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INFORMED SOURCES January 2007

ROSCO profits – DfT hoist by its own petard

Oh dear, while the ROSCOs may or may not be making excessive profits, ORR says the long term solution is to restructure franchise procurement

Last month we had the Tories somewhere to the left of the redoubtable Chairman of the Commons Transport Committee Mrs Gwyneth Dunwoody on franchising policy. This month we have the Chairman of the Office of Rail Regulation Chris Bolt joining Gwyneth on the same subject to create what I have dubbed the ‘Axis of Antipathy.

On 29 November ORR published the findings of its market study of the leasing of rolling stock for franchised passenger services. Alycidon Rail has the findings in full in Professional Stuff ( www.alycidon.com , together the Transport Committee report.

As you will recall, DfT Rail had been bullying the ROSCOs for some time now (this column passim) to hand back the £100 million a year the Department estimates they make in excess profits. And when ORR published its findings DfT Rail insiders considered it a ‘good' result.

There was less enthusiasm among the ROSCOs. As one Informed Source put it, ‘We thought it was a positive outcome until we reached the conclusions'. And it is hard going – all 134 pages of it, with almost every useful piece of financial information redacted.

About the only figures left in were DfT Rail's own estimates of the excess profits, given as present values, as opposed to cash figures. That really got up the ROSCOs' noses – but DfT loved it.

According to a DfT spokesperson, ‘today the ORR has concluded that ROSCOs are making "excess profits". We believe that a credible estimate of the scale of these would be up to £175m a year'. Equating the £175m a year to ‘an annual 8% increase on all season tickets' and ‘around £2bn over the lifetime of the train leases in question', DfT Rail said that the government believes that this money would be ‘better invested in the rail network to deliver further improvements for the travelling public'.

Rich

Coming from the Department responsible for the investment- free, premium-full South Western franchise, that is rich. But any smugness must have faded when it became apparent that Chris Bolt had parked an armoured division on DfT Rail's lawn.

Because instead of focusing on the specific subject of DfT Rail's complaint, train leasing costs, ORR has set off to find out why market forces, which to civil servants are always assumed to reduce prices, aren't working. And guess what? The market is not working because of the franchising structure and the franchise letting process. It is all DfT's fault.

Now, in Competition Law terminology, factors which work against an efficient market are called ‘Features'. And Table 1 shows the features identified by ORR in the case of train leasing prices. How many of those are down to the ROSCOs?

Table 1

Consultation

ORR is keen to emphasise that this is a consultation document. While it is ‘minded' to refer the leasing of rolling stock for franchised passenger services and related maintenance services to the Competition Commission for a market investigation under section 131 of the Enterprise Act 2002 (EA02), ORR adds that during the next three months of consultation it intends ‘to hold meetings with all key parties to seek views on our analysis and to inform our final decision'.

Emphasising the provisional nature of the findings ORR adds, ‘the information provided to us both in writing and at these meetings will help us to develop our initial thinking on remedies so that we can advise on potential options if we decide to refer the markets to the CC'. Note, ‘if' not ‘when'

And a referral to the CC is by no means certain, given ORR's emphasis on the influence of the franchising structure on the market. At one extreme, the three months of consultation could lead to the conclusion that franchising policy is the primary cause of market failure, not the commercial policies of the ROSCOs. At the other extreme, the consultation process might validate the provisional findings, resulting in a reference to the CC.

But third option could be the compromise outcome. ORR is prepared to consider proposals for changes to the market which could increase competition and address DfT Rail's concerns. This could avoid a referral and the ROSCOs have some ideas on how changes to DfT Rail policy, for example, by reducing residual value risk, could cut lease rentals leaving everyone sort-of happy.

Happy

Indeed, referring to ORR's criticisms of the franchising process DfT Rail said that it would be ‘happy' (I bet) to explore possible changes during the consultation. However the Department found it ‘difficult' to see how this could have a ‘significant impact' on the current market ‘given the technical and operational characteristics of the trains and the market of which they are part'.

Naturally,, ORR recognises that DfT Rail francise procurement policies are a matter for Government and that franchising policy is driven by a number of considerations of which rolling stock lease terms is only one. But ORR believes that there is a balance to be struck.

