On operation of franchises by overseas national rail operators

[whole diary]

[grahame]

I have been asked to share this link by a correspondent in Bristol whom I have invited to join the forum and post on his own account so that he can discuss and answer questions - see (here)

https://www.facebook.com/PeoplesMomentum/videos/383216592023734/

CTRL^▸ (Channel Tunnel Rail Link) and Click to Open Link;

SPREAD THE WORD………

A significant number of UK^▸ (United Kingdom) franchises are owned / operated by overseas national rail companies, and the video describes this and going on to make some points about it, like reporting abstraction of profit from the UK.   I may have missed it, but it fails to make the point that the sharing of experiences from other countries within our own rail network may be a positive thing.

Of the passenger train operators in Bristol (from where I received the message), neither Great Western Railway nor South West Trains are predominantly owned by an overseas national rail company to my knowledge, but Cross Country is.

Discussions on this topic are welcome, although any responses from the originator may be delayed until he signs up if indeed he does.

[ChrisB]

Seems to have been made by the TSSA^» (Transport Salaried Staffs' Association - about) union, so no real surprise that it's rather one-sided in its view.

And UK^▸ (United Kingdom) companies aren't active in other EU^» (European Union - about) countries abstracting profits back to the UK too? Pharmaceutical companies spring to mind.

[ellendune]

I thought TSSA^» (Transport Salaried Staffs' Association - about) would support the idea of nationalised industries being able to bid for franchises!

[Tim]

A private company will extract some profit (if it is run successfully that is).  That is precisely what they are set up to do.  That profit flows to their owners who may be private or public entities in this or other countries.  Once you have conceded the point that the railway can be run by for profit organisations - I don't think you can get prissy over who owns them. 

The issue I have with private ownership of railway franchises and the profit they make isn't that the profit goes overseas or that the profit exists it is that rail franchises depart from the usual capitalist principle that a profit is a reward for investment because the franchises make zero capital investment.  In that context their profit, unlike those of say the ROSCOs^» (Rolling Stock Owning Company - about) or the owner of an airport, is harder to justify.  If they were investing millions of their own money into the railway then ToC profit would be justified.  But they are not, the likes of First have been characterised as "thinly capitalised spivs" who own virtually nothing and as such I find it hard to justify them making a profit (which is not of course the fault of First - it is the fault of the governments who set up and maintain this structure)

The only possible issue with foreign governments owning franchises is the suspicion that they are able to offer the performance bonds /guarantees required by the DfT^» (Department for Transport - about) of all franchisees more easily than a proper private company who would have to pay a substantial amount to a financial institution to underwrite the franchise failing and that that is unfair and means that the DfT gets few bids for each franchise and is therefore possibly getting a worse deal.  That DfT requirement certainly discourages new start ups from bringing their drive and expertise to the industry.

[ChrisB]

Hmm, each fuill franchise does require TOCS to put in some £millions of expenditure - whether that's in CIS^▸ (Customer Information System) systems, mods (like retention toilets) and/or updating/refreshing their rolling stock etc etc

[Tim]

Hmm, each fuill franchise does require TOCS to put in some £millions of expenditure - whether that's in CIS^▸ (Customer Information System) systems, mods (like retention toilets) and/or updating/refreshing their rolling stock etc etc

I might be wrong here, but my understanding is that if a TOC^▸ (Train Operating Company) spends money on something like installing a CIS system which increases the value of the asset in their stewardship then that is accounted for such that they get compensated for handing it back in a better state then when they left it.  It isn't like they continue to own the CIS system after they have left and so I am not sure it can count as capital expenditure. 

And wouldn't retention toilets be paid for by the ROSCO^» (Rolling Stock Owning Company - about) and recovered from the ToC as a higher rental charge?  New rolling stock investment is certainly paid for like that so I don't think that the claims that franchisees invest millions stands up to scrutiny despite them often claiming to.

ToCs do of course spend plenty of money (on staff, track access charges, rolling stock lease etc) but that it is calculated to be balanced with the plenty of money they take in as fares.  The only real risk that the ToCs take is that they have got the calculation wrong.  ToCs are not a significant source of private sector capital coming into the industry.  Contrast that with the freight sector where the private owners have genuinely invested millions (and not coincidentally have managed to double productivity on the back of that investment something the passenger industry has shamefully failed to do despite record passenger growth) and I think that you will see that my general point about ToCs being thinly capitalised still stands, the odd station spruce-up not withstanding. 

I think the fact that there is needed the artificial mechanism of a guarantee / bond arrangement to prevent them walking away from a franchise underlines very well that they don't take on very much genuine risk.

