House of Commons - The Postal Services Bill - Business and Enterprise Committee

The Postal Services Bill - Business and Enterprise Committee Contents

2 The problems facing Royal Mail

Royal Mail Group's financial position

14. Royal Mail Group contains a number of businesses. They are:

Royal Mail: the core postal service, which includes the letters and packets business;

GLS, General Logistics Systems, a pan-european company offering parcel and express services, and other logistics services (acquired from German Parcel);[13]
Parcelforce Worldwide, the express parcel service (the UK arm of GLS);
Post Office Ltd, the company which runs the post office network.

15. It is important to remember that all Royal Mail Group's yearly figures must be considered in the context of its pension deficit. As Postcomm said during the last price review, "The value of the deficit on an FRS17 basis is twice the value of Royal Mail's net assets."[14] Royal Mail Group is balance sheet insolvent.

16. In 2007-08 while the Group overall made a small profit, Royal Mail, the letters part of the business, made an operating loss of £3 million. According to the Independent Review, it was the least profitable postal company among its West European peers, and the only one to make an operating loss.[15] The Group's most recent results are more promising; its third-quarter trading results showed that for the first time in almost 20 years all the group business units, including Royal Mail itself, were in profit, and that profit for the year was likely to be nearly double that for the previous year.[16] Nonetheless, a profit of some £320 million on group revenue which can be expected to be over £9 billion is hardly impressive.[17]

17. However, other postal companies are also suffering as a result of the loss of volumes to other communications media, the general economic situation, and their individual circumstances. On 25 February Deutsche Post reported a net loss of for 2008 of €1.69 billion largely caused by restructuring the US express division (DHL); we also note that part of this loss came from losses at the Postbank unit.[18] On 16 February, TNT revealed that its profits had dropped sharply. The Times reported that "earnings before interest and tax totalled only €160 million (£143.5 million) in the fourth quarter, down from €253 million at the same time last year. The group warned that it was continuing to experience tough trading."[19]

Market pressures

18. As Modernise or decline sets out, the letters market is in decline, in large part because of the rise of other forms of communication. The universal service provider can take some action to stem the decline, but it has only limited powers to do so. The first chapter of the Independent Review sets out the challenges facing the UK letters market as a whole. Changes in letter volumes are no longer related to economic performance. Whereas in the past a 1% change in GDP has led to a 1% change in mail growth, in the last few years entirely new technologies such as broadband Internet, e-mail, mobile telephony and digital broadcasting have entered the mix. They offer significant competition to mail services.

19. Mr Crozier told us:

Our market and some others are undergoing a fundamental structural shift. Everyone in this room is communicating differently; we text, phone, email and do all sorts of different things. That will not change; it will carry on into the future. Therefore, it is absolutely vital that we have to generate, like parcels, new revenue streams utilising our great skills, our network and the fact that we are everywhere every day and building new products on that. We believe that in five years' time 75% of our profit will come from parcels. That tells you in a nutshell what is happening to the letters business and in e-commerce.[20]

20. The effect of changes in letters volumes on the Royal Mail Group's finances is substantial; Mr Crozier told us that "as a ready reckoner, each percent of volume decline costs us about £70 million in revenue."[21] Royal Mail Group expects that letters volumes will decline by 4.5% in the current year and by 8% next year. That would mean a reduction in revenue of £315 million this year and a further £560 million next - £875 million over two years.

21. There is no easy solution to the decline in mail volumes. As Modernise or decline explains, raising prices may simply reduce demand:

Price rises are becoming less effective at generating additional revenue for Royal Mail. When Royal Mail increased the price of its products in 2007-08 by a weighted average of 5%, for example, revenues fell slightly

And

The fact that prices in the UK are low relative to many other European countries suggests that there is scope for an increase (see Figure 18). Yet any aggressive increase in prices could prompt a faster movement away from mail to electronic media, compounding the problem of declining volumes and revenues rather than solving it. This places even more emphasis on the need to reduce costs.[22]

Efficiency

22. Modernise or Decline was scathing about Royal Mail's lack of efficiency. It considered: "Royal Mail is much less efficient and less profitable than its main European peers."[23] It noted that "The company was the least profitable postal company amongst its Western European peers, and the only one to make an operating loss."[24]

23. The review gave five reasons for this relative inefficiency. The first four were as follows:

the network mail centres and delivery offices, which had not been rationalised;
the lack of automation in sorting and walk-sequencing;
inefficient working practices;
pay set above market rates, leading to a situation in which labour costs at Royal Mail Group were among the highest of European postal companies.

However the fifth was the high pension contributions necessary as the result of the deficit. We do not consider this deficit to be an efficiency issue, in the same sense as the other problems identified.

