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April 8, 2005: 

The Honorable Susan M. Collins, Chairman:
Committee on Homeland Security and Governmental Affairs:
United States Senate:

Subject: International Mail Air Transportation: Proposed Changes to the 
Rate-setting Process:

Dear Chairman Collins:

Provisions in the Senate's proposed postal reform legislation, the 
Postal Accountability and Enhancement Act (S.662 §1002), seek to 
address longstanding concerns about the Department of Transportation's 
(DOT) role in setting transportation rates for certain segments of the 
U.S. Postal Service's (USPS) international mail. Specifically, these 
rates are what air carriers charge USPS for transporting letter-class 
and military mail to international destinations. The methodology DOT 
uses to set these rates was established by the Civil Aeronautics Board 
(CAB) in a rate proceeding that concluded in the late 1970s. The 
transportation of this mail is subject to various statutory 
requirements, such as having DOT set the rates that USPS is to pay to 
U.S. air carriers for transporting international mail and a duty to 
carry provision that requires the air carriers to provide facilities 
and services for transporting this mail. DOT, USPS, and U.S. air 
carriers have raised concerns about the current rate process, 
particularly because the rate-setting methodology has not been 
comprehensively updated since the late 1970s. Some stakeholders view 
the current rate-setting process as an anachronism in today's 
increasingly deregulated international mail and transportation 
marketplace. USPS has stated that this system results in excessive 
rates, which negatively affects its financial position and impedes its 
ability to compete in the international postal marketplace. Some U.S. 
passenger carriers, however, are concerned that eliminating the current 
system would exacerbate their existing financial difficulties. Although 
the stakeholders made efforts over the past year to improve the current 
rate-setting process, they were not able to reach a consensus. The 
proposed legislation would eliminate DOT's rate-setting authority and 
allow USPS to negotiate contracts with U.S. and foreign air carriers 
for its international mail transportation rates and services.

Therefore, to gain a better understanding of the rate-setting process 
and the potential impact of the provisions in the recently introduced 
postal reform bill related to setting rates for international mail air 
transportation (S. 662 §1002 and 1004), our objectives were to (1) 
describe the current process DOT uses in setting international mail air 
transportation rates, how the mail transportation market has changed 
over time, and the possible implications of these market changes for 
the current rate- setting process; (2) describe applicable S.662 
provisions and the key stakeholders' views of these provisions; and (3) 
assess these provisions against key principles of postal reform--
flexibility, efficiency, and fairness. To provide information on the 
current rate- setting process and the issues raised about this process, 
we met with various stakeholders; reviewed current legal provisions, 
legislative history, the President's Commission on the U.S. Postal 
Service (the Commission) report, and DOT rate-proceeding documents; and 
analyzed cost, volume, and weight information for certain segments of 
USPS mail. To describe the provisions related to changing the rate-
setting process for international mail air transportation and 
stakeholder views of these changes, we reviewed the proposed 
legislation and interviewed USPS officials, DOT officials, and 
Department of Defense (DOD) officials. We also met with various air 
carriers that have publicly commented on issues related to the current 
rate-setting process. These air carriers included representatives from 
three of the major U.S. passenger air carriers; one U.S. cargo air 
carrier; and the Air Transport Association, which is a trade 
organization for certain U.S. air carriers. To assess these provisions, 
we applied certain principles found in past GAO reports and testimonies 
and in the Commission's report. These principles are related to the 
major transformation goals for postal reform legislation and include 
balancing increased flexibility for USPS to act more like a business 
with appropriate accountability mechanisms to ensure fairness to 
customers and competitors. These principles also include enhancing 
incentives to improve efficiency by utilizing best practices from the 
private sector. We determined that the data we used from USPS and DOT 
were sufficiently reliable for the purposes of our review. Our work was 
conducted from February 2005 to April 2005 in accordance with generally 
accepted government auditing standards. We requested comments on this 
report from USPS and DOT, and they provided oral comments to us, which 
are discussed later in this report.

Results In Brief:

DOT's process for setting international mail air transportation rates 
is based on a methodology that was established by CAB in the late 
1970s. The methodology set at that time allocated all the expenses 
required to transport the mail on the basis of the percentage of mail 
traffic to total traffic (i.e. mail, passengers, and cargo). DOT's 
process for annually updating the rates involves air carriers 
submitting the relevant cost and volume data to DOT, which then 
incorporates that updated data into the CAB methodology. Over the last 
few decades, changes have occurred in the domestic and international 
mail and air transportation markets that have greatly altered the 
environment in which these services are provided. These changes include 
deregulation of the airline industry, deregulation of some domestic and 
international mail transportation rates, increased competition from 
foreign air carriers, expansion of the global postal marketplace, and 
changes in the air transportation marketplace. Although changes in the 
market have moved toward more competition, the rate-setting methodology 
has not been updated to reflect these changes. DOT and some of the 
stakeholders have raised concerns about the appropriateness of the 
current process in light of these changes and the potential 
implications on rates and services. For example, USPS has stated the 
system does not provide market-based rates and services; however, the 
passenger air carriers we met with stated that the rates charged are 
commensurate with the services provided. Potential implications of 
these market changes on the current rate-setting process are that the 
process may not reflect the current costs of transporting mail and may 
not be consistent with deregulated and competitive air transportation 
and international mail markets, may not provide sufficient incentives 
for efficiency gains, and may not reflect or respond to changes in 
customer service demands. Thus, USPS may not be benefiting from 
potential cost saving opportunities--USPS stated it may be paying rates 
that are too high for services that it does not need, its customers, 
including DOD, may be incurring higher costs than necessary, and the 
air carriers may be providing services that are not required.

