competition in postal markets

8/3/2019 Competition in Postal Markets

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Competition in postalmarkets a smallconsumer perspectiveCem Suleyman


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Competition in postal markets a small consumer perspective 2

Contents

About Consumer Focus 3Introduction 4What do customers want from the postal market? 5The current challenges facing the postal market and USPs 6Competition from alternative postal operators 6Intermodal competition 6Internal inefficiency 6Competition in international postal markets 8E2E competition 8Downstream Access competition 8Worksharing 8The UK 8Germany 9Sweden 10The Netherlands 10Observations from international postal markets 11What are the dangers of competition to the USO and how dangerous are they? 12The benefits of access competition 13The rationale for providing access in the postal market 13The ladder of investment 14Access pricing methodologies 14

The effect of downstream access pricing in the UK 16What form of access pricing methodology is most appropriate for the UK? 17Final observations 18Encouraging dynamic competition 19Functional Separation 19Conclusion 22References 23

Notes 26


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About Consumer Focus

Consumer Focus is the statutory consumer champion for England, Wales, Scotland and(for postal consumers) Northern Ireland.

We operate across the whole of the economy, persuading businesses, public services

and policy-makers to put consumers at the heart of what they do.

Consumer Focus tackles the issues that matter to consumers, and aims to give people a

stronger voice. We dont just draw attention to problems we work with consumers and

with a range of organisations to champion creative solutions that make a difference to

consumers lives.

Acronyms

B2C Business to consumer

BCS Business Customer Survey (Postcomm)

CPs Communications providers

DAP Delivery-Area Access Pricing

E2E End to endECPR Efficient Component Pricing Rule

EAB Equality of Access Board

EOI Equality of input

FMO Full market opening

NRA National Regulatory Authority

SME Small and medium-sized enterprise

USP Universal Service Provider

USO Universal Service Obligation


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Introduction

Economists have long debated the benefits and drawbacks of competition, monopoly andstate interventions. These also apply to the postal market. Is increased competition within

the postal sector essential to providing customers with the innovative, high quality and

customer-focused services they need and want? Is increased competition to incentivise

incumbent Universal Service Providers (USPs) to become more efficient required in order

to sustain provision of the Universal Service Obligation (USO), to the benefit of

consumers? This question is even more crucial when competition to incumbent USPs is

increasingly coming from electronic forms of communication.

On the other hand, can increasing competition threaten incumbent USPs who carry the

burden of providing the USO? Is the risk of cherry picking by entrants in profitable

areas of the postal market likely to leave incumbent USPs saddled with delivery

obligations in unprofitable areas, leading them being unable to fund the USO, to thedetriment of consumers? Or is there a middle way, where competition and its associated

benefits can be encouraged while simultaneously ensuring that the incumbent USP is

able to fund the USO?

These questions are of even greater importance following the adoption of Directive

2008/6/EC in February 2008. Under the 2008 Directive full postal market liberalisation

should be completed by the end of 2012, although 95 per cent of the EU postal market is

expected to be liberalised by the end of 2010.

This paper intends to provide a knowledgeable contribution to this debate by answering

the following questions:

Firstly, what do customers want from the postal market? Secondly, what are the current

challenges facing the postal market and incumbent USPs? Thirdly, what types of

competition have developed in Europe, and what effects have these had on postal

markets? Fourthly, how dangerous is increased competition to the continued provision of

the USO? Finally, how can competitive dynamics in postal markets be improved in order

to maximise benefits to consumers?

This paper will focus mostly on the benefits that should accrue to residential and small

and medium-sized enterprise (SME) consumers predominately within the UK postal

market but with examples and information from other European postal markets to support

this papers arguments.


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What do customers want fromthe postal market?

Customers, from the largest mailers to the smallest, want postal products and services

that are innovative, affordable, reliable and high quality, and that meet their individual

needs; it is in no way different to other markets in this respect. But what do customerswant specifically? For the largest postal consumers, Postcomms Business Customer

Survey (BCS; Postcomm, 2010a) for 2009 suggests that the main catalyst for switching

(a proxy for understanding what customers want) was to take advantage of cost savings

due to higher price sensitivity.

For residential and SME customers in the UK the most important aspects of the postal

service are the elements that make up the universal service: affordable prices at auniform tariff; one collection and delivery a day, six days a week; and a service that

performs to a high standardi(as defined under Royal Mails Quality of Service targets in

Condition 4 of their Licence; Postcomm, 2009a). As such, the USO is of critical

importance to customers. There is a good reason why Postcomms primary objective is to

safeguard the USOii: customer research in the UK continually shows that customers find

it very difficult to look beyond the status quo of the elements that make up the current

USO definition when identifying their postal needs. This view has been confirmed by the

latest available consumer survey the Postcomm Customer Survey for 2009 (Postcomm,

2010b). For example 67 per cent of residential customers stated that to reduce the one

collection and delivery from six to five days a week would be unacceptable. Furthermore,

62 per cent of SME customers stated that to reduce the one collection a day from sixdays to five days a week would be unacceptable and 58 per cent said that to reduce the

one delivery a day from six to five days a week would also be unacceptable.

The research suggests that maintaining at least the current USO must be the highest

priority for the postal market, regulatory bodies and the Governmentiii. Consumer Focus

and Postcomm are currently undertaking customer research to understand more clearly

the needs of all consumers from a USO. The results from this project could lead to

amendments being made to the elements currently provided under the USO. However, itis not for this paper to second guess the results of any future customer research and as

such this paper considers that preserving the current USO should be the top priority for

the postal market. This papers view is similar to the HooperReport (Hooper et al., 2008),

the concluding report of the Independent Panel set up by the UK Government to reviewpostal services in December 2007. This stated, now is not the time to reduce the

universal service. Reducing the number of deliveries each week from six to five would be

in no-ones best interest (Hooper et al., 2008, p. 6).


