Memorandum by Tony Grayling Esq (PRF 50)
I am a senior research fellow at the Institute
for Public Policy Research (IPPR), an independent think tank on
the progressive left. I am currently engaged in a research project
on reforming the ownership and regulation of Britain's railways.
Since the tragic rail accident at Hatfield last year and its disastrous
consequences for the industry, I have advocated transferring the
ownership of Railtrack to a not-for-profit trust or company (Grayling
2001a, b and c), which has been adopted by IPPR as part of its
policy agenda (IPPR, 2001). The report of the IPPR's Commission
on Public Private Partnerships (CPPP) also recommended that for
public enterprises where there is a high degree of natural monopoly
and public interest objectives such as safety are paramount, then
a trust model would be appropriate (CPPP, 2001).
IPPR therefore welcomes the government's preferred
option for the new operator of Britain's rail network to be a
not-for-profit company limited by guarantee. We believe that,
properly designed and integrated with the other parts of the industry,
the establishment of a not-for-profit network operator is an important
step in getting the railways back on track but it is one of a
number of steps. This memorandum, extracted from a forthcoming
IPPR publication "Getting back on trackreforming the
ownership and operation of Britain's railways" aims to explain
why a not-for-profit model is the best option and to discuss aspects
of its governance, finance and structure.
There is a consensus that there are serious
problems with Britain's railways but less consensus on the causes,
although everyone appears to agree that there has been long-term
under-investment. In addition to under funding, the problem with
the railways has been attributed to privatisation, fragmentation,
regulation and sheer bad management.
A widespread perception is that the railways
have got worse since privatisation but this does not wholly correspond
to the facts. Until Hatfield, there was a 40 per cent increase
in passenger use and a 50 per cent increase in freight carried
since 1995. The drivers of these increases were largely external
to the industry, including economic growth resulting in more trade
and travel and rising road traffic congestion making railways
a relatively more attractive option, although fare regulation
also played a key role by keeping down average fare increases
(DETR, 2000a). If growth was not mainly caused by privatisation,
then at least it did not stand in the way. Given the complex reorganisation
involved, this might be seen as a remarkable outcome. The performance
of the train operating companies measured by passengers charter
standards of punctuality and reliability was highly variable but
overall slightly better than in the last years of state ownership.
Notwithstanding the major fatal accidents at Southall, Ladbrooke
Grove and Hatfield, overall standards of railway safety as measured
by the number of serious incidents endangering life and property
gradually improved, continuing the long-term trend (HSE, 2000;
Cullen, 2001). This is not to diminish the problems. Performance
indicators can provide perverse incentives and conceal underlying
weaknesses. There was evidence of deterioration in track quality
and major accident investigations have revealed serious deficiencies
in the conduct of safety. Nevertheless, reform must be careful
not to throw the baby out with the bath water. Privatisation arguably
introduced some useful innovations, including the regulation of
key fares, minimum service requirements, the passengers charter,
the national rail enquiry service, access to private finance for
investment and competition as a driver for efficiency and customer
focus. None of these is perfect and no doubt all could be improved.
It is arguable that all of these features could have been introduced
within a framework of public ownership but they were not.
Hatfield exposed serious deficiencies in Railtrack's
stewardship of the network, its failure to replace a stretch of
track it knew was in need of repair and moreover its ignorance
of the condition of the network as a whole. Consequently, as a
precautionary measure, over the subsequent days and months it
imposed more than 1,000 speed restrictions across the network,
many of 20 mph. Railtrack has haemorrhaged money in lost revenue,
compensation payments to train operators and extra costs of track
replacement. Hundreds of miles of track have now been replaced
and the speed restrictions progressively lifted but services have
yet to recover to pre-Hatfield standards. Railtrack's financial
problems have been compounded by escalating costs of upgrading
the west coast main line, which have increased from the initial
estimate of £2.3 billion now to more than £7 billion.
Even with an advance of £1.5 billion from government over
the next five years, in addition to nearly £5 billion in
direct grants already promised, Railtrack was fast going bust.
Well before Hatfield, the rail regulator, Tom
Winsor, was trying to force Railtrack to improve its stewardship
of the network, including the use of fines and enforcement orders.
His diagnosis was that Railtrack had been privatised in 1996 in
haste, with weak regulation, poor contracts with the train operators
and limited financial incentives to grow its business. The Public
Accounts Committee of the House of Commons concurred (PAC, 2000).