Provisions in the proposed postal reform legislation would end DOT's 
role in setting rates related to international mail air transportation 
and grant USPS the flexibility, under certain conditions, to negotiate 
with both U.S. and foreign air carriers about rates and services to be 
provided. Section 1004 of this legislation includes congressional 
guidance that suppliers and contractors be treated fairly and 
consistently. Section 1002 includes a reciprocity provision under which 
each contract awarded to a foreign air carrier shall be subject to the 
requirement that U.S. air carriers be provided the same opportunity to 
carry mail of the country to and from which the mail is transported 
and, if different, the flag country of the foreign carrier. DOT has not 
taken a position on the provisions in the current legislation. However, 
it has in the past supported legislative proposals to remove DOT from 
the rate-setting process. Other stakeholders, however, have voiced 
divergent views of these provisions to change the rate-setting process. 
USPS supports these provisions because it believes the provisions will 
result in lower costs for USPS, provide better incentives for service 
performance, and allow it to better compete in the global market. 
Likewise, officials we spoke with at DOD stated that, to the extent 
USPS would benefit from a reduced rate structure, the costs of 
transporting military mail should also decrease. The cargo carrier we 
spoke with supported these legislative provisions because it would move 
the international air transportation market to be more consistent with 
other deregulated markets, such as the U.S. airline industry, and 
should result in more efficient, market-based rates. However, the 
passenger carriers we met with oppose these provisions due to various 
concerns, such as the potential loss of revenue, concerns that 
international air and postal markets are not sufficiently competitive, 
and concerns that USPS could engage in unfair contracting practices.

We found that the provisions related to changing the process for 
setting international air transportation rates are consistent with key 
principles of balancing flexibility, efficiency, and fairness that we 
have identified as being important for transforming USPS so that it can 
remain viable in the competitive 21ST century environment. Similar to 
what was recommended in the Commission's report, we previously 
testified that if USPS is provided additional flexibility to act in a 
more efficient, businesslike manner, this increase in flexibility must 
be balanced with accountability mechanisms and enhanced oversight to 
ensure that USPS competes fairly and that postal customers and 
competitors are protected against undue discrimination.[Footnote 1] 
These provisions grant USPS the flexibility to utilize private sector 
best practices to improve overall efficiencies by allowing it to, among 
other things, negotiate rates and services with certain U.S. and 
foreign carriers. Furthermore, other provisions in this postal reform 
legislation are consistent with the principles of ensuring fairness and 
consistency. Section 1004 provides congressional guidance to protect 
contractors, and section 1002 includes a reciprocity provision and a 5-
year transition period in which foreign air carriers are restricted in 
competing for USPS contracts. We are in the process of further 
reviewing USPS' contracting practices to determine whether additional 
congressional oversight or other mechanisms may be needed to ensure 
that an appropriate balance of flexibility, fairness, and efficiency is 
maintained. In providing oral comments on this report, USPS agreed with 
the message of our report, while the DOT stated that it has not 
established a position on the current legislative provisions related to 
setting rates for international mail air transportation.

Background:

The statutory provisions associated with DOT-regulated international 
mail air transportation vary significantly from those for the 
transportation of most other domestic and other international mail 
classes. The transportation rates for these other classes of mail are 
negotiated and contracted by USPS and the carriers. Table 1 lists the 
current provisions that apply to the air transportation of 
international mail.

Table 1: Selected Provisions Related to International Mail Air 
Transportation:

Provision: U.S. air carrier duty to carry mail; 
Citation: 49 U.S.C. §41903; 
Description: U.S. air carriers must provide the service and facilities 
to transport international mail tendered by USPS up to the maximum load 
prescribed by DOT. 

Provision: DOT’s authority to set rates for U.S. air carriers; 
Citation: 49 U.S.C. §41901(b)(1); 
Description: Requires the Secretary of the Department of Transportation 
to set reasonable prices that USPS will pay U.S. air carriers to 
transport international mail.
Provision: USPS contracting authority—bulk mail; 
Citation: 39 U.S.C. § 5402(b); 
Description: USPS can contract with U.S. air carriers for air 
transportation of international mail if the contract is for at least 
750 pounds of mail per flight, and no more than 5 percent of the mail, 
by weight, can be letter mail. Contract must be filed with the 
Secretary of Transportation at least 90 days before its effective date, 
and the contract will take effect unless it is disapproved by the 
Secretary at least 10 days before the effective date.

Provision: USPS contracting authority—unavailable service; 
Citation: 39 U.S.C. §5402(c); 
Description: When USPS determines transportation of mail by aircraft is 
required between points in foreign air transportation where no U.S. air 
carrier has been authorized by DOT, USPS may contract with any U.S. air 
carrier for the transportation of any class of mail. Transportation 
under these contracts must cease when a DOT authorized U.S. air carrier 
begins service.

Provision: USPS contracting authority—inadequate service; 
Citation: 39 U.S.C. §5402(d); 
Description: When USPS determines that service by U.S. air carriers in 
foreign air transportation is not adequate for its purposes, it may 
contract under certain conditions with any air taxi for transportation. 
USPS must cancel the contract when adequate transportation by U.S. air 
carriers becomes available.

