1.  The Office of Rail Regulation is the independent regulator of the rail industry in Great Britain. As such, we are the economic regulator for the national railway, focusing particularly on Network Rail and its key industry relationships. Since 1 April 2006, we have also been the health and safety regulator for all railways in Great Britain. As regulator of the national railway, we are not a funder of the railway. We cannot impose requirements which are specified and paid for through franchises.

  2.  In the exercise of our functions and powers, we routinely work with DfT, Transport Scotland, and other funders of passenger services to facilitate the franchising process. We regulate Network Rail, both by monitoring its performance under its network licence, and by setting its revenue requirement over successive control periods against the background of what government wants from the railway and the franchise agreements which are in place. We do it in a way which encourages and requires Network Rail to work with franchisees to meet the needs of passengers and freight customers.

THE PURPOSE OF PASSENGER RAIL FRANCHISING

  3.  We believe that the main line railway should be a partnership of Network Rail, train operators, suppliers and funders, working together to meet the needs of passengers and freight customers, and deliver a safe, high-performing, efficient and developing railway. Within an overall specification set by government and funders, we believe it is important that decision-making is wherever possible decentralised, and taken closer to the customer. Private sector companies should be empowered to make decisions in accordance with market needs, within a framework of incentives and accountability that ensures they operate in the public interest.

  4.  Within this framework, the objective of franchising should be to facilitate improvements in safety, performance, efficiency and customer service in order to enable the railway to continue to grow and to meet the needs of government and users.

  5.  To enable this to happen, we consider that passenger rail franchising should:

—  enable the separation of the specification and procurement of publicly financed passenger rail services from the provision of those services;

—  ensure that the provision of services is aligned with the needs of passengers and efficient and safe service provision;

—  enable the risk attached to service provision, in particular revenue risk, to be allocated to those best placed to manage that risk; and

—  enable the injection of new ideas and new management, and where appropriate new investment into Great Britain's railway service provision and network.

  6.  Such improvements are more likely if we capitalise on the expertise of franchise operators and their ability to be innovative in service delivery.

  7.  To achieve this, there needs to be:

—  a clear specification by government of what it requires, a competitive procurement process, and enforcement of the specification;

—  flexibility and incentives for operators to deliver in the most effective way and to adjust their offer to meet the needs of passengers and respond to changes in the market; and

—  a partnership with Network Rail, to deliver this.

  8.  The franchising system should not only allocate risk in a way which acknowledges the ability of franchise operators to manage those risks, but also provide operators with sufficient freedom to do so. Where new investment is desirable, franchises must either be long enough to enable franchise operators to develop an attractive business case for private sector investment, or must provide alternative mechanisms to enable outgoing franchise operators to obtain a fair share of residual value for any investments made during the franchise.

THE FRANCHISE AWARD PROCESS

  9.  At present, we have very little input into the design of franchises. We are currently working with DfT and Network Rail to become more closely involved at an earlier stage in the franchising process. By doing this we hope to help funders and bidders obtain greater clarity on the availability and use of network capacity before franchise bids are made. However, if this approach is to be successful, Network Rail will need to ensure that its knowledge of, and ability to model, the capacity and performance implications of service and timetable changes is adequate.

  10.  We believe that the widest possible range of private sector operators should be encouraged to bid for passenger rail franchises. This requires a franchising process which makes available to potential bidders comprehensive and uniform sets of information about the franchise in question. If the government is to encourage the entry into the franchise operation market of new operators with fresh ideas and operating practices it should work to make it as easy as possible for such operators to bid for franchises.

THE NATURE OF FRANCHISE CONTRACTS

  11.  We consider that the length of the franchise agreement can have a material effect on the way in which the franchise operator regards it. In general, the longer the franchise contract, the more chance there is of a franchise operator being prepared to invest time and resource in making improvements to the services and facilities it operates. Equally the government must be concerned at the possibility that very long franchise contracts, without the possibility of termination in the event of poor performance, could leave it powerless to act against poorly performing franchises. Subject to those considerations, we note that many railway improvements are unlikely to achieve positive returns in less than 10 years. This means that, even at the beginning of a 10-year franchise period it may be difficult to justify such investment and, as the franchise moves on from its early stages, the case for any further investment is diminished.