24. The Review claimed:

While access competition has added to Royal Mail's pressures, … its impact has been limited. Without competition in the postal market, Royal Mail might have made a 1.4% operating profit margin.

The company's operating profit margin would have been significantly higher — 4.3% — were it not for pension costs having been set at levels well above industry standards. This has clearly been a significant constraint on the business and has been addressed by recent amendments to the pension scheme.

It is the other sources of Royal Mail's inefficiency, compared with leading European counterparts, which have the most significant impact on the company's operating profitability and long-term financial health. The comparison suggests that Royal Mail could have achieved a 7.8% operating profit margin if it had reduced costs and generated new sources of revenue to the same extent as modernised companies in The Netherlands and Germany, for example.[25]

25. In contrast, the CWU considered that there was little empirical evidence to support the review's claims of inefficiency. Mr Hayes, the General Secretary, told us that comparisons between wage rates and revenues were inappropriate, because they did not take account of higher postal prices in other countries.[26] Current inefficiency was also the result of underinvestment in previous years. Mr Baugh, the Union's head of Research, told us:

The point about inefficiency and Royal Mail's efficiency is that it is linked to a chronic lack of investment, it is linked to an unfair regulatory regime and unfair access regime which is draining Royal Mail's profits and it is also related to the point you have just made about lower prices relative to the rest of Europe. You should look at all those three elements if you want a proper assessment of Royal Mail's relative efficiency.[27]

26. Royal Mail Group's Accounts for 2006-07 estimated that the company was 40% less efficient than its competitors. In evidence to us Adam Crozier, Royal Mail's Chief Executive, suggested that this was now slightly less, but agreed that the difference was substantial. He claimed:

If you look across Europe in every market every incumbent, i.e. the original operator, is less efficient and pays more than any of the new entrants. If you think about it, that is probably true in most markets, not just in postal services. Competitors come in without the cost base and all the other obligations. You pay people less and so on. Clearly, we are more expensive; our pensions are more expensive. For example, despite all the changes we made to our future pensions the company contributions per person are still about 20%. Our competitors probably pay between 5% and 7% as we now pay for new entrants. That is a huge differential. We do not disagree that despite losing 50,000 people and improving efficiency dramatically we are still inefficient.[28]

The industry regulator, Postcomm, has repeatedly expressed its frustration with Royal Mail Group's inability to reduce costs.

27. Although there are disputes over the extent and causes of Royal Mail Group's inefficiency, it is clear that Royal Mail Group is less efficient than its competitors. Clearly, any decision about the company's future has to address this.

Labour relations

28. Some of the inefficiencies that the review points out are linked to working practices. An agreement for modernisation was reached in 2007 after lengthy negotiation, which included industrial action by the CWU. As the review notes, the effect of the dispute was:

In 2007, over 627,000 employee days were lost as a result of industrial action, the highest total since 1996. This represented 60% of days lost to strikes across the whole of the UK economy in 2007.[29]

The Trade and Industry Committee took evidence on the industrial action from the then Secretary of State for Trade and Industry, Mr John Hutton MP, on 22 October 2007. He said:

if it[Royal Mail] is going to really thrive in this more competitive market place a fundamental pre-condition for that will be that everyone in the organisation shares the challenge and they trust each other to deliver it. Of course, it is going to be much harder to make these changes if there is an absence of trust in the organisation. Trust might well have been affected by all of these debates and problems in the last few months and the industrial action; it is fairly clear it probably has, but the focus now, I would respectfully suggest, now I think we are closer to getting this agreement ratified, is to try if we can to put that behind us and focus on the challenge ahead because it is a big challenge.[30]

29. Mr Crozier told us that the relationship between the company and CWU leadership had significantly improved, but the union structure did not make it easy for that leadership to implement the agreements reached.[31]

I think the union's structure itself sometimes works against what we and in many ways the union leadership think needs to be done. For example, even if you come to a national agreement the union's structure is such that every branch is at liberty to decide whether or not it wants to take part in it. One matter we have suggested - I wrote to Billy Hayes about it recently - is that if, as Hooper suggested, what is needed is for the union itself to modernise its structure we shall be very happy to work with the TUC and whatever best practice might look like for the structure of the union irrespective of its cost we will help them to implement it and pay for it. If we get that best practice structure so that the union leaders feel we are on the same side it will be helpful not just to us but to them.[32]

30. In its final response to the Independent Review, the CWU says:

The Secretary of State has argued that the UK doesn't have the management expertise to modernise Royal Mail. We reject this view. It represents a tacit admission that the Government's own appointment of Allan Leighton and Adam Crozier as Chair and Chief Executive has failed to deliver required modernisation. Yet it is also an unfounded and uncharitable view of UK management in a country that founded the very concept of a national postal service which has been used as a model by the rest of the world.

