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Sea Containers didn't understand how the railway works
Train performance improved immediately after privatisation, before starting to decline from 1998. I attributed this surge to railwaymen getting back to the day job after the massive distraction of breaking up the industry and bidding for their futures.
During this brief spring the prevailing mood was one of cooperation. People might belong to separate organisations but they worked together in much the same way that they had before 1994. While the railway was now based on contracts between separate companies, the contracts could be put away in a drawer while management and staff got on with running the railway railway.
This might be termed the cavalier approach – personified by Gerald Corbett, Chris Green at Virgin and Christopher Garnett at GNER. For them, running the railway was more important than legal niceties.
This attitude was anathema to the contractual roundheads, with Tom Winsor as their Cromwell. For Winsor the contract was the key to performance within the overarching regulatory structure of the privatised railway. Rights and obligations had to be enforced – preferably with extreme prejudice.
Just as Cromwell's New Model Army brought shock and awe to the 17 th Century battlefield, so Tom Winsor 's relentless approach to contracts and licence conditions threatened of instant and massive retaliation on the players in the privatised railway. As you can read elsewhere in this column, Virgin cannot be displaced from its West Coast franchise, thanks to a Tom Winsor contract which, if called in, could still seriously damage Network Rail.
Two aspects of Tom's reign as Rail Regulator have now come back to haunt the Government. The first is the arcane subject of Moderation of Competition (MoC).
While privatisation was supposed to be all about competition – enshrined in the Peterborough process of train operators bidding for paths on an eight week cycle – initially it was necessary to protect novice franchisees against competitors if affordable bids were to be obtained. But, the aim was that as the industry matured this protection would be removed.
MoC was duly progressed by the Office of the Rail Regulator (ORR), the process running out of steam in 2004. It is these 2004 MoC rules which ORR now uses when deciding whether Open Access Operators should be allowed to introduce services.
Tom's second poisoned chalice, was the track access charge regime laid down in the first Periodic Review of track access charges which came into effect in April 2001. This saw Railtrack's income split into three parts – direct grants from government, fixed access charges paid by franchised TOCs and variable access charges, nominally reflecting the cost of wear and tear, paid by both franchised and open access operators.
This structure also reflected European Community Regulations, intended to break the power of the state railways and encourage open access operators. The European ideal was that any operator who could at least cover its direct costs should have access to the network.
But in its Future of rail White Paper, published in 2004, the Department for Transport rejected this policy. It claimed that open access operators should pay a ‘fair share' of the costs of the railway.
This was a meaningless concept within the 2001 access charges structure, since there was no way of calculating such costs. Given that, by now, direct grants to Network Rail were approaching £2.5 billion a year, working out a ‘fair share' was the sort of higher lunacy which keeps this column busy
“Future of Rail” White Paper‘Open access operators should bear a fair share of the costs of the railway through the access charges they pay. The ORR will apply these principles in considering future open access applications”. paragraph 4.4.10 |
Which brings us to GNER and threat to the franchise from open access operators Hull Trains and Grand Central. ORR concluded that an extra service for Hull Trains and three paths each way for Grand Central's Sunderland-London service had a higher claim to the (artificially) constrained capacity on the East Coast Main Line than GNER's proposed extra off peak Leeds services.
When ORR said it was ‘minded' to favour the open access operators, DfT Rail Director General Dr Mike Mitchell made it clear that the ‘Future of rail' policy on track access charges still stood. Why did Dr Mike pile in?
Well, I suspect that even back in February, it was dawning on DfT Rail that SRA had struck a deal too far in exploiting Sea Containers' red mist bid to retain the East Coast franchise. And an open access ORCATS raid on London-York flows could tip GNER over the edge.
Letter to ORRWhile we can understand an approach which is designed to reduce barriers to entering the rail industry thus improving competition, the fact that open access operators do not have to pay a share of the fixed charge seems to us to go against these principles. On the basis of the above we would expect, for example, all long distance operators on ECML to be charged on the same basis, all other things being equal. Dr Mike Mitchell Director General DfT Rail
13 February 2006 |
All of which brings us to GNER's case in the High Court seeking a judicial review (JR) of ORR's decision. The challenge was threefold
First, there was the charging regime. GNER claimed that for open access operators (OAO) to be charged only variable Track Access Charges TAC while it paid both variable and fixed charges was discriminatory.
GNER's second claim took this concept further. By not requiring Hull Trains and Grand Central to pay a share of fixed costs ORR's decision effectively represented unlawful state aid to the two OAO.
Finally, GNER claimed that ORR had breached its own policy by granting access to Hull Trains and Grand Central on routes for which GNER previously had the highest level of MoC protection. The new services would depend more on abstracting significant revenue from GNER than generating new ridership.
On the second day of the hearing, GNER withdrew its claim over MoC and abstraction, leaving TAC as the key issue for Mr Justice Sullivan to consider. As the judge put it ‘in a nutshell' GNER's complaint was that the two open access operators would not have to pay fixed access charges.
