Select Committee on Transport, Local Government and the Regions Appendices to the Minutes of Evidence


Supplementary memorandum by Railtrack (PRF 38A)

PASSENGER RAIL FRANCHISING AND THE FUTURE OF RAILWAY INFRASTRUCTURE

Should Railtrack's successor emerge from administration in the same form (albeit with different ownership) as the old company?

  For pragmatic reasons, the successor should emerge in broadly the same form. Indeed, major changes to the core functions of the business could not be achieved without a major, complicated and time-consuming restructuring of the entire industry. It would not be possible to hold the key management skills in place long enough to do this. Most of our activities are inextricably interlinked with others in the industry—for example the planning of trains, engineering work and the operation of the network. This further increases the difficulty of undertaking any restructuring of Railtrack, in isolation. The Government requirement to limit the duration of administration also militates against significant change to the form of Railtrack.

  Effort therefore needs to be focused on ensuring that the successor can succeed in this form; through continuing the development of robust plans for maintaining a high quality reliable infrastructure, along with associated estimates of the costs and risk of achieving this. These need to be supported by the comprehensive asset management information system and other management tools that are currently being developed, and introduced throughout all contractors, over a three-year time horizon. This will give the control and intellectual ownership that Railtrack has never had. A sustained period of high investment will be required—whatever the form of successor—to make good the legacy of Treasury-imposed under-investment over several decades.

  Some have commended vertical integration with TOCs, or regional infrastructure companies. These may be longer-term possibilities—indeed, Railtrack wished to trial these—but not for now, to avoid distraction from the activities mentioned above. Any proposals of this kind would need to be assessed against EU rail legislation which requires the separate allocation of certain responsibilities to "infrastructure managers", and "railway undertakings" (train operators).

What are the key issues regarding the interaction between train and infrastructure operation that should be addressed in the new structure for Railtrack's successor?

  As noted above, there is a need to maintain the same industry structure at least for the time being. It is clear that more focus should be brought to bear on the need to manage railways from the perspective of being a whole system. This focus might be achieved through a combination of integration of businesses, improved regulatory and commercial relationships, and better approaches to cross-industry working.

  However, the current institutional structure produces inconsistency in the manner in which the Government/SRA funded requirements are set for train operators and the network operator. In the case of train operators, the requirements are set by the SRA in franchise agreements for periods ranging from one year to 15 years. Outputs for the network operator are determined by the Rail Regulator, together with their remuneration and incentives, for a period of five years. Hence, the objectives and incentives of train operators and the infrastructure operator are in permanent overlap. It is this mismatch, and the failure to synchronise franchising and periodic reviews, which has resulted in misaligned incentives.

What is the most appropriate basis for funding Railtrack's successor? Should all of the money come from track access charges or should some come directly from Government/SRA?

  Following the periodic review we received payments from the SRA via two routes: (i) direct grants, and (ii) access payments underwritten by SRA. There is little apparent logic behind this split of remuneration which had no significance for operators, the travelling public or Railtrack. A simpler and more transparent approach would be to put in place a long-term contract including direct funding between the public sector and Railtrack's successor. This would remunerate the same baseline scope, quality and costs of the national network, which formed the focus of the periodic review. The principal role of track access charges should be to recover from operators the marginal costs associated with their use of the network, including any costs arising from scarce capacity.

  It is essential that a buffer, or financial reserve, is created if the successor to Railtrack is to bear any risks, and if every cost variation is not to be met by automatic variations (or even worse, bureaucratically agreed variations) to subsidy. This buffer, and the extent of risk transfer it brings, will cost the taxpayer money to secure, whatever may be the details of capital structures and interest and, if applicable, dividend payment policies. The buffer could be a combination of retained earnings (from higher levels of subsidy payments), subordinated debt or equity. Government must determine which will deliver a more efficient approach to managing the relevant industry risks, and consequently providing longer-term benefits to the taxpayer and travelling public. If not equity, the Treasury will, in practice, always have to pick up the tab.

