INTRODUCTION

  The purpose of this memorandum is to provide the Committee with a summary of the Department's position on passenger rail franchising. The sections below set out the Department's views under the following headings:

I.  Opening statement.

II.  Purpose of passenger rail franchising.

III.  Process for awarding franchises.

IV.  Contractual arrangements.

V.  Competition and Industry Structure.

VI.  Summary and conclusions.

I.  OPENING STATEMENT

  The Department for Transport (DfT) undertook a wide ranging review of rail policy issues in 2004 that led to the publication of The Future of Rail White Paper (WP) in July 2004.

  The overarching aim was to tackle the problems that emerged following the privatisation of the railways by putting in place a more effective industry structure in which:

—  Government sets the overall framework with the Secretary of State setting strategy/rail budget and DfT letting franchises;

—  Network Rail delivers an efficient network and takes a lead on performance;

—  Train Operating Companies (TOCs) deliver services for their customers; and

—  Office of Rail Regulation takes responsibility for economic and safety regulation.

  There were a number of WP commitments made in relation to passenger rail franchising—some proposed change whereas others endorsed maintaining the status quo. Since this time, DfT has been driving forward improvements to the franchising process, in collaboration with industry partners, through new working practices and changes to contractual relationships. In parallel, we have been successful in maintaining "business as usual" with a new franchise map formally announced in October 2005, three franchise competitions completed either on-time or ahead of schedule in late 2005, continued delivery to key milestones on four current competitions, and ongoing engagement with key stakeholders that recognises the changing roles of devolved bodies.

  In March 2006, DfT published "A Guide to the railway franchise procurement process", which provides interested parties with an overview of the policies and procedures employed, including the distinction between the roles carried out by Ministers and those delegated to rail officials. It also reinforces the WP objectives of placing greater emphasis on past performance during the pre-qualification process and awarding franchise contracts on the basis of price and a commitment to reliability. There is also the DfT's Franchise Replacement Process Manual (June 2006)—primarily an internal guidance document—which outlines the templated processes followed, including DfT's commitment to continuous review through compliance with Office of Government Commerce (OGC) best practice. We are also due to issue formally the guidance notes we have been developing for Passenger Transport Executives (PTEs), which summarises their rights and roles in the revised franchising process.

II.  PURPOSE OF PASSENGER RAIL FRANCHISING

What should be the purpose of passenger rail franchising?

Is the current system achieving that purpose?

  The WP highlighted how privatisation of the rail industry was introduced in the early 1990s on the premise that "private sector innovation and discipline would drive down the railway's public funding requirement and drive up quality of service, against a backdrop of falling demand" (WP 1.2.1).

  Although it was acknowledged that franchises were successful in some areas (eg through helping to grow the rail market), there were constraints (eg difficulty in sustaining revenue growth once network capacity became more constrained), including the original franchise contract having little capacity to deal with significant change. There were also costly renegotiations when TOCs found themselves unable to deliver the commitments outlined in their original bids. More generally, there were problems with the overall industry structure, as the attempt to create a commercial relationship between the infrastructure and service providers failed and there was a misalignment of incentives between the rail parties, particularly with respect to operational performance.

  Through the Rail Review, publication of the WP, and subsequent implementation, Government has sought to remedy these issues and redefine what the purpose of franchising should be.

  The Franchising process is designed to harness private sector commercial judgment and innovation to reduce the net cost and increase the value for money (VfM) achieved from the Government's overall support for passenger rail services.

  By setting the base specification for each franchise, the Government is seeking to achieve a number of high level objectives:

—  to set out the level of train service provision required (through a review of historic provision and forecast of future demand) where, otherwise, market forces would not normally deliver;

—  to protect the passenger from monopolistic actions in specific markets (eg through regulation of London commuter fares);

—  to protect the benefits of a national rail network in the UK mainland;

—  to provide a "level playing field" for a competition to successfully award the franchise within the terms of procurement legislation and general best practice; and

—  to allow the specification to be varied over time to reflect emerging market needs through innovation and commercial judgment.

  This approach seeks to achieve an appropriate balance between sufficient specification to deliver Government objectives and enabling the benefits of private sector innovation and commercial judgment to be applied during the procurement and subsequent franchise term.

  It is also designed to secure:

—  a continuing improvement in rail services' operational performance, in line with the Public Service Agreement (PSA) targets;

—  sufficient capacity to accommodate passenger demand—generally within existing infrastructure constraints; and

—  continued delivery of WP aims, including the new franchise map and allowing Local Decision Makers (LDMs) to exercise their right to buy/propose savings.

  It should be noted that, since 1994, the outcome of this industry structure has helped to deliver growing passenger volumes in the UK mainland. In parallel, there have been overall improvements in safety standards.

