Business, Innovation and Skills Committee - Minutes of EvidenceHC1841-i

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House of COMMONS

Oral EVIDENCE

TAKEN BEFORE the

Business, Innovation and Skills Committee

Stamp price REGULATION

TUESDAY 21 February 2012

STUART MCINTOSH, CHRIS ROWSELL AND GAVIN KNOTT

ADAM SCORER AND ROBERT HAMMOND

Evidence heard in Public Questions 1 - 73

USE OF THE TRANSCRIPT

Oral Evidence

Taken before the Business, Innovation and Skills Committee

on Tuesday 21 February 2012

Members present:

Mr Adrian Bailey (Chair)

Mr Brian Binley

Paul Blomfield

Katy Clark

Rebecca Harris

Simon Kirby

Ann McKechin

Mr David Ward

Nadhim Zahawi

________________

Examination of Witnesses

Witnesses: Stuart McIntosh, Group Director of Competition, Chris Rowsell, Competition Policy Director, and Gavin Knott, Postal Services Competition Specialist, Ofcom, gave evidence.

Q1 Chair: Welcome back, and thank you for agreeing to speak to us again. If you would like to introduce yourselves for voice transcription purposes, that would be helpful.

Stuart McIntosh: My name is Stuart McIntosh. I am an Executive Member of the Ofcom Board. I lead the Competition Group within Ofcom, which is primarily responsible for the work that we are doing on the regulation of post. On my left is Chris Rowsell, a colleague from my group who is leading the work on what we call the economic framework for the regulation of post. On my right is Gavin Knott, also a colleague from my group. Gavin is working on the economic framework as well; he joined us from Postcomm, so has provided continuity from the previous regulator to the current position.

Q2 Chair: Thank you very much. We have 45 minutes, so want to crack on quickly. While we have quite a few questions, do not feel that all of you have to answer all of them; only respond if you need to add to or subtract from anything that is said by the previous speaker. Can I just start the ball rolling? Following the consultation that ended in January, can you outline the main price regulation options being considered, and what the pros and cons are of each?

Stuart McIntosh: I will take a minute to provide a bit of context, because that is very important in terms of understanding the options. We assumed responsibility for regulating the postal sector in October of last year. We found an industry facing very significant structural challenges: demand volumes in the sector have declined by over 25% over the past five to six years. Royal Mail-as you know and understand-was not making profits and, indeed, was incurring significant losses in its traditional mail business. That situation seemed to be deteriorating. Notwithstanding the fact that Royal Mail had been making quite significant investments in the modernisation of its operations, it appeared at that point to be struggling to realise efficiency savings to keep up with the reductions in demand. That was the industry context we found.

To some extent the situation that the industry was in was compounded by the regulatory framework. This is not a criticism of my colleagues from Postcomm; with the benefit of hindsight, we would all do things differently. There was an environment where charge controls or restrictions applied to the vast majority of Royal Mail’s revenues. The specific core controls on mail revenues were too tight in light of what had subsequently happened in terms of the level of demand. There were also arrangements that were very advantageous to Royal Mail with regard to access to their network by other providers, who take advantage of Royal Mail’s network to deliver mail. Compounding all of that was quite a restrictive regulatory environment, in many respects similar to the regulatory controls that used to apply to BT going back 10 or 15 years: a licence-based regime where the regulator was very intimately involved in a lot of the detailed decision making.

That was the context we found: it was covered in considerable detail by Richard Hooper in his two reports on the sector. That led to the passage of the Postal Services Act last year, where we in Ofcom were given the primary responsibility to discharge our duties in a way that would help secure the provision of universal service. That is particularly important, because that is the key point of reference in relation to the work that we are doing in the sector and the specific options that we are considering.

As you can see from reading our document, there is a lot of detailed discussion of options in individual areas. If I could step back from that detail, there are two broad options that we have considered: one is to persevere with what might be called a traditional form of price regulation of the type that we have applied in other industries that we regulate; and the other was to adopt a different approach, which tries to deal with and respond to the specific challenges that the postal sector finds itself in today.

With the regard to the first approach-the use of price regulations-that is something we know how to do. Ofcom and Oftel, prior to Ofcom, have been implementing price control regimes for the best part of 25 years here in the UK, and in large measure have done so quite successfully from the point of view of consumers, and also in promoting competition. However, we have worried quite seriously about whether that approach is appropriate and viable in this context. The structural decline in demand for the use of postal services is ongoing: in truth, no one quite knows where this industry might proceed over the next five to 10 years. Some people suggest volumes might decline by 20%; some suggest it may decline by even more than that.

Second, because our primary duty is with regard to the provision of universal service, we felt the incentive properties that we have seen operate well in the context of BT were less likely to work well in this context. Royal Mail would always have the option of coming back to us and saying, "Universal service is threatened; we need to do something about prices." That is exactly what happened under the old regime.

The third element is we believe that Royal Mail needs a lot more flexibility than it had previously to be able to respond to this quite challenging and difficult environment. In light of that, in October we consulted on a different approach: i.e. not price regulation of a traditional form, but a different portfolio of measures, which we think is more likely to be successful in ensuring that universal service is sustained. That is built around a few things. Firstly, universal service is at the heart of it. Secondly, it removes the traditional price controls that apply to Royal Mail. It puts in place a safeguard cap specifically in the context of the second class standard letter, not as a general price control but as a measure to ensure that particularly vulnerable consumers are protected as we go through these changes over the coming years.

Thirdly, it maintains the access regime: we see real benefits from competition, and we have seen them work well in the other industries we regulate. We concluded that the way the access regime used to work was weighted against Royal Mail-we feel aspects of that need to change, and that is what we are proposing. Fourth, it establishes quite a detailed monitoring regime to determine very specifically the extent to which Royal Mail is doing what we want them to do under our duties: i.e. providing universal service and doing so in a sustainable way; to understand what is happening to its profitability; critically, to understand what is happening to the affordability of prices; and to understand what is going to happen to efficiency levels in Royal Mail. Those are the options at an aggregate level.

Q3 Chair: It was a broad question and you have given a very broad response. I would remind you that we have got 21 questions, and if everyone took that long we would be here until the division bell goes at 10 o’clock. If you could make your answers very brief, I would be grateful, and equally questions.