It stresses the importance of ‘ aligning incentives' between franchise objectives and other industry relationships ‘to ensure a satisfactory outcome for all concerned'. Thus while DfT Rail believes that the ROSCOs are charging higher lease charges than would be the case in a competitive market, ORR counters that ‘changes to the current approach to franchising could facilitate addressing this'.

To understand how far ORR has gone in not seeing the trees for the wood consider Table 2. This lists the questions ORR is posing in its consultation. How may are about the cost of leasing trains? Well, Nos 12 and 13 for sure, and perhaps No 9.

Table 2

Competition

Part of the problem is the lack of competition in the market served by the ex-BR fleets covered by the Master Operating Lease Agreement (MOLA). And this too is down to DfT Rail

Limited competition

In its provisional findings ORR considers at length the lack of opportunities for competitive bidding for rolling stock at franchise renewal. DfT had argued that franchise bidders rarely have any real choice other than to take on the ‘incumbent' rolling stock because ‘most or all' of the potential alternative rolling stock is already on lease elsewhere.

Quite. One gets the impression the Professors in Faculties of the Bleedin' Obvious across the nation have paid for Christmas with consultation work for DfT Rail and ORR. According to DfT, procurement of new trains has tended to be an option only in cases where ‘retaining the incumbent stock is not viable because of wider considerations'.

ORR concludes that in ‘many instances', TOCs do indeed have a ‘very limited' choice when selecting passenger rolling stock. In ‘many cases', and for ‘various reasons', a new franchisee has few ‘attractive alternatives' other than to re-lease the rolling stock it inherits.

Here the dreaded artificial construct emerges again.

ORR, says that this lack of surplus stock gives the ROSCOs a ‘significant degree of strength' in the negotiation of leasing terms with new franchisees. ‘Hang on', point out the ROSCOs, under their Code of Practice, they must not discriminate between bidders at franchise change. Thus everyone gets the same prices which are written into the franchise bids.

And as we know, in the latest franchise re-letting Porterbrook has been forced to reduce lease rentals on the five year old Class 458 fleet to ensure continuity of use by South Western Franchise. This has allowed SW to hand back the Angel-owned Class 442 units. And does anyone seriously think there were alternatives, other than new build, to say, the Class 455 fleets?

Indifferent?

There is also an elephant in the corner. MOLA fleet rentals were based on indifference pricing, with the worthy aim of ensuring that old trains did not price new stock out of the market. Ten years on, this is what ORR has to say. ‘The commercial case for introducing new build stock is limited by its high cash costs'. It adds that new build activity is currently ‘limited' in the absence of Government support.

So if DfT Rail succeeds, the price of existing stock will fall, making new trains even more unaffordable. Good new for Gordon Brown, tough luck, Derby .

A mismatch between the franchise lengths and new train lead times also makes new build unattractive. But this situation was foreseen at the start of franchising and was one reason for the introduction of Section 54 powers which enables DfT Rail to direct succeeding franchises to use specified fleets.

Section 54 also increases the residual value of a new fleet, reducing the rental cost. For example, the SWT Desiros were initially procured under a 20 year franchise. When the Strategic Rail Authority couldn't make 20 years work, it faced the prospect of higher subsidy because of the increased residual value risk. Section 54 powers extended the lease period and reduced costs .

Remedies

ORR also considers the ‘remedies' available to the Competition Commission, should a reference be made. And, once again, no doubt to screams of rage within New Minster House ORR returns again to the shortcomings of the franchising market within which the ROSCOs operate.

In fact ORR believes that a number of ‘i ncremental improvements to the franchising process could provide sufficient ‘liquidity at the margins' (spare stock in other words) to give TOCs more leverage in their dealings with the ROSCOs. Unfortunately, most, if not all, the remedies it proposes would have to be in place to have the desired impact.

For example TOCs would be more likely to be innovative in their bids if franchises were long enough to encourage increased spending. Or how about aligning franchise end-dates to create a large pool of stock coming off-lease simultaneously.

This, thinks ORR, would encourage ‘more-innovative' solutions to rolling stock provision. DfT Rail could also help by being less specific in Invitations to Tender and ensuring that that ‘deliverability' criteria do not create an ‘unnecessary disincentive' against changes of rolling stock during a franchise. In other words, as with South Western, the franchise agreement assumes that you ‘run what ya brung' for the next 10 years

More remedies

There's more. Although the second group of suggested remedies is qualified by ORR as having ‘wider implications outside rolling stock that would need careful cost/benefit evaluation'.

