Oral evidence: Competition in the Postal Services sector and the Universal Service obligationHC 769-iiWednesday 10 December 2014

Oral evidence, 10 December 2014.

Witnesses

Ed Richards, Chief Executive Officer, Ofcom, and Chris Rowsell, Competition Policy Director, Ofcom, gave evidence.

Chair

Good morning and welcome. Thank you for agreeing to help us with our inquiry. We know who you are, but please introduce yourselves for voice transcription purposes.

Ed Richards

My name is Ed Richards. I am the chief exec of Ofcom.

Chris Rowsell

I am Chris Rowsell and I am a policy director in Ofcom’s competition group, looking after postal regulation.

Chair

I am slightly paraphrasing, but in your report you said there was no immediate threat to the universal service obligation. What data did you monitor to come to that conclusion?

Ed Richards

We monitor the whole market very carefully pretty much all the time. We look at it in different forms on a monthly, quarterly and annual basis. We looked specifically in relation to that judgment, which it is important to emphasise is a judgment at a point in time, at the situation in the market today: what the facts are and what the empirical data tell us about the position today. Then we overlaid on that information that we received from Royal Mail and Whistl—and from other parties, but particularly those two parties—in terms of their expectations and projections about how the market would develop, particularly in light of different business plans and assumptions.

Chair

Can you tell us what elements of the business and the market you examined to come to the conclusion that you arrived at?

Ed Richards

We look at all elements of the business.

Chair

Yes, but could you just outline them?

Ed Richards

Letters. The universal service products are the principal focus, so we look at all of those, but clearly we cannot look at that alone. We need to look at the overall postal services market, because there are many products that are not part of the USO but are important in the economics of the USO, because they are carried over the same network. The only way of answering the question without going through every single element of data is to say that, in essence, when we make that judgment we are looking at the overall postal services market, the developments in that market, all the products in that, and their relationship with the USO and its sustainability.

Chair

I would not dispute anything you have said, but I am trying to drill down and find out exactly what those elements were. Chris, it may be more your area. I do not mind who answers as long as I get an answer. Did you look at labour costs, factors for growth or decline in different markets, and the cost of competitors and their market penetration?

Ed Richards

Yes, all those things.

Chair

Well, why could you not say so?

Ed Richards

Well, because all those are elements of the overall postal service.

Chair

Yes and I was asking what were the elements. That is the point I am trying to get at.

Ed Richards

Let us build it up. When we look at the postal services market, we are looking at a range of products that are part of that. We are looking at the revenues associated with those products. We are looking at the costs associated with those products and we are looking at the profitability associated with those products. However, the critical thing is that you need to look at it in aggregate, because the core test in that area is whether the USO is financially sustainable, so we are looking at that principal question. Do we look at the costs associated with a product? Yes. Do we look at likely changes to volumes? Yes, we do. Do we look at the implications for revenues associated with that? Yes, absolutely we do. Do we track all that back together to ask ourselves the core question of whether the USO is financially sustainable? Yes, that is exactly what we do. We looked at that in terms of the facts today and projections into the future. Clearly, there is more uncertainty about the future than there is the present, but we looked at that very carefully and, as I think you are aware, we looked at that on the basis of a great deal of confidential information that was given to us both by Royal Mail, which asked for it to be made confidential and remain confidential, and by Whistl, which asked for that information to be confidential as well.

Chair

Yes, I understand that there are areas of confidential information and I would not expect you, in a public session like this, to spell them out. Did you assess: first of all, the cost of the universal service obligation; secondly, the potential cost to Royal Mail of the impact of competition in these selected markets; and, thirdly, the ability of Royal Mail to offset the costs of the impact through an efficiency delivery mechanism?

Ed Richards

Yes, we looked at each one of those elements in considerable detail. As I have said, to some extent the valuation we made there is dependent upon projections, but we looked at each of those in very considerable detail—far more detail than we originally expected to. That was the result of the fact that we received such a considerable submission from Royal Mail, in particular, but then considerable submissions from others, and we found ourselves reviewing the issue in very considerable detail. That is why, having taken it through our board on multiple occasions and having reviewed it over a number of months, we found ourselves in a position to take a view, at that point in time, about what our judgment was on the financial sustainability of the USO. We looked at each of those issues in very considerable detail, yes.

Katy Clark

I just wanted to ask to what extent you looked at projections because this is a very quickly changing situation. You will be aware of the very aggressive strategies to try to take work away from Royal Mail in the most profitable areas, so to what extent did you look at how this is likely to impact on the years as we go forward?

Ed Richards

That is precisely what we looked at. That is absolutely precisely what we looked at, and we contrasted and were able to contrast the data from one company with the data from another company. Obviously, we were the only ones who had access to both sets of data and could make sure that it made sense. We tested that ourselves against our own set of assumptions and we examined it in relation to for example, as the Chairman suggested a moment ago, different responses and different alternative developments. So that was exactly what we did, yes.

Chair

You say that you have done all these forward projections. You have obviously come to the conclusion that the potential financial impact of competition could be countered by an efficiency drive with Royal Mail, and we will go into the elements of efficiency a little later on, but could you just elaborate? We might come to a situation where the market share of rivals is such that it will obviously affect the bottom line of Royal Mail even after it has implemented all reasonable efficiencies but is increasingly unable to compete because of the higher cost bases imposed upon it by the universal service obligation. What measures would you contemplate taking in order to protect this in the event of this happening?

