Regulatory Intervention C RI T IC A L TH INK ING A T TH E C ......September 2015 Regulatory...

CRITICAL THINKING AT THE CRITICAL TIMETM

September │ 2015

Regulatory

Intervention

Aligning regulatory intervention

in Royal Mail with market

conditions

Public version

Confidential information which has been redacted from this document is indicated by: []

September 2015

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Table of contents

Section

1. Executive summary 1

2. Introduction 9

3. Background 11

4. Traditional forms of regulation and applicability to Royal Mail 14

5. Revenue caps 28

6. Price caps 33

7. Efficiency targets 49

September 2015

Regulatory intervention | i

Glossary

CAA Civil Aviation Authority

CC Competition Commission

CCA Current Cost Accounting

CPI Consumer Price Index

CWU Communications Worker’s union

DNO Distribution network operator

DSA Downstream Access

E2E End to End

EBIT Earnings before Interest and Taxation

ERGP European Regulators Group for Postal Services

EPMU Equi-proportional mark-up

FAC Fully Allocated Costs

FOC Freight operating company

FRR Fundamental Review of Regulation

FRAND Fair, reasonable and non-discriminatory

IQI Information Quality Incentive

LRIC Long Run Incremental Costs

MPF Metallic path fibre

NTS National transmission system

ORR Office of Rail and Road

QoS Quality of Service

RIIO Revenue, Incentives, Innovation and Outputs

ROCE Return on Capital Employed

ROSCO Rolling stock leasing company

September 2015

Regulatory intervention | ii

RPI Retail price index

TOC Train Operating Company

Totex Total expenditure

USO Universal Service Obligation

VULA Virtual unbundled local access

September 2015

Regulatory intervention | 1

1. Executive summary

The current regulatory framework

In 2012, Ofcom followed a deregulation agenda whereby Royal Mail was afforded 1.1

increasing pricing flexibility, subject to a number of controls, including a safeguard cap

on second-class stamp products, non-discrimination and margin requirements for

access and an enhanced monitoring regime.

The decisions taken by Ofcom in 2012 followed reports prepared in 2008 and 2010 by 1.2

Sir Richard Hooper (the "Hooper reports") which had pointed to the threat to the

universal postal service posed by Royal Mail's then declining financial position. The

Hooper report cited declining mail volumes and Royal Mail’s weak financial position as

the two key challenges facing Royal Mail. Hooper argued that the Royal Mail should be

opened to private investment, the pension deficit transferred to the Treasury and that

Ofcom should take over the regulation of the postal sector.

The broad consensus as to the need for the changes identified in the Hooper reports 1.3

was based on a series of observations: among others that the universal postal service

was important; that letter volumes were falling as a result of e-substitution; that Royal

Mail needed to modernise; that decisions about modernisation needed to be made on

a commercial basis. Those observations remain as relevant now as they were then.

Ofcom's 2012 document linked the deregulatory steps that were proposed to the 1.4

existence of a number of safeguards including in particular the existence of an end-to-

end competitor. The consensus recorded in the Hooper reports as to the need for

deregulation, however, predated the arrival of any competition for delivery services.

Indeed the concern expressed in the Hooper report was rather that such competition

risked doing more harm to the sustainability of universal service (through the dispersal

of delivery volumes) than good (through any incremental incentives to efficiency).

The sustainability of the universal postal service is Ofcom's primary duty in respect of 1.5

postal services. Given the importance of continued efficiency improvements at Royal

Mail to the sustainability of the universal service, it is not necessarily surprising that

Ofcom should wish to review whether additional regulation might help to drive those

improvements. On balance, and for reasons set out within this document, we think it is

unlikely that it would.

September 2015


Any benefits of pricing interventions should be weighed against the sustainability of

the USO

In undertaking its duties: 1.6

“OFCOM must carry out their functions in relation to postal services in a way that

they consider will secure the provision of a universal postal service.”1

In undertaking its duty Ofcom should have regard to both the need to ensure that the 1.7

universal service is financially sustainable, and to ensure that it is efficient.2 This might

lead to the a priori expectation that incentive based price controls should be applied to

any economic markets in which Royal Mail may be found to have significant market

power.

Indeed, price controls have been the primary method of combining price regulations 1.8

with efficiency incentives by UK economic regulators since their conception in the

Littlechild report. Where the regulated entity also operates in downstream markets,

they may also be combined with regulations on the structure of prices or margin

squeeze tests.

However regulation comes with risks. In network industries with a high level of common 1.9

costs, unit costs are particularly susceptible to volumes changing. Where volume

forecasts are uncertain, there is a risk that the regulator sets a regulatory framework

that is inappropriate given subsequent market conditions. This can be seen in the

adjustment of the price controls on BT's metallic path fibre ("MPF") in 2008 and the

adjustments in 2009 of BT's network charge controls ("NCC"). Volume forecasting

errors were also the main driver behind the reopening of Royal Mail's 2006 price

control.

This risk exists in all network industries but in telecommunications, water and energy 1.10

demand is more stable and, for the most part, is growing. The impact of incorrect

forecasting is therefore lower than in the postal sector.

In mail, the rate of volume decline is uncertain, and costs, in a labour intensive and 1.11

heavily unionised environment, cannot realistically be cut as fast as volumes decline. In

order to maintain the high quality network needed for the USO, Royal Mail may need to

maintain a network that is "over-dimensioned" to be able to deal with peaks in demand.

In the short-run, if Royal Mail cannot easily cut costs, it must retain pricing flexibility in

order to respond to the market.

1 Ofcom (2011), Postal Services Act - Para 29(1).

2 Ofcom (2011), Postal Services Act - Para 29(3).

September 2015


Regulatory remedies should be sector specific, there is no “one size fits all”

Regulation should be specific to the sector and its particular market structure and 1.12

characteristics. Different regulators take different approaches to regulation, even

within the context of setting regulated prices. For example, Ofgem has moved away

from a price cap to RIIO, a form of revenue cap, which reduces the risk of volume

volatility faced by the regulated entities.

Even within a sector, regulators take different approaches to different groups of 1.13

products. This is because the challenges that each sector faces are different, and

regulation should be targeted to solve a specific concern. The choice of regulation will

depend on the extent of potential competition in the market, and the aims of

regulation. For example BT’s Virtual Unbundled Local Access (“VULA”) is controlled by a

margin squeeze control due to uncertain volume forecasts whereas many other

Openreach products are price controlled.3,4

Standard regulatory remedies are unlikely to prove effective

The update to the Hooper report5, in 2010, made the point clearly that Royal Mail is 1.14

“not like other utilities” and the primary reason for this was (and continues to be) that

“the delivery of the universal service in the postal sector is under much greater threat

than in other sectors”.

The UK postal sector, and Royal Mail as the USP, face a unique set of challenges: 1.15

(i) Falling and unstable letter volumes, mitigated but not offset by increasing parcel

volumes;

(ii) A combined network used to fulfil Universal Service Obligation (“USO”) and non-USO

services: the Royal Mail downstream network (Inward Mail Centres, Delivery Offices

and delivery staff) delivers USO mail, access bulk mail, retail bulk mail, and parcels –

all over a single network, which must be sustainable – and therefore profitable; and

(iii) An efficiency challenge which is fundamental to remaining competitive and

sustainable but which is doubly challenging given declining volumes, and more

challenging again with a highly unionised workforce.

3 VULA margin squeeze control discussed in Ofcom (3 July 2013), Fixed Access Market Review.

4 Ofcom (July 2015), Strategic Review of Digital Communications discusses the current functional

separation of BT and Openreach and potential changes to it.

5 Hooper (2010), Saving the Royal Mail’s universal postal service in the digital age, Page 27.

September 2015


Declining letter volumes, and increasing competition in parcels, were and continue to 1.16

be at the heart of the threat to the USO. Additionally, volumes and associated costs

cannot be forecast with any degree of accuracy in a market with unpredictable

volumes. These are the main reasons why direct regulation – over revenues, or prices,

or efficiency targets are risky. For reasons explored in Sections 5 to 7 of this document,

they are also the main reasons why direct regulation, in any of these forms, appears to

be unnecessary.

