm’s document makes frequent reference to LECG’s estimation of a potential underspend on capex during the current price control.

12.33 The comparison of actual capital expenditure with allowed expenditure is complicated by two issues – the source of the capex data for the Letters business and a change in our approach to financing vehicles during the price control period. When capex figures were provided to LECG previously they were sourced from the Letters business unit records and were adjusted to remove vehicle purchases. This potentially misses support function capex not transferred and, at the time intentionally, omits vehicles capex arising from the decision to buy rather than lease taken during 2004-05. Royal Mail believes that the vehicles capex should be included for this comparison as it has been incurred. Royal Mail estimates the total capex spend in the mails business was £625m (or £436m excluding vehicles) of which approximately £569m (or £397m excluding vehicles) relates to the regulated business. This implies an overspend against the allowance of £491m of £78m (or an underspend of £94m excluding vehicles) (in nominal prices assuming £47m impact c2.5% inflation since 2000/01). This is discussed further in Royal Mail’s response to LECG’s report.

12.34 Royal Mail has updated its planned capex spend following the January BPQ submission. This plan involves £1.6 billion of capex spend in the 4 years (2006/07 to 2009/10) above that proposed by LECG. Royal Mail’s capital expenditure includes approximately £0.4 billion for automation equipment and the move to more efficient delivery, £0.5 billion to begin replacing obsolete equipment, £0.1 billion to make the delivery network fit for purpose, £0.1 billion in processing, £0.1 billion on regular maintenance of the estate, and £0.5 billion on vehicles.

12.35 Royal Mail notes that Postcomm and LECG support the direction of its original plan and sought further evidence to support its proposed capex spend. Business cases have been developed to further support the capex spend in Royal Mail’s updated plan. Royal Mail believes this level of capex spend is required if it is to become more efficient and be able to compete in the postal market following Postcomm’s decision to fully open the UK postal market to competition in January 2006.

PENSIONS

Funding period

12.36 Regarding the funding period, Postcomm’s document states:

‘They [Hymans Robertson] believed it would be reasonable for the pension deficit costs to be recovered over a period of up to 20 years starting from 2003.’ Para 8.95

12.37 There are two key arguments that Hymans Robertson put forward for this period:

a. ‘…that Postcomm is required… to ensure that in setting the price control Royal Mail remains a viable ongoing business. There may well be other pressures that would make a default by RM on its pension obligations politically unacceptable and hence practically veryunlikely. In this context, we would anticipate that the ability of RM to mee its obligationsto the RMPP would be mo e secure than would be the case in a typical priva e sectorscheme.’

t

r t


b. ‘ This, toge he with the fac tha RMPP is open o new members, would, in our view, point to a longer deficit correction period being appropriate.’

t r t t t

12.38 Royal Mail disagrees with Hymans Robertson’s key arguments and their selected benchmark of comparing the Royal Mail Pension Plan to those of Local Government Pension Schemes, which typically pay off their deficits over longer periods than the private sector – with averages of some 20 years. This is an inappropriate comparison for the following reasons:

a. Royal Mail Group plc, the principal sponsoring employer, does not have any Government guarantee in respect to its business or its pension scheme commitments. In other words, there is no obligation on the Government to cover any pension shortfalls, which may be used by the Trustees in accepting a deficit correction period considerably in excess of the norms.

b. The Postal Services Act established Royal Mail Group plc as a stand-alone company governed under the laws of the Companies Act. Unlike a Local Government Authority the company must trade in a competitive market, generate profits and trade whilst solvent. Although Government is the Company’s shareholder, it manages the relationship on an arm's length and economic basis. In the event the Company was unable to meet its financial obligations to RMPP there could be no expectation of funding from Government. These considerations do not apply to Local Authorities, as they do not commercially trade.

c. As many Local Authorities have tax raising powers they have a higher degree of certainty over future income. Royal Mail does not have this strength of covenant due to the fact that its Regulatory regime imposes price restrictions and it faces an uncertain new competitive environment.

d. Due to this competitive environment, we also believe Hymans Robertson is placing undue reliance on Postcomm's duty to ensure Royal Mail is able to finance its regulated services. This implied safeguard for a company facing such a large pension deficit will inevitably reduce over the proposed 20 year period due to the impacts of competition.

e. We are also informed that the independent body of Trustees have historically compared the Plan to the private sector when benchmarking governance, investment and other pension matters.

f. We believe that Postcomm should also take into account the fact that private sector companies scrutinize those that remain in public ownership and are quick to challenge any measures that suggest there is not a level playing field. A price regime, which appears to endorse the repayment of the pensions deficit over a period longer than is acceptable in the private sector, is likely to provoke criticism.

12.39 Royal Mail’s presentation to Postcomm and its advisors provided extensive benchmark data that suggested that a funding period of over 15 years was very rare in the private sector. Experience shows that it has not been untypical for private sector companies to fund their deficits over the average remaining service life of the employees, and indeed it is rare for deficits to be financed over a longer period. This definition implicitly takes account of whether the scheme remains open as clearly the average remaining service life would decline once a scheme closed to new members. Royal Mail’s information


continues to support a deficit correction period that is considerably less than the 20 years being proposed by Postcomm.

12.40 Further benchmarking undertaken in June 2005 within Watson Wyatt continues to suggest a funding period based upon the average remaining service life is the most common deficit funding period. This benchmark covered a sample of 79 schemes and gave the following results:

i. 38 schemes (48%) are funding over average remaining service life

ii. 2 schemes (3%) funded with immediate cash injection of whole deficit

iii. 7 schemes (9%) are funding up to 5 years

iv. 4 schemes (5%) are funding over 5-10 years

v. 16 schemes (20%) are funding over 10 years

vi. 3 schemes (4%) are funding over 10-15 years

vii. 8 schemes (10%) are funding over 15 years

viii. 1 scheme (1%) is funding over 20 years.

12.41 These survey results are based on the position before the introduction of the new pension legislation and funding requirements, and in practice deficit funding periods will inevitably reduce in future.