III.  PROCESS FOR AWARDING FRANCHISES

How well does the process for awarding franchises work?

  DfT's approach to franchising builds on the processes developed in recent years at the Strategic Rail Authority (SRA) whilst also implementing significant improvements.

  The Franchise Replacement Process Manual outlines the staged and gated processes followed by the DfT in which individual projects are initiated about two years before a franchise is due to expire. A simplification of the key stages followed is summarised below:

—  Specification of what Government wishes to buy (with reference to VfM and affordability) in consultation with key stakeholders;

—  Procurement competition to elicit the most competitive bid from prospective TOCs;

—  Mobilisation period between announcement of award to Selected Bidder and commencement of new franchise;

—  Operation/Service Delivery by TOC for a defined franchise length, which involves Government monitoring relevant commitments to ensure benefits are realised and assessing operational and financial risks; and

—  Franchise close during the "Last 12 Months" when the Government exerts stronger contractual control.

  Simplified overviews of the DfT's Franchise Replacement Process and forward plan of activities are respectively provided in Attachments 1 and 2.

What input do operators, passengers and other interested parties have into the design of franchised services?

  In developing the specification for individual franchising projects, we employ an objective-led, evidence-based approach that takes into account available information on demand, growth and development from relevant Route Utilisation Strategies and other studies. We also seek to understand the operational and financial interdependencies between franchise propositions and continuously engage with industry partners and other key stakeholders for their input—in particular, Network Rail who provides timetabling assistance to the DfT during the development of the service specification.

  The formal means through which passengers and other interested parties (eg Passenger Focus, London Travelwatch, and local authorities) input to the design of franchised services is through our consultation process. We also work with LDMs, like Transport for London (TfL) and PTEs, during this period to enable them to exercise their right to buy additional services ("increments") or propose savings ("decrements").

  These inputs are developed into a specification that captures these requirements whilst allowing appropriate scope for private sector innovation and commercial judgment to further develop the specification over the franchise period. For instance, in previous competitions, bidders have proposed additional services and minor investment schemes that have been contractualised on the basis of being cost neutral overall.

What criteria and processes are used to evaluate franchise bids?

  "A Guide to the railway franchise procurement process" demonstrates our commitment to a consistent and transparent process. It also highlights how the revised franchise replacement process has been one of the starting points for enacting change.

  Our recently augmented pre-qualification phase gives greater weighting to track record (70%) with another 25% on bidders' plans for mobilising and operating the franchise and 5% on their approach to bidding. A proven track record of customer delivery and financial management is the best guarantee of ensuring that we shortlist a field of bidders we are confident could run a franchise were they to submit the winning bid in the next procurement stage (Invitation to Tender). Our new approach would also make it difficult to entertain any bids (for at least several years) from any TOC who, as a result of its own business decisions, gets into serious financial difficulties so that it defaults on the franchise. In addition to attracting the right bidders, we also seek to ensure we get the right price by maintaining competitive tension through the subsequent stages of evaluation by only announcing the Selected Bidder once the contract award has been firmly agreed.

  Through our procurement strategy, we seek to elicit the most competitive bid for the specification. The franchise specification itself is critical to ensuring there is a "level playing field" in which all bids are compared to a common output requirement. The evaluation of bids is underpinned by analysis of the reliability of operational deliverability and the achievability of the bid revenue, so that the bid offering the best overall deal for the taxpayer is selected.

Has there been a smooth transition of franchising arrangements from the Strategic Rail Authority to the Department for Transport?

  DfT successfully awarded the three franchise competitions (Integrated Kent, Thameslink/Great Northern, and Greater Western) inherited from the SRA either on-time or ahead of schedule and we have continued to achieve on-time delivery to key milestones on the ongoing competitions. We issued the Invitation to Tender for the South Western franchise at the end of March with bids expected to be returned at the end of June. During October 2005, we published a new franchise map, which will see a reduction in the number of franchises in the Midlands from four to three (following the expiry of existing franchises) and a better alignment with Network Rail's regional structure. Prior Information Notices for the three new franchises—New Cross Country, East Midlands, and West Midlands—were published in February 2006 with advertisements seeking Expressions of Interest being published at the start of this month. The formal consultation period for these three commenced on schedule in early June and the Invitations to Tender will follow at the end of October 2006.

  In parallel, we have enacted the policy changes discussed herein (eg revised bidding process and less prescriptive approach to franchise specification). The Department is committed to a process of continuous review and improvement for the franchising process with the aim of securing best VfM bids on behalf of rail passengers and taxpayers.

IV.  FRANCHISE CONTRACTS

Are franchise contracts the right size, type and length?

What criteria and processes are used to determine the nature and length of franchises?