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The current challenges facingthe postal market and USPs

There is a general feeling among industry participants and commentators iv that the postal

industry, and especially the provision of the USO as currently defined, is facing a

multitude of pressures that require a positive industry responsev to ensure the industrymeets the needs of its customers. The three main threats that incumbent USPs face at

present can be categorised as follows:

Competition from alternative postal operators

These include firms that acquire access to the USPs network and those with their own

downstream network who, in effect, bypass the USPs network. Competitors are takingaway an increasing share of the former monopoly USP s market, be it the upstream bulk

mail Business to Consumer (B2C) market or regional and national end-to-end (E2E)markets.

Intermodal competition

Individuals and businesses are increasingly turning to electronic forms of communication

and moving away from the postal service. One of the biggest examples of this has been

the move by various utilities towards online interaction.

Internal inefficiencyThis includes outdated machinery, inflexible working practices and inefficient network

structures (for example a failure to optimise the number of mail centres). Postcomm

estimated that Royal Mail would achieve an increase in efficiency of 0.6 per cent

compared with a target of 3 per cent per annum for 200710 (Postcomm, 2008).

However, total costs for Royal Mails letter business fell by 3 per cent in 2009/10

(Postcomm, 2010d). The USP could also face poor industrial relations.

The first two threats are exogenous pressures on USPs. The risk that competition brings

to the USP is that it might consistently lose mail volumes and therefore not be able to

generate enough revenue to cover its fixed costs as well as the cost of the USO.

According to Royal Mails annual report 2009/10, UK mail volumes were down by 7.3 per

cent in 2010 (Royal Mail, 2010). The BCS also found that businesses generally predicted

that mail volumes will decline over the next five years (Postcomm, 2010a).

There is a further risk that alternative postal operators will cherry pick profitable parts of

the USPs former monopoly postal market, leaving the USP to pick up the cost of the

unprofitable parts of the postal market. This could further lead to the dreaded Graveyard

Spiral of lower volumes and thus lower revenue.

The third threat faced by some USPs can be categorised as an endogenous threat. It is

commonly acknowledged that current incumbent USPs are the only business institutions

with the network and economies of scale to deliver the USO (at least in the short to

medium term)vi. It is therefore essential that incumbent USPs are as efficient as possible

and not only meet the threat of competition but also ensure that prices are derived at

least cost. This is key to ensuring the sustainable provision of the USO. There is, of

course, an obvious causal relationship between a lack of competition and inefficiency.


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To meet the challenges of inefficiency, competition and the e-substitution effect,

regulatory bodies can implement a number of solutions. Ex-ante price cap regulation can

incentivise USPs to become more efficient by partially replicating the normal dynamic

competitive process. It is hoped that the review of RPI-X regulation by the GB energy

regulator Ofgemvii will propose new and alternative mechanisms to incentivise monopoly

businesses to become more efficient. There may also be a need to change the ownership

of the business, from the state to the private sector. This was part of the UKGovernments postponed Postal Services Bill of 200809viii which has subsequently been

revived by the new coalition Government (HM Government, 2010). It is interesting to note

that privatisation of state-owned incumbent USPs has sometimes preceded postal market

liberalisation, partly in the belief that the efficiency and commercial focus that privatisation

can provide will assist USPs in adapting to liberalisationix.

However, this paper believes that the best way for incumbent USPs to meet the

challenges of e-substitution and inefficiency is to foster greater competition in the postal

market. This should provide the greatest spur to postal incumbents to become more

efficient, customer orientated and innovative. Similarly, Postcomms vision for the postal

market involved, a range of reliable, efficient and innovative postal services, including a

universal postal service valued by customers, and delivered through a competitive postalmarket (Postcomm, 2006, p. i).


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Competition in internationalpostal markets

The three main types of competition in international postal markets can be defined as

follows:

E2E competition

This is where an entrant completely bypasses the incumbent operators upstream and

downstream network. This has occurred mostly on a regional rather than a nationwide

basis and operators are not subject to any USO requirements.

Downstream Access competitionThis is where a rival postal operator or large mailing customer can insert mail into a

section of the incumbents network, in effect buying access to the incumbents

downstream network. In the UK the most common form of access competition is

downstream access where mail is inserted at Royal Mails inward delivery centres for

Royal Mail to deliver over the final mile. Again operators are not subject to USO

requirements.

Worksharing

These are upstream access activities involving collection, consolidation, presorting,

barcoding and transportation by customers or mail preparation companies in advance oftendering the mail to the postal operator (Crew and Kleindorfer, 2008). This form of

access competition is common in the USA.

This paper now provides empirical evidence of the experience of competition in the UK,

Germany, Sweden and the Netherlands and describes the effects of the liberalisation of

these markets on customers, the USO and the industry.

The UKx

Since April 2001 Royal Mail has had to negotiate in good faith with any postal operator or

user who seeks access to its network. If both parties fail to reach an agreement the

applicant has the right to ask Postcomm to make a determination to provide access(Dudley et al., 2009).

In April 2006 price regulation was extended to Royal Mails access services. Royal Mail

must ensure that there is sufficient headroom ie the margin between the access price

and Royal Mails equivalent bulk mail service (Dudley et al., 2009). This is to ensure

against the possibility of margin squeezexi which can eventually lead to upstream

competitors being forced to exit the market. Downstream access prices are therefore

lower than Royal Mails equivalent products. The relatively low access price is one of the

main reasons cited for the lack of E2E competition in the UK market, for example in the

B2C letter mail market, although there is more E2E competition outside the licensed area

(de Bas and van der Lijn, 2008). Another principal barrier is the VAT exempt status of

Royal Mail. This provides a disincentive for VAT exempt business customers to switch

away from Royal Mail (de Bas and van der Lijn, 2008).


