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INFORMED SOURCES December 2003

Winsor cuts OMR spend

Time for one last push on understanding the Interim Review, I'm afraid. But it should all be over by Christmas

Before we get into the detail of Rail Regulator Tom Winsor 's Draft Conclusions on Network Rail's Track Access Charges for the next five years, I thought you might find this little aide memoire helpful.

Table 1

Falling estimates for OMR expenditure

All figures £m 2002/03 prices

Source: ORR and Network Rail

In Table 1, the ‘total' column refers to five year Control Periods which are shown in bold. The top line is the Regulator's 2000 Periodic Review which set Railtrack's expenditure on Operations Maintenance and Renewals (OMR) for the five year Control Period (CP2) which started on 1 April 2001. That Periodic Review is now at one with Nineveh and Tyre .

Line 2 is Network Rail's first informed stab at a Business Plan in March 2003. Readers will recall that a year earlier, when Railtrack was still in administration, Network Rail Chairman Ian McAlister and CEO Iain Coucher had told me with straight faces than an Interim Review would not be necessary. Readers will also note that the sum is twice the allowance under CP2,

In July the Business Plan was updated (line 3) and the cost for the new Control Period (CP3) starting on 1 April 2004 had gone up to £34.9billion. However the update also identified some ‘illustrative efficiency savings' which might bring the expenditure down to £29.6 billion.

Meanwhile Tom Winsor 's consultants were beavering away and were not convinced by what they found. Network Rail was planning to do too much and what it was doing was too expensive. Reflecting this, in September Network Rail further updated the business plan again, giving a new figure of £26billion.

And on 17 October the Regulator came out with his draft conclusions. He and his team reckon that Network Rail should be able to produce an improving railway at a cost of £22.689billion over the five years. The bottom line.

Table 2

Network Rail – income and expenditure CP3

*Other single till income such as property, stations and charges to open access operators

Source: RBI analysis

Please note that Table 1 is all about how much Network Rail is to be allowed to spend on OMR over the five years of CP3. This is not to be confused with how much money, or even subsidy, the company will need, as Table 2 explains

On top of allowed expenditure on OMR, Network Rail's total income has to include a return on the Regulatory Asset Base (RAB) plus an allowance to build up a reserve to cover unexpected financial ‘shocks' in the absence of shareholder equity. The size of the RAB helps determine Network Rail's ability to borrow – of which more anon.

As you can see, Track Access Charges, the setting of which is the reason for the Interim Review, total only £18.7billion rather than the £22.689 billion headline figure. This is largely because Railtrack's income in CP2 included direct grants from the SRA.

For some reason, the SRA did not want the increased funding allowed by the Regulator to be covered in full by Track Access Charges. As a result we have around £2.5billion in grants which Network Rail has inherited and will be paid during the first three years of the new Control Period.

Add in some £3.5billion of what is known as ‘single till income' to we regulatory wonks and total income during CP3 is £24.7billion.

Slashed

Introducing his Draft Conclusions Tom Winsor reminded us that shortly before Railtrack came out of administration, the company claimed that expenditure on the rail infrastructure would have to increase to more than double what it was then spending. He added, ‘the work that Network Rail and I have done in this review has shown that these figures contained huge inefficiencies and that spending at that level would be an enormous waste of public money'.

Well, no dubiety there. But the five years of CP3 will still see spending up by 40% on CP2. Yes, but in exchange for this extra money the Regulator expects Network Rail to increase the amount and quality of maintenance and renewal work that it undertakes, delivering ‘genuine improvements in the overall condition of the network'.

Response

There was a marvellous bit of arrogance in Network Rail's press release responding to the Draft Conclusions. This welcomed ‘the contribution from the Rail Regulator to the ongoing interim review process'.

Given that it is the ORR which has done the bulk of the work, with a sizeable input from Network Rail to be fair, and that it is the Regulator's Interim Review and that what he says goes, this was insolence beyond the call of duty. I hope it was inspired by my old chum Iain Coucher who has been a bit quiet since being on the receiving end of some humiliating criticism of Network Rail by some unkind TOCs at a National Task Force Meeting.

Anyway, in its defence Network Rail also pointed out that by its own efforts the company had already cut forecast expenditure from the £35 billion in the March 2003 Business Plan to £24.5billion by September as a result of efficiency improvements and changes to outputs. The Draft Conclusions mean that further work is needed in some areas and that ‘important choices still needed to be made about the rate at which the renewals backlog should be addressed'.

Chief executive John Armitt described these further efficiency targets as ‘challenging' and added ‘we will be looking in the coming weeks to see how these further savings may be achieved and to understand the implications for performance and asset condition'.

You get the message to Tom Winsor . ‘We'll try and do it for the money, but don't blame us if we lose the ship for a ha'p'orth of tar.

Political stonewall

Now as we all know, under the 1994 Railways Act, if Tom Winsor says Network Rail needs £18.7 billion in track access charges over the next five years, the passenger TOCs simply ask the SRA for the extra money. And the Treasury either has to cough up, or allow Network Rail to borrow more money or tell the SRA to buy less railway.

