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Sir Richard Branson’s threat to pull Virgin out of running rail services in the UK should start ringing alarm bells in Whitehall as the government gears up for the busiest round of refranchising since privatisation in the mid-1990s.
Changes to rail policy earlier this year were designed not only to help cut the cost of running the railways by shifting more of the risk on to the operators but also to attract more bidders – including some of the big foreign state owned railways – into the market, to provide greater competition in the tenders.
The next three years will see three-quarters of the country’s 19 franchises re-let and the process is meant to play a crucial role in achieving the government’s target of cutting the £11bn annual cost of running the railways by 30 per cent.
The outcome of the West Coast bid has seen a significant transfer of risk to FirstGroup, which had to put up more than £200m in guarantees to secure the contract (see sidebar), which starts in December and could run until the end of 2027.
But the winning bid only envisages cutting up to 3 per cent of costs from operating the franchise, with the big returns promised to government – FirstGroup could end up paying £13bn in premiums over the 15-year contract – based almost entirely on ambitious revenue growth forecasts.
FirstGroup won the bid with projections of an annual compound revenue growth rate of 10.4 per cent, including a 5.8 per cent compound annual growth in passenger numbers, more than doubling traffic from the current levels of 31m a year.
Tim O’Toole, FirstGroup’s chief executive, defended the projections amid fierce criticism from the losing bidder – supported by politicians, unions and passenger lobby groups – who labelled the bid unrealistic.
“This is the UK network’s growth line, linking London with the key urban areas for professional services and leisure travel and its potential has barely been realised,” he said.
The new structure of the West Coast franchise gives the winning operator more flexibility than ever before – but also forces it to take on more risk, write Rose Jacobs and Mark Odell.
Rather than protect FirstGroup from overly ambitious revenue forecasts, the government will in future only subsidise sales shortfalls if GDP growth falls short of Treasury predictions by 4 percentage points or more.
On the other hand, no one wants a repeat of the 2009 East Coast rail fiasco, in which National Express reneged on its agreements when it realised that paying the premiums it had promised would be ruinous. The government has therefore demanded that FirstGroup provide £245m in bonds the company would forfeit if it broke the West Coast contract – a significantly higher guarantee than required of past franchise winners.
Investors are no doubt nervous over the terms of this contract, even if cash flows from West Coast will help support an aggressive dividend policy and avert the need for a dilutive share placement.
But the short-term appeal is clear: FirstGroup’s payment schedule is back-end loaded, meaning the biggest payouts to government start 10 years down the road. By then, the management that put this arrangement into place is likely to be long gone.
Some critics, however, questioned the levels of growth still available with passenger numbers doubling to 31m since Virgin Rail took over the franchise in 1997.
“It is pretty ambitious: how easy is it to grow the off-peak leisure market in a flat economy?,” said one consultant who has advised on many rail franchise bids.
FirstGroup has said it will lift capacity on the line by 35 per cent from 2011 levels and Mr O’Toole acknowledged the challenge would be to fill the 40,000 extra seats that represents during the off-peak hours.
Tony Collins, chief executive of Virgin Rail, dismissed FirstGroup’s bid as “undeliverable” and challenged its revenue assumptions, which envisage paying £1bn more in premiums to the government than Virgin in the final three years.
The likelihood that Virgin could now pull out of the market – it has now lost four successive franchise bids at a cost of £60m – has some experts questioning how the government will maintain enough competition in the market.
The two shortlisted foreign bidders for West Coast both fell some way short of Virgin with their final offers and no overseas operator has yet won a franchise of any size on a standalone basis apart from Abellio, a unit of Nederlandse Spoorwegen, the Dutch operator, which won a short-term contract to operate the Greater Anglia franchise last year.
“It’s too early to say as yet, but one does wonder about the impact on the losers. If you’ve invested huge energy and capital in a particular franchise and the next opportunity is 15 years away, are you going to hang on?,” said one former senior official at the Department for Transport.
“I do wonder myself whether the lobbyists for longer franchises including Virgin may end up shooting themselves in the foot. I also wonder whether the policy, in which ministers have acquiesced, will ultimately deliver quite what is hoped for,” he added.