Australia: Achieving better public transport outcomes through contestable franchising

Last Updated: 22 March 2016
Article by Owen Hayford and Steven Klimt

Most Read Contributor in Australia, August 2016

Key Points:

Recent reports on the franchising of bus and ferry services have reinforced the case for using contestable franchising to improve how we provide public transport services.

Infrastructure Australia's recent reform document calls for, amongst other things, greater private sector involvement in operating infrastructure and the franchising of public transport services to create contestable markets. Recent reports by the Tourism & Transport Forum (in partnership with L.E.K.) the NSW Auditor General and the Victorian Auditor General have highlighted the benefits that have been generated via the outsourcing or franchising of bus and ferry services in Australia, the best practices that have emerged from that experience, and areas for future improvement.

Best practices have also emerged from lessons learned on the Victorian and overseas rail franchising experiences, such as those documented in the Brown Report in respect of rail franchising in the UK. These best practices can be applied to the future franchising of other public transport services in Australia, including Sydney and regional NSW passenger rail services, and other bus services.

Extent of private sector public transport franchises in Australia

Both Perth and Adelaide now have a relatively long history of franchised bus operations dating back to the mid-1990s. Each city has more than one private sector operator, providing competitive benchmarking and a fall-back operator in the event that a private sector operator becomes insolvent. The franchise contracts have been re-tendered in both cities, delivering further benefits through contestability.

Bus services are also provided by private sector operators in Darwin, Melbourne, Sydney and Brisbane.

Some contracts have been contested in Sydney, whereas the others are yet to be the subject of an open tender process.

Government continues to provide bus services in Sydney and Brisbane (particularly in inner-city areas), and throughout Canberra and Hobart.

Sydney Ferries have been operated by the private sector under a contested franchise contract since July 2012.

Passenger rail services have been provided in Victoria by the private sector under franchise contracts since 1999. These franchise contracts were originally contested, then reviewed and re-negotiated (without a re-tender) between 2002-2004, and then competitively retendered between 2007 and 2009.

The benefits of franchising public transport services

According to the TTF report, the Perth bus franchising program has delivered substantial cost savings while also delivering service improvements. The level of government subsidy per service kilometre has been reduced by about 30% which equates to about $30m per annum or 20% of the historical cost of bus services. Over that same period, services have been better aligned with the needs of customers, such that the private sector has reversed the long-term downward patronage trend which was evident prior to franchising.

Likewise, for Sydney Ferries the NSW Auditor General has found that annual contract payments to the private sector operators are around 12% less than those previously made to the government operator, while the private operator's performance against key performance indicators has been generally good and comparable to that of the government operator immediately prior to franchising. Considerable risk has also been transferred from government to the private sector under the franchise contract.

Similar outcomes (ie. a lower cost to government and/or improved or equivalent services for customers) have been replicated by bus and rail franchising overseas. In the UK there has been a massive programme of investment in rail since franchising was introduced in 1995. New trains and large upgrades to the network have contributed to significant increases to the volume and quality of services, resulting in higher customer satisfaction levels. Further many franchisees have gone from requiring government subsidy immediately post-privatisation, to now paying a considerable premium back to government coffers.

Victoria has also experienced significant growth in the number of passenger rail services offered since the introduction of franchising. And while on-time running fell for a period from 2005, this was largely due to unprecedented patronage growth between 2005-2009, coupled with system capacity constraints, both of which were factors beyond the control of the private sector operators.

Many lessons have been learned from the UK and Victorian rail franchising experiences. The best practices which have emerged from these experiences are likely to result in improved cost, service and customer satisfaction outcomes moving forward.

Importance of contestability

The evidence, and common sense, suggests that to achieve and sustain long-term cost savings and service improvements it is important that franchise contracts are contested (ie. subjected to an open tender process) at regular intervals.

In Victoria the Auditor General reported $33 million in cost savings in FY13/14 from a re-tender of 30% of Melbourne's bus network. This represented an 18% reduction of the amount PTV estimated it would have spent if the contracts had remained in place uncontested. Similarly at the conclusion of the Sydney bus tenders the Minister for Transport announced $350 million in savings over eight years. In both cases, these savings were achieved from the re-tendering of bus contracts already operated by the private sector.

The interval between tenders needs to be long enough to enable the operator to implement its improvements to the business and generate a return on these investments. However, it also needs to be sufficiently frequent to ensure that the contract continues to provide best value for money, and to refocus the operator on delivering the services that customers actually want (which may be quite different from what they wanted in the past). Contract terms of between 6-8 years are emerging as best practice.

Governments are also finding that having an option for government to extend the contract at government's discretion having regard to, amongst other things, the operator's performance, is a useful contract management and reform tool.

Preparing the market by providing adequate notice of upcoming tenders, and good information about the contract being tendered and the condition of the relevant assets and the employment conditions of any staff that tenderers will need to make employment offers to, will also assist in generating healthy competition between potential operators when contracts are tendered.

Best practice tender processes also provide for the selection of the tenderer providing the best "value for money", as opposed to simply the lowest cost, and for the opportunity to negotiate improved offers during the evaluation process. Unrealistic or predatory bids that will ultimately lead to financial difficulties for the operator (and problems for customers and government) need to be dealt with appropriately.

