THE LONG READ
In June 2018 Virgin Trains East Coast (VTEC), 90% owned by Stagecoach, failed to run to the end of its franchise term, like GNER in December 2007 and National Express East Coast in December 2009 – a pretty damning indictment of privatisation some would say, and a gift for those promoting renationalisation as an ideological goal.
As a politically-impartial organisation, Railfuture does not promote one form of ownership over another, but it does want stability in the railway. Fortunately, the transition from VTEC to its outsourced and ostensibly semi-nationalised successor, London North Eastern Railway (LNER), which is a consortium of Arup Group, Ernst & Young and SNC-Lavalin Rail & Transit, has seen no direct negative impact. Indeed it has been very smooth with managing director David Horne remaining in his role along with the rest of the operational management. All passengers will really notice is a different name – the same situation if it were real renationalisation. However, this seamless transfer wasn’t necessary apparent when the change was announced. Unplanned change causes concern both for passengers and staff, and the “failure” of VTEC has undoubtedly tarnished the railway’s image.
Railfuture director Jerry Alderson, who is a business consultant and once co-led a business venture attempting to acquire a rail line to run a commuter service, gives his own views on the reasons why the East Coast Mainline has had a troubled history. At the end he suggests a possible revised model to reduce the chance of a future operator throwing in the towel on this or other rail routes.
So you want to run a train company?
In purely business terms there are three types of passenger transport services: a) Continuous Volume, b) Tidal High-Volume and c) Feeders and Connections. These categories pretty much exist in most industries, albeit with slightly different terminology and characteristics.
In the railway these are inter-city, commuter and the rural/interurban services respectively. Each are vital to the railway, which is why the Beeching dream of a “profitable core” will never be realised.
Which to choose?
A commuter service, such as Govia Thameslink Railway, Britain’s largest by far, crams passengers in at peak times and in one direction, with seat occupancy greatest at the city end and lowest at the country end. Whether operators make a profit depends on how high the volume is, how tidal it is, and how patronage varies at each end of the route, along with the number of station calls (no revenue is earned when a train is stationary). Despite passengers using commuter trains as a distress purchase - what other way is there of getting vast numbers of people into and out of large cities at the same time where car parking space is limited, and roads could never cope with traffic levels? – a commuter franchise may have 70% of the carriages in the sidings for much of the day and the whole weekend. At up to £2 million a carriage that is poor utilisation of an asset, and the same goes for track infrastructure and stations. The business is vulnerable to lifestyle changes, particularly the rise of working from home, but has benefited from the longer commutes as rising house prices close to cities means people live further away from work and seats are occupied for a longer time. Fares may be high – they certainly seem high if paying a lump sum once a year - and commuters are a difficult bunch to please. It is not a prestige or premium business. Thanks are few and far between.
The rural/interurban operators attract fewer passengers, usually because road congestion is somewhat lower with more ability to park cars in towns and cities. With fewer passengers the investment in these routes has traditionally been lower, and there may be frequent station calls, so the train journeys are slower. Rail is less competitive with the car, but it is still a lifeline for many and is the entry point for access to the network, with operators benefiting from commission on tickets for the full journey. Unlike key commuter routes, the proportion of passenger with access to a car is lower and as a result fares may be lower. The good news economically for the railway is that although such lines are unprofitable their costs are low and asset utilisation is higher – in many cases the same number of carriages operate all day long. Surveys often find passenger satisfaction is higher than commuter routes because the service is valued.
Intercity is a different matter. Far fewer services but using the full fleet all day long and carrying a more even number of passengers on each, and in both directions, with most passengers being only occasional travellers and more likely to enjoy the experience as the operator’s focus is – or should be – on comfort. With many people planning their journeys weeks in advance, finely-tuned yield management fill seats at fares that attract a wide range of people from business travellers on expense accounts to families, pensioners and students making leisure journeys. Such services also attract tourists, especially those from abroad. Someone crossing the Atlantic to visit London would be likely to include a trip to Edinburgh, most likely by rail. A properly run intercity service should never fail to be profitable and the positive experience should generate repeat business and word of mouth attracting others.
With inter-city, as they say, what’s not to like?
Of the main intercity operators in Britain (West Coast, East Coast, Great Western, Midland Mainline and Cross Country) the East and West Coast routes are the most prestigious. They are a prize in any portfolio and raise the profile of the owning group and ultimately its share price.
