Risks and renegotiations
9. In our detailed analysis of the franchising system
in 2006, we noted that only a very small proportion of risks are
transferred from the public to the private sector through the
current rail franchising system.
This situation remains unchanged today. Three years ago, we questioned
whether there was any point in private sector involvement in the
railways if risk was not transferred to them.
Recent events have vindicated our concerns.
10. A witness in our 2006 inquiry, Mr Segal of MVA
transport consultants, noted that the state of the economy posed
the most serious risk in relation to the railways. He highlighted
that this risk falls to the Government alone: "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".
Mr Segal told us that train operating companies
invested only small sums, relative to the turnover of a franchise.
In tough times, they would be able to walk away from that investment
without major damage to their company or reputation. 
The Government cannot walk away.
11. The retention of risk in the public sector has
been amplified over the past decade through changes in the construction
of franchise contracts. In the early franchises, franchise holders
carried the entire revenue risk, but now the Department for Transport
retains a high proportion of the revenue risk through the so-called
'revenue risk-sharing', or 'cap-and-collar' arrangement. Under
this system, the franchise holder bears the risk of revenue shortfalls
alone over the first four years of a contract, but from year five
onwards, relatively small percentage shortfalls in revenue can
lead to significant reimbursements from the DfT. The converse
is also true so that the Government takes a share of profits if
they are more than 2% above the target. 
12. As we have noted in the past, the process for
awarding franchises along with the relative absence of significant
risks for franchise holders tend to fuel very optimisitc bids.
The two failed contracts on the East Coast Main Line where operators
had offered the Government £1.3 and £1.4 billion respectively
to run the franchise are clearly cases in point. If passenger
growth and revenue forecasts are optimistic, bids tend to promise
the Government lower subsidies or higher premiums. We voiced our
concerns about the weight attached to maximising premiums at the
expense of other priorities in 2006.
The last round of franchises were let on the assumption that passenger
numbers would grow by 9-10%, and profit would rise by 10%.
The recession has, however, changed the outlook dramatically,
and passenger numbers have been virtually static in 2008-09.
There has also been a marked tendency for passengers to migrate
towards cheaper tickets, and the shift from lucrative first class
seats to standard class seats has had a particularly severe impact
on the revenue of some franchises. This has meant a decrease in
revenue even where passenger numbers have remained the same.
companies maximise profits and dividends in the good times when
the optimistic assumptions of their franchise bid are met. But
in hard times, when revenue stagnates and costs rise, there may
be insufficient financial resilience to get by without default
or at least significant fare rises and reductions to passenger
services such as ticket office closures and subsequent job losses.
Tightly specified franchise contracts limit the options available
to operators, and partially protect passengers, but also leave
tax payers at risk of having to pick up the bill. The current
risk-sharing arrangements mean operators are not held to account
on their promises. There is no point in involving the private
sector if it simply takes the profits in the good times, leaving
the tax payer to pick up the tab in bad times?
14. We have previously concluded that, given the
absence of any significant transfer of risk to train operating
companies, it was essential for the Government to resist any pressure
to re-negotiate the terms of franchises in trouble.
Such renegotiations had been common in the past, with
more than half of the original 25 franchises created at privatisation
obtaining changes to their contracts.
The Government has so far held firm that it will not renegotiate
contractual terms, but whether the Government would be able to
hold this line in the face of multiple defaults is open to question.
The Government must continue
to hold firm on its commitment not to re-negotiate franchising
15. On 1 July, the Secretary of State indicated that
the Government might invoke the cross-default provision to revoke
National Express' two other franchise contracts as well as the
East Coast Main Line.
The aim of the cross-default provision is to ensure that franchise
holders cannot choose simply to hand back the keys to franchises
in trouble whilst retaining their profitable services. It has
subsequently emerged that the use of a 'special purpose vehicle'
by National Express could prevent the Government from using the
We believe it is unacceptable
that National Express may be able to cling on to its remaining
franchises through the use of a 'special purpose vehicle'. The
misuse of legal instruments, such as 'special purpose vehicles',
to insulate parent companies from potential losses and legal problems
as a result of the failure of subsidiaries is sharp practice.
Options for the East Coast Main
16. If a franchise holder defaults on their contract,
the Government has several options. As discussed above, it could
renegotiate the terms of the contract, it could take the franchise
back temporarily in order to re-let it to another train operating
company as soon as possible, or it could run the franchise itself
under a management contract. Doing nothing, however, is not an
option, as section 30 of the Railways Act 1993, amended by the
Railways Act 2005, imposes a requirement on the Secretary of State
to act as "operator of last resort" if need be, to ensure
continuity of services. When the Connex South Eastern franchise
was taken back into the public sector in 2003, it was run successfully
by the public sector for two years.
The Government then re-let the franchise to a private operator.
There have been suggestions that the Government should retain
the East Coast Main Line franchise in the public sector as a public
should be willing to attempt different forms of franchising. Now
is an ideal opportunity to keep the lucrative East Coast franchise
in the public sector. The service could then be used as a comparator
for other types of franchises, both in terms of financial viability
and passenger service quality.
Length of franchises
17. Most franchises are currently between seven and
ten years duration (see Table 1 below). Some are shorter, such
as the recent South Central franchise which will run for less
than six years. Since
2003, no franchise has been awarded for more than ten years.
Table 1: Length of current rail franchises by start year