Ofcom has previously recognised the difficulties in setting a price control where 1.17

volumes are uncertain:

“In a highly uncertain market environment, where the level and pattern of

demand is unclear, it is not feasible to predict accurately whether a given

price trajectory would be adequate to ensure the provision of the universal

service is financially sustainable.”6

Increasing substitution provides a constraint to price rises

Transactional mail volumes are declining, as customers such as bank, utility 1.18

companies and public bodies introduce digital alternatives. Advertising – and in

particular online advertising - is growing but advertising mail revenues are shrinking in

real terms.

Competition for upstream volumes has developed rapidly since the introduction of 1.19

mandated access in 2004. The majority of business mail (including advertising mail)

volumes are now collected by a competitor and then delivered to the Royal Mail access

point (the inward mail centre). Competitors using downstream access account for c

70% of mail posted by businesses, an increase of 38% percentage points from

2007/08 to 2013/14. 7

In parcels, competitors account for 38% by revenue and 52% by volume, including 1.20

large letters used for fulfilment8. Entry has been vigorous in recent years, and

alternative delivery options are continuously being developed.

Furthermore, raising prices may not be a rational strategy in a declining market. 1.21

Customers that switch onto alternative communication channels may not return if

prices are subsequently reduced.

6 Ofcom – Securing the Universal Postal Service March 2012: Para 1.19

7 Source: FTI Consulting analysis based on Royal Mail volume and revenue data from the SPACE

model.

8 Triangle/Royal Mail estimates based on financial accounts.

September 2015


Whilst Royal Mail’s historical elasticity estimates suggest that it could in principle 1.22

increase prices profitably, in practice Royal Mail has not done so. Rather, Royal Mail

believes itself to be constrained in price setting - through the threat of e-substitution

and other competitive constraints. Its pricing profile and profitability demonstrate that,

for this reason or another, Royal Mail has not exercised any degree of market power

that it might be thought to have.

Incentives to greater efficiency are adequate

The Hooper reports recognised that the sustainability of the universal postal service 1.23

depended upon modernising Royal Mail. The pursuit of progressive efficiency

improvements remains central to this objective. Given competitive constraints over

pricing, driving efficiency improvements is also the only way in which Royal Mail can

improve its profitability. Analyst commentary on Royal Mail reflects this fact, and is

likely to provide additional oversight over management’s efforts.

However, the pursuit of efficiency in a declining market, prone to accelerated decline, is 1.24

a different proposition to the pursuit of efficiency in a growing market where efficiency

can be achieved by not putting cost in, as opposed to needing to remove costs. This is

compounded by the non-linearity of efficiency – a cost reduction programme put in

place based on one set of volume assumptions may turn out to be inappropriate or

unwarranted should the volume assumption turn out to be different from that which

was forecasted.

The labour intensity of Royal Mail’s business, combined with the unionisation of its 1.25

workforce, means that the speed of transformation is constrained by the threat of

industrial action. This is in the nature of an inherited constraint: and to date, Royal Mail

has opted to work within it, acknowledging the additional challenges to transformation

that that presents. It is not clear, however, that regulatory intervention would reduce

those additional challenges.

The USO is fragile and the risk associated with getting the price control “wrong” is

asymmetric

Regulatory oversight and commercial constraints limit Royal Mail's pricing power. Even 1.26

in downstream access where Royal Mail faces virtually no delivery competition, its

pricing power is limited. The extremely competitive retail bulk mail market, combined

with Ofcom’s regulatory margin squeeze price control and the threat of e-substitution

constrain Royal Mail’s pricing. The “threat” of regulatory intervention and competitive

constraints keeps Royal Mail's prices in letters below the monopoly level.

September 2015


A price control is typically set such that the regulated firm is expected to make a 1.27

“normal profit”. The regulated firm may make returns above or below the normal level.

If the firm makes returns above/below the normal level, then the control is not

reopened but the regulated firm takes the risk. A price control can also “share” this risk

between the regulated firm and the consumer.

In setting a price control, consistent with other economic regulators, Ofcom will require 1.28

forecasts of volumes, costs, revenues and the relationship between these key

variables. As Ofcom is aware, there is potential volatility of volumes not necessarily

seen in other industries. It was the difference between forecast and outturn volumes

which contributed to Royal Mail becoming balance sheet insolvent and which required

the Postcomm price control to be reopened. Analysis suggests that volume forecasting

has not gained accuracy as the emergence of new players and business models

happens suddenly, with little warning and it is difficult to predict which models will be

particularly successful.

The risks of “getting it wrong” are asymmetric. If a future price control set by Ofcom 1.29

was set “too low” then the USO might become unsustainable as Royal Mail could not

increase prices. The price control would then need reopened (as happened in the 2006

control). If Ofcom’s price control is set “too high” then there is a risk that Royal Mail

makes profits higher than expected by the regulator. In the absence of regulation,

Royal Mail would be constrained by other competitive pressure which would be likely to

prevent its prices becoming unaffordable. Given the asymmetry of risk and lack of

evidence regarding super-normal profits, an extension to the current price control is not

warranted at this time.

Any price control might need to be reopened. Regulatory stability is essential to 1.30

effective regulation. If the regulatory environment is uncertain this limits competitive

entry (as firms are unsure how the regulator will respond) and makes investment

decisions difficult for the regulated firm. Because of the need to maintain the USO,

Ofcom cannot credibly commit to not reopening the price control in the event that it

“gets it wrong”. This makes the price control ineffective and hence unnecessary. The

2006 price control set by Postcomm was not effective – a fact that Ofcom has explicitly

acknowledged.

Therefore due to the constraints that exist already on access and retail prices, 1.31

including the safeguard caps for 2nd class stamps and the margin squeeze test

between bulk retail and access prices, alongside the risk of forecasting errors in the

price control that could threaten the financeability of the USO, we do not consider the

application of a binding price cap on further retail or access services to be appropriate.

September 2015


An explicit efficiency target may disincentivise dynamic efficiency

An explicit “efficiency target” would be likely to distort incentives, particularly around 1.32

dynamic efficiency, or the incentives to make investments to improve efficiency in the

long-term.9 Efficiency targets are built into price controls, but if a firm fails to meet

these it is not explicitly penalised, but instead will have higher costs than anticipated.

The regulated firm then suffers through lower profits.

Were an explicit efficiency target to be put in place with penalties or rewards around 1.33

this target then management may become overly focussed on meeting that target. The

incentive would be to meet the efficiency target as defined in regulation, rather than to

necessarily make Royal Mail more efficient. Also, because the efficiency target would

be fixed in advance, Royal Mail would be unable to respond to market conditions in

improving efficiency. Royal Mail would focus on efficiency measures that were designed

to meet the short-term target, rather than on an efficiency measure that might deliver

advantages in the medium to long term.

Some issues with implementing explicit efficiency targets are: 1.34

(i) Focussing on static efficiency: Focussing on year on year efficiency to meet

the target, rather than on cost transformation programmes that realise

efficiencies over the longer term and which may require initial outlay before

the benefits are realised;

(ii) “Holding back” efficiency: In order to meet annual targets, Royal Mail might

“hold back” efficiency gains so that they could be used in future years; and

(iii) Revising cost allocations: If cost allocations were revised, Royal Mail might

appear to have improved efficiency. This would encourage management to

focus on cost allocations, rather than operational improvements. The extent

to which this is likely to be a problem would depend on the level of

aggregation of the target.

We are not aware of any regulator imposing an explicit “efficiency target” on any 1.35

regulated firm.

9 Ofcom defines dynamic efficiency as “improvements in efficiency which occur over time as

investment and innovation, for example arising from increased competition, result in the

development of new goods and services, and technological advances that make the production

of current and future goods and services less costly.” Ofcom (June 2013), Cost Orientation

Review Consultation, Page 8 - Para 2.13.

September 2015


Changes to pricing remedies should be focussed on refinements to the existing

remedies

There is no evidence to suggest that the current safeguard cap on 2nd class stamp 1.36

products is not working or that access charges are excessive. However, we recognise

that Ofcom may have concerns around safeguarding the highly competitive access

market.

