1

DISCUSSSION PAPER, February 2015

Universal Service Obligations and competition in postal services: issues of robustness and fragility in current regulatory arrangements 1

George Yarrow

Regulatory Policy Institute, Oxford

Issues surrounding the implications of universal service obligations (USOs) in postal services have been extensively analysed over a long period and their general features are broadly known and understood. However, the contexts in which these issues arise change over time, giving rise to shifts in the underlying economic trade-offs which, because the developments are new and less familiar, may be less fully understood at the outset.

The two developments on which this short paper focuses are (a) a shift in public policy objectives toward seeking the introduction of competition in the provision of postal services and (b) the emergence of electronic means of communication that serve as a substitute for communication via the letter post (“e-substitution”). Each considered on its own poses a significant challenge for the maintenance of universal service provision in the letter post. Taken in combination the scale of the challenge is likely to be significantly greater.

The outcomes of competitive processes are inherently unpredictable and competition has rightly been characterised as a ‘discovery process’. If we knew precisely where the process would lead, we could simply go to the end outcome, without the messiness and costs that the process entails. For example, the extent to which e-substitutes will take future business from the letter post is uncertain. The broad, directional pressures of e-substitution appear clear enough, but their future extent and timing is more cloudy. Forecasts can be made, but forecasts are frequently wrong, sometimes radically wrong, and we will have to wait to find out. This matters because, as will be shown, economic outcomes can be highly sensitive to future developments in the market context.

One new question that I think that these contextual changes raise for the regulatory arrangements surrounding universal service provision relates to what might called the degree of fragility or the degree of robustness of the arrangements. These terms refer to the capacity of a set of regulatory arrangements to facilitate the achievement of policy objectives across a range of different and uncertain future evolutions of the economic context in which they operate.

Major examples of fragile regulatory arrangements include the liberalized Californian electricity system circa 2000 and UK and US banking supervision pre-2008, and these serve

1 This paper is circulated for comment, correction and use in discussion of public policy issues, and it may be cited in that context. It should not at this stage be cited in papers intended for journal publication. A revised version, taking account of comments and corrections, will be available at a later date.

2

to illustrate the potential economic significance of the issues: in both cases fragility led to economic outcomes that fell very far short of the policy objectives that the regulatory arrangements were intended to achieve. Whilst public policy goals in postal services are somewhat less ambitious than in the two examples cited, they are nevertheless important enough to have led to the creation of a specialised regulatory regime. The fragility/robustness of the postal services arrangements is, therefore, a matter around which much of the discussion below revolves.

Given this, the attention is directed toward a broad set of issues of regulatory strategy based on a few ‘stylized facts’. It would be possible to approach the issues via a more detailed examination of the relevant trade-offs on the basis of current information about the state of the market and forecasts of its future evolution. The risk of this latter approach, however, is that, stripped away from a more basic conceptual framework, it can tend to lead to regulatory decisions that are excessively contingent on expectations of a particular evolution of the economic context (i.e. on forecasts of an uncertain future) and that unravel when things turn out otherwise. They tend to discount the significance of the fragility/robustness of regulatory strategies, i.e. their capacity to continue to be effective in the face of unanticipated developments.

The relevant context is the current state of UK postal services regulation, taking current UK and EU legislation and policy objectives as givens. As will be explained below, there is necessarily a considerable tension between the USO and competition objectives, but there are better and worse ways of resolving the trade-offs. These will be explored in rather broad terms, although more specific aspects of access arrangements will also be considered, to reflect the fact that the UK has achieved an unusually high level of access competition relative to EU comparators and hence that issues surrounding access are of particular significance in the UK.

The underlying economics

Geographical variations in costs and political preferences

A number of economic sectors, of which postal services is one, are characterised by the existence of substantial differences in the costs of serving customers in different locations. Other examples are to be found in the energy (electricity and gas), transport (air, rail, buses) and water services sectors. Collectively these are often referred to as ‘network industries’.

In the absence of regulatory intervention, the relevant cost structures would imply that suppliers of a similar service would charge substantially different prices to differently situated customers. This would be the case for a privately-owned monopoly supplier – because such a supplier would find it profitable to pass on to high cost-to-serve consumers at least some of the higher costs that would attributable to meeting their demands – but it is even more obviously the case for competing suppliers, since competition tends to lead to cost-reflective price structures: if there are large variations in costs from place to place there will be accompanying (large) variations in prices charged from place to place.

The point is illustrated by pricing in the other network sectors. In a competitive sector such as air transport, we expect to pay more for long-haul flights than for short-haul flights and the emergence of low-cost carriers has been a potent, general force in increasing the cost-reflectivity of air fares for different routes (for example, to reflect non-distance related factors

3

such as the density of traffic on a particular route). In more monopolistic sectors, where regulators have allowed or encouraged the setting of cost-reflective prices – electricity and gas transmission being cases in point – geographically differentiated use-of-system charges have developed.2

For political reasons, there has been a pervasive tendency – similar in different historical periods and across different countries – to suppress the resulting differences in prices. The postal services sector is often used as the paradigm example of this tendency to seek the same price-for-service for differently located customers who have substantially different cots-to-serve. Indeed the resulting, geographically homogeneous price-structures are frequently referred to as ‘postalised prices’, even in sectors such as energy, perhaps reflecting the historical precedence of Rowland Hill’s ‘one price goes anywhere’ principle

The disparity between the politically desired, levelised/postalised price structure and the price structures that would likely emerge in the absence of price regulation lies at the heart of the issues of interest here.

How can postalised prices be achieved?

The most commonly adopted policy approach in the past has been to rely on the creation of pockets of monopoly profits within the relevant economic sector, frequently referred to as economic rents (an economic rent being a payment in excess of that required to induce a relevant level of supply). These rents are then used to subsidise high cost-to-serve customers in a way that achieves geographically homogeneous prices.

The creation and protection of such rents – effectively the source of funding for the maintenance of high-cost supplies – necessarily requires that competition be suppressed, distorted or restricted in some way or other. Unrestricted competition would tend to eliminate the monopoly rents and hence the source of funding for the high-cost services.3

Putting this another way, the price structure that would be generated by competition – significant price variations from place to place – could be expected to differ considerably from postalised pricing. The two are incompatible. Something has to give.

Historically, the most frequently utilised ways of restricting competition have been via:

• A publicly owned monopoly supplier instructed to charge postalised prices. The monopoly has usually been sustained by statutory barriers to entry (a manifest restriction of competition), although it would be possible simply to charge very low prices such that no potential entrant would want to offer services in any geographic area, including low cost areas, and to fund the resulting commercial losses from general tax revenues. Note, however, that this latter variant is in itself a restriction or distortion of competition: the generally low prices then have the same economic effect as predatory pricing. Alternatively, the implicit taxpayer funding (of a publicly-owned enterprise making less than a normal return on capital) could be considered to be a state aid.

