Why the Exigent Rate Case Should Not be Approved

I have tried to avoid commenting on the exigent rate case up till now.   I have long held that the Postal Service can no longer hold accounting break-even as the standard for financial self-sufficiency.  Over a year ago I wrote that financial self sufficiency requires an operating margin of 10 to 15 percent and until the Postal Service manages its business with that goal in mind it will be in a continuing state of crisis.

In addition, I have written that the decline in First Class mail, and in particular single-piece First Class mail will impose significant costs on the Postal Service for shrinking its workforce and network that should be borne by current users of this product today as otherwise the Postal Service will not have sufficient cash to cover those costs when they incur in the future.   Then these costs will be mostly born by advertising and parcel mailers in the future as there will not be enough single piece First Class mailers left to handle the brunt of these costs. However, the current costing approach does not recognize this need so the Postal Service is less likely to take steps that cost money to quickly reduce its workforce and network as demand declines.

So if I believe that the Postal Service needs to have a significant operating margin and higher prices on products to cover transition costs, why do I believe that the exigent rate increase should not be approved?

1. Approving the exigent rate case reduces the pressure on Congress to fix the retiree benefit over-payments for pensions and miscalculations of these obligations.   No solution to the Postal Service's problems exists without this fix.   This is true regardless of whether one believes that the Postal Service should be privatized or should continue operating using a business model similar to the one it now has.   The exigent rate case reduces the level of adjustments that Congress must make to prevent an annual liquidity crisis, let alone solve this problem.
   
   
2.  The timing of the exigent rate case weakens the Postal Service's political position as it attempts to streamline its network.   The Postal Service has always faced pressure from Congress that often derailed efforts to streamline its network and modernize its retail operations.    Without the exigent rate case the Congress is more clearly faced with the choice between allowing the Postal Service to streamline its operations and subsidizing postal operations.   Given budget politics, subsidizing postal operations is clearly off the table.
   
   
3. The exigent rate case weakens the Postal Service's argument before Congress that it needs greater commercial freedom and ability to offer "non-postal" products.   The long term health of the mailing industry requires the Postal Service to have significantly greater commercial freedom to expand the value of its products to customers and to identify additional means of earning a profit off of its physical, intellectual, and human capital assets.  A change in law to expand this ability puts the Postal Service in direct competition with a number of powerful interests that benefit from these restrictions.    These restrictions weaken the U.S. economy as they limit competition in both the delivery of parcels and more importantly in the production and the delivery of advertising used to identify new customers and expand private sector businesses.
   
   
4. The exigent rate case makes little sense for an enterprise whose customers require that what they pay for postage generates a positive return.  Increasingly postal revenue is driven by advertising and parcel delivery.    These are highly competitive markets where spending on services provided by the Postal Service require that its service provide a higher return than those offered by competitive delivery modes, as well as a higher return than not advertising at all.   Higher prices reduce the number of customers that find that mail generates the positive return on their advertising spending necessary to use the mail.
   
   
5. The exigent rate case comes at the wrong time relative to the Postal Service's labor negotiations.   The Postal Service is likely to demand some significant, necessary and unpopular changes in its labor contracts within the next two years.    These changes reflect the fact that the total demand for labor, the mix of full-time and part-time employees, and a number of other contract provisions no longer make sense when few postal customers use retail outlets and most mail does not require originating sortation.    It makes little sense for Postal management to raise rates prior to beginning the negotiations and more importantly arbitration where its ability to raise rates could be a significant factor in the arbitrator's decision.   Postal labor unions recognize this fact and have been among the strongest supporters of the exigent rate case.
   
   
6. The exigent rate case does not introduce realistic financial goals for the enterprise.   It makes little sense to raise rates without changing the primary financial goal of the organization from whether there is enough money at the end of the year to pay the bills.    Before the Postal Regulatory Commission even considers raising rates, it should develop a position as to what financial goals are needed to ensure self sufficiency.  This is also critical for Congress to understand why fixing the retiree expense issues cannot be avoided but also why it is the first step and not the last step necessary if the Postal Service is to have a long-term future.
   
