The consumer impact of competition in the UK postal market

Transcription

1 The consumer impact of competition in the UK postal market

2 A study prepared for Whistl November 2014 Authors: Dr Bruno Basalisco Dr Henrik B. Okholm Anna Möller Boivie Jacek Przybyszewski

3 Table of contents Table of contents 1 Executive summary 5 1 Challenges ahead for the UK postal sector E-substitution is a major challenge for postal operators End-to-end competition in the UK is low In the long run, e-substitution has a larger impact on UK mail volumes than end-to-end competition Ensuring affordable universal service without the risk of State aid requires greater efficiency 14 2 Competition promotes efficiency European postal operators initiatives show large potential efficiency gains for Royal Mail Competition is a counterbalance to inflexible working patterns and excessive wage demands by the incumbent workforce Competition helps tracking evolving customer needs and ensuring that these are reflected in the USO Postal competition complements other efficiency drivers 28 3 Only competition guarantees consumer benefit Competition ensures that efficiency gains are passed on to consumers Absent competition, taxpayer support risks being needed to fund financial shortfall from RM s inefficiency 35 References 36 A Appendix A 39

4 List of tables 1 Planned and latest cost savings achieved a comparison between Royal Mail and PostNL 20 2 Status of modernisation progress: Royal Mail vs. key European peers 21 3 Empirical evidence of competition reducing the wage premium 24 4 Summary of country case studies 25 5 Value added for access and end-to-end competition 31 6 Empirical evidence of the benefits of competition 41

5 List of figures 1 Evolution of end-to-end competitors market share across European markets 8 2 Evolution of end-to-end competitors market share across European markets: focus on Drivers of declining revenue in DE, NL, SE and UK 10 4 Impact of e-substitution: projections for volume decline from UK letter mail decline: a long term view 13 6 Competition promotes efficiency focus on end-to-end 31 7 Variation in price ( ), domestic bulk mail, Sweden 35 8 The resource efficiency channel 40 9 The entry / exit channel The innovation channel 42

6 List of boxes 1 Focus on the latest Royal Mail employment agreement and its impact 27 2 Benefits of end-to-end competition in Denmark 34 3 Benefits of end-to-end competition in Sweden 34

7 Executive summary Ofcom s primary duty in relation to post is to secure the provision of a universal postal service, which must be not only financially sustainable, but also efficient before the end of a reasonable period and for its provision to continue to be efficient at all subsequent times 1 For this reason, Ofcom stated that if Royal Mail s profitability is under excessive pressure, this could trigger regulatory intervention on end-to-end competition unless Royal Mail s profitability is affected by an inappropriate management of efficiency. 2 Royal Mail like postal operators all over the world faces declining mail volumes. Lower volumes put Royal Mail s profitability under pressure. As mentioned, low profitability is a potential trigger for regulatory intervention by Ofcom. Any evaluation by Ofcom of end-to-end competition would include an assessment of Royal Mail s potential commercial response to end-to-end competition, including the impact of stronger incentives to improve efficiency (Ofcom 2013b). In general, Ofcom expects Royal Mail to improve its efficiency levels continuously to avoid excessive reliance on price increases which could further exacerbate volume decline in letter mail. 3 It is therefore relevant to ask how will competition affect efficiency at Royal Mail. We conclude that: Competition promotes efficiency Royal Mail has considerable scope for greater efficiency Only competition guarantees consumer benefit In a nutshell, end-to-end competition is not the defining challenge for Royal Mail. In the long run, e-substitution is a bigger challenge to Royal Mail than end-to-end competition. Under the assumption that in the next few years end-to-end competitor Whistl can both i) reach its planned roll-out, and ii) convert all its existing customers to its end-to-end delivery service where available, it can be expected that Whistl would compete away from Royal Mail 11% of nationwide letter mail volumes. However, by 2020 ongoing and cumulative e-substitution is likely to reduce Royal Mail letter mail volumes by 30%. Hence, absent efficiency improvements, e-substitution for letter mail can reduce the sustainability of the universal service obligation. It is thus important for all stakeholders with an interest in the that Royal Mail s focus is on continuous efficiency improvements. Absent this, there is a high risk that external funding or materially increased prices may be needed to support Royal Mail s universal service obligation. 1 Postal Services Act 2011, Art. 29(3). 2 if we anticipate that Royal Mail s returns will fall below 5% to 10% EBIT margin on a sustained basis we would expect to intervene unless we conclude that this is due to Royal Mail failing to take appropriate steps to respond to the challenge posed by competition, such as failing to improve efficiency levels, Ofcom, 2013 (p.2), End-to-end competition in the postal sector. Final guidance. 3 Ofcom (2012). March 2012 Statement: Securing the universal postal service. Decision on the new regulatory framework. 5

8 Competition promotes efficiency We show that competition provides multiple benefits. First, economic theory shows that competition provides incentives for businesses to be more efficient in their use of resources leading to lower costs, lower prices, and higher sales. Second, when more efficient businesses gain market shares (and less efficient ones lose it), this makes the economy more productive. Third, competition gives incentives for businesses to innovate and match changes in customer needs. As a result, for Royal Mail, competition within the s complements other efficiency drivers, such as private ownership as a listed company and the pressure from e- substitution. Competition is a key driver to induce Royal Mail to improve its efficiency. Royal Mail has considerable scope for greater efficiency Royal Mail s recent history and the developments at comparable postal operators show that the firm has considerable scope to improve efficiency. Royal Mail has shown that it has not been able time and again to achieve its efficiency objectives as confirmed recently by its July 2014 Interim management statement. When compared to key European peers, it appears that Royal Mail is significantly slower to realise efficiency gains than some of the other national postal operators in Europe. The way that Royal Mail organises its delivery operation has significant implications on costs, since delivery activities constitute a high share of costs. Moreover, Royal Mail has recently chosen to increase its staff costs and lock this for the next three years, while reducing the scope for greater flexibility. Staff costs are the major component of the firm s operational costs and are therefore key to its efficiency level. Only competition guarantees consumer benefit We show that competition is a counterbalance to excessive wage demands by the incumbent firm s workforce. Therefore competition is important to ensure that the benefits of efficiency gains are passed on to consumers. In the recent past, Royal Mail has been the recipient of lawful State Aid in the form of transfer of pension obligations from the company to the State. Hence, absent competition, there is a risk of a scenario in which taxpayer support is needed in case Royal Mail were not to make sufficient efficiency gains. End-to-end competition can play a role consistent with a sustainable provision of the USO, by stimulating efficiency at Royal Mail. 6

9 Chapter 1 Challenges ahead for the UK postal sector 1.1 E-substitution is a major challenge for postal operators A starting point when reviewing the state of s across Europe is that e- substitution (the switch of postal communication to electronic-based forms of communications such as ) is a fundamental driver of changes in the level of mail volumes. For postal operators whether larger, older incumbent operators or smaller, newer competitors e-substitution is a long wave of competitive pressure, driving mail postal volumes down. European national postal operators (the incumbent operators established as the formerly designated public monopoly in each country) have lost volume also due to competition from newer postal operators which have set up business as the sector was progressively liberalised. An end-to-end competitor is an alternative postal operator which is able to collect, sort and deliver mail to a set of recipient addresses. However, past developments across all European s show that for Royal Mail (like for each national postal operator) the major risk to mail volumes has come and is still expected to come from e-substitution rather than end-to-end competition. E- substitution has had and is likely to keep having in the long run a greater impact on the national postal operators mail volumes than end-to-end competition. An end-to-end competitor is an alternative postal operator which is able to collect, sort and deliver mail to a set of recipient addresses. As with any of its European peers, Royal Mail must improve efficiency significantly (including by cutting costs) in order to keep being profitable in a postal world with significant and persistent e-substitution. 1.2 End-to-end competition in the UK is low It is interesting to compare the UK with other European countries with end-to-end competition. Market shares of competitors to the incumbent in countries with extensive endto-end competition vary between 6% (Italy) and 18% (Spain). 4 This is shown in the figure below. 4 WIK Consult (2013a); we understand shares to be volume-based therein. Throughout this report we will refer to volume-based shares, unless otherwise specified. 7