2 Although it can be noted that energy regulators have tended to prefer prices not to be cost-reflective at the more localised level of electricity and gas distribution (i.e. carriage at lower voltages). 3 As already indicated, simply restricting competition to create market power would not in itself be sufficient: monopolies tend also to set cost-reflective prices. More specific public policy actions are required.

4

• A privately owned monopoly supply required by regulation to set postalised prices.

Again, pockets of significant market power (the source of the funding for otherwise uneconomic services) have to be sustained to make this viable.

Whilst there has been a transition from public to private provision of postal services in a number of jurisdictions, by and of itself this does nothing to fundamentally change the underlying tensions and trade-offs.4

Can anything be done to reconcile postalised prices with at least some degree of competition in a network sector?

The short answer to this question is yes, provided that the substantial variations in costs-to-serve are to be found at some points of the economic sector’s vertical supply chain (perhaps only one) but not at others.

The electricity sector illustrates. The substantial geographic variations in costs to serve are to be found in the wires businesses, not in electricity generation and not in the retail supply of electricity to final customers, whether households, businesses or government. The wires businesses can be ring-fenced and maintained as monopolies charging postalised prices whilst electricity generation and retail supply can be opened up to competition. The major geographic cost differences are thereby suppressed, whilst competition can be unrestricted in the other activities (which account for a substantial fraction of total value added). The policy approach is based on ‘unbundling’ the different activities and has been increasingly adopted around the world, the UK having been the pioneer amongst the major economies.

The analogue in postal services is related to the upstream/downstream distinction between activities. The UK has seen the development of substantial upstream competition and this does not necessarily threaten postalised prices so long as the downstream activities (provided as access services to upstream competitors of the universal service provider (USP)) continue to enjoy a sufficiently substantial level of market power in low cost-to-serve areas (LCSAs). Sufficiency is here to be assessed in relation to the adequacy of the economic rents that can be achieved in LCSAs for supporting (loss-making) services in high cost-to-serve areas (HCSAs) at geographically uniform prices.

In postal services these conditions are threatened by (i) ‘cherry picking’ 5 downstream (delivery) competition and (ii) e-substitution, which is simply a different form of competition

4 For a short, lucid and compelling elaboration of the point, see Professor Sam Peltzman, “The Control and Performance of State-Owed Enterprises” in P.W. MacAvoy, W.T. Stanbury, G. Yarrow and R.J. Zeckhauser, Privatization and State-Owned Enterprises, Rochester Studies in Managerial Economics, Kluwer Academic Publishers, Boston/Dordrecht/London, 1989. Peltzman’s comment is also notable for anticipating the financial crisis of 2008 by about 20 years, identifying an unsustainable pattern of cross-subsidisation in credit markets as a root cause of banking failures. In terminology to be used below, the relevant regulatory and corporate arrangements were fragile. 5 I adopt this colloquial term here for ease of reference whilst noting that, in many usages, its slightly pejorative connotations are misplaced: much of normal price competition could be said to be ‘cherry picking’ in that, faced with choices about which particular segments of a market to address (because resources may not permit an across the board assault), it is fully to be expected that a business will choose to address the most profitable segments first. Also, in postal services any negative connotations are not altogether unwarranted, for reasons that will be explained later.

5

in meeting the customer’s communications requirements. Each of these pressures reduces the funding potentially available to support service to high-cost customers.

It is an open question as to whether e-substitution alone might eventually come to make universal service at current service standards unsustainable: that will depend upon how technologies will evolve, which is uncertain. What is less open to question is that the two sources of competitive pressure, taken in combination, pose a greater threat to the sustainability of current USOs than anything seen in earlier years; which is a matter of some importance given that, in the UK, the Postal Services Act 2011 establishes a primary duty for the regulator, Ofcom, to carry out its functions in a way that it considers will secure the provision of a universal postal service.

Fragility and robustness in regulatory arrangements in general

It is important for public policy that the underlying trade-offs summarised above are recognised and addressed. Otherwise, policy will proceed on a wing-and-a-prayer basis. To restate: in the presence of costs that vary substantially in serving differently located consumers, unrestricted competition that tends to lead to price variations that reflect cost variations is incompatible with postalised pricing. In technical terms, the two relevant ‘geographic relative price vectors’ – the listings of the prices charged for services according to places of posting and places of delivery – can be expected to differ in substantial respects.

As just indicated, it is impossible to forecast future developments in the market with any great degree of precision, and therefore impossible to be confident about precisely when current UK arrangements – which are conducive to the development of downstream (delivery) competition – will likely become unsustainable. It is, however, possible to be more confident in saying that current arrangements give every impression of being fragile.

Fragile arrangements have the characteristic that they become ill-adapted to circumstances in a relatively wide spectrum of realistically possible market developments. The costs of fragility can take different forms, depending on circumstances.

The greatest degree of harm tends to occur when there is some form of ‘systemic collapse’ such as occurred, for example, in the reformed Californian electricity markets (2001) and in the banking crisis of 2008. In each case, the regulatory arrangements in place were incapable of responding adequately to a changing market context. Moreover, those changes in context were not ‘black swans’ (previously unconceived events), but rather changes that could and should have been assessed as realistically possible on the basis of ex ante information. In today’s postal market context, the equivalent of such information is evidence on the potential for further development of direct delivery competition and of e-substitution.

More generally, fragility in regulatory arrangements tends to lead to periods of maladaptation when economic circumstances change, followed by adjustments to bring regulatory rules more into line with the new circumstances. The costs of maladaptation will depend inter alia on the speed with which rule-changes can be effected. Ceteris paribus they will be greater when assessment lags and procedural requirements imply slow or sedate speeds.

However, a capacity for rapid regulatory response does not eliminate the costs of fragility and can in fact actually increase them. The difficulty is that rapid and low-cost adaptations in regulation, coupled with fragility of arrangements at each point in time, imply that market

6

rules will be constantly changing, and constantly changing rules tend to be a source of major regulatory uncertainties. Among other things, how can businesses develop plan ahead and make major investments and strategic choices when the rules are constantly changing?6 It can also be said, as a general proposition, that increased regulatory uncertainty tends to chill competition: new entry and business expansion tend to require initial investments whose pay-offs will be dependent on returns in later periods when rules might have changed.

In contrast, robust regulatory arrangements have the characteristic that the specified rules remain effective across a wide range of potential, future evolutions in circumstances. They do not, therefore, require constant adaptation and tinkering, and they are conducive to creating the stable and co-ordinated expectations that underpin all effectively-functioning markets and that are particularly important for business planning and investment.

