Institute for Transport StudiesFACULTY OF ENVIRONMENT

UK RAIL FRANCHISING: WHY DID THE WEST COAST FRANCHISING

PROCESS COLLAPSE?

Tony Fowkes

Seminar, ITS, 15.10.14

Overview

On 3rd October 2012, the DfT cancelled the refranchising process (using a new methodology) for ‘InterCity West Coast’, the tilting train services from London Euston to Birmigham, Manchester, Liverpool and Edinburgh.

All other refranchising exercises were halted at the same time.

It was said that some errors had been found in the procedures, but why could they not simply have been rectified, and the exercises restarted?

We will look today at what was wanted from franchises, consider why previous methods had been rejected, and investigate what went so badly wrong with this new method.

InterCity West Coast Timeline 2012

• 14 August. I am asked to appear on the following day’s TODAY program to discuss the ICWC award. Declined.

• 15 August. DfT announces ICWC awarded to FirstGroup.

• 28 August. Virgin lodges papers at the High Court asking for a judicial review. Seen as a delaying tactic.

• 3 September. Theresa Villiers (since banished to N.I.) states intention to defend the legal challenge robustly.

• 3 October. DfT announces cancellation of the ICWC competition (currently planned to restart in January 2016, with winner to be announced in November 2016).

UK Rail Franchising

The Railways Act, 1993, provided for the privatisation of state operator British Railways.

As part of that, nearly all rail passenger services were to be franchised out.

Initially, services were allocated to one of 25 new Train Operating Companies (TOCs), with their staff and rolling stock leases etc, and bids were invited to run these companies, with specified minimum levels of service, usually for 7 years, in return for a subsidy/premium profile.

All 25 were successfully franchised between 1995 and 1997.

Important Distinctions

Firstly, the franchises are not ‘Concessions’, such as the Manchester Metrolink, where RATP (the Paris local public transport operator) is paid a fee, but does not keep the revenue. Rather, it is a ‘net cost’ model – TOCs keep the revenue, pay their costs, and either seek a subsidy or offer premium payments for the right to operate services with a degree of protection from competition.

Secondly, the operating group (eg. Virgin) is distinct from the TOC (Virgin Trains), with the latter possibly going bankrupt when the former hasn’t. That situation could EITHER be referred to as Virgin “handing back the keys” OR Virgin Trains going bankrupt.

Major Problems Facing the TOCs post-1997

1. There was a crisis of confidence around 2000, epitomised by the Hatfield crash in 2000, in which the network provider, Railtrack, realised that it could not meet (or afford to buy out) the terms of a contact with Virgin Trains and so went bankrupt, leaving a backlog of maintenance, poor records of the state of the tracks, and a series of accidents (leading to an over-reaction in the imposition of speed limits and renewal works that disrupted rail services).

2. Government spending plans, particularly on new rolling stock, were halted by the 2007/8 financial crisis, accompanied by a large fall in GDP (to which rail demand is strongly positively related).

The Original Method of Franchising, and it’s Outcome

In brief, franchises were awarded solely on the financial bids, with bidders promising large efficiency gains and revenue growth over time, leading to reduced subsidies (increased premia) over time. Essentially, the bidders had a higher test discount rate than the Treasury.

Possibly due to deliberate overbidding, the Winner’s Curse, or just the crisis in 2000, one by one nearly all the TOCs asked for bailouts or to be put on ‘management contracts’.

This has been widely studied, including in a good paper by Nash and Smith in January 2006, “Passenger Rail Franchising – British Experience”. Unlike today’s seminar, that paper concentrates on the evolution of costs and revenues.

Who bears the macroeconomic risk?

By Macroeconomic Risk, I mean the consequences for TOCs of the economy performing differently to expectation.

If GDP is higher than expected then TOCs will obtain a windfall (for up to 25 years!), whilst if GDP is lower than expected TOC revenues will be insufficient to cover the cost of providing the services agreed in the Franchise Plan, unless there is a safety margin priced into the bid.

By always choosing the best financial bid in the first round, the safety margins were probably inadequate.

If we increase the penalties for bankruptcy, that would force bidders to play safe, but would cost DfT money, and TOCs still get to keep the windfalls from higher GDP.

The Second Method

For the second round of Franchising, starting in 2003 (most first round franchises having been let for 7 years) it was decided that it was inappropriate to leave the TOCs bearing all the revenue risk.

No attempt was made to distinguish between the sources of the risk (eg. GDP, delayed services, overcrowded trains), but a large part of the variability in revenue was to fall on DfT, via a ‘Cap & Collar’ mechanism.

