Rail fares and franchises - Transport Committee Contents

Rail franchising—on track?

3. In our 2006 report on passenger rail franchising, we concluded that the franchising system had failed to fulfil its objectives, and that it was nothing short of a "policy muddle".[3] We were concerned that "the drive to extract premiums from some parts of the network will result in further above-inflation fare increases and a deterioration in customer service, investment and innovation".[4] We argued that the Government needed to "conduct a strategic review of the long term needs of rail passengers, and an honest appraisal of the structure best suited to fulfil these needs over the next several decades".[5] We urged the Government to ensure that this review be included in the 2007 Rail White Paper. The Government failed to do so, telling us that the system was "delivering" both good services and value for money.[6]

4. Just a few weeks after the publication of our report, in December 2006, GNER defaulted on its franchise commitments for the East Coast Main Line service,[7] and the franchise was re-let to National Express in 2007. GNER had committed itself to paying the Government £1.3 billion in premiums for the seven year franchise. Despite GNER defaulting on this contract, National Express offered the Government even higher premiums for the line—£1.4 billion over the course of its seven and a half year franchise.[8] During the first half of 2009, less than two years into the contract, the financial strain of the recession became apparent and National Express made significant cuts in staff and services on the East Coast Main Line.[9]

5. Since February 2009, the Rt Hon Lord Adonis, Minister, and subsequently Secretary of State, has given us repeated assurances that no train operating company was reporting financial difficulties or seeking to renegotiate their terms.[10] Indeed, on 17 June, he told us that:

We are now about a year through the recession and no train operating company has defaulted on its obligations even though, of course, their share prices have come under very considerable pressure in that time and the return they are able to make from operating rail services has diminished. The evidence so far is that the franchising system has continued to prove its worth.[11]

6. Precisely two weeks later, on 1 July 2009, National Express Group announced that it would not provide any further funding for its East Coast Main Line subsidiary. On the same day, the Secretary of State made a Statement in the House of Lords, announcing that National Express had sought a re-negotiation of their contract over several months, but the Government had refused to contemplate this option. Instead, a publicly-owned company would be established to take over the East Coast Main Line until the service could be re-franchised in 2010.[12]

7. As we said three years ago, the current system of rail franchising is a muddle. Within just three years, two franchise operators have had to abandon a major franchise—both of them on the East Coast Main Line. Whilst we fully support the Secretary of State in his decision to take back responsibility for the East Coast Main Line franchise, we remain convinced that these two high profile failures are indicative of the underlying problems in the current franchising model.

Rail franchises in the recession

8. The National Express East Coast franchise is reportedly not alone in facing financial distress. South West Trains, owned by Stagecoach, is involved in a dispute over its £1.2 billion contract with the Government about when it becomes eligible for revenue support.[13] Stagecoach has warned that its rail division would face a "significant" loss if it were to fail to resolve the dispute. Virgin West Coast's revenue growth for the 48 weeks to 29 March 2009 was only 0.5%, although it is expected to remain profitable in the current financial year.[14] Arriva is facing heavy losses on CrossCountry.[15] In recent months, there have been a reported 7,000 job cuts in the rail sector, including 750 jobs at National Express Group, 480 at South West Trains, and 300 jobs at Southeastern.[16] It is unclear what the cost to the tax payer of the default on the East Coast main Line is likely to be, because much of the information is confidential.[17] It is clear, however, that if more franchises were to default, the financial implications could be very serious indeed, perhaps jeopardising funding for other transport projects. We are concerned that there is a lack of information available to us regarding the financial stability of franchise operators. Many more franchises may be struggling to meet their required financial agreements, without our knowledge. Any additional failures in the franchise system, coupled with risk sharing, will inevitably cost the Government considerable sums. We are deeply concerned about the impact this could have on the funding for other transport projects.

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.[18] 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.[19] 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. [20] The Government cannot walk away.[21]

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. [22]

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.[23] The last round of franchises were let on the assumption that passenger numbers would grow by 9-10%, and profit would rise by 10%.[24] The recession has, however, changed the outlook dramatically, and passenger numbers have been virtually static in 2008-09.[25] 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.[26]

13. Privately-owned 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.[27] 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.[28] 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 contracts.