(a) It is also worth noting that for historical reasons (and from the perspective of members and the Trustee) the Plan is often compared to the BT pension scheme, which is being funded over a period not exceeding 15 years.

(b) In establishing a deficit correction period that is dependent upon a regulatory regime, it is important to remember that Royal Mail’s licence runs for 15 years from March 2001 so would end in March 2016. This would suggest that any funding of the deficit should be completed by this date, ie. over a 9 or 10 year period from 2006. It would seem difficult to understand why Trustees would accept a longer funding period when it is not clear how the deficit would be financed should the licence be revoked.

(c) We recognise that the draft regulations on scheme funding in future (that will apply from September 2005), and the draft codes of practice published by the New Pensions Regulator, do not set out maximum deficit funding periods. However, all the indications are that the new funding regime will result in pension deficits being made good over much shorter periods. Evidence to date is that in many circumstances where the Pensions Regulator has become involved the expectation is that deficits are met over a very small number of years. The draft codes of practice state that the Trustees should aim for any shortfall to be eliminated as soon as practicable since full funding in relation to technical provisions is the stated statutory funding objective for all pension schemes (reflecting the EU directive on such matters). The Pensions Regulator’s current stance is that it is the FRS 17 deficit that companies and Trustees should focus on


and he has stated that the weaker the funding basis, or the weaker the employer’s covenant, the shorter the deficit recovery period should be. This point is discussed in further detail below.

(d) There is a new requirement to disclose the financial position of the plan on a discontinuance basis, and to comment on how this position might be expected to change in future based on the chosen funding strategy. Royal Mail’s preliminary (and we accept approximate) calculations suggest that using a deficit funding period of 12 years from 2003 may be sufficient to maintain the current discontinuance funding level. Using a longer deficit repayment period is therefore more likely to lead to the discontinuance position worsening over time, which will be difficult to justify and communicate to members.

(e) Similarly a lower level of deficit funding is also likely to mean a slower increase (if any) in the PPF funding level over time. This will result in higher PPF levies than would otherwise be payable. This potentially increases the cost of running the Plan significantly, which will need to be factored into any price control considerations.

(f) Recent guidance was issued by Standard & Poor to Trustees of pension schemes to assist them in establishing funding deficit correction periods (see their press release on 30 June 2005). S&P suggests that the use of the remaining service life as a basis for establishing the funding period may no longer be appropriate. In fact, their recommendation to the wider body of independent Trustees is to take into account funding levels and credit ratings to set the maximum funding period. Trustees using S&P’s Matrix approach would conclude that even periods as long as 12 years may be considered too long if the Sponsor’s credit rating is weaker than A rated. The suggestion is to consider a period of between 5 and 10 years in most cases.

(g) In her letter to Nigel Stapleton dated 21 July 2005, Jane Newell, Chairman of Royal Mail Pensions Trustees Limited, said that the Trustees welcomed Hymans Robertson’s view that the deficit should be recovered over a shorter period than the 40 years permitted in the Trust Deed but that the 20 year period proposed should be reduced. She noted that a period of 10 to 15 years would be more the norm for a Plan Sponsor with a strong covenant and that where the covenant is uncertain, Trustees would require a far shorter period or even immediate repair.

12.42 Royal Mail’s proposed funding within the price control is based upon the valuation deficit and not the more onerous FRS 17/IAS19 marked-to-market deficit, which must now be included in the accounts. The general expectation from shareholders, lenders and other investors is that a company must address this deficit and not simply the funding deficit. This is supported by recent commentary from the new Pensions Regulator (as referred to above). This strongly supports Royal Mail’s belief that its claim for a deficit funding period not to exceed 12 years is fair and reasonable and not at the upper end of a justifiable allowance. As discussed with Postcomm previously, it is important to take into account the impact on the Company’s balance sheet following adoption of these new accounting standards and on its ability to trade unencumbered for an extended period.

12.43 Based upon the information previously provided to Postcomm and their advisors and the information provided above, Royal Mail cannot see any justification for a deficit correction period extending beyond what is considered acceptable private sector practice, particularly


in the light of the new pensions legislation environment, the views of the independent Trustees and of our shareholders. As such, Royal Mail stands by its original requirement to fund the pensions deficit over a period of 12 years.

Mortality

12.44 Regarding mortality within the pension deficit calculations, Postcomm’s document states.

‘If Royal Mail provides updated information about the life expectancy assumption before Postcomm makes its final proposals, his information will be taken into account in the final assessment’.’ (8.30).

t

12.45 The scheme actuary on behalf of the independent Trustees has undertaken an interim investigation of mortality assumptions. This was based upon the latest Pension and Insurance industry mortality tables together with updated pensioners’ profile and death experience in the RMPP for the 2 years since March 2003, the date at which the last formal valuation was carried out.

12.46 The purpose of the review was to provide an initial assessment of the likely impact of increases in life expectancy (and reduced rates of mortality), which will be used to inform discussions between Royal Mail and the Trustees, but it should be noted that mortality will be reassessed formally at the time of the next triennial valuation at March 2006. Any results considered at this stage are therefore preliminary estimates only but should be considered sufficient to establish a minimum level for funding.

12.47 The potential impact on the ongoing funding liabilities (in March 2005 market value terms, and based on 2003 actuarial valuation methods and assumptions) is as follows:

(a) assuming pensioner mortality in line with the ‘best fit’ for the 2003-05 experience (ie. selecting the mortality table closest to recent actual experience for use in projecting forward) projected to 2006, but with the same allowance for future improvements as allowed in the March 2006 valuation, could increase liabilities by c£800m; and

(b) assuming pensioner mortality in line with the ‘best fit’ for the 2003-05 experience projected to 2006, plus allowance for the improvements thereafter as included in the standard ‘medium cohort’ (ie. assuming improvements in mortality continue at the same pace until 2020 and then slow down) projections (which is consistent with the level of future improvements built into the basis to be used for assessing the Plan’s liabilities for the purposes of determining its PPF levies from 2006), the liabilities could increase by as much as £1.75bn.