Robust regulatory arrangements are not costless to develop. They require that regulatory resources be devoted to assessing the implications of a wider range of future possibilities than is typical in the more familiar approach of ‘here is a current problem and here is a fix that will do for now’. My own experience, however, is that, after making due allowance for costs, regulatory practice is usually characterised by an under-allocation of resources to consideration of fragility/robustness trade-offs.7 The current state of play in postal services regulation is, I think, a specific example of this more general phenomenon.

Fragility and robustness in current arrangements for postal services

Taking the current UK public policy objective of sustaining the USO as given, two broad regulatory approaches appear to be feasible. Each is capable of implementation in ways that increase robustness, but in the UK and in the EU more generally, current policy practices exhibit avoidable fragility. In words extracted from a recent book on banking supervision, they might be said to be ‘fragile by design’.8 Consider, therefore, the arguments that have been used to justify this fragility for each of the two approaches.

1. Subject all downstream postal service suppliers to equivalent, or as near equivalent as is feasible9 USO obligations.

This approach involves a restriction of competition in that it prevents forms of competition that are based on selective geographic coverage (i.e. it prevents certain types of business strategy). It nevertheless has the advantage that, subject to that one constraint, competition

6 The question is not rhetorical: rapidly changing rules can potentially be made consistent with a relatively high level of regulatory uncertainty by means of establishing what I have called ‘contingent predictability’ in the process of rule change itself (see The Political Economy of Markets, Zeeman Lecture 2008, www.rpieu.org). This means that market participants can confidently anticipate how a regulatory authority will react to any realistically possible future development in economic circumstances. In effect, contingent predictability, can make regulatory arrangements robust even though the rules themselves may be changing relatively rapidly. Needless to say, contingent predictability requires a lot less effort to define than to achieve. 7 One possible explanation for this under-allocation/bias is that the resources required include significant elements of hard-headed thinking (e.g. willingness to identify and contemplate things that can go wrong) and imagination (e.g. what are the various, multiple future possibilities that are to be taken into account). In organisations, use of these faculties is frequently ‘crowded out’ by everyday firefighting, which is a form of ‘short-termism’. 8 C.W.Calomaris and S.H. Haber, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014. 9 Legislation precludes full equivalence, but not near equivalence.

7

can then be allowed to develop on an otherwise undistorted basis, i.e. there will be a level or only slightly tilted playing field.

In the UK context, the main argument against seems to be that the competition that will then likely develop would be relatively weak and would hence not impose significant competitive pressures on incumbent suppliers to reduce costs and to innovate more generally. The current regulatory approach appears to be based on this argument.

It can be noted immediately that the argument is speculative in that it grounds a policy decision on particular expectations or forecasts about the future. In reality we simply do not know about things like how the struggle between the letter post and e-substitutes will pan out or how the pressures of alternative types of competition will affect costs (including the relative efficiencies of USPs and their competitors) or innovation. In respect of the second of these points, it can be noted that that, whilst there is very strong empirical basis for thinking that competition has favourable effect on incentives for cost-reduction and innovation, this general proposition does not easily disaggregate into propositions about the relative efficacies of alternative types of competition or about the relative efficiencies of USPs and their competitors, which are the relevant issue in the current context.10 On an evidential basis, therefore, the validity of such disaggregated assertions is necessarily much less secure, which in turn implies that policies that rest on such propositions will necessarily be more fragile.

Moreover, the argument relies on a particular combination of assumptions or propositions that are in tension both with one another and with existing evidence. Thus it supposes that:

• The current performance of incumbents offers considerable scope for improvements in efficiency.

• Notwithstanding this inefficiency, entry would not occur if entrants were subject to near-equivalent obligations. An obvious question is: why not, if the level of current inefficiencies implies that incumbents’ postalised prices could be significantly undercut?

• The competitive pressures from e-substitution are relatively weak and can be expected to have only a modest impact on incumbents’ incentives to improve efficiency and innovate. But why should a substitute service that enjoys major competitive advantages in terms of both costs and speed of ‘delivery’, that has had very major impact on letter volumes over the past years, and that can be reasonably be expected to increase the price-sensitivity of demand for letter-post (about which see more below) be assumed to be a source of weak competitive pressure? On the evidence, there is, to say the least, a very realistic possibility that the assumption/proposition is incorrect.

• Geographically targeted entry from competitors substantially freed from the burdens of securing universal service provision would add greatly to the competitive pressures and give rise to substantial cost reductions that would not otherwise be attained, thereby enabling the universal services to be sustained. But why would the prospect of loss of business to downstream postal services competitors have much

10 It is to be stressed that it is relative efficiencies that matter. Under extra competitive pressures a USP might be driven to achieve greater cost efficiency, but that will not alter the fundamental position if its competitors also increase their own cost efficiencies at similar or faster rates, as they might well do in consequence of greater scale and experience.

8

greater incentive effects than the prospect of loss of business to e-substitutes? And why should it be thought that any consequential reductions in the incumbent’s costs would be large enough to enable it to continue to finance its USOs?

It is, to repeat, possible that all these assumptions will turn out to be correct (a Goldilocks position), but also very possible that not all of them will be correct. To rely on them for the purpose of establishing regulatory rules would be to make policy “fragile by design”: if things turn out not to be as assumed the current policy will fail and require adjustment. As discussed above, this imposes its own costs, including the costs associated with higher regulatory uncertainty.

2. Unbundle the cross subsidies required to sustain universal service provision.

In economic terms, sustaining universal service in the face of underlying geographic cost variations is a form of redistributive ‘micro fiscal policy’. Revenues are extracted from some customers to support services to other customers. In general, redistributive fiscal policy can be reconciled with undistorted competition if all competitors face the same structure of payments and receipts (a level playing field).

Unlike in the case of imposing equivalent or near equivalent obligations on all service providers, unbundling of cross-subsidies would permit business strategies based on targeted, geographic entry into lower cost downstream activities, but with the proviso that entrants would have to make a proportionate contribution to the revenues that support services in higher-cost areas. In my own view, this property makes it the robust strategic approach that has the lesser distortionary effect on competition.

Compensation fund arrangements in which all suppliers of letter post services operating in low-cost areas pay contributions to the fund and all suppliers in high-cost areas receive payments from the fund are the most obvious way of implementing this approach. This does not address the possible longer-term unsustainability of the existing USO due to e-substitution, but it may be that, amongst the set of arrangements that limits the funding of USOs to letter post services, there are no feasible options that could prevent this, and the unbundling approach at least has the merit of doing that which can realistically be done, i.e. achieve as much robustness as is realistically attainable.

