International Mail Air Transportation: Proposed Changes to the	 
Rate-setting process (08-APR-05, GAO-05-529R).			 
                                                                 
Provisions in the Senate's proposed postal reform legislation,	 
the Postal Accountability and Enhancement Act, 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, 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.			 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-529R					        
    ACCNO:   A21237						        
  TITLE:     International Mail Air Transportation: Proposed Changes  
to the Rate-setting process					 
     DATE:   04/08/2005 
  SUBJECT:   Air transportation operations			 
	     Competition					 
	     Financial analysis 				 
	     Interagency relations				 
	     Mail transportation operations			 
	     Postal rates					 
	     Proposed legislation				 
	     Transportation rates				 
	     Mail processing operations 			 
	     Stakeholder consultations				 

******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO Product.                                                 **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
******************************************************************
GAO-05-529R

United States Government Accountability Office Washington, DC 20548

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
Ratesetting Process

Dear Chairman Collins:

Provisions in the Senate's proposed postal reform legislation, the Postal
Accountability and Enhancement Act (S.662 S: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

               GAO-05-529R International Mail Air Transportation

related to setting rates for international mail air transportation (S. 662
S: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.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.

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

Table 1: Selected Provisions Related to International Mail Air
Transportation

               Provision            Citation                      Description 
                                             U.S. air carriers must provide   
U.S. air carrier duty                     the service and facilities to    
      to carry mail.       49 U.S.C. S:41903 transport international mail     
                                             tendered by USPS up to the       
                                             maximum load prescribed by DOT.  
                                             Requires the Secretary of the    
    DOT's authority to   49 U.S.C.           Department of Transportation to  
    set rates for U.S.   S:41901(b)(1)       set reasonable prices that USPS  
       air carriers                          will pay U.S. air carriers to    
                                             transport international mail.    
                                             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    
     USPS contracting           39 U.S.C. S: mail, by weight, can be letter   
authority-bulk mail.              5402(b) 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.       
                                             When USPS determines             
                                             transportation of mail by        
                                             aircraft is required between     
                                             points in foreign air            
                                             transportation where no U.S. air 
     USPS contracting                        carrier has been authorized by   
        authority-       39 U.S.C. S:5402(c) DOT, USPS may contract with any  
unavailable service.                      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.                  
                                             When USPS determines that        
                                             service by U.S. air carriers in  
                                             foreign air transportation is    
     USPS contracting                        not adequate for its purposes,   
authority- inadequate 39 U.S.C. S:5402(d) it may contract under certain    
         service.                            conditions with any air taxi for 
                                             transportation. USPS must cancel 
                                             the contract when adequate       
                                             transportation by U.S. air       
                                             carriers becomes available.      
                                             USPS can make arrangements with  
                                             foreign air carriers when it     
                                             determines that the transport of 
    Use of foreign air                       mail by aircraft to a foreign    
         carriers          49 U.S.C. S:41904 country is necessary. This       
                                             authority has historically been  
                                             used in situations in which U.S. 
                                             air carrier service is           
                                             inadequate.                      

Source: GAO.

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.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.3 Other types of international mail that are not subject
to DOT ratesetting 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.

2There 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. 349 U.S.C.
S:40118.

Table 2: Mail Volume and Weight for Fiscal Year 2004

                                           Percent of Mail weight  Percent of 
     Mail category    Mail volumes (in     total mail (in millions total mail 
                     millions of pieces)    volumes    of pounds)    weight   
    Domestic maila             205,261,930      99.6%   25,055,323      99.1% 
    International                  711,566       0.3%      147,838       0.6% 
mail-DOT rates                                                  
     International                               0.1%                    0.3% 
        mail-other                 132,248                  80,787 
    Total all mail             206,105,744       100%   25,283,949       100% 

Source: USPS.

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

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

                                       4

foreign carriers were paid $110 million. 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

5

rates would be updated on the basis of changes in operating expenses. 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

4According 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. 5According 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.

transportation rates with DOT.6 According to USPS' supporting analysis,
mail rates were substantially overstated when compared with the marginal
cost allocation methodology that USPS advocated.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.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.

6Discussion 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).7According 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).8Comments on the USPS Proposal and
Supporting Analysis Regarding International Mail Rates. Mercer Management
Consulting, March 10, 2004, (DOT Docket OST-96-1629).

These changes include:

o  	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.9

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

Number of flights (in thousands)

800

700

600

500

400

300

200

100

0

Calendar year

International revenue generating flights

Source: GAO analysis of DOT data.

o  	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

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

1980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004

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 Type of deregulation Date of action 
U.S. airline deregulation: The Airline                                     
Deregulation Act of 1978 ended the                          
Civil Aeronautics Board's (CAB)           Transportation      1978-1984
regulation of the airline industry in                       
several phases.                                             
USPS contracts for certain                                                 
international bulk mail: USPS                               
introduces International Surface Air                        
Lift (ISAL) service contracts under                         
which USPS contracts for reduced-rate                  Mail           1980
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.                                        
USPS contracts for domestic air mail:                                      
Air transportation rates for domestic                  Mail           1984
mail service were deregulated with the                      
sunset of the CAB.                                          
Move towards deregulating                                                  
international routes and capacity:        Transportation        1980s1990s
United States and foreign countries                         
agree to more "open skies".                                 
USPS contracts for containerized                                           
international mail: USPS introduces                         
the International Air Transportation                        
(IAT) contracts to only U.S. carriers                  Mail           2003
for the transportation in airline                           
containers (rather than in loose                            
sacks) of international air parcels                         
and Express Mail.                                           

Source: USPS and DOT.

o  	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.

o  	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.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

Percentage of total mail revenue

4

3

2

1

0

Fiscal year

International mail revenue

Source: GAO analysis of USPS data.

o  	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.