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Retail prices in the UK have increased faster than inflation for residential customers. The

latest price increases (in April 2010) were agreed to by Postcomm mainly due to the

significant fall in mail volumes, increased pension contributions and Royal Mails failure to

achieve efficiencies quickly enough. The outcomes of this have left Royal Mail in a

position where, although the Letters business is profitable, its short term cash flow is still

negative (Postcomm, 2009b).

For the whole UK postal market Europe Economics estimated that prices were five percent lower than they would have been without competition and that net economic benefits

to the UK economy were 229 million in 2008 (Stubbs, 2008b). The 2009 BCS

(Postcomm, 2010a) reported that while customers reported some improvement in choice

and also some improvement in Royal Mails quality of service, there was less agreement

on whether there had been significant price reductions in the UK postal market.

The Hooper Report found that liberalisation had provided significant benefits for large

businesses in terms of lower prices, more choice and greater quality. However, the

Report noted that although there had been minimal benefits for residential and SME

customers following liberalisation, it was in the early stages of development and the

Report believed that the benefits of liberalisation would be forthcoming for thesecustomers. The Report was of the view that the USO was under threat not as a result ofliberalisation, but rather from Royal Mails failure to modernise its business in response to

e-substitution (Hooper et al., 2008).

Germanyxii

The German Postal Act (Art. 28, German Postal Law) requires dominant postal operators

to provide downstream access to services within the licensed area on reasonable request

(Dieke et al., 2008). The tariffs for downstream access are determined by the regulator on

a retail-minus basis that must be reasonable and competitive. Due to relatively high

downstream access prices, the small spread between access tariffs and retail prices

provides incentives for entrants to bypass Deutsche Posts delivery network.

By 2007, after 10 years of gradually opening the market to competition, Deutsche Posts

competitors had a combined market share of 12.9 per cent by revenue (Federal Network

Agency, 2007). The tariffs of competitors have usually been slightly lower than those of

Deutsche Post despite competitors having to charge VAT on letter prices (Dieke et al.,

2008).

Generally, liberalisation has had a positive impact on the German postal markets ability

to continue to provide the universal service (Dieke et al., 2008). Deutsche Posts

performance is consistently above regulatory targets. Business mailers have benefited

from competition as they have a choice of providers, and prices have fallen. Prices for

residential customers have fallen slightly in real terms. The regulator(Bundesnetzagentur) is of the view that the universal service has been provided

adequately by the market and has therefore not made any interventions to ensureuniversal service (eg an external fund).


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Swedenxiii

Sweden Post continues to dominate the Swedish postal market, delivering 90 per cent of

total mail volume. Its main competitor, CityMail, had a market share of total letter volume

in 2007 of 9.1 per cent; however, it took many years for CityMail to become profitable

(this happened for the first time in 2005; Dieke et al., 2008). It is interesting to note that

CityMail went bankrupt twice (in 1992 and 1995) but re-entered the market both times

(PTS, 2008). The first bankruptcy was found to be partially the result of Sweden Post

indulging in predatory pricing in an effort to foreclose competition.

Sweden Posts quality of service improved considerably in the 1990s following

liberalisation and has remained of a good standard since. It is the view of the postal

regulator, PTS, that, the most important reason for this outstanding transit time

performance is that Posten AB for a long time has been used to competition in segments

of the postal market that in most other countries has been protected by statutory

monopolies. As a result of the liberalisation of the letter market as well, the growing

competition has furthered improvement in quality and efficiency (PTS, 2007, p. 7).

Furthermore, PTS stated that, Pressure on prices is most noticeablefor mail to the

areas where Posten AB has met competition from CityMail (PTS, 2007, p. 9). However,following liberalisation, retail prices were significantly rebalanced by Sweden Post with

retail price increases occurring simultaneously with price falls for business consumers.

The regulator subsequently introduced price cap regulation to mitigate against the effects

of price rebalancing (Dieke et al., 2008).

PTS believes that full liberalisation, has not affected the universal service providers

ability to provide a profitable nationwide postal service at reasonable prices (PTS, 2007,

p. 2).

The Netherlandsxiv

Downstream access is not directly regulated by OPTA (the NRA) but is subject toprivately negotiated agreements between the incumbent postal operator TNT and those

applying for access. However, those applying for access must be treated in a non-

discriminatory fashion. Prices are set on a retail-minus basis (de Bas and van der Lijn,

2008).

TNT is still dominant in the Dutch mail market but does face reasonable competition in

the direct mail market and the application of VAT has been implemented to ensure a level

playing field between mail operators. In 2007, OPTA estimated that competitors to TNT

had a combined market share by mail volumes of approximately 14 per cent (OPTA,

2008).

Following the privatisation of the Dutch postal incumbent and gradual liberalisation, TNThas improved and maintained high levels of quality of service. Retail price rises have

largely been limited to increases in inflation and it is highly likely that bulk mail priceshave lowered as a result of increased competition in that market (Dieke et al., 2008).

Finally, there are no indications that competition has had a negative impact on TNTs

financial position, service quality and ultimately its ability to deliver the universal service

(Dieke et al., 2008).


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Observations from international postal markets

The empirical evidence shows that competition has provided significant benefits to

consumers, especially for large mailers. Residential customers have tended to benefit

indirectly from competition in terms of incentivising the incumbent postal operator to

become more efficient and improve its quality of service. There is no evidence that the

introduction of competition has put the viability of delivering the universal service at risk at

least directly.