  12.  The government may consider that different franchises have different qualities and therefore require different models in order to achieve what is required. For example, where a franchise is likely to require significant changes in service, or enhancements to infrastructure, a different approach, in terms of the length of the franchise, or the degree of risk transfer, may be needed to that required for a relatively steady state franchise. As part of this, we also consider that the Government should be encouraging innovation and responsiveness—franchise tendering exercises which focus on the level of premium or subsidy to the exclusion of other desirable qualities may not always achieve this.

RISK APPORTIONMENT

  13.  We consider that the government should place those commercial risks with franchised operators which the operators are best placed to manage. That would imply that operators should generally take revenue risk, or at least a significant element of it. This would also help to align their incentives with the needs of passengers. However, it would be difficult to expect them to do so unless they also had greater freedom over service specification and had the ability to make changes to services where this could impact on revenue. The need for this is likely to vary according to the involvement and requirements of the funder of the services. In some cases, particularly intercity services, we consider that too prescriptive an approach to service specification can prevent operators from responding by using their expertise to optimise services in a way which meets the needs of passengers better. Some franchise operators could see themselves as simple service providers, managing cost plus contracts, rather than franchises where there is scope to improve earnings through the application of their management expertise, which we consider is likely to offer greater benefits to the passenger.

  14.  One area where the government assumes all risk is that of the effect of reviews of access charges on the costs borne by franchised train operators. At present, if we make changes which increase the charges made by Network Rail to franchised operators during the period of a franchise, the government is required by the terms of the franchise agreement to indemnify the operator against the additional cost. Similarly, if our decisions reduce charges, the operator is required to repay any gain to the government. The justification for this mechanism is that it makes it unnecessary for bidders to factor a risk premium for access charges into their bids for franchises and leaves that risk with government. In the past, the government has seen this as the best way to maximise value for money in bids.

  15.  We note that this approach can be relatively time-consuming in practice to administer for the industry. It also has the undesirable effect that changes, which we might make to the charging and incentive framework, cannot have any effect on franchise operators until the end of an existing franchise. Given the experience that now exists of the regulatory framework, and the work which we have done to improve the transparency and predictability of regulatory decisions relating to charges, it might now be worth considering whether there is a case for shifting the balance of at least some of this type of risk towards the franchise operator. If this were possible, it would ensure that franchised operators had a more direct experience of Network Rail's costs, and it would help to achieve a closer alignment of the incentives facing Network Rail and train operators.

SERVICE AND SAFETY IMPROVEMENT

  16.  The scope for improvements to be made through franchise agreements varies according to the quality of the existing service provision. Improvements are achieved either if they are specified as part of the franchise offer or if the franchise operator is given the incentive and the opportunity to identify and implement improvements during the course of its franchise. The former approach is the one largely adopted by the government and it carries the weakness that it is left to the government to identify those improvements which are desirable and affordable. Moreover, this is a static process which is carried out before the beginning of the franchise and which results in a specification which is then likely to remain in place through the life of the franchise (potentially 10 years). Passenger service provision should meet the needs of a constantly changing market. We consider that it should be made easier for franchise operators to identify potential improvements and to implement them, and that they should be incentivised through the franchise agreement to do so.

  17.  One area where we do, however, consider that there is scope for specifying improvements at the outset is that of safety—(purely by way of example, these could include matters such as improvements to stepping distances or passenger security). In this area we would like to see more discussion with the government on the potential for safety improvements which might be required with the introduction of new franchise agreements. These might not be improvements for which there is a commercial case, but ones where there are societal and other non-quantified benefits. It would make more sense to decide, at the outset, what was both desirable and affordable, so that bidders take account of such requirements when developing their bids.