One, frequent visceral response to the approach is that it implies payments from new entrants to incumbents, which looks like an uneven playing field. This is a misunderstanding. The subsidies for supply in HCSAs are available to all players. Thus an entrant with a strategy targeted on a HCSA would be in receipt of payments, on the same basis as an incumbent. Entry into HCSAs would therefore be profitable for an ‘as efficient’ or a fortiori for a more efficient entrant. Put another way, there is no reason to suppose that, after unbundling of cross-subsidies, entry prospects in HCSAs would remain substantially less attractive than entry prospects in LCSAs.

This ‘levelisation’ of incentives would strengthen prospects for ‘universal’ direct delivery competition, but it would also not preclude geographically-targeted direct delivery competition. As indicated above, the latter might be attractive for business reasons: an entrant could find it attractive to develop its capabilities gradually, beginning in some areas and then incrementally rolling out its services to other areas. In this case, the targeting would

9

have a rationale based on real economic costs and benefits, not on regulatory arbitrage (i.e. taking advantage of different rules that apply unequally to different competitors).

Further issues relating to the tension between USOs and competition

Robustness of USOs in the face of e-substitution

There remains the possibility that, even if compensation fund arrangements were introduced, the effects of e-substitution would be such as to render current USOs unsustainable because the economic rents available from LCSAs would, even with an efficient operator serving 100% of demand for letter post, be inadequate to sustain overall profitability in the presence of the USO constraints. In effect, the ‘tax base’ of the mini fiscal system becomes inadequate to maintain the desired level of provision.

In such circumstances, one policy option is obviously to abandon or weaken (and thereby reduce the cost of providing) the universal service. If, however, the USO is taken as given – and it is for Parliament to decide that matter – what is required is an extension of the funding base. This might be to general taxation, about which more will be said below when examining access pricing issues, or it could be by broadening the compensation fund to encompass a wider range of services, such as parcel services or even digital communications services.

The trade-off that these prospects engage is that between robustness and its costs. Other things equal, it would be desirable to have regulatory arrangements that could cope with the identified, future possibility, but the possibility raises very major issues and addressing them immediately, in any comprehensive way, would have substantial costs. I suspect, therefore, that the appropriate course for the moment is simply to recognise that this more fundamental non-sustainability is a realistic possibility to be borne constantly in mind when considering more modest improvements in robustness (since its prospect can be expected to affect some of the other trade-offs that are directly relevant to less ambitious policy exercises).

‘Tailored’ general universal service conditions (GUSCs)

Current arrangements allow for the imposition of GUSCs that fall well short of the incumbent’s USOs, and there is an obvious temptation to adopt a ‘tailored approach’ based on the notion of waiting to see how competition develops and then, if necessary, introducing GUSCs that are designed in some sense to be ‘proportionate’ to the assessed risks to maintenance of the USO.

There are multiple potential problems with this approach, which are more specific manifestations of the general weaknesses of fragile regulatory arrangements discussed above and of which four can be noted here:

• By the time they are perceived as requiring a regulatory response, risks to the USO that have developed may be more costly to mitigate than if they had been addressed at the outset.

• In the limit, the measures eventually adopted may come too late to prevent unnecessary erosion of the USO. Confounding factors here include lags in assessment, lags in implementation (e.g. time taken to complete consultation and decision processes), availability of regulatory resources (it is generally not feasible to

10

leave scarce regulatory resources ‘on standby’, just in case there is need for urgent action at an unknown point in time), and delays due to legal challenges of regulatory decisions.

• Competition is inevitably distorted by the approach (in practice, micro-managed competition is not undistorted competition). Policy is simply seeking to reduce distortions as and when they are perceived to become large in some sense.

• The creation of regulatory uncertainty, which itself tends to chill competition. Those contemplating investment, including businesses seeking to enter the market or to expand from an initial base, will face a situation in which they are uncertain as to how the regulator will react in response to changes in market circumstances.

In short, ‘tailored’ GUSCs amount to a more fragile regulatory approach than the approaches described above. This vulnerability can be mitigated by clearer and more specific guidance as to how the regulator will conduct itself in response to changes in market circumstances, which could restore some robustness. Guidance along the lines of “We will introduce proportionate GUSCs if and when they are considered necessary” is way short of being sufficient.

The difficultly in writing more specific guidance is that this task is a very difficult and resource intensive one because, to be done properly, it requires consideration of a wide variety of possible, future market circumstances. This counts as an argument against tailored GUSCs and raises a question as to whether a ‘tailored’ approach should even be in major contention as a possible regulatory strategy. But if the approach is to be followed it calls for an early start on the necessary thinking and analysis.

What is to be done?

What I think all this points to is an early, general review of the state of play in postal services regulation. This could start with identification of the fundamental problem – the significant divergence between a postalised price structure and the price structures that can be expected to emerge in markets that are open to competition. It could then assess what forms/types of competition are and are not consistent with postalised pricing and, finally, assess what regulatory approaches are likely to be both effective and administratively efficient in securing a reasonably robust set of regulatory arrangements better capable of addressing both current and future issues.

To return to the beginning, faced with difficult trade-offs and choices, there is an obvious temptation (a behavioural bias?) to seek to avoid them, either by ignoring them, by procrastination or by recourse to self-serving arguments to the effect that the trade-offs are ‘softer’ than they actually are (self-deception). In the postal services case the disparity between postalised and ‘competitive’ price structures is stark and the progress of e-substitution is making trade-offs ‘harder’, not ‘softer’. Regulators should seek not to be led into the temptation of not thinking early enough, and not thinking clearly enough, about difficult problems. That is not what they are on earth to do, at least not if the relevant statutes are to be taken seriously.

11

Downstream access arrangements

Charging for access to Royal Mail delivery services is currently a major regulatory issue in the UK and it will add flesh to the bones of the general points raised above to consider how they apply in the narrower context of this particular issue.

As discussed, the geographic cross-subsidisation implicit in universal service provision requires the existence of economic rents obtained from low cost-to-serve geographic areas to support provision of equivalent services in high cost-to-serve geographic areas at prices less than costs and this is, in effect, a mini, redistributive fiscal system. It is not, however, an explicit and transparent redistributive system and, given also that what follows is focused on a more extensive examination of some of the transfers involved, it might be misleading to persist with notions such as that of a ‘tax base’ and ‘tax yield’ (as if these things were determined by Parliament, which they are not). I will therefore have recourse to the more general notions of levies and payments, so that, henceforth, the sources of the relevant economic rents will be referred to as the ‘levy base’ and the economic rents themselves as the ‘levy yield’.

Cost-reflective prices again

Just as unconstrained end-to-end competition tends to lead to retail pricing outcomes that can be expected to be radically different from those mandated by a universal service requirement (in the first case retail prices will reflect geographic variations in costs-to-serve, in the second case they will not), so cost-based access charging arrangements can be expected to tend toward the same disparity when costs are disaggregated on a geographic basis.