It is important to note that the European Commission in 2006 held the view that while

competition was taking time to develop, competition had the potential to deliver real

benefits to consumers: Competition is not an end in itself, but a means to promote

innovation, investment and consumer welfare. (European Commission, 2006, p. 6).

While the empirical evidence does not seem to suggest the provision of universe service

will suffer as a result of the liberalisation of postal markets, a great deal of the academic

literature concentrates on the threat to the provision of the USO in the event of mandated

access to postal incumbents networks. This paper now turns primarily to this issue.


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What are the dangers ofcompetition to the USO and how

dangerous are they?

If competition has delivered benefits for postal consumers why should it be restrained?

The only legitimate reason to restrain competition is if it puts the continued provision of

the USO at risk.

The main danger highlighted in the academic literature (eg, Panzar, 2002) to incumbent

USPs is mandating access to their network. This could encourage entrants to compete in

profitable areas while leaving the USP to deliver all mail, including the mail collected by

the incumbents competitors upstream, who then can buy access to the incumbentsdelivery network. Entrants are able to carry out this business strategy as they are not

obliged to operate under USO requirements. This cherry picking activity has the result

that entrants will compete successfully in the incumbents profitable delivery segments,

perhaps by bypassing the incumbents delivery network (often urban areas), while the

incumbent is increasingly left to serve unprofitable delivery areas (often more rural

areas). This will result in the incumbent losing revenues in its profitable segments while

having to serve less profitable areas and therefore making an overall loss. The resulting

loss of revenues and mail volumes leads to the incumbent gradually facing a reduction of

its economies of scale and increasing its unit costs. This can lead to the USP being

permanently loss making and therefore unable to continue to provide the USO xv (known

as the Graveyard Spiral).

This situation becomes possible as the incumbent is forced by the USO, in some

circumstances, to charge uniform access prices regardless of delivery cost differentials.

Thus, a uniform tariff can lead to low cost areas being priced above cost while high cost

areas are priced below cost. This is demonstrated in Table 1 where the USP must be

allowed to break even:

Table 1. Example of USP uniform tariff pricing

Low cost area High cost area

Qty of letters 2bn 1bnUSPs cost per letter 20p 50pUSPs uniform tariff 30p 30pUSPs profit/(loss) 200m (200m)

The severity of this scenario depends on whether the entrants service completely

replaces the incumbents volumes (it is not necessarily a one for one displacement ratio).

In fact, by attracting new mail volumes ie mail not previously delivered by the incumbent

USP, the USP can benefit from increased volumes passing through their delivery network

thereby driving down unit costs.


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The benefits of access competition

If there are potential problems associated with mandating access to an incumbent USPs

network what is the rationale for compelling USPs to provide access?

Obviously if there is effective competition along the whole value chain there is no need to

mandate access. Such a regulatory policy will in all probability lead to a decrease in

allocative efficiency, blunted innovation and ultimately higher prices for consumers (Crewand Kleindorfer, 2003).

However, mandated access is more likely to yield benefits for consumers when applied to

former monopoly industries with both contestable and non-contestable elements ie where

large sunk costs exist in parts of the value chain. The major benefit of liberalisation is

that it exposes the old monopoly industry to competitive pressures, providing the

incentive to become more efficient, innovative and customer focused. So even where a

natural monopoly exists (although this is almost certainly not the case for the postal

network) the benefits of competition can still be obtained, although not on the same scale

as in a fully competitive market (Panzar, 2002). However, it is important that the regulatordoes not inadvertently pick the type of competition that will develop because of its

regulatory actions. Such a move could lead to a reduction in allocative efficiency and thuspoorer outcomes for consumers.

The rationale for providing access in the postal market

As discussed, mandating downstream access makes it possible for potential entrants to

compete with the dominant firm in the contestable element of the value chain. The

delivery network is the one large component of overall cost (mostly labour costs) whereeconomies of scale are significant in postal marketsxvi. An entrant seeking to replicate the

incumbents national delivery network to offer a universal service, with its obligation to

delivery daily to every address, would find this very costly (Rodriguez and Hill, 2005).

However, as there is no obligation on entrants to deliver daily offering a more limiteddelivery service (say three deliveries a week) would reduce the entrants start-up costs of

establishing a nationwide network.

Postal economic research suggests that there are extensive fixed and common costs in

universal service provision. However, in the postal network it is arguably the case that

very few non-replicable assets constitute an essential facility or monopolistic bottleneck.

Mail collection, sorting, transport and delivery access might exhibit economies of scale

and represent a natural monopoly in remote areas, but economies of scale alone do not

create an essential facility. Furthermore, the scale of sunk investments should not be very

high as postal operators should be able to lease any equipment needed and a large

proportion of costs are in fact labour (Heitzler, 2009).

However, it is improbable that liberalisation on its own will allow entrants and competition

to enter and flourish immediately. There is also a fear that if access is not underpinned bya regulatory commitment, incumbents will price competitors out of the market, for

example, following liberalisation of the GB gas market in 1982, British Gas Corporation

continued to exert complete dominance in the market (Helm, 2003). Other barriers to new

entrants in postal markets include the USPs economies of scale, the USPs technological

cost advantages, the USPs informational advantages when negotiating with NRAs and

the risks to competitors from potential competitive (possibly anti-competitive) response

from USPs.


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So while from a purely economic perspective mandating access in the postal market

might be unjustified, access to the monopolists network might be needed to allow

entrants to access the network required to provide the products or services in question,

thus increasing competition and market contestability. Specifically, the ladder of

investment argument articulated by Cave (2004) may override economic concerns, at

least in the short run.

