Rail franchising Contents

3Passenger rail competition

16.At the time of privatisation competition was seen as a means of delivering improved services, lower fares and driving industry efficiencies. This chapter briefly assesses the extent to which competition exists in passenger rail; then examines whether open access is a viable means of expanding competition on the network.

17.Passenger rail competition under the current franchising system takes two broad forms: competition “for the market” where operators bid for the right to run the service; or competition “in the market” at the point of delivery, where train operators compete to attract passengers for similar journeys (referred to as “on-rail competition” hereafter).

18.The current system of franchising creates competition “for the market”. Even though operators face a degree of competition from other modes of transport, it mostly creates regional monopolies once the contract is let.25 Because of this, there is currently only a small degree of on-rail competition,26 which occurs in three ways:

a)Overlapping franchises: where two or more franchised TOCs operate and compete for passengers on a route. The extent of overlapping franchises has fallen in recent years, following a policy decision in 2001 by the Strategic Rail Authority, to reduce the number of franchises.27

b)Parallel franchises: where two or more franchised TOCs operate services between the same city pairs, although on different routes, and so compete for passengers travelling between those cities.28

c)Open access operators (OAOs): these are operators of passenger services authorised by the Office of Rail and Road (ORR) to access the network on certain routes but are not contracted with the Department through franchising.

Is there adequate competition for the market?

19.Franchising is predicated upon there being competition for the market, but the reality falls well short of that aspiration. In the six years leading up to 2012, the Department had let only two contracts. At least one of those was quite a short and small contract.29 Direct awards, in which there is no competition between bidders, were used for 10 of 16 franchises in the three years following the West Coast franchise debacle in 2012 and are still in place for a third of all franchises.30

20.Franchising is also contingent upon an adequate level of market interest for franchise competitions. The general consensus is that a minimum of three bidders is preferable. In the past, there had consistently been three to four bidders31 and it was not always the incumbent who won the contract.32 Recently, however, the number of bidders for franchises has fallen, with only two bidders shortlisted for the South Western and West Midlands franchises.

21.There are different reasons for this decline in market interest for franchising. For example, barriers to market entry appear to be higher in the UK than in other European countries.33 Hugh Clancy, Commercial Director of Rail at FirstGroup, also commented that the fall in market interest is partly because “there has been an [increased] transfer of risk from Government towards the franchisees, which are now very substantial businesses that have very large financial premiums that have to be paid [ … ]”34 Profit margins in the industry have also declined on average, from 3.6% in 1997–98 to 2.9% in 2014–15.35 (see chapter 4 for more discussion)

22.The costs of bidding also present an obstacle for new entrants to the franchising market.36 Witnesses told us that the cost of submitting what they termed “enormous”37 bids to the Department, was between £5 and £10 million.38 The Parent Company Guarantee,39 which is a bond intended to protect the Department from the risk of franchise failure, is also substantial. For the TransPennine franchise, a Parent Company Guarantee in excess of £200 million was required in a mix of bonds and contingent loans. The c2c and East Coast franchises required support of £140 million and £232 million respectively.40

23.Some steps have been taken to reduce bidding costs, including the introduction of the pre-qualification questionnaire passport.41 It was suggested that franchise bidding costs could be further cut by reducing the burdensome modelling requirements,42 particularly around timetabling and revenue/crowding modelling. TfL emphasised that bidders for its London Overground concessions do not have to produce timetables or revenue projections. This removes the need for individual bidders to develop timetables in collaboration with Network Rail, which is an expensive and complex part of a franchise bidding process.43

24.There is a risk that market interest for franchise competitions could decline further. This is because a high proportion of franchise operators are owned by a small number44 of foreign-owned companies which are “increasingly international in their outlook”.45 As further markets deregulate in Europe, according to Alstom, “the risk is that [existing] bidders will increasingly find other opportunities overseas that may be more financially attractive.”46 The Department noted that East Japan Rail Company Ltd, partnering with Mitsui & Co Ltd, had recently entered the market and that it was expecting at least two further applications from new market entrants in the next 12 months.47