   
7. The exigent rate case maintains the cost plus approach dating back to regulation under the Postal Reorganization Act.   Postal rates eventually have to reflect a better understanding of demand for its products and the costs of an efficient operator.   Costing approaches, rate relationships, and worksharing discounts all take the focus away from the value of the service to the customer in determining prices.   Worksharing increased volumes of mail, not just because the private sector could sort mail cheaper because many of the automation related discounts could be received by mailers that did not have to incur any costs to sort the mail they tendered to the Postal Service at all.   Instead, the discounts put the price of the delivery service below the value of the delivery for more customers allowing advertising agencies and printers to sell their services to customers that would not have considered the use of mail previously.  Worrying about the level of cost pass-through prevents the Postal Service from asking two even more important questions.  1) What is the value of mail to the sender and how do postal prices compare with the value that senders perceive that mail has?  2) How can the Postal Service provide its services at costs below the customer's understanding of the value of the service?
     
8. The exigent rate case illustrates that a piece-meal approach to fixing the Postal Service's business model and regulatory framework does not work.  The exigent rate case, just like all other proposals made by the Postal Service is being handled independently of all other changes that may be needed to restore financial self sufficiency to the Postal Service.   As such, it is never clear if rate increases do little more than reduce the pressure on taking other steps neccesary to make the Postal Service self sufficient.

In closing, rates for Postal Services eventually need to reflect market realities and the costs of an efficient operator both capable of and working toward managing operations to cost levels that market realities can support.  This requires a better understanding of the value of mail to customers, the elimination of unwarranted retiree expenses, the streamlining of management and contract resources, the speedy restructuring of the network to minimize delivery, processing and transportation costs while still meeting universal service requirements, and elimination of restrictions that prevent the most effective use of human capital, physical and intellectual property assets.  The exigent rate case conducted in a vacuum brings us no closer to producing rates based on market realities and may hinder fixing a number of the serious flaws in the business model and regulatory framework that must be changed.

The Exigent Rate Case: Rethinking Price Regulation

Yesterday the Postal Service proposed a major change in its rate structure through an exigent rate case.   The general and postal press have focused on 1) the rate increases themselves with particular attention to the impact on First Class single piece mail; and 2) the exigent process itself, a rate setting process that is being used for the first time. 


Mailers have organized a major effort to stop the changes through a new group the Affordable Mail Alliance.   With only 90 days to press their case mailers have a major challenge in their effort to argue that:

1. the conditions necessary for invoking the exigent process had not been met; 
2. the rate increases proposed are too large;  and
3. the changes in individual rates result in rates that are not fair and reasonable and do not meet the pricing objectives in postal law.

Given the limited amount of time available for the proceeding, the level of discovery, expert testimony, and cross-examination in this proceeding will be limited.   While the procedural schedule is not yet out, the Commission will likely need around 20 to 30 days to review evidence and write its opinion which compresses the first nine months of a traditional rate case into a 60 to70 day period.

What makes the exigent rate increase particularly difficult for mailers and the Commission is that it represents more than just a simple across the board increase in rates.   The proposal represents a fairly bold rethinking of regulatory pricing and the economic thinking that guided postal pricing for nearly thirty years.  These new approach can be summarized in seven statements as follows:

1. Divergence to electronic alternatives for single piece mail is not affected by stamp prices.   "The Postal Service does not believe that the erosion of single-piece mail through electronic diversion can be materially affected by limiting the growth of the stamp price." (Statement of James M Kiefer on Behalf of the United States Postal Service, July, 6, 2010, p. 15)  "As long as these forces [that encourage electronic payment] are in play, efforts to hold down the stamp price to "protect" the single piece customer will be unlikely to spur usage of single piece mail among users, for whom continence trumps the small impact of the postage savings." (Kiefer, p. 16)
   
   From a business standpoint, this means that the Postal Service cannot protect itself from the decline in single piece First Class mail by holding prices down.   Given that single piece mail is now declining at a faster rate than it did before the recession, the Postal Service's single piece rates today will increasingly be required to bear the costs associated with reducing the workforce that currently handles single piece mail at a rate far faster than the rate of normal attrition.  The public should expect that single piece rates will begin rising faster than other postal products to generate cash to cover these costs.
   
