Select Committee on Transport Fourteenth Report


2  The objectives of passenger rail franchising

5. The railway system in Britain was created by entrepreneurs in a climate of often cut-throat competition. Incoherence, inefficiency and a failure to innovate created pressures which eventually led to the nationalisation of the railways through the Transport Act 1947. But over time, British Rail also came to be criticised for a failure to deliver an effective, innovative and value-for-money railway system.[6] These criticisms culminated in the Railways Act 1993 which started the process of re-privatisation. The original objective of rail privatisation and the creation of franchises was to re-introduce competition and thereby, it was hoped, increase efficiency and innovation, enhance responsiveness to the needs of passengers and freight customers, lever private investment in to the railways, and reduce the level of public subsidy.[7] These objectives have not changed substantively since privatisation although the Government has acknowledged that, unlike some other privatised utilities, the railways are a public service which will always depend on substantial public subsidy.[8] The Government reiterated to the Committee that the current objectives of the railways in general, and the franchising system in particular, are:

i.  to improve passenger services,[9] and

ii.  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.[10]

6. Few would disagree with the aim of increasing the value for money achieved from Government subsidies, and even fewer with the aim of improving passenger services. Some, however, question whether the current structure of the rail industry, franchising in particular, is the most appropriate and efficient means with which to achieve those objectives in the longer term.[11]

7. Privatisation and disaggregation are in natural tension with the requirement for an effective, sustainable and integrated transport system. Some witnesses argued that the Government's objectives need to be re-balanced to emphasise the key role of rail as part of a "single integrated transport network, which is accessible to everyone, delivering punctual services at a reasonable price to passengers."[12] Others believed that, in reality, the Government simply has no consistent and well thought-through objectives for the franchising system. Transport consultants Tony Bolden and Reg Harman told us that there "seems to be no proper and consistent understanding of what franchises should be and how they should operate, which in turn does not allow for proper planning and development of the railway system."[13] Nigel Harris of the Railway Consultancy echoed this perception, stating that he was unable to say whether the objectives were being met because "many of us are not entirely sure what this week's objectives are."[14] Roger Ford lamented the wider lack of long term strategic planning, development, and investment on the railways which, in his view had resulted in parts of the infrastructure now being effectively preserved in "aspic".[15]

8. GNER highlighted the tension between the interests of the Government and those of many passengers and local communities when saying that the franchising system "provides the best value operator for the Government's specification of a particular route, although this is not necessarily the same as providing the best value for the passenger or the railway which passengers and local communities would necessarily desire."[16]

Model or muddle?

9. The Government cites the growth in rail patronage as a partial indicator of the success of the post-privatisation rail system in achieving the objectives set for it.[17] Several of our witnesses were sceptical about passenger growth being used as an indication of system performance. The Railway Consultancy said that it would be invalid to claim that there is a "simple correlation between rail industry structure or franchise type with traffic growth."[18] John Segal of the MVA Consultancy told the Committee that "one of the key reasons demand increased was that fares were held down. Had fares been held down under British Rail then some of the demand growth would have happened without [franchising]."[19] Mr Ford added that the decline in patronage in the early 1990s, before privatisation, had been the result largely of macro-economic factors, such as recession and high unemployment.[20]

10. Professor Knowles evaluated the delivery of the original objectives of rail franchising from the time of privatisation, and concluded that the franchise model had failed to fulfil them. He too saw passenger growth as only partly the result of privatisation and, identifying the central contradictions behind the franchising model, questioned the basic rationale for rail passenger franchising:

    "Is it realistic to expect competition for franchises in a basically loss-making industry to lever in substantial private sector investment and deliver extensive consumer benefits? Rail privatization will struggle to meet its investment, passenger-growth, and subsidy-reduction targets in a regime with extensive regulation of fares and little 'on track' competition permitted. Rail passenger services also face intensive intermodal competition with cars, air services, and intercity coaches."[21]

One independent passenger organisation, the Railfuture Passenger Committee summed it all up: "we are frankly not convinced that franchising is the only - or indeed the best - way of running the passenger railway."[22]

11. We agree wholeheartedly with the general objectives of improving passenger services and maximising the value for money achieved from Government subsidies. But we do not believe that the current system of passenger rail franchising can achieve those aims in the long term.