The ladder of investment

Cave stated that access regulation should be implemented to generate sustainable

infrastructure-based competition where feasible. The objectives of promoting competition,

innovation and investment can be achieved by providing access to infrastructure

progressively to allow entrants to climb the ladder of investment (Cave, 2004). The idea

is as follows: the postal market needs to encourage investment by both incumbents and

entrants. Entrants may have to acquire capital assets progressively as they build up

customer base and revenues. This should also lessen the need for intrusive regulation in

future.

Postcomm implementing a headroom regime has helped competitors get a foothold inthe market which should make it more likely that new entrants develop E2E networks.

Postcomm stated that, even after FMO, Royal Mails incumbent economies of scale in

delivery (particularly social and SME consumers) are likely to constitute a barrier to

significant competitive entry for postal delivery activities. Market shares are likely to be

required by new entrants to compete in delivery (Moriarty and Smith, 2005).

However, providing access at low prices in perpetuity can dilute incentives to invest ie

bypass. Mandatory access should be set for a defined period of time after which it ceases

to exist or is made available in the form of commercially negotiated contracts or at higher

and higher regulated prices. This will provide the incentive to invest (Cave, 2004). If

access is too cheap then entrants will decide not to invest in E2E networks. The lack of

investment then may be used to justify continuing the cheap access policy. This wouldconstitute a circular argument.

It has been said that establishing a nationwide E2E delivery network in the UK has

proved more difficult than in other countries because of the VAT distortion (de Bas and

van der Lijn, 2008). If competition is to develop it would be sensible to provide a level

playing field in the charging of VAT. This seems to have helped provide favourable

conditions for efficient entry in the Netherlands. There is also the issue that there have

been no regional E2E networks for competitors to build upon.

The challenge for regulators is to achieve the competitive benefits listed above which

accrue from mandating access, but at the same time ensuring that the provision of the

USO is not put at risk by constraining unreasonably the USPs ability to ensure theprovision of the USO. This could occur if mail volumes and revenue are competed away

from the USP by virtue of inefficient entry by either access or E2E competition.

Access pricing methodologies

The objective of competition policy should be to ensure that the lowest cost producer

delivers all the different elements of the postal value chain subject to ensuring the

continued provision of the USO ie not loss making in the long run (Crew and Kleindorfer,

2003). It is therefore essential that efficient price signals are provided to entrants when

the time comes for them to take a make or buy decision.

There have been many different access price methodologies proposed to ensure thatefficient entry (both access and bypass) is properly incentivised to ensure the incumbent

USP does not cross subsidise the new entrants and does not lose the ability to fund the


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USO. One method of setting access prices involves setting prices on the basis of the E2E

price less the upstream avoidable costs (including a return on capital employed). This is

in effect a method of the Efficient Component Pricing Rule (ECPR) which is sometimes

referred to as retail minus pricing (see Figure 1; Dixon , 2010). The main alternative to an

ECPR access price methodology is cost plus access pricing.

a* = c + [p (c+u)]

Access price (a*) = retail price minus upstream avoidable costs.

Figure 1. ECPR access pricing illustration

However, where there are fixed network costs and a uniform pricing constraint on the

USP, there may be a need to set an alternative pricing formula to ensure that access

prices allow the USP to break even (Crew and Kleindorfer, 2008; De Donder, 2006).

Some academic articles consider allowing incumbent USPs to charge cost reflective and,

as such, non uniform access prices to access operators that do not deliver on a

nationwide basis similar to the incumbents delivery profile (known as fall to earth). This

in effect de-averages access pricing making it less likely that entrants will be able to

cherry pick incumbents profitable market segments.

Crew and Kleindorfer (2003), the main proponents of this form of access pricing, state

access pricing should involve the use of Delivery-Area Access Pricing (DAP) which raises

access prices charged for downstream entry to high cost delivery areas and lowers pricesin low cost areas. The authors believe that to simply apply a variant of ECPR is not

sufficient to recover the incumbent USPs avoided costs; their rule for DAP pricing

involves setting the access charge for each delivery zone to be the maximum of

ECPR/avoided cost rule and the marginal cost of delivery in that zone at a single piece

rate. De-averaging access prices makes them more cost reflective, helping to promote

more efficient use of resources and effective competition.

The access pricing literature also illustrates that where bypass is a possibility, the designof access prices makes it even more difficult for the USP to break even. In fact De

Donders (De Donder et al., 2005) models show that the welfare effect for customers

under a situation where both access and bypass are possible is worse than undermonopoly conditions.

Of course, the degree to which an access pricing solution will succeed depends on the

proportion of fixed network costs. If it is high relative to total costs this implies that prices

will have to be set much higher than the underlying marginal cost to recover the fixed

costs (Armstrong, 2006). However, the presence of a high degree of fixed costs in the

upstream network is debatable, at least in principle, especially if most of the costs are

labour (which should be classified as variable costs). The same could be said for

downstream costs. Figure 2 below shows the ratio of labour costs as a proportion of total

costs for European USPs for 2002 and 2007.

Direct cost of providingaccess

Opportunity cost ofproviding access


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Figure 2. Ratio labour costs of total cost national postal operators 2002 and2007 (graph taken from Winkelmann et al., 2009)

The graph shows that the ratio of labour costs to total costs varies from a high of nearly

80 per cent to a low of 30 per cent in 2007. Labour costs as a proportion of overall costs

for Royal Mail in 2007 were a little under 70 per cent. This suggests that a largeproportion of Royal Mails costs were in fact (in principle) variable not fixed. If this is the

case, the danger that the USP will be unable to fund the USO diminishes.