Cap & Collar

• Purpose: To mitigate revenue risk to the franchisee, so that they will make financially improved bids, with government better able to cover the risk.

• Operation: From the 5th year of the franchise, large deviations from the revenue forecast in the franchise plan would result in risk sharing.

• Method: If actual annual revenue is more than 2% away from the ‘revenue line’, then the difference begins to be shared 50/50 with DfT; until the difference reaches 6% wherefrom the DfT share is 80%.

• Surpluses are “capped” and shortfalls are “collared”.

Cap & Collar, worked example

Actual Revenue

2-6% support (50/50)

6+% support (80/20)

Total Support (-ve is TO DfT)

Total TOC Receipts

0 2 75.2 77.2 77.2

90 2 3.2 5.2 95.2

96 1 0 1 97

100 0 0 0 100

104 -1 0 -1 103

110 -2 -3.2 -5.2 104.8

200 -2 -75.2 -77.2 122.8

Suppose, the Planned Revenue (the ‘Revenue Line’ in the bid ) in a particular year is 100, what Revenue Support would be due for various levels of Actual Revenue. The table shows the Revenue Support to the TOC (-ve is a payment to DfT).

TOC Recipts as a function of Bid Revenue Levels

TOC TOTAL RECEPTS

************ BID REVENUE LEVEL *******ACTUAL REVENUE (YEAR 10) 50 100 110 120 150 200 400

400 121.4 162.8 171.08 179.36 204.2 245.6 400

150 71.4 112.8 121.08 129.36 150 184.4 338.8

120 65.4 106.8 115.08 120 139.8 178.4 332.8

110 63.4 104.8 110 114.64 137.8 176.4 330.8

100 61.4 100 104.92 112.64 135.8 174.4 328.8

90 59.4 95.2 102.92 110.64 133.8 172.4 326.8

60 53.4 89.2 96.92 104.64 127.8 166.4 320.8

0 38.6 77.2 84.92 92.64 115.8 154.4 308.8

AR400-AR0 82.8 85.6 86.16 86.72 88.4 91.2 91.2

Collar Support in 2011/12

7 TOCs RECEIVED COLLAR SUPPORT IN 2011/12

REVENUE SUPPORT AS PERCENTAGE OF REVENUE

REVENUE AS % OF TOC RECEIPTS

CROSS COUNTRY 4.6 95.6

VIRGIN WEST COAST 5.1 95.1

FIRST CAPITAL CONNECT

6.2 94.1

EAST MIDLANDS TRAINS

7.5 93.0

SOUTH EASTERN 7.8 92.8

SOUTH WEST TRAINS 10.0 90.9

Source: Roger Ford, MODERN RAILWAYS, Dec. 2012

Collar Support in 2011/12

7 TOCs RECEIVED COLLAR SUPPORT IN 2011/12

REVENUE SUPPORT AS PERCENTAGE OF REVENUE

REVENUE AS % OF TOC RECEIPTS

CROSS COUNTRY 4.6 95.6

VIRGIN WEST COAST 5.1 95.1

FIRST CAPITAL CONNECT

6.2 94.1

EAST MIDLANDS TRAINS

7.5 93.0

SOUTH EASTERN 7.8 92.8

SOUTH WEST TRAINS 10.0 90.9

FIRST GREAT WESTERN

25.7 79.6

Source: Roger Ford, MODERN RAILWAYS, Dec. 2012

First Great Western 2011/12

That 25.7% shown on the previous slide equates to £209.4M, relative to Revenue of £813.5M.

What does that imply the Revenue Line was in the Plan?

Answer: £1114.25M.

94% of 1114.25 is 1047.4, and 98% is 1092.

50% of (1092 – 1047.4) is 22.3

80% of (1047.4 – 813.5) is 187.1

Total Revenue Support is 209.4M.

Capped Revenue Share in 2011/12

Only one TOC paid a capped revenue share to DfT in 2011/12.

Northern paid £12.5 million to DfT, this equating to 4.8% of their Revenue.

An Actual Bidding Competition: South Western

The NPV of the winning bid is made public, but the range of other bids is not. However, following a Freedom of Information request in 2009, the following anonymised NPV bid premia were published relating to the South Western franchise:

(a) £501M, (b) £513M, (c) £636M

I do not know whose bids any of (a-c) are.

So, bearing in mind everything I have said, how large an NPV did the winning bid have?

An Actual Bidding Competition: South Western

The NPV of the winning bid is made public, but the range of other bids is not. However, following a Freedom of Information request in 2009, the following anonymised NPV bid premia were published relating to the South Western franchise:

(a) £501M, (b) £513M, (c) £636M

I do not know whose bids any of (a-c) are.