Stuart McIntosh: I will endeavour to be much more concise.

Q4 Chair: How did you arrive at the range of 44p to 55p for a second class letter?

Stuart McIntosh: We have done a lot of international benchmarking to understand what operators, both commercial and state owned, charge in other markets to get a sense as to what might be a reasonable commercial rate. We have provided some evidence in the consultation document, and we can provide more evidence to the Committee if that would be helpful. If you look across Europe, for example, you would typically find that in most countries where second class is provided, the price tends to be above the rate currently charged by Royal Mail, and tends to be in the range of 42p to 55/56p.

The second thing we looked at, because it is of particular concern, was affordability. We looked at how much consumers and small businesses spend on postal services to understand, if prices were to be set within this range, whether this would be a problem for vulnerable consumers. On the basis of those two considerations, and bearing in mind the need to provide Royal Mail with flexibility, we concluded that a price in the range of 45p to 55p is where that safeguard cap ought to be set.

Q5 Chair: If I can summarise that, I hope fairly, it was price comparisons with other countries and the affordability, not directly related to the cost of service. What would the cost of a second class stamp be if you just related it to the cost of the service?

Stuart McIntosh: It was not related directly to the cost of service in the way you have described, but it was indirectly, because what we are looking at is providing an environment where all the prices and revenues associated with those services are sufficient to cover costs overall.

Q6 Simon Kirby: A 53% increase: some people would say that was an outrageous increase. Surely that cannot be right in these difficult times?

Stuart McIntosh: We do not know at this stage what Royal Mail will do in the event that we do proceed with the proposals on which we consulted: we do not know what the percentage increase in the prices might be. Our primary responsibility is to ensure the provision of universal service: ensuring that mail is delivered everywhere in the country, to every address in the country, six days a week; that mail is collected either five or six days a week; and that there are uniform prices for services across the UK, and that those are sustained. There are structural changes in the industry that mean prices are going to have to change. We would almost certainly have come to exactly the same conclusion about the need for radical change had we tried to put in place a traditional charge control.

Chair: Before I bring in Paul Blomfield on vulnerable consumers, Brian wants to redefine my question.

Q7 Mr Binley: If Ofcom consider that the level of the proposed cap is somewhat arbitrary, calling it essentially a matter of judgment and saying that it would value stakeholder input and views, what would be your recommendation on second class mail price if cost and profitability of the service were the main consideration? What is a commercial rate for second class mail, ignoring other factors?

Stuart McIntosh: I am not sure I quite agree with your characterisation of it as arbitrary. Our judgment on that has been based on the need to ensure that universal service is financially sustainable, and then to take a view as to what is potentially affordable. In looking at the profitability of individual services, this is a network business, as is telecommunications and a number of others, which means there is a very large fixed cost base. It does not matter if the mail is all business or all consumer mail; the postman still has to go on his round, and he still potentially has to visit every home on that round, depending on the mail volumes that day.

The actual average cost of a letter, or particular type of letter, is very difficult to determine with great confidence, and what you have to look at is whether the overall revenues coming from the services are sufficient to cover the overall cost.

Q8 Mr Binley: Are you saying to me that you cannot establish a cost, irrespective of the factors that we are discounting?

Stuart McIntosh: One can establish a cost, and the easiest way of establishing the cost is to take the average mail volumes and divide that into the total cost. What I am saying is that it is a slightly more complicated story than that, because you need to take account of the extent to which changes in prices-

Q9 Mr Binley: Forgive me, Mr McIntosh. I said, "If those were excluded, what would be the actual cost?" I specifically asked you to exclude those, and so you are left with two sides of an equation: the first is how much does it cost to get out there, and the second is what does that end up to be, by dividing that into the number of letters that you are delivering. It is a relatively simple calculation. So how much would it be?

Stuart McIntosh: I understand fully the point you are making. It is the case that the margins-the profitability-on these services, is likely to be higher than the margins of some other-

Q10 Mr Binley: I am not asking about margins. I am asking what the cost would be if you excluded those other factors. I want to make a judgment between what you are saying is the cap and what the actual cost is, and then I can relate that judgment to the situation that you find yourselves in with regard to the service.

Chair: Yes, if you don’t know, please say so, so that we are clear about that and can move on.

Stuart McIntosh: We do have estimates of the costs of the individual services, but I am hesitant to give you a precise number at the moment in case I mislead you. We would be very happy to follow up-

Q11 Chair: Could you send us a written assessment? Thank you.

Stuart McIntosh: Yes.

Q12 Paul Blomfield: You have talked about the attention given to vulnerable consumers. Could you explain in more detail how you attempted to estimate the impact of your policies on those vulnerable consumers?

Stuart McIntosh: In looking at vulnerable consumers, we are looking at two or three classes of consumers: those on low incomes and pensions, and those with disabilities. First we looked at how much consumers use mail services. Nowadays, partly because of people using other means-telephones, email and text messages-the vast majority of consumers, whether they are vulnerable or not, do not send very much mail. It will tend to be three or four pieces per month.

We looked at that on average, and then we looked to find what information we could get in terms of lower income households and their usage of those services. While it is a little different, it is not hugely different. We were able to conclude that the average family spends less than 50p per week on mail services. With vulnerable consumers, I do not think the picture is markedly different: it may be a little different, but not hugely so. If stamp prices went up in the range that we were setting for the cap, it does not suggest that those services would be unaffordable to those vulnerable consumers.

Q13 Paul Blomfield: Not unaffordable, but did you make any assessment of what the impact in usage would be? The issue here is whether you are going to tip people into a lower level of use, and a spiral of decline.

Stuart McIntosh: It is important to remember that the vast majority of mail sent in the UK today is sent by businesses. It is a scale business, so it is dependent on the mail from them. It is possible that you would see some reduction in the level of mail, which is typically what happens when prices go up.

Q14 Paul Blomfield: Did your modelling quantify what level of reduction in use?

Stuart McIntosh: We have estimates of that: in the short term, it would not be hugely material, but it may be in the longer term. One of the points I would go on to argue is that there are many different types of mail: ensuring the mail volumes are sustained is vital to ensuring the sustainability of the universal service. One of our objectives in setting the regime as we have is to give Royal Mail the flexibility so that, with their much more detailed knowledge of the market, they are able to set prices across the market, including for stamp services, in a way that least disrupts the demand for service, so that they do not have a precipitant decline in volumes.

