INTRODUCTION

  1.  This submission forms my supplementary written evidence in response to the letter from the Clerk of the Transport Sub-Committee dated 19 May 2000. As we agreed before I submitted my initial evidence, and as we discussed at my last appearance before the Committee on 12 July 2000, this submission covers the decisions which I have reached in my final conclusions on the periodic review of Railtrack's access charges. In particular, it covers the regime, which I have put in place to ensure that Railtrack is properly funded and incentivised to maintain and renew the network, in a safe and efficient manner over the coming five years, from 1 April 2001.

  2.  At the time of writing, the tragedy at Hatfield and the subsequent need to impose speed restrictions on large parts of the network are foremost in our minds. In my last submission to the sub-committee, I noted the importance of safety on the network. I reiterate that view and continue to work closely with the Health and Safety Executive (HSE). The periodic review has ensured that Railtrack will be funded as necessary to protect safety on the network.

  3.  The periodic review of Railtrack's access charges, which I have been working on since July 1999, has been a major piece of work. We have consulted extensively with Railtrack and other players in the industry and received advice from several expert consultants in their fields. In total we have published 15 consultation documents and 19 reports from consultants. I have held formal hearings with Railtrack and others, and have listened very carefully to everything which has been said.

  4.  Following this consultation, I have assessed Railtrack's revenue requirements for the next five years by considering the level of expenditure required to operate, maintain, renew, and enhance the network to deliver the baseline outputs (£14.9 billion). I have also established the required return on the company's regulatory asset base or RAB (at £2.8 billion). Finally, I have considered the income which it is expected to receive from stations, property, freight, open access passenger services and other sources (£3.7 billion). The net revenue requirement over the next five years is therefore £14.0 billion (ie 14.9 + 2.8-3.7).

  5.  The Government has decided that £4.6 billion of this revenue requirement should be supported by a direct grant. Given this, I have concluded that £8.8 billion should be paid through track access charges from franchised passenger operators. I have also profiled Railtrack's revenues so that they are lower at the start of the period than at the end. This profile is intended to facilitate Railtrack's financing of its activities and to meet the preferences of SSRA and DETR (since the implications of the periodic review are passed on to SSRA through the terms of the franchise agreements).

  6.  The remainder of the £14 billion revenue requirement (£0.6 billion) has been added to the March 2006 RAB and will therefore be funded beyond the next five years. This is equivalent to including in the RAB the increase in allowed expenditure since my draft conclusions in July 2000 (rather than funding this work on a pay-as-you-go basis).

  7.  The review has also been about defining the outputs which Railtrack is expected to deliver, and establishing appropriate arrangements for monitoring and incentivising delivery of these outputs. I have also introduced new mechanisms which ensure that Railtrack is fully funded to deliver additional obligations which might be imposed upon it as well as providing a more robust framework for enhancement. I have made wholesale changes to the current regime. These changes, combined with the licence conditions and model clauses for access agreements which I discussed with the sub-committee in July, will put in place the right framework for delivery of the railway which we all want.

  8.  This submission covers the following issues which were raised at my last appearance before the Committee (a full summary of my conclusions is contained in the introduction to my conclusions on the periodic review):

—  Railtrack's record on maintenance and renewal of the network over the last five years: including additional renewals expenditure;

—  operation, maintenance and renewal of the sustained network over the next five years: including definition of that network, the improvements in efficiency which Railtrack can achieve, and the new incentive framework within which Railtrack will operate; and

—  Enhancements of the network: including the West Coast Route Modernisation (WCRM) and the SSRA's Incremental Output Statement, and safety related expenditure.

RAILTRACK'S RECORD ON MAINTENANCE AND RENEWAL OF THE NETWORK

  9.  Railtrack's performance over the last five years is an important factor in assessing the value of its RAB for the next control period. In particular therefore I have considered the company's:

—  underdelivery of the outputs which could reasonably have been expected from an efficient operator; and

—  additional expenditure on renewal of the network and enhancement of the network over the last five years.