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.[29] 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 cross-default mechanism.[30] 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 Line

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.[31] 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 interest franchise.[32] The Government 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.[33] Since 2003, no franchise has been awarded for more than ten years.

Table 1: Length of current rail franchises by start year
Train Operating Company
Owning Group
Franchise period
Length (years)
C2C National Express Group 1996-201115
Virgin West Coast Virgin Trains1997-2012 15
Chiltern RailwaysDeutsche Bahn AG 2002-202119
Southern[34] Govia - Go Ahead Group/Keolis 2003-20096
Merseyrail Serco-NedRailways 2003-202825
National Express East Anglia National Express Group plc 2004-20117
First Scotrail First Group 2004-20117
First TransPennine Express First group/Keolis 2004-20128
Northern Rail Serco-NedRailways 2004-20139
Southeastern Govia - Go Ahead Group/Keolis 2006-20148
First Capital Connect First Group2006-2015 9
First Great Western First Group2006-2016 10
National Express East Coast National Express Group plc 2007-20136
London Overground MTR La2007-2014 7
London MidlandGovia - Go Ahead Group/Keolis 2007-20158
East Midlands Stagecoach Midland Rail Ltd 2007-20158
Cross CountryArriva Trains Ltd 2007-20169
South West Trains Stagecoach Holdings2007-2017 10
Arriva TrainsWales Arriva Trains Ltd2008-2018 10

18. In 2006, we recommended that the Government move towards medium-length franchises of up to fifteen years "with one or two in-built break-points where contracts may be terminated if performance is unacceptable".[35] Many others have subsequently argued that current franchises are too short and fail to encourage long-term planning by train operating companies. There is little incentive for operators to invest in long-term infrastructure that will almost certainly be handed over to someone else before it has started to return revenue. It is also argued that the current length of franchises contributes to train operating companies taking short-term cost-cutting measures (such as reducing catering costs) to increase revenue, because operators are less concerned about the long-term impact of such measures. Network Rail, as well as train and freight operators, have all indicated that planning the UK's rail system in five-year chunks, or by seven-year franchises, was inefficient.[36] ATOC Chief Executive, Michael Roberts, has argued that "there should be a place for longer franchises and less prescriptive, more output-based specifications, which give operators the flexibility to respond better to customers, and reward them accordingly".[37] According to Sir Richard Branson, co-owner of Virgin Trains, the current franchise system "does not work". He emphasised that a longer franchise contract of 20 to 30 years would allow Virgin Trains to underwrite engineering work on the West Coast Main Line, such as a further £1 billion upgrade that could cut the journey between London and Glasgow by 40 minutes. He said, "a long-term contract would provide time to earn a return from such investments. Such work could increase revenues by up to £100 million a year and would be profitable within a decade".[38]

19. The Government has argued that the difficulty of predicting revenue over 15 or 20 years militates against longer franchises,[39] but the Secretary of State told us in June that a review of the length of franchises was under way in the Department, and hinted that there could be scope for a revision of Government policy in this area.[40] The current length of franchises does not encourage train operators to plan on a long-term basis. It discourages investment in the services, and contributes to train operators taking short-term cost-cutting measures that reduce passenger service quality. The Government should let franchises on a longer basis, albeit with break points so that contracts can be terminated at pre-defined points where performance is unsatisfactory.

Putting passengers first

20. The needs of passengers have not always appeared to be built into franchise contracts in a satisfactory way. However, the award of the South Central franchise to Southern Railways in June 2009 has been welcomed by passenger groups.[41] The franchise, which runs until 2015, requires Southern Railways to introduce longer suburban trains at peak times and more trains on key lines during evening and weekends, increase the number of stations staffed at night and introduce CCTV on all trains by 2011. The franchise will also deliver at least 1,000 extra car parking spaces and 1,500 additional secure bicycle spaces. Every station across the network is required to be cleaned and refreshed, and enhancements are scheduled at 34 stations in the region. In addition, the Government has required Southern Railways to set targets for passenger satisfaction and provide additional investment if these targets are not achieved. Announcing the franchise, Lord Adonis said:

We have worked closely with rail user groups such as Passenger Focus to ensure that this new franchise works for passengers.[42]

21. The needs of passengers have not always been properly catered for within rail franchising contracts. The Government must ensure that franchises are more passenger-focused, and that commitments within existing franchise contracts are also enforced. It would be good if the franchise recently awarded for the South Central line, which includes monitoring of passenger satisfaction, and the inclusion of additional factors such as cycle and car parking space targets, were to become the norm for future franchise negotiations.