Q15 Paul Blomfield: When you were looking at the affordability of mail to vulnerable consumers, you drew comparisons with fuel and water costs. Would another approach have been to look at consumer behaviour: whether families would be willing to stop buying a food item to switch an extra pound to mail services? Did you explore customer behaviour in that way? Do you think there is some merit in doing that?

Stuart McIntosh: We have not yet done that fully: in the first instance our work has been concentrated around the approach I described earlier. Now that we have taken on responsibility for regulating post, as a matter of routine we are going to be tracking and looking to understand consumer behaviour in relation to the use of postal services. Just as we regularly produce information for users of telecommunications, broadcasting, and other services, we will be providing that sort of detailed information on the use of postal services by consumers in the UK. That is work that we are now starting, and it will bear fruit in the coming months and years.

Q16 Paul Blomfield: You have not got that sort of evidence available to you now to make the recommendations that you are?

Stuart McIntosh: We do not have all of that detailed evidence, but we have taken some reassurance from the fact that, if you look at the level of usage, which is three or four pieces for most families per month, and the price of the stamps, it does not appear that for the vast majority of consumers, including vulnerable consumers, price increases would be unaffordable. I am not saying that it is desirable, but it does not look as though they would be unaffordable.

Q17 Paul Blomfield: Isn’t there a difference between unaffordable and leading to significant behavioural change? That is clearly the issue we are trying to get at.

Stuart McIntosh: It has to be borne in mind that many consumers today use first class services: they elect to pay the higher price of first class services. Research done previously by Postcomm-and we are doing further research to understand this-suggests that, if you ask people what they need in terms of reliability and predictability with regard to getting the letter there at the appropriate time, it is quite possible that second class would meet most of those objectives. Were that the case, then most of those consumers could switch from first to second, and would pay very little in addition, if anything.

Q18 Paul Blomfield: Does that statement about first class usage hold good for vulnerable groups as well?

Chris Rowsell: Broadly. Vulnerable consumers or those who have disabilities use second class slightly more than other socioeconomic groups, but predominantly still use first class. They use first class slightly less, second class slightly more, but still mostly first class even when it is not time sensitive.

Q19 Paul Blomfield: Can you quantify slightly?

Chris Rowsell: I do not have the numbers in front of me. We have got a number of different research sources working on this. Consumer Focus, for example, recently provided us with some research as part of a consultation response. We have got some preliminary results from an Omnibus survey we have commissioned; Royal Mail has provided some. I could put together a short note summarising some of those different methodologies-it is quite difficult to give a precise answer.

Q20 Ann McKechin: If I could turn, Mr McIntosh, to the impact on small businesses in particular. Can I ask why you took it as your working hypothesis that small businesses can afford price increases as much as consumers, given that their usage patterns are likely to be hugely different.

Stuart McIntosh: I will ask my colleagues to come in on this question, but I will make a start. There is a body of research available that gives us an understanding of the level of spend on postal services by small businesses, and how that changes by scale of business. It does seem to be the case that many small businesses use stamp services, so insofar as they are protected by universal service, if there were changes in prices they would be affected somewhat similarly. It is also the case that small businesses do not spend huge amounts on postal services: there is quite a lot of evidence that over the years a number of those have been reducing their spend on services, because they are relying more on the use of email and other means.

Q21 Ann McKechin: It would very much depend on the sector in which they operate. A corner newsagent is not likely to use many envelopes, but someone running a small office would.

Stuart McIntosh: Absolutely, but people whose businesses are office and communications based are more inclined to use mobile phones, text, and email nowadays. Do you want to come in on numbers?

Chris Rowsell: The vast majority of SME mail is being sent by stamp, and a large proportion of it is being put into post boxes, just like residential consumers, so the safeguard cap on second class post also applies there. Businesses are more likely to use second class post than residential consumers; 71% of SMEs spend £100 or less per month on postal services, with 35% spending £25 or less a month. Rural SMEs have a lower average spend than the national average; 47% of rural SMEs have a mail spend of £1 to £25 per month. For all these universal service products, which include metered and pre-paid services, there are other discounts available and convenience benefits for SMEs who are sending larger volumes of mail.

Q22 Ann McKechin: It is a question of affordability. Why did you think there was a connection between affordability for small businesses and their profit margins and someone who is running a household budget? To my mind they are different things.

Stuart McIntosh: They are different things, but it was also based on the notion that, if you look at the data, it does not appear to be the case that the vast majority of small businesses spend huge amounts on postal services. If there was an increase-which I agree would be regrettable-it is likely to be affordable: i.e. it is not likely to have a material impact on their profitability.

Q23 Ann McKechin: Did you segment this into different sectors? That would be a more valid comparison than taking SMEs as a whole across the UK. That, to my mind, is fairly meaningless.

Mr Ward: It is also tax deductible.

Chris Rowsell: We do have more detailed research that cuts across different types of business. I do not have those numbers to hand.

Chair: Again, further evidence would be welcome.

Q24 Mr Binley: Ann is right: many small businesses in rural areas-one man, two men at most, businesses-should be considered as vulnerable consumers; I believe the Federation of Small Business thinks that is the case too. Why do you seem to reject that advice?

Stuart McIntosh: I am not saying that we would necessarily reject that advice. I think-Chris will correct me if I am wrong-vulnerable consumers in the context of our duties are defined in the Communications Act. I had better ensure that is correct so I am not misleading the Committee. We thought clearly about business users both large and small, because business users are the engine of volumes of mail in the UK, and without usage from those users the service would be fundamentally challenged.

Q25 Ann McKechin: Royal Mail evidence on this particular area in its published form was redacted. How robust did you think it was?

Stuart McIntosh: The information that was redacted in Royal Mail’s response was largely to do with commercial information specific to them, quite a bit of it related to their own Government submissions in respect of the state aid application to Brussels regarding their pension deficit, which it would not have been appropriate to put into the public domain. We were able to replicate and understand the financial informational that they provided to us, because we have independent models and analysis, some of which we have inherited from Postcomm, which allowed us to validate that. The more detailed information that they provided to us, which it would not have been appropriate to publish, allowed us to understand a lot of the specifics regarding their efficiency programmes, and so forth, so we were able to test and understand it.