To illustrate, for any given set of upstream costs (of the competing, upstream operators), consider two possible approaches to downstream (final delivery) access to the services of an incumbent universal service provider (USP):

1. The same access charge is established for each geographic area, based on average downstream costs across all areas (both LCSAs and HCSAs)

The obvious problem in this case is that an equally efficient downstream competitor operating only in LCSAs will be able to substantially undercut the USP in supplying identical services, since the competitor’s delivery costs will tend to lie substantially below the USP’s access price. The (as efficient) USP cannot simultaneously hold on to its access business whilst maintaining its profitability: if it reduced access prices to meet the competition in LCSAs, it would have to do the same in HCSAs, and its downstream revenues, which include revenues from access business as well as from its own end-to-end volumes, would fall below average downstream costs aggregated across all areas. The levy yield would become depleted and inadequate to sustain universal service.

It can be noted that this argument is not particularly sensitive to the assumption that the USP and its delivery competitor(s) are equally efficient. The USP could be more efficient than its competitor(s) yet could still lose its access business (because its efficiency advantage, expressed in terms of per-unit costs, was lower than the per-unit levy rate required to cover part of the costs of service in HCSAs). The dynamics of the unravelling process are familiar: ceteris paribus, loss of delivery business in LCSAs leads, in addition to a direct fall in the levy yield, to higher per-unit delivery costs for the USP. This leads to an increase in access

12

costs and hence access charges (in HCSAs as well as LCSAs) in later periods, which accentuates the competitive advantage of downstream rivals in LCSAs, feeding the process of attrition.

Note also that the outcome can hardly be described as undistorted competition since it implies access charges that, at least at the outset, are below average delivery costs in HCSAs, which renders such areas an unattractive prospect for potential entrants into direct delivery (they are less likely to be able to match the below local-cost access charges of the USP).

Under these arrangements universal service could, therefore, only be maintained in competitive downstream conditions if the USP could establish and sustain a substantial cost advantage over its downstream competitors. Given the factual circumstances, it is difficult to see how this could occur (in competitive conditions): a USP would need to achieve average downstream costs (across all areas) that are as least as low as an efficient downstream competitor in a targeted, LCSA. Prima facie, that appears to be an infeasible task (although it might be attainable in circumstances where the cost differences between HCSAs and LCSAs were small).

2. Geographically differentiated, cost-based access charges are permitted

In this case, the USP is allowed to ‘meet the competition’ in local delivery via variations in the access charges it makes for downstream delivery, to at least some degree and subject to some or other implementation of the principle that the variations should be ‘cost-reflective’. That is, higher per-item access charges are levied in HCSAs than in LCSAs. This is the current approach in the UK and the issues surrounding it are to do with the extent to which geographic differentials are to be allowed.

The same difficulties are encountered with differentiated access charges as those to be found in a uniform access pricing regime, but in a slightly different and (importantly) less stark way. Suppose, for example, that the USP is allowed to set access prices in a LCSA that are equal or close to the downstream costs of an as efficient competitor (issues that this assumption might raise about possible predatory prices or margin squeezes are left aside for the moment). The USP might, in that case, be able to retain most of its access business in the area, but it will clearly lose area access revenues relative to a position in which it didn’t face competition in delivery: the levy pool would still be eroded.

Some algebra might help to indicate the potential magnitude of the effects. In relation to the activity of letter delivery by a USP in a LCSA, ignore for the moment the distinction between letters that are and are not covered by universal service conditions and assume:

Fixed costs, including a normal return on capital = f

Variable/incremental costs per unit = c

Total downstream volume in the LCSA 11, assumed constant = X 12

USP retail price, net of upstream cost (the net price13) = p

11 A more sophisticated analysis would distinguish between business covered by the universal service requirement and business that is not. 12 This would be a reasonable assumption if end prices to consumers were unchanged. See below for comments on price and volume effects that would likely be induced by differentiated access charges.

13

Downstream access price = pa (< p)

Therefore contribution to fixed cost recovery under monopoly = (p – c) X

Amount available for support of delivery services in high cost areas, the levy pool, = (p – c) X - f 14

Business taken by direct delivery competitors = ΔXd

Local delivery for upstream competitors / downstream access customers = ΔXa

Therefore the reduction in the levy pool under the hypothetical arrangements =

(p - c) ΔXd + (p – pa) ΔXa.

To give indicative numbers, suppose the net price is ten times higher than per-unit variable cost, fixed costs are five times higher than average variable costs when the USP is the only downstream supplier, 5% of the delivery business is lost to end-to-end competitors, 50% of the USP’s deliveries are for upstream competitors /access customers, and the access price is 20% below the net price. Then the reduction in the levy pool available to support services in higher-cost areas would be 35%.

Since the reductions in the access price is itself a response to the emergent competition in delivery, the whole effect can be causally linked to competition in delivery.

The point here is that relatively modest changes in market share at the final delivery level may be associated with much larger proportionate changes in the revenues available to support universal service provision in HCLSs (i.e. in the levy pool). There can, therefore, be a substantial multiplier or leverage effect: relatively modest changes in the USP’s share of delivery can be associated with much larger, proportionate changes in the financial contribution that the levy yield from LCSAs can make to supporting services in HCSAs.

Nevertheless, compared with a geographically uniform access price differentiated access charges do provide mitigation of the impacts on the levy pool of downstream competition. Thus, on the above numbers, if USP the lost all its access customers (accounting for 47.5% of deliveries) to direct delivery competitors because it was precluded from differentiating prices, the levy pool would disappear entirely.

Perhaps more importantly, differentiated pricing for access allows the USP to recover greater access revenues from HCSAs than does a uniform access price arrangement. This shrinks the amount of funding that is required from LCSAs to support universal service in HCSAs.

In practice, of course, it is to be expected that differential access charges would, in conditions of competition, have implications for both prices and volumes in LCSAs and HCSAs via their effects on the cost structures of access competitors to the USP. With uniform access charges, these costs are similar in LCSAs and HCSAs, but geographic differentiation in charges will change that position and will bring pressures to offer lower prices to end customers in HCSAs and higher prices in LCSAs which in turn could affect relative volumes.

13 The net price is that part of the full retail price that is attributable to the downstream activity. 14 Since this needs to be positive, the USP’s postal charges need to be above average costs in LCSAs.

14

This might not matter much if all end customers had similar, national patterns of business; but if there is regional differentiation in customers served, for letter post not covered by USOs competition would tend to bid down end-to-end prices to those access customers whose delivery portfolios were tilted towards LCSAs and would tend to increase end-to-end prices to those access customers whose delivery portfolios were tilted toward HCSAs. And this is just the fundamental point reappearing: substantial geographic variations in costs coupled with competition tends to lead to geographically differentiated end-to-end prices.