Ed Richards

May I just say something about the first half of the question and then return to the second half? Efficiency is an important dimension of this, of course, but it is not the only dimension. We were not exclusively looking at whether Royal Mail had an efficiency plan or potential responses to improve efficiency that would ensure that the USO was sustainable. That is an important part of the mix; of course it is an important part of the mix. I do not think anybody would want a situation where we did not have an eye on whether the USO was being delivered efficiently or not, but there are other factors. In particular, for example, there is what is going on in the parcels market, and that is one of the reasons why we have highlighted that we will undertake further work in the parcels market to make sure we understand the impact of those developments for the core USO and its financial sustainability. It is a broader range of issues, and efficiency is one, but the revenue side and the parcels market, for example, is another important dimension of it. In terms of the measures that we could look at in relation to the USO should it become a question of sustainability, the kinds of things we can look at are the general service conditions, where we could introduce obligations on competitors in order to change that balance. That is one option. The second option is the universal service compensation fund. Just as an important caveat to that, we are not able to introduce that ourselves unless directed to by the Secretary of State prior to 2016. I believe that is in the Act. The fund is a very important idea, as is the previous example. The fund would compensate Royal Mail in such a circumstance and it would be capable of being levied on any operator whose business was capable of being carried over the USO network. It is quite broadly drawn and very important in the context of, for example, what we see as developments in the parcels market where, as you know, there is a lot more competition. There is diversity of supply, much of which involves post parcels that could, indeed, be carried over the USO network, so if and when we reach that point, that is the territory that we would certainly be looking at. Can I just emphasise one other point? I did mention earlier that we have made a judgment “at a point in time”. Those are very precise words. We clearly retain the ability to review that judgment at any point in time. There is no set date and there is no specific obligation on us as to when we could reopen that, and it is important for me to emphasise that we take our principal duty in this area, which Parliament set us, extremely seriously, and we are very mindful of the need to make sure that the USO is financially sustainable as well as being efficient. Therefore, we will keep a very close eye on it in the coming months and years.

Chair

We will come back to the timing issue, but there is just one quick question that I wanted to ask. You mentioned, in response to measures that could be taken, a change in the general service conditions of other operators. What sort of conditions could those be? Can you just give me an example?

Ed Richards

There are two most obvious ones. One is an obligation to deliver over a specific geographic area and the other is to deliver on a specific number of days. In other words, there are service obligations, which would have an impact upon the underlying cost structure of the new entrant. Those are the two most obvious and clear ones.

Chair

I have another very quick one. I think I know the answer, but it would be useful to have your opinion very briefly. Why is the London zone more expensive than the others? Is it because of the verticality, as described by a previous witness, of many of the addresses, or are there other reasons?

Ed Richards

There are two reasons, as we understand it, but you need to ask Royal Mail fundamentally. The first reason is to do with density, flats and all those sorts of issues. The second is that there is a very different cost of labour in London; there is a very significant London weighting. Do we know what it is?

Chris Rowsell

Just doing a confidentiality check. Over 20%.

Chair

You can provide us with written evidence on that.

Ed Richards

It is a very substantial enhancement for London weighting and clearly that has a very significant impact on the underlying cost structure, so London, as we may return to, turns out to be a high-cost area rather than a low-cost area.

Chair

Okay. I do not want to labour the point. If you could send us any details, it would be helpful.

Caroline Dinenage

Moya Greene told us that the total cost of the universal service is £7.2 billion. Why does it cost so much?

Ed Richards

I am not sure it does cost £7.2 billion. It depends how you look at it and Moya’s approach is, I think, the cost of the entire network for a year. We have taken a different approach to it. That is the cost of the whole network, but of what goes over that network of that £7.2 billion, only 20% is USO defined—80% of what is carried over the network is not. When one then asks what costs should be associated with which area, the numbers are quite different. For example, in the Royal Mail’s own regulatory financial statements, which it has to submit to us, the allocation from the USO, or the cost of the USO, is not £7.2 billion but £2.7 billion. They are very different numbers. Those are its numbers that it has returned to us in its regulatory financial statements, and that is driven by the fact that the network is also providing all sorts of other services or carrying all sorts of other post that is not universal service post. What it does—this is its approach, but one which we accept—is then to look at how the activities are undertaken and how one therefore allocates the cost to certain activities that are USO activities and certain other activities that are not USO activities. Those numbers are not ours; they are Royal Mail’s regulatory financial statements, and there is obviously a very big difference between £7.2 billion and £2.7 billion.

Caroline Dinenage

With those figures in mind, does your evidence show that the Royal Mail makes a profit from the universal service products?

Ed Richards

It does, and Royal Mail itself reports a profit on the USO. It is important to be very clear about this. The audited 2013-14 regulatory financial statement from Royal Mail to us—so audited externally—reports an operating profit of £484 million on universal service mail after transformation costs, which are one‑off costs. If you omit transformation costs, the operating profit on the universal service was £556 million, so half a billion pounds of profit on the universal service in the audited regulatory accounts for 2013‑14. With that in mind, that is one of the important facts, I think, that probably helps you to understand why we made the decision that we did at this point in time.

Caroline Dinenage

The Ofcom response to Royal Mail’s submission of June 2014 is full of redacted sections. While we appreciate, obviously, the need for confidentiality, how can we be assured of the veracity of your conclusions if we cannot see the evidence on which you are basing them? What kind of assurances can you give us?

Ed Richards

I agree this is a conundrum and a little bit tricky. On the other hand, Royal Mail—and, indeed, Whistl—is free to decide that it can make that information available to Parliament and the Committee whenever it wishes. It is not us that has chosen to make that confidential; it is the companies. For our part, once a company—this is true of all companies we work with, not just in post, but in all the other sectors for which we are responsible—has said that information is commercially confidential and we must treat it as such, we are under a legal obligation to honour that. We would be acting illegally if we did not maintain that commercial confidentiality, so that is difficult. It is worth going on to say, however, a couple of things. First, if, in due course, our decision is appealed, which it may well be, access to that confidential information would extend to the court, and we would be very happy for that to be the case. There is a check on our judgment through the courts, and the courts would have access to precisely the same confidential information. The second point to make about it generally is that, because we are dealing with private companies of this kind that do have commercially confidential information, that is one of the reasons why Parliament creates independent regulators: so that there is a third party that is entrusted by the companies to have access to that confidential information that can be trusted and legally obliged to treat it confidentially, but then can exercise a judgment in the public interest. That is at the heart of why Parliament created the system of independent regulation, of which this is quite a good example.