As such, the structure of access prices becomes important – as recognised by Ofcom 1.37

when it imposed a margin squeeze test in 2012. Whilst this has been largely

successful, there are changes that could be considered around its structure and

around providing Royal Mail with regulatory guidance on the meaning of ‘fair and

reasonable’ as well as the ‘no undue discrimination’ obligation in USPA 5.

The primary weakness in the current arrangements appears to us to lie in the potential 1.38

suppression of service and pricing innovation – particularly at the access level. That

applies particularly to letters, in which overall market declines might be slowed if more

innovative services could be quickly configured in response to market changes, but

also to the other services that provide the incremental revenues that support the

financial sustainability of the universal service. Excessive regulatory oversight serves

not only to slow down such innovations, but also to discourage attempts to innovate.

Avoiding adverse consequences of this kind should be part of Ofcom’s objectives.

Conclusion

We do not find that changes in the market since March 2012 give rise to a need for 1.39

increased pricing regulation. Royal Mail faces a price cap on second class stamp

letters, large letters, and parcels below 2kg. To ensure these services remain

affordable to low income groups this price cap is linked to Consumer Price Index (“CPI”)

inflation as this is the metric used in annual raises of benefits. First class stamp

products are likely to be constrained by the regulated second class stamp products.

First class stamp prices have largely risen in line with second class stamp prices,

despite first class stamp prices being unregulated. In other markets, Royal Mail’s

actions are likely to be constrained by competition from other operators or by the

existing regulation of access prices.

Furthermore, we find that the imposition of any additional regulatory remedies would 1.40

be unhelpful - difficult to establish with the required precision, and likely to limit the

pricing flexibility of Royal Mail to respond to continuing declines in volumes. To the

extent that Ofcom is concerned about incentivising progressive efficiency gains, the

imposition of additional price controls or efficiency targets in this particular operating

environment is unlikely to prove effective

September 2015


2. Introduction

This report has been prepared by FTI Consulting LLP (“FTI Consulting”) for Royal Mail in 2.1

connection with the Fundamental Review of Regulation (“FRR”). We have been asked

by Royal Mail to consider the potential for further regulatory intervention by Ofcom. In

particular, we have been asked to consider price controls and efficiency targets.

We have been asked by Royal Mail to consider the forms of price controls and 2.2

efficiency targets that are typically considered by economic regulators in the UK and

the extent to which it would be suitable to apply these to Royal Mail.

Specifically, we have been asked to consider: 2.3

(i) The forms of price controls and efficiency targets that are typically

considered by UK economic regulators;

(ii) The specific market conditions in which Royal Mail is operating and whether

this makes the Royal Mail regulatory problem different to that of other

regulated industries in the UK;

(iii) The extent to which it may be appropriate to extend the price controls that

are currently applied to Royal Mail; and

(iv) The extent to which it may be appropriate to apply an efficiency target to

Royal Mail.

In undertaking this work, we have considered regulatory decisions in other sectors, 2.4

studies undertaken for other regulators and previous postal consultations and market

reviews, including the Hooper reports. We have also considered information specific to

the market conditions in which Royal Mail operates.

We make reference in this report to efficiency and competition. Further details of which 2.5

can be provided in the FTI Consulting reports that are being provided to Ofcom, by

Royal Mail, on these subjects. This report is intended to be read alongside those.

Background

On 17th July 2015, Ofcom published its FRR of Royal Mail, the purpose of which is for 2.6

Ofcom to seek initial views on the scope of its review into the regulatory framework and

the types of interventions that might be appropriate in the light of changed market

circumstances.

September 2015


Source of information

We have relied upon information provided to us by Royal Mail and published by Ofcom. 2.7

We have also used information from other regulatory authorities in the UK, advisory

reports that they have commissioned as well as from academic sources and

government agencies. FTI Consulting has not sought to establish the reliability of those

sources or verified the information provided.

Restrictions

This report has been prepared solely for the benefit of Royal Mail for use in responding 2.8

to Ofcom’s FRR. We have agreed that Royal Mail may provide this report to Ofcom and

that it may be published by Ofcom in the context of the FRR.

FTI Consulting accepts no liability or duty of care to any person other than Royal Mail 2.9

for the content of the report and disclaims all responsibility for the consequences of

any person other than Royal Mail acting or refraining to act in reliance on the report or

for any decisions made or not made which are based upon the report.


3. Background

The financial sustainability of the universal postal service is Ofcom’s primary duty, and Royal 3.1

Mail’s primary aim. As the Hooper report identified in 2008, however, the universal service is

under threat.10 That was true in 2008, true again when the report was updated in 2010 and true

again when Ofcom laid out a regulatory framework in 2012. The regulatory interventions that

have been applied to the sector have been developed with a commitment to the universal service

and ensuring Royal Mail is financially sustainable.

The Postal Services Act 2000 gave Postcomm, the postal regulator, a primary duty to ensure the 3.2

provision of a universal service at an affordable tariff and promoting effective competition. Price

caps were set through to 2011, with more than 80% of revenues being subject to this

regulation.11 Access to the downstream delivery network was granted to alternative carriers to

promote competition. However, by the end of 2008, Royal Mail had become balance sheet

insolvent.

With a growing consensus that the universal postal service was at risk and could not be 3.3

sustained under the status quo, Richard Hooper conducted two government reviews which

concluded that Royal Mail needed urgent modernisation through “commercial confidence, capital

and corporate experience”.12

Following implementation of the Postal Services Act in 2011, Ofcom followed up with a new 3.4

regulatory framework in 2012, which granted Royal Mail greater commercial and operational

flexibility. This was due to an acknowledgement that there was great uncertainty facing Royal

Mail and mail volumes were forecasted to decline “with letter volumes possibly declining by

between 25% and 40% over the next five years”.13

Ofcom set out its key aims and proposed a regulatory framework which would give Royal Mail 3.5

increased commercial freedom whilst monitoring its ongoing performance.

10 Hooper (2008), Modernise or Decline, Page 8.

11 Royal Mail Plc (Undated), Price Control. Available at: http://www.royalmailgroup.com/about-

us/regulation/price-control

12 Hooper (2008), Modernise or Decline, Page 6.

13 Ofcom (March 2012), Securing the Universal Postal Service – Decision on the new regulatory framework,

Page 12 - Para 2.7.

September 2015


Table 3-1: Ofcom’s aims of regulation in 2012 and their chosen implementation

2012 Aim Ofcom’s implementation

Commitment to the universal service Ensuring Royal Mail is financially

sustainable

Pricing flexibility Removal of price controls, only a

margin squeeze obligation

Effective and ongoing monitoring

Published Annual monitoring review

and Quarterly regulated financial

statements

Safeguard cap for vulnerable

consumers 2C price cap on stamp products

Commercial and operational

freedom

Removal of price and non-price

operational requirements

Competition benefits maintained

Ofcom would ensure that E2E

competition would not damage the

USO

Source: Summarised from Ofcom, securing the universal postal service, March 2012.

These remedies were intended to be in place for a 7-year period. Ofcom left open the possibility 3.6

of reopening the regulatory framework if it “considered it necessary to secure our statutory

duties.”14 The commercial freedom was granted subject to the presence of monitoring of

performance.

With regard to monitoring, Ofcom had noted that Royal Mail had the need to return to adequate 3.7

levels of profitability for the universal service to be sustainable, but it would consider the case for

re-intervention if “it (was) earning excess profits as a result of price rises, as opposed to

efficiency gains”.15

14 Ofcom (March 2012), Securing the Universal Postal Service – Decision on the new regulatory framework ,

Page 79 - Para 6.173.

