Memorandum by Grant Transport Strategy
Ltd (PRF 41)
PASSENGER RAIL FRANCHISING
1. This memorandum addresses the implications
for rail services of the Government's new approach to passenger
rail franchising, with particular reference to the impact on infrastructure
enhancements of a policy of negotiating short term extensions
to existing franchises.
2. The paper considers how the roles of
the Train Operating Companies and Railtrack have evolved since
privatisation and their relative ability to fund infrastructure
enhancements as a background to considering the impact of a change
of emphasis in franchising policy towards short extensions to
3. It proposes a structure within which
private sector finding can be attracted to the industry notwithstanding
Railtrack's effective withdrawal from infrastructure enhancement.
4. train Operating Companies (TOCs) are
the integrators of the industry, bringing together stations, track
and trains to deliver a service to the customer and to earn revenue.
As such, they play a pivotal part in the performance of the railway
as a transport system. They also bear both cost and revenue risk
on a considerable scale.
5. The privatisation model contained in
the 1993 Act implicitly assumed a static or declining rail industry
with little need for enhancements. In this model, there is a case
for short-term franchises as the franchisee is not called upon
to either plan or fund substantial investment.
6. Since privatisation, however, passenger
numbers have grown, putting pressure on existing infrastructure.
Last year the Government declared an objective of a further 50
per cent increase in rail passenger volumes by 2010, backed by
a £49 billion package of private and public sector investment;
£6 billion for new rolling stock and £43 billion to
enhance the national rail networki.
7. Meanwhile the SRA was encouraging franchised
Train Operating Companies (TOCs) to play a greater part in the
strategic development of the industry by holding out the prospect
of longer "replacement" franchises in return for TOC
commitments to help fund the private sector's projected 10 year
£28 billion contribution to infrastructure improvements.
The SRA's process has proved slow and cumbersome and has failed
to address the question of how TOCs were intended to invest in
assets owned by Railtrack.
8. The National Express Group has successfully
negotiated a two-year extension to its Midland Mainline (MML)
franchise in return for new rolling stock and infrastructure upgrades.
However, this franchise was already of 10 rather than seven years
duration and, if the extension contract is signed, will be for
a total of 12 years expiring in April 2008. Two-year extensions
are, therefore, potentially useful as a mechanism to "refresh"
those franchises that already have sufficiently long terms remaining
to enable new infrastructure upgrades to be planned and executed.
9. The MML example is not, however, a precedent
that would justify a policy of relying on two-year extensions
to franchises due to expire in the next 18-30 months as a mechanism
for delivering substantial infrastructure enhancements.
10. Given the elephantine gestation period
for rail infrastructure projects, any such works would hardly
be complete by the time the extended franchise ended. Consequently,
a TOC with only a short extension would in practice be taking
little or no risk that the enhancements it proposes would be effective
in overcoming existing constraints, nor would it bear the risk
that the operational or capacity benefits, once delivered, would
actually stimulate traffic and revenue growth in line with its
11. Furthermore, a competent train operator
may be reluctant to prejudice its reputation by allowing its part
of the railway to be turned into a building site for a couple
of years, with all the consequent disruption to its customers.
This is quite apart from the loss of revenue consequent upon route
closures to enable the works to be carried out, which would presumably
be compensated as part of the extension deal.
12. As well as being unsuitable as a mechanism
for delivering infrastructure upgrades, two-year extensions are
hardly adequate even to deliver rolling stock renewals, despite
the relative maturity of the rolling stock lease market.
13. Since the Government announced its Transport
2010 strategy in July last year, Railtrack's ability to fund and
manage investment has been weakened by financial and management
difficulties, in particular:
The £644 million cost of the
track remedial programme embarked upon following the Hatfield
An associated projected increase
of £700 million pa increase in the costs of operations, maintenance
Cost and time overruns on upgrade
projects, notably West Coast Main Line modernisation (£500
million) and Leeds (£80 million).
14. Railtrack's Chief Executive has admitted
that the company "has tended to over promise and under deliver".
ii Railtrack has subsequently scaled down its planned involvement
in infrastructure enhancement projects, effectively withdrawing
from key projects such as Thameslink 2000. Going forward, therefore,
Railtrack's role is "to focus on the maintenance and renewal
of the existing networkiii. ii
15. The dividing line between maintenance
and renewal on the one hand and enhancement on the other is blurred.
