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INFORMED SOURCES February 2006

Railway costs – struggling with the unknowns

ORR and Network Rail have a lot to find out in the next 18 months

On 15 December the Office of Rail Regulation (ORR) published the first major document in the 2008 Periodic Review process. This will determine the level of support the railway will need for the five years starting 1 April 2009 .

Initial assessment of Network Rail's CP4 revenue requirement and consultation on the financial framework (henceforth ‘Initial assessment') summarises what is known about Network Rail's future costs and income. It forms the starting point for DfT Rail's High Level Output Specification – the railway it wants from 2009, and the Statement of Funds Available – how much it is prepared to pay for this aspiration.

This process was laid down in the Railways Act 2005. It is meant to stop a repeat of the 2003 Access Charges Review when the Rail Regulator took these decisions, in the absence of guidance from the government, and the Treasury had to pay up. The mechaninics of the process were covered in the October 2005 Infomed Sources (on-line in the archive at www.alycidon.com)

Since there is a lot of ground to cover this month, I have introduced this quick reference guide to Regulationspeak, which may help when the going gets techie.

Into the unknown

Chris Bolt , Chairman of the Office of Rail Regulation, could well have opened his foreword to the Initial assessment with Donald Rumsfeldt's musings on knowns and unknowns, which, as you will see, is particularly apposite to PR2008.

Instead he said that to carry out their roles under the new process ministers must be ‘well informed about the cost and demand pressures on the industry and the opportunities for improved efficiency'. Well yes, but it soon becomes clear to readers that even the ‘known knowns' are currently pretty sketchy.

With less than 18 months to go before ministers have to be sufficienctly ‘well informed' to publish their HLSOs and SoFAs there is a big workload ahead for all concerned. As ORR admits, there is ‘a great deal of uncertainty' surrounding Network Rail's revenue requirement for CP4.

It warns ‘m uch more data needs to be collected, analysis undertaken, discussions held, and many more decisions remain to be made before we determine the final output expectations, revenue requirement and access charges'. I repeat – 18 months to go.

ORR's basic source of data for the Interim assessment is Network Rail's 2005 Business Plan. To give DfT Rail a rough idea of what to expect, ORR has developed two scenarios covering the theoretical extremes of the likely income requirement.

For the lower limit, ORR assumes a low level of maintenance and renewal activity implemented with high efficiency. The upper limit assumes high levels of expenditure at low efficiency.

Table 1 Typical CP4 net revenue requirement by Network Rail

All figures £ 2004-05 prices

Source: ORR

Table 1 compares expenditure in CP4 for these two scenarios with the actual figures for CP3. As you can see, the annual averages for the two extremes are broadlly between £500million and £1 billion less than the average for CP3. Table 2 shows how the two scenarios compare in terms of expenditure.

Table 2 : Possible range for the CP4 post-efficiency expenditure

Source: ORR

Table 3 is a chart I prepared earlier. It shows how much support the railway will require in 2008-09 – the last year of CP3. As you can see it comes to about £4.7 billion. While Transport Secretary Alistair Darling has disowned his official who suggested that cutting support for the railway to £3-3.5 billion would keep the Treasury off DfT's back, you can see how this number might be achieved.

Table 3

Support for railways 2008/09

All figures £ millions

Source: RBI analysis of government figures from various sources

At some point between ORR's scenarios, a moderatly busy, moderately efficient Network Rail could save, say, £750 million a year. A few more bonkers back-end-loaded franchise bids could cut support to the TOCs by £250 million a year.

So the disowned aspiration could be feasible. But at this point we have another ‘known unknown'.

Remember that PR2008 is about whole railway costs, not juct track access charges. And while back end loading promises much on paper, Informed Sources at the ORR are already worried by the screams of pain emerging from recently let franchises, such as GNER and One. And these franchises have yet to get into the heroic growth aspiration phase which drives the later years of modern premium profiles.

Chris Bolt and his team have a lot of railway experience under their belts. But while they have some confidence in Network Rail's ability to deliver cost savings on the track, they can't help noticing that the SoFA for CP4 will be dominated by the later years of franchises currently being let. Can ORR trust the TOCs to deliver?

Fig 1

Source: ORR

Actually, ORR doesn't entirely trust its Network Rail estimates either. At this ‘early stage' of PR2008, ORR warns, it is ‘quite possible' that Network Rail's actual revenue requirements will be outside its illustrative ranges, as a result of new information emerging or ‘material changes' to assumptions or output requirements in the Ministers' HLOS.