Q26 Ann McKechin: The redaction was primarily on the basis of-

Stuart McIntosh: It was on the basis of confidentiality.

Q27 Ann McKechin: Contractual confidentiality?

Stuart McIntosh: Yes, and there was nothing different with regard to the approach on redactions in respect of Royal Mail from what we applied to BT, Sky, TalkTalk, or anybody else who responded to our consultation. They were treated exactly the same way.

Q28 Ann McKechin: Thank you for that clarification. Could I come on to the Consumer Focus alternative, which proposes retention of price controls with an RPI linking over a five-year period? What were your views on that proposal?

Stuart McIntosh: That is something that we considered in formulating our proposals in the first instance. As I said earlier on, one of the major factors that led us not to propose that approach is that the uncertainties regarding mail volumes in this context are very large. The likelihood of getting it wrong is quite significant. If you contrast it with most of the price controls that we applied with BT, there are one or two decisions that, if we made them here and got them wrong, would have huge impacts and implications.

It also introduces inflexibility, because if we get it wrong, Royal Mail has to come back, and there is a lengthy process to go through before a change can be made. Given the dynamic nature of the market and the uncertainties about the declines in volumes in the market, we felt that that was taking on a lot of risk, not for us as a regulator but possibly posing a risk to the financial sustainability of the USO.

Q29 Ann McKechin: On the accuracy modelling, are there too many variations to predict accurately?

Stuart McIntosh: Yes. It is highly uncertain. We visited a European operator two weeks ago: they have seen volume declines for this past decade; in the past year, they have seen volume declines of 8%.

Q30 Nadhim Zahawi: Consumer Focus are obviously very concerned. They point to the reason that they believe underlines Royal Mail’s announcement: that Royal Mail want to set the price of a standard second class letter as high as possible, so that they could charge more for first class without causing people to switch to second class. Were you surprised that Royal Mail responded by arguing for the top of the range in second class, the price of 55p?

Stuart McIntosh: As a regulator I am getting a bit long in the tooth, so I am never surprised. I was not surprised. I can understand from their perspective that they would wish to see the maximum flexibility.

Q31 Nadhim Zahawi: With your experience, what do you think that indicates, in terms of Royal Mail’s response, for their plans for the future price of first class?

Stuart McIntosh: I could speculate about that.

Q32 Nadhim Zahawi: Why don’t you?

Stuart McIntosh: We are not taking our decisions on the basis of what we think they may or may not do, but rather what we think is appropriate to protect vulnerable consumers. We think it is very important we provide Royal Mail with flexibility, so that they are able to support the continued provision of universal service.

Q33 Nadhim Zahawi: You mentioned you could speculate: could you speculate a little bit in front of this Committee, and tell us what you think will realistically happen to first class mail prices if controls are lifted?

Stuart McIntosh: I do not want to do that, for the simple reason that we are in the process of the consultation. During the course of the next few weeks we will reach a conclusion on this point, and take a decision ourselves. Royal Mail will have to abide by that decision. That may be some point in this range, it may be at one of the extremes of the range, and we have not taken a decision on that: indeed, we wanted to have this discussion today as part of the input to that decision. It would be inappropriate for me to speculate, to be honest.

Q34 Nadhim Zahawi: Can I tempt you to set aside the conclusions and place yourself in the shoes of someone who is wanting to run Royal Mail? What do you think would happen to first class prices?

Stuart McIntosh: You are going to have the CEO with you in the next week or so.

Q35 Nadhim Zahawi: We certainly are, but I would like to hear from you, Mr McIntosh.

Stuart McIntosh: I don’t know what they would do to first class prices.

Q36 Nadhim Zahawi: What would you do if you were in their place?

Stuart McIntosh: I would set it at the level I thought was appropriate.

Q37 Nadhim Zahawi: What would that level be?

Stuart McIntosh: I am not sure, because I am not responsible for their commercial strategy. We are not micromanaging Royal Mail. I do not know what the trade-offs are between the prices they set for bulk mail and the prices they set for retail business mail-it is a very complex set of equations. One of the problems with the previous regime was that Postcomm, because of the way it operated, got involved in a lot of detail with the regard to the way that Royal Mail functioned. We do not think that is the right way to regulate the company. The management are there to run the company.

Q38 Nadhim Zahawi: You are absolutely right. At the end of the day, human nature being what it is, at some point they will inevitably get to the place where they will set second class at the highest limit of the cap so that, if they then do increase first class, you will not get people falling away into second class. That is where we are inevitably heading, isn’t it?

Stuart McIntosh: Not necessarily. I can think of charge controls, which are a bit different from the caps, that we have applied to BT, where BT, for a variety of reasons, have not taken full advantage of them. We were in the Netherlands two weeks ago to talk to both the regulator and the company in the Netherlands, and the prices they have set for some of their stamps are significantly below the ceiling that they could set and they think that is the right commercial judgment for them.

Q39 Nadhim Zahawi: How long has the ceiling been in place in the Netherlands?

Stuart McIntosh: I would need to come back and confirm the details, but I believe from memory that it has been for some time: it is not just a very recent phenomenon.

Q40 Chair: Could I come in from a slightly different angle? I can understand your reticence, but do you think I would be behaving sensibly if I bought all of my Christmas card second class stamps now before they go up?

Chris Rowsell: I have already bought my Christmas cards-in the sales.

Stuart McIntosh: I am a regulator. I do not advise on financial speculation.

Q41 Nadhim Zahawi: I think your colleague, Mr Rowsell, answered that question for us. Lifting the cap on first class is likely to take the UK overnight from one of the lowest first class stamp prices in the EU to the highest. You have said there is no observable precedent for this in the evidence you have given us. Does that mean we are leaping into the unknown-anything could happen here?

Stuart McIntosh: I do not think that an increase in first class stamp prices would be unprecedented. I suspect you have this evidence, but if not we would be more than happy to provide you with details as to where the UK currently stands relative to other countries in Europe. From memory, and we have some of the charts here-

Q42 Nadhim Zahawi: I think in your evidence you said, "There is no observable precedent for the impact of significant price rises at a time when volumes are already declining." My point is that you cannot model this, because we are going into the unknown here and there is nothing for us to compare with.