12. Our inquiry exposed fundamental tensions at the very heart of the Government's model. The Government has embraced the notion that private enterprise is best at delivering high-quality, innovative services such as the passenger railways, and yet it does not trust companies to deliver these services without highly detailed and specific contractual requirements which reduce the scope for innovation. It supports competition, and yet appears to see open access operators as a threat to stability. It wants risk to be transferred from the public to the private sector, and yet risk cannot be transferred in anything other than name because, as everyone knows, no Government could afford to let the railways go bust. The Government hails the growth in passenger patronage, and yet it does not provide the long-term strategy and investment to increase capacity on the network. It wants coordination and yet continues to operate a system of fragmentation. Finally, the Government wants the private sector to invest, take risks and innovate, and yet it prioritises price above all of these. There is scant evidence that the current model balances and optimises the benefits from conflicting priorities. It looks more like a muddle that provides little more than a complex, costly and mediocre means of maintaining the status quo.

13. The Government has announced its intention to publish a long-term vision for the railways in the summer of 2007. This initiative is welcome, though long overdue.[23] The strategy will look at long-term infrastructure requirements in the rail industry, but to have any real value, it should also contain a root and branch review of the way in which services are provided to passengers. The long-term strategy is an opportunity for the Government to provide real vision and direction for the development of the railways, backed by investment. This opportunity should not be missed through a failure to address the most fundamental questions of structure and long-term direction. The Government's long-term vision for passenger rail services should be set out as an integrated part of its vision for the railways. This vision should in turn, be fully integrated into an overarching long-term transport strategy.

14. It is clear that after more than a decade of upheaval and flux, the railways need stability and continuity to consolidate and take stock. It might be argued that this is not the right moment to commence a major reorganisation of the way in which passenger rail services are being procured and managed. However, the fact that the Government constantly has to tinker with the system in order to overcome the consequences of fundamental system failures, means that such stability is not likely to emerge without further fundamental change.

15. The objectives of the passenger rail franchising system are a self-contradictory muddle, providing no coherent framework or vision for the development of passenger services for future generations. The result is a system that is worth less, and costs more, than the sum of its parts. It is high time that the Government established a consistent and achievable set of objectives and a system capable of achieving them whilst providing good services and value for money to passengers and taxpayers.

16. The key objective of our railways for the next few decades must be to increase capacity, and facilitate growth in patronage through improvements in services to passengers. The only way to achieve this in the long term is to drop the dogmatic pursuit of competition where competition is not possible, and to make honest and tough choices about what the private and public sectors can and should do in future. We expect the Government's forthcoming long-term strategy for the railways to tackle these fundamental issues head on. It must contain a structure and a strategy capable of securing quality passenger rail services to meet demand over the next half a century.

Risk

17. The transfer of risk from the public to the private sector is a key objective in the privatisation of public services. However, a number of witnesses argued that with regard to passenger rail services, the transfer of risk to the private sector has been quite limited.[24] The reason for the lack of risk transfer is primarily because, at the end of the day, no Government can afford to let part of the railway system collapse. As a result, the Government and the taxpayer pay for a large part of the risk in the system. Mr Segal of the MVA consultancy told the Committee that:

    "Some risk is borne by the operators but it is a relatively small amount. They have £10 million to £20 million invested in this. If it is making £400 million turnover, that is a hugely small investment and they can walk away from it if necessary. They lose some credibility but they can walk away. The government would have to make sure the train services run and it can refranchise and relet it. The big risk is, if there is a downturn in the economy, almost all the train operating companies will find great difficulty on their revenue line and that means the government will end up bailing it out. As the saying goes, if you owe the bank five pounds you are in trouble; if you owe the bank five million, the bank is in trouble. In this case, the government is in trouble because if it has to relet all the franchises at once it is going to get lower bids for them. That is an unavoidable risk. The economy is the government's risk."[25]

18. Examples of areas where risk is not transferred to the private sector, as one might have expected, are track access charges and the cost of industrial action. In the case of track access charges, the Government insulates franchises against increases in Network Rail's fees for accessing the track by adjusting premiums or subsidies to take account of any changes in access charges.[26] Another example is the cost of industrial action where the Government compensates franchise operators for losses incurred. The SRA paid out £15.65 million in 2003 and £7.63 million in 2004.[27] One operator alone, National Express Group, was paid £12.65 million in respect of disputes on its ScotRail franchise.[28]

19. The transfer of risk to the private sector is also highly inconsistent. Given the high level of risks borne by the Government in areas such as track access charges and industrial action, it appears strange that franchising companies are left to bear the risk of open access operators affecting their revenue without any assistance from the Government.[29] This issue is discussed at length in Chapter 6 below.