So, bearing in mind everything I have said, how large an NPV did the winning bid have?

Answer: (d) Stagecoach, £1191M

The ICWC Franchise Process:Definition of Terms.

ICWC: InterCity West Coast. This, or just “West Coast”, is the official name of the franchise in question, covering the tilting train services from London Euston to Birmingham, Manchester, Liverpool, and Glasgow.

ITT is the DfT Invitation to Tender, issued 20/1/12.

The Contract Award Committee (CAC) is a committee of senior DfT officials tasked with recommending which bid to accept. Reported to RRPB.

The Rail Refranchising Programme Board (RRPB). Reported to BICC.

DfT Board Investment and Commercial Sub-Committee (BICC).

The ICWC Franchise Process:Definition of Terms (cont).

The Subordinated Loan Facility (SLF) is an amount of risk capital owning groups would be required to provide in order to reduce the risk of TOC bankruptcy to an acceptable level. DfT sometimes referred to it as “insurance”.

The GDP Mechanism varies the amount of the annual franchise payment, to the extent that actual GDP varies outside of a +/- 5% range around forescast GDP. The ITT implies that 80% of this GDP risk would be borne by DfT.

The DfT Model is the DfT GDP Resilience Model, used to calibrate the GDP Mechanism. It contains 500 economic scenarios, with associated probabilities. “Apparently around the time” the ITT was published, it was decided to use this model ALSO for the determining the required level of SLF.

ICWC: Franchise details.

The franchise was to be for a maximum of 15 years (with the last 2 at DfT’s discretion) from 9/12/12 to 12/12/27.

Bids had to be submitted in Excel model form, complete with Operating Manuals etc.

Monetary figures were to be in Nominal Terms, but with a deflation “switch” to convert into Real Terms (at 2012/13 prices), and NPV was to be discounted back to 9/12/12.

Bidders were invited to offer “profit share”, and there was to be automatic sharing of the GDP risk.

DfT supplied default values of RPI and GDP for bidders to use.

ICWC: Financial Risk

The ITT explained that the bid evaluation process would include a consideration of whether the risk-adjusted revenue and costs of each bid produced too high a risk of franchise insolvency, possibly requiring bidders to inject additional funds, potentially via an SLF.

The maximum permissible risk of default was set at 4.4%, over the 15 years of the franchise. With roughly 16 franchises, that implies that one franchise would default about every 10 years. Previous defaults had been a nuisance for government, with financial loss and plans knocked off course, but passenger interests had been protected. So ... was 4.4% too low?

Technical Modelling Flaws

The following Modelling Flaws were documented in the Laidlaw Report of 2012, and much of what I say here follows that report closely.

1.It was not realised that the outputs from the DfT Model were in real terms, with the result that the SLF figures resulting “were understated by nearly 50%”. I believe he meant that 50% needed to be added.

2.There was confusion regarding the GDP elasticity to be used (per capita or not, PDFH v4.1 or v5, the latter only adopted that August). Laidlaw thought, quite possibly wrongly, that this also led to the DfT Model SLF figures being too low.

Since bidders were unaware of these problems, they could not sensibly choose how much risk to build into their bids.

Administrative Flaws

1. The DfT model was not provided to bidders (as it would have been obvious that it was not designed to generate SLF requirements, and therefore open to challenge).

2. As of 23.02.12, DfT was advised that, as things stood, the material given to bidders allowed DfT to take its own view on SLF, not constrained by any particular methodology.

3. In order to mitigate this lack of transparency, on 24.02.12, the SLF Guidance document was issued. This said that increasing SLF levels would be input into the DfT model until the maximum default risk (4.4%) was reached. It suggested that no SLF would be required if a bid’s default risk was below the maximum level. A Ready Reckoner was included, but this was incredibly rough & ready.

Administrative Flaws (cont).

The bidders continued to raise concerns regarding the lack of transparency regarding the determination of SLFs.

On 13/3/12, the ICWC Project Team Leader asked colleagues, by email, “Is the exposure so great that we should dispense with the solvency test/subordinated loan requirement?”

On 21/3/12, a meeting of the RRPB decided to press on and give no more guidance.

In answers to questions, DfT said it had no policy of requiring a minimum level of SLF, and that it would not impose one on a bid with a risk-adjusted profit margin over 5%.

In early May, DfT received 4 bids, all except Virgin’s including an SLF. First’s SLF was £50M, plus £10M of equity.

In mid-June, Atkins provided “first-pass” risk adjustments, that were run thru the bidder’s models to generate re-profiled revenues and costs, which were in turn modelled with the DfT model against the 4.4% maximum default rate to determine any additional SLF requirements. The Virgin SLF (all additional) was £90M, but the others are secret.