Stuart McIntosh: Sorry, I misunderstood your point. There is uncertainty: there is no question about that, and that is a big factor Royal Mail will have to factor in to its decision making as to where it chooses to increase prices and where it does not.

Q43 Rebecca Harris: Coming back to the possible 55p price of a second class stamp, which works out as a 53% rise, what estimate have you made as to what volume of that mail might move over to other forms of communication?

Stuart McIntosh: The first point to make is that we have not assumed that is where this will come out, either in terms of what our decision will be or in relation to what Royal Mail will choose to do. If there are increases, one would expect to see demand volumes shift, but it is going to be heavily dependent on what happens to other prices. If first class prices move up, and consumers decide that the balance of the value for them is they can get what they need using second class mail, and the overnight delivery is not critical, you may find that second class volumes do not change that much. It will depend on what happens to the relativities of prices. Overall it must be the case that, if prices are going up, volumes will decline.

Q44 Rebecca Harris: You said earlier that, typically, when a price rises there is a reduction in volume, and you have also said that ensuring we keep the volumes up is essential to keeping the universal service obligations. Have you made any estimates? For example, if second class post increases to 55p, that is about 10 text messages. Could it be that it moves to other media?

Stuart McIntosh: Absolutely. One of the reasons we are in the situation we are in today is that text messages cost almost nothing at the point at which you use them, and over the course of the past 10 years consumers in large numbers have adopted these other means. If prices go up, it is going to encourage consumers to continue to switch.

Q45 Rebecca Harris: What will prevent a scenario whereby we get an ever-declining number of customers to sustain an ever-increasing postal price?

Stuart McIntosh: We know that structurally the trend is against mail; some parts of the industry are growing, particularly around fulfilment, but currently those are not large enough to compensate. There are operators across Europe who, during the past 10 years, through a combination of selective price increases and through changing their whole operational models, have managed to secure an outcome where, even in the face of sustained declines in volume, they have been able to maintain a sustained universal service. There is every reason to believe that the same is possible here in the UK.

Q46 Rebecca Harris: What would prevent that happening in the UK?

Stuart McIntosh: What would prevent that happening is if Royal Mail is not able to use the opportunity that this regime would provide it to continue to drive efficiency improvements. If we do not see improvements in efficiency, and the only way the universal service can be made financially viable is for prices to go up, there will come a point at which users, and particularly large business users, will make the investment in the systems to transfer their mail activities on to the internet.

Q47 Rebecca Harris: What I have not worked out here is what work has been done, and what you are aware of, to ensure the pricing regime is right to maintain customer loyalty and will maintain those volumes, and at what point we reach a tipping point. Is there not a case for having a more modest price rise to maintain customer loyalty? What work have you done on that?

Stuart McIntosh: We have looked at the overall market environment in terms of what is happening in the industry. It is clear to us that there is a great deal of uncertainty about that market environment. We believe the Royal Mail and the industry is in a much better position than the regulator to figure out how prices need to be set across the whole market in order to sustain its viability, rather than us attempting to second guess the management of the companies. In some respects you could say that was one of the faults of the previous regulatory regime, which failed.

Q48 Mr Ward: Can you talk about efficiency savings? The antidote to increased price is reduced volume, leading to increased price, which reduces volume, and so it goes on: there needs to be efficiency savings. Concerns have been raised by Consumer Focus about the history of managing to generate efficiency savings. In the past you have had the constraints of the universal service and price control. Why did that not generate sufficient savings?

Stuart McIntosh: I would have to be honest and say that we were not closely involved in observing the industry, so we cannot speak on the basis of first-hand experience. In an environment where volumes fell very rapidly, the need to act quickly was not fully anticipated. We have been looking at other environments, and we had a detailed session with the senior management of the Dutch postal company two weeks ago. They started working on the transformation programme that they have been implementing over the past few years almost 10 years ago. It takes a long period of forward planning to anticipate and respond to the changes.

Royal Mail will be able to talk about this more knowledgably when you see them, but it is probably fair to say that the same efforts did not get under way fully here in the UK until towards the latter part of the last decade-the investments in the machinery and the sorting equipment.

Q49 Mr Ward: In October you said that efficiency savings had proved very challenging. What confidence have you got that they will overcome those challenges in the future?

Stuart McIntosh: The confidence is in part that the changes we are putting in place are going to take away the dead hand of regulation from the day-to-day management of the company: they will have some more flexibility. It is also clear from the experience in a number of other countries, places like the Netherlands, Germany, and some of the Nordic companies, that it is possible to deal with a situation where volumes have declined, and to rationalise and improve your operation very significantly. I am not an apologist for Royal Mail, but they have made very significant and important strides in respect of that, in relation to the investments they have made in recent years in automating a lot of their processes. There is still some considerable way to go, and there is quite a lot that needs to be done to take advantage of the investment in equipment by designing new processes and putting those into place. It takes time, but the experience of others suggests it is possible.

Q50 Mr Ward: My wife will laugh at this analogy, but if you allow prices to increase, does that not release some of the pressure in the cooker, enabling you to cook-here we go-the efficiency meal?

Stuart McIntosh: I recognise the analogy and I can see that there is definitely something in it. In the short term there is the need to improve the financial viability of both Royal Mail and the universal service. In the short term prices have got to play a significant role in relation to dealing with that. In the longer term, however, we will be looking to track closely what is happening to the delivery of universal service: i.e. is Royal Mail delivering what it is supposed to in respect of universal service? What is happening to its profitability? Where are prices relative to the best of the prices we see across Europe? What is happening to efficiency? Are the efficiency targets that the company set itself being achieved and realised? Part of the monitoring regime that we are putting in place is designed to pull those things out.

Q51 Mr Ward: Is there a temptation to retain the price control until they have proved themselves able to deliver on the efficiency saving?

Stuart McIntosh: It goes back to one of my answers earlier, which is: in an environment where the volumes are falling as rapidly as they have been in this market, that would expose the financial viability of universal service to very considerable risk. It is worth remembering that during the course of the past five to six years, Royal Mail has been losing significant amounts of money-hundreds of millions of pounds-on its mail operations. During the period of the current price control, which runs from 2006 to March of this year, the cash flow in those operations has been almost £3 billion less than was anticipated when that charge control was set. The situation was dire and is still very severe: we should not lose sight of just how severe it has been and remains.