15 Ofcom (March 2012), Securing the Universal Postal Service - Summary, Page 7 - Para 1.55.

September 2015


Ofcom noted that access and end-to-end (“E2E”) competition were important to create efficiency 3.8

incentives but recognised that the sustainability of Royal Mail could be threatened with E2E

competition.16 As such, they would assess proposals for entry into the E2E market on a case by

case basis. Ofcom also pointed out that E2E competition had no significant presence in the UK at

the time and the main form of competition was in the form of access, whereby other postal

operators would use Royal Mail’s network to deliver letters they have collected from customer.17

In considering Royal Mail’s profitability and level of prices, the case for reconsidering the 3.9

effectiveness of the current regulatory structure does not seem proven. Profits remain far from

excessive and higher profits in some business areas are fundamental for sustaining the USO.

Overall, the profitability of Royal Mail’s Reported Business has improved since 2012, as Royal

Mail has kept costs under control, despite the increase in its people costs, and has only just

entered the 5% to 10% range set by Ofcom as “a reasonable commercial rate of return for Royal

Mail”; indeed, it has reached the bottom level of this range for the first time in financial year

2014/15, and only on Ofcom’s definition of “financeability EBIT margin”. Furthermore, price rises

have been small and efficiency gains have been observed over the period. Royal Mail’s prices for

addressed inland mail in the period 2012 to 2015 increased annually by on average 1.2% above

RPI. Annual efficiency gains of between 0.2% and 4.5% between 2012/13 and 2014/15, with an

average of 1.6%.18

The modernisation of Royal Mail is well advanced. A major component of this modernisation has 3.10

been to the processes and automation. Royal Mail has invested in intelligent letter sorting

machinery and enhanced existing mail processing machinery, which has directly contributed to

the amount of letters sorted through ‘sequencing’ from 1% to 82% between 2007/08 and

2014/15.19 Royal Mail has also managed to reduce headcount significantly and closed 34 of its

69 Mail Centres in 2007/08 (and opened four new ones), without any compromise to its USO

duties or quality of service.

On 11 May 2015 Royal Mail’s direct competitor in E2E, Whistl, announced it would cease its 3.11

activities in that space. Whistl’s exit from the E2E letters market may be considered a change in

the competitive conditions. However, we believe, for reasons set out in subsequent sections of

this report, that this change does not require any increase in regulatory oversight.

In considering regulatory interventions that may be appropriate to Royal Mail going forwards, it is 3.12

important to understand the background to the 2012 deregulation and why it was considered

that a more interventionist regime was not considered appropriate at this time alongside Royal

Mail’s performance and behaviour since 2012. It is against this background that the case for

additional intervention should now be considered.

16 Ofcom (October 2011), Securing the Universal Postal Service - Consultation, Page 8-9 - Para 1.49-55.

17 Ofcom (October 2011), Securing the Universal Postal Service - Consultation, Page 132 - Para 9.1-9.4.

18 See separate FTI Annexes Competitive Constraints Facing Royal Mail and on Efficiency Metrics for Royal

Mail.

19 Royal Mail plc (29 May 2015), Annual Report and Financial Statements, Page 10.


4. Traditional forms of regulation and applicability to Royal Mail

The tool kit for regulating prices

Prices may be regulated on an ex-ante or ex-post basis, through regulatory remedies or reliance 4.1

on competition law. There are a range of controls that can be considered for use.

Table 4-1: Forms of control

Intervention Ex ante or ex post Form of control Typical Duration

Competition law Ex post UK wide legal requirement for

dominant companies to avoid

excessive pricing, margin squeeze

and other forms of abusive pricing

Ongoing

Price control -Direct Price controls

Price caps Ex ante Cap the price of a service or

basket of services

Multi period

Revenue caps Ex ante Cap the total revenue of the firm or

a group of services provided by the

firm

Multi period

Rate of return

regulation

Ex ante Caps the rate of return that a firm

can make, by aligning prices with

economic costs

Single period

Price control - Price level rules

Pegged tariffs Ex ante Price in a non-competitive

segment is pegged to a tariff in the

competitive segment

Single period, although

pegged tariff maybe multi

period

Default tariffs Ex ante Price control on a single product

which acts as a constraint on the

price of other products in the

market

Single period, although

default tariff maybe multi

period

September 2015


Intervention Ex ante or ex post Form of control Typical Duration

Safeguard

tariffs

Ex ante Price control which is usually

binding and above the cost

orientated price which aims to

protect customers against

excessive prices

Multi period

Cost orientation

requirement

Ex ante Prices should be set to reflect the

level of cost of providing the

service

Single period

Price control - Price structure rules

Margin squeeze

test

Ex ante or ex post Margin between the regulated

entities wholesale price and retail

price is sufficient to support

efficient entry

Single period

Non-

discrimination

rules

Ex ante or ex post Prices charged to external parties

should be consistent with those

charged to the regulated entities

retail business

Single period

Source: FTI analysis

Direct price controls such as price caps and revenue caps are applied on an ex-ante basis and 4.2

aim to allow the regulated entity to make a normal economic profit and to achieve revenue which

is equal to the economic, efficient, cost of providing the service.

If applied in a predictable and transparent manner, where the parameters needed to set the 4.3

control can be accurately assessed then these may provide certainty to the regulated firm around

cost recovery, encouraging innovation and investment.

Furthermore, when applied for multi-year duration, they may provide incentives for efficiency 4.4

since by reducing costs the firm may be able to “beat” the control and benefit from higher

profitability in the period before the cap is reset. Being multi-period, they are also more likely to

incentivise dynamic efficiency. A firm which is dynamically efficient will be reducing its costs in

both the short and long run, usually by implementing new production processes that improve

productive efficiency. However, the risk of uncertainty sits with the regulated firm.

September 2015


In some cases, particularly where competition is emerging, the case for direct price controls may 4.5

be reduced and pricing rules may instead be considered. These take the form of specific rules,

specified ex-ante, to constrain the behaviour of the regulated entity. These are often associated

with greater pricing flexibility enabling the regulated entity to adapt to the changing competitive

environment, whilst still trying to maintain loose controls on monopoly behaviour. These have a

lower regulatory burden. These may be applied as rules to the level of prices that can be charged

or to the structure of prices that can be charged.20

Table 4-2: Strengths and weaknesses of alternative forms of price control

Source: FTI analysis

The suitability of each type of control depends on the specifics of the regulated entity and the 4.6

market in which it operates. However, the contestability of the market is an important

consideration. There are three main forms to consider:

(i) Natural monopolies: Controls are required to prevent monopoly style price setting

behaviour and to incentivise efficiencies;

20 Welfens (1997), European Monetary Union: Transition, International Impact and Policy Options states that

“higher price flexibility can indeed be expected in a more competitive setting.”

Revenue is set equal to the efficient cost of the regulated firm. Usually a multi year control.

Constrains the absolute price of one or more services, often as a safeguard where competition or other constraints may also be influencing the behaviour of the firm.

Constrains the structure of the regulated firms pricing, to help foster competition.

• Prevents predatory pricing. • Provides regulated firm with

freedom to compete on a more level playing field.

• Reduced risk that regulation will negatively impact innovation and investment.

• Requires detailed & accurate forecasts of the regulated firms demand, revenues & costs and relationships between them.

• Inflexible & difficult to re - open

• Only applicable in certain circumstances where other constraints bind the behaviour of the regulated firm.

• May not promote allocative efficiency.

• Only relevant as form of control when regulatory aim is to foster competition.

• Often a lack of clarity on how tests should be constructed and applied in regulatory context versus competition context.

• Requires detailed costing information.

• Multi year control creates incentives for static & dynamic efficiency.

• Regulatory Certainty

• Low regulatory burden • Incentives for productive

efficiency • Provides regulated firm with

freedom to compete on a more level playing field.

• Reduced risk that regulation will negatively impact innovation and investment.

Direct Price Controls Price Level Rules Price Structure Rules

Form of

Control

Weaknesses

Strengths

September 2015


(ii) Natural monopolies operating in adjacent upstream/downstream markets: As for a

natural monopoly, but controls are also required around the structure of prices to

prevent anti-competitive behaviour such as the leveraging of market power between

markets or market foreclosure; and

(iii) Contestable markets: Lighter touch to foster competition and ensure fair play.

Figure 4-1: Form of control and level of market contestability

Source: FTI analysis.

The case studies below provide examples of how the degree of market contestability may 4.7

influence the design of the price control.