  The WP proposed a reduction in the number of UK franchises and alignment as far as possible with Network Rail regions and routes in order to encourage joint working between track and train to deliver an improved service to customers. This has had consequential impacts on the general scope of franchise areas with the Government formally announcing, in October 2004, a reduction in the number of franchises from 25 to 19 with the detailed plans of the new franchise map being revealed in October 2005.

  In terms of the contractual arrangements, the DfT has proposed a number of improvements in consultation with key industry partners. For instance, we have sought to simplify franchise contracts by separating the general requirements that apply to all new franchises—the National Rail Franchise Terms—from franchise specific terms, resulting in streamlined negotiating activity. We have also reduced the number of Key Performance Indicators to lessen the management burden on franchises and avoid micro-management by the Department. This, again, reflects improving the balance between a centrally imposed specification and facilitating train operators' commercial skills and innovation.

  The overall aim of both initiatives has been to incentivise operators to focus on the key outputs sought. Likewise, contractual obligations are limited to areas where franchise operators have demonstrated the most success (ie delivering services and other minor enhancements, including third party funded initiatives, to their passenger). Capital enhancements are no longer included in the base case, which helps to mitigate a number of risks surrounding costs and deliverability. Instead, Network Rail will deliver all capital enhancements in response to the Government's High Level Output Specification.

  The Government has decided to let contracts of varying lengths. Current policy is that franchises will generally be let for periods of eight to 10 years, as experience has shown that there are challenges in forecasting cost/revenue any further ahead than that with any confidence. Also, Government takes the view that this is long enough to present an attractive business opportunity—thus encouraging a robust field of bidders—whilst allowing the taxpayer and passenger to benefit from the innovation and efficiencies associated with competitions taking place at regular intervals.

  There might be a good case to let longer contracts in specific circumstances, for instance when a franchise will cover a period of operational instability or there is an identified need to allow a longer period for a return on an operator investment. However, these would need to be balanced against the risks of TOCs seeking financial support in the later years of their franchise life for items deemed to be out of their control.

  Likewise, in some instances, it is appropriate to include "break clauses" to deal with the implications of major infrastructure projects (eg Thameslink Route Modernisation). There may also be justification for aligning contiguous franchises' terms to enable a more holistic review of future service provision. Again, such exceptions would need to be carefully considered during the development of the procurement strategy and with reference to EU Directives.

Do franchise holders deliver value for money to passengers and the Government throughout the duration of their contracts?

  Franchise specifications are developed in accordance with strict VfM guidelines, based on appraisal principles set out in the Treasury Green Book and the DfT Transport Analysis Guide. As previously highlighted, DfT also ensures that key outputs are contractualised at franchise award.

  During the life of the franchise, we ensure that benefits are realised through the review of contractual obligations. These include monitoring TOCs' financial and operational performance on a monthly basis and taking a quarterly review of the financial health of their owning groups. Review of these operational and financial obligations provides an early warning system for the DfT. In addition, on the newer franchises, there is a forward planning requirement to submit an annual Business Plan. TOCs are also incentivised to continuously improve operational performance, as the achievement of specified performance targets allows them to retain the right to continue operating the franchise in its later years.

  We have also committed to conducting Post Project Evaluation reviews to confirm whether the original business case justification, as agreed by the DfT, was realistic and seek independent confirmation that the franchise obligations are being (and will continue to be) delivered in line with original contract terms.

  There are also cross-industry PSA targets, where joint success has been achieved by exceeding operational performance of 85% of trains running on-time, as measured by the industry standard Public Performance Measure (PPM), by March 2006. This was achieved six months early. Passenger Focus also performs a valuable role for the industry through reviewing customer satisfaction via the National Passenger Survey and London Travelwatch provides a similar challenge function (where appropriate).

Are risks suitably apportioned between the Government and franchise holders?

  DfT has attempted to incorporate an appropriate balance of risk between the public and private sectors in the new franchise contracts through provisions such as:

—  a variation mechanism to cope with changes during the life of the franchise;

—  revenue share/support arrangements so TOCs are not held accountable for major revenue risks beyond their control (eg GDP dips or Government action) whilst simultaneously ensuring that any windfall revenue gains are shared with Government;

—  pass through mechanisms so TOCs are not held accountable for certain cost risks beyond their control (eg Track Access Charge changes); and

—  force majeure provisions to cope with certain extraneous events beyond the TOCs' operational control (eg natural disasters or terrorism).

  However, we have also made clear that we expect contractual commitments to be delivered. For instance, new franchises are expected to ensure the financial viability of the business through a requirement for their Management Accounts to include compliance with specific financial ratios. Failure to deliver such obligations leads to graduated penalties, ultimately resulting in them being liable to lose their franchise. If necessary, we are prepared to use our Operator of Last Resort powers (as shown when Connex South Eastern was failing as a franchise) and consequently have robust plans in place to ensure the continued provision of train services to the public.