12.48 If liabilities increased by £800m, the annual deficit payments from 2006 (on an ongoing funding basis) could increase by c£87m pa from 2006/07, assuming deficit funded over 12 years from 2006/07. The number represents the regulated share of a group figure of c£100m pa. However, given the possible range and scale of outcomes, any increased exposure to mortality above the £800m following completion of the March 2006 valuation should be included in the passthrough of pension costs.

Passthrough

12.49 Regarding passthrough of the pension payments, Postcomm’s document states:


‘Postcomm does not believe it would be appropriate for Royal Mail to be allowed to passthrough pension deficit costs or have an automatic re-opening mechanism for pension deficit costs. Unlike companies in many other regulated sectors, Royal Mail is increasingly subject to competitive pressures that might give it an incen ive to recover as much of the deficit as possible in the short term, rather than applying areasonable distribution between present and future customers.’ (8.91)

t

12.50 The pension scheme costs and volatility are so very significant to Royal Mail and, given the scale of the payments, Royal Mail is seeking pass-through for variations but gives assurance that it would not seek to pass through any reduction in the repayment period during the duration of the next price control from that proposed in this submission in the event that the Trustees seek a faster repayment.

12.51 The passthrough would therefore be restricted strictly to differences between currently assumed figures and actual deficit calculations following the March 2006 valuation.

12.52 This is discussed further in Section 13 in the context of risk management.

Levy

12.53 Postcomm’s proposals do not refer to the levy for the new Pension Protection Fund. At this stage the amount involved is unknown, and the PPF Board has not set its levies for 2006/07 (it is still consulting on the calculation method). Royal Mail had previously estimated that the levy could be £16m per year (the regulated business share of Group cost of £18m), based on information available at the time of its submission. Royal Mail’s understanding from meetings with Postcomm is that it was not allowed.

12.54 On 12 July 2005 the Pension Protection Fund Board issued a consultation document relating to the calculation of the risk based levy. The levy for 2005 is based on scheme membership and is expected to be £5m-£6m for Royal Mail. From 1 April 2006 the levy will be calculated as a scheme based component and a risk based component. Based on current PPF Board information the scheme based component could be up to £0.5m pa for RMPP. The risk based component will be based on the ‘PPF’ funding level of the plan and the insolvency risk of the sponsoring employer. The intention is that the insolvency risk will be assessed by using some credit ratings of sponsoring employers. If the PPF board is unable to obtain a rating or insolvency risk measure then a sponsoring employer would fall into a ‘generic risk band’ and the assigned levy will be determined once the nature of all the entities in that grouping has been established. It is intended that asset allocation will be taken into account in future years although it will not be for 2006/07. Although it is not possible to accurately estimate the risk based levy at this stage, as it depends on the credit assessment of Royal Mail, and on the way in which the PPF Board decides to scale up or down the levies to ensure that it raises enough money, the expectation is that Royal Mail’s estimate of £16m pa from 2006 is on the low side and the costs could be considerably in excess of this estimate.

12.55 Given that this is an unavoidable additional cost imposed on Royal Mail through new legislation, Royal Mail continues to believe the full amount of this levy must be allowed as additional operating expenditure.


Normal contributions – impact of investment mix changes

12.56 Hymans Robertson’s report states:

‘We can also confirm tha the direc ion and exten of the proposed switches out of equities (to a 65% equity holding) is also consistent with curren market practice.

t t tt

tt t f

t t t

…It is not clear to what extent a change in investmen strategy will impact on the assumed return on future con ribu ions and hence on the assessed cost o future pension accrual.…WW [Watson Wyatt] has indicated that he effect of the proposed switch to a 65%equi y holding will increase the future service con ribution rate by 1.2% payroll to 13.8% of payroll.’

12.57 Normal contributions in the base year, 2003-04, were 12.6% of pensionable pay but the anticipated impact of changing the investment mix away from equity and into property and bonds is, as noted above, to increase this contribution rate – and it was estimated that the increase could be to 13.8% (or more). Postcomm’s proposals support the investment switches proposed but do not appear to take account of the increase in ongoing costs of at least c£29m pa.

12.58 Given that this is an additional cost to Royal Mail arising from derisking the pension plan and meeting independent Trustee expectations, this increased expenditure should be allowed as additional operating expenditure.

12.59 It should be noted that the ongoing service charge for pensions under International Financial Reporting Standards (International Accounting Standard 19) is at 19.6% of pensionable pay due to different, more prudent, assumptions used in the accounting approach. The funding rate that Royal Mail expects to pay, and is seeking allowance for, is 13.8% and the extent to which we do not fund up to 19.6% represents a risk, arising from the inherent assumptions, that Royal Mail is prepared to take and considers acceptable in the light of actuarial advice.

Normal contributions – impact of mortality assumptions

12.60 If mortality assumptions changed as described above these would also have an impact on the ongoing cash contributions to the scheme. This could be of the order of 0.8% of pensionable pay, c£19m pa and should be included in the ‘passthrough’.

Allowed profit and depreciation

12.61 By convention, the ‘allowed profit’ is calculated as the multiple of the RCV and real pre-tax WACC for the price controlled area. Postcomm assumes remaining lives and new asset lives for the tangible assets. On this basis, Postcomm’s document uses estimates based on the opening RCV at £2.2bn and pre-tax real WACC at 8%, for the Letters business; and therefore the pre-tax allowed profit (as measured by the RCV x WACC) is c£175m.

12.62 Royal Mail’s changes to these financial assumptions are discussed in Section 11 of this response to which Royal Mail adds a remaining asset life for intangibles of 15 years. For ease of comparison, Royal Mail assumes the same tangible asset lives and adds an opening intangible asset life of 15 years53. Royal Mail uses estimates of the opening RCV at £4.6bn (having capitalised leased assets as discussed in Section 10) and the pre-tax


53 A shorter remaining life would lead to an increase in the required revenue in the next price control period; and vice versa.

real WACC at 10%, for the Letters business; the corresponding pre-tax allowed profit of c. £380m54.