10 Figure 1 Evolution of end-to-end competitors market share across European markets Source: Copenhagen Economics, based on WIK Consult (2013a) Market shares for end-to-end competitors have not evolved considerably after 2011 in general. In the UK, the share was constant at 0.1% until 2012 and it reached 0.4% in

11 Figure 2 Evolution of end-to-end competitors market share across European markets: focus on % 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% DE ES IT NL PL SE UK Note: Latest available figures have been used where missing data. Source: Copenhagen Economics, firms annual reports, AGCOM (2013; 2014), Boston Consulting Group (2013), Office of Electronic Communications Poland (2013) While the Whistl plans signal ambition to grow market share, the above figure shows clearly that the starting point for end-to-end competition in the UK is much lower than in the above set of European markets with end-to-end competition. 1.3 In the long run, e-substitution has a larger impact on UK mail volumes than end-to-end competition In a previous study for the European Commission (Copenhagen Economics, 2012) we analysed the causes of revenue declines experienced by three Universal Service Providers (USPs) subject to competition. We decomposed the fall in revenues into: i) revenue decreases caused by competition, and ii) revenue decreases caused by declining markets (i.e. e-substitution). The result was very clear, e-substitution is by far the most important cause of declining volumes, cf. Figure 3. 9

12 Figure 3 Drivers of declining revenue in DE, NL, SE and UK Deutsche Post ( ) PostNL ( ) 24,7% 25,3% 75,3% 74,7% Competition Decline in mkt size Competition Decline in mkt size PostNord ( ) 19,8% Royal Mail ( ) 1,2% 80,2% 98,8% Competition Decline in mkt size Competition Decline in mkt size Note: Loss due to competition calculated as loss in market share * revenue in year 2. Loss due to decline in market size calculated as decrease in total market size * market share in year 1. PostNord refers to the operations in Sweden. Source: Copenhagen Economics, based on Ofcom CMR (2014), Copenhagen Economics (2012), firms annual reports We found that for incumbents in Germany, the Netherlands and Sweden (countries with relatively well-developed competition in the mail market to an extent much greater than presently in the UK), competition is responsible for around 20-25% of the revenue losses experienced in In other words, 75-80% of revenue losses were due to the declining market size (i.e. e-substitution). In the UK, as shown above, it turns out that the decline in the overall market size is the clearly dominant driver of revenue loss at Royal Mail. When considering the set of revenues lost to either e-substitution or end-to-end competition, variations in end-to-end competition accounted for only 1.2% of all revenues lost. Given the above context, e- substitution in the UK has had and is still having an impact which is larger than the historic impact of end-to-end competition. As found in a study commissioned by Royal Mail: 10

13 UK total inland letter volumes declined by 3.1% p.a. from 2005 to 2008, and by 6.3% p.a. from , as the economic downturn increased the rate of decline PWC (2013), p. 7. UK mail market: expected future impact of end-to-end competition and e- substitution We now turn from looking backward to looking forward. When focusing on the impact of end-to-end competition it is helpful to build a simple scenario based on assuming that Whistl is fully effective at converting its existing customers to its new end-to-end delivery service. Based on this assumption and based on Whistl s stated plans to provide delivery to 42.3% of total UK addresses in 2017, we can estimate a volume impact in We understand that Whistl currently handles 26% of the UK mail 5 (relying predominantly on Royal Mail for delivery not on its own delivery). If Whistl can convert its customers to its end-to-end service, it can do so only for the mail traffic addressed to the areas where it plans to deliver. Thus, we multiply 26% times the Whistl 42.3% planned coverage share and obtain a figure of 11%. Similarly, we look forward and consider the likely impact of e-substitution. While the magnitude of e-substitution varies year by year and across different European countries, its impact on mail markets is unequivocally marked. Based on a series of observation and forecasts, Figure 4 below projects the corresponding impact of e-substitution from 2014 to 2020 for Royal Mail. 5 We understand that Whistl has handled 3.9 billion items in year ended December Ofcom CMR (2014, p. 379) states that UK addressed mail volumes were 14.8 billion items in As a result, we estimate Whistl to handle 26% of the UK mail. 11

14 Figure 4 Impact of e-substitution: projections for volume decline from Note: The values at year 2020 for e-substitution are calculated as the cumulative impact of yearly volume losses in a 6-year projection starting from The projection is based on estimates and forecasts of volume declines relative to the periods and countries specified in each column. For example, in FR ( ), La Poste experienced due to e-substitution a -6% change in volumes in one year. Projecting this over 6 years, this corresponds to a change of -31%. Source: Copenhagen Economics, based on operators annual reports and PWC (2013). As shown above, the expected volume impact of end-to-end competition (at the stage where Whistl has achieved in full its plans) is lower than the expected impact of e- substitution. In fact, e-substitution can reduce letter volumes by up to 10% per year, resulting in a loss of mail volumes of 50% at the end of a six year interval such as what was experienced in Denmark (addressed inland mail, ). In the Netherlands, PostNL has experienced an overall 40% fall in mail volumes between 2005 and 2013, with an acceleration in the period , when annual declines of around 10% have occurred. France has experienced an annual decrease decline of 6% in addressed mail ( ) and it is forecast that a similar rate of decline will cover the entire period ranging from 2008 to

15 In summary, the UK mail market is experiencing lower levels of e-substitution than its European peers. It can be expected that in the future e-substitution in the UK could remain less extreme than what has occurred in other European markets. Even so, the above figure shows that likely impact of e-substitution is clearly larger than that of end-to-end competition. In fact, the UK letter mail forecasts by PWC indicate that e-substitution in the UK is expected to be less marked than in some other European markets (see above figure) yet still large as shown in the figure below. Figure 5 UK letter mail decline: a long term view Volume of items (bn) 19, , , ,3 1,3 1, Year UK letters market UK parcels market Source: PWC (2013) Royal Mail as stated in its July 2014 Interim management statement expects a 4-6% decrease in addressed letter volumes every year nationwide. When compared against the maximum planned market share for Whistl (of 11% nationwide), this shows that the volumes impact of end-to-end competition at full roll-out is matched by the impact of circa two years of e-substitution. This is assuming full conversion of Whistl s access-based service to end-to-end delivery service and an evenly paced roll-out of Whistl s delivery services. In the year to end of June 2014, Royal Mail experienced a 3% decrease, net of the effect of elections. 6 If this holds, then about four years of e-substitution match the full impact of end-to-end competition on volumes. In any case, over time ongoing and cumulative e- substitution will reduce the Royal Mail volumes to a greater extent than volumes lost to end-to-end competition which correspond to only a handful of years of e-substitution losses. 6 Royal Mail (2014b). 13