  There appears to be a misunderstanding in Government on levels of risk over the next three or four years. It is not the case that if new major commitments are given to SPVs, the residual risks of Railtrack's successor are "low". They are "high", partly due to the poor state of infrastructure, and also because the predictive tools previously referred to will take around three years to introduce. This has huge implications for risk, whatever the transfer model adopted.

What should the division of responsibilities be between the SRA and the Rail Regulator?

  The current split of responsibilities has proved confusing and unworkable.

  The SRA should be the principal agency within Government that sets the output requirements for the publicly funded railway network. The focus of the SRA should be balanced (eg safety, operation and maintenance) and not just related to enhancement and upgrade priorities. Consistent with this, one would expect the Regulator to have no role in determining the level of the outputs that the SRA requires of the network operator for the public funds it wishes to make available. Rather, it is for the Regulator to determine an efficient price for delivering these outputs.

  Independent regulation of the industry is likely to be necessary in most models of industry structure. Government must be seen to rebuild confidence in the independence of Regulation. The activities of regulation should be confined to two distinct areas:

    (i)  economic regulation of the monopoly elements in the industry—principally to allow the network operator and (where not covered in their franchise bids) train operators, the right to seek an independent (periodic) assessment of the level of efficient costs at which they should be expected to deliver the outputs required of them; and

    (ii)  ensuring fair play between train operators and the network operator in the ongoing provision of services.

  The first should be conducted within a single organisation responsible for regulation of both train operators and the infrastructure manager—unlike the current arrangements with different bodies regulating train operators and Railtrack. Combining the functions within an SRA also responsible for specifying output requirements for the network would be feasible—providing there remains a right of appeal to an independent body such as the Competition Commission.

  The second role, involving approval of track access agreements and adjudicating on disputes, could be performed by a separate body. However, it would be worth considering whether there remains a case for requiring individual regulatory approval of track (and other) access agreements, which has been a distinguishing characteristic of the domestic regulatory regime in rail. If, instead, these agreements were merely regulated by the Competition Act, the role of this regulatory body would be limited to the adjudication of disputes (perhaps building on the current industry disputes resolution mechanisms).

  Uncontrolled and overbearing regulation by competing bodies—and the lack of effective co-ordination between ORR and SRA—are among the problems which have led to the present situation. For the successor to Railtrack to succeed requires significant reform on the current structure of industry regulation.

Is it sensible to separate responsibility for enhancement projects from that for the operation of the network as is proposed with the use of Special Purpose Vehicles?

  There are significant issues with the proposed use of SPVs or major enhancement schemes. These are quite apart from the untested nature of the SPV proposition—unlikely to happen in practice before 2003/04, despite being the main plank of Government policy.

  First, the SPV needs to undertake investment when most projects involve integrated renewal and enhancement programmes on the network. Such schemes would require the renegotiation of the pre-existing maintenance and renewal contracts.

  Secondly, where SPVs undertake upgrades, the question of which party efficiently takes the associated risks on safety and train performance on operational parts of the network needs to be resolved.

  Experience on the WCML demonstrates the contractual complexities of upgrading an existing operational railway. SPVs require a rigorous process of ensuring that the contractual interfaces and risk allocations are well understood by all parties in developing proposals or upgrading the network. Whether this additional complexity is manageable will depend very much on the nature of the scheme. SPV structures would be much more straightforward on green field developments—such as on the Channel Tunnel Rail Link and also on stations and depots—which are not themselves part of the core multi user network.

  There is a direct link here to the earlier financing question. It is likely that some important elements of risk associated with big upgrades will be required to be borne by the network operator, for SPVs to be financeable at acceptable value for money. This implies the need for a further "risk cushion" in Railtrack's successor, either in the form of hard Treasury funding guarantees or equity.

  In the event that SPVs cannot be proven to work in the more complex cases, the logic for separating responsibility for enhancement projects from the operation of the network is weakened.

John W Smith

Director of Regulation & Government

19 November 2001


 
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