Rail franchising Contents

4Taxpayer support and the transfer of risk to the private sector

Taxpayer support of the railway

43.A core objective of franchising was to reduce the taxpayer subsidy required to operate passenger services. The franchised railway now pays for itself in terms of running costs.89 However, factors other than franchising have contributed significantly to this: input costs for operators, namely track access charges, are not reflective of the full cost of use;90 and rail fares have risen significantly off the back of a policy decision91 by successive governments to allow fares to rise above inflation for much of the past 12 years.

44.Franchised operators are consequently making a greater contribution to government through premiums. In 2015/16, TOCs made a £877 million net contribution to the government, more than double the £400 million paid in 2011/12.92 Yet whole-of-industry government support for the railway remains significant, with the net total at £4.8 billion in 2015/16; still double the level recorded (in real terms) in 1985–86 (see figure).93 The vast bulk of this subsidy is for infrastructure investment and maintenance.

Figure 2: Total government support at 2015–16 prices

45.Private investment in passenger services also remains limited, with the Network Rail control period the main means by which investment in the network occurs.94 However, some of those giving evidence acknowledged that rolling stock investment has improved in recent franchises and according to the Rail Delivery Group (RDG) is up 55.3% to £622 million in 2015–16.95 This is evident most recently in the £1.4 billion replacement of the entire fleet of trains for the East Anglia franchise, with 1,043 new carriages to be delivered by the end of 2020.96 Although there is still some way to go improving rolling stock, with the average age of British passenger trains at 21 years.97

Financial risk in operating a franchise

46.Transferral of financial risk to the private sector (i.e. the franchised operator) was another central premise of rail franchising.98 This was on the basis that there is a reasonable risk that revenues from operating rail passenger services may fall or costs may increase, thus undermining the profitability of an operator.

47.Using the accounts of nine train operating companies between 2007–08 and 2014–15, we can see that operator revenue increased by nearly 40%, offsetting the 30% rise in costs.99 These companies collectively recorded profits in 88% of annual reporting periods between 2007–08 and 2014–15.

Figure 3: Operating revenues and costs, 2007–08 to 2014–15

Source: Company accounts

48.Using wider data from the ORR, income increased for all but three operators between 2011–12 and 2014–15; the weighted average increase in operator income for that period is 15.4%.

Figure 4: Train operator income, 2011–12 to 2014–15

Source: ORR, GB Rail Financial Statistics, 2011–12 to 2014–15

49.Additionally, almost all operators were profitable in 2014–15;100 and between 2011–12 and 2014–15, operating profits were recorded in 75% of reporting periods across all franchises. Although operating margins have gone down, on average, from 3.6% in 1997–98 to 2.9% in 2014–15.101

Figure 5: Profitability, by operator, 2011–12 to 2014–15

Source: ORR, GB Rail Financial Statistics, 2011–12 to 2014–15

50.Although profitability and financial results vary from year to year, it is clear that a franchised operator is generally exposed to a relatively low level of financial risk. This is partly because rail passenger numbers continue to increase consistently. Fares have also been rising consistently following policy decisions102 by successive governments to allow fares to rise above inflation for much of the past 12 years. The cost base of an operator is also largely predetermined through regulation and not exposed to large swings or volatility.103 Much of the financial risk in rail still resides with Network Rail, a public sector body, which has responsibility for maintaining and enhancing the infrastructure. Operators are mostly remunerated for delays or cancellations resulting from the infrastructure failures via Network Rail compensation payments (Schedule 4 and 8 payments, see chapter 6). Operators are also not exposed to changes in track access charges during the life of a franchise.

51.Weighed against this are industry perceptions that the size and complexity of franchises are increasing the financial risk borne by franchisees.104 Larger and more complex franchises require operators to take on higher value financial risks. This, combined with the falling profit margins, means that owner groups must now be highly capitalised to be able to absorb such risks. The DfT acknowledged that this could deter all but the biggest potential operators from bidding for franchises.105

52.The transfer of financial risk to the private sector was a central premise of rail franchising, but historically there has been a relatively low level of financial risk from operating a passenger rail franchise. However, falling profit margins for passenger operators in recent years, and the increasing size and complexity of franchises, appears to be increasing risk to private operators. Much of the financial risk in rail has always resulted from maintaining and enhancing the infrastructure and this is still the case, with whole-of-industry Government support still substantial. There are wider issues related to this, which go beyond the scope of this inquiry. These will be addressed in further detail in our forthcoming Rail Governance and Finance inquiry.