[ChrisB]

I might be wrong here, but my understanding is that if a TOC^▸ (Train Operating Company) spends money on something like installing a CIS^▸ (Customer Information System) system which increases the value of the asset in their stewardship then that is accounted for such that they get compensated for handing it back in a better state then when they left it.

I think you're very wrong here - in that they don't, at all. Show me where any franchise lists that in the contract? If required in the franchise, it's investment.

It isn't like they continue to own the CIS system after they have left and so I am not sure it can count as capital expenditure.

It doesn't get refunded so it's investment - I guess they might write it off as they don't retain the system, but it's money they don't recover, regardless.

And wouldn't retention toilets be paid for by the ROSCO^» (Rolling Stock Owning Company - about) and recovered from the ToC as a higher rental charge?  New rolling stock investment is certainly paid for like that so I don't think that the claims that franchisees invest millions stands up to scrutiny despite them often claiming to.

If the franchise requires the expenditure, I guess the ROSCO rubs its hands in glee. I do know that TOCs have been required in their franchise to refurbish stock. It's investment, because they don't get anything back from the ROSCO for example.

ToCs are not a significant source of private sector capital coming into the industry.

Sorry, don't agree. We wouldn't have seen the new rolling stock around the country that is now due if left to 'BR^▸ (British Rail(ways))' as a nationalised industry. Can you see the £billions being added to the national debt? That's one of the reasons privatisation came about because Government couldn't afford to buy in the amount of new stock needed & why so much stock is now well past its use by date

I think the fact that there is needed the artificial mechanism of a guarantee / bond arrangement to prevent them walking away from a franchise underlines very well that they don't take on very much genuine risk.

Why do they need to take on risk though if the franchise requires £x million of investment? If that's more £££than Government can afford to spend, surely that's an increase in investment to be welcomed? Or would you rather Government put up fares even more than currently to raised these funds? Or do they just add it all to the national debt? Even Labour weren't prepared to do that

[Noggin]

The figure often quoted is that TOCs^▸ (Train Operating Company) make about 3% net profit, which is way less than Tesco, and way, way less than Apple (which makes about 40%). So unless some serious creative accountancy is going on to abstract revenue to the parent company, that's hardly worth getting out of bed for in corporate terms, and the sort of margin that could easily be lost by an operator that was not on the ball.

Personally I've always been a big fan of employee ownership - works well for John Lewis and Waitrose, so perhaps it could work for TOC's? 

[Tim]

Sorry, don't agree. We wouldn't have seen the new rolling stock around the country that is now due if left to 'BR^▸ (British Rail(ways))' as a nationalised industry. Can you see the £billions being added to the national debt? That's one of the reasons privatisation came about because Government couldn't afford to buy in the amount of new stock needed & why so much stock is now well past its use by date

The investment in the stock is made by the ROSCOs^» (Rolling Stock Owning Company - about).  They raise billions on the markets and then buy trains.  A reasonable profit for them therefore seems reasonable.  It is the price paid for using their capital.  BR could have rented trains from a private sector financial institution if it had been told to by the Government.  That is precisely what happens with hospitals, schools, motorways etc.  But remember Governments can borrow money cheaper than anyone else.

Capital investment by ToCs is tiny as a proportion of their turnover and tiny compared to FoCs and to other industries. 

You seem to think I would favour renationalisation.  Well only in preference to the system of phoney capitalism we have now.  My preference would be for full privatisation with the recreating of something like the original GWR^▸ (Great Western Railway) which owned everything. 

[CyclingSid]

This doesn't only happen with railways. I think you will find that Arriva buses are ultimately "owned" by DB^» (Deutsche Bahn - German State Railway - about), although some on the Reading-High Wycombe run are possibly older than some of the railway rolling stock. I think you will find that some of the buses in the Bournemouth/Christchurch area are run by part of the Paris Metro. Whether it is rail or bus, has the percentage increase in dividend been larger than the increase in fares?

[Tim]

The figure often quoted is that TOCs^▸ (Train Operating Company) make about 3% net profit, which is way less than Tesco, and way, way less than Apple (which makes about 40%).

3% looks and sounds like a reasonable number.  This is presumably why it is quoted so much by the industry. 

It is however a completely meaningless statistic.  More relevant would be the rate of return on investment.  The industry turn-over (ie total of all the fares) is about £10billion pa.  3% of that is £300 million.  £300 million is a significant sum to be extracted from the industry as profit.  Is that a reasonable reward for the capital expenditure of the ToCs?

