Department for Transport: The InterCity East Coast Passenger Rail Franchise - Public Accounts Committee Contents

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]

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.[3] Nevertheless, the company failed to meet its financial targets from very early on (Figure 1).[4]

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.[5] 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.[6]

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.[7] 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.[8]

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.[9] Arrangements to support franchises where passenger revenues fail to meet expectations are being reviewed by the Department.[10] 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.[11]

6. Under the terms of the contract, the termination of the East Coast franchise cost National Express nearly £120 million.[12] 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.[13] 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.[14]

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.[15] 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 profitable franchises.

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 termination.[16]

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.[17] 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.[18] 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. [19]

2   C&AG's Report, paras 4, 1.17 and 2.6 Back

3   Qq 1, 72 Back

4   Q3 Back

5   Qq 3, 7 Back

6   Qq 6-8; C&AG's Report, para 2.9 Back

7   Q111 Back

8   Qq 20-22; C&AG's Report, para 17 Back

9   Q3 Back

10   Q71 Back

11   Q63  Back

12   Q44 Back

13   Qq 54-56, 59; C&AG's Report, para 2.35 Back

14   Qq 56, 58, 70: Ev 13 Back

15   Qq 48, 51, 52, 60; C&AG's Report, para 2.19 Back

16   Qq 39, 41-43; C&AG's Report, paras 2.21 and 2.24 Back

17   Q59 Back

18   Q29 Back

19   Qq 32, 37; C&AG's Report, para 2.33 Back

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© Parliamentary copyright 2011
Prepared 9 July 2011