Provision: Use of foreign air carriers; 
Citation: 49 U.S.C. §41904; 
Description: USPS can make arrangements with foreign air carriers when 
it determines that the transport of mail by aircraft to a foreign 
country is necessary. This authority has historically been used in 
situations in which U.S. air carrier service is inadequate.

Source: GAO.

[End of table]

The segment of international mail that is subject to rate-setting by 
DOT does not encompass all of USPS' international mail. The types of 
international mail that fall under this regulatory structure include 
letter class and military mail that originates from the United 
States.[Footnote 2] According to DOD officials, DOD is obligated by law 
to use U.S. carriers for the transportation of military cargo, and 
reimburses USPS for the transportation costs associated with the 
international air transportation of military mail.[Footnote 3] Other 
types of international mail that are not subject to DOT rate-setting 
include those moved by surface transportation (i.e., trucked to Canada 
or Mexico) or bulk air shipments whose rates are set through negotiated 
contracts. Table 2 shows that the volume and weight of USPS 
international mail subject to DOT air transportation rates in fiscal 
year 2004 were less than 1 percent of USPS' total mail volume and 
weight.

Table 2: Mail Volume and Weight for Fiscal Year 2004:

Mail category: Domestic mail[a]; 
Mail volumes (in millions of pieces): 205,261,930; 
Percent of total mail volumes: 99.60%; 
Mail weight (in millions of pounds): 25,055,323; 
Percent of total mail weight: 99.10%. 

Mail category: International mail-DOT rates; 
Mail volumes (in millions of pieces): 711,566; 
Percent of total mail volumes: 0.30%; 
Mail weight (in millions of pounds): 147,838; 
Percent of total mail weight: 0.60%. 

Mail category: International mail-other; 
Mail volumes (in millions of pieces): 132,248; 
Percent of total mail volumes: 0.10%; 
Mail weight (in millions of pounds): 80,787; 
Percent of total mail weight: 0.30%. 

Total all mail; 
Mail volumes (in millions of pieces): 206,105,744; 
Percent of total mail volumes: 100%; 
Mail weight (in millions of pounds): 25,283,949; 
Percent of total mail weight: 100%. 

Source: USPS.

[A] According to USPS, all military mail transported overseas is 
recorded as domestic mail for financial accounting purposes because 
customers are charged domestic postage rates.

[End of table]

In 2004, USPS spent about $555 million for the international 
transportation of DOT-regulated mail; of this amount, U.S. carriers 
were paid $445 million and foreign carriers were paid $110 
million.[Footnote 4] Furthermore, DOD's expense for reimbursing USPS 
for the costs associated with transporting military mail overseas was 
$344 million in 2004. Revenues from transporting mail account for about 
less than 1 percent of total annual operating revenues for U.S. air 
carriers.

The Current Rate-setting Process and How Changes in the Marketplace May 
Affect This Process:

DOT's process for setting international mail air transportation rates 
involves gathering operating data from the carriers and annually 
updating the rates by applying cost adjustment factors to the rate- 
setting methodology originally established by CAB in the late 1970s. 
After applying these cost factors, DOT calculates updated rates. These 
proposed rates are then issued in a show cause order, and interested 
parties are provided an opportunity to comment on the proposed rates 
before the rates are finalized in a DOT order.

The rate methodology resulted from a nearly 5-year rate proceeding 
before CAB in which air carrier groups and USPS differed about the 
appropriate methodology for allocating costs to the mail (e.g., fuel 
costs and facility costs). CAB eventually decided upon the fully- 
allocated cost methodology to be used when calculating rates, set the 
rates through June 1979, and established a process whereby future rates 
would be updated on the basis of changes in operating 
expenses.[Footnote 5] When CAB was discontinued in 1984 due to 
deregulation of the airline industry, the responsibility for setting 
international mail transportation rates was transferred to DOT.

DOT's process for setting international mail transportation rates was 
not challenged until late 2003 when USPS filed its analysis of 
international mail transportation rates with DOT.[Footnote 6] According 
to USPS' supporting analysis, mail rates were substantially overstated 
when compared with the marginal cost allocation methodology that USPS 
advocated.[Footnote 7] USPS also filed a request for all interested 
parties to meet and strive to reach consensus on a reasonable 
alternative(s) to the existing rate-setting process. Although some 
passenger carriers did not oppose the notion of informal discussions, 
these carriers submitted a report that was conducted on their behalf to 
refute USPS' analysis that rates are excessive.[Footnote 8] In March 
2004, DOT issued an order directing the parties to engage in informal 
discussions about possible revisions to the current methodology for 
determining rates. The order pointed out that DOT recognized that there 
were inherent problems with the historical update methodology used to 
project cost increases. An initial workgroup meeting with 
representatives from DOT, USPS, and U.S. passenger and cargo carriers 
took place in May 2004. In a subsequent meeting, the parties agreed to 
strive for more market-based rates that could facilitate more frequent 
and efficient rate-setting. Little progress was made, however, in 
alleviating the concerns raised by USPS and the passenger carriers, and 
the group has since been discontinued.

On March 15, 2005, DOT issued an order requesting comments within 30 
days from the interested parties regarding whether DOT should conduct a 
new rate proceeding, what the procedure for doing so should be, and 
what methodology should ultimately be applied to determine mail rates. 
This proceeding could result in the rate-setting process being changed 
to account for the changes in air transportation and mail markets.

