Business, Innovation and Skills Committee - Stamp PricesFurther supplementary written evidence submitted by the Royal Mail

Cost of the USO and Second Class USO Services

1. Royal Mail’s statutory obligation, as the designated universal service provider, drives the architecture and the economics of the universal service mails network. This obligation, re-confirmed by Parliament in the Postal Services Act 2011, results in Royal Mail needing to collect mail from circa 12,000 post offices, circa 115,000 pillar boxes and circa 83,000 businesses on a daily basis, as well as the capability to visit up to 29 million delivery addresses six days per week.

2. Royal Mail has developed a network to collect, move and deliver mail throughout the country, overnight, to ensure it can offer a next day service. The diagram below illustrates the scale of the integrated mails network used to provide the universal service, including:

six day collection and delivery services;

an overnight domestic service for First Class USO and Special Delivery1 USO items;

a domestic service for Second Class USO items;

exit from and entry to the network for outbound and inbound international mail; and

capability to deliver to up to 29 million delivery addresses 6 days each week.

Source: Royal Mail Data—2010–11

3. This mails network is shared by both USO services (for example stamped and franked First and Second Class mail) and, to varying degrees, by non-USO services (for example, First, Second and Third Class bulk retail and access mail, other First and Second Class business mail services which are not part of the USO). The costs of running this network are therefore shared by both USO and non-USO services.

4. In 2010-11 the cost of running this network was c£6.7 billion (including modernisation costs), whilst the revenue generated from the products which used the network was c£6.4 billion. The scale of the financial challenge for Royal Mail is significant. Over the last four years Royal Mail has lost c£1 billion and the core USO mails business remains loss making.

5. The cost of the universal service network is, to a large degree, insensitive to changes in volume or changes in the mix between USO and non-USO services. The critical cost is the need to visit every address every day whether there is one letter for delivery or ten. It is therefore neither straightforward, nor informative when looking at financeability and profitability of the USO, to identify those costs which relate solely to individual services using the USO network.

6. The revenue generated from USO services in 2010–11 was £2.9 billion, of which stamped mail accounted for £1.1 billion. Given the cost of the USO mails network is £6.7 billion this clearly illustrates that the revenue contribution from non-USO services is essential to USO financeability. It also demonstrates the scale of the financial challenge for Royal Mail in covering the cost of the universal service.

7. Allocating costs to individual products using the USO mails network implies that Royal Mail could cease to offer a particular product with a consequent and definable reduction in its underlying costs. This is simply not the case for the USO mails network. Royal Mail’s network architecture and associated costs are driven by the universal service obligation. The joint/common nature of the network costs mean that if Royal Mail was to cease to provide a non-USO service which uses the USO mails network, a broadly unchanged cost base would need to be spread across a smaller portfolio of remaining services, raising their notional cost. This would undermine the financial viability of the universal service and increase the pressure to raise prices on the remaining services.

8. Given the integrated nature of the USO mails network, Royal Mail has long argued that the right way to assess USO financeabilty and profitability is to consider all of the costs of the activities required to deliver a universal service against all of the revenues generated by all of the services which make use of the universal service mails network, even when these are not USO services. This approach has been recognised by Ofcom as the appropriate starting point for considering the financeability of the universal service in their October 2011 consultation document on the future regulatory regime for postal services.2

9. Product cost allocations can be generated by Royal Mail’s internal costing systems based on allocation rules which have been devised to comply with the EU Postal Services Directive. Royal Mail believes that these allocations are artificial and potentially misleading due to the integrated nature of the mails network, the requirements of the Directive and the predominance of joint/common as the CEO pointed out to the Committee3 for the reasons described in paragraph 7. In summary, all of the costs of delivering the USO need to be covered by the total revenues of all products which use the USO mails network, and a reasonable commercial rate of return needs to be generated.

10. As the Committee will be aware, up to and including the 2009/10 financial year, Royal Mail produced Regulatory Accounts which included profitability information for USO services split by a consolidated view of both First and Second Class services. This information was generated on the basis of an operational traffic measure (Reported Operational Traffic or ROT). This publicly available information showed that in 2009–10 Royal Mail made a loss for first class stamp and meter services of £(22) million and for second class stamp and meter services of £(42) million.

11. For clarity, Reported Operational Traffic (ROT) data for account based traffic is sourced from accounts receivable, while Stamp and Meter traffic is sourced from sampling within operations through a combination of machine counts and average number of items in a container.

12. Following discussions with the former Regulator (Postcomm), from 2010–11 Royal Mail moved to a revenue derived traffic measure (RDT). This movement was in response to a regulatory consultation on the most appropriate basis for traffic measurement and the fact that Royal Mail’s broader approach to strategic business planning and Statutory Reporting was based on RDT. Revenue Derived Traffic (RDT) data for account based traffic is sourced from accounts receivable. However, differently from ROT, Stamp and Meter traffic is sourced from the revenue received divided by average unit prices, both of which are identified through business sampling.

13. In 2010–11 Royal Mail also moved to the reporting of a regulatory cashflow in the audited financial statements and away from the provision of financial information at the level of a particular class of service.