You can read Mr Justice Sullivan's official judgement in Professional Stuff in Alycidon Rail ( www.alycidon.com ) and I recommend it as a commonsense dissection of the Roundhead railway. A telling point was his conclusion that GNER's fixed access charge is ‘an artificial construct' which does not reflect the actual cost of maintaining the ECML.
‘The ability of franchised passenger operators to bear a mark-up above the marginal track access charges should be reflected through the franchise bidding process. We would expect that a bidder would take into account the level of the fixed charge in determining its costs for the purpose of a bid'. Mr Justice Sullivan |
He began by pointing out that in bidding for the franchise GNER knew what the fixed costs would be and allowed for this before setting the premium payment. Echoing a point made in this column in April Mr Justice Sullivan explained that a higher fixed charge would result in a lower premium or increased subsidy. ‘Therefore, even if the fixed charge were very low, then the level of fares set by the franchised passenger operator would not be affected as the lower fixed charge would simply result in a higher bid premium'.
‘The level of fixed charges faced by franchised passenger operators therefore has no impact on the relative competitive positions of franchised and open access operators' Mr Justice Sullivan July 27 2006 |
Another line of argument followed by Mr Justice Sullivan were the significantly different commercial conditions facing franchised and open access operators. Far from a defenceless GNER threatened by rampaging buccaneers, it was the open access operators who faced the greater risk
As he pointed out, franchise agreements provide Government-backed indemnity against increases in TAC following periodic reviews, incorporate cap & collar revenue-risk sharing agreements and also have force majeure clauses in the event of revenue shortfall due to external factors, such as the 7/7 London bombings.
In contrast, open access operators have no such protection against changes in access charges. The judge declared that imposing fixed access charges would be discriminatory because ‘ORR would be treating two very unlike cases as though they were alike'.
GNER had argued that the open access operators could afford to pay a contribution to fixed charges. Hull Trains and Grand Central had replied that the addition of a fixed charge on top of the variable charge would make their businesses unviable.
‘GNER is entitled to respond “well they would say that, wouldn't they?”, remarked Mr Justice Sullivan wryly, but he added that there was no reason to believe that the two operators would be able to pay the fixed charge, ‘not least, because unlike GNER they would not have taken it into account in any of their business plans'.
‘Nevertheless it remains a fact that since May 2004 (when Moderation of Competition protection for franchised operators was further reduced) there has not been a large number of applications for track access for open access operations. If Grand Central begins its services in December 2006, it will be only the second open access operator. Given the hurdles that any would-be entrant to the open access market has to surmount, that is hardly surprising, but the dearth of applications does not suggest that the market is capable of bearing any significant rate of return over and above existing charges'. Mr Justice Sullivan July 27 2006 |
This difference between franchised and open access operation ran through the judgment. Any attempt to draw comparisons between their overall positions would be ‘an attempt to compare chalk with cheese'.
Mr Justice Sullivan saw the two types of operator playing very different roles. Open access operators serve parts of the network not covered by franchised services, either because DfT did not identify the opportunity when letting a franchise or did not think its inclusion appropriate.
As for the ‘state aid' complaint, Mr Justice Sullivan said that GNER was ‘again' isolating one element of a complex regime which, when viewed as a whole, does not distort competition by favouring either franchised or open access operators. He added ‘the charging regime simply treats them differently because … they are different (even though their trains may be distinguishable to the individual passenger only by their different liveries)'.
‘It is also helpful to apply a measure of common sense when evaluating GNER's underlying claim: that competition between franchise operators and open access operators is distorted because the latter are given favourable treatment by the charging regime. If that really is the case then surely there would be many more track access applications by such operators eager to enjoy the benefits of such favourable treatment'. Mr Justice Sullivan July 27 2006 |
Mr Justice Sullivan also drew attention to the lateness of the objections. On Dr Mitchell's letters he remarked that it was ‘somewhat curious' that this was the first occasion on which DfT had raised this concern ‘about a long standing feature of the charging regime'.
In the same vein the Judge pointed out that GNER could have challenged the lawfulness of the access charging regime at any time since Hull Trains' first track access agreement in September 2000. ‘It is now ‘simply too late' for GNER to seek relief for Hull Trains' additional daily return service.
Moving on to Grand Central the Judge pointed out that GNER had been able to make allowance for the financial impact of a successful application from in its franchise bid. And the company ‘could and should' have challenged the charging regime at an earlier stage. Had this last minute JR application been successful, the introduction of fixed access costs would have wrecked Grand Central's business case, ‘rendering the application process pointless from the outset'.
Faced with this vindication of the Roundhead tendency, the cavaliers at GNER rallied and charged onto ORR's pikes yet again, led by Sea Container's President & Chief Executive Officer Bob Mackenzie. You can understand his reaction since you really need have followed the development of the privatised railway over the last decade to be able to take such a dysfunctional structure seriously.