What is the scope for improving services through franchise agreements?

  We previously highlighted the contractual mechanisms in place to incentivise continuous improvement in operational performance throughout the life of the franchise.

  More generally, in re-letting franchises, the DfT reviews the scope of the proposed franchise services, including future market requirements, which gives us an initial view of the minimum service levels required. One of the key aspects of the procurement process is that there is flexibility for bidders to be innovative through proposing additional services—provided there are no adverse effects on operational performance and there is no abstraction of revenue from other operators. There is also the opportunity for bidders to propose additional investment, for instance to rolling stock or minor station enhancements (eg Passenger Information Systems and CCTV). This helps to secure improvements before the franchise contract is let through the sound commercial judgment of the private sector.

  It is likewise accepted that services should not remain static and we are committed to working with TOCs as changes arise during the franchise life—employing the variation mechanism where needed—in line with principles previously described to harness the innovation, commercial judgement, knowledge and skills that the private sector brings.

V.  COMPETITION AND INDUSTRY STRUCTURE

Do we need more competition and vertical integration?

  The foremost competition for the passenger rail industry is with other modes of transport, so we work to ensure that the rail offer is competitive, for example, with air travel between London and Manchester, and with the M4 alternative between London and Bristol and South Wales.

  Competition within the rail industry is achieved by the holding of vigorous competitions for new and replacement passenger franchises. The aggressive bidding that has characterised recent franchise replacement contests has ensured a good deal for the taxpayer, and there is no sign that the forthcoming round of franchise letting will be any less competitive.

  The main competition within the rail industry, therefore, is the competition "for the ground" rather than "on the ground". The actions of TOCs since privatisation have shown that competition for lucrative passenger flows on congested routes results in a poor use of track capacity, because the incentive is for operators to concentrate more on maximising their returns through the revenue allocation system than on the provision of a coherent service pattern.

Is franchising compatible with open access operations?

  The DfT maintain the position "that operators should continue to be free to apply to run passenger services under open access rights" as "the possibility of purely commercial services supplementing those provided under franchise remains a valuable one" (WP 4.4.9) but we think "access rights should not be granted for services which just poach passengers from other services and do not increase the overall market" (WP 4.4.10).

Should train, rolling stock and track operation be more closely integrated?

  The main reasons for not combining track and train are (a) EU restrictions and (b) the fact that the revised franchise model between infrastructure owner and train service operators has been working well, especially since Network Rail sharpened its focus on network performance. The wheel/rail interface issues are controlled effectively by industry working groups involving both Network Rail and the TOCs.

  One of the successes of rail policy since the demise of Railtrack and publication of the WP has been the evidence of much closer alignment of incentives between Network Rail and the TOCs. This has led to more co-ordinated working at the ground level, as evidenced by the setting up of new integrated control centres at Waterloo and Swindon. Similarly, the development of the High Speed Train replacement project at national level is benefiting from a close working relationship between DfT and Network Rail. The DfT continues to believe that such alignment of incentives and collaborative working is the optimal solution for the rail industry, as there are a number of drawbacks to combining ownership of track and train.

  Vertical integration of infrastructure and train operation, on any geographical area of the rail network, would lead to difficulty in securing sufficient competition without additional regulation, as monopolies could be created through merging track and train operations. In addition, it would require measures to ensure the effective operation of any "inter-regional" and freight trains that might be required to operate over the infrastructure, as the "owning" operator would naturally be inclined to favour its own trains. In general, there would be a loss of synergy and associated economies of scale from moving away from a body that is able to manage network issues at a national level.

  There are similar issues with integrating rolling stock, although ORR has been taking account of different types of rolling stock in setting access charges with a view to incentivising behaviour towards minimising total long-terms costs. Overall, DfT continues to maintain that rolling stock risk is generally best left to the market to take. The asset life of rolling stock tends to be 30 to 40 years, whereas the franchise terms are considerably shorter, so there is an incentive on the Rolling Stock Leasing companies to develop and improve their trains to make them commercially attractive for new franchisees.

VI.  SUMMARY AND CONCLUSIONS

  The Rail Review and subsequent WP implementation sought to address cross industry rail issues, including a number relating to passenger rail franchising. This memorandum has sought to address all of the questions posed by the Transport Select Committee through providing the relevant background leading up to the DfT's current policy.

  DfT has sought to learn from historical industry experience and enact a franchising policy that achieves an appropriate balance of risk, reward and involvement between the public and private sectors. Good progress has been achieved since taking over direct responsibility for the franchise replacement process which is reflected by the on-time and ahead of schedule delivery of key milestones on both completed and ongoing competitions.

  DfT will continue to review and monitor progress through Post Project Evaluation and continued compliance with OGC best practice with the ongoing aim of delivering the best deal for both the passenger and taxpayer.

21 June 2006