Rail franchising Contents

5Structure of franchising

55.It is clear that franchising is not yet maximising benefits for passengers, nor driving the efficiencies initially envisaged at the time of privatisation. One of the key problems has been the considerable rise in train operating costs that are linked to the structure of the franchises; indeed the ITS noted that “rail franchising has been associated with higher costs in contrast to reforms elsewhere.”109 The Government previously acknowledged that “ … current incentives do not adequately reward franchisees for reducing costs.”110

Size and complexity of franchises

56.Rail franchises in the UK are larger than elsewhere in Europe.111 The number of franchises has reduced from 25 at privatisation to 15 now. The size and complexity of franchises has also increased.112 This is most evident in the procurement of the TSGN franchise in 2014. This franchise covers around nearly 20% of the network and includes a variety of different commercial and commuter markets.113 The Department’s decision to combine HS2 services with the West Coast franchise, for an initial period of between three to five years from 2026, also creates a franchise that accounts for a significant proportion of the long distance network. (see Chapter 7 for more discussion)

57.There are potential benefits from having larger franchises, particularly regarding economies of scale.114 However, the ability to exploit economies of scale with rail services is limited by the extent to which franchises have different operations and use different types of rolling stock.115 Similarly, large franchises can often include very different types of rail services and do not, therefore, always provide a clear market focus.116

58.Other witnesses felt that the size of current DfT rail franchises did little to promote competition in the market.117 This is related to the level of Parent Company Guarantee required of prospective operators in bidding (see Chapter 4). While this financial capital is an important lever in ensuring TOCs meet their financial obligations, “it is limiting the number of bidders to those who can raise the required level of capital.”118

59.The ITS concluded that on the balance of the current evidence moving to smaller franchises could reduce costs and increase on-rail competition.119 Transport Focus, Transport for London, the Rail Delivery Group (RDG) and CMA all concluded that smaller franchises would provide a lower cost option, with reduced exposure to financial risks, and may encourage new entrants into the market.120

60.There are important operational considerations from increasing the number of franchises on the network. NECTAR, in their submission raised a general point that, “as a rule of thumb, the greater the number of rail operators serving a particular section of railway, the greater the potential confusion and misinformation about levels of service, types of ticket, and quality of accommodation that can arise.”121

61.There is also the consideration of a more congested franchising schedule. Currently, the Department has to manage 15 franchises. An increase in franchises would create a potentially higher resource burden on the Department and industry. This could be offset by the fact that the franchises procured would be more targeted in terms of the services specified. This may reduce the complexity of a franchise agreement and streamline the procurement process. A congested franchise schedule may also be managed through procuring longer franchises on certain parts of the network (see discussion below).

62.There are potential benefits from operating smaller franchises, particularly in terms of providing a greater market focus for the operator. There is also less financial risk from taking on smaller franchises, which may enable new entrants into the franchising market. A wide restructuring of the current franchise system would, however, be prohibitively impractical because of the resource burden this would create for the Department and the restrictions from current franchise contracts. We therefore recommend that, as franchises expire, the Department considers whether they can and should be restructured to align better with the specific market they serve.

Length of franchises

63.The maximum length of rail franchises is mandated by European law and may be awarded for 15 years, with an extension for 7.5 years.122 There had previously been cross-party political support for longer franchises.123 In 2012 the Government stated that franchises “will be longer, giving operators more responsibility and more flexibility in the services they provide, as well as more incentives to invest.”124 However, the Brown Review recommended a more cautious approach to letting longer franchises, involving shorter initial franchises of between 7 and 10 years with the potential for extensions.125 This is broadly the approach that has been pursued since.

64.A number of witnesses noted that, because of the shorter franchise terms, franchised TOCs have limited incentives to invest and to put pressure on Network Rail to increase efficiency.126 The ITS also noted that “short franchises give limited incentives [to operators] to tackle the cost base [and] to invest in the network or rolling stock.”127 In the current environment operators look too much to the short term and are too risk averse. This limits the potential to shrink life cycle costs and embed innovation.128

65.Network Rail supports longer franchise terms as they provide for greater alignment of train operator incentives with Network Rail regulatory output targets (see Chapter 7), albeit on a five-yearly basis.129

66.One of the problems with having longer franchises is that it can be difficult to predict revenue and other risks with certainty over longer term horizons. This was a finding of the Brown Review and was emphasised by Paul Maynard who commented that a balance needed to be struck “between assessing revenue and other types of risk so that the Department could have reasonable confidence in what it was granting to the train operating company.”130 Yet, as shown recently, it can be difficult enough to predict revenue and passenger growth in the short term.

67.The Department should be seeking more innovative ways of contracting that would enable an appropriate risk share arrangement between the Department and the operator in the event of significant gaps developing between forecasts and performance outturns. It is also important to ensure that longer contracts are flexible and enable the Department to agree changes, particularly for major infrastructure enhancements. This was a key finding of the McNulty report131 and as the RDG point out, inflexibility remains a problem area of the Department’s current approach to contracting and in-franchise changes.132

68.We believe that there are benefits from procuring longer franchises, particularly in terms of incentivising investment and efficiencies from an operator. However, a one-size-fits-all approach is inappropriate. We recommend that the Department, upon the expiry of existing franchises, seeks to procure longer franchises where a franchise’s operational risks are relatively low and historical performance has been strong. This would have the dual benefit of enabling operators to improve efficiencies and provide more space for the Department in a highly congested franchising schedule. It is important that the necessary enforcement levers against underperformance, as well change mechanisms for infrastructure works, are contracted for by the Department for franchises with longer terms. The Department should also find more innovative ways of contracting with operators to mitigate the unpredictability of financial risks over longer term horizons.

109 Institute for Transport Studies (RFG0011)

110 Department for Transport, Reforming our Railways: Putting the Customer First, March 2012

111 Institute for Transport Studies (RFG0011)

112 Rail Delivery Group (RFG0019); Alstom UK&I (RFG0021)

113 Office of Rail and Road, Passenger rail usage, 2015–16

114 That is diminishing per unit costs as total output increases.

115 Institute for Transport Studies (RFG0011)

117 Transport for London (RFG0025)

118 Alstom UK&I (RFG0021)

119 Institute for Transport Studies (RFG0011)

120 Transport for London (RFG0025)

121 NECTAR (RFG0026)

122 Articles 4.3 and 4.4 of Regulation 1370/2007/EC

124 Department for Transport, Reforming our Railways: Putting the Customer First, March 2012

125 Department for Transport, The Brown Review of the Rail Franchising Programme, December 2012, p.26

126 Competition and Markets Authority (RFG0005); Social Market Foundation (RFG0008)

127 Institute for Transport Studies (RFG0011); ASLEF (RFG0014)

128 Institute for Transport Studies (RFG0011)

129 Network Rail, CP5 Performance Plan, p.28

131 McNulty, R, Realising the Potential of GB Rail, May 2011

132 Rail Delivery Group (RFG0019)

2 February 2017