2. The markets for single-piece and presorted First Class mail are different.   By separating the markets for single-piece and presorted First Class mail, the Postal Service presents a direct challenge to the theory behind workshare discounts as they are currently constructed. "Traditional workshare theory suggests that increasing presort First-Class Mail prices would simply cause customers to re-evaluate their decision to perform worksharing activities.  Essentially, the theory argues that if it costs less for a customer to presort mail than the postal discount, then they will do the sortation. Conversely, if it costs more to presort mail than the postal discount, then the customer will choose to tender unsorted mail to the Postal Service. While this argument may have been valid at the inception of the automation program, it ignores the realities of decisions that customers are making today. Much of today’s presort mail is generated not by physically sorting mail pieces but by using presorted mailing lists to produce the resulting mail in presort order. 
   
   Customers pay prices, not “discounts” and decide whether to mail or not to mail based on the total cost of mailing, including the postage paid (not just the price differential between single-piece and presort mail) and the costs of producing that mail. While at some level the size of the discount affects workshare decisions, the overall postage price affects the decision to mail or not to mail. If this price goes up substantially (because discounts are reduced) the decision to mail at all may be reconsidered."  (Kiefer, p. 18)
   
   The Postal Service carriers maintains the separation between individual and commercial users of First Class mail in its development of First class mail products regardless of shape and is clearly seen in the discussion of both letter and parcel rates.  
   
   The separation of individual and commercial mailers requires the Postal Regulatory Commission to overturn current precedent on First Class rates and worksharing discounts as applied in the Postal Regulatory Commission's 2009 Annual Compliance Determination.   The Postal Regulatory Commission will like spend some time deliberating this change but much of the public work on this issue has been completed as part of another proceeding, Docket No. RM2009-3.
   
3. Pricing is still subject to the Postal Regulatory Commission's worksharing rules even if the Postal Service does not believe it makes sense.   Mr. Kiefer's statement has numerous sections on worksharing to deal with the Commission's approach to measuring traditional worksharing discounts.   The inconsistency between these sections and the Postal Service's thinking on separating single piece and pre-sorted First Class into two separate markets indicates that the Postal Service still must prepare its proposal to meet Commission precedent even if it believes that the precedent does not allow for postal prices to reflect market realities.  While the Postal Service may want to challenge worksharing precedent and law, the Postal Service is holding off that challenge until at least 2011.   
   
4. Weight Categories for First Class Pre-sorted mail require rethinking.   The Postal Service has proposed allowing single piece First Class letters to hold 1.2 ounces and still pay a single ounce rate.   This allows more advertising inserts in letters, items that help make mail that normally is a business expense become a profit generating advertising opportunity.   The question that this change makes is: why 1.2 ounces?  As mailers and the Postal Service experiment with this proposed change, it is possible that the Postal Service may want to allow commercial mailers to send higher weights as long as the mailing meets automation requirements.
   
5. Pricing should not reflect bad operating processes or short term economic challenges.  The prices proposed for Standard Flats and Periodicals both are more modest than traditional price setting rules would require.   The process for handling flats are currently in flux and the costs associated with moving them in one to two years should reflect a different operating process than the Postal Service now uses.  Also if the Postal Service, started an aggressive program to remove excess capacity through a new round of early retirements and a national distribution strategy for flats similar to what it did with the NDC's it may be possible to reduce costs even further.
   
   The Postal Service's rates also reflect a limited recognition that catalogs and magazines are struggling in the marketplace that sees significant reductions in consumer demand.   Magazines in particular have seen significant drops in ad pages that reduce the amount of postage a magazine pays per issue.    The recovering economy has seen some increase in the number of advertising pages sold that will increase the amount of revenue the Postal Service generates per magazine.
   
6. Not all products that look the same compete in the same market.   The Postal Service in its press conference described two Standard Parcel markets.   The first is a product sample market that is a form of advertising and competes with other means of distributing product samples.    The second is fulfillment and includes the distribution of light weight parcels.   Physically, these items look very similar.  However, the value of the item to the sender is very different.   Samples are designed to generate sales so the postage price, combined with all other costs of producing the sample must product a positive return on the advertising expenditure.   Fulfillment parcels rates must allow the seller of the item to earn a profit on the sale including the item's cost as well as all other sales, marketing, and overhead costs associated with the sale.   The differences between the two markets are intuitive, proving this as part of a regulatory proceeding may not be. 
   
