Supplementary memorandum by the Rail Regulator
PASSENGER RAIL FRANCHISING AND THE FUTURE
OF RAILWAY INFRASTRUCTURE
This note contains the Rail Regulator's response
to a number of supplementary points that were requested following
his appearance before the Sub-Committee on 7 November 2001.
Should Railtrack's successor emerge from administration
in the same form (albeit with different ownership) as the old
(a) Should the opportunity be taken to create
a new company with regional subsidiaries which would be responsible
for the maintenance and renewal of the rail network?
An operator of the national rail network needs
an appropriate balance between requirements of network integrity
(such as timetabling, operations control, engineering and operational
standards, prioritisation of resources and dealing with train
operators who cross boundaries) and those of local delivery (day-to-day
operation, maintenance and renewal). This was true for Railtrack,
which sought to achieve it by means of its zonal organisation,
and it will be so for any successor organisation.
Creation of separate subsidiary companies, rather
than just management units as was the case with Railtrack, could
facilitate comparison of performance between subsidiaries. It
could, under certain circumstances, also facilitate development
of alternative structural models (eg local vertical integration
were this considered desirable). However, there would be a risk
of much more complex contractual relationships (most train operators
operate over more than one Railtrack zone, and freight operators
over all zones) between operators and individual subsidiaries
which could seriously disadvantage operators and undermine processes
such as the national timetabling procedure, acceptance of new
rolling stock and major network improvements.
What is the most appropriate basis for funding
(a) Should all of the money come from track
access charges or should some come directly from the Government/SRA?
Response to main question
Railtrack's successor will require adequate
funds which reflect the costs of sustaining the network effectively.
It is most appropriate for the funding level to be determined
in a fair and transparent way, as well as ensuring that there
are sufficient incentive effects to prevent the abuse of the company's
Response to supplementary question
The note entitled "Railway Industry Money
Flows" attached to the Regulator's written evidence sets
out the framework under which Railtrack PLC receives its income.
In outline, the Regulator independently determines Railtrack's
revenue requirement for the competent and efficient operation,
maintenance and renewal of the network. For control period two,
this amounted to £14 billion after taking into account single
till income. Of this, £0.6 billion was to be deferred to
2006 and the remaining £13.4 billion paid over the five-year
Access charges are then raised automatically
to meet this requirement. However, the franchise agreements between
franchisees and the SRA (clause 18) contain a pound for pound
indemnity by the SRA in favour of the franchisee in relation to
any change in access charges resulting from the Regulator's decision.
Thus, the SRA is contractually obliged to pay the whole of the
increase in track access charges.
In respect of the periodic review, the SRA requested
that, rather than pay the increase to operators for them to pay
Railtrack, it should pay this increase by way of network grants
direct from the SRA to Railtrack. The Regulator agreed to this
request on the basis that payment of these grants would be unconditional
so that there was no addition to the perceived level of regulatory
risk. The SRA accordingly agreed unconditionally to pay £4.6
billion of network grants to Railtrack. The first instalment of
£162 million was payable on 1 October 2001.
As to the method of funding, as long as the
existing unconditional obligation to pay remains, and subject
to principles outlined in the response to the main question, the
Regulatory is unlikely to be concerned by whether the SRA pays
Railtrack's successor via the passenger train operators or directly.
If the Government's proposals for a company
limited by guarantee are implemented, would you expect lenders
to view the company as a very low credit risk?
(a) How are major cost uncertainties related
to maintenance and renewal work best dealt with?
(b) Is a company limited by guarantee appropriate
in an industry which has found it difficult to estimate costs
Response to main question
The assessment of the risk of the proposed company
limited by guarantee (CLG) will not be possible until the Government's
proposals are more fully developed. Then lenders will form their
own views about risk, having regard to a wide range of factors
including the rating accorded to the company's bonds by the credit
rating agencies. The Sub-Committee will be aware that the credit
rating agencies apply a number of criteria to assess the appropriate
credit rating for bonds, both qualitative and quantitative:
(a) Qualitative criteria include perceptions
of management and the strength of independent economic regulation.
(b) Quantitative criteria are expressed in
terms of actual and forecast financial ratios, which mainly relate
to a company's expected case flow position.
There are a number of aspects of debt-only companies
which may affect the risk profile for lenders:
(a) in the equity model, equity provides
the front-line cushion against adverse shocks that impact on the
company's revenue and costs;
(b) in an equity-based company, the structure
of corporate control is familiar and clear. If equity is totally
withdrawn then control is less straightforward. Loan covenants
may reproduce de facto the ownership rights of shareholders
but this is more ambiguous; and
(c) there has been a marked shift away from
mutual structures in other industries, such as building societies
and the insurance sector. Some commentators believe this is due
to difficulties of decision-making in these structures.
