Select Committee on Transport, Local Government and the Regions Appendices to the Minutes of Evidence

Supplementary memorandum by the Rail Regulator (PRF 53B)


  This note contains the Rail Regulator's response to a number of supplementary points that were requested following his appearance before the Sub-Committee on 7 November 2001.


  Should Railtrack's successor emerge from administration in the same form (albeit with different ownership) as the old company?

    (a)  Should the opportunity be taken to create a new company with regional subsidiaries which would be responsible for the maintenance and renewal of the rail network?


  An operator of the national rail network needs an appropriate balance between requirements of network integrity (such as timetabling, operations control, engineering and operational standards, prioritisation of resources and dealing with train operators who cross boundaries) and those of local delivery (day-to-day operation, maintenance and renewal). This was true for Railtrack, which sought to achieve it by means of its zonal organisation, and it will be so for any successor organisation.

  Creation of separate subsidiary companies, rather than just management units as was the case with Railtrack, could facilitate comparison of performance between subsidiaries. It could, under certain circumstances, also facilitate development of alternative structural models (eg local vertical integration were this considered desirable). However, there would be a risk of much more complex contractual relationships (most train operators operate over more than one Railtrack zone, and freight operators over all zones) between operators and individual subsidiaries which could seriously disadvantage operators and undermine processes such as the national timetabling procedure, acceptance of new rolling stock and major network improvements.


  What is the most appropriate basis for funding Railtrack's successor?

    (a)  Should all of the money come from track access charges or should some come directly from the Government/SRA?

Response to main question

  Railtrack's successor will require adequate funds which reflect the costs of sustaining the network effectively. It is most appropriate for the funding level to be determined in a fair and transparent way, as well as ensuring that there are sufficient incentive effects to prevent the abuse of the company's monopoly position.

Response to supplementary question

  The note entitled "Railway Industry Money Flows" attached to the Regulator's written evidence sets out the framework under which Railtrack PLC receives its income. In outline, the Regulator independently determines Railtrack's revenue requirement for the competent and efficient operation, maintenance and renewal of the network. For control period two, this amounted to £14 billion after taking into account single till income. Of this, £0.6 billion was to be deferred to 2006 and the remaining £13.4 billion paid over the five-year period.

  Access charges are then raised automatically to meet this requirement. However, the franchise agreements between franchisees and the SRA (clause 18) contain a pound for pound indemnity by the SRA in favour of the franchisee in relation to any change in access charges resulting from the Regulator's decision. Thus, the SRA is contractually obliged to pay the whole of the increase in track access charges.

  In respect of the periodic review, the SRA requested that, rather than pay the increase to operators for them to pay Railtrack, it should pay this increase by way of network grants direct from the SRA to Railtrack. The Regulator agreed to this request on the basis that payment of these grants would be unconditional so that there was no addition to the perceived level of regulatory risk. The SRA accordingly agreed unconditionally to pay £4.6 billion of network grants to Railtrack. The first instalment of £162 million was payable on 1 October 2001.

  As to the method of funding, as long as the existing unconditional obligation to pay remains, and subject to principles outlined in the response to the main question, the Regulatory is unlikely to be concerned by whether the SRA pays Railtrack's successor via the passenger train operators or directly.


  If the Government's proposals for a company limited by guarantee are implemented, would you expect lenders to view the company as a very low credit risk?

    (a)  How are major cost uncertainties related to maintenance and renewal work best dealt with?

    (b)  Is a company limited by guarantee appropriate in an industry which has found it difficult to estimate costs accurately?

Response to main question

  The assessment of the risk of the proposed company limited by guarantee (CLG) will not be possible until the Government's proposals are more fully developed. Then lenders will form their own views about risk, having regard to a wide range of factors including the rating accorded to the company's bonds by the credit rating agencies. The Sub-Committee will be aware that the credit rating agencies apply a number of criteria to assess the appropriate credit rating for bonds, both qualitative and quantitative:

    (a)  Qualitative criteria include perceptions of management and the strength of independent economic regulation.

    (b)  Quantitative criteria are expressed in terms of actual and forecast financial ratios, which mainly relate to a company's expected case flow position.

  There are a number of aspects of debt-only companies which may affect the risk profile for lenders:

    (a)  in the equity model, equity provides the front-line cushion against adverse shocks that impact on the company's revenue and costs;

    (b)  in an equity-based company, the structure of corporate control is familiar and clear. If equity is totally withdrawn then control is less straightforward. Loan covenants may reproduce de facto the ownership rights of shareholders but this is more ambiguous; and

    (c)  there has been a marked shift away from mutual structures in other industries, such as building societies and the insurance sector. Some commentators believe this is due to difficulties of decision-making in these structures.

