An update on the UK rail franchising market

The UK has a mature rail franchising market and one which is currently attracting substantial interest from international operators.

Why is this? The franchising process is well structured, clear and transparent; demand for rail services is increasing; the European market is beginning to open up and the UK provides a first step into Europe and into the competitive process.

The first rail franchise in the UK was let in 1996. Since then 25 franchises have been let, and 10 have been replaced, one franchisee has been stripped of its franchise, several have been transferred to management contracts, the infrastructure company has gone into administration and then been taken over, and two franchise owning groups have been taken over by others. It has not been a dull eight years.

During this busy period the franchising model has evolved as the Government1 has learnt and the industry matured. The current model was developed through discussion and consultation with the industry and focusses on two distinct phases – pre-qualification and bid.

In the pre-qualification stage, launched with a notice in the Official Journal of the European Union, the Government is particularly looking for operators with the necessary financial wherewithal, commitment to continuous improvement, and with the necessary operating expertise to run a punctual and efficient railway. It is easy to write about delivering punctual good quality passenger services and less easy to do in practice, hence on the management and operational side, interested parties must demonstrate their capability either through evidence of their existing operations in the UK and abroad or through the demonstrable competence and experience of their team. Financial strength and commitment to continuous improvement are both seen as vital for delivering amid the changes which will affect the business over a 7-10 year franchise life and to protect the value of the business, since that is an asset which will return to Government ownership at the end of the franchise.

In this pre-qualification stage each applicant is looking to ensure that their own merits are well understood by Government and that once pre-qualified they have a reasonable chance of securing the franchise. In line with good procurement practice, the Government has a policy of pre-qualifying 3-5 bidders only. This policy has received considerable support from industry and from investors, since putting a full bid together typically costs millions of pounds and bidding costs may range from £1-2 million and only a relatively high probability of success makes such investment worthwhile.

Once bidders have pre-qualified they receive an Invitation to Tender setting out what the Government would like to buy (the base case). Various mandatory options are also required. Bidders have access to a data room with details of the history of the business they will be taking over if they are successful. A standard franchise template has been developed and a customised draft specific to the particular competition is also provided to bidders. Bidders are given approximately three months to develop the details of their bids and to build positive relationships with the stakeholders they will be serving if successful, e.g. passenger representatives, local Governments and business groups.

Bids cover all aspects of the approach to the franchise and are evaluated on two dimensions – the quality and robustness of the approach to operation of the franchise and the financial stability of the subsidy requirements (or premium to be paid where costs can be covered from the revenue generated by the services).

The evaluation period is approximately three months, including clarification from bidders and the necessary approvals for award of the contract. Negotiation with the preferred bidder should take a month and at least two months are required for the transfer to the new operator. The whole process from OJEU notice to start of the new franchise is therefore approximately a year to 15 months long.

Details of the franchising process and the SRA approach to evaluation are available on its website www.sra.gov.uk and are updated regularly as the approach evolves.

Demand for rail services is increasing

There are currently 23 franchised operators in the UK all under contract with the Government for a period of 7-15 years. The smallest franchise is Island Line and has an annual turnover of £4.3m (03/04), 40 staff, 24,000 trains per year and carries 2,465 passengers per day, whilst the largest franchise in terms of passenger kilometres is South West Trains which has an annual turnover of £433.7m (03/04), 5,250 staff, 584,000 trains and carries 393,150 passengers per day. The franchises are broadly definable into three different categories: long distance high speed, commuter, and regional.

Last year these franchises carried, between them, over one billion passengers – for the first time in 40 years. The industry, as with rail industries in most of the industrialised world, has struggled against car and airline competition since the Second World War. Eight years ago it was believed that the market would continue on its downward path but (with the exception of the years after the Hatfield derailment in 2000 in which punctuality was significantly reduced) there has been year on year growth of passenger demand.

On 4th November 2004, the Daily Telegraph quoted a market analyst at Dresdner Kleinwort Wasserstein, as saying that rail had shown a “remarkable turnaround in two years. It’s gone from being an absolute basket case industry to something acceptable and valued by the markets”.