Describing the Judge's decision as ‘truly extraordinary', Mr MacKenzie continued, ‘it has serious commercial consequences for GNER and for the Department for Transport. It undermines the profitability of GNER, which already operates to modest margins, and devalues a recently-awarded public contract agreed with Government and the East Coast franchise in perpetuity. It will also make bidders for other franchises elsewhere on the network more risk-averse'.
‘We believe we had a strong case to contest the ORR's decision. The real losers from today's judgment are not just those who believe in fair competition, but also passengers on the East Coast Main Line and other rail users on the network who may not see as much money reinvested into their railway'.
I won't try to untangle the argument and emotion in that statement. But Sea Containers is clearly in denial over the nature of the UK passenger railway.
Consider Mr MacKenzie's, further comment. ‘We will be discussing the serious implications of today's decision with the Department for Transport, as it is likely to jeopardise GNER's ability to pay some of the premium payments agreed with the Government over the course of our franchise. This cannot be what the Government intended to happen to any of its newly-awarded rail franchises'.
This represents a total misreading of DfT Rail's publicly stated hard line policy on franchising.
Shortly before GNER initiated its call for a judicial review DfT Rail published a new guide to franchise procurement which firmly ruled out rescues for failing new-style franchises. Under the new regime, other than in ‘exceptional circumstances', defined as those covered by cap & collar or force majeure, DfT will ‘insist' that a franchisee which is unable to operate to the price it bid should surrender the franchise.
This guidance may well have been a warning against any further ‘red mist' bids, where incumbent operators, desperate to retain the franchise at all costs, have bet on ambitious perpetual growth. DfT's guide comments that while it does not intend to ‘second-guess' bidders on the ‘realism of their bids', it has to take into account the ‘adverse consequences' of an unrealistic bid on passengers and on the long-term financial viability of the franchise.
DfT Rail emphasied that while past rescues may have been justified in a ‘relatively immature market with limited experience on which to base revenue and cost forecasts', today's market is ‘more mature'. Franchisees are now expected to build ‘resilience' into operational and financial plans to deal with possible changes ‘in the economic environment to which a passenger rail operation may be subject'.
But what about Bob MacKenzie's rhetorical final comments that ‘this cannot be what the Government intended to happen?' I'm not so sure'.
Here is an excerpt from the Witness Statement to the High Court hearing by Adrian Caltieri, GNER's Planning and Development Manager.
‘When it became apparent on 3 March 2005 that the DfT wished to proceed to enter into a franchise agreement with GNER, the issue of GCR's section 17 application, which was made following the submission of tenders for the franchise in 2005, was raised. The SRA immediately offered GNER protection in the Franchise Agreement against GCR obtaining consent to operate any service to London on the ECML in the form of such access amounting to a "change" which would enable GNER to seek compensation from the SRA. This protection was withdrawn by the SRA on 18 March 2005, just before GNER entered into the Franchise Agreement'.
It has since emerged that the SRA, which was then responsible for letting franchises, gave GNER an ultimatum - with a two hour deadline – sign the franchise agreement without the competition caveat or see the franchise re-tendered. According to Sea Containers spokesman ‘obviously, being faced with such an ultimatum at the eleventh hour was a surprise, given the value that had previously been offered. And the threat that the franchise would have to be re-tendered, if we did not sign there and then, put us in an impossible position. What is worse is that the verbal assurances that the SRA gave us at the time, that open access would not adversely affect GNER, have now been shown in the High Court to have been no use whatsoever'
Now this was a massive bluff by SRA over a minor issue. What SRA knew, but GNER didn't, was that the second place bid from Stagecoach also included the competition caveat but the Net Present Value of the premium was a around £300 million less.
So if GNER had said ‘no caveat, no deal', SRA would have faced the prospect of explaining to the National Audit Office why it had paid more for the franchise than was necessary. But GNER Chief Christopher Garnett had admitted that emotion played a part. Ae has said, ‘We were determined to hang onto GNER. We spent nine years building it up. We were not prepared to let it go to someone else'.
According to informed sources such bluffing is not uncommon in franchise procurement, but this one seemed to have been particularly aggressive. SRA had retained a consultant to lead the InterCity East Coast franchise procurement and, as I understand it, it was a call he received that triggered the bluff.
What made it really nasty was that GNER were, allegedly, also told that if they didn't sign, then the franchise would be re-tendered without their involvement. No wonder that DfT Rail wanted to scupper open access on the ECML, to the extent of Dr Mike challenging the access charge regime.
Which brings us back to the last of the cavaliers, Chris Garnett, who was cruelly exploited by Government. His announcement, shortly before the judgement, that he was retiring brought more genuine tributes and expressions of regret from veteran railwaymen than for anyone I can remember. ‘A breath of fresh air' was a recurring theme.
I always think of him as the prince of customer service and remember an occasion when we went forward to footplate an IC125 and Chris stopped off at the buffet for some muffins and a coffee for the driver. Whoever made that phone call cost the industry a good man and Edmund Burke summed up his departure, ‘the age of chivalry is gone. That of sophisters, economists, and calculators has succeeded'.