There is, then, likely to be a complex matrix of potential effects on competition, prices and volumes according to differences in: costs to serve; patterns of delivery for the USP and access customers / upstream competitors; direct delivery competitors; and letter post that is and is not covered by the USO. It is beyond the scope of this short paper to delve into these complexities, but two general points can be made:

• Whilst geographically differentiated access prices can mitigate the impact of direct delivery competition on the ability of a USP to sustain universal service, they do not eliminate the impact.

• The extent of mitigation can be expected to be lower in the presence of regulatory constraints that significantly limit the degree of differentiation in access charges that is allowed.

That is, although this approach to access pricing might suffice to address tensions in the shorter-term, in the longer-term the inevitable incompatibility between cost based pricing/charging structures and ‘postalised pricing’ can be expected to re-appear, perhaps as the unintended consequences of measures that are not grounded on an approach that explicitly addresses the incompatibility at the outset. These will emerge as competitors gradually adapt their own business strategies to the different incentive structure and this can be expected to occur more quickly if the differentiation is unduly constrained. Put another way, there is an inbuilt fragility to the approach which would be exacerbated by sub-constraints that limited its mitigating effects.

In summary, differential access charges that are cost reflective imply geographic variations in costs for access competitors (direct delivery competitors encounter these spatial cost variations directly, in their own, internal cost structures). In competitive conditions these cost variations will be reflected in retail price variations. In the first instance, these may take the form of geographic price variations for services not covered by the USP, which will distort price relativities of the different services (those covered by the universal service requirement and those that are not). In the longer term, the unintended consequences will likely extend to the prices and volumes of those activities that are encompassed by the universal service provisions.

Unbundling cross-subsidies

The challenges in access pricing are, then, connected with the basic cost/price problem and, to repeat earlier points, in the face of substantial cost variations the only ways of shifting to a more robust15 set of arrangements for sustaining postalised pricing are:

15 As discussed earlier, this is a relative statement since sustainability may come to be undermined by e-substitution.

15

1. To restrict competition, particularly in delivery, so that its tendency towards cost-reflective prices does not undermine the politically desired price structure. In this case, uniform access pricing does not cause major difficulties.

2. Establish an explicit, transparent system of cross-subsidisation or of ‘taxes/levies’ and ‘subsidies’ within the postal services sector. In this case, geographically differentiated access pricing subject only to the normal constraints of competition law can be expected to suffice.16

The first of these is the way in which public policy in the sector has traditionally been conducted, but the policy stance has tended to move away from it because of a general view that the loss of competition that it tends to entail comes at too high a price, for example in terms of reduced pressures for cost reduction and innovation (although it can be noted that this view developed before the emergence of e-substitution as a major source of competitive pressures).

The second of the alternatives allows a supervising authority to address competition issues by way of a standard competition law approach and it therefore avoids unnecessary distortions of competition. It does, on the other hand, raise major implementation issues. Chief among these in the UK are existing legislative provisions concerning the earliest date at which a compensation fund could be established.

The fact that there are obstacles that give rise to implementation lags does not, however, preclude use of the compensation fund approach to inform and guide the development of public policy in the nearer term. The fundamental ideas are that cross subsidies should be explicitly accounted for and, as when dealing with other types of unbundling issue in network industries (for example separation of business activities in network sectors) benefits can be achieved by partial movements in the desired direction.

This would, in particular, have the manifest advantage17 of identifying and making transparent the inter-area financial transfers that are required to sustain universal service. Such transparency can then assist in the assessment of other measures that might be taken in the nearer term, including decisions concerning the structures of differentiated access charges that can be considered reasonable.

There are two main implementations of the unbundling approach, each of which has sub-variants that can potentially be combined to provide ‘hybrid’ approaches:

• Payment to a USP from general public funds for specific services, mirroring public policies that are to be found, for example, in rail and bus services in rural areas.

• Sectoral compensation funds, which finance otherwise uneconomic services from revenues obtained from within the sector itself.

16 If subsidies for universal service were to be supported by the Exchequer, there would also be a requirement for arrangements to be consistent with EU legislation on state aids. State aid has been an issue in relation to support policies pursued in postal services by other Member States of the EU such as Belgium, France, Germany, Greece, Italy and Poland. 17 Except perhaps to those who would prefer to keep things hidden so that they can point out the advantages of cross-subsidies to those who benefit from them (here consumers in HCSAs) and conceal the cost to those who finance them (here consumers in LCSAs).

16

Both implementations are permitted under EU legislation. The former appears to have been the more favoured option in the postal services sectors of other EU Member States, but the current fiscal position of the UK suggests that there will likely be little parliamentary appetite for moving in this direction in the foreseeable future. I will therefore focus here on the second option on the basis that it is capable of providing more practical guidance in making shorter-term decisions in relation to access charges.

Intra-sector compensation funds as a benchmark

In monopoly conditions, universal service requires the postal operator to generate economic rents in LCSAs and to use the proceeds to support services in HCSAs. The same transfers can be made in non-monopoly conditions if all service providers in LCSAs make payments into a fund from which all providers in HCSAs can draw.

The payment and subsidy rates in the different areas have two immediate effects:

• They modify the cost structures of postal services operators in a way that evens out the geographic cost variations. The levies add to each operator’s costs in LCSAs and the subsidies reduce costs in the HCSAs.

• Competition can then proceed normally, and competition policy and law can be applied in a standard way.

Using this position as a benchmark, it is easier to see why direct delivery competition in the absence of such a provision is problematic, i.e. the benchmark makes the issue more transparent. As things stand, there are strong financial incentives for entry into direct delivery on account of the fact that the current UK arrangements, when assessed against the compensation fund benchmark, allow avoidance of the LCSA levy. The analogy in fiscal policy is that they are given a tax break.

There are always arguments for and against tax breaks, but a prudent, supervising public authority will generally want to proceed on the basis that, if they are to be granted, (a) the putative benefits should be clear and compelling, and (b), if the benefits are found to be clear and compelling, the scope of the breaks is limited so that they do not significantly undermine the tax base. If these principles are made transparent, market participants will be able to take them into account in their own planning and future disputes and litigation will be reduced.

In postal services, entry into direct delivery services has the effects of (a) eroding the levy base and hence (b) reducing the levy yield required to finance the desired subsidisation service in HCSAs. The leverage effects described above indicate that these impacts can be substantial, even when the market share taken by direct delivery competitors is small.