That recovery has four key sources:

1. This growth of demand and the recovery from the Hatfield experience – some operators and their owner groups are now benefiting from this growth of revenue on a high fixed cost base. Passengers are also experiencing a better quality of service as on-time performance improves and the new rolling stock and infrastructure projects are delivered.
2. The solidity of the new franchising template which protects operators and Government alike from the extremes of risk – with levels of revenue support and share being agreed at the outset of the franchise.
3. The strong financial footing of Network Rail, the infrastructure provider. Network Rail has just launched a major debt issuance programme backed by the Government to ensure that it can fund proper operation, maintenance and renewal of its network to meet the needs of its customers under the oversight of its independent regulator. In addition, Network Rail has demonstrated that it can deliver on commitments to upgrade the infrastructure – with improvements in the West Coast Main Line at last being delivered. The West Coast Main Line project was widely seen as the fatal blow for Railtrack. They had contracted to deliver an upgrade to 140mph capable infrastructure on the route at initial estimates of £2 billion. When Railtrack went into administration the estimates of the cost of the project were £13 billion and that sum will only deliver 125mph infrastructure.
4. Confidence in the re-franchising process. Two years ago several franchises were struggling financially and there was little experience with the re-letting process. There had been a couple of false starts where operators had developed expensive bids for franchises including substantial infrastructure investment projects but the Government had not awarded contracts. Confidence has been restored with the publication of the SRA’s Franchising Policy Statement in November 2002 and the development of clearer specifications for bidding and a transparent evaluation. Finally, confidence has been built up as theory has been turned into practice and the published programme has been delivered. Great Anglia, ScotRail and Northern franchises all now operate on new franchises.

The European market is beginning to open up

The UK has led the European market in separation of infrastructure and operations and in franchising of operations. Other countries have now restructured and are beginning to introduce competition for parts of the operational delivery of service – e.g. The Netherlands in 1995, Denmark in 2003, and Germany via the Lande for regional services.

This means that European rail operators want to learn about how to compete for franchises. They need to be ready to compete when their own Government starts to open up their market. In addition, some managers are aware, particularly those in companies which have been privatised or commercialised, that they must build up other aspects of their business to ensure that if (and probably when) they lose market share in their home territory they have protected overall growth of their business through these other avenues.

Internationally, the UK is seen as a safe route into Europe where European franchising will become a substantial growth market over time. The English language is part of this attraction for some; the transparency and maturity of the market for others. It also provides a base from which these businesses find it easier to begin to understand the European market which can be less transparent (sometimes because there are several markets within one country; sometimes because of the political relationship with the incumbent operator) and in which relationships with the private sector are just being developed. The strength and knowledge of the procurement body is also important to bidders because it provides them with security about their likelihood of success and a level playing field on which to compete.

The maturity of the UK market and the knowledge that the programme of franchising is being delivered over time means that bidders know that whilst they may not be successful on their first attempt that there will be further occasions in which they can use knowledge they gain from that first bid. In addition international operators can demonstrate to their investors that whilst one international operator in the UK failed others have succeeded (Keolis and Ned Railways).

The future of UK franchising

Currently the SRA has two franchise competitions running – for high speed intercity services on the East Coast Main Line and for commuter services in Kent. In the latter franchise high speed services will be introduced for domestic use on the Channel Tunnel Rail Link from 2009. These competitions will be completed during 2005. aNew competitions are soon to be initiated through OJEU for:

• The Greater Western franchise (covering long distance, commuter and regional services to the West of London from Paddington and into Devon and Cornwall, bringing together three existing franchises: Great Western, Thames and Wessex).
• The Thameslink and Great Northern franchise providing services from the North of London through London into the South and South East of England.

Thereafter, probably for commencement in 2007, the programme will include South West Trains and following consultation on the restructuring of the Central franchise, may include Silverlink and Cross Country. The Department for Transport and SRA are currently working with the operators to determine this programme to ensure that the restructuring of the franchise map does not result in higher industry costs and does deliver more effective operations.

The move from the SRA to the Department for Transport is likely to take place next year and the Government announced on 25th November 2004 the new structure for the Rail Directorate within the Department for Transport. This new directorate will be responsible for the operation of the franchising process and it has already expressed via consultation with the industry a commitment to the transparent and clear process described in this article. Investors should expect an evolution – not a revolution.

Reference

1. This document refers to the Government as the procuring entity. The Government in the UK has chosen to procure through two different organisations to date – the Office of the Passenger Rail Franchising Director (OPRAF) and then the Strategic Rail Authority (SRA). New legislation is currently being debated in Parliament to transfer responsibility to a third organisation (the Department for Transport). The Department for Transport has consulted the industry on some changes to the procurement practices it will adopt but it has done this in conjunction with the SRA and the substance of the statements within this article is unchanged. Passenger Transport Executives are currently co-signatories of franchises operating in their areas and in Scotland the Scottish Executive will become the procuring agency under the Governments current proposals.