DfT also used its Ready Reckoner gave “materially different” figures, the Virgin figure being £72M.

A CAC meeting on 19/6/14 decided, in an unminuted meeting, with anonymised figures, to use the Ready Reckoner numbers, since that was all the bidders had, in oral communication with bidders. Virgin wrote back to challenge the £72M.

Atkins included further adjustments, including taking some account of a suggestion from First, which resulted in Atkins advising DfT to make further risk adjustments to all bids. On both the full model and the Ready Reckoner, First’s SLF rose (to £252M on the RR, and the DfT model figure would have been £355M if the “real terms” mistake had not been made), but Virgin’s fell to zero (due to First’s suggestion).

CAC met on 27/6/12 to review all the figures, and their final decision on SLF was £200M for First (ie. £140M additional) and £40M for Virgin (all additional).

The Laidlaw Inquiry team interviewed all 14 attendees at the 27/6/12 meeting but “There remains a significant lack of clarity and a large degree of inconsistency in the evidence as to the discussions and decisions taken at the meeting. This is surprising, not least because it was an important and fairly recent meeting attended by some senior DfT officials. ... “Unhelpfully, ... the short draft minutes circulated following the meeting were replaced with even shorter final minutes.”

Laidlaw concluded that the 27/6/12, meeting had:

1.Taken account of extraneous factors in a way that treated First and Virgin inconsistently;

2.Paid no regard to the SLF Guidance, which did not mention the use of discretion;

3.Imposed a minimum level of SLF, contrary to previous advice to bidders, and done so in a way that favoured one bidder over the other;

4.Baulked at asking First for a significantly higher SLF than previously advised (even though that was a “first pass” using Ready Reckoner numbers rather than DfT Model numbers.

Both remaining bidders were given their SLF numbers and quickly agreed to provide the SLFs requested, though First told the Transport Select Ctte that their figure was reduced by £15M in negotiation/clarification.

Between 29/6/14 and 2/7/14, DfT’s external advisors Eversheds raised concerns regarding the SLF determination, but Laidlaw finds that their concerns were not formally escalated within DfT.

On 16/7/14, CAC agreed to hold final negotiations with First.

Around 20/7/14, Virgin was told it was not the preferred bidder, and R. Branson wrote on 23/7/12 to the PM and others, claiming First had overbid, but not mentioning SLF.

On 30/7/12, Virgin wrote to the DfT DG responsible for refranchising, asking what First’s SLF was and how it had been calculated (refused on 9/8/12), and mentioning a judicial review.

On 31/7/12 BICC met to agree to seek authority for franchise signature. Virgin’s objections were raised, and it was agreed that “BICC fully satisfied itself on these issues”. It decided it needed further information, and requested a paper for a follow-up meeting on 2/8/12.

That paper contained the untrue statement that “The SLF required is calculated by reference to the 500 macro-economic scenarios ..., to ensure that the calculated probability of default ... is no higher than 4.4%”

Clearly, the chosen SLF values were chosen not to be higher than the “first-pass” figures already given to bidders, so did not satisfy the 4.4% maximum in the case of First. Those figures, in turn, were based on the Ready Reckoner and not the DfT model, as had been specified in the SLF Guidance, and so had not been run over the 500 scenarios.

The major influence on the choice of SLF numbers was the desire for a minimum SLF, expressly against previous advice to bidders, and the fear that an SLF meeting the 4.4% test would have been too high for First to stand, and even if they managed it they would not have wanted to bid for other franchises on that basis. These matters were not even raised in the 2/8/12 meeting, even though some of those in the 27/6/12 meeting were present on 2/8/12 too.

The 2/8/12 meeting decided to proceed. The Secretary of State having learned of the identities of the bidders, ministerial approval was obtained from the Minister of State.

On 15/8/12, the award of the ICWC franchise to First was announced.

Conclusions

The method used for the ICWC Franchise exercise:

1.Was not based on a defendable/publishable model, and so failed the test of transparency, which led to large errors being made.

2.Put DfT in the position of having bids each good in one key respect but bad in another, since bidders did not know what weight DfT would place on each and so could not make an intelligent bid.

3.Required successful bidders to carry a larger share of the risk than was conducive to having numerous bidders, some of whom held several franchises.

Hence, a fourth method is being tried .........

References

Ford, R. (2012), Cap & Collar hitting DfT’s budget, Modern Railways, December.

Laidlaw(2012), Report of the Laidlaw Inquiry, TSO, London.

Nash, C. A. and Smith, A. S. J. (2006), Passenger Rail Franchising – British Experience.