25.Joint ventures are a possible way of new entrants accessing the franchising market. There are five joint ventures operating at present.48 Abellio, which entered the market in joint venture with Serco, has moved on to be a franchise operator in its own right. The company is also now partnering with JR-East and Mitsui in a bid for the West Midlands franchise.49 However, other owner groups with a presence in the UK rail market may not always be willing to partner with new entrants where it could potentially erode their future competitive position.50

26.Franchising delivers the most benefits to passengers where there is robust competition between bidders to operate services. The direct award dependency of the Department and recent fall in market interest demonstrates that genuine competition has been restricted to a limited number of franchises. This core policy objective is not being met and the potential benefits from this model are therefore not being maximised by the Department. We recommend that the Department take steps to streamline bidding costs where possible; even if the effect of this on market interest is likely to be marginal. The Parent Company Guarantee is crucial in protecting the public purse and should not be removed or amended significantly. Wider reform is required, possibly through open access operators in appropriate areas, or creating smaller franchises, to attract new entrants into the market and promote competition in rail. Without change it is difficult to see how the current model will be sustainable in the longer term.

Open access operators

27.There are currently just two OAOs in Britain, First Hull Trains and Grand Central Railway,51 which represent less than 1% of the entire network but around 15% of the approximately 180 services a day on the East Coast Main Line.52 Other OAOs are planning new services on both the West Coast and East Coast Main Lines. Open access was conceived as a way of filling marginal capacity on the network and providing services to places not adequately serviced by franchised operators.53 Given the decline in market interest and relatively high barriers to entry for franchising, open access is seen as one way of attracting new entrants and promoting greater passenger rail competition.

Benefits and risks of open access

28.The core objectives of open access competition are to improve the quality and choice of rail services,54 increase competition on fares and stimulate efficiency improvements.55 To date they have been relatively successful on these measures56 and in the latest survey of passenger satisfaction, Grand Central and First Hull came first and second respectively.57 Additionally, the ORR and Institute for Transport Studies (ITS) found that OAOs had costs 10 to 30% lower than those of franchised TOCs, taking into account the size of operation.58 This is because they have greater operational flexibility, make greater use of outsourcing and have lower staffing costs. OAOs are also free from franchise specifications and have the flexibility to change their strategy more quickly according to changing demand and customer preferences.59

29.One of the main concerns with increasing the share of OAOs on the network is that splitting up the market into multiple operators might risk losing important economies of scale. The ITS concluded, however, that in general this was not the case, and that “OAOs have unit costs that are around the same as franchised inter-city TOCs.”60

30.There are other considerations such as making best use of capacity, especially when train paths are limited.61 Some witnesses commented that an increase in OAOs may further fragment an already complicated market and result in a potential loss of co-ordination between operators and Network Rail.62 NECTAR (North East Combined Transport Activists’ Roundtable) stated that passengers value frequently spaced and well connected services, which requires cooperation between train operators.63 While this was achievable between a small number of operators, they argued that adding multiple operators along the same track mileage may undermine effective cooperation because of differing rules, fare levels and ticketing systems.64

31.In the context of declining market interest in franchising, Dr Andrea Coscelli, Acting Chief Executive of the CMA, felt that open access could provide opportunities for new entrants to the rail market beyond the current “very big binary type of [franchising] competition”.65 Rail Minister Paul Maynard, told us that he is “a great apostle of open access.”66

32.Open access is likely to be aided by the pipeline of rail investments due for delivery over the next decade. HS2 has the potential to free up capacity for commuting and stopping services on the West Coast Main Line.67 Investment in new rolling stock, signalling technology and electrification are also likely to increase the capability of the network to accommodate open-access entry.68

