Rail franchise margins European Transport Conference 2014 Andrew Meaney, Partner Christopher Davis, Consultant 30 September

Purpose 2 To better understand the link between contract design, the size of rail franchise margins and value for money To outline a framework that public authorities can use to design passenger rail contracts such that the margin required by railway undertakings offers value for money 30 September 2014

Overview Background on franchising Some observations A framework for delivering value for money 3 30 September 2014

Background (I) What is a franchise? the right to operate rail services on a given collection of rail routes formal contract with government franchises broadly split by region or mainline awarded by competitive tender to private companies competition for the market passenger-facing part of the rail service day-to-day management of the train services 4 30 September 2014

Background (II) What are the aims of franchising? increased efficiency and innovation an improved service offering for passengers reduced government subsidy enhanced certainty on future public expenditure by contractually underpinning premium/subsidy payments flexible tool with which to vary the specification of rail services across different areas of the country 5 30 September 2014

Background (III) Rail margins TOCs require a margin (compensation) for providing rail services margin assumption incorporated in franchise bid affects size of the premium or subsidy required to operate the franchise link between the level of risk and the level of return (i.e. the margin) franchises have different cost and revenue characteristics that may affect owning groups’ risk exposure 6 HIGHER RISKHIGHER RETURN 30 September 2014

Overview Background on franchising Some observations A framework for delivering value for money 7 30 September 2014

1. Rail franchises are asset-light businesses... investors in asset-light businesses require a return on the risks they take from running the business and/or the intangible assets created over time required profit margins will decrease as assets decrease (relative to revenues) required margins lower than the market average 8 Required profit Assets Required profit Revenue Assets Revenue 30 September 2014

2....but margins are non-zero finance theory is based on the assumption of a ‘return on investment’ franchises require little or no direct asset investment does this mean any profits are unnecessary? 9 Upfront investment Required return on investment Risk of loss Target profit (capital * return) Commitment to provide capital Required return on investment Risk of loss Asset ownerFranchisee 30 September 2014

3. Observed margins across TOCs vary widely 10 There is significant variation in the profitability of different franchises There is a clustering of EBIT margins at or below the 5% level Total operating profits across the GB passenger rail industry were around £250m in September 2014

4. Margins are driven by cost risk, revenue risk and operational leverage Volatility of net cash flows Revenue risk Cost risk Underlying volatility of demand Proportion of business passengers Subsidies or premium payments Revenue support mechanisms Open access regime Operational leverage Capacity utilisation Structure of contracts with the ROSCOs and Network Rail Transition of revenue volatility in the volatility of net cash flows Type of rolling stockHedging policy The critical driver of required returns Input costsInitiatives Results in potential losses for investors where capital is committed 30 September 2014

5....which will vary across franchises 12 Inter-modal competition GDP Disposable income City employment Premium or subsidy Open access Wages Materials Schedule 4 Power Schedule 8 Initiatives Revenue riskCost risk Operational leverage and capital structure utilisation of available capacity structure of lease contracts premium or subsidy payments capital requirements 30 September 2014

6. Rail franchise design will affect risk exposure and thus the required margin franchise term risk-sharing mechanisms only at risk for controllable factors? within period changes profit share arrangements two-sided? symmetric? exposure to cost shocks e.g. energy costs, track access charges exposure to open access operators timetable flexibility bid assessment criteria capital requirements (bonds and parent company guarantees) September 2014

7. Franchise contracts can take a number of different forms 14 Management contract ‘Cap and collar’ TOC takes cost risk, client body takes revenue risk Exogenous risk-sharing mechanisms TOC takes all risk Low risk Weaker incentives High risk Stronger incentives Source: Adapted from English. K-L. (2014), ‘Overview of the UK rail market’, Department for Transport, 19 May. 30 September 2014

8. It is generally agreed that TOCs should only bear the risks they can manage 15 Marketing initiatives Revenue from unregulated fares Service quality Brand / reputation Local GDP National GDP Unemployment Inflation Track access charges Endogenous riskExogenous risk Exposure to exogenous risks reduced through revenue risk-sharing mechanisms (e.g. GDP mechanism) and inflation-linked changes in regulated fares 30 September 2014

9. Inappropriate risk transfer can lead to higher subsidy than is necessary leaving TOCs exposed to too much risk can lead to higher than necessary franchise margins removing all risk can dampen incentives and lead to overbidding potential negative impact on alignment of incentives across industry if TOCs fully protected from changes in track access charges balance needs to be struck risk transfer should be tailored to each franchise September 2014

Overview Background on franchising Some observations A framework for delivering value for money September 2014

A framework for ensuring value for money Ensure that rail franchise design reflects policy objectives—i.e. what is the tender or direct award meant to achieve? Find ways in which the contract also aligns incentives between the railway undertaking and the infrastructure manager Balance risk transfer such that the operator faces appropriate growth incentives but limited exposure to events that are outside its control Reflecting step 1, require that the contract includes incentives for efficiency, innovation and service quality improvements September 2014

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Revenue risk sharing mechanisms Brown Review’s recommended approach Agree appropriate (franchise-specific) mix of exogenous risk drivers (e.g. national/regional GDP, CLE) and the elasticity of demand to them ITT includes base forecasts for national GDP, regional GDP and CLE to give exogenous revenue growth assumption (which feeds directly into bid) Bids are on endogenous revenue growth (i.e. companies’ own initiatives) with proposed costs, margins and resulting payments Contracted premia or support payments are adjusted for the outturn level of the indices relative to the base forecast September 2014

Case studies Recent prospectuses Thameslink seven-year management contract DfT takes full revenue risk Govia takes cost risk operating costs plus 3% margin (4% cash margin) Northern 8–10 years bidders will take full revenue risk profit-sharing arrangement including a profit cap no sharing arrangement where operator incurs losses East Coast 8–9 years GDP indexation mechanism based on national GDP covers 90% of difference in revenue resulting from outturn GDP symmetrical with nil band (±2%) elasticity of 1.2–1.4 profit share with profit cap September 2014

Further reading Oxera (2014), ‘Something for nothing? Returns in low-asset industries’, Agenda, March. Oxera (2012), ‘Chuffing hell: is the British model of rail franchising dead?’, Agenda, November. Oxera (2012), ‘Sold to the slyest bidder: optimism bias, strategy and overbidding’, Agenda, September September 2014