COMPETITION

  18.  In recent years, the trend has been for a smaller number of larger franchises, moving towards the principle of one operator per major London terminus. In general, this approach has reduced the amount of direct competition between franchised operators over routes—although this continues in a limited number of cases.

  19.  There are arguments for and against this: consolidation can reduce the overhead costs of operations, and might also have a positive effect on train performance on routes leading to busy termini. However, this is, as yet unproved—for example, performance on services into Liverpool Street Station has not improved materially since the introduction of the "one" franchise. The passenger benefits of simplifying the service offer might be offset by the reduced choice available to passengers and some benefits of market competition might be lost. In addition, in cases where urban, local and inter-city operations have been merged, there is the possibility that the operator will be less responsive to the different requirements of its passengers.

  20.  Competition between operators can lead to improvements in the service to passengers. This includes competition by "open access" operators (ie companies operating rail services without a franchise). Hull Trains, which has significantly improved services between Hull and East Yorkshire and London, is an example of this.

  21.  We have a statutory duty to exercise our functions in part 1 of the Railways Act 1993 (which include the allocation of access on the network) in a way which promotes competition in the provision of railway services for the benefit of users of railway services. This duty is balanced by a number of other statutory duties, including a requirement to have regard to the effect of our decisions on the funds available to the Secretary of State and the Scottish Ministers. Before approving open access operations, we consider all matters relevant to our statutory duties in order to achieve an appropriate balance. We also have to make sure that we act in accordance with relevant European legislation.

  22.  Whilst we do not approve open access services which are expected to be primarily abstractive of revenue, it is still normal for such services to abstract some revenue from franchised operations. Our experience to date is that open access services can generate significant additional revenue. We consider that new open access services have the potential to bring worthwhile benefits for passengers and for the locations which the new services connect together directly.

  23.  The competition provided by such services can also generate other benefits—by stimulating a competitive response in existing franchised operators. Such benefits can range from improved customer service and facilities, to improved train frequencies and reduced fares. However, such benefits can only be achieved if franchised operators are able to respond. Our perception is that it can be difficult for them to do so under the terms of most current franchise agreements.

INTEGRATION OF TRAIN AND NETWORK OPERATION

  24.  There is a requirement (under both European and domestic law) for train and network operation to be separated for accounting purposes. This is intended to ensure transparency and to help market entry, and there is no reason for that to prevent greater alignment of those two activities—indeed we support that approach, so long as the interests of third parties are properly protected.

  25.  Network Rail and train operators should regard themselves as in a partnership—the development of joint performance improvement plans, joint boards and shared control rooms are all examples of this positive trend. In addition, we would support initiatives such as the proposal to transfer responsibility for the Merseyrail network from Network Rail to Merseytravel—which already has responsibility for train service specification and procurement in that area. This would have represented a useful pilot, and would also have provided the opportunity for some more direct benchmarking of performance, costs and efficiency than has previously been possible. Even without full vertical integration as proposed by Merseytravel, we believe there is much more scope to develop partnership at local level between franchisees and Network Rail, so that the franchise can be seen as effectively a joint venture.

ROLLING STOCK

  26.  Rolling stock for passenger train operators is mostly leased from rolling stock companies. Franchised operators are very unlikely to be able to fund rolling stock themselves unless franchises are significantly longer than at present, or mechanisms are in place to accommodate the residual risk associated with such funding.

SUMMARY

  27.  We believe that franchising can and should deliver improvements for passengers and better value for money for funders. We believe that this requires government to set a clear specification of what it wants to buy. This should contain enough flexibility to enable decisions as to how it is to be delivered to be made closer to the customer. Franchisees should be able to use their considerable railway expertise to respond efficiently to the needs of customers, within a framework of incentives and accountability which ensures this happens. The franchise needs to be operated and developed in partnership with Network Rail. We are keen to work with all industry stakeholders to facilitate this approach.

20 June 2006