7. The Postal Service's regulated parcel services, regardless of class, are offered in competitive markets.   The Postal Service with the exigent filing has begun the process of moving its parcel products into the competitive product category. This would allow it to offer all parcel services to commercial customers within contracts just like its competitors do and offer services to individuals based on rates contained in published tariffs.  The Postal Service at its press conference stated that it will propose moving Standard parcels to the competitive category this fall and is evaluating moving other products to this category as well.  
   
   The Postal Service's position in the parcel market is unique in that it both offers services directly to consumers and businesses and offers its delivery network to its competitors for delivering light weight items and items destined to the rural households.   All of the Postal Service's parcel products sold directly to shippers have private sector substitutes, although some are offered at prices that the private sector finds unprofitable and no private sector carrier offers a service that is price competitive. 
   
   The Postal Service's last mile delivery service competes with other firms that can offer last mile delivery as well as the employees and regular contractors of United Parcel Service and FedEx Ground.  The use of the Postal Service's last mile service reflects a classic make or buy decision that United Parcel Service and FedEx Ground that these companies constantly evaluate to ensure that they meet their profitability objectives.   The Postal Service ability to raise its prices for the last-mile delivery of light weight and rural parcels depends on price of its customer's alternatives. 

The seven items listed above should give the mailing community a lot to think about as they deal with the details of the Postal Service's proposal.   They all reflect long-term issues that go beyond the rates themselves.  For many stakeholders, including the Postal Rate Commission, postal unions, and many mailers, the changes reflect challenges to their long standing positions.  In 90 days we will see if the Postal Service has overcome the pull of precedent and traditional viewpoints or if a new era in postal pricing has begun.

Postal Service to Announce Price Changes

The Postal Service will announce the price changes that will be included in its exigent rate case on Tuesday, July 6, 2010.    The Postal Service will then file the rate changes with the Postal Regulatory Commission shortly thereafter.    The Postal Regulatory Commission will have 90 days to review these rates.

The rules regarding written comments on the Postal Service's proposal in an exigent rate increases define the 3 issues that will like be the focus of the PRC's decision on the proposed rates.  They are:

1. The sufficiency of the justification for an exigent rate increase;
2. The adequacy of the justification for increases in the amounts requested by the Postal Service; and
3. Whether the specific rate adjustments requested are reasonable and equitable.

As this will be the first exigent rate case, it would not be surprising if any decision is taken to court regardless of whether the PRC approves the Postal Service's proposed rates as they are presented, modifies the proposed rates or rejects them.

Irrational Pricing at the Postal Service

The Postal Service may be on the verge of having an irrational price structure. The irrationally of the Postal Service's price structure is driven by the regulatory constraints within which it must price its products. Until the Postal Service is free from those constraints, irrational pricing will have detrimental effects on the Postal Service, its customers and its competitors.

How is the price structure made irrational?

The Postal Service had only two choices in setting prices for its regulated products. 1) It could not raise prices and adhere to the requirements of the legislated price cap. 2) It could file an exigent rate case and open up its entire price structure for review by the Postal Regulatory Commission. The first option freezes rates that should rise due to price changes of competitors and changing cost structure affecting particular products. The second option opens up the entire rate structure to regulatory review and would force prices to confirm to nearly 40 years of PRC precedent on pricing and relationships between the prices of various postal products. In particular, this precedent would have likely required that the Postal Service institute a major rate increase on nearly all products at a time when customers are most sensitive to postal prices. Furthermore, an exigent rate case would have the effect of protecting preferred classes of postal customers from rational price changes that violate PRC interpretation of postal pricing law and would most likely cause the most economically and price sensitive mail to see price increases that market-based pricing would not justify.

The choice the Postal Service had is known as Morton's Fork, a choice between two bad options. In choosing to adhere to the price cap, the Postal Service held prices constant at a time that competitive pressures, rising operating costs and substantial operating losses would justify some increases. Opening up its entire pricing structure to regulatory review would reinforce decisions on price relationships made in market environments unlike what now exists and could raise rates far beyond what the Postal Service would want in the depressed economy. Given the difficulty of over tuning PRC precedent, and especially precedent on rate relationships, the Postal Service would have little confidence going into an exigent rate case that the new rate structure would have the rate structure changes that it needs to get back on the path to financial self-sufficiency. Given its options, sticking to the price cap appears to be marginally better for the future of the Postal Service, but it was still not a "good option."