Changes in the Air Transportation and Mail Markets:

Significant changes have occurred in the domestic and international 
mail and transportation markets since the rate-setting process was set 
in the late 1970s. These changes have greatly altered the environment 
in which international air transportation services are provided. Air 
transportation, particularly to international destinations, was 
relatively limited at the time CAB originally set the methodology; 
however, significant increases in traffic both within the United States 
and internationally have changed this market. Furthermore, the 
international postal marketplace has become more competitive, with many 
foreign postal administrations operating in the United States. Some of 
these changes, such as the increases in competition from foreign postal 
administrations and changes in air transportation, are likely to 
continue in the future.

These changes include:

Deregulation of the airline industry: The U.S. airline market has been 
deregulated and become more competitive as U.S. air carriers (both 
passenger carriers and cargo carriers) serve markets in the United 
States and internationally. Between 1980 and 2004, the number of 
revenue-generating flights flown by U.S. carriers within the United 
States has doubled from over 5.2 million flights to over 10.8 million 
flights. During this same period of time, the annual number of 
international revenue-generating flights flown by U.S. carriers has 
also more than tripled from about 235,000 flights to over 709,000 
flights (see Fig. 1). The structure of the U.S. airline industry has 
also changed due to carrier consolidations and the emergence of 
regional and low-cost airlines. Although actions, such as the signing 
of the first Open Skies agreements in 1992, have helped to reduce 
government restrictions in the international air market, this market is 
still not as deregulated as the U.S. airline market. For example, some 
European governments have restricted night-flight operations and have 
limited U.S. carriers' access to their markets.[Footnote 9]

Figure 1: Trend in the Annual International Revenue-Generating Flights 
Flown by U.S. Air Carriers:

[See PDF for image]

[End of figure]

Deregulation of some domestic and international mail air transportation 
rates: Rate-setting for the air transportation of most domestic mail 
and certain segments of international mail has been deregulated (see 
table 3). Currently, less than 1 percent of all USPS mail volume is 
subject to transportation rates set by DOT. For most other domestic and 
international classes (except for mail transported by air within 
Alaska), USPS now negotiates with carriers about the prices and 
services that are to be provided. USPS began contracting the 
transportation rates for certain bulk international mail in the 1980s 
and expanded its contracting to include international parcels and 
Express Mail in 2003.

Table 3: Timeline of Selected Changes to Mail and Transportation 
Markets:

Action: U.S. airline deregulation: The Airline Deregulation Act of 1978 
ended the Civil Aeronautics Board's (CAB) regulation of the airline 
industry in several phases; 
Type of deregulation: Transportation; 
Date of action: 1978-1984.

Action: USPS contracts for certain international bulk mail: USPS 
introduces International Surface Air Lift (ISAL) service contracts 
under which USPS contracts for reduced-rate bulk mailing shipments for 
certain classes of printed matter such as publications, advertising 
mail, and catalogs that are offered mailers as a 7-to 14-day service; 
Type of deregulation: Mail; 
Date of action: 1980.

Action: USPS contracts for domestic air mail: Air transportation rates 
for domestic mail service were deregulated with the sunset of the CAB; 
Type of deregulation: Mail; 
Date of action: 1984.

Action: Move towards deregulating international routes and capacity: 
United States and foreign countries agree to more "open skies"; 
Type of deregulation: Transportation; 
Date of action: 1980s-1990s.

Action: USPS contracts for containerized international mail: USPS 
introduces the International Air Transportation (IAT) contracts to only 
U.S. carriers for the transportation in airline containers (rather than 
in loose sacks) of international air parcels and Express Mail; 
Type of deregulation: Mail; 
Date of action: 2003.

Source: USPS and DOT.

[End of table]

Increased competition from foreign air carriers: Since deregulation, 
there has been an increasing international presence of foreign air 
carriers on routes that originate in the United States. USPS' ISAL 
contracts, which were initiated in 1980, can include foreign carriers; 
and as of June 30, 2004, 30 percent of USPS' ISAL contracts were 
awarded to foreign carriers. In addition to ISAL contracts with USPS, 
foreign carriers can enter into code-sharing agreements with U.S. 
carriers, under which the foreign carrier transports USPS' DOT- 
regulated mail on one of its aircraft. In this instance, USPS pays the 
international rate to the U.S. carrier, which then pays a portion of 
this cost to the foreign carrier for the service.

Expansion of global postal marketplace: The international postal 
marketplace has expanded, and USPS faces increasing competition from 
foreign postal administrations. As figure 2 shows, USPS has lost market 
share in this environment as its international mail revenue as a 
percentage of its total mail revenue has been decreasing. Several 
factors have contributed to this change. First, the distinction between 
the roles of public and private providers of postal services has 
blurred as the deregulation of postal administrations continues in many 
foreign countries. For example, the German national postal operator, 
Deutsche Post World Net, is partially privatized and has expanded 
globally in Europe and the United States, offering a wide range of 
international postal products. Second, several foreign postal 
administrations have set up facilities in the United States that can 
transport international mail from the United States to a third country 
without going through USPS.[Footnote 10] According to USPS, as of March 
2005, nine foreign countries were operating 25 such facilities in the 
United States; and at the end of fiscal year 2004, nearly 20 postal 
operators have established 100 such facilities worldwide.