16 In conclusion, we note that as shown in the figures presented above Royal Mail faces today less pressure than its peers on both account of e-substitution and end-to-end competition. Thus the effect of end-to-end competition on Royal Mail s revenues should not be confounded with the larger, longer-term impact of e-substitution. It is the evolution of and response to e-substitution which should be of greatest interest to decision makers at Royal Mail and if appropriate at Ofcom. This is consistent with previous assessments of s in a set of European countries with end-to-end competition in place Ensuring affordable universal service without the risk of State aid requires greater efficiency In addressing head on the challenges of e-substitution for any USP, it is important to improve efficiency, which is key to ensure ultimately the affordability of the universal service. Affordability is an important consideration for regulation, as shown in the Ofcom 2012 Statement on the regulatory framework, which found: The need for the provision of the universal service to be efficient, after a reasonable period, and to remain so, including the need for the regulatory framework to provide appropriate incentives for efficiency. (Ofcom, 2012, p.43) Based on the last Ofcom assessment, once the safeguards on 2 nd class stamps are factored in, affordability is not a concern today for example due to the much lower share of household budgets spent on postal vis à vis other forms of communications or utilities. However, it cannot be excluded that affordability of postal services may become a concern in the future: we do not consider that current prices raise affordability concerns for small business or residential customers [ ] However, going forward, we are going to be monitoring prices and will look to further understand consumer behaviour in relation to the use of postal services. Looking forward, in a scenario where prices (or incomes) change so that affordability becomes a problem then Ofcom and the Government face a tough trade-off, given that they would be forced to either: Allow prices to rise and harm consumers and small businesses; or Tighten price caps and put the financing of USO at risk; or Call for a reduced definition of USO, which can also reduce the range of affordable services, which Ofcom may in any event only do if it is reflective of user needs 7 The loss of volume to competition has had some negative influence on the revenues and profits of universal services providers. However, this competition appears to be much less important a risk than the decline of total market volume that result from changing demand behaviour and electronic substitution. How postal operators meet these challenges appears as the most important factor determining whether or not they can maintain financial success. WIK Consult (2011), p

17 This would certainly be an uncomfortable position for policy makers to be in. A key solution to avoid or minimise the risk of this trade-off is to ensure that Royal Mail s focus is on continuous efficiency improvements. Failure to secure greater efficiency gains at Royal Mail would risk having to compensate Royal Mail for the universal service obligation. This would not be the first time that Royal Mail has found itself under pressure and challenged to finance its obligations via its income. In the recent past, Royal mail has been the recipient of lawful State Aid in the form of transfer of pension obligations from the company to the State (cleared by the European Commission). 8 Looking at this recent history of State support, in a scenario where Royal Mail were not to make sufficient efficiency gains, taxpayer support could be a likely outcome of this situation. 8 The State Aid provided to Royal Mail was based on two components: i) a relief of historic pension deficit, estimated by the UK authorities at up to 8bn; ii) a debt reduction contribution (in the context of a broad restructuring plan), of bn. The total taxpayer cost of the package implemented was thus in the region of 9Bn. See European Commission press releases at:

18 Chapter 2 Competition promotes efficiency Policymakers appreciate the benefits of competition. For instance, the Department for Business Innovation & Skills (BIS) has stated that: Competitive markets are the best way of making sure a country s resources are put to their best use. They encourage enterprise and widen choice for consumers. [ ] One of the government s 3 growth objectives is that the UK should become the best place to start, finance and grow a business. (BIS, 2014) Indeed, competition provides multiple benefits. First, economic theory shows that competition provides incentives for businesses to be more efficient in their use of resources leading to lower costs, lower prices, and higher sales. Second, when more efficient businesses gain market shares (and less efficient ones lose it), this makes the economy more productive (in the extreme case via exit or entry of new firms). Third, competition gives incentives for businesses to innovate and match customer needs changes. 9 As a result, for Royal Mail, competition within the s complements other efficiency drivers, such as private ownership as a listed company and the pressure from e- substitution. A frequent result of competition is entry of new firms and market share gains for smaller firms. New companies managing to gain a foothold in the market usually do so because of a competitive advantage in the form of high productivity. Furthermore, superior efficiency is needed by entrants in industries with high economies of scale. In network industries e.g. post, small scale is a disadvantage, due to the presence of joint and common costs which do not vary with scale (i.e. must be incurred by both smaller and larger firms). Thus, in an industry such as postal services, without superior efficiency no entry is possible. It must also be noted that the postal USO leads to the exit of the USP not being a practical option. Therefore market share gain and loss is the natural vehicle for efficiency to make an impact on productivity and ultimately consumers. In the rest of this chapter, we explain how competition can induce Royal Mail to improve its efficiency, given that its past history and the developments at its peer postal operators show that Royal Mail has scope to improve efficiency. We then consider that competition is a counterbalance to excessive wage demands by the incumbent workforce and that therefore competition is important to ensure that the benefits of efficiency gains are passed on to consumers. Next, we reappraise how competition by promoting innovation can help track evolving customer needs and ensure that these are reflected in the USO. We conclude by discussing how postal competition is an important complement to other efficiency drivers. 9 We have reviewed these points in greater detail in Appendix, which discusses how competition provides incentives for businesses to reduce costs and to innovate. 16

19 2.1 European postal operators initiatives show large potential efficiency gains for Royal Mail Amongst the European s with end-to-end competition, the UK presents a lower intensity of end-to-end competition, as shown in Figure 1 and Figure 2. This is because the end-to-end network of Whistl is in its starting phase, with a smaller scale of operation and a roll-out target that is sub-national. That notwithstanding, the nature of end-to-end competition is such that the alternative operator can within its footprint perform the entire set of activities necessary to process bulk mail, from mail collection all the way down to delivery to individual households. As previously mentioned, end-to-end competition requires the performance of delivery, an activity carrying a high share of costs and thus value added. For this reason, end-toend competition can be particularly effective in inducing greater efficiency in the incumbent operator, lower prices on the market and induce innovation across a broad span of the postal value chain innovation not just limited within the alternative operator but also at the incumbent firm. What happens when end-to-end competition takes off? In the letter markets surveyed in the WIK Consult (2011) study, the incumbents have experienced substantial entry of end-to-end competitors. As a result, the national postal operators market shares of delivery ranged between 83 and 90 per cent. The study found that the end-to-end market structure was accompanied by a series of benefits. First, the Universal service is continued to be provided in all the countries surveyed. Moreover, the universal service continues to cover all parts of the countries. Second, the study found that generally, the universal service quality has improved as a result of end-to-end competition. For instance, Universal Service Providers (USPs) have improved their routing times and provided longer opening hours in the postal agencies that replace traditional rural post offices. 10 E2E competition promotes efficiency in the USO provision Furthermore, the pervasive competitive pressure from end-to-end competition has led to a more sustainable and efficient USO operation. In fact, in three countries with end-toend competition, the national universal service provider (Dutch PostNL, German Deutsche Post, and Sweden Post) does not receive any compensation for the USO provided. On the contrary, these operators provide their USO products on profitable commercial terms. For instance, PostNL has posted a 2013 result of underlying cash operating income margin (segment: domestic mail) of 69m, equivalent to 3.2% of corresponding revenues. In the same year, Deutsche Post (division: mail) posted an EBIT of 1,226m, corresponding to a 8.5% return on sales WIK Consult (2011). 11 PostNL (2013), p.2; Deutsche Post DHL (2013), p