The effect of downstream access pricing in the UK

Having set out some of the theory behind setting efficient price signals for access and

bypass, what has been the effect of downstream access pricing for consumers, the USO,

the USP and competition? The following will focus primarily on the UK experience but will

also bring in some of the international experience.

In the UK the increase in market share for downstream access operators into the

upstream bulk mail market has been fast and represents profound change. Accessoperators had a market share equal to 38 per cent of Royal Mails volumes in 2010

(Postcomm, 2010e). On the other hand Royal Mail continues to deliver over 99 per cent

of E2E volumes. It would seem, therefore, that cost-plus access pricing and the use of

headroom to prevent margin squeeze has encouraged access rather than E2E

competition: buy rather than make. It has been claimed Postcomm sought to ensure

that the headroom requirement erred towards being generous for potential entrants so as

to help kick-start competition and give competitors a foothold in the market (Dudley et al.,

2009).

The first question to answer is whether the practice of cherry picking has occurred on a

large scale in the UK.


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It is important to note that the Postal Directive (2008/6/EC) makes it clear that imposing

uniform tariff requirements should be avoided and only implemented where the

public/consumer interest demands it: In a fully competitive environment, it is important ...

that the principle that prices reflect normal commercial conditions and costs is only

departed from in order to protect public interests. (Directive 2008/6/EC p. 6).

As such, in 2004 Royal Mail provided entrants and large users with the opportunity to

negotiate uniform access prices for a national average profile of mail (as well as zonalaccess agreements). This means that access operators or CDA operators can only use

the access product if their mail profile matches the national geographical average profile

of Royal Mails products. This prevents Royal Mail receiving a disproportionate number of

mail items in high cost delivery areas (Dudley et al., 2009).

It seems that the introduction of zonal access pricing (as envisaged by Crew and

Kleindorfer) has reduced the likelihood that access customers will have the ability to take

advantage of arbitrage opportunities that uniform access prices would provide, because

prices are rebalanced for high and low cost delivery areas. In any case, the take-up of

zonal access agreements has been quite small. This is partially explained by the fact that

large mailers post close to Royal Mails national fall to earth and therefore accessoperators prefer to negotiate national access agreements (Dudley et al., 2009).

Therefore, it is safe to conclude that cherry picking is unlikely to have happened on a

grand scale in the UK, and the effects on the ability of USP to ensure the provision of the

USO have been overstated according to the empirical evidence.

What form of access pricing methodology is mostappropriate for the UK?

We now turn to the question of what is the best access price to set in the postal market.

This in effect is a choice between retail-minus and cost-plus access pricing. International

evidence suggests that retail-minus pricing, by allowing the incumbent USP to collect thefull avoided cost upstream, including the return on capital employed for both USO and

non-USO products, has provided a disincentive for entrants to buy access and a greater

incentive to bypass. This is because the relative price of access is high or sufficiently

equivalent in comparison with the option of bypassing the incumbents E2E network. This

seems to be the case in the Netherlands and Germany (de Bas and van der Lijn, 2008).

The use of cost-plus pricing in the UK seems to have had the opposite effect.

However, the use of retail-minus access pricing can be thought to be over generous to

incumbent USPs. Postcomm stated that it believed prices should be based on a

reasonable allocation of costs and not, as Royal Mail had argued, based on a retail-

minus principle (Postcomm, 2004, p. ii). The reason given was as follows:

If Royal Mail was split into two companies (upstream and downstream) and the

downstream business charged the upstream business a fee for final delivery, it isinconceivable that this charge would include costs incurred by the upstream business. A

retail-minus approach to access pricing would, however, require third party operators that

compete with the upstream business to pay for such costs. This would therefore be

discriminatory: Royal Mail would effectively be favouring its own upstream business by

charging an excessive price to third parties (Postcomm, 2004, p. ii-iii).

Furthermore, William Baumol, who developed the ECPR for pricing access to Rail Track,

recognised criticism (from William Tye for example) that the ECPR would not play a

constraining role on monopoly pricing ie that ECPR preserves full monopoly rents. In

response Baumol proposed a second allocative efficiency rule to address this issue. Also,

the UK competition Appeal Tribunal rejected the use of the ECPR in the Albion case for

preventing virtually any market entry (Albon, 2007).


18/28


For these reasons a cost plus rather than a retail minus pricing methodology should be

adopted to ensure that new entry is encouraged and that monopoly rents are competed

away.

Final observations

This paper concludes that access should be mandated because of the ladder of

investment argument. Access pricing should be made using a cost plus methodology notECPR although there is a need for some zonal access pricing. This is required to ensure

the sustainable provision of the USO. Economic arguments about essential services are

superseded by the previous arguments, including the ladder of investment. Furthermore,

if the threat of entry is not credible the pressures on Royal Mail to become more efficient

are likely to subside over time. It is important to remember that the main threat to Royal

Mail is coming from alternative communications media notalternative postal operatorsxvii.

If anything, the threat of the incumbent USP behaving anti-competitively is a greater risk

to new entrants than the potential threat to USPs from new entrants (as competition

cases in Sweden demonstrate).

Any decision made on downstream access pricing needs to be made on the basis thatthe cost information provided by the incumbent USP is accurate and that the access

charge properly reflects the companys costs. One of the major criticisms made in the

Hooper Report was that there was little agreement between Royal Mail and Postcomm as

to what extent the access price reflected actual underlying costs (Hooper et al., 2008).

