Oxera: Rail franchising benefits from return to basics

06 November 2014 Consultancy.uk

The letting of new franchises in the rail sector is becoming normal again. This is welcome, but (as with any activity) it is worth frequently reminding ourselves why we are doing it, says Andrew Meaney, partner at economics consultancy firm Oxera.

The Department for Transport (DfT), Transport Scotland and Transport for London are getting back into the swing of letting rail franchises and concessions, with approximately 80% of the industry’s passenger revenue expected to be refranchised by the end of 2018. The process, conceived as part of the industry’s privatisation in the mid-1990s, has enabled these funders to work with the private sector to deliver improvements in passenger services over the past two decades. The observed benefits are well known: passenger journeys have doubled since 1993; and passenger satisfaction has increased by 10% over the last decade alone.

However, with the Westminster election looming, and uncertainty around the future of European legislation in this area, it is worth ensuring that we are clear about the policy objectives against which franchising is supposed to be delivering.

Eurostar train - London

Objectives
Richard Brown, in his 2012 review of rail franchising, suggested six objectives for franchising:

• ensuring value for money for funders through periodic competition for the right to run services
• harnessing private sector skills and innovation to deliver value for money for taxpayers and increase passenger satisfaction
• ensuring stability of services for passengers and communities
• securing franchisees to work in partnership with funders and other parts of the value chain to enable investment in rail and the delivery of efficiencies
• facilitating devolution of service specifications to regional authorities
• ensuring that services are delivered by organisations that are closely attuned to routes or geographic markets. 

These objectives are a good representation of what franchising is meant to deliver today. The long-lived nature of railway assets means that it is important to create a mechanism for funding (and, implicitly, providing protection for) passenger services over a number of government Spending Rounds. However, I would add one objective that is perhaps less well understood —and may well be considered controversial. This is the ability of funders to develop and sell the rights to a monopoly package of services.

Westminster

By creating monopoly rights to customers on certain services or routes — even if, in reality, there are alternatives from other train operators’ services on different routes, or from other modes of transport—funders are more likely to be able to do two things. First, they can, in conjunction with overall fares policy (i.e. whether fares rise with RPI, RPI + 1, etc.), manage the balance of funding for rail between taxpayers and users. The franchisee is incentivised by its contract to maximise revenue within the scope of the fares that it is allowed to charge. By limiting the rights to run services to one company, this policy lever is much more effective, where the promise of a fixed customer base can be used to provide incentives to operators to deliver revenue increases and cost reduction within the franchise period.

Second, funders (especially the DfT) can use franchising to — in effect — move money around the country. Franchising enables services in one part of the country to support investment (and, in some places, the existence of passenger services at all) in other parts of the country by paying a premium to the DfT. As an aside, this may be why funders generally do not like open access, which restricts monopoly rights and, therefore, inhibits the effectiveness of these policy levers. On the other hand, if a suitable balance can be found, the services provided by open access should result in a better deal for passengers, increasing choice and competing on fares and service quality against franchisees. 

Transport

Achieving objectives
The question then arises: is franchising achieving these objectives? Or, more importantly, is there an alternative mechanism available that would meet these objectives better? 

This is a large topic, and space is limited. However, I would make a couple of remarks, focusing on improvements to the status quo. First, we know that franchising as it currently operates struggles to promote efficiencies across the value chain. In particular, while Toc’s have relatively strong incentives to manage their own costs, they have limited incentives to help Network Rail achieve efficiencies, as the charges they pay to Network Rail are largely independent of the way in which they operate services on the network*. A notable exception here is traction electricity. Toc’s are on risk for their share of network costs in this area, and have been able to help Network Rail deliver considerable efficiencies. 

Second, while there are some incentives to innovate during the franchise contract (e.g. to improve passenger satisfaction scores), much of the innovation required is restricted by the franchising process to the activities of bid teams. While much preparation goes into each bid ahead of shortlisting, the usual three months of bid activity (where innovation should be at its height to ensure a successful bid) seems to me to be disproportionately short in comparison with a seven-year franchise. And, quite often, the bid process can require intense effort in unlikely areas — such as timetable compliance — perhaps at the expense of developing service quality. Moreover, tightly specified contracts often grant limited scope/flexibility for ‘genuine’ innovation in the way services are provided on a particular line. As a result, conflict may arise between ensuring a transparent procurement process and delivering the objectives listed above.

Andrew Meaney - Oxera

Summary
Franchising is probably here to stay. I have described its importance to funders as they seek to exert control over rail in return for its taxpayer contributions. It has been successful in encouraging passenger growth onto the network, but comes at the cost of reducing competition in the market. Policymakers should be transparent about the overarching objectives of the process, and how the franchising and regulatory framework are aligned to them, to ensure that the forthcoming franchises deliver maximum benefits to passengers and taxpayers.

* The ORR’s new route-level efficiency benefit sharing (REBS) mechanism — which it has introduced due to its inability to expose Toc’s to changes in access charges — is unlikely to have a significant impact on incentives, and Toc’s are allowed to opt out for CP5.

An article from Andrew Meaney, partner and head of Oxera’s Transport team. 

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