20 Over the past two decades, these operators have relied on their commercial flexibility to modernise their operations. Thus, their cost structure has gained considerable flexibility and has enabled them to respond to variations in market conditions. In these countries, the universal service provider has modernised its operations across several dimensions: 12 Post office and delivery networks Sorting technology Sorting and transportation networks Formats Price structures Operational and management structures Against this backdrop, we now consider the situation at Royal Mail. Past efficiency challenges at Royal Mail There are a number of reasons why a firm may be inefficient. These include: 1. Using more inputs than necessary to produce a given level of output (a form of productive inefficiency) 2. Not using the optimal mix of inputs given prices of labour, capital and other inputs (a form of allocative inefficiency) 3. Furthermore, a firm exposed to ineffective competition may have insufficient incentives to pursue product or process innovation (a form of dynamic inefficiency) Understanding a company s history of efficiency performance can be very helpful to understand which direction of travel should the firm pursue to optimise its efficiency. Looking back at Royal Mail s past performance we find that Royal Mail has a challenged history on efficiency. LECG (2005) estimated an efficiency model comparing the performance of units composing the Royal Mail network. By doing so, it found that the overall level of inefficiency at Royal Mail stood at 220m to 330m. This estimate was based on a comparison to the Royal Mail best practice at that time. Thus this inefficiency was an underestimate of the real inefficiency value, i.e. relative to best practice across the industry. Indeed, in 2006/7, the Royal Mail accounts stated that the firm was 40% less efficient than its competitors. Royal Mail was aware at the time (like most peers) of the importance of improving efficiency and embarked on a Renewal Plan. That notwithstanding, in 2008, the Hooper report found that at the time Royal Mail was inefficient (compared to key European operators). The report reckoned that inefficiency was due to: Pay significantly above market average rates; and A defined benefit pension scheme with contributions significantly higher than average RM s network of mail centres and delivery offices was largely unchanged, 12 WIK Consult (2011), p.8. 18

21 Low level of automation at Royal Mail, particularly for walk-sequencing Working practices (early finish times and overtime payment for absence covering) Since 2008, some of the above issues have been addressed (even if partially), however the legacy still reduces efficiency at RM today. This may be linked to the employment structure (skill mix of staff employed vis à vis what is used by competitors) and processes and organisation. However, the overall track record of past reforms at Royal Mail can be questioned: The implementation of Royal Mail s Renewal Plan, a collection of initiatives intended to meet Postcomm s targets, was not as successful as planned (NERA, 2013, p.8) This inability to achieve efficiency targets has also been recently acknowledged by Ofcom, which stated that Royal Mail could not improve efficiency at the pace expected by its own or the regulator s targets. 13 RM has failed to meet efficiency targets in its latest full year results The Royal Mail decision on the terms of agreement with the CWU may suggest that the firm considers to have achieved all it can in terms of efficiency in use of labour inputs. However, Across several industries, regulators have noted the risk of bias in regulatory business plans, as regulated companies have incentives to understate the scope for efficiency savings. (NERA, 2013, p. 27) While Royal Mail has made some efficiency improvements but the impact of these efforts seems to be decreasing over the last few years. When taking stock of its past productivity improvements ahead of its stock market flotation, the Royal Mail investment prospectus stated that: Over the past three financial years, the Transformation Programme has delivered year-on-year productivity improvements within the Royal Mail Core Network of approximately 4.4 per cent. in FYE 2011, 3.2 per cent. in FYE 2012 and 1.7 per cent. in FYE (Royal Mail, 2013c, p. 72) In its 2013 prospectus, Royal Mail targeted 2-3% efficiency gains, but failed to meet them. 14 In fact, the firm recently stated that: Collections, processing and delivery productivity improved by 1.7 per cent [ ] The productivity improvement of 1.7 per cent was disappointing (Royal Mail 2014c, p.5, p.12) Ofcom (2011), para In the future, the Group is targeting productivity improvements within the Royal Mail Core Network of approximately two to three per cent. per year Royal Mail (2013c), p In results released on 19 November 2014, ( half year results), Royal Mail stated a productivity change of 2.1% (Royal Mail, 2014d) 19

22 Amongst the indicators targeted in Royal Mail s own balanced corporate scorecard, the above result led to the lowest achievement level (2.4 points out of 10). 16 In other words, efficiency performance appears to be taking a low priority amongst management incentives. In conclusion, the above evidence indicates that today there remains considerable scope to improve efficiency at Royal Mail: there may be little doubt at present that Royal Mail has scope to improve its efficiency in the short to medium term (NERA, 2013, p. 34) Limited plans to improve efficiency at Royal Mail However, Royal Mail does not seem to be aiming to improve its efficiency over the next few years. In fact, its latest cost savings programme while on track to achieve 25m of savings is relatively small. 17 In order to put the Royal Mail cost performance and savings plan into perspective, the following table shows a comparison with Dutch national postal operator PostNL. Table 1 Planned and latest cost savings achieved a comparison between Royal Mail and PostNL Cost savings achieved in 2013 Royal Mail (Cost increase of 93m) PostNL Deutsche Post DHL 79m to 95m 830m Cost savings targeted for m to 50m 115m to 135m N/A Total Operating Costs (2013) 7.3bn 3.9bn 54.2bn Ratio of cost variation (2013) to cost base +1.3% -2.0% to -2.4% -1.5% Ratio of targeted change in costs (2014) to cost base -0.3% to -0.7% -2.9% to -3.5% N/A Source: Royal Mail 2013 Annual report, Royal mail Full Year results, p. 18 (Operating costs before transformation costs up 1%, i.e. from 7,144m to 7,237m) PostNL 2013 Annual report, p.22, PostNL (2014) Q results presentation. Deutsche Post DHL 2013 Annual report, p. 135 (Total operating expenses, which include DHL operations, decreased from 55,015m to 54,185). As shown above, the 25m planned cost savings at Royal Mail pale when compared to the savings achieved and further targeted at PostNL. This is particularly marked when considering that: PostNL has a smaller cost base, since it serves The Netherlands, a smaller country PostNL has already cut costs aggressively over the latest years, i.e. it is further down the line in the path of cost cutting (compared to Royal Mail) This suggests that Royal Mail has a larger scope available to cut costs compared to what it is envisaged in its current plans. 16 Royal Mail (2014c), p The programme is expected to generate annual cost savings of approximately 50 million, of which approximately 25 million is expected to be realised in , Royal Mail (2014c, p.21). The management reorganisation programme announced in March 2014 is on track to realise cost savings of around 25m, Royal Mail (2014b). 20