12.63 When applied to the regulated business these yield significantly different results. The overall cash flow position of the Letters business is also influence by non regulated activities.

THE LEVEL OF X

Level differences

12.64 Postcomm’s modelling, as presented to Royal Mail in Postcomm’s financial model, calculates the X values in the RPI-X for four separate baskets. Table 8.14 of the document presents two of these values, for Postcomm’s “captive” and “non-captive” baskets. This presentation of the X assumes that the X applies to a single average price in each basket. It also assumes that it is applied for each of the four years of the proposed control with no price rebalancing.

12.65 For the purpose of comparison, Royal Mail has combined the four baskets into a single basket for the price controlled area, and derived the X in the RPI-X formula. The X derived from Postcomm’s model is then 3.4 such that the formula applies RPI-3.4 to the average price in each year of the control.

12.66 Royal Mail has developed Postcomm’s financial model to incorporate changes to volumes, prices and costs consistent with Royal Mail’s updated plan, and as discussed above, this produces a cash flow position before financing (i.e. interest dividend and tax) that increases over the period. To stabilise the cash flow position over the period, and recognising the step increase in pension deficit payments in 2006/07, Royal Mail has calculated the initial step increase in prices in year 1 to be RPI+8.0 and subsequent change in the average price to be RPI.

Definitions

12.67 The current licence and Postcomm’s proposed draft licence modifications apply the RPI-X to a disaggregated group of product prices rather than a single average price. Royal Mail has been given the model used by Postcomm to set the figures stated in its document

‘Postcomm is proposing an ‘X’ of 3% for he cap ive basket and 2% for the non-captive ba ke ’. (8.115)

t ts t

12.68 From this Royal Mail has established that the two X-values stated in Postcomm’s document (8.115) were applied to the average price of services in each of the two baskets and not to the disaggregate groups of product prices in each basket. Hence these values are not consistent with those required for the draft licence modification. Royal Mail expects the X to be calculated for a disaggregated set of prices in the final decision document.

12.69 In addition, Royal Mail expects Miscellaneous Services to remain outside of the single basket.


54 This is equivalent to the RCV without capitalised leased assets multiplied by the pre-tax, real WACC.

12.70 In summary, the changes in the price levels described above and proposed by Postcomm are presentational and would need to be adjusted to correspond with the values to be used within the draft licence modification.

FINANCEABILITY

12.71 Royal Mail has updated Postcomm’s financial model, entered its updated plan and retained the PO and X assumed in Postcomm’s original model and document for the Letters business, assuming a single average revenue yield for a 4-year control. The P0 and X assumed is a price change of RPI-3.4%. The cashflow before dividend55 is shown in Table 12.3 to be negative on average and in the final year; the financial ratios are not met. Given the inconsistencies of Postcomm’s modelling process, this is a preliminary analysis of Postcomm’s proposals in Postcomm’s financial model, and is subject to further review and analysis56,

Table 12.3: Letters Business Results from Royal Mail’s updated Plan In Postcomm’s Model Constraining Price Changes to RPI-3.4%

First year average price

increase

%

Subsequent years average price change

%

Average cashflow before dividends

£m

Final year cashflow before dividends

£m

4-year control, Postcomm’s proposed X, Royal Mail updated plan

RPI-3.4 RPI-3.4 -810 -1025

Source: Royal Mail’s update of Postcomm’s Financial Model with Royal Mail data, all figures are rounded.

12.72 In addition, Royal Mail has undertaken preliminary work to estimate the P0 and X for the Letters business in a scenario where there is price rebalancing and a single basket, average revenue yield control. This is illustrated in Table 12.4 for a 4-year price control scenario and is subject to further review and analysis.

Table 12.4: Letters Business Results from Royal Mail’s updated Plan in Postcomm’s Model adjusting price changes to meet revenue requirements


increase

%


%


£m

Final year cashflow before

dividends

£m

4-year control, Royal Mail’s updated plan

RPI+8.0 RPI 210 330

Source: Royal Mail’s update of Postcomm’s Financial Model with Royal Mail data, all figures are rounded.

55 Defined as operating profit plus depreciation minus capex minus tax and after funding of the pension deficit.


56 Royal Mail received Postcomm’s financial model from Postcomm on 8 July and the second of two sessions by LECG to cover the model was held on 29 July.

12.73 The figures are based on an iteration of setting prices consistent with volumes to match the required revenue within Royal Mail’s update of Postcomm’s financial model. The results shown still require further iteration to ensure that the prices and volumes match the required revenue. Further iteration could increase the RPI+X requirement and/or require a higher basic weight step 1C price than the 39p assumed in 2009/10. The constraint of 39p represents a significant compromise since, at 39p/41p, the business would not be able to generate a commercial return for its shareholder (after pension deficit funding) consistent with its investment in the business, and would expose the business to very significant competitive risks since price rebalancing would be severely restricted.

12.74 It is also noted that these values do not reflect the P0 and X that Royal Mail would expect to see in the final Licence since, for example, it expects a disaggregated average revenue control to continue to apply for which these values may change. Nevertheless they provide a comparison with those in Table 12.3 and a healthier cash flow position57. Even so the cash flow before dividends is relatively small at an average of £210m pa given the risks facing the business. This is developed further in the next Section which discusses the risk of adverse downside scenarios that reflect the risks facing the business and adjustments to the price control to manage these risks more effectively.


57 Comparable to a post tax WACC of about 8% and RAB, excluding capitalised leased assets of about £3.8bn of £300m. The lower figures in the table arisies from capex exceeding the regulatory depreciation allowance.

13 MANAGEMENT OF RISK

OVERVIEW

13.1 This section sets out Royal Mail’s response on the management of risk of the next price control for Royal Mail.


Postcomm proposes an RPI-X form of the control with RPI as the indexation; Postcomm proposes to retain the existing clause for reopening the price

control and sees this as a means of managing risk; Postcomm proposes that the new price and service quality control

arrangements should last for four years. This reflects a balance between the next price control being long enough to provide market and regulatory certainty, whilst not being so long that market conditions could change drastically from the assumptions upon which the control was set.