This highlights the importance of Postcomms current cost transparency work designed to

ensure that access operators pay an appropriate price for the use of Royal Mails

services for delivery (Postcomm, 2010c, p. 10). Postcomm is therefore proposing to buildupon Royal Mails Activity Based Costing methodology by establishing guiding and

methodological principles to detail the fundamental requirements of the product costing

methodology for regulatory purposes. Further, Postcomm wish to implement a costing

manual which will contain a description of the costing methodology as well as itsunderlying assumptions, and a change control process to ensure regulatory oversight. xviii


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Encouraging dynamiccompetition

As has been demonstrated above, competition in postal markets can deliver major

benefits for consumers, both large and small, either directly or indirectly. However, can

the competitive dynamic be improved by making changes to the market structure or itsoperation? If it could then there is an increased chance the postal market will deliver the

innovative, affordable and customer oriented products and services that all consumers

want. This is of vital importance if the postal industry is to grow the market and increase

mail volumes (be it letters, packets or parcels) in the face of an increase in the e-

substitution effect.

One of the main criticisms in the UK about the way that competition has developed is thatthe main competitors to Royal Mail in the upstream bulk mail market only offered the

same products and services as Royal Mail. The only difference is that they have provided

them more cheaply (which is not in itself a bad thing) there has been little in the way of

innovation (Dudley et al., 2009). However, the counter claim is that Royal Mail has made

it very difficult for other operators to innovate by placing increasing restrictions upon

access operators attempts to introduce new products and services (Stubbs and

Broomfield, 2009).

In this section this paper examines functional separation for the incumbent USP as one

potential way to improve the competitive dynamics in the postal market.

Functional SeparationOne of the main potential problems with mandating access to parts of the incumbent

USPs network is that there may be insufficient incentives for the USP to sell its network

capacity efficiently and proactively to rivals. The USP may be defensive in negotiating

with rivals, preferring to keep market share and thus mail volumes and revenue. In effect

it may not provide elements of their network on equivalent terms to rivals as it does to its

own upstream business (especially in non-price terms). This is not only bad news for

competition, it is bad news for the postal industry and consumers, because if postal

volumes are to be grown in the face of e-substitution it requires the incumbents delivery

network to be sold actively to all upstream competitors not just its upstream affiliate. One

way to do this is to separate the less contestable part of the incumbents network andensure that it sells its capacity on equivalent terms both to itself and to its rivals.

The most interesting experiment today in the UK utilities market has been undertaken by

Ofcom in requiring a separation in BTs vertically integrated company (Ofcom, 2009).

The objective of Ofcoms Strategic Review of Telecommunications was to ensure the

development of a competitive communications market. The central conclusion was that in

order to improve competition it was essential to address the long-standing barriers to

competition and investment by providing communications providers (CPs) with equality of

access to the parts of BTs network that represented a bottleneck. This was implemented

by requiring equality in the provision of inputs and functional separation (the

Undertakings; Ofcom, 2009).This required BT to separate its delivery and systems functions to ensure that particular

wholesale products and services were delivered by BT on an equality of input (EOI)


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basis. To ensure function separation BT created a new organisation, Openreach, which

operates distinctly from the rest of BT Group and provides almost all the wholesale EOI

products.

What is very important is that where BT sells specified wholesale EOI products it does so

to the same timescales, terms and conditions and using the same systems and

processes to both its own downstream affiliate and its rivals. This is to ensure that

downstream competitors use a common and equivalent set of inputs when offeringcompeting services to customers (Ofcom, 2009).

Openreach has been operating as a separate organisation since 2006. It is Ofcoms view

that Openreachs engagement with customers and service quality has improved. Areas

that have proved more challenging include Openreachs approach to product

development and its implementation of systems separation (Ofcom, 2009). The

Undertakings established the operational dividing line between Openreach and BT

Wholesale. It is Ofcoms view that the Undertakings have worked well in creating two

separate entities, Openreach and BT Wholesale, which understand their roles and

responsibilities. Ofcom believe that BT Wholesale has achieved a degree of regulatory

freedom compared to the period before the Undertakings came into place enabling it tofocus its efforts better on participating in the competitive market (Ofcom, 2009). This is

crucial in growing the market.

The Equality of Access Board (EAB) was established to monitor BTs performance in

delivering the Undertakings and presents its work each year in the form of an Annual

Report that is subject to independent assurance. It said that based on progress made

during the last three and a half years, we believe that the Undertakings have come a long

way to fulfilling their original goal of creating a level playing field (Equality of Access

Board, 2009, p. 2).

There have also been some key benefits for competition and consumers. Ofcom is of the

view that the Undertaking has played a major role in increasing choice, innovation and

increasing value for money (Ofcom, 2009). However, Ofcom has needed to monitor the

market to ensure that product offerings are available to third parties. Difficulties with the

need to ensure the availability of products to competitors have arisen from the fast

moving technological innovation that characterises the telecoms market. This should be

less of an issue in mail and logistics due to the slower pace of technological change.

It is also worth noting that competition between 2005 and 2007 led to a fall in the cost of a

basket of residential fixed voice services on average by 10.5 per cent in real terms each

year. However, Ofcom does acknowledge that while business users have benefited from

the introduction of product level equivalence, the benefits do not seem to have been as

broadly based for consumers (Ofcom, 2009).

This example provides some interesting possibilities for the postal market, in that this

structural separation in the telecoms industry has led to an improvement in the

competitive dynamic and provided benefits for customers. Such a reform might beconsidered in the postal industry if the market is to be grown and if competitors believe

looser forms of business separation (Chinese Walls for example) have stifled

competition and innovation.