23 Delivery Mail processing (sorting + sequencing) The consumer impact of competition in the UK Comparing Royal Mail to its European peers Finally, we turn to an indicative comparison of Royal mail vis à vis a set of European peers namely those operators included in the WIK Consult (2013b) report for Ofcom on operators efficiency. We take as a starting point the evaluation undertaken by WIK Consult in 2013 and we then proceed to make an initial assessment of where does Royal Mail stand today when set against the indicators upon which the other European operators were assessed. This is presented in Table 2 below. Table 2 Status of modernisation progress: Royal Mail vs. key European peers Centralise Austria Germany Denmark France Netherlands Sweden UK Activity Cost Austrian Deutsche Post cost La Poste PostNL Posten Royal Mail share Post Post Denmark category sorting Distinct mail and parcel sorting centres Automate sorting Sequence sorting of letters by machine Sequence sorting of flats by machine Centralise sequence sorting by machine Centralise manual sequence sorting d (planned) d (planned) d (planned) Optimise delivery Increase flexibility in delivery 20% 45% Other 35% Source: Copenhagen Economics, based on WIK Consult (2013b), Section 3.4 and Table 3.4, at p. 32. Share of costs by activity is based on WIK Consult (2013a), Table 3-5, p.197. While the outcome of the above table is based on a preliminary effort, it is meant to open a debate at a practical level on what measures should be within grasp of Royal Mail if it wished to embark on a path of more vigorous pursuit of efficiency. We also note that the six comparator operators have also made progress to some extent since In any case, 21

24 we consider it relevant to compare present day Royal Mail with the modernisation status of those six operators in 2013, as the time interval is relatively short. A first important consideration is that the management of delivery operations is the area where the efficiency gains with the greatest magnitude can be tapped. This corresponds to the bottom two indicators in the table which affect a large share of the costs of letter mail. For this reason, Royal Mail management and policy makers alike should focus their attention on the firm s plans and performance related to: 1. The optimisation of delivery; and 2. Increasing flexibility in delivery Moreover, the automation of sorting via mechanised equipment has been completed by most postal operators being one of the lowest hanging fruits in the modernisation process. For this reason, we will focus in what follows on the two delivery indicators. The optimisation of delivery The optimisation of delivery covers aspects such as the systematic application of geographical information systems (GIS) also known as route optimisation software. It also includes a flexible work organisation and the centralisation of mail preparation activities (including walk sequencing). We understand that Royal Mail has introduced GIS and that its application relies on the degree of collaboration provided by delivery staff (which are accustomed to greater stability and control over choice of delivery route). A flexible work optimisation should be an ongoing pursuit for Royal Mail, in order to manage efficiently the all-important delivery costs. However, the 2013 employment agreement includes a commitment not to expand the scope of part-time or outsourced employment, as well as to offer the same terms to new staff. It is therefore very important to monitor whether and how Royal Mail will leverage its existing workforce and forms of employment to manage a more flexible organisation of delivery work. This could be a challenge of paramount importance in terms of efficiency impact. At the same time, the question remains on how could the firm achieve any savings if volumes continue to decline and no further significant restructuring is planned. As to the centralisation of mail preparation activities, this is also an important aspect impacting delivery costs. We understand that across several mail categories Royal Mail is able to not only sort but also walk-sequence mechanically a task performed centrally at the sorting centres (i.e. inward mail centres). However, for mail classes which are not currently amenable to machine walk-sequencing (e.g. some large letters), this activity is performed at a decentralised level (i.e. at delivery offices). Insofar as that is the case, therein lies a potential for greater efficiency to be pursued via centralised teams dedicated to mail preparation activities. Increasing flexibility in delivery 22

25 Flexibility in delivery is closely related to operations systems to deliver non-priority mail items only on a limited amount of days per week. For instance in the case of Post Danmark and PostNL, this is limited to no more than three days per week (albeit with different methods). This approach is consistent with the minimum universal service requirements specified in the EU Postal Directive. By pursuing flexibility along the temporal dimension of delivery flows, Royal Mail could also gain greater efficiency in an area with significant cost implications. Of course flexibility as to timing of delivery (of less time-critical mail) and flexibility as to the geographic specifications of routes are interlinked: the experience of PostNL and Post Danmark shows that gaining efficiency at the delivery stage requires that the organisation is able to manage systematically different delivery routes every other day. Realising greater flexibility is as important as obtaining cost savings including via collective negotiations of employment terms. This applies not only to Royal Mail, but also to most of its European peers and is also recognised by operators outside Europe Competition is a counterbalance to inflexible working patterns and excessive wage demands by the incumbent workforce The opening of a market to competition can lead to more flexible labour contracts (part time workers and outsourcing). In a related manner, in a, this process could lead to a reduction in employment package premiums for postal workers where they are above market rates. In previous work for the Norwegian Government, we have found this to be the case across a variety of liberalised s; 19 at the same time we found that in the UK, wage premiums in the past have not been material, while non-wage conditions have been an important factor we also note that after the Copenhagen Economics (2010) study, Royal Mail has introduced in 2013 a clearly more costly employment package, which has resulted in higher costs across the business. The link between the opening of a market and wage adjustments has been tested by a set of academic studies, such as those summarised in the table below. 18 For instance, Canada Post (2013) stated in its recent five-point plan that success will hinge on its ability to address labour costs across the organization and that Canada Post s objectives in all collective bargaining are to [...] align its costs more closely with those of its competitors and improve operational flexibility. 19 Copenhagen Economics (2010). 23

26 Table 3 Empirical evidence of competition reducing the wage premium Study Conclusion Data Summary Card (1986) Peoples (1998) Deregulation brings wages in line with comparable industries Liberalisation shifts prices to competitive levels, which makes it unprofitable for employers to maintain wage levels not justified by productivity US airline industry and manufacturing sector US trucking, railroad, airline and telecommunications industries Source: Copenhagen Economics (2010). Airline mechanics in the US earned essentially the same wage at all airlines prior to deregulation. In contrast, mechanics at the aircraft manufacturer earned 5-10 percent less. Thus, due to above-market prices and rent sharing between the airlines and their workforce, airline mechanics enjoyed a wage premium prior to market opening. Deregulation of the market encouraged the entry of new airlines. This resulted in reduced employment at the established carriers and created pressure on the wages of airline mechanics towards the wage level paid by comparable firms outside the industry (i.e. aircraft manufacturers). Five years after deregulation, airline wages were in line with those of manufacturers. That is, the wage premium was eliminated as a result of deregulation. Pre-liberalisation wages in trucking, railroad, airline and telecommunications industries were at least 14 percent higher than in comparable industries. Moreover, abovemarket prices allowed carriers to pass on costs to costumers, which contributed to the rent-sharing and high wages. Peoples found that the shift from above-market prices toward competitive pricing makes it unprofitable for employers to pass on higher wages which are not justified by higher productivity. Consequently, in a deregulated industry, larger emphasis on cost savings and the declining power of trade unions put further pressure on moving wages towards the market based level. Opening to competition and labour conditions In a previous study (Copenhagen Economics, 2010), we have analysed how liberalisation impacts labour conditions in the postal sector. We found that changes in wages and employment conditions are driven by a combination of several factors, such as preliberalisation wage premiums in the postal sector, increased automation, lower mail volume and increased competition from new operators. Thus, while wages and employment conditions can and have been affected by liberalisation, this depends on the situation before market opening. If wages in the postal sector were above wages in private sectors with similar skill levels, new operators will most likely create a downward pressure on wages and other employment conditions towards a more market-based level. For example, this has been the case in Germany, the Netherlands and New Zealand. 20 The opening of s has enabled greater responsiveness of the postal industry to processes of technological development and declining mail volumes. These imply that a present-day postal operation can be run with a different structure and skill levels of employees compared to what was the case in the decades pre-liberalisation. In practice this means: 20 In its assessment of the UK, the study found a gap between the USP s wages and the competitor s. Though the study did not find evidence of postal wages below the minimum wage or below comparable skill groups. 24

