Articles



Developments in Rail Franchising: UK and Europe

The operation of passenger rail services in the UK and Europe has been a hot topic in the past year, and activity is soon due to ramp up significantly. The UK has operated a privatised railway for some 19 years and in that time private companies have won a number of generations of franchise contracts to operate trains on the network. Many other European countries have also privatised some of their services, but all are being told to continue to shift towards fully privately operated passenger services. How countries do this is subject to fierce debate; the policy followed by the UK most recently gave rise to a hiatus in the procurement programme that is only just getting going again. How successful these procurements will be, how attractive they are to industry, how beneficial they are to passengers, and whether other European countries will follow this UK model of a privatised railway, are all questions that remain.

A History of Liberalisation

The UK is often labelled the most liberalised rail market in the world. Margaret Thatcher’s governments of the 1980s privatised a number of largely public industries, with the rail sector being one of the last, longest, and most difficult privatisations, mostly carried out by the subsequent government of John Major. The legacy of British Rail is a number of private companies and public regulations set in a structure to incentivise the operation of an economic market (Box 1). One aspect of this structure is allowing train operating companies (TOCs) to run passenger services by collecting fares from passengers, operating trains, and paying for access to the infrastructure. The government periodically awards contracts to the TOCs to run services on specified sections of the network. Some of these franchise contracts result in payments to the government (premia), but some require public subsidy (support). Some require support in the early years, then pledge to pay premia in later years; though perverse incentives have been known to cause the opposite. These payments in both directions depend on factors such as growth in passengers and the optimisation of revenues through yield management processes. An “open access” policy has also more recently allowed additional operators onto the network to occupy otherwise vacant train paths, increasing levels of competition for customers. In terms of passenger patronage, privatisation has been a huge success, preceding an 86 percent increase in passenger kilometres since 1993, ending a long-term stagnation.

 

Rail Value for Money Study 

The fixed infrastructure is owned, maintained, and operated by another private company, Network Rail. Network Rail is the contracting authority for almost all works on the infrastructure but it comes under regular scrutiny for its costs. In 2010, Sir Roy McNulty, a UK aviation industry expert, was asked to investigate the cost of the railway and make recommendations to bring costs down (Box 2). The scope of the study and its recommendations were vast, encompassing unit cost savings of 30 percent within eight years. Specific recommendations related to incentivising TOCs to undertake capital investments on the network themselves, as opposed to leaving it all to Network Rail. This more direct relationship between network enhancements and the benefits thereof (e.g. allowing faster journey times, which justify higher fares charged by the TOC) would ensure greater alignment of investment and benefi ts. It would also mean projects taking place outside of Network Rail’s current processes and procedures, blamed for some of the high cost of projects.

 

Former Franchising Programme Aims

To incentivise TOCs to undertake these investments, a significant change to the franchise process was required. A common complaint from TOCs was that with contracts of less than 10 years, it was impossible to plan and execute works, and then extract sufficient benefits or revenue streams. The government therefore decided to offer 15 year franchises and, on the routes considered sufficiently profitable, the TOC would also take on revenue risk. In the recent past the government had been badly affected by TOCs defaulting before making their premia payments. To insure against this risk in the current round of franchising, the government made assessments of the inherent risk of default in any given bid, then requested a loan (subordinated loan facility, or SLF) from the TOC, to be retained by the government in the event of such a default. The government was also consulting on combining franchises to form super-franchises, giving greater scales of economy.

Procurement Collapse and Fallout

The first franchise to be awarded in this procurement programme was the West Coast Main Line (WCML) in August 2012. The incumbent, Virgin Trains, came second in the competition after First Group plc. Virgin immediately protested and requested a review of the process, given that First Group’s bid was predicated on an allegedly unrealistic passenger growth of six percent per annum for 15 years.

Virgin followed this with a legal challenge. In preparation of the material for court, the government discovered “significant technical flaws” in the way the procurement had been handled. In October 2012, the contract award was cancelled and other ongoing procurements were paused. An independent inquiry and review were launched, as were parliamentary and governmental reviews, all of which were completed by March 2013. The key flaw was found to be in the assessment of risk which determined the size of the SLF requested from each bidder. The independent reviews raised serious issues of governance in the Department for Transport and recommendations were made on how to progress. These focused on the allocation of risk (including risk of default), market capacity, government resource (skills, capacity, and governance), levels of specification, franchise duration, and the new bidding process.

