Transcript slides

Rail franchise
margins
European Transport Conference 2014
Andrew Meaney, Partner
Christopher Davis, Consultant
30 September
Purpose
To better understand the link between contract design, the
size of rail franchise margins and value for money
To outline a framework that public authorities can use to
design passenger rail contracts such that the margin required
by railway undertakings offers value for money
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Overview
Background on franchising
Some observations
A framework for delivering value for money
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Background (I)
What is a franchise?
• the right to operate rail services on a given collection of rail routes
• formal contract with government
• franchises broadly split by region or mainline
• awarded by competitive tender to private companies
• competition for the market
• passenger-facing part of the rail service
• day-to-day management of the train services
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Background (II)
What are the aims of franchising?
• increased efficiency and innovation
• an improved service offering for passengers
• reduced government subsidy
• enhanced certainty on future public expenditure by contractually
underpinning premium/subsidy payments
• flexible tool with which to vary the specification of rail services across
different areas of the country
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Background (III)
Rail margins
• TOCs require a margin (compensation) for providing rail services
• margin assumption incorporated in franchise bid
• affects size of the premium or subsidy required to operate the franchise
• link between the level of risk and the level of return (i.e. the margin)
• franchises have different cost and revenue characteristics that may
affect owning groups’ risk exposure
HIGHER RISK
HIGHER RETURN
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Overview
Background on franchising
Some observations
A framework for delivering value for money
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1. Rail franchises are asset-light businesses...
• required profit margins will
decrease as assets decrease
(relative to revenues)
• required margins lower than
the market average
40%
35%
Average operating margin (2008–12)
• investors in asset-light
businesses require a return on
the risks they take from running
the business and/or the
intangible assets created over
time
30%
25%
20%
15%
10%
5%
0%
0
-5%
1
International Consolidated
Airlines Group
2
3
5
Capital intensity (2012)
Required profit
Assets
Required profit
Assets
Revenue
Revenue
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8
2. ...but margins are non-zero
• finance theory is based on the assumption of a ‘return on investment’
• franchises require little or no direct asset investment
• does this mean any profits are unnecessary?
Asset owner
Franchisee
Upfront investment
Commitment to
provide capital
Risk of loss
Target profit
(capital * return)
Required return on
investment
Risk of loss
Required return on
investment
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3. Observed margins across TOCs vary widely
0.16
Lower interquartile range
0.14
Density of UK TOCs
0.12
There is a
clustering of EBIT
margins at or
below the 5% level
Upper interquartile range
GB franchise average
0.10
0.08
There is significant
variation in the
profitability of
different franchises
0.06
0.04
0.02
0.00
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
Total operating profits across the GB passenger rail industry were around £250m in 2013
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4. Margins are driven by cost risk, revenue risk and
operational leverage...
Type of rolling stock
Input costs
The critical driver of
required returns
Hedging policy
Cost risk
Volatility of net
cash flows
Initiatives
Results in potential
losses for investors
where capital is
committed
Operational leverage
Capacity utilisation
Transition of revenue
volatility in the volatility of
net cash flows
Structure of contracts
with the ROSCOs
and Network Rail
Revenue risk
Revenue support
mechanisms
Proportion of
business passengers
Underlying volatility
of demand
Open access regime
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Subsidies or premium
payments
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5. ...which will vary across franchises
Revenue risk
Cost risk
Inter-modal
competition
Wages
GDP
City
employment
Materials
Power
Disposable
income
Premium or
subsidy
Schedule 4
Schedule 8
Open
access
Initiatives
Operational leverage and capital structure
• utilisation of available capacity
• premium or subsidy payments
• structure of lease contracts
• capital requirements
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6. Rail franchise design will affect risk exposure and
thus the required margin
• franchise term
• risk-sharing mechanisms
• only at risk for controllable factors?
• within period changes
• profit share arrangements
• two-sided? symmetric?
• exposure to cost shocks
• e.g. energy costs, track access charges
• exposure to open access operators
• timetable flexibility
• bid assessment criteria
• capital requirements (bonds and parent company guarantees)
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7. Franchise contracts can take a number of
different forms
• High risk
• Stronger incentives
TOC takes
cost risk,
client body
takes
revenue risk
Management
contract
‘Cap and
collar’
TOC takes all
risk
Exogenous
risk-sharing
mechanisms
• Low risk
• Weaker incentives
Source: Adapted from English. K-L. (2014), ‘Overview of the UK rail market’,
Department for Transport, 19 May.
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8. It is generally agreed that TOCs should only bear
the risks they can manage
Endogenous risk
Marketing initiatives
Revenue from
unregulated fares
Exogenous risk
Track
access
charges
Service quality
Local GDP
National GDP
Unemployment
Inflation
Brand / reputation
Exposure to exogenous risks reduced through revenue risk-sharing
mechanisms (e.g. GDP mechanism) and inflation-linked changes in regulated
fares
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9. Inappropriate risk transfer can lead to higher
subsidy than is necessary
• leaving TOCs exposed to too much risk can lead to higher than
necessary franchise margins
• removing all risk can dampen incentives and lead to overbidding
• potential negative impact on alignment of incentives across industry if
TOCs fully protected from changes in track access charges
• balance needs to be struck
• risk transfer should be tailored to each franchise
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Overview
Background on franchising
Some observations
A framework for delivering value for money
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A framework for ensuring value for money
Ensure that rail franchise design reflects policy objectives—i.e. what is the tender
or direct award meant to achieve?
Find ways in which the contract also aligns incentives between the railway
undertaking and the infrastructure manager
Balance risk transfer such that the operator faces appropriate growth incentives but
limited exposure to events that are outside its control
Reflecting step 1, require that the contract includes incentives for efficiency,
innovation and service quality improvements
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Contact:
Name
Tel
email
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Revenue risk sharing mechanisms
Brown Review’s recommended approach
Agree appropriate (franchise-specific) mix of exogenous risk drivers (e.g.
national/regional GDP, CLE) and the elasticity of demand to them
ITT includes base forecasts for national GDP, regional GDP and CLE to
give exogenous revenue growth assumption (which feeds directly into bid)
Bids are on endogenous revenue growth (i.e. companies’ own initiatives)
with proposed costs, margins and resulting payments
Contracted premia or support payments are adjusted for the outturn level
of the indices relative to the base forecast
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Case studies
Recent prospectuses
Thameslink
Northern
• seven-year management contract
• 8–10 years
• DfT takes full revenue risk
• bidders will take full revenue risk
• Govia takes cost risk
• profit-sharing arrangement including a
profit cap
• operating costs plus 3% margin (4%
cash margin)
• no sharing arrangement where
operator incurs losses
East Coast
• 8–9 years
• GDP indexation mechanism
• based on national GDP
• covers 90% of difference in revenue resulting from outturn GDP
• symmetrical with nil band (±2%)
• elasticity of 1.2–1.4
• profit share with profit cap
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Further reading
• Oxera (2014), ‘Something for nothing?
Returns in low-asset industries’,
Agenda, March.
• Oxera (2012), ‘Chuffing hell: is the
British model of rail franchising dead?’,
Agenda, November.
• Oxera (2012), ‘Sold to the slyest
bidder: optimism bias, strategy and
overbidding’, Agenda, September.
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