Royal Mail agrees that the form of the control should be RPI-X with RPI as the measure of indexation; Royal Mail believes that there should be a P0 adjustment to reflect the step up in costs to recover pension deficit before the application of efficiency through the X; in addition, it believes that pension deficit movements from this allowance should be made to facilitate the pass-though of pension costs;

Royal Mail believes Postcomm’s document significantly understates the potential financial exposure to Royal Mail from the loss of volume;

Royal Mail believes that regulatory precedence does not support the level of profit exposed to service quality within Postcomm’s proposals, nor Postcomm’s approach to providing Royal Mail with downside without any potential for upside for outperformance;

Royal Mail believes that Postcomm’s clause for reopening the control is inappropriate given the scale of the risks involved. Royal Mail does not believe that Postcomm’s approach is consistent with its objective of treating Royal Mail as an independent, commercial business. On the contrary, its proposals increase Royal Mail’s potential reliance on the regulator to intervene to a level that, Royal Mail believes, is unprecedented within good regulatory practice and therefore would be unacceptable to any independent commercial business. Royal Mail believes that the risks of the business need to be assessed and addressed more directly so that Postcomm does not rely so heavily on the reopening clause for a managing risk. Royal Mail sets out several alternative ways of addressing areas of significant risk;

Royal Mail believes that with risks managed more appropriately as discussed in the response, the duration of the price control could be up to 5 years.


DOWNSIDE RISKS

13.2 In Postcomm’s document there is some recognition of the financial exposure from risks relating to mail lost to competitors, lower efficiency improvements, downturns in quality of service and adverse movements in pension deficit payments. However, its analysis only considers the first three of these. It does not analyse the potential impact of change to the pension deficit payments nor the potential impact of industrial action. Its analysis also potentially understates the scale of the risks involved, not only on an individual basis but also by not considering the combination of several simultaneous and plausible adverse effects.

Mail transferred to entrants

13.3 For setting the control, Postcomm’s document sets a projection of total volume that is similar to that forecast by Royal Mail, but with significantly more end-to-end volumes and much lower access traffic. This has the effect of improving the financial position of Royal Mail within its modelling relative to that envisaged by Royal Mail. Royal Mail believes that the basis for Postcomm’s higher end to end volume case uses an approach to forecasting that is flawed (as discussed in Section 12).

13.4 From its better financial start point, Postcomm’s document recognises there is uncertainty as to what mail volumes will do in the future and how entrants will respond to full market opening:

‘Postcomm recognises that forecasting volumes is inherently a difficult process and i is almost cer ain that any forecast will turn out to be wrong when ompared to the outturn.’ (8.56)

tt c

13.5 Postcomm considers two scenarios with downside volumes relative to its main case. The first, relating to a 10% lower volume case presented by Postcomm (8.127), pays no regard to the fact that, following Postcomm’s decision to fully open the market from January 2006, survey analysis undertaken for Royal Mail and already presented to Postcomm indicates that potentially over 80% of end-to-end mail is contestable and a substantial part of it could transfer from Royal Mail in the future. The second, relating to a high access volume case considered by Postcomm (8.127), is less significant than a case where volume is lost to by-pass (provided that the access price is set appropriately). A significant tranche of Economics literature has set out and explained that the financial impact on the USP from mail loss to bypass is more significant than loss to access (provided that the access price is set appropriately) because of the loss of contribution to

the fixed network costs arising from bypass 58.

13.6 Royal Mail’s financial position is also weaker in a downside scenario relative to that modelled by Postcomm owing to the speed of response to volume reduction considered. Postcomm’s analysis makes unrealistic assumptions relating to the speed with which costs can be removed in the event of volume reductions. Royal Mail has submitted evidence to support its case, including evidence from the US.

ct


58 See, for example, 2005, De Donder P, Cremer H, Rodriguez F, ‘Access Pricing and the Uniform Tariff in the Postal Sector’ in ‘Regulatory and Economic Challenges in the Postal and Delivery Se or’ edited by M.A Crew and P.R. Kleindorfer, Boston, MA: Kluwer Academics Publishers.

Lower efficiency improvements

13.7 Postcomm’s proposals assume a real reduction in real unit operating expenditure of 3% per annum (in constant volume and mix). This is reported in LECG’s report (26.44). Postcomm’s sensitivity analysis considers a scenario in which the real reduction in real unit operating expenditure is 2%p.a. (in constant volume and mix). This would require a test on the financeability of a 1%p.a. lower efficiency improvement

13.8 Royal Mail sets out its response to the appropriate level of the RUOE for setting the control in Section 12.

13.9 Royal Mail notes that LECG’s report identifies the long-term annual scope for RUOE reduction to be around 0% p.a.; Royal Mail’s response to the LECG report amends LECG’s analysis but is consistent with this conclusion. Consequently, Royal Mail believes that the sensitivity analysis on efficiency alone should assess the financeability of Royal Mail under such a scenario. Given an RUOE of 1.5% for a central case scenario, a test of financeability on efficiency alone should include a scenario whereby one of the adjustments is a 1.5%p.a. lower efficiency improvement.

Quality of service

13.10 Postcomm’s proposal for setting the level of the control assumes no failure of service quality targets. However, Postcomm proposes significant penalties for failure of service quality. Failure of service quality then has two significant impacts, firstly it increases the likelihood of volume loss to entrants and secondly it directly worsens the cash flow position. Hence Postcomm’s proposals involve double jeopardy – something that was avoided in telecommunications where no C-factor has been applied.

13.11 In addition, Postcomm’s document proposes no means of increasing its allowed revenue through outperformance of the targets. Hence the risk is one sided.

13.12 Further, regarding the scale of downside exposure, Postcomm’s document stated that

‘Postcomm has estimated the maximum amount of money that Royal Mail would have to pay back tocustomers via bulk compensation or through the ‘C’ factor as about £280m.’ (8.133)

c

– t t

13.13 Postcomm’s proposed maximum revenue exposure for quality of service failure of £280m of its price-controlled area is c.160% of the c.£175m figure of its WACC x RCV, which

forms an estimate of the cash flow before ‘financing’.59

13.14 Royal Mail asked Oxera to report on the regulatory precedence and best practice regarding the level of exposure and absence of any upside for outperformance; the report is included in Annex 15. The Executive Summary makes two conclusions:

‘Two main con lusions emerge from this report.