Under-delivery

  10.  Since the December 1999 provisional conclusions on Railtrack's revenue requirements, it has been clear that I do not believe Railtrack provided all the outputs for which it was paid over the last five years. This is confirmed by the advice which Booz Allen & Hamilton, a leading firm of consultants in this field, gave in their November 1999 report on Railtrack's stewardship of the network. In particular, I have been advised that, on track and signalling, Railtrack has not delivered what might reasonably have been expected (eg track renewal rates were less than assumed at privatisation, particularly sleepers and ballast).

  11.  In considering the case for an adjustment to the RAB, I have had regard to the fact that the outputs, which Railtrack was expected to deliver, were not fully specified. I have also taken account of the additional expenditure which Railtrack has incurred since privatisation and the extent to which this has been included in the RAB (see below). Finally, on determining the appropriate adjustment to the RAB, I considered the approaches adopted by other regulators. My final conclusions therefore reduced the March 2001 RAB by £120 million, which is the minimum amount consistent with the available evidence on under delivery and the adjustments made by other regulators.

adjustments made by other regulators.

Additional renewals and enhancement

  12.  Despite this evidence of under delivery, Railtrack points out that it has spent around £1.9 billion more on renewals than was anticipated when the initial price controls were set. I have included two elements of this additional expenditure in the RAB:

—  £700 million of additional renewals which were anticipated at privatisation (net of the associated reduction in tax) have been included in the RAB since these additional requirements were equivalent to selling the company with additional debt (which would have been included in the RAB);

—  £514 million of additional expenditure which was not anticipated at privatisation has been included in the RAB. Although this expenditure had initially been classified as renewals, it represents an investment in additional outputs such as improved performance (this is in addition to £851 million of enhancement expenditure in the first control period which has also been included in the RAB).

OPERATION MAINTENANCE AND RENEWAL OF THE NETWORK

The level of activity required to sustain the network

  13.  The level of expenditure which the periodic review has provided for will enable Railtrack to deliver the baseline outputs in accordance with best practice, and in a timely, economic manner so as to satisfy the reasonable requirements of its customers and funders in respect of the quality and capability of the network.

  14.  I have assessed this expenditure based on detailed analysis of the level of maintenance and renewal activity required to sustain the network. This has involved extensive discussion with Railtrack and the use of external consultants. In most areas, Railtrack has accepted my conclusions on the required level of maintenance and renewal activity. In the case of track renewal, however, following the advice of my consultants, I have allowed for significant additional activity, and therefore expenditure, compared to the company's initial projections.

  15.  Although I have made expenditure projections for the next five years, I would generally expect Railtrack to be funded for the efficient cost of meeting additional obligations which are imposed upon it during this period (eg additional safety or environmental obligations). I have indicated that I would generally expect this to be achieved through an adjustment to the RAB at the next periodic review (eg I have proposed an automatic mechanism for adjusting the RAB to compensate Railtrack for any additional cost arising from the current investigation into broken rails). In some cases, however, the short term impact on Railtrack's financial position may mean that charges need to be adjusted before the next review. I have therefore provided for the possibility of an interim review of access charges and would expect Railtrack to make representations to me if it believes that there is a compelling case for such a review.

Improvements in efficiency

  16.  The initial assessment of Railtrack's revenue requirements was based on current costs and expenditure. However, I also consider that Railtrack should be able to work more efficiently. Given the requirement for increased activity, there is no suggestion that Railtrack should reduce its expenditure, rather it should do more with the money it receives.

  17.  To assess the scope for efficiency gains, I have examined:

—  bottom-up engineering estimates of possible efficiency gains;

—  improvements in efficiency achieved by other privatised utilities;

—  international comparisons with other railways;

—  Railtrack's efficiency at privatisation and the improvements made in the first control period; and

—  the conditions of the supply market.

  18.  All this evidence has led me to conclude that Railtrack should be able to achieve significant efficiency improvements. I have therefore assumed savings of 2 per cent in the first year, 3 per cent in the second year, 4 per cent in the next two years, and 5 per cent in the last year of the control period. This is equivalent (in present value terms) to a constant rate of 3.1 per cent per annum compared to 2 per cent per annum proposed by Railtrack and 3.8 per cent per annum assumed in my draft conclusions in July 2000. The reduced efficiency assumption since July is attributable primarily to the impact of increased activity in the construction sector on the input prices which Railtrack is likely to face over the next five years.

on the input prices which Railtrack is likely to face over the next five years.