Rebecca Harris

Your monitoring report stated last week that the majority of consumers or the majority of the British public, however you look at it, are satisfied with their postal services and that the prices remain affordable to almost all customers. Can you just give the Committee a bit more of an explanation of how you arrived at that conclusion, firstly?

Chris Rowsell

Yes. We carry out considerable research into consumer affordability. We did a major piece of work, which we published last year, and we keep this up to date in tracking research. We did a series of focus groups looking at only consumers who were on very low incomes. We did a separate piece on SMEs, because there is a separate shaped question there, but, if we are focusing on residential consumers, we looked, essentially, at people who were in the lowest couple of deciles—the lowest 20% of income in the UK—and we asked them. We asked them in quantitative surveys whether they felt postal services were affordable and whether they felt there were things they could not send, and we did focus groups to dig into that a bit more as well. When we were thinking about what is essential, we included both things that are legally essential, where you have to file a return or something or send a letter to the local council, and things like birthday and Christmas cards and presents. They are an essential part of using the service. There were two areas we found where there may be consumers who could not afford to pay for everything that they needed. Consumers on very low incomes with a desire to send international parcels may not be able to afford that and, particularly, some sets of immigrant communities working in low-income jobs and wanting to send parcels home to their families, for example. The other was groups of people on very small or no incomes who needed to engage with the authorities in a formal way in writing. That particularly related to immigration cases and so forth—people applying for citizenship.

Rebecca Harris

Did you look at these groups to see if they were also digitally excluded as well?

Chris Rowsell

We did not do that in the same exercise, but we have a companion piece of work looking at the same issue in telecoms.

Ed Richards

We have looked at the issue of digital exclusion pretty carefully elsewhere. I am not sure we have done a precise mapping across. Digital exclusion is not quite as easily predicted as you might think, so while it does skew towards lower-income groups, it also skews quite heavily to older-age groups, some of whom are not poor. There is a big age effect and there is a low-income effect. I will go slightly out on a limb here. We can check this, but I doubt there is much of an ethnicity skew in digital exclusion. There is a low-income element of it and there is an age element of it, but I think ethnic communities in the UK are among the more digitally engaged, generally speaking.

Rebecca Harris

I was thinking about those people who maybe find it difficult to afford the postal service and have no other alternative, but you did not find that.

Chris Rowsell

These are scenarios in which people need a postal service. There is not a digital way of sending a parcel to another country, so it is very specifically about the postal services, and then again it was about those people needing to send forms back to the Government, for example, on paper.

Ed Richards

These are things that cannot be done by e-mail; that is the key.

Rebecca Harris

What you produced last week was a snapshot in time. What steps could you take if you found that opinions were changing on this—that people were finding themselves either unsatisfied or unhappy with the price and unable to afford it?

Ed Richards

We would look at this. This raises a much bigger question, which is how we and, indeed, the industry respond to changing patterns of demand, and this is one of the critical questions of the next few years. The postal service was, in some ways, very stable for decades, and now it faces a huge amount of change through technology, changing consumer habits and all sorts of different things. The reality of that is that we and others—this will include Parliament in due course—are going to have to look at how we specify the universal service, what is in it, what pricing arrangements there are and how we make sure that that is kept up to date with the specific kind of problem that we have just been talking about, but also the much more general question of how the whole population is changing its habits and its needs in relation to postal services in the future. We already know there has been very radical change in that respect in relation to both letters and parcels even in the last decade—change that we have not seen in postal services since their inception. This will be a critical issue for us, and we have means through which we can consult and engage on that, but in due course it will come back to Parliament to look at as well.

Ann McKechin

I want to come to zonal access costs. In your paper last week—I am going to quote this because it is a pretty complex phrase—you said: “Our objective is to design a remedy that enables Royal Mail to reflect differences in its zonal costs in its zonal charges and does not constrain Royal Mail in determining its absolute return, but at the same time removes the potential for Royal Mail to set charges in a way that can undermine beneficial entry into delivery.” Is it possible to find a third way that does not constrain it, but does not undermine beneficial entry or, if I can put it this way, is there bound to be a solution that will, to some extent, not manage to achieve both of those?

Ed Richards

It is possible, but what we are trying to do genuinely is to strike the balance that we have articulated there. The reason why we are trying to strike that balance is because there are two important sides to this equation. One side is that we want to design an approach that does permit and ensure that there is enough freedom for Royal Mail to make a commercial rate of return. We should be very clear about that. We want Royal Mail to be healthy and profitable. We should be very clear about that. We want the USO to be commercially sustainable, and we want that to happen on the basis of a healthy, efficient and profitable Royal Mail. On the other side, as I know you have heard from other contributors to the Committee, it is important, where we can, to create some space for the stimulation and the discipline of competition when that is consistent with the underlying sustainability of the USO. Let me just elaborate on that by taking the detailed conditions that we have proposed. Just to give you one by way of illustration, what we have said on zonal pricing is that Royal Mail has the freedom to set its margin as it chooses. However, what we have said to ensure that that is consistent with a fair approach for the market overall is that that should be consistent from zone to zone, and that the prices should be reflective of the costs in the zones. That seems, to us, to be a reasonable and fair basis. In other words, where Royal Mail has higher costs, it is able to charge a higher price, but it is not able simply to select a price that suits its ability to inhibit, or to risk inhibiting, competition when that competition can offer something useful for consumers and the market. We are trying to strike a balance—I accept that—and at the moment our judgment is that that can work and should work but, as I mentioned earlier, that is something that we will keep under review.

