The rail industry breathed a collective sigh of relief when it was announced that Cap and Collar would end with the current franchise cycle, but in a masterstroke that threatens to grab defeat from the jaws of victory, the replacement scheme based around GDP risk sharing has seemingly inherited many of the major weaknesses of its forebear. Worse still, it is missing a real opportunity to use the franchising model to provide a desperately needed boost to the UK’s rail infrastructure.

Under Cap and Collar, rail franchises incorporated mechanisms for revenue support (government top-ups if revenue falls short) and revenue gain-share (the reverse should revenues exceed forecasts). The standard tolerance was a tiny 2 per cent – meaning most franchises soon fell into one or the other mechanism, albeit revenue support was only offered from year four of a franchise agreement.

Looking at the last set of reported numbers makes for staggering reading – First Great Western receiving an extra £209.4 million, South West Trains £69 million and Virgin West Coast £44 million – all in a single year from government. These numbers are even more surprising when you consider that these are the three biggest franchises in terms of revenue, representing three of the primary routes into London.

So, what happened? The DfT accepted some very over optimistic revenue forecasts from operators, who had worked out how to game the bidding system to gain maximum marks at lowest commercial risk – in this instance the risk of being ‘collared’ by the Cap and Collar system. It’s the age old problem of setting out overly prescriptive rules in a tendering process only to have them used by the bidder’s commercial and legal teams to their advantage. These forecasts made it into the resulting franchise agreements and the net effect is today’s staggering revenue support numbers.

These issues have not escaped the attention of our most recent high profile rail reviews:

‘A common criticism of franchising has been that bidders have too often constructed over-optimistic revenue forecasts in order to win franchise competitions. This was certainly the case with some franchises let under ‘Cap and Collar’ because bidders knew they would enjoy a measure of protection from approximately year four of the franchise, and therefore had much less to lose by bidding aggressively in later years. Over-optimistic forecasting was also a concern with the two East Coast franchises which ended in default and, in some quarters, with the recent ICWC competition.’
The Brown Review of the Rail Franchising Programme – Dec 2012

‘A more generalised problem with unrealistic bidding is that it can lead to unexpected shortfalls in revenue for the taxpayer and corresponding pressure on the budgets available to support the railways.’
Reforming Rail Franchising, DfT – July 2012

Limited incentive to delight passengers

In a salutary lesson about the danger of unforeseen consequences, an additional challenge was that once at the maximum level of revenue support, the operator received a generous 80 per cent of the revenue against its forecast from government. Meaning for every £10,000 of additional revenue it generates, the extra value received is only £2,000 – which is often greater than the cost of generating the revenue in the first place. For passengers, this means one thing – operators have very limited incentive to delight them, particularly given the fact that if many more passengers travel, the operator enters revenue gain-share and loses a proportion of the gain their investment created.

By ditching Cap and Collar the government showed at least it is not willing to bankroll a system that just isn’t working. In the new system a weighting factor will be decided by government at the time of tender together with predictions of annual GDP rise or fall through the franchise lifetime. This weighting factor will be applied to the forecast and actual GDP deviation and a difference calculated. Any difference above and beyond 5 per cent in either direction (as opposed to 2 per cent last time) will be applied to the revenue generated to yield a revenue support or gain share value for the operator (the actual money to change hands likely to be 80 per cent of the answer to this calculation).

This mechanism will effectively tie the operator to rises and falls in overall UK GDP disregarding any local variances, or the impact of rail specific (but non-GDP affecting) incidents such as poor weather or rail infrastructure failure. The 5 per cent ‘dead zone’ means that on a £1 billion/year franchise (using a generous weighting factor of 1.25) roughly the first £50 million of GDP related loss would not be covered by this mechanism – bigger than the EBIT of any franchise last year (with those numbers even including generous revenue support).

No doubt this new set of risks will need to be factored into franchise bids, resulting in inflated bid prices to counter risks over which operators have no control.

To compound the issue, the DfT has also left the door open to recoup ‘excessive’ profits from operators. While this step is undoubtedly populist and may indeed de-risk the government’s financial position, two things are immediately apparent.

Firstly, this now sounds a little one-sided and reinforces the perceived divide between the public sector DfT and private sector operators regarding commercial matters, without actually removing any real cost from the equation (it will simply become bid risk premium).

Secondly, it doesn’t remove the choke on innovation – why will operators be incentivised to make investments to delight customers and increase modal shift to rail if the net answer is that they may lose (if the innovation fails) or not win (if they must return excessive profits)?

‘Excessive’ profits used for rail projects

Given that Network Rail recently announced a significant additional spend of £37.5 billion to develop UK rail infrastructure over the next five years and this money needs to come from somewhere, let’s be ambitious and suggest a different way.

Let’s mandate that if the franchisee makes ‘excessive’ profits, these are added to the financial guarantee made to the DfT – making it even harder for a successful operator to walk away. This money could then be used by government to help kick-start some much needed second tier rail infrastructure projects and then returned to bidders upon successful completion of the franchise, as recognition of consistent good performance over the lifetime of the deal.

It is likely that a number of the new fifteen year franchises will be generating revenues of £1 billion – £2 billion a year – meaning even a small percentage increase in revenue for each of the fifteen operators will generate a significant pot of much needed investment infrastructure cash.

Just looking at the ten largest operators, let’s assume that mid-way through the new franchises there will be five operators forecasting revenues of £1.5 billion and five of £750 million/year. If these operators each managed a 10 per cent uplift in revenues from forecast, the additional financial pot created would equate to over £1 billion/year.

Given the Department’s ticket price increase constraints, this revenue would have to come from additional passengers who have chosen to use the railway – an indicator that they have actually been impressed by it.

This arrangement will reduce the burden on UK Plc (requiring less immediate funding from government to pay for rail infrastructure projects) and ensure that operator incentives are more closely aligned to passenger needs.

For what would be a relatively simple scheme to set up and administer this change could yield significant value for UK Plc and finally see rail private and public sector interests gaining alignment. It may not provide all the funding we need, but why wouldn’t we take this opportunity?

Now that sounds like a win–win instead of the current system’s lose–lose.

Amish Patel is a member of the Transportation Team at management consultancy Boxwood