53.There have been recent circumstances in which a franchised operator might have been exposed to a substantial degree of financial risk, but the Department chose to insulate it. A number of witnesses saw the recent experience on the TSGN franchise as a failure by the Department to transfer sufficient risk to the operator.106 In the case of TSGN, the Department took on all the revenue risk from the franchise because the risks from the infrastructure changes, from the Thameslink programme, were perceived to be too high for the private sector to take on. As a result, a management contract was used in which Govia Thameslink Railway (GTR) essentially receives a fixed annual fee, in the region of £1 billion, for delivering the service. Even accounting for the anticipated infrastructure delays, the prolonged industrial dispute, subsequent compensation claims107 and the £20 million of taxpayer’s money intended to get the franchise back on track, will see the Department receive considerably less revenue from this franchise than originally anticipated. GTR, which runs the TSGN franchise, has estimated that the likely net revenue fall since 1 April 2016 will be in the region of £38 million for this financial year.108 This is, in effect, revenue, which could have been re-invested in rail services, lost to the public purse.

54.With respect to the ongoing problems on the TSGN franchise, the ultimate financial risk remains with the taxpayer. We recommend that in response to this report, the Department publish updates on the financial losses to the taxpayer from the TSGN franchise and set out the options available to recoup these losses. Given the exposure of the taxpayer to the failings of this franchise, it is unacceptable for the Department to maintain its current ‘arms-length’ approach. We recommend the Department intervene to ensure that all possible steps are being taken to stop the haemorrhaging of income. In response to this report, as well as setting out the steps the Department is taking, a full explanation should be given of the range of options considered in dealing with this franchise and why the current ‘arms-length’ approach was deemed suitable. If GTR is officially found to be in breach of its contract, we recommend the Department consider restructuring the franchise and determine who is best placed to operate it. Ultimately any potential restructure should rectify the contractual shortcomings of the current franchise, realigning the incentives and focus of the operator back to the passenger and reducing the financial exposure of the taxpayer.

89 Campaign for Better Transport (RFG0013)

90 Office of Rail and Road (RFG0022)

92 Office of Rail and Road, 2015–16 Annual Rail Finance Statistics, 13 October 2016

93 Office of Rail and Road, 2015–16 Annual Rail Finance Statistics, 13 October 2016

94 Competition and Markets Authority (RFG0005); RMT (RFG0006)

95 Rail Delivery Group (RFG0019); Alstom UK&I (RFG0021); FirstGroup (RFG0018); Rail Delivery Group, Rail’s transformation in numbers, November 2016

98 Department for Transport, The Future of Rail Franchising, 2010

99 Revenues and costs cannot be measured accurately and consistently for all operators over time. This is because franchises have different financial years, differing franchise periods and varying availability of full accounts. The 9 franchises include Arriva Trains Wales, CrossCountry, East Midlands, London Midland, Northern, South Western, Southeastern, Transpennine and West Coast. These operators account for 53% of franchised passenger journeys.

100 It should be noted that this is not an accounting profit in a statutory reporting sense due to statutory financial reporting adjustments for the treatment of deferred tax, pension costs, interest costs, dividends etc. For full methodology, see: ORR, GB Rail Financial Statistics 2011–12 to 2014–15, March 2016

101 Rail Delivery Group, Rail’s transformation in numbers, November 2016; It should be noted that the dataset of the ORR and indeed that presented on profit margins by the RDG is different from the data collected nine train operating companies earlier in the report.

103 For more info and statistics, see: ORR, Trends and comparisons for franchised operators, March 2016

104 Rail Delivery Group (RFG0019)

105 Department for Transport (RFG0003)

106 LondonTravelWatch (RFG0012); Campaign for Better Transport (RFG0013); RMT (RFG0006)

107 The Government recently announced 1 month’s compensation for Southern passengers.

108 Committee correspondence with Paul Maynard, 17 November 2016.

2 February 2017