Ann McKechin

Could you give us some idea of the rate of return that you think Royal Mail would achieve? Would it be within the parameters that other mail delivery companies with USO obligations in the EU are achieving?

Ed Richards

We have said an indicative EBIT margin of 5% to 10%. The emphasis there is on “indicative”. There is no scientific number that one can arrive at. It is the right to earn that range; it is not a guarantee. We cannot give a private company a guaranteed rate of return. The market, to a degree, needs to determine that, and it needs to determine that for itself through its own actions, but we have said that that is the indicative range within which we believe a commercial rate of return is operating. That is something we will probably return to. We set that indicative range before privatisation or around privatisation.

Chris Rowsell

It was in March 2012.

Ed Richards

Okay. These numbers can change through time, as you have suggested. You look at them in comparison with what other companies operating commercially in the sector elsewhere in the world are earning, so that is something that we will look back on, but the indicative range is there to help everybody.

Ann McKechin

Entry into delivery is starting, at the moment, at a slow pace, but it could speed up very rapidly, and we know that Whistl has ambitious plans for expansion. We have also heard from Amazon, which is changing the types of model in the way of its delivery. How can the USO be provided at the lowest possible cost, which you say it is your responsibility as the regulator to try to achieve, while ensuring that the business is making sufficient profit for long‑term stability? To what extent does a business of this nature need to have—perhaps you could argue—a larger than average reserve to allow it to cope with such rapid changes that are taking place in the market?

Ed Richards

There is a fine line between us doing Royal Mail’s job for it and asking Royal Mail to manage and determine its own destiny. Most good regulatory practice involves regulators setting frameworks that allow companies to determine their own destiny, so I would be very cautious about going too far down the road of us dictating this level of reserve or that level of reserve, or any other specific variable. Primarily, we have to say to the companies we regulate—this is true of all other areas as well—“The principal job is for you to get on with it.” Within that, we set a framework in which we are conscious and mindful of the need for it to be sustainable in the long term. The heart of your question is: are there going to be dramatic changes that could change the economics and the situation in the market? That is possible, but that is why we have said we will look at this again and we will keep monitoring. However, I am bound to make it absolutely clear to the Committee that we looked at this in great depth over the last few months because of the submissions we were given by the parties and particularly Royal Mail. We looked at it in terms of the best possible information that we have at this point in time—facts and projections—and we took that view.

Ann McKechin

You have made a lot about it being at a point in time, but should there be a greater precautionary approach, given the fact that you, as well as many other people in this market, are finding it very difficult to predict where we may be three or five years down the line? Should there be a greater emphasis on a precautionary approach?

Ed Richards

We have thought very carefully about the level of risk that we think we should take, given our duties. We have thought very carefully about what one might call the precautionary principle, and our board is comfortable with the position that we have taken today. However, as I have said, we will re-look at that in due course.

Mr Bain

In our previous session, Ms Greene said we need a forward‑looking regulatory approach that looks at the hazards of cherry-picking. Can you explain why you do not consider that competitors being able to enter the market on a selective geographic basis represents unfair competition?

Ed Richards

Yes, I can. Let us start with the phrase “cherry-picking”, which is essentially the heart of your question. Cherry-picking is one of those slightly emotive phrases that I have come across over the years in many different circumstances. It was used frequently in other regulated industries in the past—particularly but not only, in telecoms. What is usually meant by cherry-picking is when you have a uniform price and a company goes into a low-cost area and cherry-picks the margin that is available in those circumstances. When we examine what is happening in the market at the moment, it turns out to be quite a lot more complicated, and I do not necessarily think it is very helpful to think about it as cherry-picking. Let us take the example that was raised by the Chairman earlier. It turns out that one of the principal places—arguably the principal place—that the new entrant has brought services into the market is London. London does not adhere to the traditional view of what cherry-picking is. It is not a low-cost area where they have come in to take the margin between the average price and the low cost; it is a high-cost area. In some ways, it is the precise opposite of what people have historically regarded as cherry-picking. The second thing is that what we have said in our approach is that Royal Mail is able to price access according to costs in different zones. That allows it to be able to set prices higher where costs are higher and, indeed, lower where costs are lower, which gives a significant degree of flexibility to respond to the traditional notion of what cherry-picking is. The situation is, in fact, much more complicated, and it is not entirely consistent with what economists regard as standard cherry-picking.

Mr Bain

London is a particular case because of high housing costs and the London premium that is paid on wages, of course. There are other parts of the country where there has been selective entry by Whistl and other companies in which those factors are not quite as pronounced. Can you explain why they are operating in Manchester but not in some of the rural counties around Greater Manchester?

Ed Richards

I cannot explain that. I should not explain that. That is a matter for them. You will have to ask them.

Mr Bain

Do you ask them that?

Ed Richards

We discussed the issues with them and they discussed them with us confidentially, but I am not in a position to tell you why they opened in Manchester rather than Shrewsbury or anywhere else. I would highlight one other point, though, to illustrate the complications on this and why it is not as simple as often presented. Let’s take the example of London again, which is a high-cost area and yet they are there. One of the things that happened in relation to the cherry-picking argument is that Royal Mail set out some prices to deal with that and it priced in a very low way in London to address the competition. The consequence of that was that prices had to go up elsewhere, so prices went up in rural areas, particularly Scotland. What we have heard from a number of operators operating in Scotland is that they are very concerned about that response, because it excludes them from the market. It has raised costs to them and what they say to us is that in Scotland they are able to offer a high-value-added service in addition to Royal Mail, but the consequence of that reaction to cherry-picking is that they will no longer be able to do so or their business would be placed at risk. I make that example to illustrate the fact that there are often two sides to this coin. In our experience so far, to think about this as very conventional cherry-picking of the old kind that we all grew up to understand does not turn out to give you a very insightful understanding of what is going on and the freedoms that are available to respond to different kinds of entry, and the consequences for different geographies and different communities. That said—where the picture is far more complicated than often presented—let me sit back and take the overview of the question. It returns us fundamentally to the question that was at heart of the previous question as well: could this entry lead to questions about the financial sustainability of the USO and the nature of competition? My answer to that is yes, it could, and, in due course, there may well be scope or the need for us to respond to that using the kinds of terms that I described to the Chairman at the start—the service conditions or, indeed, the compensation fund post‑2016 in our case. That is quite possible, so we may find ourselves evaluating the information in six months, a year, two years or three years and saying to ourselves, “The nature of that challenge and the advantage that the entrant has, for example, by not having to deliver six days a week has meant that there are developments in the market that we need to take account of and, to ensure that we deliver our primary duty in relation to the USO, make a response to.” The door is open on that; it will remain open. We have not closed that door and we will never close that door. We have taken a view at this point in time and we will look at it again in the future, I have no doubt.