Maintenance

So much for the indicative numbers. What confidence can we place on the detail behind them?

Not a lot, according to ORR. While ‘significant reductions' in maintenance expenditure are being achieved, ORR points to a lack of quantitative information on these activities and, particularly, the relationship between work paid for and outputs achieved.

So tenuous is this relationship that ORR can only assume that pounds in the budget equate directly to pounds in the ground. Given that ORR has spent, and is spending, millions on trying to resolve this known unknown, and that Network Rail's own benchmarking suggests that UK costs are high compared with similar activities on European railways, this really isn't good enough. Nor is it likely to be resolved in between now and July 2007 when the HLOS has to be brought down from the mountain.

But assuming, as it must, that Network Rail is getting value for money, and stripping out the minimal 2% a year long-term efficiency gains forecast in BP2005, ORR estimates that maintenance activity will fall by 2% over the five years of CP4. And here's another known unknown.

Network Rail claims that increased track renewals will reduce maintenance cost. ORR accepts that there is a relationship between renewals and maintenance requirements, but wants proof of the trade-off.

As a result, Network Rail's submission for CP4 will have to ‘provide greater clarity…than has been possible in the past'. The final version of this submission is due in October 2007.

Renewals

Despite all the work by ORR uder Tom winsor, the effectiveness of renewals expenditure is yet another area of opacity. That said, ORR has sought to improve its understanding of Network Rail's ‘engineering policies, forecasting methodologies, key issues behind renewal plans for CP4 and the principal assumptions that underpin the business planning process'. Phew!

This work has allowed ORR to apply its own analysis of ‘risks and opportunities' to Network Rail's expenditue projections. The result is ‘plausible upper and lower estimates' for the levels of activity required to deliver the BP2005 outputs and sustain the network.

More unreality. He we have the biggest organisation in the railway industry, with a turnover of more than £4billion being double guessed by a small team of people and their consultants who will tell it what its expenditure on maintenance and renewals should be when no one really understands the link between expenditure and results.

For example, ORR has focused on the big spending disciplines – track and signalling renewals and structures. And has found that the ‘robustness' of the underlying analysis and the accuracy with which work volumes have been specified, varies.

True Network Rail is ‘making progress' in understanding both cost the links between traffic levels and the amount of work needed to sustain a given level of outputs. But, the recurring refrain is ‘much remains to be done'.

For an example of praising with faint damns, how about this ORR qualification of analysis to date. ‘In broad terms Network Rail's activity plans do not appear to be unreasonable projects at this time'.

Steady state

In the 2005 Business Plan, renewals volumes (Table 3) are set to rise over the next two years and then continue at much the same level through CP4. All those identical numbers from 2008-09 onward look very ‘indicative' to me, yet they have to be firmed up if the HLOS is to be costed accurately.

Table 4 : Network Rail's BP2005 projections of CP4 renewals activity

Table 5: Pre-efficiency projections of CP4 renewals expenditure

Anyway, ORR has done its best and produced its own high and low cost estimates for renewals expenditure in CP4 (Table 5). Except for signalling, the upper ranges of its projections for individual categories are ‘at or above' Network Rail's BP2005 figure.

Signalling

Signalling remains a known unknown. Joint work during the medium term signalling review has indicates that the BP2005 renewals figures (Table 4) are ‘substantially overstated'.

Where BP2005 puts total expenditure on signalling renewals in CP4 at £3.9 billion, ORR's separate analysis estimates it at £2.5-2.7billion, a massive £1.2bn or one third below the number the people actually running the business first thought of.

Signalling expenditure is quantified in terms of Signalling Equivalent Units (SEU). Examples of an SEU are a signal head or a point end.

Network Rail in BP2005 proposed an annual renewal rate of 1900SEUs. ORR is taking 1700SEU/year as its lower estimate.

Few enhancements

ORR's Initial Assessment excludes major enhancements such as Thameslink 2000 which could come within CP4 but have yet to given a ‘firm start date'. BP2005 identifies only £617 million of ‘committed enhancements for CP4, with a further £200 million planned but not committed. This conpares with just under £2.3 billion being spent on enhancements in the current Control Period, including £660 million on the West Coast Route Modernisation.

Identified enhancements in CP4 include work at stations under the Disability Discrimination Act, preparatory work for the European Rail Traffic Management System programme and developments at Kings Cross. With atypical optimism ORR expects that as DfT Rail develops the HLOS ‘further enhancements are likely to emerge'.

Continues.........