3   Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, paras 122-124 Back

4   Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, para 58 Back

5   Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, para 122 Back

6   Transport Committee, First Special Report of Session 2006-07, Passenger Rail Franchising: Government Response to the Committee's Fourteenth Report of Session 2005-06, HC 265, pp 1-2 Back

7   BBC, GNER to surrender top train route, 15 December 2006, http://news.bbc.co.uk  Back

8   National Express awarded contract for growth on InterCity East Coast, DfT Press Release, 14 August 2007 Back

9   It has been reported that National Express' revenue growth in the first quarter of 2009 was just 0.3%. The premium increased by just over £50 million this year, and will do so again in each of the next two financial years. The 'cap and collar' risk-sharing arrangements for Government support do not apply until the end of 2011. See: Modern Railways, Hard times are getting harder, June 2009 Back

10   Qq 233 and 243 Back

11   Q 319 Back

12   HL Deb, 1 July 2009, col 225, Statement by Rt Hon Lord Adonis Back

13   See paragraph 11. Back

14   Stagecoach Group Trading Update Press Release 28 April 2009 Back

15   "Off the Rails", The Independent, 20 May 2009 Back

16   "Rail Company to cut jobs", BBC News Website, 9 January 2009 Back

17   Q 566 Back

18   Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, paras 17-25 Back

19   Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, paras 25 Back

20   Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, para 17 Back

21   Under section 30 of the Railway Act 1993, amended by the Railways Act 2005, there is a requirement on the Secretary of State to act as 'operator of last resort' if need be, to ensure continuity of services. Back

22   As an example, if, after four years, actual revenue out-turns fall between 98% and 94% of target revenue, then the DfT will provide support equivalent to 50% of the shortfall. If it out-turns below 94%, then DfT will provide support equivalent to 80% of the further shortfall. Conversely, if actual revenue out-turns are between 102% and 106% of target revenue, then 50% of the excess between 102% and 106% will be shared with DfT. If it out-turns above 106%, then 80% of the further excess will be shared with DfT. See: Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, para 20. Back

23   Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, para 58 Back

24   "What a ridiculous way to run a railway", Yorkshire Post, 6 July 2009 Back

25   Christian Wolmar, "Interesting Times for Rail", Public Servant Magazine and Conference Proceedings, 21 May 2009 Back

26   Q 174 Back

27   Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, para 23 Back

28   Preston J. M., (2008). "A Review of Passenger Rail Franchising in Britain: 1996/7 - 2006/7." Research in Transportation Economics, 22, pp 71-77 Back

29   HL Deb, 1 July 2009, col 225, Statement by Rt Hon Lord Adonis Back

30   BBC Web site: Robert Peston Blog: Peston's Picks: I could operate trains  Back

31   Robert Jupe, A "fresh start" or the "worst of all worlds"? Critical Perspectives on Accounting 20 (2009) pp 175-204 Back

32   Q 318 Back

33   Q 318 Back

34   The franchise is officially called South Central but is operated under the name Southern-see http://www.go-ahead.com and http://www.dft.gov.uk  Back

35   Transport Committee, Fourteenth Report of Session 2005-06, Passenger Rail Franchising, HC 1354, para 90 Back

36   "Network Rail and operators consider longer-term rail strategies", Rail Magazine, 3 June 2009 Back

37   "ATOC strikes back", Rail Magazine, 3 June 2009 Back

38   "Branson calls for overhaul of rail franchise system", The Guardian, 20 May 2009 Back

39   Paul Clark MP in Westminster Hall Debate, 3 June 2009, cols 67-90WH Back

40   Q 330 Back

41   The South Central franchise is, and will continue to be, operated under the name Southern-see http://www.go-ahead.com Back

42   Department for Transport press release, "More frequent and more secure rail services for London and the South East", 9 June 2009 Back

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