Most of the UK regula ors tend to favour a two-sided incentive scheme of penal ies and rewards as a way of creating adequate incentives for the companies to achieve service standards. Of all the sectors reviewed in this report, the only example with a one-sided incentive scheme is BAA’s London airports. However, the industry


59 This proposed maximum revenue exposure would be equivalent to around 98% of the proposed regulatory profit before this financial exposure, which, according to Postcomm, would be of about £285m on average per year.

regulator expressed no automatic preference for a one-sided scheme, acknowledging the advantages o two-sided incentives. Therefore, Postcomm’s one-sided incen ive approach appears to be out of line with the regulatory trends in other UK sectors.

f t

– t s r

r t

t

The levels of profit60 exposure of other UK regulated u ilitie vary conside ably, but are typically limited to a mid-range of around 15% of allowed profits, and do not exceed around 40%. In the case of BT, the p ice con rol has never included a financial exposure for service quality failure. In the case of the railways, the level of exposure isunlimited, although in the three years to April 2004, the average has not exceeded 70% (including the Hatfield derailmen ). Consequently, the level of financial exposure for service quality failure proposed by Postcomm is not generally supported by regulatory precedent and appears to be out of line with all other UK regulators.’

13.15 Royal Mail believes that Postcomm’s proposals for the financial level of exposure for quality of service failure are at odds with regulatory precedent. Given the RCVxWACC allowance within Postcomm’s proposals of c.£175m for the price controlled area, Royal Mail believes that regulatory precedent indicates that a mid-range figure would need to be c.£30m (i.e. 15% of c.£175m) for the price controlled area.

13.16 Royal Mail believes that the financial exposure for failure of service targets should take account of the impact of reduced quality of service on volumes and the level of expected allowed profit (as measured by WACCx RCV).

13.17 Further, Royal Mail also believes that Postcomm’s proposals for the financial level of exposure for quality of service underperformance to lead to an adverse financial impact and quality of service outperformance to lead to no financial reward is at odds with regulatory precedent. Royal Mail believes that this should be addressed in Postcomm’s final proposals.

Industrial action

13.18 Postcomm’s document does not consider a scenario where there is significant industrial action. The high proportion of its costs being related to labour means that industrial action remains a significant risk for Royal Mail. Indeed, industrial action adds a further downside risk to the level of exposure to quality of service failure. Industrial action does not just impact on quality and hence penalties. It also impacts on mail lost to competitors or other media, or just lost altogether.

13.19 This is further exacerbated by the need for significant change as set out in the Royal Mail’s plan, the direction of which is supported by LECG. Royal Mail will need to make many major changes in order to become more efficient and competitive. These changes could lead to protracted industrial action, particularly if Royal Mail is not fully funded under the control to provide the rewards scheme built into the plan.


60 The definition of allowed profits used by Postcomm to arrive at the estimate of £285m is unclear in the Initial Prpposals document. Postcomm has stated that the profit allowance will be set as a weighted average cost of capital (WACC) multiplied by Royal Mail’s regulatory asset base (RAB). See, for example, Postcomm2005), op. cit. para A4.5. To arrive at the profit allowance of £285m per year, the regulator has used a pre-tax cost of capital of 8% and opening RCV of £2.203 billion, and Postcomm’s assumptions on how the RCV should roll forward (see Postcomm 2005, op. cit. para A4.46). However, WACC*RCV does not result in £285m per year. If the allowed profit is measured assuming WACC*RCV = £176m, the profit exposure to service quality incentives would exceed 100%.

Pensions

13.20 Postcomm’s document does not assess the financial impact of an adverse movement in pension deficit payments within its sensitivity analysis. It proposes an opex allowance for the pension deficit in setting the control, with no passthrough.

13.21 In response, Royal Mail believes that Postcomm’s proposals would expose Royal Mail to significant downside risk on pension. This arises from the potential re-evaluation of the deficit and other elements during the period of the control (see Section 12).

13.22 Regarding its approach to pension deficit payments, Postcomm’s document states:

‘Under such an approach Royal Mail would be expected to make contributions a leas consisten with the allowance. Postcomm would review at the time of set ing he nex control the reasonableness of Royal Mail’s contributions.’ (8.92).

t tt t t t

t t tt

t tt

t t

13.23 This statement appears to imply that Postcomm expects Royal Mail to make pension deficit payments that equal or exceed Postcomm’s allowance and that the benefit of any underpayment may be recouped in the setting of the subsequent control. This would expose Royal Mail to the risk of pension deficit payments above its allowance having to be paid out of profit – a risk that would be asymmetric in the sense that Royal Mail is only penalised and not rewarded.

13.24 Further, Postcomm’s document appears to recognise that the risk to Royal Mail could be significant stating:

‘Given the size of the pension defici and the impor ance of the issues, Pos comm would welcome views on the advan ages and disadvantages of passthrough.’ (8.93).

and that pension deficit payments are volatile and not necessarily under management control:

‘Allowing all costs to be passed through can have certain advantages as pension contributions by their nature are volatile and to an extent can be considered to be outside of management control.’ (8.90).

POSTCOMM’S RELIANCE ON THE REOPENING CLAUSE

13.25 Royal Mail believes Postcomm places heavy reliance on a reopening clause within its draft licence modification. Royal Mail regards the degree of reliance on this clause to be excessive and contrary to Postcomm’s own stated objective to treat Royal Mail as an independent commercial business.

13.26 Postcomm recognises a degree of risk in its proposals and clearly sees the reopening clause as a major means for addressing such risk.

