British Rail

The British Rail Regulator Case TEPE Home Assignment 2

Francisco Furtado Raul Pires

Table of Contents Introduction .................................................................................................................................................. 1 Privatization and Restructuring .................................................................................................................... 1 Information to set access charges ................................................................................................................ 3 How was it done in 1995............................................................................................................................... 4 Key issues for next review............................................................................................................................. 6 Proposals ....................................................................................................................................................... 7 Private TOC personality ................................................................................................................................ 8 Bibliography ................................................................................................................................................ 10

Introduction The purpose of this report is to make an assessment on the transformations the British Rail went through in the last years, after that our aim will be to advise the Office of the Rail Regulator (ORR) on the key issues to address in the next charge review.

British Rail was created in 1948, when all of the British rails were nationalized. It was then a single company vertically integrated (managing the infrastructure, rolling stock and service supply both freight and passengers). In 1992 the conservative government takes the decision of reforming and privatizing the system. In the previous year’s British Rail´s market share was declining, although some reforms were made in the 60s and 70s the sector required substantial public subsidies.

Privatization and Restructuring In July 1992 the government issued a White paper on Rail Reform which was the starting point to a major reform in the way the British rail system was managed. The main goals of this restructuring were: • Improve Efficiency; • Reduce the government expenditures to maintain the Rail system, and in the medium term eventually receive payment from the new operators; • Provide new and better services for the users; • Increase the competiveness of rail facing other modes (stop falling market shares for rail).

The core of the reform was the privatization of the British Rails. This way the state intervention in this marked shifted from a supply oriented view, to a demand oriented perspective. Instead on focusing in being directly responsible for providing services and infrastructures, government was to let private companies operate the system, with the regulatory and institutional framework provided by the state.

By introducing competitive pressure in this market1, and allowing the system to be run by profit seeking companies the government expected that the operators would have a greater incentive to increase efficiency and innovation in how operations were managed, and with this gain in efficiency both reduce the overall system costs, and provide better service to the users.

Competitive market forces would allocate resources more efficiently then bureaucratic structures, privatization would liberate managers and employees and allow them to reach their 1

By market here we mean providing freight and passenger’s services, as well as managing and maintaining the infrastructure, and leasing and providing maintenance to the rolling stock.

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full potential. Also according to the public choice theory it´s believed that public services become inefficient as they tend to be run in the interests of employees, and other special groups, rather than the public interest. Moreover the ability of shareholders to sell their shares if a company performance is poor, would promote efficiency, and also bring in accountability to those in charge of the companies.

We should also add that, besides the theoretical arguments, the British Government had already in the 80s privatized electricity, gas, water and other public utilities, and the government perception was that there were performance gains in those sectors due to privatization.

In order to introduce competitive pressure the government broke up British Rail in 70 different companies, the main decision was to separate infrastructure from service providing.

This was done to enable a level-field for all the operators to play, and prevent one of the agents getting monopoly power over the others. So, from British Rail 6 types of companies emerged: Railtrack (own and operate the infrastructure, track and stations); 7 FOCs (Freight Operators); 25 (Passengers Operators); 3 ROSCOs (Rolling Stock Companies); 12 INFRACOs (Infrastructure and equipment maintenance). To regulate the market the State set up two institutions, both appointed by the Secretary of State of Transportation. The Office of the Rail Regulator (ORR), is independent from government, and it´s main mission is to oversee Railtrack (the sole infrastructure provider), with power to issue licenses and to review the access charges the train operators (both freight and passengers) pay to Railtrack for using the infrastructure. These charges reviews were set according to the “Price cap” (or RPI-X2)regulation, so the regulator would have to estimate the productive/efficiency gains Railtrack should provide each year of that the charge review covers. The other regulatory instance was the Office of Passenger Rail Franchising (OPFRA), to oversee the TOCs operations (setting fares, frequencies and other characteristics of the services required).