27 Fewer full-time employees Simplification of the tasks performed by postal workers Overall lower skill level needed than in pre-liberalisation periods Reduction in wages Competitive pressure (especially end-to-end competition) is a key mechanism to ensure that these changes enabled by the opening of the into a liberalised market, are actually effected by the national postal operator. Absent competition, these risk remaining only a potential efficiency improvement. This is shown in the table below, which compares the international experience reviewed in Copenhagen Economics (2010). Table 4 Summary of country case studies Germany Netherlands New Zealand Sweden UK Pre-liberalisation wage premium Yes Yes Yes No No Pre-liberalisation premium in non-wage benefits Yes Yes Yes Yes Yes End-to-end competition (>5% of addresses) Yes Yes Yes Yes No Reduction in wage premium Partly Partly Yes No No Reduction in non-wage benefits Partly Partly Yes Yes Partly Change in employment structure Yes Yes No Yes Partly Source: Copenhagen Economics (2010) As is shown, market liberalisation opening and competition are both important to induce the incumbent to improve its efficiency via a redefined employment structure and conditions. This is in particular consistent with the evidence from Germany, New Zealand, and the Netherlands all endowed with material end-to-end competition. Therein, we observed reductions in wage levels and non-wage benefits for new employees, as well as larger shares of part-time workers. In Sweden, we note that strong labour unions ensure that incumbent s wage level is market based. Focus on the UK As to the UK, our previous study concludes that liberalisation of the in the UK has not had any significant effect on wages and employment conditions in the sector. Rather, in our 2010 study we found that wages for postal workers at Royal Mail had broadly been on a market-based level, i.e. it is likely that there was no pre-liberalisation wage premium (however, we discuss below recent developments which have impacted this historical position). We observed that many postal workers still enjoyed some nonwage benefits from the time they were public sector employees, but these benefits had been slowly decreasing (e.g. as membership of the old defined benefit pension scheme declined). We also noted that the trade union had a strong position and attempts from Royal Mail to lower wages or non-wage benefits had been met with extensive strike actions, making change slow. In the years up to 2010 the wage increase had even been higher than in comparable sectors (but similar to the increase in the statutory minimum wage). 25

28 We found that end-to-end competition in the mail market was very limited. We noted that due to non-wage factors such as pension conditions Royal Mail employment conditions were more favourable than for comparable skill levels. We also noted that the wage level at the main competitor Whistl 21 was lower than at Royal Mail, although both firms monetary remuneration conditions were within the range of remuneration in sectors hiring workers with the same skill level. Consequently, existing wage differences were most likely a result of difference in employment structure at Royal Mail vis à vis Whistl. In summary, our 2010 analysis found that in the UK, limited end-to-end competition has placed limited pressure on the incumbent to adapt its labour employment structure. Looking now at the period up until the present day, we note that to remain competitive in a fully liberalised market Royal Mail has been for a limited period trying to use more part- time staff and a bonus system linking pay with efficiency. However, attempts to cut back staff or freeze wages to deal with continuous losses have been met by actual or threatened, extensive strike actions. Regarding non-wage employment conditions such as pension benefits, working hours and annual vacation, we observe that the conditions at Royal Mail are better than those applied by its competitors, even though several labour conditions have been modernised in the past 5 years: Defined pension scheme closed to new members from April 2008 Related pension deficit covered via lawful State Aid New contracts based on Defined Contribution system Box 1, below, highlights the key features of the recent employment agreement adopted by Royal Mail and their implications. 21 At that time known as TNT Post. 26

29 Box 1 Focus on the latest Royal Mail employment agreement and its impact Royal Mail has modernised its labour conditions in the period up to However, Royal mail has recently changed course in its 2013 employment agreement, which shows that the firm is increasing and will continue increasing its labour costs its key cost base for the coming years. The agreement includes: The maintenance of existing terms and conditions of employment [i.e. for any new employees]; A commitment to retain a predominantly full-time workforce No additional franchising or outsourcing The expected three-year pay deal amounts to an overall compound base pay increase of 9.06 per cent The advantageous nature of this agreement for the employees was recognised by its union leadership. 22 However, this comes at a cost for Royal Mail in terms of the efficiency level that it is now able to achieve. In conclusion, Royal Mail has chosen a strategy that may not only increase its labour costs but also make it harder to find solutions to respond to market challenges over the coming years. This development at Royal Mail appears to go against the trend at many of Royal Mail s peers across Europe and worldwide. Source: Royal Mail (2013b). 2.3 Competition helps tracking evolving customer needs and ensuring that these are reflected in the USO Focusing on the postal sector, despite potential innovations, the USO forces designated operators to maintain a given set of services even though other services might match the preferences the consumers better. However, as shown by the experience of a series of Europe-wide and national updates in postal legislation (at the time of liberalisation or even more recently), the USO can be adjusted over time according to the changing needs of the postal users. It is possible that present day USO may be leading to disproportionately large costs associated with providing universal postal services to a small number of users. This is an empirical question which requires an analysis of the demand for USO services. In a previous study for the European Parliament, we concluded that the USO should be defined according to contemporary needs, taking the rapid development of information and communication technologies into account (Copenhagen Economics, 2013). We based this conclusion on a consideration that users should choose the services that best fulfil their needs. Sometimes this implies that postal services should be substituted by electronic communication. This does not necessarily means a complete surrender of volumes by postal operators to non-postal firms. In fact, postal firms may develop services that meet 22 The deal was so good that when put to the membership it was carried by 94 per cent of members voting. Speech by Billy Hayes, UK postal union president,, addressing the 2014 APWU Convention. 27

30 the needs of their users best, e.g. by offering virtual delivery (open, scan, and ) instead of physical delivery. Another possibility is that the USO may evolve so that postal firms subject to it may offer less frequent delivery if it matches consumer needs. Similarly, innovation on competitive markets may lead to the USO including Sunday deliveries (e.g. of parcels) or delivery to locked boxes (e.g. parcel boxes). These are all possibilities, however, they depend on the actual needs expressed by consumers. Competing supply by alternative operators is a key tool to elicit these needs. In conclusion, envisaging the future role of the USO requires understanding its present value which requires empirical testing, since user needs and technologies have evolved and will continue to evolve. The presence of end-to-end competition in a is a way by which the market needs are tested as ultimately a new entrant s business depends entirely on its ability to identify and interpret the customer needs and serve them in the most cost efficient way. Therefore, by looking at the experience of end-to-end competitors in s and of their customers, policy makers can find valuable evidence to consider the role and merits of different specifications of the USO. In the long run, this can be an important benefit that end-to-end competition brings to s. A set of European countries have effected changes to the USO or are planning to do so in the future. The European Regulators Group for postal services, of which Ofcom is a member, has launched a consultation running from September to November 2014 on the implementation of the USO and on its future scope. 23 The experience of a variety of postal market players is important to paint a comprehensive and robust picture of the evolution of user needs and competition helps in this process. 2.4 Postal competition complements other efficiency drivers Postal operators like Royal Mail are subject to a variety of efficiency drivers. We consider that postal competition such as end-to-end competition plays an important, irreplaceable role amongst these drivers. In fact, Royal Mail, as a listed company, competes for the resources of capital holders which can promote efficiency to some extent. Moreover, Royal Mail competes against firms offering services based on electronic communications, which have allowed many former postal purchases to be replaced by e-substitution. This can also promote efficiency to some extent. Finally, Royal Mail competes against other UK postal firms, with the most complete competition occurring vis à vis end-to-end competitors. All of this is necessary to drive efficiency. Competition for investors drives efficiency yet is an imperfect mechanism As a stock market listed company, Royal Mail reports to its shareholders. The latter have an incentive to make the firm attractive to both: 23 See the ERGP (2014) discussion paper. 28