Enhancements frequently include renewal and affect maintenance
costs. For example. Upgrading the electrical power supply on South
Central to support a more frequent train service with faster and
heavier new rolling stock would entail replacing equipment installed
in 1935 as part of the original electrification. Enhancement in
this example would reduce Railtrack's maintenance costs and obviate
the need for it to replace life expired equipment on a like-for-like
basis. The question of who pays for what is, therefore, not straightforward.
As a monopoly supplier, with no direct relationship with the end
user customer and therefore no revenue risk, Railtrack can afford
to take an intransigent position in negotiations with TOCs.
16. Classic economic theory has it that
monopoly pricing is fixed by the most inefficient supplier. Whilst
the Office of the Rail Regulator attempts to benchmark Railtrack's
performance it is an inherently difficult task. Ultimately, as
has been demonstrated by the recently negotiated advance of £1.5bn
of future subsidy, the Government has to meet Railtrack's costs
or risk the consequences of its financial collapse.
17. As a monopoly infrastructure supplier,
remote from the ultimate customer, Railtrack is insulated to some
extent from the consequences of inadequate performance.
18. Railtrack is also in a position to frustrate
the SRA's concept of Special Purpose Vehicles (SPVs), whereby
TOC-led consortia would implement enhancement programmes agreed
with the SRA. The Chiltern and South Central SPVs have made only
slow progress over the last year.
19. The Design, Build, Finance and Transfer
(DBFT) SPV model for infrastructure enhancement rests on the assumption
that Railtrack would be in a position to pay for infrastructure
improvements on completion, which now seems unlikely. An alternative
model is therefore needed that enables the cost of the enhancement
to be paid down before transfer.
20. It is relatively easy to point out flaws
in the present structure of the rail industry; less easy to develop
alternatives that are free of drawbacks. Nevertheless I would
like to propose an alternative industry structure as an "Aunt
Sally" for debate.
21. Starting with the fact that the Government
has sold the national rail network and it is now the property
of Railtrack's shareholders but that those shares are now of relatively
little value, it may be possible to construct a deal whereby Railtrack
is reduced to the status of a freeholder, leasing unimproved infrastructure
to "Railway Companies"iv and earning a "utility"
return on its assets commensurate with the relatively low risk.
Railway Companies would be Design, Build, Finance
and Operate (DBFO) consortia consisting of funders, builders,
maintainers and operatorsand, crucially, with professional
procurement and project management skills. The Railway Companies
would have contracts with the Government/SRA to deliver specific,
agreed enhancements and would bear costs and time overrun risks
as well as revenue risks.
23. The Railway Companies would be funded
by a mixture of debt finance and shareholders' risk equity.
24. In return for rental payments for the
lease of the unimproved network, Railtrack would grant access
to the Railway Companies to operate, maintain, renew and (in line
with commitments to the SRA) enhance the assets. At the end of
the lease term, the infrastructure, including improvements, would
revert to Railtrack to be re-let.
25. Market and operation logic, together
with the need to achieve economies of scale, points to some 8
to 12 Railway Companies.
26. Not all train operations would be in
the hands of Railway Companiesfreight and cross-country
passenger services are obvious exceptionsand there would
be considerable inter-running between the Railway Companies themselves.
The concept could also be extended to create "mini franchises"
to manage branch line services with a genuinely local focus.
27. There would, therefore, still be a need
to ensure equitable infrastructure access rights for all operators
and to preserve through journey opportunities between operators;
one option would be to place national timetabling under SRA control.
28. Integrating train operations with infrastructure
development is, in my view, the best way to ensure that enhancements
are delivered on time and on budget, with as little disruption
as possible to customers.
29. The SRA's recent round of negotiations
with TOCs was based on a 20-year duration for replacement franchises.
However, this is not necessarily the optimum; several factors
have to be taken into account to determine an appropriate length
of tenure for a franchisee Railway Company.
30. Depending on the scale of infrastructure
works to be carried out and time to completion, and on the basis
that Railtrack is not in a position to purchase an infrastructure
enhancement on delivery, sufficient time will be needed to pay
down the Railway Company's capital investment from revenue and/or
subsidy earned over time. This points to a franchise term of at
least 20 years; 40-50 years would probably be optimum.