‘Postcomm proposes to retain the presen mechanism within the price control tha allows Royal Mail to seek a “re-opening” of the price control if it were o believe there was a significant risk to its ability to finance i s licensed activities. Royal Mail has no used this provision under the present control. However, its proposed continuation recognises thatthere are some risks that could possibly have severe financial consequences for Royal Mail and jeopardise its ability to provide price controlled services.” (s25)


13.27 Postcomm’s first step is to allow some profit margin as a cushion and require Royal Mail to reduce costs further. Postcomm believes that any downside should be managed through lower costs,

‘Postcomm believes tha the price con ol should give Royal Mail strong incentives to manage he risks associated with this business, rather than seeking recourse to provisions allowing i s price con rol to be changed if out urn costs are higher then forecast when the control is set’ (5.21),

t trt t t t

f t t

trt

t

t t tt t

t tr

t t

t

tt

t t t

t tt t

and that a profit has been added solely as a cushion against shocks as

‘Postcomm has also taken account o he major risks Royal Mail faces in set ing the cost of capital and profit allowance’.

13.28 Postcomm’s second step is to emphasise a fallback position. In respect of the risk of setting the control using equi-proportional mark-ups and two baskets

‘Postcomm believes that the risk can be managed through the price con ol re-opening provisions” (6.31) “In roducing separate controls covering “captive” and “non captive” customers will prevent any price rebalancing between these groups of products within the control period, subject to provisions to re-open the con rol’ (6.32)

and in respect of the risk of pensions, Postcomm states

‘If (subsequently) i became clear tha Royal Mail’s pension defici costs had increased materially compared to the allowances made by Postcomm, such tha i might no longer beable to finance i s activities, then the re-opening mechanism will provide a safeguard tha allows Postcomm to re-examine the level of requi ed revenue to cover contributions” (8.91) and “if there is serious risk that Royal Mail cannot finance i s licensed activities in total thenthe re-opening provisions within the price control mitiga e this risk.” (8.139).

13.29 Yet Postcomm’s document does not define when the second step would be implemented. Postcomm seems to wish to portray the re-opener as a real possibility without properly defining the conditions under which it would be implemented:

‘If events outside of Royal Mail’s reasonable con rol adversely affect its financial position then the reopening provision in the price control could be used” (8.139)

and

‘It is impor ant to bear in mind that Postcomm is proposing to include a re-opening provision in he price control in the event that Royal Mail’s financial position were to deteriora e to such an exten that its abili y to provide the universal service and finance itsother licensed activities was in doubt”. (8.141)

and

‘Postcomm believes tha a more precise defini ion [mechanism] could distort Royal Mail’s behaviour and any applica ion by Royal Mail to re-open the con rol is likely to reflect a unique [undefinable] set of circumstances, which might or might not fit guidance’.

13.30 Hence Postcomm sees some margin arising from the RCVxWACC multiple as its first lever for ensuring the financial viability of Royal Mail and sees the reopening clause as its second lever.

13.31 Royal Mail believes that such a heavy reliance on a discretionary re-opening clause of this type is inappropriate in the light of the scale of the risks involved and illustrated above.


Firstly, Royal Mail does not believe that Postcomm’s approach is consistent with its own stated objective of treating Royal Mail as an independent, commercial business. On the contrary, its proposals increase Royal Mail’s potential reliance on the regulator to intervene to a level that Royal Mail believes is unprecedented within good regulatory practice and therefore would be unacceptable to any independent commercial business. Secondly, Royal Mail believes that there could be significant delay in reviewing the financial position at the time of an application to reopen the control under the clause, during which time the position could deteriorate further.

13.32 Royal Mail proceeds to set out how some of these risks could be addressed by second levers such that the reliance on the re-opening clause is reduced to a third lever.

APPROPRIATE WAYS TO MANAGE SIGNIFICANT RISKS

13.33 Royal Mail believes the potential risks associated with the downside scenarios are particularly significant for it given the relatively low cash flow before dividends -which averages a little over £200m pa for Royal Mail’s central planning scenario, as described in the previous section. Royal Mail believes that the means of addressing risk more appropriately are to increase cash flow and revenue allowance or (and potentially more efficiently) to more directly address such risks to ensure the financeability of Royal Mail against such downside scenarios. Royal Mail believes that these are well within the capability of Postcomm and are reasonable and appropriate means of better managing risk for Royal Mail. Royal Mail believes that with risks managed more appropriately as discussed in the response, the duration of the price control could be 4 or 5 years.

Mail transferred to entrants

13.34 In setting the control, Royal Mail believes it is important to assess the impact of a downturn in volumes that is feasible and significant and to put a mechanism in place that would secure the financial position of the business while the situation was reviewed. This would support Postcomm’s primary duty to ensure the provision of the universal postal service. Royal Mail set out such a mechanism in its December 2004 response to Postcomm’s request for clarification as to how such a mechanism could operate. Royal Mail believes that this follows regulatory best practice within the CAA for NATS and other regulated businesses where there are potentially both fixed and variable costs present. Given Postcomm’s acknowledgement of the uncertainty around volumes, its recognition that there are fixed costs within the network (particularly in delivery) and the magnitude of the risk, Royal Mail does not understand why it is not prepared to engage in managing this risk appropriately through such a mechanism. Royal Mail believes that by failing to do so Postcomm is failing also to demonstrate that it is meeting its primary duty with regard to ensuring the provision of the universal postal service.

13.35 Such a mechanism should ensure that the financial ratios are met in the event of a significant downturn in volumes. Royal Mail believes this could be implemented with revenues increased to a degree if volumes fall below those used to set the control by certain limits and revenues reduced to the same degree if volumes exceed those used to set the control to the same extent.


Lower efficiency improvement

13.36 Royal Mail believes that the financial position of the business under Postcomm’s proposals, as measured by the appropriate financial ratios (see Section 10), should be sufficient to withstand a RUOE at the long-term level of 0%. In the event that the financial ratios are not met in such a scenario, an additional margin should be added in setting the control to ensure the revenues satisfy the financial ratios in such a scenario.

13.37 Further, Royal Mail also believes that its financial position under Postcomm’s proposals should be sufficient to withstand both a downturn in volumes and reduction in the RUOE. Such a case is developed at the end of this section.