Monitoring and incentivising delivery

  19.  As part of the review I have defined the baseline outputs which Railtrack is expected to deliver over the next control period. These include measures relating to the capability and performance of the network as well as measures of the condition and serviceability of the assets. I have also proposed three licence modifications to enable me to monitor delivery of these outputs more effectively (these relate to regulatory accounts, the annual return and the appointment of independent reporters).

  20.  In addition, I have set out the approach which I would expect to adopt for the next periodic review. In particular, I propose to adjust the RAB to compensate for under- or overspend on train control systems. In other areas, I propose to increase the RAB so that Railtrack retains the benefit from unanticipated efficiency savings for a period of five years (regardless of whether they are achieved at the beginning or end of the period). On the other hand, I would also expect to reduce the RAB in the event of significant underdelivery against the specified baseline outputs in these areas. This approach should therefore provide a clear incentive for Railtrack to deliver the baseline outputs as efficiently as possible.

  21.  Given this incentive based approach to the next periodic review, failure to deliver the expected levels of serviceability and condition, or the assumed activity levels, would not generally need to result in enforcement action. However, if the company is seen to be falling well short of the relevant targets, this may be an indicator of serious stewardship problems, necessitating immediate enforcement action. Railtrack has provided constructive input towards defining the relevant targets and my final conclusions have defined both the circumstances in which action would be required and the basis for establishing monetary penalties (if any) if enforcement action is required.

Structure of charges and the performance/possessions regimes

  22.  I have argued consistently that Railtrack has public interest obligations in its stewardship of the network. I have now put in place a framework which will incentivise it to meet those requirements and I believe that this should minimise the need for intrusive regulation. The main changes to the structure of charges which I have introduced will:

—  ensure that Railtrack's charges are broadly cost-reflective by increasing the extent to which these charges vary with the level of traffic;

charges vary with the level of traffic;

—  increase transparency and predictability of charges by replacing negotiated charges with predetermined tariffs;

—  provide an incentive for Railtrack to be more responsive to the needs of its customers and funders through an explicit volume incentive in the RAB; and

—  ensure that Railtrack has an incentive to manage its property portfolio efficiently while ensuring that any outperformance is shared with the industry.

  23.  I have also made significant changes to the performance and possession regimes:

—  the incentive rates in the performance regime have been increased to reflect the increased societal values proposed by the SSRA and recalibrate the performance points (benchmarks) to the expected level of performance over the next control period. The arrangements have also been simplified to a significant degree to improve the transparency and effectiveness of the regime. However, as emphasised in both my draft conclusions and my final conclusions, safety is paramount and well managed companies will be both safe and efficient; and

—  the possessions regime has been modified to remove the free possessions allowances (which are different for different operators) and to provide the same compensation for operators regardless of whether the possessions arise from enhancements or renewal work. This should incentivise and make it simpler for Railtrack to make better use of possessions including, where appropriate, use of longer but less frequent possessions. In addition I have incentivised Railtrack to give operators early notification of the proposed possessions where this is possible.

ENHANCEMENTS OF THE NETWORK

Enhancement framework

  24.  Although the precise terms for most new enhancements to the network are outside the scope of the periodic review (eg those arising from the franchise replacement process), I have provided considerable detail on the regulatory framework for enhancement. In particular, I have clarified the basis upon which I would expect charges to be established where these are subject to my approval. I have also clarified the way in which these enhancements will be treated at future periodic reviews (ie how they will be treated in the RAB). The basic principle is that the terms should be agreed at the outset so that these terms can be adhered to. This should provide the necessary transparency and predictability to facilitate investment in the network.

