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Goodbye to the cap-and-collar

March 2011

Robert Wright

Behind the headlines of longer, less prescriptive franchises, the government’s plans for changes to franchising don’t seem to encourage innovation any more than the existing system. Robert Wright does some probing

There are, surely, few political games easier and more rewarding to play on the railways than redesigning how passenger franchises work. A transport secretary announcing a new, reformed system can easily give the impression that he or she is addressing all the moans dearest to commuters’ hearts, confident in the knowledge that almost no one will understand the proposals’ implications. Even if the policy is an abject failure, meanwhile, the consequences will take years to emerge.

Given the UK’s turnover of transport secretaries, it is almost inconceivable that the incumbent who proposed the system will be the one who clears out the wreckage when it all collapses. It is, nevertheless, important to address the new franchising policy that the Department for Transport published in January with an open mind.

It certainly professes to have laudable aims. It seeks to revive the incentives for train operators to take smart, commercial decisions to maximise revenue and minimise cost. Since nearly everyone – except for Lord Adonis – agrees that the present system’s mix of private sector operation with limited decision-making freedom is flawed, the direction of travel at least should be the right one. The question is whether the new approach will increase franchisees’ freedom – and, if it does, at what cost to other important principles of the privatised railway?

On the straightforward freedom front, there is one worrying point. The government is scrapping the ‘cap-and-collar’ system under which franchisees whose revenue undershoots get more subsidy or pay less premium, while those who surprise on the upside get less subsidy or pay more premium. The system, so the government says, has reduced train operators’ incentive to maximise revenue. But the government is retaining the right to cream off any higher-thanexpected profits.

This lop-sided arrangement must, surely, stifle train operators’ incentives to maximise revenue just as surely as the present system does. The unbalanced risks facing government partly justify the arrangement. A train operator facing really unpalatable losses on a franchise has the ultimate option of handing back the keys to the operation, albeit at the loss of the various financial guarantees lodged with the Department for Transport.

However, a system truly aimed at encouraging entrepreneurial verve would surely dispense with such a blunt, initiative-sapping instrument. Perhaps train operators could be required, when profits exceed expectations, to increase the size of their guarantees to the DfT. That would increase the disincentives for operators to cream off profits in good times then walk away when the profits dry up.

Other parts of the document, meanwhile, make one wonder precisely how much will change. The government appears to have recognised that train operators may not be queuing up to take on the uncertain risks of rail revenue over the next 15 years. It has undertaken that there may be some ‘risk sharing’ on certain contracts – presumably, mainly commuter ones. These risksharing arrangements will be more flexible than the cap-and-collar arrangements but will be tied to economic growth, central London employment and various other key indicators. But there appears to be ample scope for them to curb innovation and risk-taking just as effectively as cap-and-collar.

On top of that, there are the ‘mumbled-answer’ elements of the policy. These are innovations that many people want, but which no one can coherently defend. The most obvious is the idea that train operators, rather than Network Rail, the network owner, should fund some investment in the rail network. It remains obvious that, since more than one train operator uses nearly every part of the rail network, such arrangements could produce major conflicts of interest. It remains unclear how conflicts between two users of the network will be resolved in these circumstances. The second objection is that train operators’ investment horizons are inappropriate to long-life investments in the network. Network Rail is far better placed to judge how best to make investments in the network over the long term.

Pressed about these objections, the new approach’s advocates tend to wave their hands dismissively and insist they are not serious problems. They then enter the ‘mumbled-answer’ phase, muttering about how they are sure rules will be devised to resolve conflicts of interest, and that there must be mechanisms to ensure Network Rail is satisfied with how investments are being used. Since past rail franchising policies have all produced unintended consequences, it remains legitimate to ponder such unresolved contradictions and wonder if they will ultimately seriously undermine the present policy.

Taking a step back from the detail, however, the wider impression of this policy is that, like all past franchising policies, this one has been devised to address immediate concerns. The existing policy was designed to increase government control over the sector, reduce its potential to cause political embarrassment, and avoid future franchise renegotiations of the kind that had to take place after the Hatfield crash aftermath sent operators’ revenues plummeting. The policy before that, in privatisation’s early days, was supposed to encourage entrepreneurial thinking. The new policy ultimately looks designed primarily to cut the railways’ costs to government, by forcing train operators to promise to pay for improvements currently met by the Department for Transport and by letting train operators cut back on services in a way the government would never dare try.

The risks for the new policy remain that train operators will be unwilling to bid the startling sums to secure franchises that some operators have in the past. Operators may not prove the ready source of funding for infrastructure and rolling stock that ministers fondly imagine. The ‘mumbled-answer’ points will also almost certainly produce greater problems than the government anticipates.

It would be nice, some day, to have a calm, government-led thinkthrough of franchising policy, inspired by nothing more than a desire to devise the best balance of risks and rewards. The likelihood is that franchising policy will continue to be re-examined amid crises, and the results skewed by the need to tackle a single, perceived problem. The outcomes, like this one, will also be flawed but robust enough to see out a parliament before another unfortunate minister needs to rethink them.

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