New Franchising Programme

In March 2013, the government announced a new programme for procuring these franchises (Box 3). The procurement pause, combined with ongoing fears over government and market capacity to complete procurements, has meant the programme is now much more spread out, resulting in a cumulative 29 years of extensions being awarded to incumbents. Discussion of amalgamation has somewhat given way to discussion on devolution and remapping of franchises. Two of the routes that were expected to see much disruption due to infrastructure investment programmes will now be undertaken as management contracts where the TOC does not take revenue risk. Franchise durations could still be as long as 15 years, but with break points to reevaluate and renegotiate revenue growth projections, since the difficulty in assessing the revenue risk on the TOCs’ 15-year projections is what brought the programme down last time. The government has also tried to allay TOC fears that 15 years was an insufficient payback period for capital investments, and so an improved residual value mechanism will be set up whereby the incumbent is paid for any residual benefit at franchise termination.

Capital Investment

Aside from the franchising review, the government and Network Rail have spent the last two years defining the major capital works to be carried out on the railway in the 2014-2019 period. In the midst of pressure to invest in infrastructure during the recession, and to reduce carbon emissions from transport, the government committed to significant investment in rail, especially on the overhead electrification of a number of routes and major local schemes. This was planned at a time when the original franchises were going ahead and bringing premia payments into the Treasury. With 29 years of extensions being awarded on existing terms and conditions, there is a question as to how the Treasury will fill this funding gap.

Outlook

Concerns will continue to be raised over the attitude of international investors in TOCs following the cessation of the franchising programme and the delay before its replacement emerged. There is also concern over whether TOCs really will invest in capital schemes, and whether TOCs will eventually provide sufficient premia to fill the funding gap in the capital investments already defined and announced by the government. With an election looming in May 2015, in a country which views the railway as providing a public service, it will be interesting to hear the political debates that emerge. Now the reviews are complete, the government is clearly expediting the restart of the programme with all possible haste to restore trust in the process (many TOCs are owned by publicly listed companies that suffered share price drops when the franchising system ran into trouble) and to minimise damage to both the taxpayer and the government. It is, however, hard to claim that the industry isn’t feeling buoyed by the recent announcements about franchising getting restarted and the scale of capital investment in the railway up to 2019. One thing is certain, the UK passenger rail sector has both exciting and uncertain times ahead.

European Perspective: The “Fourth Railway Package”

The aim of the “Fourth Railway Package” is to complete a single European railway area, managed by the European Railways Agency, part of the European Commission. It is a package of new proposed regulations which will be presented to the European Parliament and debated over the next two to three years. This package would open domestic rail passenger services across Europe to more competition. European research has shown that these measures could contribute to ticket price reductions of up to 30 percent, ultimately increasing ridership, enabling a modal shift to rail that should support the demanding EU target of 80 percent CO 2 emissions reduction by 2050.

The proposals also seek to make the European Railways Agency responsible for the safety certification of rolling stock and Railway Undertakings (TOCs in UK terminology). Additionally, EU member states will be required to create strong infrastructure managers that would integrate all functions, including long-term planning, path allocation, circulation management, and maintenance. In most circumstances, this should be done independently of train operators. Whilst it is possible that international operators remain subsidised by their domestic governments, it is hard to say whether these international competitions are truly fair.

These proposed regulations look to create a railway industry in each country that is very similar to the model used in the UK, with one major exception—the UK government specifies the private sector services to too high a degree, resulting in most UK services being defined as a public service offering. In certain areas, the UK Parliament sees the package as not going far enough, especially regarding maximum franchise size: the proposals allow franchises to be as large as one third of the domestic passenger volume. Parliament also fears that international governance arrangements are yet to be sufficiently defined.

It must also be noted that the previous three railway packages have had successes and failures. A key success is interoperability, where Europe-wide technical standards have been created which should allow services to run more smoothly from country to country. On the other hand, failures in creating an economic market have necessitated the measures detailed in this fourth package.

 

Image Header Source: Matt Buck (Creative Commons)