Remedies in this second group include the modest proposal for a ‘major rethink of the franchising model' which would allow TOCs to take their commercial decisions for new rolling stock procurement ‘based purely on their own assessment of future revenue and the needs of the passenger'. You can see that going down a storm with today's Stalinist Ministry of Railways, although it could have appeared in a speech by a Transport Minister selling the benefits of privatisation circa 1993.

And how about rolling stock being provided through finance, as opposed the current operating, leases. These would appear on TOCs' balance sheets, ‘rebalancing the incentive structure between stakeholders'. I can't see that going down well with the Treasury. Nor would ORR's proposals for encouraging new build - longer franchise lengths plus Government sponsorship of new builds which to introduce some surplus into the market.

ROSCO remedies

Conceding that changes in these two groups would take some time to implement – probably until hell freezes over, ORR argues that ‘ at the very least in the short-term' ‘supplementary behavioural remedies' could be needed for pricing. What they mean is cutting the ROSCOs' MOLA fleet rentals. Price setting or price control for the ROSCOs is exactly what DfT Rail wants. But think about the practicalities. For example, there is plenty of competition for new build stock. So blanket intervention covering both the MOLA and post-privatisation fleets ‘might not be appropriate', according to ORR.

Nor would setting a ‘fair' price for each class of stock be straightforward because individual ROSCOs and TOCs have had different policies on refurbishment and upgrades. How, for example, would the different specifications of re-engineered Class 43 Intercity 125 power cars be reflected in the centrally determined lease rentals? In addition, ORR comments that ‘calculating asset values is difficult in the case of assets that have not been individually sold on the open market for, in some cases, a number of years'. Yes, what is a Pacer worth nowadays?

Just imagine trying to set a ‘fair' price for a Class 313. Price control Undaunted ORR concludes that, price controls have been devised for other markets and industries. Were the Competition Commission to consider price remedies ORR believes appropriate solutions could be found. A tantalising prospect of new artificial constructs to come.

At the end of the 134 page document there is a 27 page appendix analysing attempts to benchmark a fair rate of return for the MOLA fleets. Virtually every number is redacted, leaving little of practical value.

This is all about valuation of the assets on which to base a rate of return and is an acronym rich environment. I particularly like WACC (Weighted average Cost of Capital). But of course we are fast getting away from the real-life leasing world to the sort of abstract and abstruse calculations used to determine things like Network Rail's income.

Detriment

To illustrate the problem, the ROSCOs' forecast returns on MOLA stock look high when calculated using some asset valuation methods, but much more modest when calculated using others. Meanwhile ORR has not made up its mind on how to value the ROSCOs' assets.

For example, if the depreciated price of the fleets at privatisation is used, DfT Rail calculates that what ORR calls the ‘consumer detriment', and we call ‘excess profits, from the ROSCOs' charging above the ‘competitive level' is £157-£177m a year.

But, of course, the ROSCOs were subsequently sold-on, with the prices paid largely based on the net present value of the long term lease rental cash flows being acquired. If the excess profit calculation is made on the depreciated purchase price paid by the current owners, the excess profits fall to £34-£70m a year. Note these are present values not cash figures.

DfT also ran its program using depreciated cost of replacement new trains. This was based on a small sample from the MOLA fleets and gave an excess profit figure of £23-£25m. However, ORR does not favour this methodology.

ORR did sums itself and confirms that the results are ‘critically dependent' on the asset valuation methodology used. Duhh!. It concluded that estimates of the ROSCOs' Return On Capital Employed on MOLA stock were high when calculated using the original value of the MOLA fleets but much more modest when subsequent revaluations were used. Some ROSCO MOLA fleets have been revalued several times.

So, there we are then, another three months of infighting. Still, at least ORR has been more than open handed – everyone is unhappy.

Fun

Of course there is some fun within the 134 pages. Take this table for example, produced by DfT Rail. Note some of the Inter-Regional/Outer suburban units in the 25kV AC box. If you could squeeze an 18 car TGV clone through Thameslink FCC's capacity problems would vanish.

Figure 23 - Product market segmentation – inter-regional / outer suburban routes (speed requirement of 90/100mph)

And finally

Gosh, I've been so busy, what with the reliability report and features for this special issue that there's only space to wish readers a Happy Christmas and a lively new year.