Executive Summary
The Intercity East Coast (ICEC) franchise has a troubled history. The joint-venture between Stagecoach and Virgin, operated as Virgin Trains East Coast (VTEC), is the third time in just over a decade that this franchise has failed. The actual day-to-day operations of the franchise were managed successfully by VTEC. Based on passenger satisfaction, it was amongst the highest performing long-distance franchises on the network. In terms of VTEC’s operational finances, the franchise was performing well and VTEC made an operational profit of around £260 million in the financial year prior to its termination.
Despite this, the operating surplus generated did not fully cover the premium obligations it had with the Department for Transport (DfT) as part of its franchise contract. To cover the revenue shortfalls, VTEC had to forego the £165 million parent company guarantee it committed to the DfT when the franchise was let. By the end of January 2018, the last parent company support was drawn down and the franchise went into technical default. The latest ICEC franchise therefore failed because the revenue projections underpinning the VTEC bid were over-optimistic and it simply ran out of money.
Revenue fell short of expectations from day one and passenger growth that was anticipated never materialised; the franchise eventually failed after just three years of operation. Franchises should be able to withstand normal fluctuations in the economic cycle. The fact that this franchise did not suggests that Stagecoach and Virgin built very little resilience into their bid. Their assessment of the financial risk associated with their bid was wholly inadequate and VTEC’s bid for the franchise was over-optimistic. This was naïve, and it should have been more aware of the financial risks involved, particularly given the history of this franchise and Stagecoach and Virgin’s long history of bidding for and running franchises in this country. We conclude that Stagecoach and Virgin bear prime responsibility for the failure of this franchise.
The DfT must also take responsibility for not managing the bid process effectively enough. The DfT encouraged overbidding by setting unrealistic benchmarks in the Invitation to Tender, and the bid process lacked the necessary boundaries to temper over-optimistic bidding. Specifically, the DfT’s financial stress-testing of the bids was not robust enough. If the DfT had conducted appropriate due diligence and identified weaknesses in the assumptions underpinning the bid, it may not have been in this position today.
Network Rail do not bear any responsibility for the early termination of this franchise. To date, Network Rail have provided all the infrastructure upgrades that it had formally committed to when this franchise was let. A series of other upgrades were assumed to occur by the DfT and VTEC to deliver an enhanced timetable from 2019 onward; though there was no formal funding commitment to these upgrades when the franchise was let. The delivery of these enhancements will now occur but later than was initially anticipated by the DfT and VTEC. This delay would have undermined assumed revenue growth from 2019 onward but did not directly contribute to the early termination of this franchise. While Network Rail’s performance in managing the ECML had not been up to standard, and this clearly undermined franchise performance, it was not on a scale that led to VTEC defaulting on their contract. Further, compensation for revenue losses are dealt with through normal industry mechanisms.
Knowing that the financial picture was bleak from day one of this franchise, it might have been a simpler for the DfT to find an early contractual solution to this problem. One option might have been to rebase the revenue forecasts at the beginning of the franchise. At the time the franchise was let, the DfT had a policy of not renegotiating franchises once they had been let. This was to preserve the financial interests of the taxpayer and to preserve the integrity of the franchising market. Given this policy and the fact that there were no material changes in the wider economic environment (e.g. a recession), renegotiation of the contract with VTEC may have set a precedent for other operators in similar financial positions. The DfT therefore had no alternative but to let the contract run its course to default.
Various reports of a bail-out emerged after it appeared, and was then confirmed, that the VTEC contract would be terminated prematurely. The franchise has not delivered the premiums to the taxpayer that were originally envisaged when the franchise was let. Because of the contract termination, the tax-payer will no longer receive the entirety of the £2 billion that had been expected over the remainder of the franchise. It is important to note, however, that based on the contract that was originally agreed with the Government, the taxpayer has not bailed out Stagecoach and Virgin. This is because Stagecoach and Virgin had their liability capped at £165 million, which was the amount of their parent company guarantee.
The Secretary of State terminated VTEC’s contract on 24 June 2018 and transferred operations to the operator of last resort, under the brand ‘London North Eastern Railway’. While it is too early to know whether the decision to transfer control to the operator of last resort was the right one, we are critical of the Secretary of State for a lack of a clear plan and timescales upon which the interim operator will run the franchise. We recommend that the Secretary of State set out how long he expects the operator of last resort to run the franchise and clarify exactly how the DfT will manage any operational and investment risks until the longer-term arrangements are in place. We are not aware of the existence of formal obligations and targets for the operator of last resort for the Intercity East Coast franchise. We recommend that whenever the operator of last resort arrangement is invoked, the DfT should revise and publish obligations and targets for the operation of the failed franchise by the operator of last resort, in order to provide passengers, taxpayers, Parliament and industry certainty of its business plan, strategy and development plans. This should be done within six months of assuming responsibility for a franchise.
The DfT are developing plans to launch the ‘East Coast Partnership’ in 2020, though the exact date remains uncertain. This new operating model, where both track and train operators will be managed ‘under one roof’, is designed to encourage a more integrated and joined up approach to running this franchise. We conclude that greater joint-working and clear lines of accountability through a single person responsible for track and trains offers potential for significant improvement in services. The mechanics and complexity of the current financial and regulatory environment has meant that all previous attempts to establish deep alliances have not worked. Based on the current framework, we conclude that the East Coast Partnership is unlikely to provide scope for the step-change in performance that the Secretary of State might be anticipating. This proposal also risks adding an additional layer of complexity to this part of the network. Passengers will ultimately bear the risk if this proposal goes wrong. This seems to be an unnecessary risk on this part of the network, particularly given that passenger satisfaction is already relatively high. We recommend that any review of franchising should consider what change would be needed to the financial and regulatory framework to make partnership working a viable and sustainable model for operating the railway in the future. We recommend that the Department set a timetable for publishing the detail of how it expects the East Coast Partnership will work.
Decision-making should be based on a clear plan and a transparent assessment of that plan. In the case of the East Coast Partnership, neither of those things has occurred and we are concerned that future operations on a major part of the UK’s network will be captive to a concept for which there is no plan or impact assessment. Before experimenting with this Partnership, we recommend the Secretary of State lay out in detail how the new partnership will work and conduct a proper assessment of its feasibility against those plans. This assessment needs to demonstrate that his proposal will offer better value for money for the taxpayer and better outcomes for passengers than other ways of operating. We recommend the Secretary of State review his decision to go-ahead with this Partnership based on the findings of this assessment.
The East Coast franchise is but one vulnerable rail franchise on the network. There have been reports that several other franchises are either in revenue support, or potentially drawing on their parental guarantees to meet their obligations to the DfT. Given the problems on these franchises and the possibility of franchise failure, we conclude that the Government has not found the right balance between the risk of franchise failure and return they might obtain from encouraging ambitious bids. We recommend that the Department revisit its approach to franchise failure, which should be embedded in how they assess the risk and feasibility of each bid. We also recommend that it keep our Committee informed about any franchises that look likely to default on their contracts and whether it is resourcing the operator of last resort to take over any of these franchises and find a way to brief Parliament on the de facto reality on the railways.
Published: 12 September 2018