Winsor attempted to address these problems through:
tougher network licence conditions,
including requirements to establish a register of the condition
of its assets and to ensure independent monitoring of its maintenance
and renewal work;
stronger and simpler contracts with
the passenger and freight operators, to specify better its responsibilities
and the remedies for when things go wrong;
greater financial incentives to grow
its business and do work well, through the periodic review of
Railtrack's track access charges.
Unfortunately, these reforms came too late to
save Railtrack. The periodic review was published shortly after
the Hatfield accident, which along with most of the other new
regulations came into force in April 2001, at the start of new
five year period (Office of the Rail Regulator, 2001). Whether
Railtrack could have been made to work, as a company owned by
shareholders, is a mute point. It has been incompetent, taken
taxpayers and ultimately its shareholders for a ride and lost
public credibility. Faced with the choice of throwing good money
after bad or a fresh start, the government chose the latter. It
was right to do so. There are good in principle reasons why Britain's
rail network operator would be better as a not-for-profit public
enterprise at arms length from government.
In work for the IPPR's Commission on Public
Private Partnerships (2001), John Hawsworth established criteria
for the form of ownership that would be appropriate for particular
public enterprises (Hawksworth, 2000):
The degree of direct competition
possible in the market, with more competition tending to favour
The significance of non-commercial
objectives such as social, cultural or environmental considerations,
which may support some degree of public ownership where the market
would not deliver these outcomes and where regulation is problematic.
The scale and complexity of the required
future investment programme, which may require private sector
investment skills although not necessarily private sector ownership.
The extent of uncertainty as to required
future service provision, which will require flexible contracts
if a public-private partnership (PPP) option is to be effective.
The extent to which the business
can be broken up without losing significant economies of scale
and scope, which may limit the list of viable options.
These criteria are applied to the train operators
and the three main parts of Railtrack's business in table 1. For
the train operators, they suggest that public ownership may be
unnecessary. There is a reasonable degree of direct competition
in the contest to win passenger franchises and the competition
to win passengers and cargo. Public interest objectives may be
secured through franchise regulation.
In the case of Railtrack's core business of
operating, maintaining and renewing the network, the criteria
would seem to favour public ownership, given Railtrack's monopoly
status, the importance of its non-commercial objectives including
safety and the problematic nature of its regulation. There are
asymmetries of information between Railtrack and its regulator,
which tempt Railtrack to make excessive profits at the expense
of taxpayers and train operators, although this temptation appears
to have been self-defeating.
SHOULD RAILWAYS BE PUBLICLY OWNED?
| Criterion|| Train operating|
|Railtrack area of business Core network
|Degree of direct competition||Reasonable: Contest to win passenger franchises and competition to win passengers and freight from other transport modes, and to a more limited degree with other train operators
||Non (monopoly). Indirect competition with other transport modes.
||Potential for competitive procurement
||High for commercial developments|
|Non-commercial objectives||Safety, reducing traffic congestion, pollution and climate change, protection of landscape and biodiversity
||As for train operators||As for train operators
||Protection of land for future rail and other transport developments
|Scale and complexity of future investment programme
||Relatively straightforward purchase or leasing of rolling stock and its maintenance
||Large and complex||Large and complex, with a history of delays and cost overruns
||Significant, but contributes financially to rail investment
|Uncertainty about future pattern of service provision
||Passenger and freight growth depends on external factors, including economic growth, traffic congestion and price of alternative modes
||As for train operators||Higher risk than for established network
||Dependent on property market, with a history of boom and bust
|Economies of scale and scope||Network benefits such as connecting trains and through ticketing
||Network benefits as for train operators
On the other hand, in the case of major enhancement projects,
the potential for competitive procurement would suggest that a
public private partnership route is appropriate, tailor made for
each project. Phase two of the Channel Tunnel Rail Link provides
a model. It will be constructed by Bechtel and London and Continental
Railways and then operated by Railtrack's successor on completion,
as part of an integrated network.
While property is in a highly competitive market, it is also
integral to the railway business and continued ownership by the
network operator may often be necessary to protect land for future
rail and other transport developments. If property or land is
not required in the short term, then leasing arrangements may
be more appropriate than selling it off. Property makes a major
financial contribution to investment in the network, due to amount
to about £1 billion over the next five years.