Mr Bain

On the precise tools that you have available to you, you have mentioned a couple of them, which are to introduce potentially more requirements on participants in the market in terms of their obligations on delivery. One of the other aspects is also to broaden the extent of the geographical landmass of the UK that such operators cover as well. Again, I would put to you some of the original pitches that Whistl and other companies made was that by this stage they would be covering Glasgow, Edinburgh and other parts of the UK. They have not done so. They have delayed their plans. They have almost focused on the areas that they have prioritised. Is there not a strong case for you to be looking proactively at putting some geographical percentages on the amount of the UK that such operators should cover?

Ed Richards

The direct answer to that is not at the moment, and the reason for that lies in precisely the observation that you have just made. What your observation about what they said they would do and what they have done, and the absence of the roll-out in those areas, reveals is that the impact of Whistl is not as great as people originally expected. It has not rolled out in those areas and, therefore, it has not taken revenue away from Royal Mail in those areas. That is part of the reason why we have made the judgment that we have made. Had it rolled out in those areas and had a huge impact on the market in those areas, it is possible we would be making a different judgment, and that is what we will look at in the future. At the moment, we do not think we need to do that, but as I have said, that could easily change. We are comfortable with the judgment we have made at this point in time, but we will look at it again in the future, and those kinds of things are the kinds of things that, should there be a risk, we would of course look at.

Chair

Could I just raise a couple of points? The first is that you are saying the zonal pricing should be based, if you like, on the costs of delivery in that particular area. That does not really deal with the potential for another operator to operate in, say, London, which is a higher-cost area, but do it at a reduced level purely and simply as a marketing device to capture Royal Mail’s market. If Royal Mail was unable to compete by lowering its price because of the criteria that you have set that should determine the price, you are, by virtue of your regulation, effectively pricing it out of that market. It is not fair competition. Would you give flexibility to Royal Mail in that circumstance?

Ed Richards

I am not going to say to the Committee that all things as between the operators are equal, because patently they are not, so I am not going to advance that argument. As I said in answer to Ms McKechin earlier, we are trying to strike a balance. I am not going to advance an argument that says the new entrant has exactly the same obligations as Royal Mail. That is patently not true. We are about striking a balance, because we think there are some benefits that can be brought from that. Having said that, there are significant freedoms available to Royal Mail to respond. Some of those are all the conventional management responses that everybody running a company thinks about when they face competition. Anyone running a company has to deal with those sorts of things, and you do not want me to list the various tools and levers available to an executive team and a board when they respond to competition; everybody knows what they are. Equally, though, let me give you an example of a freedom it has in response to this kind of entrant. What Whistl has done is focused on certain areas, but it has also focused on bulk mail, which is very low margin and not part of the USO. A crucial point is that it is not part of the USO, so it is available to Royal Mail to offer its own bulk mail service that does not match USO obligations to compete directly with Whistl. That is a significant freedom.

Chair

Yes, but coming back to a point I made to the previous panel, what you are talking about are the virtues of competition. In this context, the great virtue of competition is you could get a reduced service. Would the consumer not think that was slightly odd?

Ed Richards

I do not think that is right.

Chair

Well, surely, if you are getting a six‑day delivery now and it is reduced to three days, that is a reduction in service.

Ed Richards

No, it is not, Chairman, because we are talking about business users, who are perfectly happy with a three‑day service.

Chair

Yes, I understand what you are saying, in effect—that business users do not need the six‑day service—but it is still a reduction in service. I would also be interested to know if you have evidence to demonstrate that business users would be happy with that reduction in service.

Ed Richards

Business users determine the service they want. They go to the suppliers.

Chair

On that basis, when they are delivering six days, surely that is what they want.

Ed Richards

No, because when they go to Whistl, for example, or others, they say, “We are content with a three-day-a-week service,” which is precisely why Whistl has offered a three‑day service. If business users wanted a six‑day service for their bulk mail, Whistl would have to offer it, so there is a big difference.

Chair

The counter to that is that those who go to Royal Mail want a six‑day service and as a result of competing with Whistl they may not get it.

Ed Richards

The six‑day service is part of the USO, so they will get it while the USO is financially sustainable, which we have an obligation to ensure.

Chair

I thought you just said that it was not part of the USO.

Ed Richards

The six‑day letters service is part of the USO.

Chair

I am talking about the bulk delivery service.

Ed Richards

No, that is not part of the USO.

Chair

I understand that, but they still get a reduced service.

Ed Richards

They choose to have that, though, because it is a commercially determined service. It is not dictated by the regulator. That is a commercially determined service.

Chair

What I am trying to get to is, yes, you could argue that those who take Whistl on a reduced service are making a choice. If those who currently use Royal Mail find that their service is reduced to three days as opposed to six, that is a service dictated not necessarily by their preferences, and it arises as a result of this competition.

Ed Richards

That will not happen while the USO is in place, because the USO requires six days a week.