  Thus, the risk profile of the CLG will depend on:

    (a)  the precise scope of its business;

    (b)  whether it is able to, or wishes to, assume a different mix of business risk;

    (c)  its financial structure; and

    (d)  its control and decision-making processes.

  Great importance will be given to the nature and structure of regulation.

Response to first supplementary question

  The Regulator addressed the appropriate allocation of risk for cost over-runs as part of the periodic review. He concluded that this risk should generally be borne by investors in Railtrack since it is largely within the control of the company (although the company may choose to pass on some of the risk to its contractors). This provides strong incentives for management to control these costs and reduces the degree to which Railtrack's customers are exposed to cost over-runs over which they have no control.

  However, the Regulator recognised that where these risks are not within the control of management they should be borne by customers rather than investors. This is because the risk premium which would be required to compensate the company for bearing these risk is likely to exceed any benefit to customers in terms of reduced uncertainty. For example, due to the considerable level of uncertainty about the required level of signalling works, the Regulator concluded that the risk of overspend in this area should be shared between customers and investors. This was achieved by adjusting the Regulatory Asset Base (RAB) at the next review to compensate the company for overspend so that there was still some incentive for Railtrack to manage these costs efficiently without exposing shareholders to the full risk. The Regulator further concluded that increases in costs arising from new obligations (eg in relation to safety) should be paid for by customers. He proposed that this could be achieved either through an interim review or through an addition to the RAB.

  These issues may need to be re-visited if Railtrack is replaced by a CLG.

Response to second supplementary question

  While the structure of the new arrangements for provision of infrastructure services is a matter for Government, the Regulator believes that, whatever structure is established, it will need to have regard to the following objectives, all of which are pertinent to accurate cost estimation:

    (a)  the establishment of a financial structure which is closely related to allocation and management of risk;

    (b)  the need for incentives for operational efficiency; and

    (c)  cash and financial stability—which means either a Government guarantee or independent regulation.

  The Regulator believes that good asset knowledge is extremely important, regardless of structure, if the infrastructure provider is to improve its cost estimation processes. For this reason, on 18 April 2001 the Regulator amended Railtrack's network licence so as to require the company to establish and maintain a register of its assets, their condition, capability and capacity.


  The Secretary of State has said that he intends to rationalise the regulatory structure of the rail industry in order to reduce "the burdens of day-to-day interference in the industry". How should those burdens be eased?

    (a)  He has also referred to the "self-defeating system of penalties and compensation" imposed by the existing regulatory structure. How should this be changed?


  The Regulator has a number of statutory duties. These duties are set by Parliament and can be removed only by Parliament. If the definition of burden and interference is regulatory action carried out in the course of the Regulator exercising his functions by discharging his duties, that is a function of legislation passed in 2000 and brought into force on 1 February 2001.

  When Railtrack was privatised, it was done with a weak regulatory system which did not meet the needs of its customers or the public interest. The Regulator's programme for the reform of Railtrack's accountability, which is almost complete, has been widely supported by the industry and Parliament, including the Transport Sub-Committee and the Public Accounts Committee. It would be remarkable if, now that the infrastructure provider is to be recreated or restructured following the railway administration of Railtrack, the strengths of the regime created in the last two years and so recently completed were to be taken out and the weaknesses which caused so many problems in the past retrofitted.

  In respect of Railtrack or its successor, as the Regulator said in his oral evidence to the Sub-Committee, the major failings of Railtrack's management to date has been their lack of focus on their customers and on the actions they should have taken to ensure the competent stewardship of their assets. The greater the customers' dissatisfactions in relation to the adequacy of an industry's asset stewardship plans, the more any regulator will be called upon to intervene. Had Railtrack done the things it should have done to satisfy its customers and plan for the long-term health of its assets, the Regulator would not have had to intervene to require the company to do them. The Regulator does not consider that he required of Railtrack anything that a competent and efficient company would not have chosen to do for itself. This is borne out by the considerable public and industry support for the actions he has taken. Examples of this would be his requirements of Railtrack to generate an asset register, develop an effective network management strategy, and provide a clear recovery plan post-Hatfield; had Railtrack been doing its job properly, there may have been no requirement for a post-Hatfield recovery plan.

