UK: VVO Model - The End of Rail Franchising as we know it?

The UK rail network is an expensive asset, passengers are faced with high fare increases yet the network remains heavily dependent on its public subsidy. Is the current separation of train and track therefore achieving the necessary cost efficiencies? Are the Government's proposals on reforming rail franchising sufficient or should a programme of wider reform be considered which better reflect the different businesses that make up the industry? These are issues which have been acknowledged by the Government in its response to the interim findings of Sir Roy McNulty's Rail Value for Money report, with a high-level government and industry group being established and chaired by Philip Hammond to "drive reform". This group is due to publish its proposals by November 2011.

What form will these proposals take? We believe that the industry is ready for a new model made up of vertically integrated, virtually integrated and open access operators. A "VVO" model would deliver the cost efficiencies which are necessary and be more responsive to the needs of the passenger.

The current state of play

At privatisation almost all of the vertically integrated system previously operated by the British Railways Board, a state owned statutory corporation, was transferred to the private sector. In the process the UK railway industry was split into almost 100 companies. The result, despite infrastructure maintenance being brought back in-house by Network Rail and consolidation of some of the smaller franchises, is a structural framework fundamentally unchanged since privatisation.

Infrastructure is separated from train operations with centralised infrastructure ownership and management vested in Network Rail, passenger operators are regulated on a contractual basis via franchise agreements let mainly by the Department for Transport and the Office of Rail Regulation exercises economic and safety regulatory functions vested in it by statute. Underpinning all of this is a legislative framework including the Railways Act 1993, the Railways Act 2005 and numerous other enactments and regulations including those implementing European directives.

Within this structural framework performance has improved with increases in passenger journeys and freight moved. Capacity has increased with the introduction of new rolling stock and infrastructure enhancements while safety, train reliability and customer satisfaction have all improved, despite overcrowding remaining an issue on the busiest parts of the network. Nevertheless improvement has come at a price with a significant increase in expenditure. Train operating costs, rolling stock charges, renewals expenditure and infrastructure enhancement have all, in real terms, increased rather than decreased since privatisation, with a significant proportion of this expenditure coming from the public purse.

Cost constraint and reform

The Government signalled a continuing development of rail in the Comprehensive Spending Review, confirmed by recent announcements relating to Thameslink, rail electrification, commuter carriages and new intercity rolling stock. However these projects are to be funded from a transport budget cut by 21%. It is estimated that the public subsidy for rail currently stands in excess of £5 billion, a level which Sir Roy McNulty's Rail Value for Money scoping report describes as "unsustainable". At the same time the cost to passengers is increasing. Significant cost reductions are sought and Sir Roy McNulty's interim findings suggest that running costs could be cut by up to £1bn per year.

The Government's consultation paper "Reforming Rail Franchising" considered at length the various franchise models that have been developed by the DfT and its predecessors as well as by other devolved franchisors such as Transport for London, Merseyrail Passenger Transport Executive, Transport Scotland and the Welsh Assembly Government. The benefits and disadvantages of these various models are well rehearsed and are not reproduced here save to say that they are generally prescriptive in approach.

The Government's desire to move from a prescriptive and input based approach to a model that encourages significant private sector investment in passenger operations and related infrastructure by granting longer more flexible, output based franchises has now been confirmed, a move which will be generally welcomed by the industry. The details of the new franchise model, with franchises running for typically 15 years if performance criteria are met, are now to be developed in conjunction with the proposals for wider reform. If the new franchise model is combined with bid evaluation criteria which place less emphasis on price and more on quality, then investment via private sector debt or equity is likely to increase.

Is this the only model though? Various models are being proposed in the industry press and the Government, Sir Roy McNulty and the wider industry are in agreement that one size does not fit all. London commuter services, intercity services and regional services are all different. Add the fact that huge differentials exist between load factors in the peak and off peak within and across these services and you begin to appreciate that an extremely wide range of differing economic and public service factors influence a train operating company's viability as a sustainable business.

Any proposal for structural reform will need to consider whether the structural framework outlined above will remain with train separated from track on a commercial and legal basis. While this approach may be appropriate in certain circumstances, for example, the CrossCountry franchise, it may not be appropriate in others. The remainder of this article therefore considers some of the alternatives to the existing framework, possible obstacles and the changes that would be required to the underlying legislation.

Alternative structures

One starting point is to ask whether a wholesale return to vertical integration would be sensible, possible or desirable. An immediate effect would be to remove many of the interfaces and dependencies that exist in the current structure which drive up cost. It would also assist in removing some of the behavioural barriers to greater cooperation which many in the industry feel are perpetuated by the existing structure. However as a network wide solution it is not credible, not least because the private sector would be wary of assuming the risks associated with owning and maintaining a track network that has not recently been constructed, is shared with other operators and as shown by the recent cold weather is arguably subject to inherent design defects.