Case study – On going regulation for monopolies without competition

Case study – Natural upstream monopoly with competitive downstream market

Ex Ante Price

Controls

• Price Caps

• Revenue Caps

• Rate of return

Pricing Rules

• Pegged tariffs

• Default tariffs

• Safeguard tariffs

• Cost orientation

requirement

Price Structure rules

• Non –

discrimination

rules

• Margin Squeeze

test

Increasing competition and decreasing market power

Case Study:

Industries such as national rail networks (National Rail) and electricity networks (National Grid)

are likely to require a form of ongoing regulation. The natural monopoly elements that cannot

be replicated may be isolated and subject to price controls (such as RPI-X). In the absence of

competition price regulation should provide incentives for the monopoly provider to make

efficiency savings. These savings are partly kept by the regulated firm, but in the long run are

passed onto the users of the network.

Case Study:

There may be no prospect of competition at the wholesale level, but competition at the retail

level. Openreach has the near monopoly on telephone access lines, but there is a highly

competitive market downstream because the copper loop can be used by firms such as Sky

and TalkTalk to provide services. The wholesale business may still need to invest in new

services (e.g. superfast broadband) so a mix of price controls (on old services) and lighter touch

regulation (on new services).

September 2015


Application of the tool kit to Royal Mail

Figure 4-2 illustrates the Royal Mail operating model, and highlights the key elements of the end 4.8

to end process of delivering letters and parcels.

Figure 4-2: Overview of Royal Mail operating model

Source: Royal Mail

Royal Mail is already subject to a number of pricing constraints. 4.9

DeliveryDelivery Prep

Cross dock at RDC

InwardProcessingNetwork

Unsorted International Export

InternationalExport

Downstream Access

Presort

Delivery Offices

Collection Hubs

(at Delivery Offices)

International Hub

RDC

Outward ProcessingCollection

International Hub

InternationalImport

Inward Mail Centres

Door to Door

Outward Mail Centres

within Mail CentresBusinesses

c.79k

Post Offices c. 11.5k

Pillar boxes c. 115k

3737 c. 1,300Delivery Pointsc. 29m

Van

Shared Van

HCT and Foot

Firm

Walk Bundling Centres

September 2015


Table 4-3: Pricing remedies and constraints on Royal Mail

Product Group Level of competition

for products

Price Controls21 Non Price

Regulation

Low volume unsorted

Letters and Large

Letters

Limited end to end

competition.

Safeguard price cap is

defined for 2nd class

stamp, and for a

basket of 2nd class

large letters and light

parcels

Accounting

separation (as part

of USO)

Bulk business Letters

and Large Letters

Retail market is

increasingly

competitive

Ex-ante margin

squeeze test

Accounting

separation

Access Letters and

Large Letters

Currently no delivery

competition,

uncertainty on potential

future entrants.

Competition from

digital and other media

for bulk letters and

large letters.

Fair reasonable and

non-discriminatory

and ex-ante margin

squeeze test

Accounting

separation

Retail Parcels The parcel market is

competitive with

several end-to-end

competitors.

None Accounting

separation

Access Parcels The parcel market is

competitive with

several end-to-end

competitors

No regulation is

introduced and Royal

Mail has no obligation

to offer access, but

delivery of parcels

from the inward

mailing centre is

offered on a

commercial basis

Source: Royal Mail

*markets have been grouped by level of prospective competition.

This regulatory framework was introduced in 2012 when, following the Hooper Reports, a 4.10

deregulation agenda was proposed in order to provide Royal Mail with the pricing, commercial

and operational freedom that was necessary to safeguard the USO subject to Royal Mail

complying with an enhanced monitoring regime.22

Therefore when considering the application of the tool kit to Royal Mail, we are starting from a 4.11

point of existing, but relatively light touch, pricing remedies that were considered necessary in

order to safeguard the USO following the reopening of the 2006 price cap as Royal Mail’s

volumes, revenues and profitability fell faster than forecasted.

21 Price controls may include direct price controls (such as safeguard caps) and also margin squeeze controls.

22 Ofcom (March 2012), Securing the Universal Postal Service – Decision on the new regulatory framework.

September 2015


Royal Mail is operating in market conditions that are different from the majority, if not all, of the 4.12

other entities regulated by UK economic regulators. This point was recognised in the update to

the Hooper report, in 2010, which made the point that Royal Mail is “not like other utilities”23

The primary reason being that “The delivery of the universal service in the postal sector

is under much greater threat than in other sectors which also have monopoly

characteristic such as telecommunications, electricity, gas and water. This is for two

reasons.

First, in contrast to these other sectors, delivery volumes… are in sharp decline”.

Table 4-4: Table showing difference between Royal Mail and other regulated industries

Regulated

entity

Present in

wholesale and

retail levels of the

value chain

Change in

volumes24

Level of competition USO and

financeability

Royal Mail Yes

Letters

Parcels

While Royal Mail is the

only significant letter E2E

operator, there are

significant competition

constraints such as e-

substitution and other

advertising media, as

well as a highly

competitive parcels

market.

It is one of the

primary duties of

the regulator to

ensure that the USP

operator has the

means to finance

the USO. The USO

imposes service and

quality obligations

on Royal Mail.

Network Rail No Within rail market, none.

Other forms of transport

may act as weak

constraints.

Network Rail is

government owned,

and does not face

the same

financeability

constraints.

23 Hooper (2010), Saving the Royal Mail’s universal postal service in the digital age, Page 27.

24 Volume descriptions contained within table notes.

September 2015


Water Yes Largely still geographic

monopolies with recent

increase in the retail

market.

Regulator must

allow operators to

maintain an

investment grade;

monitoring is based

on financeability

indicators

Electricity No Geographical monopoly

for distribution and

national monopoly for

transmission

Regulator has the

obligation to allow

operators to

maintain an

investment grade;

monitoring is based

on financeability

indicators

Gas No Geographical monopoly

for distribution and

national monopoly for

transmission

Regulator has the

obligation to allow

operators to

maintain an

investment grade;

monitoring is based

on financeability

indicators

Telecoms Yes &

Downstream competition

but still limited upstream,

hence Openreach

separation.

There are fewer

constraints on

financeability as

there is a larger

product pool on

which BT can rely,

and volumes are

increasing.

Sources: Royal Mail: data provided by Royal Mail, includes all volumes excluding parcels.

Network Rail: 2015 Annual report page 72. Volumes used are passenger km, passenger numbers x

distance travelled per passenger.

Thames Water: 2015 Annual report page 155. Volumes are distribution input, which includes leakages.

Severn Trent: 2015 Reported financial statements page 128. Volumes are distribution input, which includes

leakages.

National Grid: Gas - 2013/2014/2015 annual reports. Volumes are TWh of gas distributed. Electricity -

“Although demand for electricity is generally increasing around the world, in the UK it is expected to remain

broadly flat over the next five to ten years”.

SSE: 2015 Annual report. Volumes are therms of gas delivered to households and kWh of electricity

delivered to households.

September 2015


Telecoms: Depends on product, some are increasing while others are decreasing. Business Connectivity

Market Review – May 2015.

Royal Mail operates in a declining and uncertain market. Letter volumes are falling, and have not 4.13

yet fully stabilised. Increasing parcel volumes may or may not compensate for this in the longer

term as parcel volumes are increasing, but there is significant competition for these services.

Access competition has led to reductions in retail bulk letter volumes.25 Furthermore, competitors

may “cherry pick” in the parcels market by parcel operators only operating in low costs areas,

rather than nationally as Royal Mail does as the USO operator. Therefore, there is potential

volatility not seen in other regulated industries due to possible acceleration of decline from

increased e-substitution – ‘tipping points’ and fluctuations in volumes in the short term. This

leads to greater uncertainty and risk.

We expect that these volumes will continue to decline and be volatile. Some regulated industries 4.14

such as energy show declining volumes and also volatile volumes, but the regulators have a

mechanism to address this by setting revenue, rather than price caps. In telecoms, volumes of

fixed lines have been virtually static for the past 5 years.

