Monday, 23 April 2007

Too high a price?

Even in a capitally intense industry such as rail, a billion pounds is a lot of money. It’s not, therefore, surprising that eyebrows were raised when it was announced that First Great Western would pay the government a £1.1bn premium for running the Greater Western franchise for ten years.

Can First Great Western meet their financial obligations to the government? The broad answer is: yes, they can. From an external perspective, the financials do stack up. Admittedly, they are not easily attainable: the business model relies on consistently high levels of revenue growth, say 5-7% per annum, and a tight management of operating costs. Nevertheless, the bottom line is that they are within the realms of feasibility.

That’s all well and good, but asking whether First Great Western can meet its obligations is actually the wrong question to ask. The thing the commentators should be asking is: what value are travellers going to get from the £1.1bn being paid to the government? And let’s be clear on one thing: the £1.1bn will come directly from the pockets of travellers; it is the equivalent of a 15% tax on ticket sales.

One of the problems with the current rail system is that it simply isn’t transparent. Most people don’t realise that a large part of their travel costs go directly to the government’s coffers. As such, they don’t hold the government to account as they do when it comes to discussions of how more visible forms of taxation, such as income tax, are spent. Yet, First Great Western customers, especially regular travellers and commuters, should hold the government accountable. They should ask questions. And they should demand that part of the ‘travel tax’ they pay is spent to improve their travel experience.

Over the past ten years, and over the next ten, the Greater Western franchise region has been, and will continue to be, financially transformed. Back in 1996/7 when rail was first privatised all constituent parts of what is now Greater Western received an operating subsidy. Great Western mainline services were given £61.9m a year; Thames Trains received £43.7m a year; and, Wessex, received a subsidy of £84.6m. By the end of the last franchise which ended in 2006, both FGW mainline services and FGW Link services were paying the government a premium. Wessex still received a subsidy, albeit one that was much reduced. All of this is testament to the private involvement of the train operating companies which dramatically improved efficiency.

Over the next ten years, the amalgamated franchise will more than pay its way. Even including the former Wessex operation, it will be a net donor to the government. It is, therefore, right that travellers should expect something back for the money they pay. Exactly what they should get is a matter for debate, but extra capacity would be a good starting point. What wouldn’t be fair is for the premium payment to be used exclusively for the benefit of other projects or franchise regions. At the very least, the government should be honest and let people know how they are intending to spend the money and how much of it will benefit Greater Western.

In reality, of course, the whole system is completely the wrong way around. The government, which has instilled and explicitly built into the franchising system a culture of high premium paying tenders, should actually have done something else entirely. They should have created a system where bidders were encouraged to maximise investment into their own operations, not the amount they pay to government. That way, money would find its way directly into front line benefits without being eroded away by Whitehall bureaucracy.

The point, then, is not whether the price of the franchise is too high; the point is whether or not the price will, ultimately, be of any real benefit to Greater Western customers.


Billyo said...

"What wouldn’t be fair is for the premium payment to be used exclusively for the benefit of other projects or franchise regions."

Before we start talking about where it would be fair for the money to end up; lets ask if it's fair where the money comes from.

In January FGW rose commuting fares into London by inflation +1%, whilst in the Bristol area fares rose by 13%; thus SW commuters are picking up a larger share of the tab that has to be paid back to government. How is that fair?

And if the money is put back into the Greater Western Franchise, will more of it be spent on the SW, because we paid for more than our fair share? Will it balls.

CJ Harrison said...

Thank you Billyo, I can always rely on you for some feedback. Not that I necessarily agree with you...

The majority of commuter fares are regulated by the government: First Great Western can’t increase them by more than RPI +1 even if it wanted to. So yes, maybe it is unfair but, once again, it comes down to a problem with the system which doesn’t give operating companies a free hand in determining ticket prices and spreading the ‘pain’ more evenly. That said, I doubt London commuters quite see it that way!

The other fact is that the former Wessex operating doesn’t currently pay for itself – at least it doesn’t by my analysis. In it final year of operation before Greater Western, Wessex received a £56m operating subsidy. Over the course of Greater Western not only will that subsidy disappear but it will also need to be translated into a significant premium payment. Wessex’s contribution to this will be negligible compared to other areas of the franchise region. So, technically, the South West is not paying its fair share; indeed, parts of the former Wessex Trains operation are probably being subsidised by the more profitable routes.

Look at it this way: if Wessex had been left as a stand alone business and the subsidy had been cut – let alone transformed into a premium – the railway in the South West would have been completely decimated. The problems seen over the past year would be nothing to what would have happened. By merging the Wessex operation into a larger franchise area, this problem has been largely avoided.