Owning groups will compete more fiercely for franchises that build value in their company more than simply generate revenue. Of the 19 or so franchised operators there are only a handful of prestigious ones to choose from. This is why three different companies have thrown caution to the wind in order to secure the East Coast inter-city services and have reaped the consequences. In 2012 First Group were saved from a similar folly on the West Coast mainline by the Department for Transport’s failure to run a fair contest.
What went wrong on the East Coast and why?
Actually, the cause of all three “failures” (GNER, National Express East Coast and Virgin Trains East Coast) was an arguably greedy and certainly intransigent landlord, better known as the Department for Transport, and their bosses at the Treasury. It was the relationship between the operator and government that failed, not the day-to-day business. All operators were profitable but couldn’t pay the exorbitant rent.
Let’s look at the post-BR operators…
Operator 1 - Great North Eastern Railway (GNER) owned by Sea Containers
GNER was one of the stars of Privatisation Mark I. Led by the experienced and highly-competent Chris Garnett, it rebranded British Rail’s inter-city east coast operation, creating a quality image and increased the number of services by almost 50% without acquiring any new trains. Essentially it made efficient use of the ex-BR trains (and temporarily deployed some unused Eurostar trains). The train interiors were completely modernised and the engines within its locomotives were replaced to improve reliability.
Unlike, say, National Express, which at the time had nine franchises under its ownership, GNER was the only franchise held by Sea Containers, initially for seven years and subsequently extended by two years.
It was a franchise that Sea Containers had to retain and it bid high – too high – to do so, believing that the business would continue to grow continuously.
In March 2005 the then Strategic Rail Authority awarded GNER a seven-year the franchise (with the ability to require GNER to continue for three further years if targets were met) starting on 1 May. Just two months later, on 7 July 2005, a terrorist attack killed 52 people and injured hundreds more. The Underground was attacked but not the railway. However, it made people nervous, it reduced tourism to Britain and it led people to reconsider whether they should travel to London or other large cities. Discretionary long-distance leisure travel was impacted. GNER’s bid need strong growth, not a reduction in passengers.
In 2006 new open-access operator Grand central was awarded the right by the then Office of Rail Regulation (ORR) to run new services between London and Sunderland. This was not a GNER end-to-end route, but the new operator would compete on the lucrative London-York market. In July 2006 the High Court rejected GNER's judicial review over the ORR’s decision. Many saw this as GNER making a mountain out of a mole hill. The London-York flow was highly profitable but Grand Central was tiny. It would only operate a few trains a day using short trains. Fares would be lower but it would not offer the image and first-class dining experience that GNER offered. Many of the passengers would be new customers to the railway so the impact should have been quite small, and certainly not a business destroyer. Any over-allocation of inter-available ticket revenue to Grand Central could soon be rectified by passenger counts.
Other impacts on GNER’s expected growth were low-cost airlines and Virgin Trains on the west coast mainline having completed the launch of its Pendolino services, which improved reduced its journey times to be competitive with GNER.
With passenger growth stalling GNER increased both unregulated fares and car parking charges to generate extra income, both at the risk of reducing patronage. Its ambitious plan to invest in an "Electric Horseshoe" around Leeds came to nothing.
In October 2006 Sea Containers filed for bankruptcy protection under the US Chapter 11 process and was therefore unable to pay the substantial bonds that GNER that was required to lodge with the government, thereby failing to meet the terms of its contract. If GNER was considered to be a viable business to the end of its contracted term then it could have borrowed the money. However, financial commentators regarded GNER’s eye-watering premium repayments (“rent”) to the government, the largest at the time, particularly towards the end of its franchise, as crippling and undeliverable.
The Department for Transport would not allow GNER to continue (it was given an interim management contract to keep it afloat) and in August 2007 it awarded the franchise to National Express, which took over in December 2007 (ironically the same month that Grand Central commence running services).
Operator 2 – National Express East Coast (NXEC)
National Express East Coast’s Chief Executive was the accountant Richard Bowker, former Chairman and Chief Executive of the Strategic Rail Authority, who had overseen the award of several franchises, although he left in 2004 before GNER’s bid was accepted.
National Express East Coast, which should have operated until 31 March 2015, roughly the same date as GNER franchise, bid a £1.414 billion premium in “present value” (PV) - even more money than GNER’s £1.3 billion - but over a shorter period of time (seven years, four months, i.e. 32 months less). If GNER’s bid was considered crippling, what was this? Suicidal?
While GNER suffered from the terrorist attack on London. NXEC was hit by a worldwide recession on a scale not seen since the 1930s.
