Secretary of State acts to shore-up Franchise Model with hints of deeper reform to come
13 December 2017 | Author: Ed Thomas, Partner, UK Head of Transport, KPMG LLP

The successes of Britain's rail franchising system are well established. A doubling of passenger numbers since privatisation, steady increases in punctuality and passenger satisfaction between 2001 and 2013 and a rail system with the best safety record in Europe are the achievements that are cited most commonly. Intense competition at the bidding phase has helped turn £2bn of Government subsidy to the TOCs in 1997 into a net premium today. Franchising also allows for a regular injection of fresh thinking and innovation into rail operations – something that has not necessarily been seen on the infrastructure side of the industry.

However, in the past three years, even the biggest advocates of franchising would have to concede that progress has stalled. PPM has gone into reverse, passenger satisfaction has plateaued and journey growth has started to slow. There are also questions around the commercial sustainability of the model and whether it provides adequate returns to shareholders. Whilst TOC margins in aggregate remain around 3%, the contracts with the highest profitability tend to be those that have been extended rather than the more recent competitive awards. DfT's significant capital requirements have also deterred the market with last year's West Midlands and South Western competitions both attracting only two bidders.

It is against this background that the Secretary of State has published his new Vision for the railway. Unlike the Labour Opposition, the Vision is clear in reaffirming a belief in the benefits of franchising. However, it is fair to say that the picture it presents is much more nuanced than the 2012 Brown Review and hints at more wide ranging reforms to come.

At one level, the Vision continues to see some place for traditional franchises in which revenue risk is transferred to TOCs for the short to medium term and infrastructure issues remain largely in the hands of Network Rail. As such, the document explains a number of incremental changes to shore-up the current model for the next round of transactions.

Firstly, given the uncertainty around passenger growth, the Forecast Revenue Mechanism (FRM) will give the operators of the new South Eastern and West Coast franchises greater revenue support. Essentially FRM is a more generous version of the "cap and collar" that was a feature of the second round of franchise contracts.

Secondly, smaller contracts, with the potential splitting of Great Western and Thameslink Great Northern, are another pragmatic step towards improving financial sustainability. Whilst some of the initial contracts were small enough to be management buyouts, the combination of a consolidation of the franchise map and massive growth in passenger revenues means that several franchises are now major companies in their own right with annual revenues of over £1 billion. Trying to transfer the risks inherent in businesses of this scale through tightly specified franchise contracts has become increasingly tortuous, and as East Coast shows, not always effective.

Finally, it is anticipated that the introduction to South Eastern and East Midlands of joint TOC and Network Rail performance teams under a single Alliance Director will improve integration between track and train and reverse recent declines in PPM.

However, moving beyond these incremental changes, the Secretary of State has provided his clearest indication yet that he considers that beyond 2020, materially different approaches, that more clearly integrate track and train, are necessary to address today's industry challenges. The Vision sets out plans for integrated, 15 year Partnerships with TOCs playing a more significant role in developing future infrastructure plans. The new model is still under development. However, changes in how franchises are procured and managed, in the commercial relationships between the TOCs and Network Rail and potentially even in the range of market players will be required if these types of long term Partnerships are to succeed.

For example, to be a genuine Partner, Network Rail must become more directly involved in franchise awards and endorse fully the plans of incoming TOCs at the outset of the new contracts. Then, once the Partnership has been agreed, one would expect a more conventional commercial relationship between the TOC and Network Rail. This is in contrast to today's regulatory arrangements which effectively hermetically seal the TOCs from changes in Network Rail's costs.

The history of franchising has shown that forecasting rail revenues is highly uncertain even over a relatively short term. Therefore, a more flexible approach to both demand risk transfer, and to contract management, will be required from DfT to support 15 year franchises. Indeed, the Vision acknowledges this by hinting at periodic revenue resets during the term of the new contracts.

Finally, Government has made it clear that beyond CP5, funding for enhancements will be heavily constrained. Therefore, whilst the Vision states that the majority of infrastructure risk will remain with Network Rail, it may be incumbent on Partnerships to bring private finance in order to enhance the network in a way that limits the impact on Government's balance sheet. This hints at new players, with greater balance sheet capacity, entering the market to support today's TOC owning groups.

Despite recent challenges, the outlook for franchising is strong. Government investment in the railways is at record levels and DfT has 15 Passport holders that are able to bid for contracts. Indeed, such is the level of interest in the UK rail market from overseas, that this list of potential bidders gets longer each year. Stagnant industry performance suggests that reform is needed. It could well be that in time, the Secretary of State's Vision is seen as an important step both in shoring up today's franchise model, and in identifying new structures for the most complex parts of the network that can meet the challenges of the next decade.

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