Chair

Sorry, but it does not apply to bulk delivery.

Ed Richards

Bulk mail users could elect to have six days a week if they wished to, but they would rather have a lower price and accept three days a week. That is a matter for them.

Chair

What I think you are saying is they could elect to pay more.

Ed Richards

They can pay more or less. They can choose.

Chair

That is still a change in service.

Ed Richards

No, I do not think so. The users who wish to continue to use the Royal Mail service can continue to use the service.

Chair

Chris, you seem to want to come in on this. I do not think we are going to agree on this, but it may be that you can shed some sort of light on it.

Chris Rowsell

Quite often what the business users are after is speed of delivery, and so D plus three is the typical second class service, and you can deliver to the customer sending a D-plus-three service while delivering every other day of the week, because some people get their mail on the second day and some on the third day, and it rotates depending on when the mail was put into the system. What Whistl will be offering its customers is a D-plus-three service, a three days after posting service, which arrives alternately, so some people in some streets will get it on the second day, some on the third day, but it is all arriving within the same quality standard rather than six days a week. In some other countries what we have seen is universal service providers flexing their workload on different days. For example, in Denmark and the Netherlands, they have essentially busy days where they deliver a lot of mail, including the bulk mail, and then quiet days where they are delivering the first class mail. The consumers are still getting deliveries six days a week, but they are using their resources flexibly to reduce costs overall to support the universal service while still delivering the same quality of service to their bulk mail customers and to their residential customers.

Chair

It would appear on the basis of what you have said that, even if the bulk deliverers were not too bothered about the timing, there would be a reduction in the flexibility that Royal Mail would have arising from this.

Chris Rowsell

No, I do not think so.

Chair

You just said that they use this flexibility. Because they have to deliver those anyway, there would still be a reduction in flexibility, or they would have to operate the other elements of the universal service obligation at a higher price with lower capacity.

Chris Rowsell

In the Netherlands and Denmark, the way it works is three days a week the postie walks around the streets very quickly delivering the far smaller amount of first class mail and consumer mail. On the other days of the week, they have a shorter route that takes a longer period of time, and you have more posties on the street that day as opposed to on the light delivery days. That is how they have found a way of maximising the return.

Chair

This is obviously a very specialised area, so I would be grateful if you could put that all in writing so that we can examine it in detail and, if necessary, test it with Royal Mail, because there is something that does not quite fit to me.

Ed Richards

The fundamental point for us remains that business users can determine their needs in the way that normal commercial arrangements are determined, and we need to make sure that developments in that area are consistent with the USO and the six-days-a-week delivery. At the moment, our view is that that is the case, and that is the most fundamental point. If, in due course, those developments in the business market, the bulk mail market, have an impact on the underlying sustainability of the USO, as I have said throughout the meeting, we will then look at it—and they might.

Chair

This is the whole thrust of Royal Mail’s argument here.

Ed Richards

They might, but in our judgment they are not at the moment. We are very nervous about over‑dictating in any kind of market. It is a very dangerous area. You have to leave companies, to a degree, the ability to make their own decisions and their own judgments. We set a framework and we look at the overall delivery of the critical objectives that Parliament set.

Chair

We understand that. The argument is that, in effect, Royal Mail has to respond to a framework that puts it at a disadvantage.

Nadhim Zahawi

I am pleased to hear you say that you are keeping an open mind on every bit of the competition, and you are right to be nervous about over‑intervention. Are you also then nervous, just picking up on William Bain’s point, that part of the reason perhaps for the competition not going further so quickly is the tipping point? That is, they are concentrating on bits where, once it tips, which is one of the arguments we have heard as well, it is very hard to take back. How are you monitoring that? That could be detrimental where you cannot do anything about it because it is then too late.

Ed Richards

The idea of the risk of tipping points is a serious one. It is not what we have seen so far. Certainly we have not seen an extreme form of it so far. You see significant mail change, but we have not seen incredibly dramatic tipping points so far, but we are mindful of the risk. That is why we need to keep monitoring it on a very careful and frequent basis, and it is why we need to be alert to what we would do in such circumstances—and I think we are. I am certain we are. It is something we have thought about quite carefully and we will continue to do so. This is an opportunity to make one other point clear to the Committee: Whistl is under an obligation to provide us, in advance, with its plans for roll-out, so we do have visibility of the plans and the implications well in advance, which allows us to begin to condition our thinking prior to the facts.

Chair

How far in advance?

Chris Rowsell

We collect their business plan that is signed off by the board on a periodic basis, and that goes out several years to sort of 2018-19. We have been looking at that. The notification condition that requires it to send it to us on a quarterly basis, I think, looks six or nine months in advance, but I will go back and check that.

Nadhim Zahawi

It can amend that, though. There is no obligation on it.

Ed Richards

We do get its business plans, and they are board business plans, so it is relatively safe. They are not going to have 12‑month business plans. That is very helpful and it allows us to have visibility of those kinds of risks. The two things that we then bring together are the experience in a market they have entered, so what we know from the facts about whether it tips or not, and then you can associate that with the roll-out plans and bring the two together. It is a serious point, and it is something that we need to keep looking at.

Nadhim Zahawi

That is good to hear. At our previous oral evidence session, Dave Ward from the CWU told us that “if the regulator is using labour standards to compare efficiency, we say that is completely and fundamentally wrong. We say it is outside their remit”. What is your response to that?

Ed Richards

I do not know exactly what he means by labour standards. Let me put it this way. Are we taking a view on labour costs and wages? No, we are not taking a view on that. That is outside our remit, and if anybody wishes to do anything about that from a regulatory or legal perspective, it cannot be us because it is nowhere near our powers. In other countries that sort of thing has been looked at, but it is certainly not part of our powers or remit. We take a general view of efficiency which involves, as we know, lots of different things: working practices, automation, flexibility—all sorts of different things. So the direct answer to that is no.