Access to assets, employees and information

The bus franchising experience is reinforcing the importance of retaining control of the assets used to provide the services. Depot access has proven to be a critical factor in achieving true contestability. If the incumbent private sector operator has ownership or control of the bus depots, it is difficult to attract new operators to bid against the incumbent.

An obvious solution to this problem is to ensure that ownership of the relevant assets remains with government during the contract term, or is transferred to government at the end of the term. Another solution is for such assets to be owned by a third party, who then leases the assets to whichever operator holds the franchise contract from time to time. This solution can keep the assets off the balance sheets of government and the operator. It can also enable government to access low cost finance for asset replacements, as occurred for the Department of Defence's Fleet Marine Services Contract.

Case Study: Fleet Marine Services Contract

Under this Department of Defence contract, the vessels used by the private sector contractor to provide the required services to the Royal Australian Navy (such as tug boats for moving war ships) are owned by a private sector lessor who leases them to the contractor. The leases are operating leases (as opposed to finance leases) and have a term based on the economic life of the relevant vessel, which may be more than the 10-year term of the Fleet Marine Services Contract. If at the end of the term of the Fleet Marine Services Contract the leases are not novated to a new incoming contractor, the Department of Defence must assume the obligations under the leases (or pay the leases out).

The franchise contract should also facilitate future contestability by providing government with access to information that can be provided to future tenderers, and facilitating the transfer of key employees to the new operator.

Good contract design

Good contract design, including a performance based payment regime and appropriate risk allocation, is essential for optimal outcomes. Attempting to transfer too much risk to the operator can be counter-productive, as demonstrated by the initial Victorian rail franchise contracts (where one of the franchisees, National Express, effectively became insolvent).

Operating and maintenance costs, including labour costs, are generally best managed by the operator. There can be some exceptions, such as fuel costs in the case of bus contracts.

The allocation of revenue risk is more problematic. The allocation of this risk to operators on the initial Victorian and UK rail franchises has been beset with difficulties.

During the first series of UK rail franchises all revenue risk was passed to operators, including external risks from the wider economy. This lead to a number of early operators running into financial difficulties in the early 2000s. The next round of franchises in 2003 introduced the "cap and collar" mechanism which required the government to provide revenue support if revenue fell below pre-agreed levels and allowed it to share in any outperformance in revenue above pre-agreed levels. This created significant problems for government in forecasting public expenditure. It also resulted in bidders gaming the tender process by bidding aggressive revenue forecasts, and reduced incentives for operators to stimulate revenue once in revenue support.

It seems that a more nuanced approach is necessary.

In Australia, governments now generally prefer to control fare levels and service frequencies, so fare box revenue risk is generally best managed by government.

Patronage levels are influenced by many factors outside the control of the operator including fare levels, service frequency, road congestion, petrol prices and employment growth. Accordingly, patronage risk is generally best allocated to government.

However, contracts with no patronage incentive run the risk of the operator not caring about the passenger. For instance, if there is only an on time running KPI with no patronage incentive, the operator could slow the bus network down to such a speed that the service becomes irrelevant to the commuter but achieves near 100% on time performance. Obviously, this is not the desired outcome.

This highlights the importance of appropriate incentives on the operator to care about the customer or, at the very least, to care about the things that are important to the customer.

There are a number of factors within the operator's control that can materially influence the experience of customers and, hence, patronage, such as journey time, on-time running, vehicle cleanliness and passenger information. Although allocating some patronage risk to the operator will encourage good operator performance in these areas, and encourage the operator to minimise fare evasion, it also exposes the operator to the risk of other factors affecting patronage that are outside the operator's control. On balance, a simpler and better approach may be to financially motivate the operator to perform well in these areas via the performance-based payment regime.

Best practice performance-based payment regimes for public transport franchises generally provide for deductions to the operator's service payment for:

  • failure to provide timetabled services;
  • failure to achieve required journey times;
  • poor punctuality or on-time running, generally measured at stations and wharves (in the case of trains and ferries) and at several points along a bus route;
  • failure to keep the buses/trains/ferries sufficiently clean and free of graffiti;
  • interior temperature or lighting not within agreed ranges;
  • poor customer information during service disruptions;
  • unacceptable customer satisfaction levels, typically measured via customer surveys, and poor complaints management; and
  • excessive fare evasion.

The TTF report suggests that abatements should be significant enough to be material, but not so large as to cause financial distress. TTF suggests that a maximum abatement level of 10-20% of the operator's profit margin is generally sufficient. This seems low to us, and we doubt most operators would expect to still earn 80-90% of their expected profit if their performance is very poor.

Opportunities for future improvement

There are many opportunities to further improve how we provide public transport services in Australia through contestable franchising. Many public transport services are still provided by government, such as:

  • the inner-city buses in Sydney and Brisbane, and bus services in Canberra and Hobart; and
  • rail passenger services in the Sydney metropolitan area and the regional NSW network.

Further, many private sector bus contracts in Sydney and Melbourne have never been contested.

Introducing contestability to these contracts will almost certainly reduce the cost to government and result in improved service outcomes for customers.

Contestability also provides government the opportunity to reassess its assumptions and invites an opportunity for revised service delivery models that consider evolving demand pressures which may require new or different services.

Contracting and tendering models have matured to a point that best practices have emerged. The most recent experience with Sydney Ferries has also shown that the unions and the public will embrace these reforms, if properly implemented.

It's time to seize these opportunities.

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.

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