Figure 2: USPS' International Mail Revenue Share of Total Mail Revenue 
Has Been Decreasing:

[See PDF for image]

[End of figure]

Changes in air transportation marketplace: The roles of U.S. carriers 
(both cargo and passenger) in transporting mail and freight have also 
changed over time. Since the fall of 2001, security restrictions 
prohibited U.S. passenger carriers from transporting mail domestically 
weighing 1 pound or more. As such, USPS has moved most of its Priority 
Mail and larger mail pieces to a U.S. cargo carrier. Furthermore, since 
1980, revenue from transporting freight internationally has increased 
significantly for the major U.S. cargo carriers to about $3.6 billion 
in 2004 (see figure 3). This increase was due in large part to the 
demand for worldwide express and expedited delivery services. In 
comparison, revenues from transporting freight internationally for the 
major U.S. passenger carriers were about $1.3 billion in 2004.

Figure 3: International Freight Revenues For the Major U.S. Cargo 
Carriers Has Been Increasing:

[See PDF for image]

[End of figure]

As freight revenues for these carriers have been increasing, the 
percentage of domestic carrier operating revenues from mail has 
decreased (see Figure 4). In regards to DOT-regulated international air 
mail, however, USPS stated that its costs paid to domestic carriers' 
for this segment of mail have more than doubled, from $216 million in 
fiscal year 2000 to almost $445 million in fiscal year 2004.

Figure 4: Mail Revenue as a Percentage of Total Operating Revenue for 
U.S. Carriers Has Been Decreasing:

[See PDF for image]

[End of figure]

Potential Implications of Market Changes on Current Rate-setting 
Process:

Although changes in the market have moved toward more competition since 
1978, the rate-setting process has not been updated to reflect these 
changes. DOT's process for annually updating the rates involves 
reviewing cost and volume data submitted by the air carriers and 
incorporating this data into the methodology established by CAB. Some 
potential implications that may result from using a methodology that 
has not fully incorporated these changes are that the rate-setting 
process may not reflect a competitive, efficient, and service-oriented 
market. Therefore, postal customers, including DOD, may not be 
benefiting from potential cost-saving opportunities and may be paying 
higher rates than necessary. Specifically:

The process is inconsistent with deregulated and competitive markets. 
According to DOT officials, the system may not reflect current 
accounting and economic principles. DOT has raised questions about how 
effectively the update process incorporates changes in carrier costs. 
USPS has raised concerns that the system is inconsistent with its rate- 
setting process for negotiating domestic mail transportation rates. 
USPS believes that its inability to contract for and receive more 
market-based competitive rates may result in loss of international 
market share. In addition, the U.S. cargo carrier we met with stated 
that the current rate-setting process is not needed and expressed 
concern that the process is unlikely to achieve a true market-based 
competitive rate. On the other hand, the three passenger carriers we 
met with raised concerns that some segments of the international 
transportation market are still not sufficiently competitive. For 
example, they noted that some foreign governments have operational 
restrictions, such as limitations on U.S. carrier access to certain 
routes. They also told us that some foreign governments provide 
subsidies to their national air carriers, which give these air carriers 
an unfair advantage in terms of the rates they could charge for 
transporting mail and cargo. Further, they all had concerns that USPS 
would unfairly leverage its government mail monopoly when negotiating 
for international mail transportation contracts. To offset these 
limitations, these carriers believe that some level of regulation is 
needed.

The process does not provide sufficient incentives for efficiency 
gains. The current statutory requirements and rate-setting process 
limit the ability of stakeholders to achieve potential efficiency 
gains. For example, under the current statutory requirements, in order 
to be eligible to transport the segment of USPS' international mail 
subject to DOT rate-setting, U.S. air carriers are required to make 
available the facilities and services necessary to do so. This may 
result in duplicative costs because USPS already has facilities nearby 
at many of these departure locations. Furthermore, the current rate 
structure does not require USPS to submit known volumes or mail in a 
containerized form--two actions that may result in more efficient mail 
transportation. These components are typically negotiated between the 
customer and the air carrier in transportation contracts, particularly 
for USPS in its domestic mail air transportation contracts. Thus, USPS' 
ability to provide variable amounts of mail in a noncontainerized 
manner results in additional costs for the air carriers and higher 
rates charged to USPS. These cost increases may be directly passed on 
to international postal ratepayers. The current rate-setting process 
may also not provide the necessary incentives to air carriers to seek 
cost-saving approaches (either by actually cutting costs or by 
reporting lower costs to DOT) because the higher costs they incur and/ 
or submit will be reimbursed through higher rates charged to USPS.

The process does not reflect customer (USPS) service demands. USPS 
raised concerns about the quality of service it receives and noted that 
few incentives exist in the current process for air carriers to provide 
better quality service. For example, USPS reported that service 
problems are of a greater concern now because, under new arrangements 
with foreign postal administrations, USPS can be penalized if service 
performance standards, such as timeliness of delivery, are not met. 
USPS also noted that U.S. carriers do not always have schedules that 
meet mail service requirements or provide sufficient capacity. Further, 
USPS said that it has only limited methods to correct service issues; 
and it has to pay rates for some services that it does not need (e.g., 
priority boarding associated with the duty-to-carry requirement), which 
results in costs higher than necessary. USPS would prefer rates similar 
to cargo market rates for similar products and would prefer to be able 
to negotiate service loads. The passenger carriers stated that they 
provide services for USPS that are required by law; and because the 
services are significantly different from what they typically provide 
other customers, they incur higher costs. These higher costs must be 
reflected in rates that are higher than the rates some other customers 
are charged.