Thus, the risk profile of the CLG will depend
(a) the precise scope of its business;
(b) whether it is able to, or wishes to,
assume a different mix of business risk;
(c) its financial structure; and
(d) its control and decision-making processes.
Great importance will be given to the nature
and structure of regulation.
Response to first supplementary question
The Regulator addressed the appropriate allocation
of risk for cost over-runs as part of the periodic review. He
concluded that this risk should generally be borne by investors
in Railtrack since it is largely within the control of the company
(although the company may choose to pass on some of the risk to
its contractors). This provides strong incentives for management
to control these costs and reduces the degree to which Railtrack's
customers are exposed to cost over-runs over which they have no
However, the Regulator recognised that where
these risks are not within the control of management they should
be borne by customers rather than investors. This is because the
risk premium which would be required to compensate the company
for bearing these risk is likely to exceed any benefit to customers
in terms of reduced uncertainty. For example, due to the considerable
level of uncertainty about the required level of signalling works,
the Regulator concluded that the risk of overspend in this area
should be shared between customers and investors. This was achieved
by adjusting the Regulatory Asset Base (RAB) at the next review
to compensate the company for overspend so that there was still
some incentive for Railtrack to manage these costs efficiently
without exposing shareholders to the full risk. The Regulator
further concluded that increases in costs arising from new obligations
(eg in relation to safety) should be paid for by customers. He
proposed that this could be achieved either through an interim
review or through an addition to the RAB.
These issues may need to be re-visited if Railtrack
is replaced by a CLG.
Response to second supplementary question
While the structure of the new arrangements
for provision of infrastructure services is a matter for Government,
the Regulator believes that, whatever structure is established,
it will need to have regard to the following objectives, all of
which are pertinent to accurate cost estimation:
(a) the establishment of a financial structure
which is closely related to allocation and management of risk;
(b) the need for incentives for operational
(c) cash and financial stabilitywhich
means either a Government guarantee or independent regulation.
The Regulator believes that good asset knowledge
is extremely important, regardless of structure, if the infrastructure
provider is to improve its cost estimation processes. For this
reason, on 18 April 2001 the Regulator amended Railtrack's network
licence so as to require the company to establish and maintain
a register of its assets, their condition, capability and capacity.
The Secretary of State has said that he intends
to rationalise the regulatory structure of the rail industry in
order to reduce "the burdens of day-to-day interference in
the industry". How should those burdens be eased?
(a) He has also referred to the "self-defeating
system of penalties and compensation" imposed by the existing
regulatory structure. How should this be changed?
The Regulator has a number of statutory duties.
These duties are set by Parliament and can be removed only by
Parliament. If the definition of burden and interference is regulatory
action carried out in the course of the Regulator exercising his
functions by discharging his duties, that is a function of legislation
passed in 2000 and brought into force on 1 February 2001.
When Railtrack was privatised, it was done with
a weak regulatory system which did not meet the needs of its customers
or the public interest. The Regulator's programme for the reform
of Railtrack's accountability, which is almost complete, has been
widely supported by the industry and Parliament, including the
Transport Sub-Committee and the Public Accounts Committee. It
would be remarkable if, now that the infrastructure provider is
to be recreated or restructured following the railway administration
of Railtrack, the strengths of the regime created in the last
two years and so recently completed were to be taken out and the
weaknesses which caused so many problems in the past retrofitted.
In respect of Railtrack or its successor, as
the Regulator said in his oral evidence to the Sub-Committee,
the major failings of Railtrack's management to date has been
their lack of focus on their customers and on the actions they
should have taken to ensure the competent stewardship of their
assets. The greater the customers' dissatisfactions in relation
to the adequacy of an industry's asset stewardship plans, the
more any regulator will be called upon to intervene. Had Railtrack
done the things it should have done to satisfy its customers and
plan for the long-term health of its assets, the Regulator would
not have had to intervene to require the company to do them. The
Regulator does not consider that he required of Railtrack anything
that a competent and efficient company would not have chosen to
do for itself. This is borne out by the considerable public and
industry support for the actions he has taken. Examples of this
would be his requirements of Railtrack to generate an asset register,
develop an effective network management strategy, and provide
a clear recovery plan post-Hatfield; had Railtrack been doing
its job properly, there may have been no requirement for a post-Hatfield
All competent companies measure and manage their
performance effectively and efficiently. The railway industry
is no different. Having measured performance, it is economically
and commercially efficient for the relevant contracts for the
delivery of the services in question (in this case, infrastructure
services) to contain provisions which incentivise good performance
and penalise poor performance. This works far better and with
greater clarity and certainty than the innocent party having to
resort to costly, uncertain and lengthy claims for damages in
litigation. These types of provisions are found in a very large
proportion of commercial contracts in every industry and in every
part of the world. They have been in use for many years and are
a well-established feature of such contracts. In this respect,
the railway industry follows where other mature and successful
industries have gone before.