Instead we believe, in a post McNulty environment that the solution lies in identifying which component of a VVO model is best suited to a particular business. Any structural changes should also be combined with a review of the public service requirement and fare policy to enable load factors to be spread across the peak and off peak and to facilitate the provision of a more innovative and flexible service by the train operators. In particular, where capacity permits, should the train operator be given the right to run fewer trains during the off peak in exchange for enhanced peak services to alleviate overcrowding?

Vertical integration

Decision making by those closest to the passenger, namely the train operator, is often cited as a reason for vertical integration of train and track. Nevertheless many existing franchises are a combination of different businesses running on parts of the network which may be accessed by a variety of other franchised, freight and open access operators. All factors which complicate the vertical integration model. There are a limited number of businesses where a long term concession to run a vertically integrated railway is likely to be appropriate.

An obvious example is Chiltern and here it is easy to imagine a model where the infrastructure transfers from Network Rail and is vested in the operator. More controversial would be to adopt this model on the East and West Coast Main Lines. Freight operators and open access operators in particular would be vehemently opposed unless national controls were retained via the ORR or otherwise over capacity and access charging, to name but two concerns. Nevertheless the recent sale of HS1 Limited, which holds a long term concession to manage track and stations, to a consortium comprising Borealis Infrastructure and Ontario Teachers Pension Plan creates an obvious precedent.

Virtual integration

At a recent industry conference Network Rail talked at length about "enabling devolution". At the heart of this suggestion are many of the factors put forward in favour of vertical integration as well as devolving responsibility from the centre to its regional operations and the train operator while retaining ownership of key infrastructure and responsibility for those matters to be undertaken at a national level. The Government also acknowledges the need for a move from centralised infrastructure management and has suggested that reforms could lead to route or area based alliances between track and train operations. Businesses which may be suitable for this approach include the London commuter services, Greater Anglia (including Essex Thameside) and Great Western.

This partnering approach has been taken one step further by another industry commentator who proposes a form of vertical integration through formal joint ventures or Railcos comprising a joint venture between a franchise operator holding a long term franchise and the relevant regional subsidiary of Network Rail. There are legal disadvantages in this approach though, which replicates a PPP/PFI model, as inevitably it would result in a further complication of the contractual matrix.

Open Access

For certain services we believe it is inevitable that open access will increase and become more relevant where there is sufficient capacity on the track, although at least for the time being it seems as if open access will continue to co-exist with franchised operators. These services are likely to be longer distance and point to point. Two examples are West and East Coast Main Line and here it is clear that there are viable businesses which customers want to use. If the market is sufficiently robust it will reduce the risk of dominant operator failure, improve competition, facilitate a more responsive approach to the needs of passengers and enable fare price flexibility. Last but not least market pressures and the absence of a public sector subsidy incentivise an open access operator to invest.

The open access component of the VVO model would see key infrastructure including the track retained by Network Rail as part of its "central" function. Operations would be bundled into service paths, analogous to the situation which will soon be seen on HS1 when Eurostar will operate in competition with Deutsche Bahn operated ICEs.

Legislative change

A concern with any changes to the current structure of rail franchising is that instead of simplifying the existing matrix of contractual arrangements which have been described as resembling a bowl of spaghetti, the complexities inherent in the current system are increased leading in turn to greater inefficiency. In addition a wholesale revision would require detailed legislative changes which would delay the ability of the industry to improve its service offering and reduce the cost to government.

By aligning the contractual relationships more closely with the way the businesses operate, the VVO model should produce opportunities to reduce the leakage arising from the current contractual arrangements without requiring years to implement. Indeed there are already good examples of how these changes could work. Heathrow Express is an example of an open access operation which has been functioning well for many years and in Chiltern with their progressive investment programme we can see a shift towards vertical integration. Virtual Integration with the transfer of the non-track assets to the lead operator by way of outright transfer or the grant of long leases should encourage greater investment in those assets by the operator without compromising the ability of other operators to access them.

Conclusion

Political imperatives aside, it is clear, as it was before privatisation, that both passengers and operators want the Rail Industry to change. Neither passengers nor taxpayers are getting best value for money and the industry itself is not making the best use of the passion and drive of those operating it. A complete overhaul runs the risk of taking too long, costing too much and failing to deliver. With the benefit of the experience of nearly 15 years of rail franchising we believe that the VVO model will deliver a more cost effective passenger focussed Rail Industry fit for the 21st Century

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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