What would a reasonable return on capital investment look like?  Well, it will vary depending on the risk to which that capital is put.  I would suggest that very roughly, 2 or 3% would be about right for a no risk investment (ie a cash ISA).  6 or 7% for a low risk equity investment, and perhaps 10 to 15% for higher risk.  Now the rail industry is fairly low, but not zero risk (and the risk is mitigated by things like cap and collar) so lets choose 10% as a generous return on capital.   I would venture that at that rate, the £300m profit ought to be sufficient to support £3billion in capital investment by the ToCs (note that this is not spending pa.  It is capital tied up in the industry).  I'd love to see some real figures of ToC CapEx^▸ (Capital expenditure), but very ball park if GWR^▸ (Great Western Railway) is 10% of the industry you would be expecting them have about £300m of their capital tied up in the industry. 

Does anyone know their total capital investment?  (and ChrisB, I mean "capital investment" not "spending") if it is less than about £300m then I would venue that the tax payer is not getting good value and that the profits are excessive. 

Edited - have just found First Groups consolidated accounts for 2015 and they show a balance sheet with their rail division (which is bigger than just FGW^▸ (First Great Western)/GWR) having total assets of minus £176.7m (ie their liabilities exceed their assets by that amount)

[4064ReadingAbbey]

There seems to be, in general, a serious misunderstanding of the purpose and structure of the Train Operating Companies and the profits they make.

AT the time of the ‘privatisation’ of the railways the view that the railways were in permanent state of decline - in broad terms passenger and freight traffic had been declining since 1950. Following various restructurings during this period the concept of the Public Service Obligation whereby the Government funded the operation of trains deemed to be socially necessary was introduced.

One of the hopes of the Government of the time was that private sector operation would result in lower costs of train operation and by offering groups of services to bidders an award could be made to those who offered to operate a given group of services for the lowest subsidy. The franchise system was developed so that state support for train operation would be funnelled to private sector operators in a transparent and manageable way.

It was never intended that the TOCs^▸ (Train Operating Company) would invest in infrastructure or rolling stock, such investments were reserved for the infrastructure operator and the ROSCOs^» (Rolling Stock Owning Company - about). At the time it was hoped that private sector operation would increase passenger numbers so it was expected that most expenditure would be on maintenance and renewals, not in purchasing large increases in capacity. At the time nobody predicted the subsequent doubling and more of ridership.

TOCs were intentionally lightly capitalised at the start of the privatisation era - the hope was that service companies from other industries would become involved without putting themselves too much at risk financially. As such the metric of 'return-on-investment' is the incorrect measure to use, 'return-on-turnover' is more appropriate - and this is one which is currently used. The need for the TOCs' holding companies to have deep pockets in order to post large performance bonds and the like is a direct consequence of Richard Bowker's time at the Strategic Rail Authority when he changed the franchising model. This why the TOCs are now owned by large companies such as Stagecoach and the continental railway administrations - only they have pockets deep enough to post bonds for more than one or two franchises. The smaller backers, such as Prism, have long since disappeared.

Investments made by the TOCs have to be amortised within the period of the franchise - unless DfT^» (Department for Transport - about) identifies a particular investment as a 'franchise asset' when different rules come into play. So investments tend to be on things, such as information systems, which anyway have to be updated quite frequently and thus are written down in three to seven years. This does not make them any less valuable.

The point is the TOCs do not make investments in either increased capacity in infrastructure or rolling stock - nor are they expected to. Such expenditures are for the infrastructure provider and the ROSCOs to make - and the TOC pays for these indirectly through higher usage charges.

[grahame]

Personally I've always been a big fan of employee ownership - works well for John Lewis and Waitrose, so perhaps it could work for TOC^▸ (Train Operating Company)'s? 

I wonder what would be happening on the Brighton line at present if Waitrose were running it and their staff were all partners in the business.

[Tim]

Thank you Reading Abbey for a great explanation.

I think you explain very nicely that private involvement isn't about getting the private sector to stump up money for investment so that the public sector doesn't have to, despite ChrisB seemingly confusing all ToC spending with ToC investment

But I don't agree with your point that "As such the metric of 'return-on-investment' is the incorrect measure to use, 'return-on-turnover' is more appropriate - and this is one which is currently used. " I think you are letting the ToCs off of the accusation of profiteering too easily and I note that the question as to what rate of profit is reasonable still arises.