West Coast Route Modernisation

  25.  As part of the periodic review, I have assessed the cost of the West Coast Route Modernisation—this includes substantial expenditure on renewal of the network which is subject to the periodic review as well as enhancement expenditure which is outside the scope of the review. In June 2000, I indicated that Railtrack's estimate of the cost of the entire project had increased from £2.3 billion to around £5.8 billion. My assessment of the total cost of the project is around £5 billion which is made up as follows:

—  £1,092 million of expenditure on renewal in the first control period—£371 million of this was paid for in access charges in the first control period. This was effectively a fixed price contract. However, I have included £170 million of the additional expenditure in the RAB since this represents investment in improved outputs (eg performance). This therefore implies unremunerated expenditure of around £551 million in the first control period;

—  £2,524 million of maintenance and renewals expenditure has been provided for in access charges over the next control period. In addition, £105 million of costs are expected to arise in the third control period and will therefore be subject to further assessment at the next periodic review. Although these costs are much higher than originally estimated, this element of the project was clearly not intended to be subject to a fixed price contract; and

clearly not intended to be subject to a fixed price contract; and

—  the cost of the enhancements required by West Coast Trains plus the cost of the additional 42 slow line paths is estimated at £1,306 million. The West Coast Trains element is subject to a fixed price contract valued at £546 million and the Regulator has concluded that delivery of the 42 slow line paths would also be a reasonable requirement if Railtrack is paid £500 million linked to delivery of these enhancements. This therefore leaves around £260 million of unremunerated costs associated with these enhancements.

  26.  In addition to the charging arrangements, I have set out the way in which I propose to establish milestones for delivery of the project in conjunction with the SSRA and Railtrack. Given the importance and the history associated with this project, I have also set out the way in which I expect to monitor and incentivise delivery of these milestones. If Railtrack fails to deliver a milestone it would be required to take remedial measures and may face penalties if it fails to implement these.

Incremental Output Statement (IOS)

  27.  As well as the large programme of enhancement on the West Coast, the SSRA has asked Railtrack to cost a programme of small enhancements to the network which can be delivered quickly and at relatively low cost. The total cost of this programme currently stands at around £409 million.

  28.  I have concluded that there is more work to be done in defining these outputs and the SSRA wishes to consider further the value for money which each represents, and hence I intend to review these schemes by around July 2001. Following that review, operators will pay Railtrack only on delivery of the outputs (or part of the output if I agree that it has been delivered).

Safety related expenditure

  29.  The periodic review includes substantial allowance for safety related expenditure. This includes £3.7 billion for maintenance and renewal of track, including £150 million specifically targeted on reducing the incidence of broken rails, and £4.2 billion on maintenance and renewal of train control systems (ie signalling and telecoms).

  30.  Further expenditure in respect of the second control period has been included in the RAB. This consists of £781 million of expenditure on signalling, including £460 million of enhancement expenditure relating to TPWS and other train control systems, plus £42 million on platform stepping distances.

  31.  As noted above, I have also introduced new mechanisms to ensure that Railtrack is funded to deliver any further obligations which are imposed during the next control period.

any further obligations which are imposed during the next control period.

CONCLUSIONS

  32.  The most significant single part of my programme of reform has been the restructuring and resetting of the financial regime in which the company operates. The financial framework of the railway industry needs to provide the companies concerned with a stable and sound environment for investment. That means improving the incentives to invest in new capacity and better services, and ensuring that they have certainty and predictability in how that investment will be treated in future regulatory reviews. This is essential if the industry is to raise the finance needed to deliver the required level of investment in the network.

  33.  Accordingly, I have also announced new accountabilities of Railtrack for the proper and timely use of this money, with the ability to check on the progress and quality of spending and work and the ability to correct shortcomings before they become serious. My reforms involve new licence conditions relating to provision of information by Railtrack and the verification of this information by independent reporters. They also include restraints on the disposal of its assets (including land) which may be needed for railway uses in the future, and the establishment of a reliable and comprehensive register of the condition, capacity and capability of the company's assets.

  34.  This review delivers a financial framework for Railtrack—and through Railtrack the industry—which establishes a better, clearer and fairer balance of responsibility and obligation in the industry. It creates a virtuous circle of effective incentive-based regulation, strong and empowered management, clear contracts and sound accountability. These things are necessary for a long-term framework for sustained improvement in performance.

  35.  This review equips Railtrack to invest strongly and efficiently. The shortcomings of the current regime are swept away, replaced by a sound framework for investment and the finance to carry out a rail renaissance whose momentum must increase strongly and quickly. Thus endowed, Railtrack has no more excuses. The responsibility on Railtrack, buttressed by increased accountability through stronger and fairer contracts, a reformed network licence and clear financial incentives, is considerable. Together, this public-private partnership can and must be made to work well for the industry, for investment and above all for passengers and freight.

November 2000