Therefore, unlike many other regulated industries, Royal Mail does not have a stable volume and 4.15

revenue base.

Table 4-5: Historical changes in volumes

Company Industry 2014 2015

Royal Mail (excluding parcel volumes, including

unaddressed items

Post [] []

Thames Water – distribution input Water 1.6% 0.2%

Severn Trent - distribution input Water 2.9% -0.2%

Network Rail - passenger km Rail 2.9% 4.5%

National Grid - Gas distribution Energy -13.7% -1.5%

SSE - gas supplied Energy -14.5% -5.8%

SSE - electricity supplied Energy -7.2% -3.7%

UK passenger numbers Airports 4.5% na

Number of fixed lines Telecoms -0.2% na

Royal Mail: data provided by Royal Mail, includes all volumes excluding parcels.

Thames Water: 2015 Annual report page 155, 2014 Annual Report page 187. Volumes are

distribution input, which includes leakages.

Severn Trent: 2015 Reported financial statements page 128, 2014 Reported financial

statements page 126. Volumes are distribution input, which includes leakages.

25 Royal Mail’s volumes in bulk mail / business parcels has have decreased from over 6bn items to below 4bn

items between 2009-10 and 2013-14 while Access volumes have increased from around 6bn items to

around 7bn items. Ofcom (December 2014), Annual monitoring update on the postal market, financial year

2013-14, Figure 3.3

September 2015


Network Rail: 2015 Annual report page 72. Volumes used are passenger km, passenger

numbers x distance travelled per passenger.

National Grid: 2013/2014/2015 annual reports pages 20, 33 and 30 respectively. Volumes are

TWh of gas distributed in the UK.

SSE: 2015 Annual report page 27. Volumes are therms of gas delivered per household and kWh

of electricity delivered per household

Airports: CAA http://www.caa.co.uk/default.aspx?catid=1279&pagetype=90&pageid=9793.

Telecoms: Ofcom 2015 Communications Market Report, page 255. Volume is the number of

fixed lines.

The risks associated with volume uncertainty are known to regulators. There are many examples 4.16

of regulators being conscious of the possibility and impact of inaccurate volume forecasts, “Since

December there has been continued volatility in the economy, which makes it even more difficult

than usual to forecast accurately … We will need to carefully consider how best to manage this

risk and uncertainty so that DNOs do not make windfall gains at customers’ expense”26 and “It is

inherently difficult to project how demand will evolve. This is illustrated by last winter’s reduction

in demand which was larger than expected by National Grid”27.

To minimise the effect of forecast uncertainties Ofgem included many reopeners in their 2013 4.17

electricity distribution price control to adjust for various areas with significant uncertainty over the

volumes. Examples include pass through costs associated with additional call out charges for

smart metering, any additional costs incurred to accommodate changes in load related

expenditure and allowances for reopening if large single projects of over £25m arise.28

Additionally, to enable Ofgem to be able to easily adapt their allowances they require the 4.18

Distribution Network Operators (“DNO”s) to provide a detailed breakdown and narrative of how

their costs are altered by volatility in the uptake of low carbon technology.

26 Ofgem (May 2009), Electricity Distribution Price Control Review Methodology and Initial Results Paper, Page

i.

27 Ofgem (June 2014), Electricity Capacity Assessment report, Page 17 - Para 1.38.

28 Ofgem (March 2013), Strategy decision for the RIIO-ED1 electricity distribution price control – Uncertainty

mechanisms.

http://www.caa.co.uk/default.aspx?catid=1279&pagetype=90&pageid=9793

September 2015


“We acknowledge that each DNO’s best view may not be the scenario that materialises

during the RIIO-ED1 period. Therefore, DNOs must present a narrative on how their

investment strategy can flex to meet demands associated with any of the DECC

scenarios. This will form part of the core narrative section of DNOs’ business plans.

This should cover how the DNO will monitor the scenario that materialises, including

use of notification processes for installation of low carbon technologies. We also

expect explanations of how unit costs of managing problems on the network may

change across scenarios. DNOs are able to choose how best to construct and present

this narrative.”29

In its regulation of energy transmission and distribution, Ofgem moved away from an RPI-X price 4.19

control due to increasing instability in network expenditure. With an increasing need for

investments to make the energy network cleaner, secure and more reliable, a performance based

model termed as RIIO (Revenue = Incentives + Innovation + Outputs) was introduced to reflect

the costs that would need to be borne by energy generators and distributors. An RPI-X approach

would focus strictly on keeping costs low, with revenues allowed to increase by the RPI-X formula.

Under RIIO, allowed revenue can vary based on planned investments and other objectives,

making it a more holistic price control.

The lack of stable revenue and volume base at Royal Mail leads to a number of problems: in 4.20

particular, it is more difficult to make efficiency gains by removing costs than is the case when

volumes are increasing. Volume growth makes it easier to redeploy resources available in the

form of permanent staff members, and reduces the need to pursue costly redundancy

programmes.

In addition, it should be noted that: 4.21

(i) It is harder to make efficiency gains where pay costs are a large proportion of total

costs and where the workforce is highly unionised;

(ii) It is harder to justify investments when there is already spare capacity, particularly in a

private company where investments must pass hurdle rate tests and these are more

difficult to pass with falling revenues; and

(iii) Environment becomes ill suited for innovation.

It is the combination of falling and volatile volumes combined with high levels of fixed costs that 4.22

make Royal Mail unique. The high level of fixed costs amplifies the effect of any difference in

forecast and outturn volumes. Whilst there are examples of other regulated utilities which have

falling volumes, their costs are unlikely to be so influenced by fixed costs and their volumes may

be less volatile. Furthermore, those industries that have downward volumes are, for the most

part, no longer subject to price caps. For example, Ofgem have moved over to a different, more

incentive based, RIIO framework rather than an RPI-X price control.

29 Ofgem (March 2013), Strategy decision for the RIIO-ED1 electricity distribution price control, Business plans

and proportionate treatment, Page 27 - Para 4.23.

September 2015


RIIO is Ofgem’s new framework for setting price controls. Over the next decade the

network companies face an unprecedented challenge of securing significant

investment to maintain a reliable and secure network. As the regulator, Ofgem must

ensure that this investment is delivered at a fair price for consumers. To help achieve

this, Ofgem developed RIIO (Revenue=Incentives+ Innovation+ Outputs) – a new

performance based model for setting the network companies’ price controls, which will

last eight years.30

The European Regulators Group for Postal Services (“ERGP”) published a report in November 4.23

2014 discussing “Tariff regulation in a context of declining volumes”. This report states that with

declining volumes, a different tariff regulation problem arises. Firstly, for service providers with a

certain amount of fixed costs, declining volumes leads to an increase in unit costs. Secondly price

cap mechanisms as well as other price regulation regimes may require a traffic forecast over a

few years horizon and of unit cost evolutions, which takes into account efficiency gains.31 The

report discusses that volume uncertainty is particularly acute in the postal sector:

“ there are no reliable objective data on the future of the mail market and there is a

wide divergence between international forecasts and actual, current developments.”32

Declining volumes in the presence of fixed costs would tend to lead to allowed price increases. 4.24

However, because of the uncertainty surrounding volumes, a price cap could be set to allow

prices to increase above inflation, but this still may be insufficient to allow the regulated postal

firm to recover its costs. An inaccurate price cap could lead to the situation where the

financeability of the USO operator is placed in jeopardy.

Our analysis indicates that where price caps have been reopened, this has been for reasons 4.25

which include misforecasting of volumes and / or costs. This can be seen in the adjustment of

the price controls on BT's metallic path fibre ("MPF") in 2008 and the adjustments in 2009 of

BT's network charge controls ("NCC"). Volume forecasting errors were also the main driver behind

the reopening of Royal Mail's 2006 price control, and cost and volume forecasts were one of

several drivers behind the Government stepping into to assist Railtrack in 2002. In addition the

Civil Aviation Authority (“CAA”) amended their price controls imposed on National Air Traffic

Services (“NATS”) due to severe declining volumes in 2002.33,34

Where price controls are reopened this will weaken the incentive on the firm to make efficiency 4.26

incentives or maintain/increase volumes. The regulated firm has less incentive to make

efficiency improvements or maintain/increase volumes because it knows that the regulator will

“rescue” it if its costs are too high or volumes too low.