Q52 Mr Ward: One area where volume could increase is in second class post, where the satisfaction levels are currently very high. How would you envisage the pressure being on the organisation to deliver such high standards with an increased volume of second class post?

Stuart McIntosh: Is this on the basis of the...?

Mr Ward: Shifting from first to second.

Stuart McIntosh: Given that prices have been going up overall, we would expect some aggregate reduction in the volumes, and I would imagine, although Royal Mail would be able to answer your question as well, that if the volume is largely a shift from first to second class, the delivery network ought to be able to support that and sustain the quality of service levels. In many respects it is supporting a higher quality service level for the same volume through delivering some of that first class to date.

Q53 Mr Binley: Why have you chosen the RPI to index the price cap?

Stuart McIntosh: We have not chosen it yet. What we have done traditionally in the charge control regulations that we have applied in other industries, certainly in telecoms, is use RPI, and we have tended to be consistent in the use of RPI across all those controls. However, we did flag in our consultation document that there are some arguments for considering the CPI in this area, and we are still looking at that. That is one of the decisions we will take over the next few weeks.

Q54 Mr Binley: I am delighted about that, because you will know there are vulnerable customers-the elderly, disabled, or those on low incomes-who are reliant upon benefits. You know that the Government has totally adopted CPI as their measure of inflation, and it would seem to me to be sensible that you should do the same. Will you do so? Go on-get out there on a limb.

Stuart McIntosh: Well, I will not repeat what I just said, but it is still in very active consideration and we are very alive to exactly the issues you have just mentioned.

Q55 Mr Binley: I am quite elderly-

Stuart McIntosh: I am too.

Mr Binley: If I am going to buy my Christmas stamps next year, can I expect that I will be doing it on an increase of CPI rather than RPI?

Stuart McIntosh: You won’t have too long to wait.

Q56 Mr Binley: Go on. Really, really go out on a limb-be adventurous.

Stuart McIntosh: You don’t get hired to be a regulator because you are adventurous.

Mr Binley: Sadly.

Q57 Chair: On that note, can I thank you for your contribution? There were a number of issues that we asked for further information on: if you could submit that in writing, we would be grateful. If you feel there is a response to a question that we need to know but did not ask, feel free to send that information to us, and if we feel that there was a question that we should have asked but did not, we will do that as well and await your response. Thank you very much.

Stuart McIntosh: Chairman, thank you.

Examination of Witnesses

Witnesses: Adam Scorer, Director of Policy and External Affairs, and Robert Hammond, Director of Postal Policy and Regulation, Consumer Focus, gave evidence.

Q58 Chair: Thank you very much. For voice transcription purposes, could you just introduce yourselves?

Adam Scorer: Thank you very much. I am Adam Scorer. I am the Director of Policy and External Affairs at Consumer Focus.

Robert Hammond: I am Robert Hammond. I am the Director of Postal Policy and Regulation at Consumer Focus.

Q59 Chair: Thanks very much, and I reiterate what I said to the previous panel: don’t feel that you both have to answer every question.

Ofcom argues that price controls have failed. Do you agree?

Adam Scorer: It is not so much that the previous regime has failed; rather, the market fundamentals and the regulatory framework have changed significantly, and it is right that Ofcom take a serious and robust view of what is needed. As with Ofcom, we have to recognise the decline in volumes of mail, in particular over the past four years, and the prospect of that continuing, and the use of electronic substitution-even though it will never be a total substitution-for letters is on the increase. We have had price controls rolled over twice. We have had change in the regulatory framework from Postcomm to Ofcom. We have had Hooper, a couple of Postal Service Bills. It is appropriate to have a fresh look at what price control and regulation of the market needs to do.

For us, as a consumer organisation, we are particularly concerned about the interests of vulnerable consumers. I would not restrict that to disabled people and pensioners. I would look at remote and rural communities, at low income and low internet usage, and SMEs that do not have the ability to take advantage of discounted bulk purchasing. The consequences of the changes that Ofcom will come up with for those consumers should be at the front of their minds to determine what the appropriate final solution they reach should be, and there should be a model to assess its success and the need to review it going forward.

Q60 Chair: You broadly believe there should be some degree of price regulation in the future. Given that Royal Mail’s current problems have occurred under price regulation, where do you think it can work in the future?

Robert Hammond: It is not just about the price regulation mechanism that existed in the past. Adam Scorer has already set out the fundamental change that there has been in the market over the last few years. It is also about something you have touched on before in the Committee here: Royal Mail getting control of its costs and also making itself an efficient organisation, rather than one that is just able to increase its income by raising prices. Our belief is, and the modelling that we have done suggests, that if it stays on its current course it is in for a very rough few years ahead, but if it does get to grips with its costs, and makes some very modest efficiency gains of around about 5% per annum, the business can be turned around quite significantly. We do not see price rises as the saviour of Royal Mail; it is potentially one aspect, but the other two parts of that trinity-cost control and efficiency-are just as important.

Adam Scorer: We do not underestimate the scale of the challenge that Royal Mail faces to drive out inefficiencies from their business and build a sustainable, profitable model, given the characteristics of the market fundamentals that are out there. We do not want to see any pressure taken off that impetus by a price control mechanism that would allow it to do the far easier thing of raising prices in what is often a captive market, rather than addressing those difficult and stubborn inefficiencies issues that will plague every large network industry and company, not just Royal Mail.

Q61 Chair: Do you not agree that, to get the investment needed, there has to be some degree of price increase to generate the extra money required?

Robert Hammond: That is why our suggestion to Ofcom was to make it an RPI minus zero. That would give Royal Mail the ability to raise prices within a fairly narrow band, but at the same time places far greater emphasis on these areas where its track record to date is not very good. Under previous price regimes, it has not engendered the cost constraints that we would like to see. That has to be the central issue that is addressed.

Adam Scorer: You warned both of us not to answer every question-I am aware of that. You are right: Royal Mail needs greater flexibility to reflect the market and to address the short-term revenue issues-we would not dispute that. If Ofcom goes the portfolio way of introducing minimal caps, but has other requirements on it, we would say there is more that Ofcom could do down that route by having structural reviews halfway through a seven-year period, which seems to us a long period, as well as strengthening that part of the Royal Mail offer and product range that would be captured by the price regulation framework they suggest: not just second class standard letters, but large letters, which would be excluded, and packets up to a certain size, which is a growth part of the market.