Rebecca Harris

Could I push a bit further on that? Dave Ward was very clear. He said that “what Ofcom is really saying is that postal workers’ pay and conditions need to be cut in the name of efficiency. In criticising Royal Mail’s efficiency, Ofcom is preparing the ground for postal workers’ terms and conditions and pay to be dragged down to the level of its competitors”. He went further and said it was time to take you to judicial review for this, so how do you react to that?

Ed Richards

The allegation or the prospect of judicial review?

Rebecca Harris

Both.

Ed Richards

I am very relaxed about the prospect of judicial review. CWU, like everybody else, is very welcome to take us to court if it wishes to; that is its right. I am perfectly happy if it does not happen, but I am perfectly happy if it does happen. I have no particular view on that. We find ourselves in court on these sorts of issues all the time, so this would be nothing abnormal for us. On the first issue, we absolutely do not have that view. We are taking a view on efficiency overall, as Parliament requires us to do. This is terribly important. We have talked a lot today about the risks to the USO.

Chair

That is your priority consideration.

Ed Richards

It is.

Chair

Yes. So it is perfectly legitimate to do that.

Ed Richards

It is.

Chair

I want to move on, but can I just get something quite categorically? When you are talking about efficiency, you are not talking about wages and the working conditions of employees. You are talking about investment and possible changes in working practices.

Ed Richards

We are talking about everything that contributes to the productivity and efficiency of an organisation—everything. Our approach is to look at efficiency, which has many determinants, and to compare it with other standards and performances elsewhere.

Chair

Are wages and conditions part of that?

Ed Richards

The cost of labour is inevitably one of the inputs among many. In some cases you have higher labour costs and higher productivity because it is associated with more efficient working practices or, indeed, capital investment. These things are very complicated, and I would resist the notion of distilling this down to a single input, when anybody who has run any kind of organisation knows full well that these things have many different factors and the outcome is determined by all of them rather than one. I do not think it is right to try to isolate a single factor.

Chair

Could you again send us a written brief on what criteria you judge efficiency on? I am conscious of time and it is PMQs at noon.

Mike Crockart

I will keep it short, Chair. When we were talking about the universal service obligation and its sustainability, I wanted to enquire about the relationship you see between profitability and sustainability of the USO and the parcels sector. You seem to have identified Royal Mail’s performance in the parcels sector as a threat to the USO, but also earlier in your evidence you seemed to hint that perhaps better cross‑use of the facilities used for the universal service obligation for parcels delivery would be a way to help to support the USO. Are we talking about cross‑subsidy really between Royal Mail’s parcels service and Royal Mail’s letters service?

Ed Richards

And the USO, for sure. We are absolutely talking about that. We are not in the business of criticising or commenting on Royal Mail’s performance, other than making factual observations about it. That is an important first point. The team there have done a very good job over the last few years, so let’s make sure we are clear about that. However, what does matter to us is that if you look at the parcels market, what you discover is very intense competition—really very intense competition—with a lot of different supply and very tough times for everybody in the market. Now, to the extent that that parcels business is being carried over the Royal Mail network and is, therefore, making a contribution to the costs of that network, and that revenue disappears because it has been taken by somebody else, even though those parcels are not part of the USO, we need to take care about that, because that is affecting or could affect the underlying sustainability of the USO. We have chosen, because of our primary duty to secure the USO, to make sure we understand what is going on there and how it is likely to develop. That is the context of it; it is not a criticism of Royal Mail.

Mike Crockart

That is not the same as a direct cross‑subsidy of some income from parcels being used to maintain the sustainability of the USO.

Ed Richards

No. It is about the contribution that is made from a certain product revenue stream, which is, in this case, parcels that are outside the USO, which help to contribute to the overall cost of the network, and that helps the cost of the network.

Mike Crockart

Okay, but given that you have said it is an intensely competitive sector, is the end result of what you are suggesting not then likely to be that Royal Mail would separate out its parcels service, charge it separately for carrying it over the USO, and enable the parcel service then to compete on a much freer basis with the rest of the parcels sector?

Ed Richards

Outside the USO, its parcels business is free to compete and does compete, and it is not for me to hope one thing or another, but it has had a challenging set of circumstances in the last year or so with parcels. It may well be that it competes more effectively in the future and recovers some of that business. I do not know; we will have to wait and see, but it is an important component of how you finance the overall network. The way Royal Mail chooses to do it, and it makes a lot of sense, is that it has the underlying network in place for the USO, but wherever it can put business in addition to that on the network, it helps the underlying sustainability. You can call that a cross‑subsidy if you want. You can call it a contribution to the costs of the network. I do not think it really matters. The fact is that if more business is carried on the network, it helps the underlying sustainability of the network. So, where we see an area where there is significant change, of which parcels is the most obvious, we need to make sure we have a weather eye on that just to understand what is going on, to understand what the economic implications are of that in the medium term, and to ensure that we meet our duty in the round.

Katy Clark

I wish to make a declaration and make reference to my entries in the Register of Members’ Interests. I want to ask specifically about labour costs. It is not in the public interest for companies to be using devices such as zero‑hour contracts or, indeed, low pay, because, as a society, we simply have to deal with that in another way and the Government, for example, have to pay an awful lot more in benefits to people who are on low pay. Is that something, as a Government regulator, you take into account in any way?

Ed Richards

We are conscious and aware of those sorts of issues, but labour costs, and employment law and the regulation of the price of labour—the minimum wage and all those sorts of things—are clearly not part of our remit. We cannot deal with that. We are very much a creature of statute. We do what the statute tells us to do, and it is very clear that that is not part of our duties. Fundamentally, it is a matter for the Government and Parliament, so the direct answer to you is that we cannot look at that. We are obviously mindful of the general issue—of course we are—and aware of the general point that you are making, but it absolutely is outside our remit.

