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INFORMED SOURCES February 2006

Railways in hock

By 2009 Network Rail will need £2billion a year for debt interest and amortisation

So far we have covered only what Network Rail is planning to spend on operations, maintenance and renewals. But its income also has to cover interest on the company's debt and amortisation of its assets.

ORR's Interim assessment reveals the sums involved in the next control period. With net debt reaching £21 billion at the start of CP4, and rising to £24 billion over the five years, interest payments alone will be £1 billion a year.

Does £1 billion a year ring a faint bell? Yes, at today's prices it represents the total subsidy needed by British Rail at the peak of the last economic cycle.

What ORR is doing in PR2008 is determining how much revenue Network Rail needs to earn to run the business. Revenue has three main elements - operating and maintenance expenditure, amortisation and the return on the Regulatory Asset Base (RAB) which pays the interest on the debt.

Operations and maintenance are covered on a ‘pay-as-you-go' basis, but renewals and enhancements are funded through the amortisation allowance. If renewals expenditure exceeds amortisation, Network Rail has to borrow to cover the difference. Each year, the expenditure on renewals and enhancements is added to the RAB.

Don't get too hung up about the detail of the RAB. It is simply a regulatory device, enabling ORR to calculate a notional return which is is used to pay the interest on the debt. This return also forms part of Network Rail's revenue – in other words it comes from the farepayer and the taxpayer. Table 1 shows how expenditure and revenue will match up in 2008-09.

Table 1

Source: ORR

But in CP4, ORR is looking to cut amortisation to £1 billion a year. Add the same again for debt interest payments, and you can see why ORR is concerned by the way these fixed payments limit the scope for reductions in support for the railway.

As one ORR Informed Source put it, ‘After amortisation and interest payments Network Rail will have to run very fast on efficiency just to stand still'. Currently Network Rail is forecasting just 2% a year efficiency savings on maintrenance and renewals in CP4 while debt and the RAB will be increasing.

ORR's £1 billion a year amortisation allowance is based on what it thinks Network Rail would need to maintain a steady state railway. In reality, over the five years of CP4 renewals and enhancements are forecast to average between £1.54 billion and £2.21 billion a year, depending on activity levels and efficiency gains.

Network Rail will borrow to cover the difference and by the end of CP4 in 2014/15, its net debt will have increased to around £24 billion. In 2004/05, the figure was £15.65 billion.

Similarly, the RAB will have grown from £18.77 billion on April 1 2004/05 to £32.5-32.9 billion by the end of CP4. ORR is projecting an annual rate of return on the RAB of between 3.5% and 4.4% in the final year. Go figure, as they say

Re-privatisation?

Having got your brains round that, I should warn that ORR is to consult on Network Rail's future financial framework as part of PR2008. We can look forward to a consultation document in July or August this year.

Regulators are absolutely besotted with incentives and the consultation will be part of a wider consideration of the role of incentives in encouraging Network Rail to ‘achieve and outperform' regulatory expectations while meeting the demands of its customers and funders. Seeing that Network Rail's current board of directors needs the prospect of a 60% bonus to get out of bed and do the best job they can, ORR has its work cut out.

But one thing ORR will be looking at is the possibility of allowing Network Rail to raise additional capital on the market. Why bother, one wonders, given Network Rail's quasi public sector status?

Not only is half its revenue requirement paid as direct grants from government, Network Rail's borrowings are covered by a government backed Financial Indemnity Mechanism (FIM). Should Network Rail default on its interest payments, the government would meet the company's liabilities.

This gives Network Rail access to low-interest debt. And since debt is risk free, ORR might as well set the rate of return on the RAB to cover debt interest. But ORR reckons that rate of return above the cost of debt could incentivise Network Rail‘s management to take risks.

What sort of risk? Well investing in new track plant to achieve higher efficiencies which might not materialise. And here we come across a dichotomy.

After the demise of Railtrack weren't we told by that nice Mr Darling that Network Rail would be a ‘not for dividend' company, with the assumption that any ‘profits' would be ploughed back into the railway? Well according to ORR Network Rail has a ‘commercial (“for profit”) status'. Not only that access to new debt would allow the government to reduce progressively the amount of borrowing covered by the FIM.

This, in ORR's alternative universe would start the process of transferring risk from the taxpayer and funders to investors. Yes, privatisation lives.

Indeed Network Rail is currently examining the costs and benefits of raising capital outside the FIM, with the inteest rate linked to the company's financial performance. This, claims the company, would open up more flexible long term financing.

Then ORR spots the dichotomy and slips in a proviso, Since Network Rail depends on state subsidy to pay its interest bills ORR would need proof that the benefits of borrowing outside the FIM would outweigh the higher interest charges.

Continues.........