Public ownership of Railtrack's core business, that of operating,
maintaining and renewing the network, need not mean state ownership.
A well designed not-for-profit company limited by guarantee run
on commercial lines but in the public interest, would have advantages
over both a traditional state owned industry and a profit maximising
private company. Such a company could have clarity of purpose,
without potential conflict between public and commercial interests,
direct accountability to stakeholders, without day-to-day interference
by government, and access to private finance for investment without
recourse to the treasury. It would be possible to design a state-owned
company with such characteristics but that is unlikely under current
The establishment of a not-for-profit company to acquire
Railtrack PLC's assets and liabilities does not require legislation
but the registration of a new company limited by guarantee under
the Companies Act 1985. While Railtrack's administrators must
consider alternative offers in the interests of its shareholders,
it is the Secretary of State who must approve any transfer of
ownership and should use this power to prevent take-over by a
profit-maximising company. To do otherwise would undermine public
coincidence and make nonsense of the whole process. When the opportunity
arises, there could be merit in statutory underpinning of the
new network operator's not-for-profit status so that it would
require primary legislation to change it.
There are parallels with the recent acquisition of Welsh
Water by Glas Cymru, a not-for-profit company limited by guarantee,
which help to shed light on designing the company structure for
the new rail network operator. Glas was established specifically
for the purpose of acquiring and carrying out the business of
Welsh Water as a water and sewerage undertaker. Its constitution
prevents it from diversifying into unrelated activities. The objects
of the new rail network operating company could do likewise. It
could be set up for the sole purpose of operating, maintaining,
renewing, developing and improving Britain's rail network.
Glas has a board chaired by the distinguished former permanent
secretary to the treasury, Lord Burns, with three executive members
and six non-executive members, including the chair. The Secretary
of State, Stephen Byers' outline proposals for the board of the
new rail network operating company suggest that it would have
12 to 15 members, including five executive directors and up to
10 non-executive directors. The executive directors would include
a chief executive and directors of engineering, finance, safety
and commerce. The non-executive directors would include the chair
of the board, one director nominated by the Strategic Rail Authority
(SRA), one director appointed after consultation with the passenger
and freight train operating companies and up to seven others.
Thus, unlike Glas, the board will include some stakeholders but
still have a majority of independent members, which is regarded
as good practice in private sector corporate governance. There
is an alternative proposition that other stakeholders such as
trade unions and passengers should have nominees on the board,
which deserves further consideration. The argument against is
that the board should have a clear professional focus on the company's
objectives and not be an assembly of interest groups fighting
their own corners. However, for example, Canadian air navigation
services since 1996 have been successfully operated by a non-share-capital
corporation called NavCanada, widely known as a trust, whose fifteen
strong board includes five members nominated by aviation interests,
two by the unions and three by government. Other aviation interests
are also represented on an advisory committee.
NavCanada does not have a membership equivalent to the membership
of Glas Cymru and the new not-for-profit rail network operating
company limited by guarantee, who play the same role as shareholders
in a company limited by shares. Members have no financial interest
in the company but a powerful role in scrutinising company performance
and holding the board to account, not least by approving the appointment
of directors and voting on other matters, which could include
business plans and the remuneration of directors. They have a
duty to support the company's objectives. Glas has established
an independent selection panel to appoint a balanced membership
of about 50 people according to published criteria. The Secretary
of State has proposed that the SRA would be the founder member
of the new rail network operating company. It could establish
an independent membership selection panel, to appoint a representative
membership according to published criteria who would include individuals
drawn from rail companies, passenger groups, trade unions, the
SRA (or its successor), and other interests such as financial
institutions, local government, construction companies, non-governmental
organisations and transport professionals.
One of the major arguments in favour of Glas' acquisition
of Welsh Water was that it would be able to reduce its financing
costs. In place of a combination of equity and debt finance it
would be financed wholly by debt, and interest payments on bonds
are usually cheaper than dividend payments on shares. Glas bought
Welsh Water for about £1.9 billion, slightly less than its
regulatory asset base value of about £2 billion, which it
raised by issuing a portfolio of private sector bonds that were
70 per cent over-subscribed. The bonds were rated from triple
A, the highest credit rating, to unclassified, with maturation
periods ranging from 30 years to four years and a weighted average
real interest cost of 4.5 per cent per year. This is more than
a quarter less than the 6 to 6.5 per cent weighted cost of capital
permitted by the Office of Water Regulation (OFWAT) in the current
five-year regulatory period until April 2005. The cost of capital
is the largest single element in Welsh Water's costs. One estimate
suggests that, all other things being equal, customers' bills
could be up to 10 per cent lower in future as a result of the
discount purchase price and lower cost of capital (Stones, 2001).