The Provisions in the Recent Postal Reform Bill to Change the Rate- 
setting Process and Stakeholder Views of this Change:

Congress has recently proposed making a substantive change in how rates 
are set for the segment of international mail currently regulated by 
DOT. Provisions in the recent postal reform bill (S. 662, §1002) would 
end DOT's responsibility for setting rates and grant USPS the 
flexibility to negotiate with both U.S. and foreign air carriers under 
certain conditions about the rates and services to be used in 
international mail air transportation. Section 1002 would also repeal 
some of the current service requirements, such as duty to carry for 
U.S. carriers, and require foreign carriers to be authorized by DOT. 
Further, it sets forth a "reciprocity" provision which specifies that 
each contract awarded to a foreign air carrier shall be subject to the 
requirement that U.S. air carriers be provided the same opportunity to 
carry mail of the country to and from which the mail is transported 
and, if different, the flag country of the foreign carrier. Section 
1004 provides congressional guidance for USPS to protect contractors 
and suppliers by ensuring fair and consistent treatment in its 
purchasing policies. Stakeholders have voiced divergent views of these 
changes, with USPS and the cargo carrier generally supporting them; the 
three U.S. passenger carriers we met with strongly opposed them. While 
DOT has not taken a position on the current legislative provisions, it 
has in the past supported legislative proposals to remove DOT from the 
rate-setting process. Table 4 summarizes selected provisions in this 
legislation related to rate-setting for international mail air 
transportation rates.

Table 4: Selected Provisions Included in S. 662, the Postal 
Accountability and Enhancement Act:

Citation: S. 662, §1002; 
Summary provision: USPS may contract rates and service terms with U.S. 
or foreign air carriers for the transportation of mail by aircraft in 
foreign air transportation, either through negotiations or competitive 
bidding, except that: 

* Contracts can only be awarded to air carriers that are authorized by 
DOT to provide air transportation; 
* Mail transported under such a contract is not subject to any duty-to-
carry requirement; 
* USPS cannot contract for service in foreign air transportation or 
tender mail to or with a foreign carrier or an air carrier in a code-
sharing arrangement where the air carrier's code is used to identify a 
flight operated by a foreign air carrier, for a period of 5 years 
beginning 1 year after enactment of the proposed legislation, subject 
to certain exceptions; 
* Beginning 6 years after enactment of the proposed legislation, every 
contract that USPS awards to a foreign air carrier shall be subject to 
the requirement that U.S. air carriers be provided the same opportunity 
to carry mail of the country to and from which the mail is transported 
and the flag country of the foreign air carrier, if different, as USPS 
had afforded the air carrier; 
* The Postmaster General must consult with the Secretary of Defense 
concerning actions that affect the carriage of military mail in foreign 
air transportation.

Citation: S. 662, § 1004; 
Summary provision: Congress wants USPS to ensure the fair and 
consistent treatment of contractors under USPS purchasing policies and 
procedures, and to implement commercial best practices in its 
purchasing policies to achieve greater efficiency and cost savings, as 
recommended by the President's Commission.

Source: S. 662.

[End of table]

USPS, DOT, and Air Carriers Have Divergent Views of the Proposed 
Changes to the Rate-setting Process:

Stakeholders have voiced divergent views on these potential changes and 
their implications. USPS and a U.S. cargo carrier generally support the 
changes to move toward a negotiated, competitive process in contracting 
for international mail air transportation rates because they feel that 
this system would result in market-based rates and service. The 
passenger air carriers that we met with, however, prefer the current 
DOT rate-setting process. These carriers are opposed to the changes 
because they have concerns about restrictions on competition that exist 
in international mail and transportation markets, as well as about 
USPS' ability to ensure fair and consistent treatment in its 
contracting practices.

Issues Related to Competition in International Mail and Air 
Transportation Markets:

USPS supports these provisions and would like to establish a 
competitive contracting environment for this segment of international 
mail. USPS stated that the proposed changes could address its concerns 
mentioned previously regarding the current rate-setting process. The 
officials believe that negotiating rates and services will enhance 
innovation, provide incentives for improved service performance, and 
allow USPS to better compete in the global postal marketplace. 
Specifically, USPS stated that this new rate-setting system will help 
it to meet its contracting objectives, which include achieving greater 
service performance, improving document control, and reducing 
transportation costs. USPS stated that experience suggests that 
allowing foreign carriers to participate in transportation contracts 
would stimulate competition and result in lower prices. The U.S. cargo 
carrier that we met with told us that it also supported the changes 
because they would establish a competitive contracting process that 
would likely result in true market-based rates and services. DOT has 
not taken a position on the current legislative provisions. However, in 
the past, DOT has supported legislative proposals that would have ended 
what it characterized as its outdated role in setting rates for 
transporting international mail. DOD officials we spoke with stated 
that to the extent that USPS would benefit from a reduced rate 
structure, the costs of transporting military mail should also 
decrease. DOD officials also stated that to the extent that USPS would 
receive equal or better services, DOD would expect to share in that 
equal or better service.