33.The ORR pointed out that the passenger rail market is far from homogenous, so the form of competition appropriate in differing market segments will vary.69 There was a broad consensus that the benefits of OAOs are limited to intercity long distance routes (East Coast, West Coast and Great Western main lines).70 Other commuter operations are natural monopolies with captive markets, with passengers using high frequency “metro style” services, which limits the opportunity for on-rail competition.71 Other regional franchises are subsidised and deliver important social objectives and have limited scope for on-rail competition.72

34.Open access has been a success, albeit on a limited scale to date. The balance of evidence points to potential benefits in open access having an expanded role on long distance routes, beyond just filling marginal capacity or connecting unserved markets. Although it is not a complete substitution to franchising because of fragmentation risks. It is important to note that there are operational complexities that need to be addressed and we acknowledge that it will take time to test open access on a larger scale, to fully understand its feasibility, particularly in terms of operational risks.

35.In the context of declining market interest in franchising, open access may be an avenue for new and smaller entrants into the market. Additionally, given the lack of an operator of last resort, open access operators may be able to serve a role in franchise enforcement—possibly through the reallocation of capacity away from underperforming franchisees.

Future reform for open access

36.The ORR is responsible for assessing open access applications against its statutory duties under Section 4 of the Railways Act 1993. The ORR recently granted rights to Great North Western Railway to run services from London to Blackpool on the West Coast Mainline from 2019. And in May 2016, it granted rights to FirstGroup to run services from London to Edinburgh on the East Coast Mainline, competing with the franchisee (Virgin Trains East Coast) from 2021. It is currently assessing a bid from Alliance Rail Holdings Ltd, under the branding of “Grand Southern”, to run open access services from Southampton to London.73

37.The current framework for OAOs was designed for relatively small scale entry, providing services to under-served destinations. Because of this, OAOs currently only pay variable charges for use of the network.74 However, when applied to areas of the network where capacity is scarce, or to applications that are large relative to franchise operations, the existing regulatory framework:

a)creates an uneven playing field between TOCs and OAOs, because the TOCs are required to pay fixed and capacity charges; and

b)imposes costs to taxpayers through lower franchise premiums, either at the point of bidding or through lower payments during the franchise term.75

38.Dr Coscelli told us that “some fairly substantial changes”76 would be required to address these shortcomings and enable an expanded open access model. The CMA concluded in their policy paper that “action is required now in order to address the issues in the current system and to put the necessary steps for reform in place.”77 FirstGroup called for a “long term open access charging methodology, with clear criteria to guide how competing calls for the available capacity will be resolved.”78

39.The ORR has responsibility for overseeing changes to the framework for network charges via the Periodic Review.79 The ORR said they wanted to ensure that costs are “more competitive” and that charges better reflect the full cost of usage which could help improve incentives for all train operators to support cost reduction.80 The Minister indicated it was his intention to work with the ORR on reforming these charges.81

40.A public service obligation (PSO) levy would enable OAOs to contribute towards the costs of socially beneficial but commercially unviable parts of the network that might need subsidy from the taxpayer.82 The design and implementation of a such a levy, which could be used to offset the decline in premiums, is a matter for the Government. It would likely require primary legislation.83 We were concerned when Secretary of State Chris Grayling told us recently that he did not “immediately envisage change in the current arrangements.”84

41.Franchised TOCs raised concerns regarding the uncertainty85 that open access applications, such as those made on West Coast Main Line and the East Coast Main Line,86 create in the franchise bidding process. Bidders for franchised services clearly want to be able to assess the potential impact of open access before they submit a bid. The Rail Delivery Group (RDG) argued that a lack of consistency will result in significant tension within the market and potentially fewer and lower bids for franchise competitions.87 The CMA suggested that “uncertainty for franchised TOCs would be reduced by reserving a portion of track capacity for an open access operator in advance of issuing the Invitation to Tender for the franchise.”88

42.Reforms are needed if open access is to be expanded on the network. We recommend that the Department and the ORR work together, as they develop the financial framework for the railways over Control Period 6 (2019–24), to present a comprehensive set of reforms to track access charges. These reforms need to manage the differing requirements of OAOs and franchisees and ensure that operators, taxpayers and passengers get a fair deal. A specific proposal for a PSO levy should be put out to consultation over the next 12 months, so that a new regime can be introduced from April 2019. We further recommend that timetabling spaces for open access services are determined upfront during franchise development prior to the publication of the Invitation to Tender. This will provide the certainty that industry needs to plan, particularly at the bidding stage of franchising but it will also help to encourage OAOs.