Should the SW get rail investment? Yes, I think it should. Why, because I think it can be made profitable over the longer term. I think with investment the railway can be made more efficient and more attractive. I also think that, economically, it will be highly beneficial to the region and this, in turn, will boost demand for rail travel. Also, do not overlook the fact that the SW is linked to the rest of the country. A scheme to improve signalling in Reading helps London commuters but it also helps anyone travelling into the capital to and from the West Country by making their journey times quicker.

But, for any of that investment to happen, money needs to come back to the Greater Western operation as a whole. And that is the start point.

Billyo said...

As you seem to have all the numbers, I would be interested in what Wessex's turnover was before being absorbed into the Greater Western Franchise. What percentage of their turnover was subsidy?

Billyo said...


"The majority of commuter fares are regulated by the government: First Great Western can’t increase them by more than RPI +1 even if it wanted to."

What is this majority rule which means as long as most fares only go up by inflation +1% then some can go up by more? How is that fair?

Was it the government who wanted SW fares to go up by 13% or FGW. I believe it was FGW, and that the government approved it even though it's against their general policy. Both as bad as each other.

CJ Harrison said...

In its last full year of operation, Wessex’s financials looked like this:

Passenger revenue: £42.567m
Grants and subsidy: £62.931m
Miscellaneous income: £8.277m

TOTAL: £113.775m

As a proportion, subsidy and grants (which is wider than government subsidy alone) represented 55.3% of total turnover.

Wessex’s operating expenses that year were £98.783m. So, without subsidy the company would have made a loss of £47.9m. Indeed, without subsidy the company would have quickly become insolvent.

Billyo said...

Fair enough. Makes sense, though if this section of the franchise is still (despite inflation busting price hikes) making a loss it's an arguemnet that the "meddling" from Whitehall is essential.

If FGW were given free reign to decide what services should be run then services would be massively slashed because this line isn't proitable.

CJ Harrison said...

The first question I would ask is: can this section of the franchise be profitable? If it does have potential, then there is no need for government meddling, private business will reorganise it over the longer term so that it makes money. From what I have seen I believe it does have potential and that it can be reorganised. Sure, it’s not an easy task and there may be some unpopular decisions that need to be taken, but it is feasible.

If it can’t be made directly profitable the second question I would ask is: would a private company operating the former Wessex region as part of a larger franchise zone, close large parts of the western operation? A stand alone operator, as Wessex Trains was, would obviously have to undertake such an action, but the situation for First Great Western is more complex. The reason is that even though the region itself may not be directly profitable, the services run may well boost the profitability of other lines and services. The argument goes something like (and this is purely fictitious): the St Erth to St Ives branch line is extremely unprofitable, yet 25% of passengers who travel profitably from London to St Erth do so only because they can then get a connection to St Ives; take away the connection and you lose the business from London and your overall profitability decreases. This was actually an effect which wasn’t anticipated in the Beeching cuts, but which subsequently manifested itself.

If, having asked these two questions, you come up with the answer that large parts of the rail operation are just not economically viable, you then have a choice. You can subsidise them through government, or, you can let them close and allow market forces to find alternative ways of managing demand for travel.

The latter option is often discounted because of the outcry it would bring from the public. However, it may be a sensible route. Rail, where it is subsidised, can have a crowding out effect on other services. For example, a subsidised rail service may mean there is a much lower incentive for more, better or faster bus services. Remove the rail service and other forms of public transport will increase and improve.

On the former option of subsidy, obviously this does need to be managed by the government. However, there are two caveats I would bring up.

First, demand, and not supply, should be subsidised. This is not what happens under the current system where supply is subsidised. What does this mean? Well, it means that if the real cost (i.e. what FGW have to charge to cover their costs) of travelling from Liskeard to Looe is actually £81, then this is what the real ticket price should be. The government should step in, however, and say “look, this is too high for people to pay and we still want a service on this line; for each ticket you sell we’ll give you £75 so you only have to charge people £6.” This is what I mean about subsidising demand.

This is not an ideal system but it is better than the current system for several very good reasons. First, it does not skew demand as much and, consequently, does not result in overt market distortions. Second, it is more responsive to demand – a company still needs to attract people to a line in order to get money, and the more people it attracts, the more money it receives. This means there is an incentive to improve which there isn’t always under the current subsidy regime. Third, it is much easier to review this system and understand the economics of individual lines and services. For example, if a line suddenly starts to see an upsurge in demand, the price-subsidy ratio on tickets can be adjusted accordingly. This means value for money is provided for the taxpayer.

The second caveat on subsidy is the degree to which meddling is required. This is a matter for debate. Any subsidy will distort the market and result in imbalances between supply and demand. However, that aside, it does not follow that subsidy needs to be accompanied by an unduly restrictive and burdensome system. It is quite possible to have subsidy and a lightly regulated, lightly managed system. We absolutely do not have this at the moment. We have a ridiculously complex and over managed system.

Um, sorry this has turned into something of a ramble, but I think that covers everything…!