20. Changes to franchise contracts in recent years have served to reduce the risk exposure of TOCs still further.[30] These changes are an attempt to minimise the risk for the Government of operators getting into financial difficulties and seeking to re-negotiate the terms of their contracts part-way through the franchise.[31] Franchise contracts now generally include "revenue risk-sharing mechanisms", also known as "cap and collar protection". This typically means that after the first four years of the franchise contract have passed:

i.  "50 per cent of any fares revenues in excess of 102 per cent of the TOC's original forecast are shared with DfT;

ii.  DfT makes a contribution equivalent to 50 per cent of any revenue shortfall below 98 per cent of the TOC's original forecast;

iii.  but for any shortfall below 96 per cent, DfT's contribution increases to 80 per cent."[32]

21. In the past, a significant number of franchise contracts have been re-negotiated part-way through their term because franchise operators have found themselves in financial difficulties.[33] Since taking back the responsibility for franchises from the defunct SRA, and implementing the new arrangements outlined above, the Government has been adamant that it will no longer re-negotiate contracts under any circumstances, and that it is prepared to see an operator go to the wall rather than renegotiating contractual terms.[34] This resolve remains to be seriously tested. But with some operators entering into very high premium contracts on the basis of very optimistic growth forecasts, it is likely to be a question of time only before the Government has to show its mettle. GNER has already admitted that the growth projections upon which it agreed to pay £1.3 billion for the East Coast Main Line franchise just 18 months ago were unrealistic.[35] On 22 October 2006, The Sunday Times reported the Chief Executive of Seacontainers, GNER's parent company, to have said that GNER would have to hand its franchise back to the Government by May next year if the terms of the franchise were not renegotiated.[36]

22. The Government already appears to be shifting its position and opening the door to renegotiations, despite its firm commitment to the contrary when giving evidence in July. Mr Lambirth, the Director of Rail Strategy & Finance at the DfT assured us in oral evidence that, in the case of the newer types of franchise contracts with revenue-risk-sharing mechanisms built in, the Department would be 'sticking to the letter of the contract,' and not renegotiating.[37] When asked to confirm this commitment in October, the Secretary of State wrote to us that 'more generally […] we are not prepared to renegotiate the main terms on which a franchise was awarded in the first place other than in circumstances where doing so would clearly benefit the public purse.'[38] The emphasis on optimising the benefit to the public purse is new, and appears to open up the possibility of renegotiating contracts where it would be cheaper to do so than to refranchise. This change of emphasis has undoubtedly come about because the Government may soon face the choice of either renegotiating a contract, or seeing a major franchise, awarded just eighteen months ago, being handed back. The implications of such a change would be significant and damaging. Operators would be able to produce over-optimistic revenue forecasts and bid wild sums to run franchises, safe in the knowledge that the Government would bear the full risk of any failure to meet the forecast revenue figures.

23. The practice of renegotiating contracts effectively meant that the Government was underwriting franchise operators in the past. This is the ultimate form of risk retention by the Government. Having re-designed franchise contracts to include 'revenue risk-sharing mechanisms', it is crucial that the Government resist any pressures to renegotiate franchise agreements if operators get into difficulties. If it were to bail out operators through renegotiation despite taking over most of the medium- and long-term revenue risks, the Government would have failed doubly.

24. The risk to the Government is potentially compounded by the fact that the concentration of the market means that a few large companies increasingly run multiple franchises.[39] If the Department for Transport were to use the cross-default principle, as has been hinted, whereby a franchise operator that runs multiple franchises will lose all its franchises where it fails to fulfil its obligations in one of these, the Department could be left with a very large financial and management problem.[40] The concentration in the market also means that, in such situations, it might be difficult for the Government to find bidders able and willing to take on a whole series of franchises removed from a failing incumbent at an acceptable price.