14. However, for the Committee’s information, in 2010–11 on both the revised RDT and the historic ROT traffic definitions for First Class Stamped Mail alone, and Second Class Stamped Mail alone, we can confirm that Royal Mail made a loss (after modernisation costs).4

15. In summary, Royal Mail has now been cash flow negative for several years and our core mails network has made losses of c£1 billion over the last four years. This clearly indicates the scale of the challenge facing Royal Mail to move the USO to a financially sustainable position in which it both covers its cost of provision and generates a reasonable commercial rate of return.

Impact on Volumes of Potential Second Class Stamp Price Increase

16. Advances in technology such as the internet are increasing the level of competition between different communication channels. This has led to a serious decline in the volume of letters sent in the UK and other countries with advanced postal networks independently of the price of mail.

17. Given the structural change it is extremely difficult to assess the individual impact of new technologies on the demand for mail and on the impact of price. Ofcom, in the October 2011 consultation document on the future regulatory regime for postal services stated, “Not only is the market in a state of long-term structural decline, it is also characterised by great uncertainty … the extent to which post will continue to be relied upon as a means of communication competing with electronic substitutes has yet to become clear.”

18. Despite this challenge, Royal Mail clearly invests in customer research and econometric modelling to attempt to provide some insight into price and non-price impacts on demand. This analysis is part of the information Royal Mail uses when assessing its pricing decisions and we understand and expect that, regardless of structural changes as prices rise, there will be a negative impact on volumes, although the exact impacts are difficult to assess.

19. The Committee specifically asked what theoretical reduction in demand Royal Mail expected to see if the price of a second class stamp rose to the top of the proposed price cap range, ie 55p. This analysis can only be conducted on a theoretical basis using econometric analysis of historical data. We believe that the price elasticity for stamps (First Class and Second Class letter mail) is in the region of 0.2 to 0.4. That implies that a 1% increase in the price of stamps is associated, on average, with a decrease in total (First and Second Class) stamped letter mail volumes in the region of 0.2% to 0.4%. This attempts to isolate the impact of other movements, such as the impact of new technologies.

20. This analysis does not imply Royal Mail’s intent to set prices at a particular level. Royal Mail will only be able to announce its prices for USO services, including stamps, once Ofcom has made its final decision on the regulatory framework.

21. For the Committee to appreciate how this analysis can be applied, it is essential that we make clear that the behaviour which informs it is based on historical price rises of lower magnitude. These could potentially be less reliable.

22. Regardless, stamp prices should be put in a European context, where UK compares very favourably. Royal Mail charges below the European average for 0–20g items for First Class Stamps and for 0–100g (using UK mail weight characteristics) the UK is the seventh cheapest in the EU. Royal Mail also provides one of the cheapest Second Class mail services in the EU for items weighing 0–20g. Indeed a number of European operators charge more for their Second Class service than Royal Mail charges for First Class.

23. Given the scale of losses in Royal Mail’s core mails business in recent years, and the legacy of low prices for the level of service enjoyed in the UK, there does need to be a resetting of prices to match the value which is offered in order to allow a financially sustainable universal postal service in the UK. Royal Mail seeks to strike an appropriate balance between the commercial return and the impact on customers, and one which meets the regulator’s and other stakeholders’ expectations now and in the future. This includes balancing the effect on revenue of declining demand, including reductions which are the result of price rises.

Customer Research

24. Following the questions raised by Mr Binley and Mr Zahawi, we would draw to the Committee’s attention that Royal Mail takes consumer research very seriously and uses a range of sources of information to build a picture of our customer base to inform our decision making processes. As noted by the Committee, we naturally used research undertaken by Postcomm and Consumer Focus on consumers and SME’s to inform the analysis undertaken to understand the impact of increases in the price of stamps, the question of affordability and the development of its views on the level and the scope of Ofcom’s proposed safeguard price cap. To assist the Committee this research is attached in full.5 Other research used by Royal Mail to inform its analysis, from the Office of National Statistics and Postcomm, is also attached.6 We believe it is right that our decisions should be underpinned by evidence from third parties with a specific remit to protect the consumer.

25. As there was some debate over the consumer expenditure analysis which Royal Mail undertook to support its submission to Ofcom’s consultation on the future regulatory framework for postal services, we would like to clarify the position for the Committee.

26. When discussing the level and scope of the safeguard cap, Royal Mail made use of data drawn from our Consumer Panel Survey. The Consumer Panel Survey comprises a panel of 600 households who record what they send and receive through the post each day. Panel members are recruited to statistically represent the UK population—the proportion of vulnerable customers on the panel is therefore representative of the proportion in the UK population as a whole—31% of households on the panel are in vulnerable (D/E) socio-economic groups. The Consumer Panel survey is a quantitative survey independently run by TNS on behalf of Royal Mail and has been in place continuously since 1985.

9 March 2012

1 Special Delivery Next Day stamped and franked services form the USO registered and insured service.

2 Ofcom Securing the Universal Service: Proposals for the future framework for economic regulation, para 5.12.

3 In response to Q92.

4 Single piece inland mail paid for using stamps.

5 Not printed here.

6 Not printed here.

Prepared 3rd April 2012