An Post is facing fundamental change with rising competition in the letter post market set to pose a strong threat to profits, already described as "completely inadequate".

The European Commission is expected next week to seek the opening of some 30 per cent of the EU's mail business to competition from 2003 and unions at the State-owned company are to vote on a complex transformation agreement before the end of next month.

The company's current profit margins could not sustain the impact of competition in three year's time, so work practice changes under the transformation plan will be crucial.

An Post is also negotiating the future of its network of rural subpost offices, which it regards as unsustainable. The discussions are aimed at changing the Government's policy of not closing any rural outlets.

The proposed transformation agreement involves an employee share ownership plan (ESOP) giving some 14.9 per cent of the company, worth more than £22 million (€27.93 million), to its 8,500 staff. The stake will be granted in return for work changes, but no money will change hands, unlike ESOPs at other State companies. The Government has authorised An Post to enter a strategic alliance with another European operator, although it will be difficult, if not impossible, to secure a link if its business is not radically transformed.

"The ESOP is in the context of liberalisation and alliance," said An Post's chief executive, Mr John Hynes. But he continued: "I rate the prospect of an alliance at only 50/50 at this time."

The narrow field of possible partners includes Britain's Royal Mail, the publicly-quoted Dutch firm TPG and La Poste of France. A spokesman for Deutsche Post, the German firm which is to be floated this autumn, said the company was not involved in discussions on an alliance with An Post.

Asked about the possibility of a link with the Royal Mail, Mr Hynes said: "The partner with whom we have the strongest trading links is Royal Mail, so it would be very high on our list." But he declined to comment on whether An Post had started talking to the British firm.

Mr Hynes added, however, that the British company and La Poste were in weaker positions than their Dutch and German counterparts, which have or will have access to private capital as well as airborne delivery systems.

There are no plans to float An Post on the stock exchange at present, he said. The alternative to an alliance was for the company to go it alone in the short to medium term.

But this could leave An Post vulnerable to takeover, as it would lack the scale and resources needed to compete in a fully-liberalised European market, where operators in the larger states are already gearing up for full cross-frontier competition.

The proposals of the EU's Internal Market Commissioner, Mr Frits Bolkestein, must go before the EU Council of Ministers but the ministers have already called for greater liberalisation in postal markets, most recently at a summit in Lisbon last month.

Mr Bolkestein's proposals will be no less significant than the EU's liberalisation of the telecoms industry in the 1990s, which was also once dominated by slow-moving State monopolies.

There are three measures, which are likely to be applicable from 2003.

Firstly, Mr Bolkestein wants to reduce the letters monopoly to mail weighing less than 50 grammes, from the present 350 gramme limit. Mr Hynes argued this would be difficult to police as each mail item near the limit would have to be weighed individually, causing inefficiency.

An Post, the Royal Mail and La Poste have also lobbied for a gradual reduction of the limit, though other EU operators are in favour of the proposal.

Secondly, the entire direct mail market, usually for advertising material, will be opened to competition.

Thirdly, the entire market for outbound, but not inbound, cross-border mail within the EU will be opened.

According to Mr Bolkestein's spokesman, this would increase the scope of the open market from 3 per cent of EU mail to about 30 per cent. Mr Hynes claims as much as 45 per cent of An Post's business could be affected, because of outgoing international mail volumes.

Further changes are expected after an EU review which begins in 2004. "My understanding is that there is a political realisation in Europe that the industry will be fully liberalised," Mr Hynes said.

This will increase pressure on An Post, whose current margins of about 2 per cent have already been described as "completely inadequate" by Mr Hynes. Margins must rise to 7 or 8 per cent to compete against firms such as the Royal Mail or Deutsche Post, he has said.

These companies, TPG and other international operators are already competing with An Post in the parcels business and some, at least, could be expected to enter the letter post market.

Defending An Post's business against such competition would be difficult; the ESOP and transformation plan indicate that the company accepts this.

An internal document outlining details of the ESOP proposal, which has been seen by The Irish Times, states that the likely changes in 2003 will "significantly increase" An Post's exposure to competition. "This would represent a serious and significant challenge to the business of An Post to generate sufficient revenues going forward in the face of such a threat."

The main difficulty is that new entrants would engage in cherry picking - competing for business in cities, which have 76 per cent of mail volumes and 39 per cent of costs - while leaving unprofitable rural services to An Post.

While EU regulations allow for "compensation funds", in which market entrants would cross-subsidise traditional post office groups to provide universal service at a single price, Mr Hynes claimed it would be unworkable. He argued that a regulator should determine the scope of a "reserved area" which would allow An Post maintain rural mail services at a single price.

An Post's difficulties in the rural market do not end with the universal service obligation.

Questions about the viability of its network of 1,816 sub-post offices throughout the State have long been on the political agenda. The company's stance has been that it will operate within the confines of Government policy, which is against closures, but it is no secret that it regards many of these businesses as unsustainable. Some 1,100 of the sub-post offices generate just 14 per cent of An Post's turnover.

The company is involved in urgent discussions with the Irish Postmasters' Union about the sustainable development of the sub-post office network. These talks are being chaired by industrial relations consultant, Mr Phil Flynn.

Mr Hynes said it will be increasingly difficult for urban post offices to subsidise the rural network as the profits from larger outlets are falling. This is due to lower returns from social welfare payments, the post office savings bank, the television licence business and telephone bill payment services.

"There's no possibility of a cross-subsidy from urban post offices to rural post offices because we're not getting the margins." Citing the Government's "obligation" not to close rural outlets, he said: "The purpose of the talks with Phil Flynn is to square that circle, to find a means of discharging that obligation from the Government. "What's going on at the moment is unsustainable and it has the potential to bring down the entire business."