31 Investors willing to acquire stocks Investors willing to finance corporate debt The former are necessary to maintain or raise the stock price valuation. The latter are necessary to finance the firm s corporate debt. Royal mail s efficiency performance will be one of the indicators by which royal mail will be evaluated by those considering investing in Royal Mail shares or lending money to the firm (e.g. by purchasing a bond). However, asymmetric information between management and owners limits the ability of investors to make a firm more efficient. Asymmetric information is the unavoidable result of imperfect information and of gaps between what is known inside the firm vs. what can be known from the outside. This limits the ability of (prospective) shareholders and bondholders and their advisors (e.g. analysts) to evaluate: How efficient a firm is How efficient a firm can become Moreover, even in a scenario where company management has an explicit duty to maximise shareholder value 24, shareholders control is limited by the agency dilemma. This occurs when management (agent) makes decisions that impact owners (principal). The dilemma exists insofar as the management is motivated to act in its own best interests rather than those of the owners. As a result, any listed firm will not per se (due to its listed status) be fully oriented to drive efficiency. Furthermore, in the postal sector asymmetric information is larger than in other utilities. This is because fewer postal companies have been private or listed and for a shorter period than in other sectors, e.g. telecoms or energy. For this reason, investors have a smaller pool of comparator companies and a smaller set of available information to make decisions on: Purchase of stocks and debt Choice of company management team Choice of company strategy (incl. efficiency programs) As a result, for Royal Mail as a listed business, competition for investors drives efficiency yet is an imperfect mechanism. It is unlikely to be enough on its own for the firm to achieve its full efficiency potential. Finally, the unavoidable imperfections on controlling the performance of a listed company are amplified insofar as the State holds a major shareholding in the company, as is the case at present for Royal Mail (a residual share of 30% with the State). 24 Where company management duties are defined more broadly (i.e. duties beyond maximising shareholder value) then this may be an additional factor that reduces the management s pursuit of efficiency. 29

32 E-substitution drives efficiency yet is an incomplete mechanism In the first chapter we have shown the considerable impact of e-substitution on the postal market, which is a form of competition coming from outside the itself. E- substitution leads to net postal volume losses, in particular notable as a disproportionate amount of reductions in letter volumes. E-substitution puts continuous pressure on postal companies, which in turn can respond by enhancing their efficiency level. However, in the case of Royal Mail, the company has pursued a strategy focusing on a greater degree of integration between mail and parcel delivery compared to its peers. From the point of view of company management and workforce, gains in the volumes of parcels delivered may to some extent compensate the decline in mail volumes due to e-substitution and shift the focus away from the pursuit of efficiency savings in mail delivery. As a result, for Royal Mail, e-substitution drives efficiency yet is an imperfect mechanism. It is unlikely to be enough on its own for the firm to achieve its full efficiency potential. Postal competition improves efficiency the most under end-to-end competition The effect of competition on efficiency depends on the extent to which the incumbent s activities are subject to competition. There is an important difference between the activities set to competition by access-based competition vs. end-to-end competition Access-based operators perform only upstream activities, such as mail preparation, but do not engage in cost-heavy activities such as door to door delivery: they procure this from Royal Mail. Therefore, irrespective of whether a letter is handled entirely by Royal Mail or also by an access-based competitor, door to door delivery (and the necessary sorting and sequencing of mail) will be performed by Royal Mail (cf. figure below). 30

33 Figure 6 Competition promotes efficiency focus on end-to-end Source: Copenhagen Economics, based on Ofcom (2011), Figure 3, at p.100 Access operators handle 49% of all UK mail volumes yet this amounts to only 2% of market revenues. 25 This reflects that low share of value added associated with access-based operation, due to the limited scope of activity. This is proxied by the average earning per item; as shown in Table 5, this is ten times lower for upstream than for upstream operations. Table 5 Value added for access and end-to-end competition Revenue ( m) Volume (m items) Average revenue per unit Activity Royal Mail access provision ,21 Downstream Access-based competition ,02 Upstream End-to-end competition ,20 End-to-end Source: Copenhagen Economics, based on Ofcom (2014) CMR, pp. 380, 382 In other words, end-to-end covers a scale of activities an order of magnitude larger than access-based competition, which relies only on in house upstream activities. This has profound implications on productive and dynamic efficiency: Productive efficiency: if an end-to-end competitor and an access-based competitor are both 30% more efficient than Royal Mail, every time a customer procures from the former this will improve productive efficiency in the industry by 30%; if procuring from the access-based operator this will be only of 3% 25 Ofcom (2014) CMR, pp. 380,

34 Dynamic efficiency, if competitive pressure on an activity induces Royal Mail to become 2% more efficient every year, over a decade competitive pressure from end-toend operators will drive efficiency improvements of 20%, while that from accessbased operators will only amount to 2% It is only end-to-end competition that puts pressure on the incumbent s activities across the entire postal delivery value chain. This is an important factor driving efficiency in Royal Mail s key European peers, as was recognised by a study prepared for Ofcom: Deutsche Post, PostNL and Swedish Posten face some competition in their domestic letter markets which additionally drives efficiency and customer orientation (WIK Consult 2013b, p. 19) It must be noted that unlike other EU countries at present there are no end-to-end networks covering a substantial part of the territory. Therefore for most mailers there is no alternative to delivery via Royal Mail network today, since an alternative network requires prior investment and roll out. In the case of Whistl, this is a process which is currently expected to require 3-4 years to reach only a subset of UK addresses (42%). 26 Furthermore, as shown in section 2.1 (cf. Table 1), the cost savings potential at Royal Mail appears larger than at peers such as PostNL or PostNord. This could be because in markets where end-to-end competition has been a substantial reality for longer, incumbent postal operators have already realised large savings. Conclusion: E2E competition adds a further constraint to drive efficiency While competition vis à vis other firms seeking investment and competition vis à vis e- communications firms can drive efficiency at Royal Mail, these are not perfect mechanisms. Even taken together, they cannot replace the effect of competition within the postal market. Postal competition provides an efficiency incentive above and beyond those other factors and is therefore essential to achieve maximum efficiency improvements within the incumbent. Of all forms of competition, it is above all end-to-end competition that can drive efficiency improvements across the broader set of operations performed by Royal Mail. 26 Moreover, the evolution of alternative end-to-end networks is subject to country specific characteristics, which may not follow a predictable pattern, cf. observations on geography in Mail Competition Forum (2014) submission to Ofcom. 32