The CWU believe the UK has the management expertise - what we need is people appointed to run Royal Mail committed to the principles of a modern public enterprise, with experience of public service provision and who are prepared to sit down and negotiate change with the recognised trade union.[33]

We note that this is far from a vote of confidence in the current management.

POLITICAL CONTEXT

31. Modernise or decline suggests that poor labour relations are, in part, a product of the fact that the Government owns Royal Mail:

These difficulties are exacerbated by a lack of understanding about the Government's role as Royal Mail's sole shareholder. However strongly the Government emphasises that Royal Mail must follow commercial objectives, the union perceives that it is in the interests of its members to encourage Ministers to intervene in the management of the company. This would be the case irrespective of which political party forms the Government.[34]

We ourselves were struck by the fact that when the CWU was asked "do you believe that modernisation is possible under the present management structure and indeed personnel?" Mr Hayes responded as follows:

It was possible under the Conservative Government during the 1980s; a lot of change took place under a Conservative Government and there is no reason why it cannot take place under a Labour Government.[35]

32. Whether or not the Postal Services Bill [Lords] is enacted in its current form, the country needs a modern, efficient Royal Mail Group. Good labour relations are essential to achieve this. It is clear to us, from our previous experience as the Trade and Industry Committee, that in the past there have been faults on both sides. If Royal Mail Group is to have a prosperous future, whether or not it remains in the public sector, both sides must change. Royal Mail Group must ensure that its current rhetoric is matched by its actions. The unions must accept that negotiations on working practices are not a matter for Government, and that national agreements should be honoured. We emphasise that this relates to matters of day-to-day management; it is of course legitimate for the union to raise matters such as the ownership of Royal Mail Group with the shareholder — Government — and therefore with Parliament. But both Government and Parliament must be confident that the management issues can be properly addressed by the company itself.

Investment plans

33. In 2006 the Government provided Royal Mail Group with a loan of £1.2 billion to fund modernisation. When he appeared before us, Lord Mandelson suggested that the fact that only half of that money had been spent was an indication of Royal Mail Group's inefficiency. The delay in spending the loan also concerned the unions, and led them to question the competence of management. However, Mr Crozier told us that

Those funds were there to cover a five-year period and clearly we would need to be shot if we spent all of it in the first year because we would then have no money left. Therefore, that money is allocated and we know what we are doing with it.[36]

New machines for automatic sorting had been ordered, and would be paid for on delivery. As such machines have to be built individually, there was an inevitable delay in expenditure.

Royal Mail Group and the universal service obligation

34. The size of the mail market will fluctuate. The market increased significantly as a result of the growth in direct mailing; it is now decreasing as it faces competition from other communications channels. However, not everything can be e-substituted. There will always be a need for the physical transport of letters and parcels throughout the United Kingdom. We make this Report in the confident assumption that the universal service obligation for postal services is necessary for the United Kingdom. There is no doubt that, as the Independent Review of the Postal Services Sector said, "the ability to deliver items toward 28 million business and residential addresses in the UK is part of our economic and social glue."

35. Whatever the problems facing Royal Mail Group, it is generally agreed that it is the only company currently able to fulfil the Universal Postal Service Obligation. Royal Mail Group is charged with the universal service obligation, and if the obligation is to be sustained, Royal Mail Group needs a suitable financial and regulatory framework. The Independent Review concluded that these were not currently in place, and we agree, in the words of its report, that the status quo is not an option. But that does not mean that the package of changes proposed by the Government is the only way forward.

13 http://www.supplychainleaders.com/provider/general-logistics-systems-gls/185/ Back

14 Postcomm, 2006 Royal Mail Price and Service Quality Review: Initial Proposals, June 2005, S. 21 Back

15 Cm 7529, p 10 Back

16 Royal Mail Group News Release, Third quarter, Trading Update, 21/01/09 Back

17 Trading profit for the first thee quarters of the year was £255m; RMG forecasts whole year profits "nearly double the £162m achieved in 2007-08".Revenue for the current year is 3% above that last year: revenue for 2007-08 was £9,388bn Back

18 Deutsche Post "Deutsche Post World Net meets 2008 operating target - focus 2009 on cost and the businessperformance", http://www.dpwn.de/dpwn?tab=1&skin=hi&check=yes&lang=de_EN&xmlFile=2010661 Back

19 http://business.timesonline.co.uk/tol/business/industry_sectors/industrials/article5744256.ece Back

20 Q 272 Back

21 Q 266 Back