1 Protecting the taxpayer |
1. National Express agreed in 2007 to pay the Department
£1.4 billion over the seven and a half year contract to run
the East Coast Mainline, the largest ever payment for a passenger
rail franchise, on the basis of annual growth in passenger revenue
of 5% -12%. But falling revenues as a result of the economic downturn
put substantial pressure on the franchise and, after April 2009,
cumulative profits quickly became cumulative losses.
2. In its bid, National Express had included planned
measures to cut costs and generate new business during the first
year of the franchise. These plans were tested by the Department
for deliverability. Taking into account the reliance of the franchise
on discretionary business and leisure travel, rather than commuter
journeys, and favourable forecasts for future growth in the economy,
the Department judged that the National Express bid would be profitable
and deliverable. Nevertheless,
the company failed to meet its financial targets from very early
on (Figure 1).
3. The Department should have been more rigorous
in questioning National Express on its assessment that they could
grow passenger revenue by 5%-12% per annum. By any measure, this
appears to be an over-optimistic assessment of the business.
Figure 1: East Coast franchise cumulative profit
and loss December 2007 to October 2009
When bids for the franchise were being considered,
neither the Department nor the company appears to have considered
the prospect of an economic downturn. During the downturn
which then materialised, other franchises dependent on discretionary
travel suffered, but their holding companies did not request additional
public support. National Express, however, had accumulated more
than £1 billion in debt to expand its business and needed
to refinance this debt in uncertain market conditions.
Part of the solution for the company was to avoid heavy forecast
losses on the East Coast franchise by negotiating with the Department
to leave the contract. The Department now accepts that, in future,
it should test the impact on bids of a downturn in the economy
and take a closer interest in the overall financial position of
bidders' and franchisees' holding companies.
4. The failure of the franchise led to a shortfall
in expected income for the Department estimated to be £330
million - £380 million to the end of 2012.
However, following public ownership in November 2009, the franchise
has recorded better than expected profits and, for 2011-12, expects
to make around two-thirds of the payments to the Department that
had been forecast by National Express in its original bid.
5. In undertaking stress testing on future franchises
for an economic downturn, the Department considers that there
is a balance to be struck between mitigating against what would
be an unlikely event and encouraging bidders to use their commercial
judgement in putting forward proposals to increase passenger revenues.
Arrangements to support franchises where passenger revenues fail
to meet expectations are being reviewed by the Department.
The difficulty with such arrangements is that although no taxpayer
support would be provided to franchisees for the first four years,
support is automatically payable thereafter. Such a lifeline from
the taxpayer risks reducing the incentive for franchisees to work
to increase passenger revenues.
6. Under the terms of the contract, the termination
of the East Coast franchise cost National Express nearly £120
million. During the
two years that the company ran the franchise, it paid the Department
£235 million out of the promised £1.4 billion. The reason
for terminating the contract rather than agreeing a consensual
exit was that the Department did not consider that a holding company
should be able to hand back a loss-making franchise, while keeping
others that were profitable.
National Express' other franchises did make a profit - the profits
on C2C were around £4 million in 2010-11 and on East Anglia
around £15 million. The East Anglian franchise also received
£37 million in revenue support from the taxpayer during 2010-11.
7. Before terminating the East Coast contract, the
Department sought the return of all three franchises run by National
Express on a consensual basis. Based on a range of advice, the
Department also considered whether all three franchises could
be terminated, but it was advised that there was no clear event
of default in the other two franchises.
Clearly the government should in future consider this issue in
the letting of franchises. Companies should not be able to walk
away from less profitable franchises but retain control of more
8. In terminating the contract, the Department wanted
to send a strong message that it placed greater weight on holding
companies' supporting their loss-making franchisees, thereby preserving
their reputations, than on payments for a consensual exit. However,
National Express had offered £150 million for a consensual
exit, some £30 million more than it ended up paying on contract
9. The Department tried to balance the direct costs
of terminating the franchise with the potential cost of other
franchises seeking to negotiate exits from loss-making franchises
on similar terms. At the time, as many as five other franchises
were in financial difficulty. Renegotiating the contract with
National Express and the contracts of the five other franchises
might have cost £420 million. The cost of terminating the
East Coast franchise came to about £250 million, making it,
in the Department's view, the more cost-effective option.
10. The Department told us that allowing National
Express a consensual exit would have been better for the company's
reputation and general market performance.
The Department was very clear in its view that there would be
real moral hazard if it was seen not to be penalising failure.
However, in December 2010, the Department informed National Express
that the failure of the franchise would not be held against the
company if it bid for future franchises -National Express had
continued to run the East Anglia and C2C franchises profitably.
The Department said that it could not rule the company out of
bidding for future franchises but had made no promises that it
would automatically pre-qualify. In judging bids for future franchises,
the Department has to be satisfied that bids would be deliverable
and would in future place more importance on past performance.
2 C&AG's Report, paras 4, 1.17 and 2.6 Back
Qq 1, 72 Back
Qq 3, 7 Back
Qq 6-8; C&AG's Report, para 2.9 Back
Qq 20-22; C&AG's Report, para 17 Back
Qq 54-56, 59; C&AG's Report, para 2.35 Back
Qq 56, 58, 70: Ev 13 Back
Qq 48, 51, 52, 60; C&AG's Report, para 2.19 Back
Qq 39, 41-43; C&AG's Report, paras 2.21 and 2.24 Back
Qq 32, 37; C&AG's Report, para 2.33 Back