The explicit ‘levy/tax and subsidy’ approach also points the way to the elimination of other distortions. In current conditions, direct delivery competition is actually impeded in HCSAs: an ‘as efficient’ potential entrant would not be able to make a normal rate of return on capital. Although this might be considered an insignificant issue on the basis of a presumption that delivery competition in HCSAs is infeasible, a moment’s reflection should suffice to realise that the presumption lacks any solid foundation. Economics textbooks do not teach that competition in a market will necessarily be significantly impeded if, say, supply costs double.

17

These HCSA effects reflect the other side of the coin from the phenomenon of a LCSA entrant into direct delivery that avoids contributing to the levy pool: a potential entrant in a HCSA is not fully ‘credited’ for its contribution to serving customers in the HCSA. Compensation payments have the capacity to eliminate the latter, anti-competitive distortion. Using a compensation funds mechanism as a benchmark helps both identify this distortion and to understand why it occurs.

Explicit cross subsidies and the application of competition law principles

Given the explicit and transparent nature of an unbundled payment/subsidy structure, competition law principles in relation to pricing generally, and in relation to access charges in particular, can straightforwardly proceed in a standard way, just as they would in other contexts in which there existed either per-unit commodity taxation or per-unit subsidisation. Thus, the comparisons of prices and costs that occur in competition policy assessments normally include allowances for commodity taxes, either by netting them from revenues or by adding to them to cost before the price-cost comparisons are made. For example, if there was an allegation of predatory pricing in, say, petrol retailing, no competition authority would fail to take account of petrol duty rates when making price-cost assessments.

If this is how things would be done with a compensation fund in place, there is no substantive economic reason for failing to take account of the USP’s implicit levy contributions (the analogue of duty payments in the supply of petrol) when making price-cost evaluations simply because such a scheme has not been implemented. To do so is incoherent: it is to allow non-transparency to have a substantial impact on the way assessment is done and the way policy is implemented. Put another way, in terms of the language of Judicial Review rather than economics, it would amount to the neglect of evidence that is of significant relevance to an administrative decision (the evidence being that all of the approaches to universal service regulation depend on the creation of a source of funds to be used in supporting services in HCSAs).

With compensation payments in place, the usual cost-based tests for predation or margin squeezes could be applied. The cost floor test for predation that lies closest to the implications of economic analysis is short-run marginal cost, although for ease of assessment this quickly became approximated with (short-run) average variable cost, the “Areeda-Turner rule”. Each of these standards has subsequently given way, at least in applications to network industries, to use of alternatives because of complications arising from factors such as vertical links between relevant activities and high ratios of fixed costs to (short-run) marginal or average variable costs. Examples of alternatives include average avoidable costs, which encompass fixed costs that can be avoided within some defined time horizon, and one or other of the variants of long-run incremental cost (LRIC), which is also suitable for margin squeeze assessment in that it explicitly includes allowance for a normal rate of return on capital (which may account for its more frequent use in telecoms where margin squeeze issues have been more prevalent than in, say, the energy sector (at least in the UK)).

Whichever cost-floor test is chosen, in the absence of an actual compensation fund what is minimally required then is the explicit inclusion of allowances for the designated levies and subsidies (i.e. transparency and consistency in what public policy is seeking to do).

18

To illustrate the application of the principles involved, suppose that the relevant factual circumstances lead to a public authority judgement that LRIC is an appropriate floor price for an access charge when testing for predation in a LCSA. In applying this benchmark when comparing prices with costs, the authority would, in a standard case, either add any applicable per-unit taxes/levies to the business’s internal costs or, equivalently, subtract the taxes/levies from the final selling price. Explicit allowance for a universal service levy would do the same thing, irrespective of whether a compensation fund was or was not actually in place.

In the absence of an actual compensation fund, then, the equivalent or benchmarked floor price would be LRIC, as standardly calculated, minus the estimated, required, per-unit levy, say t, implying the access pricing constraint:

pa ≥ LRIC – t.

This standard is identical in economic effect to the one that would apply if a compensation scheme with per-unit levies, at rate t, were in place.

If, on the other hand, access price floors were set using an unadjusted LRIC standard, or by using something that is even more constraining, such as a fully allocated cost standard, it would imply that access price structures that would be allowed if a compensation fund was in place (something that is explicitly provided for by legislation) would be prohibited simply in consequence of it being decided not to implement a compensation fund. That seems to me to be both irrational and prima facie more restrictive or distortive of competition than is necessary to secure the public policy objectives.

It is to be stressed again that, in the above remarks, the compensation fund is taken to be hypothetical (i.e. not implemented), but that is no bar to doing the necessary calculations (i.e. doing the accounting is not conditional on actually implementing such arrangements) and using them to establish what a non-distortionary policy toward differentiated access charges would look like.

In summary a higher price floor (than one calculated after benchmarked levy adjustments) might look pro-competitive at first sight because it encourages more entry in LCSAs, but, on a second inspection, such a conclusion can only be reached by ignoring the facts that encourages such entry (a) at the cost of reducing the size of the levy pool available to support universal service and (b) by serving to restrict competition in HCSAs (on the other side of the coin from LCSA effects, and associated with the under-remuneration of direct delivery competitors in those areas).

Other relevant issues: e-substitution and market definition

The bulk of the exchange of textual and visual information is nowadays done electronically. The new technologies have, of course, greatly expanded the volume of such exchanges by dramatically reducing their costs and most of the growth in volumes is associated with this expansion of communications traffic. The statistics for letter volumes over recent years indicate, however, that electronic means of communication have also taken a substantial volume of business from the letter post. Obvious examples (there are many others) of this ‘business stealing’ effect are to be found in the distribution of utility bills and bank statements and in the exchange of Xmas greetings.

19

The effect of e-substitution, like direct delivery competition, has been to erode the levy base (the source of the economic ‘rents’) and the funding pool that support universal service provision, and in considering the implications for the sustainability of USOs it is the combined or cumulative effect of the two factors that matters (because it is the sizes of the levy base and pool in their entirety that matter for sustainability).

When multiple factors (here direct delivery competition, e-substitution, etc.) are at work, there is a frequent tendency, which I have observed to occur time and again in competition assessments, of considering each factor individually and, if its individual effect is considered to be relatively small, of then putting it to one side and treating it as if it were irrelevant. The fact that this is a manifest error does not appear to prevent its persistent recurrence.

In terms of its effects on the levy pool, e-substitution does not, however, appear to be a minor factor, even when considered in isolation. For example, even in the absence of direct delivery competition a 10% loss of letters business would, in the above numerical example, lead to a 22.5% reduction in an LCSA’s contribution to the pool. As with direct delivery competition, the relevant economic rents are highly vulnerable to erosion on this count.