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

1980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004

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

Millions of dollars 5,000

4,000

3,000

2,000

1,000

0

Calendar year

Freight revenue

Source: GAO analysis of DOT data.

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.

1980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004

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

Percentage of total operating revenue

4

3

2

1

0

Calendar year

Mail revenue

Source: GAO analysis of DOT data.

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:

o  	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 ratesetting 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

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

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.

o  	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.

o  	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 Ratesetting
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, S: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 ratesetting 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

                                Source: S. 662.
                              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:  o  Contracts                      
                              can only be awarded to air                      
                              carriers that are                               
                              authorized by DOT to                            
                              provide air                                     
                              transportation.  o  Mail                        
                              transported under such a                        
                              contract is not subject to                      
                              any duty-to-carry                               
                              requirement.  o  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     S. 
                      S. 662, identify a flight operated  662, 
Citation            S:1002 by a foreign air carrier,     S: 
                              for a period of 5 years     1004 
                              beginning 1 year after           
                              enactment of the proposed        
                              legislation, subject to          Congress wants
                              certain exceptions.  o           USPS to ensure
                              Beginning 6 years after          the fair and
                              enactment of the proposed        consistent
                              legislation, every               treatment of
                              contract that USPS awards        contractors
                              to a foreign air carrier         under USPS
                              shall be subject to the          purchasing
                              requirement that U.S. air        policies and
                              carriers be provided the         procedures,
                              same opportunity to carry        and to
                              mail of the country to and       implement
                              from which the mail is           commercial
                              transported and the flag         best practices
                              country of the foreign air       in its
                              carrier, if different, as        purchasing
                              USPS had afforded the air        policies to
                              carrier.  o  The                 achieve
                              Postmaster General must          greater
                              consult with the Secretary       efficiency and
                              of Defense concerning            cost savings,
                              actions that affect the          as recommended
                              carriage of military mail        by the
              Summary         in foreign air                   President's
            provision         transportation.                  Commission.

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 marketbased 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.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. 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.

11GAO-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).
12President'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).

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
[email protected] or by telephone at (202) 512-2834. Major contributors to
this assignment included Teresa Anderson, Joshua Bartzen, and Tonnye
Conner-White.

Sincerely yours,

Katherine Siggerud
Director, Physical Infrastructure Issues

(542061)

This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
its entirety without further permission from GAO. However, because this
work may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this material
separately.

                                 GAO's Mission

Obtaining Copies of GAO Reports and Testimony

The Government Accountability Office, the audit, evaluation and
investigative arm of Congress, exists to support Congress in meeting its
constitutional responsibilities and to help improve the performance and
accountability of the federal government for the American people. GAO
examines the use of public funds; evaluates federal programs and policies;
and provides analyses, recommendations, and other assistance to help
Congress make informed oversight, policy, and funding decisions. GAO's
commitment to good government is reflected in its core values of
accountability, integrity, and reliability.

The fastest and easiest way to obtain copies of GAO documents at no cost
is through GAO's Web site (www.gao.gov). Each weekday, GAO posts newly
released reports, testimony, and correspondence on its Web site. To have
GAO e-mail you a list of newly posted products every afternoon, go to
www.gao.gov and select "Subscribe to Updates."

Order by Mail or Phone 	The first copy of each printed report is free.
Additional copies are $2 each. A check or money order should be made out
to the Superintendent of Documents. GAO also accepts VISA and Mastercard.
Orders for 100 or more copies mailed to a single address are discounted 25
percent. Orders should be sent to:

U.S. Government Accountability Office 441 G Street NW, Room LM Washington,
D.C. 20548

To order by Phone: 	Voice: (202) 512-6000 TDD: (202) 512-2537 Fax: (202)
512-6061

                           To Report Fraud, Contact:

Waste, and Abuse in Web site: www.gao.gov/fraudnet/fraudnet.htm

E-mail: [email protected] Programs Automated answering system: (800)
424-5454 or (202) 512-7470

Gloria Jarmon, Managing Director, [email protected] (202)
512-4400Congressional U.S. Government Accountability Office, 441 G Street
NW, Room 7125 Relations Washington, D.C. 20548

Public Affairs 	Paul Anderson, Managing Director, [email protected] (202)
512-4800 U.S. Government Accountability Office, 441 G Street NW, Room 7149
Washington, D.C. 20548

                                   PRINTED ON
*** End of document. ***