The passenger air carriers we met with oppose the proposed changes to 
DOT's rate-setting authority because they believe that some parts of 
the international mail air transportation market are not competitive 
enough to ensure market-based competitive rates. These carriers noted 
that the reciprocity provision would not provide a level playing field 
for the U.S. carriers or ensure that U.S. carriers have access to 
foreign markets. They noted that certain international air 
transportation remains regulated due to flight restrictions, route 
restrictions, and foreign country restrictions that limit U.S. 
carriers' ability to fly mail to or from certain foreign countries. 
These carriers also stated that this proposal would unfairly benefit 
foreign carriers because there is significantly more outbound USPS mail 
than incoming mail to the United States from other foreign postal 
administrations. Another disadvantage they cited that would affect the 
competitive position of the U.S. airlines in the international air 
transportation marketplace is that some foreign air carriers are 
subsidized by their governments. One U.S. passenger carrier, in 
particular, raised concerns that foreign carriers have not had to make 
similar capital investments in facilities or equipment to process and 
transport USPS international mail. This carrier stated that the 
proposed change would ultimately have three consequences: (1) it would 
cause U.S. air carriers to lose revenue, (2) more international mail 
would travel on foreign carriers, and (3) customers would not receive 
better service even if the international mail rates decrease.

Issues Related to Fairness in USPS' Contracting Practices:

The U.S. passenger carriers that we met with also raised concerns about 
USPS leveraging its monopoly in ways that could result in unfair and 
inconsistent USPS contracting practices. Specifically, one carrier told 
us that its concerns have arisen from negative experiences in other 
areas where USPS has been granted unfettered contracting authority for 
the domestic transportation of mail. All of the carriers felt that the 
current processes USPS uses, as outlined in the USPS Purchasing Manual, 
do not provide adequate protections for the carriers if USPS breaches a 
transportation contract. These carriers contend that USPS has 
unilaterally changed the terms of domestic mail transportation 
contracts.

However, when asked about ensuring fair and consistent treatment under 
its proposed expanded contracting authority, USPS stated that 
appropriate competition will be ensured, similar to how it is provided 
under the competitive contracting for other international mail 
segments. USPS officials noted that U.S. carriers are still the primary 
contractors for most of these contracts and that DOT has not 
disapproved any of the contracts for this type of mail. Further, an air 
carrier stated that under the proposed changes, if USPS requests for 
price and service terms are unreasonable, it may not receive 
competitive bids that could result in lower costs.

Provisions in S. 662 Related to International Mail Air Transportation 
Rate-setting Incorporate Key Principles:

We analyzed the provisions in the proposed postal reform legislation 
and compared them with key principles of balancing flexibility, 
efficiency, and fairness that we and the Commission recognized are 
important when postal reform is considered and found that the proposed 
provisions are consistent with these principles. We have testified and 
reported on multiple occasions that we support postal reform 
legislation that would provide USPS additional flexibility to act in a 
more efficient, businesslike manner along with appropriate 
accountability mechanisms to ensure fairness.[Footnote 11] Similarly, 
the Commission's report called for USPS to take advantage of corporate 
best practices to improve overall efficiencies, and stated that in 
instances where USPS is granted additional flexibility, mechanisms are 
needed to ensure fairness and transparency in USPS operations.[Footnote 
12] Although we found that the provisions in S. 662 related to setting 
rates for international mail air transportation are consistent with 
these key principles, additional congressional oversight may be needed 
to ensure that a balance of flexibility, fairness, and efficiency is 
maintained under this new contracting authority.

These provisions in the recent postal reform legislation give USPS the 
flexibility to utilize private sector best practices to improve overall 
efficiencies. Flexibility and efficiency are consistent with what we 
have reported in our prior work and with the Commission's report that 
USPS needs to increase overall postal efficiencies--both in terms of 
cutting costs as well as improving service. The additional flexibility 
granted to USPS to negotiate with carriers (both U.S. and foreign) 
about rates and services may help to promote a more successful and 
efficient contracting system--one that balances the current service 
needs of the customer with rates that reflect the actual costs incurred 
to meet those needs. To the extent that the proposed change to 
competitive negotiations helps to drive out inefficiencies in the 
current system, customers should benefit from paying market-based rates 
that are commensurate with the services that are being provided.

In addition, the postal reform legislation contains proposals aimed at 
ensuring fairness and consistency in contracting practices that are 
consistent with our prior work and the Commission's report. In 
instances where USPS is granted additional flexibility, this 
flexibility is coupled with accountability and transparency to help 
facilitate fair and consistent treatment of consumers and contractors. 
We have previously stated that postal reform legislation should clarify 
USPS' mission by defining the scope of the monopoly to ensure that it 
competes fairly. The legislation should also provide enhanced oversight 
to protect postal customers and competitors against undue 
discrimination. The postal reform legislation in section 1004 includes 
a statement on the sense of Congress that suppliers and contractors be 
treated fairly and consistently. Section 1004 promotes specific 
mechanisms, such as competitive contract award procedures, effective 
dispute resolution mechanisms, and socioeconomic programs, to improve 
fairness and access to contracting opportunities. Further, section 1002 
contains other provisions, such as a 5-year transition period during 
which foreign air carriers are restricted in competing for USPS 
contracts, as well as the reciprocity provision. We have not examined 
USPS contracting practices to determine how the concerns of the 
passenger carriers we met with related to USPS' contracting practices 
need to be addressed. We have been asked to review USPS' proposed 
changes to its contracting procedures and are in the process of 
determining if further congressional oversight or other mechanisms may 
be needed to ensure that a balance of flexibility, fairness, and 
efficiency is maintained.

Agency Comments and Evaluation:

USPS and DOT provided oral comments on a draft of this report. USPS 
agreed with the message of our report, while DOT stated that it has not 
established a position on the current legislative provisions related to 
setting rates for international mail air transportation. We also 
incorporated technical comments from USPS where appropriate.