25. The transfer of risk to the private sector was a core objective of privatisation. But in the current system only a very limited proportion of risks are, in reality, borne by franchise operators. There are also significant inconsistencies about what risks are borne by operators, and which by the Government. The relative lack of risk transfer calls into question the fundamental assumptions and objectives of the franchising system. If risk is not transferred, there is little point in involving the private sector in the running of the railways.


6   Pryke, R.W.S and Dodgson, J.S. The Rail Problem (London, 1975); See also Bonavia, M.R. British Rail: The First 25 Years (Newton Abbot, 1981); Gourvish, T. British Railways: A Business History (Cambridge,1986) Back

7   See Ev 222 [Professor Richard Knowles]; Richard D. Knowles: "Impacts of privatising Britain's rail passenger services - franchising, refranchising, and Ten Year Transport Plan targets", Environment and Planning, volume 36, 2004;Stephen Glaister, "British Rail Privatisation - Competition destroyed by Politics" Centre for the Study of Regulated Industries, Occasional Paper 23, November 2004, p 7ff. and p 17 ff Back

8   Department for Transport, The Future of Rail, White Paper, Cm 6233, July 2004 Back

9   Q 408 [The Parliamentary Under Secretary of State, Derek Twigg MP] Back

10   Ev 142 [Department for Transport] Back

11   Ev 208 [Simon Norton]; Ev 39 [Railfuture]; Q 326 [Mr Ford] Back

12   Ev 59 [Merseytravel] Back

13   Ev 212 [Tony Bolden & Reg Harman] Back

14   Q 167 [Dr Nigel Harris, The Railway Consultancy] Back

15   Q 293 [Mr Ford] Back

16   Ev 7 [GNER] Back

17   Ev 142 [Department for Transport] Back

18   Ev 93 [Railway Consultancy] Back

19   Q 168 [Mr Segal, MVA] Back

20   Q 273 [Mr Ford] Back

21   Richard D. Knowles: Impacts of privatising Britain's rail passenger services - franchising, refranchising, and Ten Year Transport Plan targets published in Environment and Planning, volume 36, 2004 Back

22   Ev 39 [Railfuture] Back

23   This strategy is due to coincide with the High Level Output Statement (HLOS) which sets out a five-year purchasing strategy for the network. Back

24   Ev 93 [The Railway Consultancy] Back

25   Q 203 [Mr Segal, MVA] Back

26   NERA Economic Consulting: Implications of Amending Franchise Agreements Final Report for ORR, July 2006, pp 4-7. Available at http://www.rail-reg.gov.uk Back

27   HC Deb, 24 November 2005, col 2226W Back

28   HC Deb, 15 May 2003, col 340W Back

29   See HC Deb, 18 May 2006, col 1129W Back

30   NERA Economic Consulting: Implications of Amending Franchise Agreements Final Report for ORR, July 2006, p 2. Available at http://www.rail-reg.gov.uk  Back

31   Such renegotiations have occurred on a number of occasions in recent years, sometimes resulting in TOCs "operating for extended periods under 'cost plus' contracts" See Ibid.  Back

32   Ibid. p 3  Back

33   More than half of the original 25 franchises created at privatisation agreed changes to their contracts in the course of the contract. Back

34   Q 489 [Mr Lambirth, Department for Transport]; See also Q 28 [Mr Furze-Waddock, First Group; Mr Smith, Govia]; Qq 35-38 [Mr Smith, Govia; Mr Lyons, Railway Forum; Mr Franks, National Express] Back

35   The Independent, 17 October 2006, p 36; see also The Guardian 17 October, p 26. When awarding the franchise to GNER in March 2005, the SRA hailed it as "the biggest deal in European rail history". See SRA press release, 22 March 2005, available at http://www.sra.gov.uk  Back

36   Sunday Times, 22 October 2006 Back

37   Qq 406-407 [Mr Lambirth, DfT] Back

38   Ev 206 [Department for Transport] Back

39   See paras 71 and 72 above Back

40   Modern Railways, July 2006, page 3 Back


 
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