Royal Mail needs a degree of flexibility-that is uncomfortable for us, because that will mean higher prices. But within the regulatory framework that is brought about by this consultation and review process, consumers must have a protected group of services and products that makes sense and provides a viable, affordable communication product.

Q62 Mr Binley: Can I put it to you that it is inevitable that there will have to be a period of higher prices to compensate for under-pricing and underinvestment in the period up to 2007?

Robert Hammond: That is true, but Royal Mail has enjoyed some fairly large price hikes over the last few years: typically since 2003 first class has gone up 75% and second class by 80%. In the rollover periods that we have had, the previous regulator, Postcomm, was sympathetic to the financial plight of Royal Mail, and so was Consumer Focus. We did not stand in the way of those price increases that Royal Mail wanted, because we recognised how universal service needed to be protected for all consumers. It is not the case that we are saying no to price rises under any circumstances; we are saying it must be done in a measured way so there is not a free licence to print your own prices. There must be a quid pro quo, which is to bring your business under control.

Q63 Mr Binley: You talk about possible tipping points with regard to pricing. Can you explain your evidence for those tipping points?

Robert Hammond: Yes. In December of 2011, just a couple of months ago, we did a piece of research-with this consultation by Ofcom very much in mind-and we looked at three distinct consumer groups. We looked at, if you like, a general consumer group; we looked at a vulnerable consumer group that was based on age and also income; and we took a third group, which was that vulnerable group, but also with a very low internet usage. We asked them a series of questions about what sort of levels prices would have to achieve for it to make a difference to their current behaviour, and where it was that they were likely to make some significant changes.

The tipping point evidence is very interesting, inasmuch as it clearly shows that, as prices rise, general consumers-and, to some extent, vulnerable consumers-will decrease their usage of Royal Mail services, whether it is first class or second class, across the product range. This will reduce quite dramatically, as far as consumers are able to.

The difficulty, though, is with regard to the third group-the group that do not have an alternative, or very much of an alternative, in terms of communication in its own right-in other words, the vulnerable consumers who are low internet users. That group we found, in particular, were very sticky-if I can put it that way-in terms of the prices. They could not switch away in the numbers because they had no other option, and that is an area that gives us grave concern, inasmuch as if Ofcom is going to pursue a policy of allowing Royal Mail to set its own first class prices, we feel that the suite of second class prices needs some protection so that consumers-and particularly vulnerable consumers-have a safety net. At the moment, these proposals provide none whatsoever.

Q64 Mr Binley: I am glad you raised the issue about vulnerable and lowweb users, because the predicted rate of dropoff is relevant. Can you explain your modelling in that respect?

Robert Hammond: Yes. As I say, we did a number of face-to-face interviews with this particular consumer group.

Q65 Mr Binley: Can I ask how many?

Robert Hammond: 220 was the number.

Q66 Mr Binley: Which is what percentage of representation of the total market in that respect?

Robert Hammond: I don’t have that figure with me but we can certainly provide that for you.

Mr Binley: Thank you; I think that is relevant.

Robert Hammond: That was against a sample size of just over 2,000 that we did on an online basis, which covered-if I can put it like this-general consumers and those from a low-income elderly age bracket that did have internet connections. We have looked at it, as I say, and our model has looked at the different segments of the group, so that what we have done is we have predicted something that could be used as a proxy for the nation.

I absolutely accept that, with a sample size of 220 or whatever it is, it is indicative research only, and that has to be said with that caveat in mind, but, nevertheless, I think this is a better sample than perhaps has been used for some of the other evidence that Royal Mail has used in support of its case. I think that what it does show is that, as I say, whilst the general consumer or vulnerable consumer groups decline their use of mail, switch to other things, downsize from first to second class post, a very common trend is that these vulnerable, lowinternet users do not do so to the same extent.

Adam Scorer: It is important to recognise the point previously made by the Committee that affordability is a critical issue, of course, but so is consumer behaviour.

Q67 Mr Binley: I understand that. I am glad you offered to send us the figures, and not only of the number of surveys; we would also like to see the sort of questioning processes you went through, and we would like to see what percentage of the total market you were dealing with, because I think it is pretty important evidence, and whilst I recognise it is only 220, you are right in saying it is the largest survey done in this respect, so it has a considerable relevance to us.

Can you expand on your concerns about the reliability of evidence, which, in a way, leads on from what I have just said, on vulnerable consumer usage patterns?

Robert Hammond: Yes. Royal Mail, in their response to Ofcom, have provided some evidence, and you have already heard that there have been some redacted elements of that. Some of it relates to vulnerable consumers; it is difficult to imagine that could contain information that would constitute being commercially sensitive, but nevertheless it is not there. As I understand it, the Royal Mail survey is built on its consumer group, which is around 600 consumers, and I am assuming that the social group D and E element of that would typically be about 30%. Royal Mail will doubtless be able to confirm this. If so, you are talking about a relatively small number, less than our 220, and you are talking about that social group. You have not included in that those who do not have the alternative who are not internet users; actually, it could be an even smaller group.

Now, to base one’s policy-and, particularly, lobbying for a drastic change to the regulatory framework and requesting the ability to be able to set second class and first class stamp prices at will-on that kind of evidence, I have to say, does give us some concerns. We would like to see a far more indepth impact assessment being done that looks at all of the contingent parts of our society. Let us not forget that universal service is not there for its own sake and it is not there to keep Royal Mail in business; it is actually for us, as citizens, as users of the service, and for the businesses that use Royal Mail. So we would like to see a far greater impact assessment before a massive decision is taken that will be very hard to reverse.

Mr Binley: Can I thank you for that? I accept what you say and I would urge the Chairman to think about writing to the regulator in that respect. I think it is very important to do so before they make the decision, and it needs to be done quickly. Thank you.

Chair: Our intention is to complete this very quickly and then we can incorporate it in. That is the purpose of holding it now.

Q68 Katy Clark: Can you explain your concerns about whether substitute parcel delivery providers can provide a realistic alternative to Royal Mail, particularly in remote areas?

