INTRODUCTION

  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 existing franchises.

  3.  It proposes a structure within which private sector finding can be attracted to the industry notwithstanding Railtrack's effective withdrawal from infrastructure enhancement.

EVOLUTION OF THE ROLE OF TRAIN OPERATING COMPANIES

  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.

TWO YEAR EXTENSIONS

  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 forecast.

  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.

RAILTRACK

  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 derailment

—  An associated projected increase of £700 million pa increase in the costs of operations, maintenance and renewal

—  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.

RAILWAY COMPANIES?

  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 operators—and, 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 Companies—freight and cross-country passenger services are obvious exceptions—and 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.

FRANCHISE LENGTH

  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 unsustainable losses.

  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 static—generally 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 projects—the 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 TOC earnings.

—  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 debt funding.

Stephen Grant

1 October 2001

REFERENCES

  i  Transport 2010—The 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.