There are considerable economies of density that make mass rail transit routes natural monopolies, so since direct competition in the same track is undesirable, one option to introduce a competitive environment in Rail is by giving short-term franchises in given routes(Savage, 1995). This was the option taken by the British government and it lead to the disintegration of a large Company, in a system where there are unquestionable scale and network economies. It was expected that the gains obtained by introducing competitive pressure would surpass the losses in scale economies… A bold decision, almost a leap of faith…

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RPI – Retail Price Index, to account for the general level of price, and X, the annual reduction(or change) in charges taken in account the expected productivity gains.

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Information to set access charges The Regulator knows that it is of paramount importance that these charges are set correctly so that the privatization process can be in fact successful for all the parties involved, the Railtrack, the TOCs and ROSCOs and specially the final consumers who ultimately are the ones who should benefit the most.

For the Regulator it is important to exactly understand what is expected from the Railtrack in terms of self autonomy, what is the income that is expected from Railtrack by the government and at the same time what is the expected income for the years until the next access charge review. A clarification in what regards subsidy is also required in this process because3, if the access charge fees are very low then it is Railtrack that will need subsidy and if this charge is higher than the subsidy will have to be given to the TOCs to cover this fee.

Nevertheless, it is clear that directly or indirectly, Railtrack will need subsidy, the question is to decide how much. The access charges will also have a great impact on the franchising of the TOCs companies and therefore the regulator needs to know what the government expected levels of subsidies to these companies will be.

In order to fully assess what will be the Railtrack maintenance and operating costs the Regulator needs to have a clear idea of what In order to fully assess what will be the Railtrack maintenance and operating costs the Regulator needs to have a clear idea of what are the current assets of Railtrack. An inventory of all the assets owned and their value should be made available to provide more accurate information to the Regulator.

Railtrack efficiency needs to be assessed by introducing efficiency benchmarking comparisons with other international companies that have the same line of work as Railtrack.

This assessment and comparison will indicate the Regulator how Railtrack is performing and what areas should be addressed as well as give an indication to what access charges should cover, or not, to meet efficiency targets that will be set4.

Since there exist different levels of demand in each part of the network and since these parts of network are operated by different TOC companies it is also important for the Regulator to determine this information so that the set of access charges is set within a fair system for the TOC’s operating in each area.

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See (Ibanez, 1999) See (Smith, 2004)

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The access charges setting process is not an easy task for the Regulator as it as to gather information that it is not immediate. In the end it is an exercise of balancing the charge in a way that the interactions between all the actors maximize the overall system performance.

How was it done in 1995 The regulator faced many challenges when setting the Charges in 1995. The first issue was to clarify the nature of Railtrack, in a first stage it was thought it should be financially self supporting through the fees it charged train operators and should also be publicly owned. This last option was very important because in the end the government, one way or the other, had to pay for the system costs. If the access charges were low, the subsidies given to the TOCs could also be low, but Railtrack might need some government subsidy, if access charges were higher Railtrack could be self-sufficient (and that was the aim), but the amount of subsidies allocated to the TOCs would rise. In the end, a decision was made to privatize and sell Railtrack5 which lead to two consequences, first the charges would need to fully finance Railtrack, second the charges also should be sufficiently high so that the government could sell the Company for a good price.

Second, as stated in the previous point, to set an adequate RPI-X regulation, the regulator needs to make a good assessment on the company assets, operating costs, and desired (and achievable) productivity gains6. The fact is that the regulator was never able, due to several reasons7, to evaluate properly both this variables, and the charges were set based on rough guessing.

Although the decision was taken without fallowing the more suitable process and all necessary steps, one can argue that at this early stage it was of paramount importance to “get the ball going”. And give a starting point for the restructuring rail system. Still, setting access charges is one of the corner stone’s in the design of the new system. They are the vital revenue source for Railtrack, and influence the subsidies awarded to the TOCs, getting them right sends a very sound signal to the market, if they are too off mark they can upset the entire structure of the system.

It´s not absolutely clear what was the weight the access charges had on the events that followed, but since they set the revenues of Railtrack and the way the Railtrack budget was constructed we can say it had a great influence. So to properly assess the impact of setting the charges we will make an overview on the performance of the system in the following years.

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The argument was that without privatizing Railtrack it wouldn´t become a innovative and commercially minded company.