In the first half of 2009 NXEC ticket sales income decreased by 1% over the same period a year earlier, partly as a result of business travellers downgrading from first class to standard class and others choosing discounted advance fares rather than full-price walk-on fares. NXEC reacted by introducing a £2.50 charge per leg for seat reservations (an alien concept in Britain although fees apply in many European mainland countries) and withdrawing its “at-seat service to standard class customers enabling them to order hot food which will be delivered to seat” along with “a full restaurant service on 87 train services Monday to Friday with an improved range of full meals.” Both were counter-productive measures that risked a vicious circle of declining patronage.
NXEC also suffered because Network Rail performed better than expected and did not pay it as much compensation. The fact that an operator builds into its bid the profit from Network Rail compensation rather than passing it onto the passengers (either for the inconvenience or by reducing fares and marketing to attract customers) shows a disconnect in the structure of the railway.
With NXEC haemorrhaging money and still a long way off the automatic Cap & Collar rescue mechanism kicking in, on 1 July 2009 it was announced that NXEC’s franchise would be terminated once its financial commitment, including the cost of refranchising, was exhausted. This occurred five months later. It was the first time that an operator that was in trouble had failed to reach an agreement with the government. A deal was not rejected on ideological grounds but a fear that in the then economic climate a renegotiation would lead to a domino effect among other operators.
Operator 3 – East Coast owned by Directly Operated Railways (DOR)
East Coast was a subsidiary of Directly Operated Railways, formed by the Department for Transport as an “operator of last resort”, on a ‘steady state’ minimum-investment basis because it was only envisaged as a short-term operator. It failed to introduce the direct London-Lincoln services that NXEC had promised. However, East Coast did abolish the reservation charges and reversed some catering cuts although it never reinstated restaurant cars.
In the five years and three months it operated (ending one month earlier than National Express should have), East Coast paid back “more than £1 billion” to the government, substantially less than the £1.228 billion National Express had contracted to pay in the same period.
The chart above shows the NXEC premium profile for each year and the approximate equivalent for each year East Coast operated (treating each month as an equal amount). In its last 11 months East Coast returned £215.7m to government, compared to the £285m calculated for NXEC for the same period.
We do not know what premium National Express would have paid the government had it successfully renegotiated the franchise as it hoped (the government, under Secretary of State of Transport, Lord Adonis, refused to do so), but the fact remains that the nationalised company paid at least 80% of what National Express was supposed to, which was reasonable given the country’s slow recovery from a deep recession, albeit one that remarkably only had a small impact on the railway. Had East Coast matched NXEC’s commitment, and even exceeded it, the benefits of franchising to the commercial sector would have been seriously called into question.
Before the 2010 General Election the then Labour government indicated its intention to let a new East Coast franchise to the private sector in late 2011. This didn’t happen, despite the arrival of a Conservative-led Coalition government also saying it would do so. In the end, East Coast’s business was privatised (unnecessarily) as a going concern just prior to the General Election in 2015, which the government expected to lose to Labour.
Operator 4 – Virgin Trains East Coast – majority owned by Stagecoach
Virgin Train East Coast (VTEC), which was 90% owed by Stagecoach but used the more-prestigious Virgin brand, took over the nationalised business on 1 March 2015 with an eight-year franchise to 2023. It bid £2.55 billion prevent value (£3.3 billion nominal) in franchise premiums to the government (plus £153 million of quality improvements on stations, trains and staff).
The winning bid exceeded those from losers First Group and Keolis/Eurostar by a very substantial margin. The Department for Transport later revealed that the two other bids were remarkably similar at £1.98 billion and £1.92 billion (but did not say which company bid what). If one takes the £1.4 billion bid by NXEC in 2007 and applies inflation plus already achieved growth then these two bids were realistic.
Stagecoach believed that the Virgin brand and its marketing was stronger than the competition and – in the style of Heineken - would attract passengers that the others cannot reach, along with a higher yield.
Advance fares can be so cheap that many travellers are willing to pay a bit extra to travel in first class, and inter-city trains on the East Coast mainline provide free meals and drinks.
VTEC introduced the ability to place bids for a first-class upgrade using the Seatfrog mobile app and this innovation has been retained by its success, LNER.
It also began with good news for passengers: a 10% cut in standard class walk-on fares – something it clawed back in successive years.