31. On the other hand it is very difficult
to forecast traffic volumes and revenues over extended timescales.
A one per cent per annum variance between plan and actual outturn,
compounded over 20 years, becomes either excessive profits or
32. Also, whereas it is relatively obvious
what infrastructure enhancements are required now it is much more
difficult to speculate about what may become a requirement in,
say, 15 years time.
33. Thirdly, a mechanism has to exist to
replace a persistently under-performing train operator.
34. Accordingly, I would suggest that Railway
Companies should be granted an initial 10-year term, with a formal
review and potential extension every five years. In each case,
the first five years would be the subject of a detailed business
plan (traffic, revenue, costs and franchise payment) together
with specific infrastructure enhancement commitments. The five
yearly review would examine performance both in terms of service
delivery to the customer and cost-effective operations, as well
as stewardship of the infrastructure and progress with enhancements.
If the Railway Company is performing satisfactorily, it and SRA
would normally then agree a five-year extension together with
detailed plans for the next five years, and so on.
35. In the event that the Railway Company's
performance is unsatisfactory, and if adequate remedial commitments
cannot be agreed, other Companies would be given the opportunity
to bid competitively for the franchise. A mechanism will be needed
to transfer debt capital subscribed for infrastructure enhancements
to the incoming Railway Company.
36. The proposal outlined above:
Transfers project delivery risk to
Railway Companies and their equity investors.
Offers the opportunity for reliable
Companies to develop a railway business and a relationship with
customers over the long-term, whilst providing a mechanism to
terminate under-performing Companies.
Ensures that the SRA and the Government
have effective control over how public sector finance is being
spent and what it is buying.
37. I am conscious that a proposal of this
kind needs considerable development and refinement but I suggest
that it offers a potential way forward out of the current difficulties.
Will funding be available?
38. Financial markets have developed an
appetite for railway assets, largely as a result of observing
the success of the ROSCOs. However, unlike rolling stock which
can be refurbished and redeployed, infrastructure assets are essentially
staticgenerally only a small part of the value of the investment
can be unbolted and moved elsewhere.
39. Accordingly, lessors and other debt
investors will need to be sure that the assets will continue to
be used and paid for until their investment has been paid for.
The SRA and the Government have been reluctant to give such guarantees,
instead asking investors to form their own view of the likelihood
of such investments being taken out of use.
40. This is extremely difficult. Whilst
is may seem obvious that, for example, the Brighton line will
not be closed, this is not the same as saying that a particular
investment will be adopted by an incoming franchisee.
41. The rail industry has its fair share
of "white elephant" capital projectsthe Bletchley
flyover and freight marshalling yards of the 1960s are examples
as is the modern but abandoned Charing Cross terminus of the Jubilee
Line. Investors price risk and a refusal to underwrite the future
use of investments will certainly make projects much more expensive
and may well make them unmarketable.
42. To summarise:
TOCs are the interface between the
railway and the customer, responsible for the quality of service
delivered and living or dying by their ability to grow revenue
and manage costs.
Two year extensions to existing franchises
are useful as devices for updating those original franchises with
long remaining terms but provide an inadequate timescale for delivering
significant infrastructure upgrades and rolling stock renewals
on those franchises that expire within the next three years.
Railtrack have neither the motivation
nor the financial and managerial resources to deliver infrastructure
enhancements on the scale needed to deliver the Government's targets
of 50 per cent passenger and 80 per cent freight growth by 2010.
An alternative model is needed.
One such alternative would be for
Railway Companies, consisting of operators, maintainers and project
managers, to lease unimproved infrastructure from Railtrack and
deliver enhancements agreed with the SRA on a DBFO basis, funded
by a mixture of debt finance and risk equity and remunerated by
Successful operators would have franchises
renewed on a rolling basis, unsuccessful ones would be terminated,
with debt funding for infrastructure projects in progress transferring
via the SRA to the new franchisee.
Government/SRA underwriting of the
future use of infrastructure assets is a pre-requisite of cost-effective
1 October 2001
i Transport 2010The Ten-Year Plan,
DETR July 2000.
ii Railtrack 2000-01 Annual Report and Accounts,
Chief Executive's Review.
iii Press Notice: Transport Sub-Committee
inquiry into passenger rail franchising.
iv A term most recently coined by Roger
Ford: "Creation of a functioning railway", article in
Modern Railways, September 2001.