30 Ofgem (March 2013), Price Controls Explained, Page 1.

31 EPRG (November 2014), ERGP report on tariff regulation in a context of declining volumes.

32 EPRG (November 2014), ERGP report on tariff regulation in a context of declining volumes, Page 9.

33 NATS (February 2002), Application to Reopen the Eurocontrol Charge Control.

34 Civil Aviation Authority (December 2002), Decision under Section 11 of the Transport Act 2000: NATS (En

Route) Limited Eurocontrol Charges Control.

September 2015


In summary – Royal Mail is facing a unique set of operating conditions, one in which volumes are 4.27

decreasing, and efficiency gains are harder to make, and where Royal Mail remains committed to

providing a high quality universal service. The standard regulatory toolkit cannot be applied on a

“one size fits all” basis and the standard economic theory around the application of controls and

their incentive properties needs to be considered in the light of the particular challenge that

Royal Mail, and the postal industry, is facing. The standard regulation espoused by Ofcom, and

informed by other regulated industries operating in stable environments, was recognised in

2008, 2010 and 201235 as being inapplicable. Our comparison of Royal Mail’s current market

environment suggests that it is still inapplicable in 2015.

The case against increased regulation

Whilst the traditional regulatory toolkit of price controls may not be appropriate for Royal Mail, 4.28

this does not answer the question of whether the current regulatory structure is effective.

However, the characteristics of the market, which serve to make the application of the traditional

regulatory toolkit risky, also mean that pricing regulation per se may be less necessary.

First, there is no evidence to suggest that Royal Mail is currently making super-normal economic 4.29

profits that need to be constrained. While there has been an increase in profitability margin, the

Reported Business has just reached in 2014/15 the bottom level of the 5% to 10% margin set by

Ofcom as “a reasonable commercial rate of return for Royal Mail”36 based on Ofcom’s

“financeability EBIT” measure.

Second, to the extent that Ofcom is concerned about future increases in profitability, we note that 4.30

there are significant competitive constraints which restrict Royal Mail’s ability to raise prices

across virtually all its services. In a declining market, the impact of these constraints is greater.

Royal Mail’s own documents show concern that even relatively small price increases will

encourage customers to switch to alternative communications channels. Moreover, Royal Mail

faces significant competition in areas such as upstream mail, advertising and publishing mail and

parcels.37

Third, Royal Mail remains committed to making efficiency savings, with a goal of achieving a 2-3% 4.31

productivity improvement per year. This is natural behaviour for any publicly listed company,

subject to scrutiny from the financial markets, with competitive constraints over pricing. In a

market in which the forward rate of decline is uncertain, with costs dominated by the labour costs

of a highly unionised workforce, and with important requirements for quality of service, any

assessment of the achievable rate of efficiency improvement is bound to be difficult. Any

proposed enforcement of an efficiency target would therefore carry strongly asymmetric risks.

35 Hooper (2008), Modernise or Decline , Hooper (2010), Saving the Royal Mail’s universal postal service in

the digital age, Ofcom (March 2012), Securing the Universal Postal Service – Decision on the new regulatory

framework .

36 Ofcom (March 2012), Securing the Universal Postal Service – Decision on the new regulatory framework,

Page 46 - Para 5.25.

37 See the separate FTI Annex on Competitive Constraints facing Royal Mail.

September 2015


Fourth, while the absence of downstream competition gives rise naturally to concerns about 4.32

discrimination against upstream competitors, the evidence, and specifically Royal Mail’s

diminished market share of upstream volumes, points towards vigorous and effective upstream

competition. The regulatory risk in these circumstances is that a lack of innovation in the supply

and pricing of access products will accelerate market decline, to the detriment of the USO.

Ofcom should consider clarifying the rules relating to fair, reasonable, and non-discrimatory

pricing; and the tests by which proposed pricing changes will be assessed, in order to allow, and

indeed to promote, greater service and pricing flexibility.

In the following chapters, we provide more detail as to why price controls, specifically revenue 4.33

and price caps, and ex-ante efficiency targets, do not appear suitable for Royal Mail in the current

climate and why the existing regulatory framework - consisting of commercial flexibility for Royal

Mail alongside safeguard anchor price caps on second class stamp products and non-

discrimination on the wholesale access business and margin squeeze obligations on the retail

bulk mail/wholesale access businesses – remain more appropriate.

September 2015


5. Revenue caps

Introduction

Instead of directly controlling prices, regulators might in principle place a cap on overall revenues. 5.1

Revenue caps are similar to RPI-X price controls, except that they allow for price changes in

response to changes in volumes. They may be more suitable where there is significant volume

uncertainty, or where there are extremely low marginal costs.

The regulator forecasts “allowed revenues” in each year and the regulated firm can derive no 5.2

more revenue than that allowed under the cap. The allowed revenue will be derived from

operating costs, depreciation, and an appropriate economic return.38 There is usually a

mechanism for returning excess revenues or carrying forward under-recoveries.

In practice, pure revenue caps are rarely applied and tend to be combined with “adjustors”. 5.3

Under a pure ex-ante approach, a regulated firm has no incentive to increase quality because it

receives no reward for it. But if a revenue cap can be adjusted and linked to relevant measures of

quality, the firm is incentivised to provide additional quality.

Incentive properties

A revenue cap, properly developed, has some good incentive properties. It has good efficiency 5.4

incentives, in that if the regulated firm lowers its costs, it will increase profits (as revenues are

capped). This is the only way for the regulated firm to increase profits.

A revenue cap, however, has poor volume incentives: A revenue cap can lead the regulated firm 5.5

to not care about volumes, as there are no returns to securing higher volumes. It also has poor

innovation incentives, because the regulated firm has little incentive to innovate when it is

unlikely to be rewarded as a result of any increases in volumes which may result.

For similar reasons, it has poor quality of service incentives: The regulated firm has the incentive 5.6

to reduce costs by reducing quality of service.

A revenue cap has mixed incentives for investments. Revenue caps place the risk of any 5.7

deviation from the demand forecasts on customers. This could reduce Royal Mail’s costs of

capital and encourage investment as the hurdle rate for investment will be reduced. However, the

risk profile for those purchasing Royal Mail’s services may increase and this could reduce the

investment of those parties.

38 As we explain in the following section the underlying “building block” approach to calculating gross revenues

may be similar as between a revenue and price cap.

September 2015


A revenue cap also has poor flexibility and adaptability. If it is expected that the regulator will 5.8

reopen the control then regulatory uncertainty is introduced and the incentive power of the

control is reduced. However, there is the opportunity to review and refine the control at the

periodic review. This is done through the use of “adjustors” as outlined above which are aimed at

increasing the adaptability of the control within a pre-defined framework so as to limit regulatory

uncertainty.

A revenue cap has a high regulatory burden. Ex ante controls can be complex and involve 5.9

significant analysis by the regulated firm and the regulator.

Risk allocation

Revenue caps reduce the risk of volume uncertainty to the regulated firm. Therefore revenue 5.10

caps tend to be advocated where there is a great degree of volume uncertainty, but unavoidable

costs. This places the risk of movements in market demand on the customer, protecting the

firm’s profitability and reducing the cost of capital. However, if the cost base is primarily variable,

profitability may decline when demand increases, putting the risk on the firm and potentially

leading to a higher cost of capital.

Regulatory precedent

Pure revenue caps are relatively unusual, as they can lead to poor incentives unless marginal 5.11

costs are very low or there is little scope for innovation, “Given the nature of this form of price-cap

arrangement a supplier may have perverse incentives to reduce the volume of sales and degrade

the quality of services… A supplier may have incentives to set inefficient price structures.”39 As a

result, when they are applied, they are usually applied alongside another form of control or an

adjustor. This is the case in rail, where Network Rail has both revenue and price controls in

place40 and energy which applies a revenue cap with adjustments.41

39 Ofgem (February 2009), Characteristics of Alternative Price Control Framework, Page 7.

40 ORR (October 2013), Periodic review 2013 – Final determination of Network Rail's outputs and funding for

2014-19, Page 540.