25 Office of Rail and Road (RFG0022)

26 Office of Rail and Road (RFG0022); Competition and Markets Authority (RFG0005)

27 Strategic Rail Authority, Passenger Rail Franchising, December 2001; See passenger franchise map.

28 For example, between London and Birmingham, Cambridge and Peterborough.

30 These include the West Coast, West Midlands, South Eastern, East Midlands and Great Western franchises.

31 Transport Focus (RFG0009)

33 Competition and Markets Authority (RFG0005)

35 Rail Delivery Group, Rail’s transformation in numbers, November 2016

36 RMT (RFG0006); Rail Delivery Group (RFG0019); Transport for London (RFG0025)

37 Alstom UKI (RFG0021)

38 Rail Delivery Group (RFG0019); FirstGroup (RFG0018)

39 The Department is protected from the risk of franchise failure by the provision of Parent Company Guarantee (PCG) which is normally achieved with a Bond.

40 Rail Delivery Group (RFG0019)

41 For more discussion, see: NAO, Reform of the rail franchising programme, November 2015

42 The models have to be submitted for a best practice review and supported by a letter from the financial advisor which together costs £200k for each bidder.

43 Transport for London (RFG0025)

44 Based on the experience of the last 20 years, it is likely there are fewer than 10 organisations capable of successfully bidding.

45 Campaign for Better Transport (RFG0013)

46 Alstom UKI (RFG0021)

47 Department for Transport (RFG0003)

48 Virgin West Coast, Virgin East Coast, London Midland, South Eastern and TSGN.

49 Transport Focus (RFG0009)

50 Transport for London (RFG0025)

51 TravelWatch NorthWest (RFG0017)

52 Lodge, T, Rail’s second chance, 2014, Centre for Policy Studies

53 Competition and Markets Authority (RFG0005)

54 Department for Transport (RFG0003)

55 Competition and Markets Authority (RFG0005); Office of Rail and Road (RFG0022)

56 Department for Transport (RFG0003); Transport Focus (RFG0009)

59 Office of Rail and Road (RFG0022)

60 Institute for Transport Studies (RFG0011)

61 Campaign for Better Transport (RFG0013)

62 Railfuture (RFG0016)

63 NECTAR (RFG0026)

64 See paragraphs 5.160 to 5.207, CMA rail policy document.

67 Office of Rail and Road (RFG0022)

68 Office of Rail and Road (RFG0022)

69 Office of Rail and Road (RFG0022)

70 Campaign for Better Transport (RFG0013); Office of Rail and Road (RFG0022); Institute for Transport Studies (RFG0011); Competition and Markets Authority (RFG0005)

71 Transport for London (RFG0025)

72 Office of Rail and Road (RFG0022); Transport for London (RFG0025)

73 Office of Rail and Road, Current track access applications, accessed 23 December 2017

74 For more info on track access charges, see: Office of Rail and Road website.

75 Office of Rail and Road (RFG0022); Department for Transport (RFG0003)

77 Competition and Markets Authority (RFG0005)

78 FirstGroup (RFG0018)

80 Office of Rail and Road (RFG0022)

83 Office of Rail and Road (RFG0022); Department for Transport (RFG0003); March 2016 Ministerial Statement

85 Q284; Q285; Competition and Markets Authority (RFG0005)

86 In 2016, ORR approved a number of applications to run additional services on the ECML.

87 Rail Delivery Group (RFG0019); Alstom UKI (RFG0021)

88 Competition and Markets Authority (RFG0005); For more info, see: Paragraphs 7.22 to 7.53, CMA rail policy document.

2 February 2017