Scope and Methodology:

To provide information on the current rate-setting process, how the 
international mail air transportation market has changed over time, and 
the potential implications of these changes, we met with DOT officials 
and various stakeholders, such as USPS, DOD, the Air Transport 
Association, three U.S. passenger carriers, and one U.S. cargo carrier. 
These carriers also participated in recent efforts to improve the 
current rate-setting process. We also reviewed current legal provisions 
related to USPS' contracting authority for international air 
transportation rates subject to DOT; DOT rate-proceeding documents, 
including DOT orders and submissions from USPS and various U.S. 
airlines; and the President's Commission on the U.S. Postal Service 
report. To provide quantitative data on the various segments of USPS 
mail, we reviewed USPS' periodic reports and financial statements and 
discussed the specific operating and financial information with USPS 
officials. USPS officials then supplemented this data with other volume 
and cost information related to DOT-regulated mail, which we also 
reviewed with them. The DOT financial and operating data was generated 
from a database that GAO recently reviewed. On the basis of these 
efforts, we determined that the data provided to us was sufficiently 
reliable for the purposes of our review.

To identify the proposed legislative changes to USPS' contracting 
authority and the views of key stakeholders, we interviewed officials 
from DOT, USPS, the Air Transport Association, three U.S. passenger 
carriers, and one U.S. cargo carrier. These carriers have been active 
in congressional discussions regarding proposed legislative changes in 
this area. We also reviewed the contents of current and previous postal 
reform legislation, as well as any pertinent legislative history, 
committee reports, or DOT and stakeholder comments.

To assess the proposed changes to USPS' contracting authority, we 
applied certain principles found in past GAO reports and testimonies 
and in the Commission's report. These principles are related to the 
major transformation goals for postal reform legislation and include 
balancing increased flexibility for USPS to act more like a business 
along with appropriate accountability mechanisms to ensure fairness to 
customers and competitors. Another key principle is to enhance 
incentives to improve efficiency by utilizing best practices from the 
private sector. We conducted our work from February 2005 to April 2005 
in accordance with generally accepted government auditing standards.

We are sending copies of this report to the Chairman and Ranking 
Minority Member of the House Committee on Government Reform, Ranking 
Minority Member of the Senate Committee on Homeland Security and 
Governmental Affairs, Senator Thomas R. Carper, the Secretary of the 
Department of Transportation, the Postmaster General, and other 
interested parties. We will also provide copies to others on request. 
This report will also be available on our Web site at no charge at 
http://www.gao.gov.

If you have any questions regarding this report, please contact me at 
siggerudk@gao.gov or by telephone at (202) 512-2834. Major contributors 
to this assignment included Teresa Anderson, Joshua Bartzen, and Tonnye 
Conner-White.

Sincerely yours,

Signed by: 

Katherine Siggerud:

Director, Physical Infrastructure Issues:

(542061):

FOOTNOTES

[1] U.S. Postal Service: Key Reasons for Postal Reform, GAO-04-565T 
(Washington, D.C.: March 23, 2004).

[2] There are three types of military mail: (1) Military Ordinary Mail 
(MOM) that is official military mail, (2) Space-Available Mail (SAM) 
that is military personal mail, and (3) Military Priority Mail.

[3] 49 U.S.C. §40118.

[4] According to USPS officials, the amount paid to foreign carriers 
does not reflect the amounts paid to them under any code-sharing 
agreements they have with U.S. carriers. Under these agreements, USPS 
would pay the U.S. carrier the DOT-set rate for transporting the mail, 
the mail is transported on a foreign air carrier, and the U.S. carrier 
pays some portion of their compensation to the foreign carrier. 

[5] According to DOT, the fully-allocated cost methodology allocates 
all the expenses associated with the assets, materials, services, and 
labor required to transport mail on the basis of the percentage of mail 
traffic to total traffic--mail, passengers, and cargo.

[6] Discussion of International Mail Rate Methodology, Before the 
Department of Transportation, Office of the Secretary, Washington, D.C; 
December 1, 2003 (DOT Docket OST-96-1629).

[7] According to USPS, marginal cost allocation methodology reflects 
the additional costs incurred by carriers for handling and transporting 
USPS mail, as well as some general and administrative expenses and 
profit component. Notice of the United States Postal Service of Filing 
of Supporting Data, Before the Department of Transportation, Office of 
the Secretary, Washington, D.C; December 30, 2003 (DOT Docket OST- 1996-
1629).

[8] Comments on the USPS Proposal and Supporting Analysis Regarding 
International Mail Rates. Mercer Management Consulting, March 10, 2004, 
(DOT Docket OST-96-1629).

[9] GAO, Transatlantic Aviation: Effects of Easing Restrictions on U.S.-
European Markets, GAO-04-835 (Washington, D.C.: July 21, 2004). 

[10] These facilities, extraterritorial offices of exchange (ETOE's), 
are offices that postal operators establish outside of their national 
territory to process and tender international mail. 

[11] GAO-04-565T; Need for Comprehensive Postal Reform, GAO-04-455R 
(Washington, D.C.: Feb. 6, 2004); U.S. Postal Service: Key Elements of 
Comprehensive Postal Reform, GAO-04-397T (Washington, D.C.: Jan. 28, 
2004); U.S. Postal Service: Bold Action Needed to Continue Progress on 
Postal Transformation, GAO-04-108T (Washington, D.C.: Nov. 5, 2003).

[12] President's Commission on the United States Postal Service, 
Embracing the Future: Making the Tough Choices to Preserve Universal 
Mail Service, (Washington, D.C.: July 31, 2003).