  All competent companies measure and manage their performance effectively and efficiently. The railway industry is no different. Having measured performance, it is economically and commercially efficient for the relevant contracts for the delivery of the services in question (in this case, infrastructure services) to contain provisions which incentivise good performance and penalise poor performance. This works far better and with greater clarity and certainty than the innocent party having to resort to costly, uncertain and lengthy claims for damages in litigation. These types of provisions are found in a very large proportion of commercial contracts in every industry and in every part of the world. They have been in use for many years and are a well-established feature of such contracts. In this respect, the railway industry follows where other mature and successful industries have gone before.

  For the railway industry as a whole, whatever the structure, there will be a need for regulation in respect of safety, performance and efficiency, with specific controls to prevent the abuse of monopoly power wherever that might arise.


  Sir Alastair Morton described the outcome of the periodic review of Railtrack's access charges as being like "the Regulator's hand getting into the SRA's pocket to remove money". Should it not be for the SRA to determine how the overall amount of Government funding for the railway is used?

    (a)  Given the difficulties with reconciling the competing claims of different train operators to use congested routes, should capacity issues not be decided as part of the SRA's rail strategy, rather than through the track access process?

Response to main question

  Through undertaking independent reviews, a regulator's job is to determine the fair price for funding the long-term stewardship of a vital national asset (be it the railway network, or the distribution systems for water or power). Doing so on a periodic cycle allows the industry to plan ahead with the certainty that its investment will be financed, so long as it behaves competently and efficiently, without having to build a large premium into its prices up front to cover unforeseen risks.

  It must be for the SRA to decide how to get the best result from its budget, in line with its statutory duties and the objectives, instructions and guidance issued by the Secretary of State. However, there are important existing contractual commitments and statutory provisions which were established at privatisation, as described in the response to Point Two, namely:

    (a)  Government has agreed (by means of clause 18.1 of each of the franchise agreements) to pay any increase in track access charges arising from the Regulator's determination of the revenues required to fund the efficient expenditure necessary to sustain the network;

    (b)  this price control determination should be carried out independently of the providers, users and customers of the rail infrastructure (as for other regulated utilities);

    (c)  the Regulator has to have regard to the financial position of the SRA (this is a statutory duty).

  The contracts and other arrangements binding on the SRA should be honoured, not disregarded or broken.

  Another major issue is whether the SRA, as the dominant purchaser of railway services, should also determine both the quality of those services and the price at which they are to be delivered, and how often it should be able to change its mind. Not only must there be a question as to whether any private sector company could enter into such a one-sided deal with Government, it is clear that even a wholly public sector company—British Rail—suffered from such a regime, with the long-term investment planning vital for the railway undermined by annual revisions to its budget. For the train operators—the passenger and freight companies—confidence in the long-term stewardship of the rail infrastructure is a prerequisite for underwriting investment in new trains, and, indeed, for taking part in the provision of train services to the public, who need those services to be reliable. That confidence would be hard to win with a return to stewardship dictated by the amount of cash the SRA had available in any one year.

  Thus, it would be possible for the SRA to specify different outputs from Railtrack although this would need to be agreed with Railtrack's other customers. Whatever outputs are agreed, they should still be priced independently. It should be noted that the Incremental Output Statements, which were included in the periodic review, are an example of the SRA requiring some additional outputs and then asking the Regulator to determine an efficient price for them.

Response to supplementary question

  The current regime provides for capacity allocation decisions to be made by the Regulator on application from operators and Railtrack. The Regulator consults all interested parties, including the SRA, and determines:

    (a)  whether there is capacity available for allocation;

    (b)  whether the capacity is most appropriately allocated to that operator; and

    (c)  how long the capacity should be allocated for.

  This allows the Regulator to take an independent approach balancing the needs of different operators (those passenger operators with and without franchises, and freight operators) according to his duties under section 4 of the Railways Act 1993. The Regulator does consult the SRA on the criteria he adopts and on specific cases.

  Since the SRA is providing funding for the services offered by some operators and not others, it would not be possible for it to act in such an independent fashion.

  The SRA is currently considering the capacity of the network as part of its development of an overall rail strategy. It is considering the long-term implications of demand growth and the need for enhancement of the network in particular locations to meet that growth. This work will inform its responses to the Regulator when he consults on specific access agreements and its investment decisions for new infrastructure.

  The balance of responsibilities therefore allows the SRA to set priorities for its investment whilst the Regulator ensures that there is a level playing field for all participants in the industry.

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