Glas proposes customer bill rebates in 2003-4 and 2004-5. Meanwhile,
without share capital, to cope with the contingency of external
financial shocks Glas will build up financial reserves to lower
financing costs. It will be raising a further £1 billion
over the next seven years to finance investment and re-finance
The new rail network operating company will start from a
different position. Welsh Water was a viable if ailing business.
Railtrack PLC is in administration with substantial debts and
liabilities that the new company will inherit. Its true financial
condition has yet to become clear. Operating, maintaining and
renewing Britain's rail network in current circumstances is a
more risky business than operating, maintaining and renewing a
water and sewerage system in Wales. This is reflected in the eight
per cent real weighted-average cost of capital currently permitted
by the rail regulator as a result of the periodic review. Railtrack
currently has a regulatory asset value of about £5.5 billion,
due to rise to about £7.1 billion in 2006 (ORR, 2000). Nevertheless,
the principles of financing are similar. The new company should
have lower financing costs than Railtrack PLC. This is partly
because bond finance is cheaper than share finance and partly
because major, higher-risk projects such as the upgrading of the
east coast main line will in future be separately financed through
"special purpose vehicles". These are likely to be bespoke
joint venture companies financed by a combination of government
grant and private sector debt and equity. Partners in these joint
ventures may include train operators and construction firms as
well as the new network operator. There could also be merit in
separating out and restructuring the financing of Railtrack's
committed major projects such as the west coast main line and
Thameslink 2000. The government has promised to ensure that the
new company will have at least a triple B credit rating. In practice,
like Glas, the new network operator is likely to be financed by
a portfolio of bonds, some with a higher credit rating. It will
be able to issue bonds backed by relatively secure sources of
revenue from track access charges, property and government grants.
To date, the government has refused the suggestion that it should
provide any guarantees, though there is a precedent in the government
underwriting £3.75 billion of debt as part of the rescue
package to finance phase one of the Channel Tunnel Rail Link (Glaister
et al, 2000). However, in the absence of share capital, it has
promised to provide a capped loan facility for financial emergencies,
transferring some risk to the public sector. Unlike Railtrack
PLC, instead of distributing profits to shareholders, the new
network operator will retain financial surpluses to reinvest in
the system. Over time, like Glas, the idea is that the new company
will use financial surpluses to build up reserves to cover financial
risks without recourse to extra public funds. That should further
reduce its costs of capital.
Glas has a remuneration policy for directors designed to
attract, retain and motivate managers of the required calibre
(Glas Cymru, 2001). Initially, it has fixed basic salaries for
executive directors at the lower end of market levels by comparison
with industry benchmarks, with performance-related bonuses capped
at 100 per cent of basic salary. Half the bonus is based on financial
performance, measured by the growth of financial reserves, and
half is based on service delivery, measured by the overall service
performance independently assessed and published by OFWAT annually
for all water companies in England and Wales. Thus directors'
financial incentives are closely aligned with the interests of
Welsh Water's customers. It is not beyond the wit of man to design
a similarly appropriate remuneration scheme for the directors
of the new rail network operating company, with adequate pay rates
and incentives aligned with its public interest objectives. The
notion that only share options can motivate top level managers
is not only wrong but is misplaced in the case of public services.
It can be argued that without shareholders, a not-for-profit
company has lost one of its main efficiency drivers, the ambition
to maximise share value and dividends. The situation is not so
simple in the case of a company with its own regulator such as
OFWAT or the rail regulator, which requires efficiency savings
as part of the regulation of charges. In the case of Welsh Water,
Glas has also introduced an innovative approach by outsourcing
service provision through competitive contracting, as a new efficiency
driver. While contracting out is new in the provision of water
and sewerage services in Britain, it is well established in France
and has been adopted in Australia and the USA. Railtrack already
contracts out its maintenance and renewal work, though that has
caused problems. To promote efficiency, innovation and benchmarking
of performance, there is no reason why the new network operator
should not continue to contract out maintenance and renewal work,
provided that is done in a way that is safe, well managed and
integrated with network operations.
