Since the mid 1990s, passenger rail services have been delivered through a system of franchises. Each franchise is a competitively procured contract, typically lasting seven to ten years, between the Department for Transport and a private train operating company. Companies bid for franchises on the basis of the amount of subsidy they require, or the premium they would be prepared to pay, to run services on a defined part of the rail network. Bids include each company's forecast of what revenue they can expect, based on assumptions about the number and type of passenger journeys and the prices they can charge.
The InterCity East Coast Mainline is a hugely significant rail service, carrying around 19 million passengers a year between London, the North East and Scotland. The franchise has had a troubled history. In 2005, a contract was awarded to Great North Eastern Railway, but financial difficulties at its holding company meant that the franchise failed 18 months later.
In 2007, a new contract was awarded to National Express to run the franchise on the basis that it would pay the Department £1.4 billion over seven and a half years. At the time, the East Coast franchise was one of three operated by National Express, which also ran passenger services in the South East and East Anglia. As a result of the economic downturn, expected passenger revenues did not materialise and National Express announced in July 2009 that it wanted to opt out of the contract and would not provide the necessary financial support to the East Coast franchise.
Following negotiations with National Express, the Department terminated the contract in November 2009 and transferred services to a new publicly owned company, Directly Operated Railways, until the franchise could be re-tendered. Although other franchises suffered financial difficulties during the economic downturn, East Coast was the only franchise that failed.
In negotiations, the Department turned down an offer worth £150 million from National Express to exit the franchise by mutual consent. Instead the Department chose to terminate the contract, and received £120 million from National Express. The Department judged that foregoing the extra cash would reduce the risk of other train operating companies with loss-making franchises seeking similar deals, but the taxpayer did forfeit £30 million. The Department allowed National Express to keep its two other franchises, and in December 2010 told National Express that the termination would not be held against the company if it bid for future franchises.
Since the East Coast termination, other franchises have been in financial difficulty and their holding companies have not sought to hand them back. We are, however, concerned that the Department created a moral hazard by allowing National Express to pay a lesser financial penalty through terminating a contract than it would have done by paying £150 million to exit consensually, and by choosing not to hold the termination against National Express in future bids.
The Department has potentially incentivised other holding companies with loss-making franchises to terminate, rather than renegotiate, their contract with the Department, as they know doing so will cost them less and will not affect their ability to compete for other contracts.
On the basis of a report from the Comptroller and Auditor General we took evidence from the Department and Directly Operated Railways on protecting the taxpayer, performance of the franchise in public ownership and the lessons to be learnt.