Quality of Service

13.38 Royal Mail believes that the maximum financial exposure for failure of service targets should be between 0% and 15% of the allowed profit (as measured by the WACCxRAB). Royal Mail believes that such levels reflect both the impact of quality of service failure on volumes in a developing competitive postal market and regulatory precedence in other UK regulated sectors.

13.39 Further, Royal Mail also believes that its financial position under Postcomm’s proposals should be sufficient to withstand both a downturn in volumes, reduction in RUOE and full service failure of its network. Such a case is developed at the end of this section.

13.40 Further, Royal Mail believes that any C-factor should have incentives for outperformance, with increased allowed revenue, and penalties, with reduced allowed revenue for underperformance.

Industrial Action

13.41 Royal Mail believes that there should be an exemption from the full impact of major industrial action on quality of service penalties provided that Royal Mail has taken all reasonable steps both to prevent the circumstances from occurring and to prevent them from having that effect. It believes Postcomm should do this as part of the incentives for change and efficiency that it too seeks for the business.

Pensions

13.42 Postcomm’s document recognises the regulatory precedence for the passthrough of pensions:

‘Ofgem adopted such an approach for a la ge majority of the pensions costs of the electricitydistribution companies. The CAA is also allowing NATS to pass through contributions on cash terms for existing members on existent terms’ (8.90)

r

13.43 Postcomm states that this preference arises from a concern that passthrough could lead to Royal Mail and the Trustees agreeing excessively large deficit payments.

13.44 The regulatory precedent of a passthrough of pensions is supported by financial institutions. This provides the means of securing funds to cover the pension deficit liability that appears on the company’s financial statement.


13.45 insofar as increased levels of contributions cover these deficits, have been included in setting their price limits.

13.46 Postcomm proposes an RPI-X form of the control with RPI as the indexation; Royal Mail agrees that the form of the control should be RPI-X with RPI as the measure of indexation but Royal Mail believes that there should be a P0 adjustment to reflect the step up in costs to recover pension deficit before the application of efficiency through the X.

13.47 In addition, Royal Mail believes that pension deficit movements from this allowance should be made to facilitate the pass-though of pension costs. Further it believes that Postcomm’s concern could be addressed by setting the period over which the deficit is to be funded, while allowing the other inputs into the actuarial calculation to vary to reflect the volatility of the deficit. Indeed, Royal Mail gives assurance that it would not seek to pass through any reductions in the repayment period during the duration of the next price control from that proposed in this submission in the event that the Trustees seek a faster repayment. The passthrough would therefore be restricted to differences between currently assumed figures and actual deficit calculations following the March 2006 valuation. The pension deficit payments could then be treated as passthrough with the calculation forming part of the annual audit under LC19.

THE FINANCEABILITY OF ROYAL MAIL’S UDATED PLAN: DOWNSIDE SCENARIO

13.48 Royal Mail has developed a downside scenario to test the financial viability of the business under the P0 and X values presented in Table 12.4 of this response from Royal Mail’s updated plan.

13.49 The downside scenario considers a case where volumes and efficiency outturn lower than the projection underpinning Table 12.4. Use is made of the low volume scenario set out in the BPQ submission in January 2005 and in particular the entry and phasing risks identified there61. Compared with the central case these imply a higher level of bypass entry by a factor of 1.2 (but lower access by a factor of 0.8) with the pace of entry accelerated by two years so that the full impact of market opening is projected to occur by 2010/11 rather than 2012/13 as in the central case. Additionally, underlying efficiency improvement is 0.5% per annum rather than 1.5% per annum as in the central case.

13.50 These changes to the central case are relatively modest and well within the scale of risk faced by Royal Mail. For example, volumes could be lower also through greater e-substitution and/or an economic recession, the two other risks included in the low volume scenario in the January 2005 BPQ submission

13.51 To this scenario Royal Mail would also add the potential downside arising from Postcomm’s current proposals for recovery of the pension deficit. However, this would not be necessary in the event of pension deficit payment passthrough as proposed by Royal Mail. It has not been added to the scenarios on the assumption that a passthrough of pension costs will be included in the final proposals, and to focus attention the remaining major risk to the financial viability of the business that should be addressed more directly within the first and second levers available to Postcomm and before reliance of the reopening clause as the third lever.


61 Royal Mail. Business Plan Questionnaire Submission, January 2005(Ref. No. 2032)

13.52 The cash flow (before dividends) results of the downside scenario are shown in Table 13.1, using the P0 and X results from Table 12.4, using Postcomm’s financial model. As noted in Section 12, this work is preliminary and subject to further review. The downside scenario implies that Royal Mail could be in a situation of broadly neutral cash flows before dividends. Even if, in the short run, Royal Mail and its shareholder could absorb the financial implications of such a scenario, this is not sustainable as it does not allow for an adequate renumeration for its investor. The underlying cashflow position deteriorates through the period of the control as volumes follow a worsening trend and, in the last year, has negative cashflow before dividends. In subsequent years the position deteriorates further.

Table 13.1: Letter Business Results from the Downside Scenarios for Royal Mail’s updated Plan assuming the P0 and X in Table 12.4


increase

%


%


£m

Final year cashflow before dividends

£m

Scenario in a 4 year control RPI+8.0 RPI 30 -30

Source: Royal Mail’s update of Postcomm’s financial model with Royal Mail data, all figures are rounded.

13.53 The scenario demonstrates the need to manage risks more directly than proposed by Postcomm. Royal Mail has not set out in detail how each mechanism should be parameterised in this response. Royal Mail believes that this should be done in meeting with members from the regulator’s team, building on the outline presented in Royal Mail’s December response in the case of volumes and the factors identified in this response. Royal Mail believes this should be progressed as a matter of urgency.


Response to Postcomm’s initial proposals for the 2006 ... · 6 COVERAGE OVERVIEW 6.1 This section...

Documents

Transcript of Response to Postcomm’s initial proposals for the 2006 ... · 6 COVERAGE OVERVIEW 6.1 This section...