41 Ofgem (October 2010), RIIO: A new way to regulate energy networks.

September 2015


Case study – regulation of the UK Rail industry42

42 ORR (October 2013), Periodic review 2013 – Final determination of Network Rail's outputs and funding for

2014-19.

Current regulation of the UK Rail industry

The privatisation of the rail industry in 1993, as specified in the Railways Act 1993 resulted in

a ‘tripartite’ structure of ownership for the national network that remains broadly intact today

within England and Wales:

Infrastructure manager Network Rail owns and runs the physical network of tracks,

stations etc. Network rail is regulated by the Office of Rail and Road (“ORR”);

Train operating companies (“TOC”s) and Freight operating companies (“FOC”s) run,

respectively, passenger and freight train services.;

Rolling stock leasing companies (“ROSCO”s) lease rolling stock to TOCs and FOCs.

Network Rail is the monopoly provider of track infrastructure. It does not have any significant

downstream operations and as such there is no risk of it leveraging its market power to

foreclose downstream markets. The main focus on regulation is to provide Network Rail with

incentives to (i) invest in the provision of infrastructure services that meets the requirements

of the downstream operating companies; (ii) set absolute price levels at an appropriate level;

and (iii) make continuous efficiency savings.

The characteristics of the market in which Network Rail operates is similar to Royal Mail’s

delivery business – where significant end to end (“E2E”) competition is uncertain where the

delivery business is an essential input into the mail access operators business.

The ORR imposes a hybrid revenue and price cap form of incentive based regulation. The

portion of Network Rail’s revenue requirement that is recovered through fixed charges is based

on a revenue cap. The rest of the revenue requirement, recovered through variable charges, is

subject to a price cap which establishes caps on individual charges but does not impose a limit

on the level of revenue that Network Rail can earn. A five year review period is in place which

the ORR believes is a long enough period to provide incentives to Network Rail, but also short

enough to reflect the inherent difficulties in forecasting.

September 2015


Case study – The change to RIIO approach in the Energy sector43,44

Applicability to Royal Mail

5.1 Royal Mail is subject to considerable volume uncertainty and therefore, a revenue cap could be

more appropriate than a price cap and would reduce the likelihood of the price cap needing to be

reopened.

5.2 However, a revenue cap also incentivises inefficient pricing behaviour and cross subsidisation

between products. For a natural monopoly, this may be of less concern. However, cross

subsidisation is a concern in post, where (i) access providers are seeking to compete in many

services, including potentially competing in end to end parcel services; and (ii) any cross

subsidisation needs to be considered in the context of the larger question of the financeability of

the USO.

5.3 It would also decrease Royal Mail’s incentives to invest and innovate in new technologies, such

as tracking, which aim to increase quality of service and slow the decline in volumes – since

there is no revenue upside from doing so.

5.4 Alternatively, a revenue cap could be applied only to the delivery parts of Royal Mail’s business.

However, it would be difficult to categorise the business in this way and it would still leave the

43 Ofgem (October 2010), RIIO: A new way to regulate energy networks.

44 Oxera (April 2015), Menu regulation: is it here to stay?

Change to RIIO regulatory structure in the Energy sector

In 2010, Ofgem moved to a RIIO approach (revenues, inputs, incentives, outputs) where

revenues were capped, but then subject to potential increases/decreases if firms hit various

quality targets.

The overall goal of the RIIO model is to encourage energy network companies to be responsible

for the development of a sustainable energy network and to deliver long-term value for money

network services for existing and future consumers.

Ofgem believed that the RPI-X approach was not attracting sufficient innovation in the energy

industry and that it would not meet Britain’s £30bn energy infrastructure shortfall. RIIO is

expected to allow the industry to be flexible to current and future changes.

The price control is based upon the business plans of the regulated companies. These are

submitted to Ofgem who then undertakes a review of the costs and planned capex and makes

any adjustments for efficiencies.

Companies have an incentive to accurately report their forecasts to Ofgem. This is set out in

the Information Quality Incentive (“IQI”). Companies are rewarded for accurately reporting their

costs, i.e. if their actual costs match their reported expected costs. They are also still

incentivised to incur costs lower than the expected benchmark but are more greatly rewarded

if they had forecasted and reported it to Ofgem.

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question of how the USO should be financed. Therefore it may still require an intervention around

the structuring of prices with respect to competition from access providers.

5.5 Furthermore, there does not appear to be a concern around Royal Mail’s revenues or level of

profitability per se, rather more around the extent to which Royal Mail is being incentivised to

make efficiency gains.

5.6 It is therefore not clear that a revenue cap would enhance the regulatory regime and would likely

lead to another layer of regulation that would increase the regulatory burden and reduces

incentives for investment and innovation, whilst not further advancing the fundamental question

of how you continue to finance the USO and continue to promote access competition.

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6. Price caps

Introduction

A price cap is usually in the form of an RPI-X control and may be applied to a product, or a basket 6.1

including a number of products, as either one control or with sub controls.

The system is intended to provide incentives for efficiency savings, as any savings above the 6.2

predicted rate X can be passed on to shareholders, at least until the price caps are next reviewed

(usually every three to eight years). A key part of the system is that the control should be in place,

and unchanged, for a sufficient period of time for the regulated business to enjoy the benefits of

any gains in efficiency it achieves above those that are targeted.

The value of X is usually set, in the UK, using a building block approach, as shown in the diagram 6.3

below. This requires demand, revenue and efficient costs to be forecast for the period of the

control alongside estimates of the parameters that link these such as price elasticity of demand

and cost and asset volume elasticities. Prices can then be regulated so that the regulated firm is

earning a target economic return (typically equal to the cost of capital). This expected return can

either be achieved by the end of each price control (as it is in UK telecoms, and historically was in

UK post) or over the period of the price control (as it is in Irish broadcasting markets and in UK

energy.)

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Figure 6-1: Building block approach to calculating the value of X in RPI-X price controls45

Source: Adapted from Frontier (July 2010), Future Price Limits – Form of Control and regulated

/unregulated business, Page 130.

The system works best if price controls are not expected to be reopened during the period. There 6.4

is a tension between longer controls (better for efficiency incentives) and shorter controls (less

reliant on long term forecasts that are hard to make).

When determining the appropriate price cap there are various decisions to be made: 6.5

45 A building block approach can also be used to set a revenue cap, or the “Gross Revenue Requirement”.

Capex (renewals and enhancements)

RAB

Operating Expenditure

Amortisation Allowance

Allowed Return

+

+

=

Gross Revenue Requirement



+

÷

Forecast Volumes

Allowed price cap

=

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(i) Appropriate duration of the price cap given the likelihood of forecasting errors;

(ii) The areas of the business that are subject to any caps;

(iii) Anticipated volumes within those areas over the forecast period;

(iv) Efficiency improvements that the firm can reasonably be expected to achieve over the

forecast, given anticipated volume changes;

(v) The way in which costs are allocated between price-controlled and non price-

controlled areas; and

(vi) The appropriate rate of economic return.

Following the publication of the Littlechild report (1983) 46 into the regulation of BT’s profit, there 6.6

was a general transition by regulatory authorities away from rate of return regulation towards

incentive based price controls. However, more recently, we have observed a transition away from

price caps in some industries such as energy.

There are many examples of situations of price caps having the desired effect. As an example, in 6.7

The State of Telecommunications Industry Under Price Cap Regulation (2000), Abel says "Under

price-cap regulation, telephone prices have either fallen or remained the same, productivity has

generally increased, modern infrastructure has been deployed at a more rapid pace, and firms

have performed at least as well financially relative to the other methods of regulation available"47

Incentive properties

A price cap, properly deployed, has generally good incentive properties. It has good efficiency 6.8

incentives, in that if the regulated firm increases efficiency, it gets to keep the rewards of this (at

least until the charge control is reset).

It also has good volume incentives, in that the firm is incentivised to increase volumes above the 6.9

forecasts in the price co

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