Alternatively, Postcomm have proposed to implement separated accounts of Royal Mails

upstream and downstream businesses (Postcomm, 2010c) designed to support the

development of transparent transfer prices. This is important to ensure that Royal Mail

and its competitors pay the same price for using Royal Mails downstream network and

thus compete on equal terms. Postcomm have rejected a form of functional separationproposed by UK Mail (Stubbs, 2008a) stating that it would not meet their regulatory


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objectives of preserving the USO and targeting regulation (Postcomm, 2010c). It could

also be more expensive and disruptive to Royal Mail.

It remains to be seen whether accounting separation will encourage more dynamic

competition. The evidence from other regulated industries (such as UK telecoms)

suggests that a more intrusive form of separation ensures fairer competition where a

vertically integrated company dominates a particular market.


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Conclusion

The main conclusion of this paper is that the provision of the current USO is criticallyimportant to residential and SME customers. The major threat to incumbent USPs in

delivering the USO does not emanate from rival postal operators but from alternative

communication media, and in some cases internal inefficiency. The only way to ensure

the sustenance of the USO is an intensification of competition in postal markets.

Competition in postal markets should incentivise the most efficient producer to undertake

different elements of the postal value chain subject to the continued provision of the USO.

This can achieved by implementing access prices that provide efficient make or buy

signals.Although, in purely economic terms, very little of the postal network can be

classified as an essential facility, the continuation of mandatory downstream access

seems justified in order to allow entrants to get a foothold on the first rung of the ladder

of investment. This facilitates potential entry into the E2E market. However, mostimportantly from a UK perspective, it is essential that competitive pressure continues to

be exerted on Royal Mail to incentivise it to become more efficient.

The risk of harmful cherry picking is greatly reduced by de -averaging access prices ie

introducing zonal access prices. These should be set on a cost plus not retail minus

basis, as the ECPR preserves monopoly rents and can prohibit effective competition. Allaccess prices should be set to reflect the USPs underlying costs.

While Postcomm has advocated the implementation of separated accounting, this policy

might not prove adequate to foster dynamic competition; some form of functional

separation might be required. Finally, a level playing field in VAT facilitates competition in

postal markets, especially in E2E markets.


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Notes

i The Hooper Report stated that, the universal service has a strong social and economicrationale. Customers place a high value on the affordability of the service, on a uniform

tariff, and deliveries on six days per week (Hooper et al., 2008, p.8).

ii Postcomm must act, in the manner which it considers is best calculated to ensure the

provision of a universal service (Postal Services Act, 2000, p. 2).

iii Furthermore, the recommendations made by the Hooper Report (Hooper et al., 2008)

were made to ensure the provision of the USO.

iv The Hooper Report is arguably the most important articulation of this opinion. For

example the report states, The universal service is under threat and the status quo is

untenable (Hooper et al., 2008, p. 60).v At a roundtable meeting in March 2010 organised by Consumer Focus, the consensus

among industry participants was that Royal Mail would be able to finance its current

universal servi ce provision at least for the next three to five years, provided it controls its

costs in a sensible manner. However, it was recognised that if volume declines continue

at a rapid rate Royal Mail could find it more difficult to finance the universal service in

three to five years time. The consensus at the meeting was that Royal Mail can afford to

finance the universal service in the short term, which suggests that there is no need to

reduce the USO in the near future. This is important, because if it is the case that the

USO is not under as great a threat as previously thought, the argument against

introducing competition becomes weaker.

vi Postcomm stated in 2006 that, Royal Mail is the only organisation that currently has the

infrastructure to meet the universal service requirements of the Postal Service Act (2000)

(Postcomm, 2006, p. xiii). This point was reiterated in the Hooper Report (Hooper et al.,

2008).

vii Please seehttp://bit.ly/gs8bh6for details of the review.

viii Interestingly, the attendees at a Consumer Focus roundtable meeting in March 2010

agreed that Royal Mail could modernise without private partnership. It was noted that

other national postal companies had achieved substantial cost efficiencies by changing

their networks and working practices before private involvement.

ix

This was the case in other UK utilities industries (gas, telecoms etc.; Stubbs andBroomfield, 2009).

x For further information please see Dieke et al. (2008).

xi See Oxera (2009) for a fuller discussion of the concept of margin squeeze.

xii For further information please see Dieke et al. (2008).

xiii For further information please see Dieke et al. (2008).

xiv For further information please see Dieke et al. (2008).
http://bit.ly/gs8bh6http://bit.ly/gs8bh6http://bit.ly/gs8bh6http://bit.ly/gs8bh6


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xv This argument, to a certain extent, presupposes that the USO represents a net burden

for the USP; for example, providing the universal service could give advantages to the

USP in terms of brand awareness. Sweden Post has long maintained that the USO is a

competitive advantage. In the UK, Postcomm undertook an assessment of whether, and

by how much, providing the universal service imposes a cost or benefit on Royal Mail.The analysis indicated that Royal Mails capability to deliver to every address in the UK

represented a commercial advantage and not a burden. For the purpose of this paper itassumes that the USO can impose, at least a slight burden, on the USP in principle.

xvi One potential development that might occur due to the reduction of mail volumes could

be to reduce the economies of scale present in the USPs delivery network. This could as

a result increase the contestability of the market.

xvii As the Hooper Report made clear, But as of today, it is not competition with the postal

sector, but competition much more broadly across the communications sector, which

poses the greatest threat to the universal service (Hooper et al., 2008, p. 38).

xviii A similar approach has been followed by the Australian regulator, ACCC, in its

regulatory accounting framework for Australia Post (Postcomm, 2010c).


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Competition in postal markets a small consumer perspective

For more information please contact Cem Suleyman on 020 7799 7932 or [email protected]

www.consumerfocus.org.uk

Copyright: Consumer Focus

Published: Month 2011

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