In three years VTEC delivered on its commitments and offered more besides:
- Ran all of the contracted train services
- No service cuts
- Reduced price of standard class walk-on fares by 10% (and lowered higher-priced advance fares accordingly)
- Introduced on-the-day advance fares
- No additional charges introduced for passengers
- Invested £75 million in improving services (including completely overhauling train interiors)
- Grew passenger numbers by 5%, achieving 21.8m journeys in 2017/18, 1.3m more than when it took over the route
- Achieved an average of 245 passengers per train kilometre operated – the highest of any operator in Britain (Eurostar may be higher but it is a reservation-only international operator)
- Introduced an innovative ‘seat auction’ first-class upgrade mobile app, for which it won an industry award
- Attained industry-leading customer satisfaction scores from the Transport Focus surveys
- Paid contracted premiums to the government – 30% more than East Coast in the same timescale
- Prepared the ground for the future introduction of the new Hitachi inter-city trains.
But it failed, big time, on one key objective:
It didn’t deliver a profit for its shareholders. In fact Stagecoach and Virgin collectively lost more than £200 million over three years, which exceeded the £165 million guarantee that the government required when they took on the franchise.
That money could never have been recovered over the remaining five years of the franchise. However, any hope of avoiding future losses vanished when it became clear that Network Rail (a subsidiary of the Department for Transport) would not deliver the vital infrastructure requirements for VTEC to operate more trains and more seats in each train (replicating the impact of Virgin’s 2008 West Coast High-Frequency timetable on the East Coast from 2019 onwards) in order to generate the large patronage increase it needed.
It continued incurring losses while it tried to reach a deal with the government, hoping for a management contract, which never materialised.
Unlike both GNER and NXEC before it, VTEC has not experienced dramatic shocks. Any financial repercussions from the Brexit referendum are probably quote minor – VTEC hasn’t been impacted by a fall in the value of Sterling, and although the UK has, it is claimed, experienced lower growth than in the rest of the EU, VTEC has not cited this as a reason. The fact is that growth on Britain’ railway has slowed down after an astonishing 20 years of rising passenger numbers – something that everyone knew was coming sooner or later.
Chris Grayling, Secretary of State for Transport, has said that Stagecoach/Virgin “got its numbers wrong”. Their bid required a 50% increase in passenger numbers with revenue growth of 10% each year. The rail industry is currently achieving 4% and that includes inflation-linked fare rises, which was what East Coast achieved in its final year, but VTEC had not even achieved that. One must ask why the government thought near- miracles were possible.
The root problem is that the franchised train operators have very small margins: they make around 3% profit. Given that the operators do not really invest then this is a reasonable return provided that the risk is low. However, when VTEC needed 10% growth each year in order to pay the government, it is clear that anything less than 7% growth would mean a loss that year.
Like Lord Adonis before him, Grayling had decided not to throw VTEC a lifeline and instead has contracted a consortium of companies under the name London North East Railway (LNER) as an operator of last resort, having lined them up in advance.
Retention by LNER of VTEC’s Managing Director (who had no involvement in the reckless bid) and all other management staff shows that the Department for Transport did not see the VTEC management as a problem. In contrast, the RMT union published claims from its members of dissatisfaction with VTEC management, accusing them of failing to manage staff properly and cutting costs. Readers can decide whether these views were politically motivated but the RMT claims that 90% of respondents to its survey would prefer public ownership – something they have still not got!
Operator 5 – London North Eastern Railway – controlled by the government but outsourced
London North Eastern Railway, a revived name chosen by the government, conforms to its recently-introduced policy of unbranded geographically-based names. Like East Coast, it has no premium profile that must be achieved – so it cannot “fail” - and like East Coast in 2009 is seen as a stop-gap.
Operator 6 – Some kind of public-private partnership
Rather than re-franchising the route after this stabilisation period, during which a new fleet of trains will be introduced, its successor will be some kind of public-private partnership, since described by Lord Adonis as “Alice in Wonderland”. How it will be structured is yet to be revealed, and it is likely that the government, civil servants and consultants are still scratching their heads to find the right solution.
What about other routes?
Whatever type of public-private partnership is dreamt up for the East Coast mainline, it will either be a pilot or a one-off. Assuming that a Labour government bent on renationalisation is not elected, following a snap Brexit-induced election, several more franchises will be let with premium (or subsidy) profiles based on, what sometimes seems like, little more than “finger in the air” predictions of the future state of the industry and the country.