Chair

I am going to close the session at about 11.50 am to enable Members to get into PMQs. We have four more questions. If you could make them as concise as possible, I would be grateful.

Rebecca Harris

In our previous session, Moya Greene said very clearly, “We do need a more forward-looking regulatory framework, one that is more encompassing, looks at quality of service across the whole industry, not just Royal Mail, that looks at labour standards across the whole industry, not just Royal Mail, and that looks at how much latitude Royal Mail needs to be given.” What is your direct response to Moya’s statement to us?

Ed Richards

We have a forward‑looking framework. It depends what your time horizon for forward‑looking is, but from our perspective, as I hope I have made clear, we are looking at projections. We are looking at assessments of how things will develop in the coming years so, from our perspective, we are certainly taking a forward‑looking view. There is no question about that, and our determination to review the position in the future, should that be necessary, is, I think, an example of how we are forward looking. As you look further forward than that, you are into broader territory. We can do only what Parliament tells us to do and we can act only within UK law and European law, so if there are broader issues that are raised for the longer term on a more forward‑looking basis, that will, ultimately, be a matter for you. I am sorry, I missed the second half of the quotation.

Rebecca Harris

The phrase “one that…looks at quality of service across the whole industry, not just Royal Mail, that looks at labour standards across the whole industry, not just Royal Mail”. What is your response to that?

Ed Richards

I have made some comments about labour standards, so I will not repeat those in the interests of time. Quality of service is something that we look at, and we will, I am sure, have a further discussion with Royal Mail about whether there are issues to do with quality of service or mail integrity—all those kinds of things—that we need to look at on a forward‑looking basis. We would be very happy to do that.

Rebecca Harris

What is really important is your opinion on the “not just Royal Mail”.

Ed Richards

That is one of the questions, obviously, but we are able to have a look at that on a forward‑looking basis and we are very happy to have that conversation. I am not in a position today, obviously, to give you an answer as to whether we will or will not change anything of that kind. We have to look at it properly.

Chris Rowsell

One slight clarification: Royal Mail has no regulatory quality of service standards on bulk mail. It is on exactly the same footing as, say, for example, Whistl, and Royal Mail’s parcel wing, Parcelforce, is on the same footing as UPS, etc. When Royal Mail delivers parcels outside the universal service over its own network, yet again the quality of service standards are dictated by its customers—the senders of that mail—not by us.

Nadhim Zahawi

Very briefly, two very quick questions. Do Ofcom’s duties need to be reformed now that Royal Mail is a private company? The second one is, Ed, you are leaving your post at the end of the month. What advice do you have for your successor in terms of securing the provision of the universal postal service?

Ed Richards

Whether our duties need to be changed needs some considerable deliberation. There is no doubt that we are in slightly uncertain territory, which is why you have all heard from me the commitment we have to monitoring and evaluation. I have to tell you that that is wholly exceptional. There is no other market that we look at and that we are responsible for that has this level of attention, in this detail, with this frequency. None at all. That is the internal Ofcom position on this. We are in some uncertainty and we do not know for sure how things will unfold, and that was why I kept emphasising earlier that we had made a judgment at a point in time. I do not know what the judgments will be in future and, in relation to the question, I do not know for sure yet that we have precisely the right duties. They feel all right for now, but that does need to be kept under review. In terms of what I would say to my successor, and I am assuming you mean in relation to postal services, I would start from something that perhaps is not said as often as it should be and that we have not dwelt on today. The fact is that Royal Mail is in a stronger financial position today than it has been at any point in last 10 years. It is important to start with that. We are in a better position. Its economics are better. Moya and her team and the staff of Royal Mail have taken the organisation to a better and more robust position than at any point in the last decade and they deserve a lot of credit for that. I would start with that. I would then underline the need for us to be mindful and very alert to the changes and developments in the market, more so than in some other sectors because of these uncertainties, and for us to then be working really effectively with everybody involved in the sector. I am not going to say that this area is an absolutely unique case, but it does need particular attention and focus over the next few years because of the uncertainties. It is an unusual case. In some of the other areas we work, the story has been just of growth and growth and more growth. This is an unusual and difficult case, because you have obviously a decline of our propensity to send letters, but you also, on the other hand, have the revolution of e-commerce and the delivery of parcels, so it is a complicated beast with a very subtle balancing act, and I would say to my successor that they need to concentrate very carefully on it.

Chair

We have a few seconds left and I wanted to ask you a very specialised question. We will be publishing written evidence submitted by this person on the website, but in anticipation of that I would like your comments. We have received evidence from a Mr Jerry Cox, who is the sole inhabitant of Boreray Island off the Western Isles—no doubt he is enjoying splendid weather at the moment. He describes the difficulties he has had on a regular basis in connection with parcels. As the regulator, what would you say to reassure him of the future service?

Chris Rowsell

There are a number of features. It sounds as though he almost certainly is one of the 2,000 or so delivery exceptions where Royal Mail is allowed special rules on not doing six days a week. I would assume he is; they quite often map on to the islands. Supply from other delivery companies I can imagine being more difficult. I suppose I would refer the Committee to the work that Citizens Advice and Citizens Advice Scotland have been doing with BIS in the UK generally, but also with the Scottish Government on parcel delivery to remote localities. It tends to be issues more dictated by the online retailer in the way they want to contract with their parcel operators rather than the parcel operators’ willingness themselves to deliver at a standard rate. It is complicated, and I know the Scottish Government and UK Government have been looking at this issue very closely, and he is the sole inhabitant of an island.

Chair

Okay. Your reaction reminded me of a session I attended at a school last week when I was asked what the easiest part of my job was, and I had to say delegating difficult questions to my staff. Oral evidence: Competition in the Postal Services sector and the Universal Service Obligation, HC 769-ii 35