For the railway industry as a whole, whatever
the structure, there will be a need for regulation in respect
of safety, performance and efficiency, with specific controls
to prevent the abuse of monopoly power wherever that might arise.
Sir Alastair Morton described the outcome of
the periodic review of Railtrack's access charges as being like
"the Regulator's hand getting into the SRA's pocket to remove
money". Should it not be for the SRA to determine how the
overall amount of Government funding for the railway is used?
(a) Given the difficulties with reconciling
the competing claims of different train operators to use congested
routes, should capacity issues not be decided as part of the SRA's
rail strategy, rather than through the track access process?
Response to main question
Through undertaking independent reviews, a regulator's
job is to determine the fair price for funding the long-term stewardship
of a vital national asset (be it the railway network, or the distribution
systems for water or power). Doing so on a periodic cycle allows
the industry to plan ahead with the certainty that its investment
will be financed, so long as it behaves competently and efficiently,
without having to build a large premium into its prices up front
to cover unforeseen risks.
It must be for the SRA to decide how to get
the best result from its budget, in line with its statutory duties
and the objectives, instructions and guidance issued by the Secretary
of State. However, there are important existing contractual commitments
and statutory provisions which were established at privatisation,
as described in the response to Point Two, namely:
(a) Government has agreed (by means of clause
18.1 of each of the franchise agreements) to pay any increase
in track access charges arising from the Regulator's determination
of the revenues required to fund the efficient expenditure necessary
to sustain the network;
(b) this price control determination should
be carried out independently of the providers, users and customers
of the rail infrastructure (as for other regulated utilities);
(c) the Regulator has to have regard to the
financial position of the SRA (this is a statutory duty).
The contracts and other arrangements binding
on the SRA should be honoured, not disregarded or broken.
Another major issue is whether the SRA, as the
dominant purchaser of railway services, should also determine
both the quality of those services and the price at which they
are to be delivered, and how often it should be able to change
its mind. Not only must there be a question as to whether any
private sector company could enter into such a one-sided deal
with Government, it is clear that even a wholly public sector
companyBritish Railsuffered from such a regime,
with the long-term investment planning vital for the railway undermined
by annual revisions to its budget. For the train operatorsthe
passenger and freight companiesconfidence in the long-term
stewardship of the rail infrastructure is a prerequisite for underwriting
investment in new trains, and, indeed, for taking part in the
provision of train services to the public, who need those services
to be reliable. That confidence would be hard to win with a return
to stewardship dictated by the amount of cash the SRA had available
in any one year.
Thus, it would be possible for the SRA to specify
different outputs from Railtrack although this would need to be
agreed with Railtrack's other customers. Whatever outputs are
agreed, they should still be priced independently. It should be
noted that the Incremental Output Statements, which were included
in the periodic review, are an example of the SRA requiring some
additional outputs and then asking the Regulator to determine
an efficient price for them.
Response to supplementary question
The current regime provides for capacity allocation
decisions to be made by the Regulator on application from operators
and Railtrack. The Regulator consults all interested parties,
including the SRA, and determines:
(a) whether there is capacity available for
(b) whether the capacity is most appropriately
allocated to that operator; and
(c) how long the capacity should be allocated
This allows the Regulator to take an independent
approach balancing the needs of different operators (those passenger
operators with and without franchises, and freight operators)
according to his duties under section 4 of the Railways Act 1993.
The Regulator does consult the SRA on the criteria he adopts and
on specific cases.
Since the SRA is providing funding for the services
offered by some operators and not others, it would not be possible
for it to act in such an independent fashion.
The SRA is currently considering the capacity
of the network as part of its development of an overall rail strategy.
It is considering the long-term implications of demand growth
and the need for enhancement of the network in particular locations
to meet that growth. This work will inform its responses to the
Regulator when he consults on specific access agreements and its
investment decisions for new infrastructure.
The balance of responsibilities therefore allows
the SRA to set priorities for its investment whilst the Regulator
ensures that there is a level playing field for all participants
in the industry.