See (Smith, 2004) One is the sheer complexity of the task, even more if those in charge of evaluating have no knowledge on what they are evaluating.

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In the first years Railtrack was able to show good financial results, even if service levels were heavily debated8, the fact is that several accidents and incidents occurred. In 2000 the Hatfield accident was a turning point, Railtrack was forced to heavily invest on the maintenance

Figure 1 - Total rail cash costs per train(Smith, 2004)

of the infrastructure and it went bankrupt, government took over for a period, and now a new institution Network Rail, private, but non-profit, takes it place (although the financial balance keeps worse every year‌). Some TOCs were accused of having large profits since the access charges were too low, but one should bear in mind a huge risk was involved for the first to operate in this new system, besides that 13 of the 25 original TOCs failed and 4 renegotiated their contracts9. The level of subsidies asked was lower than expected10, nonetheless the private contractors often use low-balling schemes to raise later their revenues, to do this they take advantage of asymmetry of information (favoring them), and the fact that government cannot afford the railway service to stop.

Other set of problems that derivates from this institutional design is the problems with interface issues, one of this is the charge setting, but others have to do with assigning responsibilities, no matter how the contracts are made, reality as so much nuances that it´s very common that all the players involved will try to put all the costs of the system on the other

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See (Gibson, 2004), and (Leyland, 2004) See (Preston, 2008)

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But it´s rising in the recent years see (Smith, 2004)

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players back and the benefits all on their side, these generates prolonged argues and can result in dragging urgent matters for long and have as an end result a general loss of efficiency.

As mentioned on (Gibson, 2004), rail infrastructures require returns and investments to be made thinking on the medium-term, so the institutional framing of the rail system to enable a good environment for decision making should be stable, the Railtrack, now Network Rail, tale is not a good example.

Last, but not least in this overview, one as to mention the high costs of transaction of all this process. There were major losses of information with the British Rail break up, and many highly experienced personnel left the system. Actually there are evidences that suggest that it was the Government and Regulator11 intention to provoke an abrupt change, they should have better assessed this transaction costs. Namely, the asymmetry of information between the Regulator and the different kind of Operators is a major flaw of the whole system.

So if the charges would have been well set in the beginning the system might have behaved better, yet the system presents too many interfaces, fragilities, and marks such a cut with the past that problems would be inevitable. Many of the questions addressed would have happen even if the charge was well set, but since it wasn’t it only made matters worse.

Key issues for next review12 The major issue that was posed to the regulator was concerned with Railtrack: “Under the privatization and regulation arrangements there was no financial incentive to channel revenue into upgrading the system”(Leyland, 2004). The primary objective of privatization was to increase the benefit to the users, either by a improving the service provided or by providing low fares is not being met.

One of the major concerns the Regulator has is related with the state of the network that Railtrack is responsible to maintain and improve. The soaring profits of the company, which indirectly are paid by the State since they subsidize the access charges the TOC’s have to pay to Railtrack13, raise some questions about the investments and maintenance being made by Railtrack and, even if the access charges are too high (enabling the company huge profits), Railtrack is not investing it´s profits in its major obligation, the network. These concerns are related not only with the level of service provided but also and most importantly, with security issues. Railtrack is having a great amount of profit and both the Government and the Regulator lack clear powers to oblige Railtrack to conform to their obligations. This implies that the 11 12 13

The way the regulator was appointed and acted reminds a lot the Jacobin députés en mission of the French Revolution

We are adressing the 1999 charge review See (Leyland, 2004)

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regulator must address this accountability issue of Railtrack, ensuring that the company is somehow forced to perform its duties.

Other extremely important information for the Regulator to gather in order to set correct access charges is to have an investment plan of Railtrack for the next years. This plan should take in consideration not only the investments to enhance and improve capacity of the network but also the investments need to maintain the existing capacity. This plan and the information about the network investment needs will be considered by the Regulator and will have a considerable weight while setting the future access charges.

There are also problems related with the accountability of the problems that arise in the day to day operations. The fragmentation of the roles of each actor makes it particularly difficult to establish responsibilities14.