Robert Hammond: Yes, indeed. Thank you for that question. Yes, part of the Royal Mail evidence to Ofcom was a suggestion-firstly for SMEs-that they could use AllSort and PremierSort products, which are offered by a company called TNT, as an alternative, but both of these products-on the research that we have done-show that you would have to be sending out some fairly hefty amounts in terms of volume to be able to qualify for the lower prices. You have already heard how SMEs and, indeed, microbusinesses behave in a not too dissimilar way to us, the ordinary domestic consumer. That, as an option, really is not an option.

Also, it has been suggested that if consumers were to look on a website called Parcel2Go, they could see that there were different courier services that could act as competitors, if you like, to Royal Mail for us domestic consumers to use as alternatives. Again, looking at those, they generally offer a next day service or a twoplus day service, unlike the three- to five-day standard parcel service of Royal Mail. A lot of these companies, as well, impose a surcharge, particularly if you are sending to Northern Ireland or the Highlands and Islands of Scotland, and some of these companies won’t deliver there at all, so your options are very limited. Regarding other outfits that exist that we could, as domestic consumers, perhaps access, as you move away from the urban centres, the pick-up points or the drop-off points for this type of mail become few and far between.

Quite frankly, regarding a universal option to Royal Mail, at the present time in this country there is not one. There are a few options if you are prepared to pay three or four times more than Royal Mail is currently charging, and it is not absolutely certain whether or not that service will be offered.

Q69 Katy Clark: On a separate issue, how exactly do you arrive at the conclusion that a safeguard cap is required across all second class products?

Robert Hammond: I think it is one of logic to start with, inasmuch as what we see from the survey and the research that we have done is that, whilst general consumers and vulnerable consumers may move away as prices rise-and typically it may be 58% down to 25% or 51% down to 12% for the general consumers-it is because they have an alternative. You can text someone. You can pick up the phone. You can send an email. If you do not have that option, you are immediately constrained by how you can express that communication. Everything here shows that a small but significant group in our society cannot do that, and that is why we feel this protection needs to be there.

You also cannot send a parcel electronically. You cannot send it through your mobile phone or by text. The thing has physically got to get from A to B. That affects all of us, not just vulnerable consumers, and so that is why we feel that as a very basic service-a safety net-there has to be an element there that protects all of us from potentially overpricing.

Q70 Chair: Thank you. Can I just conclude? Royal Mail said it needs business certainty and that the regulatory framework, therefore, needs to be stable or constant for seven years. What is your view on this?

Adam Scorer: We think seven years is a rather unnecessarily excessive period of time. We think that five years is perfectly adequate to provide that certainty. Royal Mail do need certainty. We should not give the impression that they do not. Every business needs regulatory certainty to be able to invest and plan and price plan and all of those sorts of things, but we think that five years would be an adequate period of time.

Should it be the case that Ofcom decide they will go for a seven-year price control period, we think it is absolutely vital that they institute some form of formal, structured review process during that period of time. I think the intention is that they will monitor, they will observe, they will keep on top of the situation by the data that is available to them. We are uncertain about the quality and the adequacy of the data that would be available through an informal monitoring process, so we think five years would be ideal. We think that seven years has some issues with it, and those issues would need to be mitigated by a formal structural review process, perhaps halfway thorough.

Q71 Chair: What are the issues? Because although you have said, effectively, you think it is too long, you have not really articulated any specific reasons.

Adam Scorer: I shall defer to my colleague.

Robert Hammond: I think there are a number of issues. If I could just flag up one thing, the USO-let us be honest about it-is largely underpinned by big mailers sending out lots and lots of mail, and that helps the price of stamps for you and me to be kept perhaps lower than would otherwise be the case. What banks and insurance companies are telling us is that the price increases they sustained last year, in the April 2011 price increase round, has not yet fed through to their mailing habits. It takes time if you are going to substitute electronic communication for mail. There is the purchasing of that and the infrastructural changes. So we know that is already in the pipeline but has not happened.

What they are also saying to us is that if Royal Mail is allowed this carte blanche to raise their prices, that may well accelerate their move away from post, so we have a very uncertain future here that will play out in the next few years. We need to see what happens with mail volumes. We need to see how consumers react if these price rises go ahead and, also, it is true to say that Ofcom have begun a review of the USO and whether it is meeting the needs of consumers today. We ourselves are looking at this. The USO is not set in aspic. It needs to reflect the needs of the 21st century consumer as well as the business. So we feel that all of this could radically change the landscape in the next three to four years, and that is really why we feel it is right to have this type of review at that point in time.

Q72 Chair: Sorry, can I just understand this correctly: are you saying that the USO, basically, is potentially reneged upon, or could be over the next few years?

Robert Hammond: I am not saying it can be reneged upon. Clearly it is set out in very clear legal terms at this moment in time and would require an Act of Parliament to change what it is. What we are saying is that some research that we did in 2010 jointly with Postcomm reflects the fact that for a lot of consumers the necessity, shall we say, to have deliveries six days a week is not one that they particularly value now as much as they used to perhaps 20 years ago. The problem with that is that consumers will say to you, "Yes, by all means lose a day during the week." Whereas businesses will say to you, "No, lose Saturday. We want mail during the weekdays."

What I am saying is that I think to inform both perhaps potential changes at a European level to what would constitute a USO and nationally over a medium to long term, what needs to be looked at is what people need now, not what they have just enjoyed for the last 100150 years.

Q73 Chair: Okay. Can I just come to the issue of CPI and RPI? What is your view on CPI being adopted to index price increases?

Robert Hammond: Generally speaking, I think we probably favour CPI over RPI because of the nature of the index itself, and it is probably far more relevant. It has to be said, in terms of the Ofcom response, we have not made a big deal about it, simply because we would just like to get them on board about having a price index-related price control at all.

I have to say the moment the difference between CPI and RPI is very minimal. As of January this year, last month, RPI was running at 3.9% and CPI at 3.6%. The projection going forward is not too much of a change. It is a refinement, but let us get to the principle, first of all, of having some form of price control.

Chair: Yes. That will be the case until interest rates go up.

Robert Hammond: Yes, indeed.

Chair: Right, that concludes the questioning. Thanks very much and, again, I will repeat that if there is any information that you feel we have not teased out of you that we should have, please send it to us. If there is any question we feel that we would like an answer to but didn’t ask, we may do the same to you, but thanks very much.

Adam Scorer: Thank you very much.