Government policy on rail franchising (both Labour and Conservative) has swung between ambitious long franchises (so that the franchisee can spend large sums on infrastructure and other assets and see a return on its investment) and risk-averse short franchises (or even direct awards) at the cost of little improvement.
When signing new contracts after the railway’s ”collective nervous breakdown” following the Hatfield accident in 2000, the Labour government introduced the lop-sided Cap and Collar mechanism to support franchises through the bad times (from the fourth year of operation) and ensure tax payers benefit from the good times (from day one). But it was deeply flawed. By the time the “collar” kicked in cumulative losses were probably already high – with revenue was falling further behind target each year - and any financial propping up was not hypothecated so it simply reduced further losses incurred by shareholders rather than providing money to revive and strengthen the business. Therefore the operator was never able to get back on track – once on the collar it would remain on it. The cap, which creamed off excess profit removed any incentive to introduce new services as there was little to be gained from the effort it they were successful.
For the benefit of taxpayers the government rightly seeks to leverage the highest-possible premium payment from operators, rather than them taking unjustifiably large profits, but it does so at the expense of a) passengers, who may pay higher fares or get less good services, and b) increased risk of an operator failing. It has now failed to receive the contracted premiums on several operators across Britain, including Great Western Railway, which exercised its unique break clause just before the back-loaded premiums increased substantially. The government must accept that there is no point agreeing large sums if there is little chance that they will be paid. Pragmatism is required.
If the government wants to keep the current “bid what you hope you will earn over several years in which anything could happen” system then it needs to introduce a refinement that would see significant investment but lower risk providing stability without any more embarrassing early terminations.
Creating franchises that more closely resemble normal commercial businesses
The rail franchise system does not work like a normal business.
A business may have a long-term plan, and invest accordingly to enable growth, but it will set a realistic budget each year based on the forecast of the actuals for the current year. Therefore each year’s budget has the prospect of being achieved and bettered.
In the case of VTEC the government expected bidders to take the forecasted actuals for 2014 from the business it was bidding to buy out (nationalised East Coast) and predict (based partly on yet-to-be-appointed senior management’s ability to grow the business) what both their turnover and costs would be in 2023 and sign a contract requiring it to pay a third party (the DfT) a significant proportion of hopeful turnover based on that. It was utterly bonkers.
A financial model that would avoid any spectacular failures is to revise the premium payment each year based on a pre-defined (at bidding time) percentage increase of the forecast actuals for the current year. Then if there is a poor year it will make a loss that year, perhaps a heavy one, because it will still have to pay a premium based on what it hoped to earn not what it actually earned (hence there is still a strong financial incentive to succeed), but the baseline will be reset for the next year based on actuals. Rather than an exponential divergence between prediction and actual, with a modified system the divergence goes back to zero each year. It would no longer be impossible to get back on track, unlike the current franchises with or without Cap and Collar.
The graph below (click to view in full size) shows various scenarios, the first two modelling the VTEC scenario where it needed 10% growth, one showing success (3% profit margin each year) and the other the spectacular losses when it only achieved 4% growth. The other two scenarios both show a franchise hit by a shock part-way through, one having exceeded expectations in the first years, and the other had merely been on target. Both manage to recover towards the end of the franchise thanks to the new re-baselined premium payments.
The bidding would be based on the percentage improvement on turnover on successful years. This could be the same percentage throughout, as shown in the simple examples above, or a varying percentage. There would still be aggressive competition, but with lower risk in later years, to generate a good return for the taxpayer.
Various formulae could be used. The one modelled above is based on profit (to avoid having to show estimates of costs in the table), rather than turnover, but the principle uses a percentage increase of the gross value (i.e. before the operator’s margin) as the intention is to reduce losses rather than encourage profits.
Will it work?
Will franchise premium/subsidy profile that is re-calculated each year, based on targets set at bidding time, prevent a future franchise from ending prematurely?
Clearly it will not prevent it, since a business can run into difficulties for a variety of reasons, but it reduces the chance of it happening. Potential losses in any one year will be lower. This means that shareholders (and that typically includes people’s pension funds, not just rich investors) ought to be more willing to support the loss-making venture both as a damage-limitation exercise and also because of the possibility of escaping from the loss-making vicious circle that currently exists.
However, if franchise bidders merely offset the reduce risk by setting themselves even more aggressive targets then we are back to square one.
Clearly change is inevitable. At the time of writing this article, it is suggested that the West Coast mainline franchise, which includes operating HS2, will be won by a Chinese bid because no British-owned company is prepared to take the financial risk from the current system.
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