Proposals At this point it is clear that the actions between each of the participants needed to be fully coordinated to provide efficiency, reliability and safety.

In order address the problems and issues related with the state of the network, the Regulator has to obtain accurate information about the current state of the network: • • •

Reports about all problems related with traffic signaling and rail tracks in bad state.

Network maintenance and operating costs Future investments to upgrade and improve it

Ideally, this information should be provided by Railtrack since they are the ones who are responsible for it but since their information have not been the most accurate, we propose that a group of Railway industry specialists would be formed in ORR (and permanently employed by the Regulator) to access the full extent of the network requirements.

It also seems clear that the fact that Railtrack is a profitable oriented company has corrupted her initial goal of correctly managing the rail infrastructure so it is our recommendation that this company should be transformed in a non profitable organization with the sole responsibility of managing and improving the network. The access fees would still be maintained but, based on the reports, we suggest these should be set so that they cover the necessary costs to implement a safe and modern network that can in fact serve the general public interest.

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See (Leyland, 2004)

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A final recommendation we make is that both TOC and ROSCO status as privately operated companies, ought to be well evaluated to determine if they should (or not) return to be publicly owned.

Perhaps most crucially, state ownership as much as, if not more than, privatized firms requires good regulation focused on process. That is, effective public sector organizations should have quality assured through process (in line with the precepts of total quality management), rather than “end of the pipe� solutions. Such a regulatory regime also reinforces the requirement of openness. It is essential that effective regulation prevents excess public sector employment for political purposes, and the employment of politically connected people, rather than those best qualified (Akram, 2003; Boycko et al., 1996; Kreuger, 1990)

Private TOC personality Given the set of actions made public by the regulator, with particular attention to the reassessment intention, we realize that the company future may be in stake. Given this, we have 2 options which can be analyzed and deepen: 1. Pursue a strategy that assumes that the regulator will remove our franchising right to operate on the network.

2. Pursue a strategy that does not assume anything but instead will do its best to convince the regulator that we are a serious company with a clear vision of what our role and responsibilities are and that our goal is to maximize efficiency and costumers satisfaction.

As we believe that our company ability to provide a good service and at the same time be a profitable business, we will focus our efforts on devising a business plan that will convince the Regulator.

Our first goal will be to demonstrate our financial viability and reduce as much as possible the subsidy needs from the State. To achieve this, we need to create partnerships with other TOCs, with whom we share some parts of the network, as well as with maintenance companies. In doing so, we will target the operation and maintenance cost reduction and try to gain efficiency and create synergies with these companies as well as strengthen our position in the market share. These synergies could be in the form of better schedules, better price combined ticketing or market segmentation with the aim of maximizing consumer comfort and experience. With the reassessment of the schedules it could be possible to analyze which routes were not profitable and that required adjustments to minimize those operations or even improvements

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in efficiency by reducing train size and thus energy consumption. Other initiatives could be for instance free bike carrying at every hour, etc.

One other possible measures for cost reduction but that required some initial investment and therefore should be carefully analyzed would be to lease robust and efficient Rolling Stock. We could show our will to invest a part and suggest the government to either provide some initial subsidy or for instance, ensure ROSCO companies to have this type of rolling stock available for leasing them. This Rolling Stock would also demonstrate the government our commitment to a long term operation as opposed to a somehow common short term profit maximization strategy that was common at this time.

As a measure of convergence to the Regulator decisions to do a complete check up of the network, we will also set up or hire one of the maintenance companies with whom we have business to do a complete evaluation of the state of the network area in which our company operates.

In order to improve our revenue and passengers carried we will also devise a marketing campaign with our established partners advertising environmental benefits of train ridding, our improved schedules and combined ticketing options. Along with this, we will also think in strategies with municipalities to provide cheap car parking fares for users that are daily commuters.

With this set of measures we are showing the Regulator our willingness to improve the overall system functioning. We this and with a realization of a long term plan to assess the viability of our initiatives we could discuss with the Regulator the price of the access charges to be set. In our point of view, this set of measurements and our commitment to accomplish them gives us a good power of negotiation.

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