I would suggest that as the private sector is not risking any capital then the profit cannot be justified on those grounds.  I therefore ask an open question as to on what grounds is profit of the ToCs justified?  Remember that Toc profit is no more or less than the money that goes, after tax deductions, to the owners of the companies (ie the shareholders of First).  They get it for owning the franchise not for running the franchise so I don't think simply saying that the profit is the reward for running the franchise or for running it well can be correct.  The people who run the franchise are the management and staff and they are rewarded via their pay package.  Profit is the reward for owning the franchise holder and I can't see how it can be justified on any grounds other than being the cost of using the owner's capital. 

If I buy £100 of shares in First Group plc (which any of us could do and some of us will do via our pensions) I would expect profit (taken as rising share price or dividends) from First Group.  That would be the my reward for letting them use my £100.  It wouldn't be my reward for running the franchises held by First Group.  I wouldn't be running anything.

I would therefore submit that in assessing the reasonableness of otherwise of profit, looking at profit to capital investment ratios cannot be avoided for the simple reason that profit flows to no one other than the owners and that all the owners do is provide capital.

If the owners where the same entities as the people genuinely running the franchise (ie the managers and staff) then the problem go away and the only people rewarded for running the franchise are the people who are running the franchise.  Noggin's suggestion of a John Lewis type set up makes a lot of sense.   Of course you could say that the John Lewis model should be adopted more widely in all sorts of industries.  The main obstacle to it has always been that if you require the staff to own the company, how do you avoid asking them to pay a large amount of capital into the firm when they join bearing in mind that not many staff will have that capital and those that do may not want to risk it.  John Lewis avoided the problem by gifting the staff the capital in his will.  But with a ToC there is hardly any capital risked by the owners anyway so it ought not to be much of a problem.   

[4064ReadingAbbey]

One has to realise that the presumptions made at the time of privatisation no longer hold true as the structure which now exists bears little resemblance to that first created.

As I tried to make clear - it was not considered in 1991/92 that large capital investments to increase infrastructure capacity would be needed and no provision was made for such investments. On-going renewals and maintenance and some small-scale enhancements would be paid for out of the day-to-day income made up of fares, fees and subsidies. The infrastructure was intended to remain state-owned and any enhancements funded in the same way as trunk road improvements using the same criteria. However the first Railtrack chairman successfully argued that the company should be privatised so that long term contracts with Government could be agreed as he had close experience of the effects of short term, and short notice, Treasury budgetary changes on BR^▸ (British Rail(ways))'s planning.

However, even though the ownership of the company was changed the issue of the source of funding for capital enhancements was not resolved - possibly because it wasn't considered important.

All of Railtrack's income was funnelled through the TOCs^▸ (Train Operating Company) in the first years. The system was creaking before and broke after the Hatfield crash when the then Government made direct grants to what had become Network Rail rather than modify the contracts with the TOCs. From this point it would seem that financial discipline within NR^» (Network Rail - home page) was lost, the underestimates could be covered by borrowing money as the borrowings were guaranteed by the Government.

In the meantime it has become clear that the infrastructure needs some significant enhancements. This is a task for NR as it is (a) the organisation which owns the assets and (b) it is the only permanent player - apart from the freight FOCs^▸ (Freight Operating Company) and the ROSCOs^» (Rolling Stock Owning Company - about). Enhancements are paid for by increased access fees paid by the TOCs who should recover these extra payments by the extra income made possible by the increased infrastructure capacity.

The fundamental error that you make is the assumption that the TOCs own the franchise. This is not true, the franchise is owned by the DfT^» (Department for Transport - about), not by the TOC. The franchise is awarded to the TOC by the DfT to allow it to operate trains for a limited period in a geographically defined area. The franchise may be reclaimed by the DfT if the franchisee does not fulfil his side of the bargain - which pretty much demonstrates where 'ownership' lies. As a result the concept of a 'return on capital' for a TOC is inapplicable.

The holding groups behind the TOCs need to make a profit. Although the capital requirements for the TOCs in the early days were not high there are costs involved. The major ones are the costs of bidding - this has been increasing over the years because of the ever more detailed Invitations To Tender. For a large TOC the bidding costs alone are now reported to be around £10 million. These costs have to be recouped. There are also opportunity costs - if the companies' staff were not running a TOC they would be running something else which would be generating incomes and profits. So the DfT has to pay the TOC at least the (notional) forgone profit from an alternative business in the same general area, transport, run by these people. As the TOC is running the franchise on behalf of the DfT the DfT pays a management fee. All these items come together and, globally, 'the railway' pays about 3% of its turnover as profit to the TOCs. This seems a reasonable figure - it's about what one would receive from a long term bond.