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


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 track—reforming 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.

DEFINING THE PROBLEM

  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.

THE QUESTION OF OWNERSHIP

  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 private ownership.

    —  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.

Table 1

SHOULD RAILWAYS BE PUBLICLY OWNED?
Criterion Train operating
companies
Railtrack area of business Core network

Major
enhancements

Property
Degree of direct competitionReasonable: 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 objectivesSafety, reducing traffic congestion, pollution and climate change, protection of landscape and biodiversity As for train operatorsAs 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 complexLarge 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 operatorsHigher risk than for established network Dependent on property market, with a history of boom and bust
Economies of scale and scopeNetwork benefits such as connecting trains and through ticketing Network benefits as for train operators LimitedLimited


  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 treasury rules.

ESTABLISHING A NOT-FOR-PROFIT NETWORK OPERATOR

  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 short-term bonds.

  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.

THE QUESTION OF INTEGRATION

  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.

CONCLUSION

  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 maximising company.

    —  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 it.

    —  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 objectives.

    —  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

REFERENCES

  Brown, Richard (2000) "Power to the operators", in The railways: where do we go from here, Transport 2000.

  Commission on Public Private Partnerships (2001) Building better partnerships, final report, IPPR.

  Cullen, The Rt. Hon. Lord (2001) The Ladbrooke Grove rail inquiry—part 2 report, HSE.

  DETR (2000a) Transport 2010—the background analysis.

  Ford, Roger (2000) "Simplification of the structure: fewer, bigger, better", in The Railways: where do we go from here? Transport 2000.

  Glaister, Stephen, Rosemary Scanlon and Tony Travers (2000) Getting partnership going: PPPs in transport, IPPR.

  Glas Cymru (2001) Interim statement of Glas Cymru policy for the remuneration of directors, annual general meeting 2001.

  Grayling, Tony (2001a) "Railtrack could be a not-for-profit trust", article in The Guardian, 10 January 2001.

  Grayling, Tony (2001b) Should Railtrack be publicly owned? paper presented to the "Rail Renaissance" conference organised by IPPR, London, 21 February 2001.

  Grayling, Tony (2001c) "Trains and shares and planes", article in The Guardian, 4 May 2001.

  Hawksworth, John (2000) Labour and public enterprise: does the government have a coherent approach? New Economy, volume 7.3, IPPR.

  HSE (2000) Railway safety—HM Chief Inspector of Railways' annual report on the safety of the railways in Great Britain during 1999-2000.

  IPPR (2001) A progressive future—IPPR's agenda for a better society.

  Nash, Chris and Jeremy Toner (1998) Railways: structure, regulation and competition policy, OECD.

  ORR (2000) The periodic review of Railtrack's access charges: final conclusions, volume 1.

  ORR (2001) Accountability of Railtrack.

  PAC (2000) The Office of the Rail Regulator: Ensuring Railtrack maintain and renew the railway network, 35th report of the Select Committee on Public Accounts of the House of Commons, session 1999-2000.

  Stones, Clive (2001) Changes in the pipeline? Economic and public policy implications of water restructuring, Social Market Foundation.

  Wolmar, Christian (2001) Broken rails: how privatisation wrecked Britain's railways, Aurum Press.


 
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