Notwithstanding the above point, the significance of e-substitution might erroneously be discounted on the argument that the cross-price effects between postal services and electronic communications are not sufficiently strong as to be able to conclude that they lie in the same product market for competition law/assessment purposes. If they are not found to be in the same market, the ‘neglect bias’ just identified tends to lead to the effects of e-substitutes then becoming underweighted in subsequent analysis (because they do not lie ‘in the market’). This is just the more general ‘cumulative effect’ point above but, in the specific context of market definition, it has been labelled the ‘zero-one fallacy’ by Professor Sir John Vickers: either the alternative service is in the market and taken into account, or it is out of the market and frequently discounted entirely.

It is trite economics to say that whether a substitute is defined to be in the market or out of the market has no implications for its economic effects: market definition is simply a classification or labelling exercise and its value added comes from the information and analysis gathered in the assessment process, not from the final in/out decision. The simple point about the availability of e-substitutes is that, in addition to reducing letter post volumes, they can be expected to increase the price elasticity of demand for letter services, as new substitute products tend to do (an additional substitute product gives consumers an extra alternative to turn to when faced with an increase in price).

Moreover, since email and letter mail perform similar functions, it can be expected that the addition of the substitute service can, in this case, be reasonably expected to have a significant effect on the own-price elasticity of letter mail in general (the letter-mail price elasticity of demand). From the narrower perspective of a USP, they will increase the firm-level price-elasticity of demand, in the same way as the emergence of a competing postal services operator, and the effect must properly be taken into account.18

18 We can see here one of the pathways of ‘neglect bias’. If a market has been defined, the emergence of a new competitor will affect market shares and its implications are likely to be spotted and analysed. If one or more new substitutes emerge, there will be no effect on market shares (in the defined market) and their implications are liable to be neglected.

20

The relevance of this to the immediate issues is that an increased elasticity of demand for postal services puts downward pressure on the prices that can profitably be set by a postal services operator, and hence is a source of further pressure on the levy pool. Put another way, potential erosion of the pool comes from price effects as well as volume effects.

Finally, it may be relevant to consider one further economic error that is frequently made in matters of market definition and assessment of market power. In considering whether an increase in price to an above competitive level (a level that itself is never precisely defined) would be profitable – an exercise that lies at the heart of the hypothetical monopolist or SSNIP (‘small but significant, non-transitory increase in price’) test – it has been conventional to assess the profit effects of the hypothetical price rise over durations of a year or so.

This ignores the fact that, in very many contexts, pricing decisions have an investment dimension, i.e. their effects may be spread out over a rather longer future period and, notwithstanding the demand curves exhibited in basic economic textbooks, may not be costlessly reversible (e.g. by reducing price again). Two very frequently observed contexts (among others) in which this is relevant are:

• When there are switching costs. If a customer is lost this year, it will be costly to recover the business in later years: the customer will need to switch back again, which will give rise to costs for which the customer will need to be compensated if the re-switch is to be made. In the presence of switching costs, businesses tend to compete to establish and grow a ‘customer base’, via marketing, initial price discounting and so on. The ‘rewards’ from ‘acquiring’ a new customer, for example by making an attractive price offer, tend to be spread out over a period of years.

• When one product or service is subject to faster technological change that is steadily increasing its attractiveness relative to its substitutes. In this case, the other products or services may gradually lose business over time and what might happen, if they increase their prices, is that they will bring forward the time at which switches away from their services occur for particular customers. Once lost, the relevant business may never profitably be re-captured. Moreover, when the relevant activities are subject to economies of scale, the earlier, additional business captured by the providers of substitutes may provide them with enduring competitive advantages extending into later periods (lower unit costs, incentives and resources to improve quality of services, and so on).

Postal services are characterised by both of the above features, with the implication that, when testing for market power, the effects of a price hike on profits are properly evaluated on a net present value (i.e. investment) basis. The question is not whether a 5% increase in price would increase profits over the course of a year, but rather whether a 5% increase in price would increase the NPV of profits. When today’s pricing has longer term consequences, the answers to the two questions can easily be different.

Concluding summary of the main points

The universal postal service requires that prices for delivery of letter mail are the same irrespective of the location of the point of end delivery. Given the variations in costs of

21

delivery in different geographic areas, competition in final delivery can be expected to establish a significantly different pattern of prices, as prices come to reflect costs.

In some circumstances it is possible to engineer this outcome by placing restrictions on competition so that the resulting ‘managed’, competitive process does not undermine the required, postalised prices for services encompassed by a USO. A major difficulty with this approach is that the economic context is likely to be constantly changing, as has occurred for example via e-substitution. A structure of competition that is consistent with sustaining universal service in one time period may, therefore, create a sustainability problem in the next period.

The ‘reverse engineering’ approach (starting with a desired end outcome and seeking to establish rules of the competitive game that will be consistent with it) implies regulatory arrangements that will be inherently fragile and, because of repeated interventions to manage and modify competitive processes, a source of regulatory uncertainty – and regulatory uncertainty is itself a factor that tends to chill competition. Although individual period-by-period adjustments in arrangements, such as the current proposal to align the structure of area access charges with the structure of fully allocated costs, can look ‘analytically neat’ when viewed in isolation, they are essentially ad hoc (and hence fragile) in nature, and their future evolution is therefore difficult to predict for market participants.

The better, more robust approach, which has the minimally distorting effects on competition, is to unbundle the necessary pattern of cross-subsidies. This has the effect of ironing out the geographic variations in the relevant costs. Competition that tends toward cost-reflective prices will then tend toward postalised prices: the tension between the USO and competition objectives of policy can be reduced for a more sustained period. Although continued e-substitution could put arrangements that are based on intra-sector financial support for unprofitable services at risk, an unbundling approach would at least not require repeated tinkering in the period before public policy came to address that risk.

Constraints on the implementation of unbundled cross-subsidies need not delay a shift to this approach. For example, existing and proposed or possible regulatory constraints/rules can be checked for consistency with benchmarked properties of an actually-implemented compensation fund. This would help ensure that a consistent set of principles is applied over time, reducing regulatory uncertainty, and would ease the transition if and when more formalised unbundling of cross-subsidisation becomes the favoured policy option. At a minimum, therefore, I think there is a strong case for an early review of the existing strategic approach, which appears to be based on ad hoc adjustments in regulatory rules and to be content with a relatively low level of transparency. Whilst postal services regulation has made significant strides over the past few years, the emergence of first e-substitution and then direct delivery competition have together appear to have now created a very real and potentially urgent question about the viability of a set of arrangements that relies on generating sufficient intra-sector economic rents to cross-subsidise otherwise uneconomic services. As is the case for the economy more generally, questions concerning the integrity of the funding base for the provision of goods and services deemed desirable by public policymakers are matters that are unlikely to benefit from neglect.