At the root of many of the problems with Britain's railways
has been put not simply the fact of privatisation but its manner,
which fragmented a single company, British Rail, into abut 100
parts, each sold or franchised separately, creating a web of contracts
perhaps employing more lawyers than engineers. In particular,
it has been suggested that the separation of track and train operations
is problematic. Some commentators and industry players, such as
Richard Brown, the chair of the Association of Train Operating
Companies (ATOC), have called for vertical integration by giving
train operators control of their own track (Brown, 2000). The
idea is that the incentives for safe and efficient infrastructure
operations would be aligned with incentives for safe and efficient
train operations. However, it would also create a new set of problems
and potentially increase fragmentation in the industry. Most tracks
are used by more than one train operator and most train operators
use tracks across more than one region. For example, the west
coast main line has 15 different operators and even Scotland has
three passenger and three freight train operators. If control
of a track is given over to a particular train operator, that
means problems of policing access to the track by rival operators
who do not have the advantages of control, which has led some
to conclude that there should be many fewer, regional passenger
franchises (Ford, 2000). Parts of the industry, notably the Rail
Freight Group, already the poor relation to passenger services,
are deeply wary of losing out as a result of handing over track
operations to rival train operators. To counter the argument for
vertical integration, we can look to experience abroad (Nash and
Toner, 1998). Sweden separated track and train operating companies
under its 1988 Transportation Act, apparently with success. Amtrak
in the USA has 30 years of experience operating passenger services
on 20 different freight railroads covering 24,000 miles of route,
and only owns 450 miles of track. Germany does not have complete
separation but more than 150 different train operators use the
national network owned by a single public corporation.
There is clear evidence of poor management of maintenance
and renewal contracts by Railtrack, highlighted in Lord Cullen's
report on railway safety (Cullen, 2001). He recommended not only
clearer lines of accountability but fewer subcontracts, of which
there are currently about 2,000. The problem appears to have been
exacerbated by an artificial separation between maintenance and
renewal contractors at privatisation (Wolmar, 2001). There was
also loss of skilled engineering staff through cut backs and dissipation
of information about the condition of the infrastructure. Maintenance
and renewal work could be better organised in future with fewer,
longer-term contracts by geographical zone (Ford, 2000). Railtrack
is currently organised in seven zones, though Ford has suggested
that this should be reduced to five. That would provide the opportunity
for innovation and benchmarking of performance between zones,
retaining a useful driver for efficiency. There is no substitute
for the establishment of the asset condition register that is
now required by regulation, combined with good contract management
and expert oversight of the quality and timeliness of work, in
which the new network operator must properly invest. To provide
a stronger voice for train operators, the new network operator
could have zone management boards including representatives of
the train operators who use the infrastructure in that area. This
would ensure that their concerns were heeded and they were involved
in the planning of maintenance and renewal work but also that
their interests were balanced against one another. There would
be nothing to stop train operators from bidding for long-term
maintenance and renewal contracts in open competition.
There are other aspects of reform that are beyond the scope
of this memorandum but will be discussed in the forthcoming publication,
notably regulation, franchise replacement and delivery of the
10 year transport plan. The following recommendations are made:
The Secretary of State should reject transferring
the ownership and operation of Britain's railways to another profit
A new not-for-profit company limited by guarantee,
the government's preferred option, should take over the operation
of Britain's rail network.
The new network operator should have clear public
interest objectives, not compromised by shareholders, to operate,
maintain and improve Britain's rail network.
Is not-for-profit status should subsequently be
backed by statute so that primary legislation is required to change
In addition to nominees of the SRA and the train
operators, the government should consider including nominees of
other stakeholder interests on the board of the company, notably
passengers and trade unions.
An independent panel should be established by
the SRA to select a representative stakeholder membership by open
application according to published criteria.
Members should vote annually on directors' remuneration,
including performance-related bonuses, based on service delivery
and financial performance, aligned to the company's public interest
There should be fewer, longer-term maintenance
and renewal contracts on a zone basis, with relevant train operators
represented on zone management boards.
As well as providing an emergency loan facility,
depending on Railtrack's true financial condition, the government
should consider underwriting or paying off part of the debt to
put the new network operator on a sound financial footing.
The financing of Railtrack's committed major enhancement
projects such as the west coast main line and Thameslink 2000
should preferably be ring fenced to reduce the risk to its core
business and improve its credit worthiness.
31 October 2001
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