To understand why both options are bad, one only has to look at the pricing decisions of Postal Service competitors, UPS and FedEx and foreign postal operators. All of these firms are expected to raise rates in 2010 and none of these firms are expected to raise rates uniformly across their product lines, delivery locations, or type of customers.

UPS and FedEx are raising rates, after taking into account the decline in the fuel surcharge by around 4%. FedEx's published rates are rising the most for envelopes and parcels under 2 pounds, parcels delivered to residential addresses, and parcels traveling the greatest distance over the FedEx network. (A full price comparison was produced by Parcel Magazine.) The price increases are changing rate relationships across FedEx's range of services.

The published rate changes only affect the rates that parcel customers pay when they tender a single parcel or single envelope at a FedEx Office location or at an independent franchisee, or purchase the service on line and drop the single parcel in one of FedEx's drop boxes. FedEx's largest customers expect that their rate increase will be less due to negotiated discounts that vary based on the volume the customer tenders and the distribution patterns of the parcels shipped.

By not raising its single-piece parcel rates, the Postal Service is likely to gain market share over UPS and FedEx in parcel markets that it already dominates. It will do so at a cost to its financial well being as it will bear rising costs without additional revenue. Without the legal constraints, the Postal Service could raise its First Class parcel, Standard parcel, and single-piece Parcel Post rates as a price follower without affecting the market share of competitors.

Not raising single-piece parcel rates also creates problems for the Postal Service's competitive parcel products. By holding its single piece rates constant, the Postal Service reduces its negotiating room with large scale parcel shippers. The difference in rate between the heaviest First Class parcel and the lightest Priority Mail shipment will grow, possibly encouraging shippers to split parcels to take advantage of lower single-piece rates. It is possible that a profitable contract with a large-scale shipper would be at prices above what single-piece rates are and the Postal Service would be forced to sell services at a loss to customers who can use the capped single-piece rate.

Foreign postal operators have expanded the difference between single-piece rates and rates charged to large volume mailers well beyond the cost differences. A recent strategic review of Canada Post examined the impact of a price cap on single piece rates at Canada Post and recommended that higher rates are required for the financial well-being of Canada Post and the continuation of universal service within a financially self-sufficient entity. (Recommendation 30(iv)) In response, Canada Post has announced a five year pricing plan for the 30 gram (approximately 1 ounce) single-piece First Class letter. Single-piece letter rates are rising 3 cents in January, 2010 and 2 cents each year from 2011 through 2014. To offset the impact on small business, Canada Post is offering a rebate on the first $1,000 of postage equal to the January, 2010, 3 cent increase. Rates for large volume mailers are set within contracts so the actual increases for these customers are unknown.

The Postal Service's single piece First Class rates are still set under two assumptions. First, there should only be a current-cost based relationship between single-piece and volume-tendered mail. Second, the only differences between First Class single-piece mail and volume tendered mail should be the cost differences in handling the two types of mail.

These assumptions worked as long as single-piece First Class volumes were rising or steady. The decade long decline in single-piece First Class mail have shattered both assumptions.

The decline in First Class single-piece mail creates significant transition costs to handle the costs of reducing the workforce, equipment, and facilities that handle this mail that are no longer needed. The decline in First Class single-piece mail also requires that current users of this product bear the future cost of debt (including debt for current losses), retiree benefits, and workers compensation claims. Otherwise rate increases in the future will have to be even greater to cover the annual cash outlays to cover debt payments, retiree benefits, and workers compensation claims in the future.

Limiting price differences between single-piece and volume tendered First Class mail to just cost differences ignores real market differences between postal customers. The two types of customers differ in terms of sensitivity to both price and economic cycles. These differences logically support removing links in price setting for single-piece and volume tendered mail.

The two examples are similar in that the rational solution would require a major change in precedent and conventional thinking, and mostly changes in legislation. Instead it was left at Morton's fork, a place with two directions neither one offering a path to self-sufficiency.