35 Chapter 3 Only competition guarantees consumer benefit 3.1 Competition ensures that efficiency gains are passed on to consumers Policy makers appreciate that competition is key to ensure pass-on of efficiency gains to consumers. It is naturally agencies tasked with enforcing competition law provisions (like Ofcom) that have an understanding of the role of competition The incentive [ ] to pass efficiency gains on to consumers is often related to the existence of competitive pressure from the remaining firms in the market and from potential entry. (European Commission, 2004, recital 84) The Commission, therefore, will direct its enforcement to ensuring that markets function properly and that consumers benefit from the efficiency and productivity which result from effective competition between undertakings. [ ] Rivalry between undertakings is an essential driver of economic efficiency, including dynamic efficiencies in the form of innovation. In its absence the dominant undertaking will lack adequate incentives to continue to create and pass on efficiency gains. (European Commission, 2009, recitals 5, 30) In essence, competition leads to price decreases and consumer gain. In the case of Royal Mail, this means in practice that insofar as its services are subject to competition - Royal Mail stands to lose customers if it does not lower prices in a way compatible with competition. 27 Thus the action of competitors will push lower Royal Mail prices. Price reductions are a direct benefit for consumers, due to: Higher consumer surplus for each product bought A larger amount of products bought Therefore consumers benefit from a larger access to market and lower prices for the services sold on a competitive basis. As previously mentioned, an important effect of endto-end competition is that competitive pressure is applied throughout the value chain. On the contrary, access-based competition provides pressure limited to upstream activities. A large share of costs pertains to downstream activities, which are performed by end-to-end firm but not by access- based competitors. As shown in Table 5, the upstream activities conducted by access-based operators amount to only 10% of the overall value added associated with an end-to-end operation. Access- 27 Royal Mail has an obligation to comply with both competition law provisions and ex-ante regulatory measures concerning its pricing conduct. 33

36 based competition has thus a limited scope to affect market outcomes such as final prices. For this reason, end-to-end competition can reduce prices further than access-based competition. Looking at the experience in other European countries, we have found evidence of consumers benefiting clearly from competition. This is because of the price-lowering effect of end-to-end competition, which is shown in the following short case studies. Box 2 Benefits of end-to-end competition in Denmark [ ] interviews with large mailers in Denmark show that business mailers were able to reduce their mailing costs substantially when Citymail entered the market in 2007 (the prices offered by Citymail were up to 50 per cent lower than those offered by the USP). However, cost reductions were not caused by the USP lowering its prices. Instead the cost savings were caused by low prices from the competitor, Bring Citymail. Citymail had to offer lower prices to be able to compete with Post Danmark s full -service offering (e.g. nationwide geographical coverage and six -day delivery) and VAT exemption. As Citymail left the market in 2010, mailing costs increased again. Source: Copenhagen Economics (2012), Pricing behaviour of postal operators (A study for the European Commission), p. 142 Box 3 Benefits of end-to-end competition in Sweden One country where competitors have entered the market for addressed mail is Sweden. In the first years after FMO and the entry of Bring Citymail, the price of large consignments of pre-sorted non-priority mail applied by the USP increased by on average 11 per cent whereas the price of large consignments of pre-sorted priority mail increased by 25 per cent. At the same time, the USP s price in areas where Bring City mail was present (metropolitan areas) decreased by 6 per cent Source: Copenhagen Economics (2012), Pricing behaviour of postal operators (A study for the European Commission), pp The differentials in incumbent postal operator s prices are shown in Figure 7 below. This shows that for products and areas where competition was stronger, the incumbent decreased prices or lowered them less than for products and areas with less or no competition. This trend is evident for both priority (D+1) and non-priority (D+3) mail. 34

37 Figure 7 Variation in price ( ), domestic bulk mail, Sweden Note: CPI increase during the period: 7% Source: PTS (2003), Copenhagen Economics (2012), Pricing behaviour of postal operators (A study for the European Commission), Figure 79 at p Absent competition, taxpayer support risks being needed to fund financial shortfall from RM s inefficiency Ahead of the privatisation, the UK government agreed to use taxpayer money to cover some of the historic RM pension deficit. This form of lawful State Aid was linked to unsustainable defined benefit pension conditions. Without significant competition across a larger share of the value chain (i.e. not just upstream mail preparation), there is a risk that Royal Mail s inefficient choice of inputs would: Add a burden to taxpayers (via a state aid bailout) Subtract gains from consumers, which otherwise should benefit from long due efficiency improvements in postal operations (as performed by the most advanced RM peers in other countries) Absent competition, this is a scenario that could materialise and pose tough trade-offs for policy makers. As mentioned above, end-to-end competition can play a role consistent with a sustainable provision of the USO. 28 Since the USO is an important safeguard for consumers, competition plays not only a direct role in promoting efficiency improvements and the pass on of these improvements to consumers. It also plays a role in ensuring that the important safeguards embedded in the USO are preserved for future postal users. 28 WIK Consult (2011). 35

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41 Appendix A The economic link between competition and efficiency In this appendix, we reappraise the benefits of competition. First, competition gives firms an incentive to be more efficient in their use of resources leading to lower costs, lower prices, and higher sales. Second, when more efficient businesses gain market shares (and less efficient ones lose it), this makes the economy more productive (in the extreme case via exit or entry of new firms). Third, competition gives incentives for businesses to innovate. As a result, for Royal Mail, competition within the s complements other efficiency drivers, such as private ownership as a listed company and the pressure from e- substitution. Incentives for businesses to reduce costs Competition provides multiple benefits. First and foremost, economic theory shows that competition provides incentives for businesses to be more efficient in their use of resources leading to lower costs, lower prices, and higher sales. This effect is amplified by competition driving less productive businesses out of the market (or losing market share) while allowing more efficient businesses to expand or enter the market altogether as new businesses. As productive businesses replace less productive ones, overall efficiency in a sector rises. Increased efficiency means that the sector can reduce prices and thus sell and produce more. When the buyers are other businesses, the lower prices make these businesses more competitive, which in turn enable them to expand. When the buyers are private consumers, the lower prices will imply higher real income and potentially increased consumption. 29 The effect of competition is normally divided into the effect on: Productive and allocative efficiency Dynamic efficiency In what follows, we will discuss the competition impact on the former by reviewing the resource efficiency channel and the entry/exit channel. We will then consider the role of the innovative channel in allowing competition to foster dynamic efficiency The resource efficiency channel 29 Copenhagen Economics (2013); see for example Nalebuff & Stiglitz (1983), OECD (2004), Schmidt (1997), Tirole (1988) and Willig (1987).

42 Figure 8 The resource efficiency channel Source: Copenhagen Economics (2013) Competition leads to efficient use of resources. For this reason, it is an important condition for growth. In a competitive market firms constantly face the challenge of being at least as productive as their competitors in order to maintain or gain market share. When competition is effective, consumers choose the cheapest products at the quality they desire. As a result, companies must engage in a constant struggle to keep costs down and make the best use of available resources. An important element in keeping down costs is to have low input prices Seen from another point of view, competition allows informed consumer choice. The presence of competitors under effective competition makes it possible to compare products or services across companies with respect to performance and price. This puts pressure on managers and encourages incentives to increase productivity or lower prices. As a result, companies facing effective competition will experience stronger responses from customers following changes in price or quality. For instance, by introducing special offers and discounted products, retailers experience an almost immediate effect on their market share under effective competition. The entry / exit channel Figure 9 The entry / exit channel Source: Copenhagen Economics (2013) Where entry into the market and exit from the market depend on company performance (as opposed for example as to entry / exit based on a public licence) this mechanism increases overall productivity. Entry and exit are the extreme manifestations of shifts in supply between firms. The same effect is the result of different firms losing and gaining market shares even without the outcome of exit or entry. 40