So you can understand why Transport Secretary Alastair Darling tried to remain non-committal when tasked with the increased funding for the railways implicit in the Draft Conclusions. And it is easy to obfuscate in a situation where the relationship between track access charges and support for the total railway is unclear

Fortunately, we have Table 3, taken from an SRA presentation. This strips track access charges out of the TOCs' costs, enabling a rough balance sheet to be created. And, as we all know, in 2003-04, total public support for the Railways set to total £3.8billion

Table 3

Railway income and expenditure

1) Includes joint industry costs

2) Excludes track access charges

Source: SRA

So since Tom Winsor is set to allow expenditure on OMR of £5billion in 2004-05, on the SRA's own figures the industry's deficit is likely to be around £1.5billion. Or perhaps more, since we know that recent replacement franchises and franchise extensions have seen costs rise.

Readers should also note that the nominal £1billion cost of the Southern Region power supply upgrade, plus associated station and depot works to accommodate the Mk 1 replacement electric multiple units, is not covered by the expenditure allowance in the Draft Conclusion. This is likely to be funded through debt, but how interest is covered is still to be decided.

Anyway, back to Alastair Darling who ducked awkward questions on the Draft Conclusions by referring to them as ‘interim'. This allowed him to claim that he could not comment on the funding implications until the final conclusions were published in December. However, he did say while the Interim Review had brought Network Rail's costs down, ‘they need to come down further'.

As for having to pay whatever the Regulator decided, Mr Darling said that Network Rail could be funded through a combination of access charges, grant and debt finance. However, he repeated that this depended on the ‘final conclusions'

Never-never solution?

Debt finance certainly seems to be the likely solution to the immediate financial embarrassment. According to the Draft Conclusions, ‘shortly before' the Draft Conclusions were published the Regulator was told that SRA was ‘discussing' with Network Rail the ‘possibility that certain credit facilities which had been due to be withdrawn in 2005 might be extended'.

Depending on the outcome of these discussions, ‘it may be appropriate for the Regulator to revise his views on the amounts that Network Rail can borrow'. This could result in a ‘lower level of access charges'.

Also ‘shortly before' publication of the Draft conclusions SRA said that it wanted enhancements within the West Coast Route Modernisation to be added to Network Rail's Regulatory Asset Base and funded through future access charges. Expenditure on enhancements during CP3 is forecast at £813million but every little helps.

This last minute request, says the Regulator, represents a ‘significant change' from the approach to WCRM enhancements adopted during the October 2000 Periodic Review. Further discussions between ORR, SRA and Network Rail will lead to a decision in the final conclusions in to be published in December.

RAB

Borrowing brings us to another bit of Regulatory Arcana which you won't read about anywhere else, but is vitally important to understanding Network Rail's funding. The Regulatory Asset Base (RAB) represents a virtual valuation of Network Rail's assets.

Tom Winsor needs an RAB so that he can calculate the level of return on assets employed and the amount he allows in the accounts for amortisation - the money which has to be put aside each year to renew the assets. It is also crucial in determining how much money Network Rail can borrow.

Obviously, while imaginary, the RAB is not a fixed sum. As enhancements are made, so the value of the assets increase. Similarly where renewals in modern form improve performance.

Amortisation puts a numerical valuation on the decline of the value of the assets each year. So, if you don't renew, the value of the assets falls. As an aside, British Rail had an allowance for amortisation in its accounts and over the years renewals were less than amortisation. Hence it is true to say that there was a net disinvestment in the rail network between 1948 and 1993/94.

In his 2000 Periodic Review the Regulator set Railtrack's starting RAB for CP2 at £7.332 billion. Then spending went out of control and Railtrack went into administration. Coming out of administration involved Network Rail taking on Government backed debt.

Since Network Rail is a new company it would not be reasonable for it to be handicapped with this debt, or the interest, inherited as a result of Railtrack's overspending. So Tom Windsor is resetting the RAB from 1 April 2004 to give the new business a clean start.

This adjustment increases the RAB to £17.543 billion, so you can see that the notional value of the railway has more than doubled. The RAB is also more than Network Rail's current forecast debt of £13.7billion, which means that the company will be able to borrow more money.

Table 4 The Regulator's allowances for amortisation (£ million)

Don't forget that the Regulator also uses the RAB to calculate the allowance in the Track Access Charges to cover amortisation, in other words the cost of maintaining the assets as wear and tear takes place. Table 4 shows the figures for amortisation in CP3.

Heavy lifting

Since the bigger the RAB, the more Network Rail can borrow, here is a way for Alastair Darling to get round that £1.5billion deficit - cover the shortfall with borrowing. Which is where the ‘Heavy lifter' Group comes in.

This is a 15 strong working party of senior Treasury, Department for Transport, SRA, ORR and Network Rail managers who are trying to square the circle of meeting the demands of the Interim Review without adding to the Treasury's expenditure on public services. Increasing the RAB even further would allow more borrowing and the fiction that Network Rail is a private company would, in the Government's parallel universe, mean that the debt was not on the Government's books, even though my City chums will not touch it unless it has government support.

Continues.........

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