Presentation by Dr Tony Fowkes delivered as part of the seminar series at the Institute for Transport Studies (ITS), October 2014. www.its.leeds.ac.uk/about/events/seminar-series http://www.its.leeds.ac.uk/people/t.fowkes

1. Institute for Transport Studies
FACULTY OF ENVIRONMENT
UK RAIL FRANCHISING: WHY DID
THE WEST COAST FRANCHISING
PROCESS COLLAPSE?
Tony Fowkes
Seminar, ITS, 15.10.14

2. Overview
On 3rd October 2012, the DfT cancelled the refranchising
process (using a new methodology) for ‘InterCity West
Coast’, the tilting train services from London Euston to
Birmigham, Manchester, Liverpool and Edinburgh.
All other refranchising exercises were halted at the same time.
It was said that some errors had been found in the
procedures, but why could they not simply have been
rectified, and the exercises restarted?
We will look today at what was wanted from franchises,
consider why previous methods had been rejected, and
investigate what went so badly wrong with this new method.

3. InterCity West Coast Timeline
2012
• 14 August. I am asked to appear on the following day’s
TODAY program to discuss the ICWC award. Declined.
• 15 August. DfT announces ICWC awarded to FirstGroup.
• 28 August. Virgin lodges papers at the High Court asking for
a judicial review. Seen as a delaying tactic.
• 3 September. Theresa Villiers (since banished to N.I.) states
intention to defend the legal challenge robustly.
• 3 October. DfT announces cancellation of the ICWC
competition (currently planned to restart in January 2016,
with winner to be announced in November 2016).

4. UK Rail Franchising
The Railways Act, 1993, provided for the privatisation of state
operator British Railways.
As part of that, nearly all rail passenger services were to be
franchised out.
Initially, services were allocated to one of 25 new Train
Operating Companies (TOCs), with their staff and rolling
stock leases etc, and bids were invited to run these
companies, with specified minimum levels of service, usually
for 7 years, in return for a subsidy/premium profile.
All 25 were successfully franchised between 1995 and 1997.

5. Important Distinctions
Firstly, the franchises are not ‘Concessions’, such as the
Manchester Metrolink, where RATP (the Paris local public
transport operator) is paid a fee, but does not keep the
revenue. Rather, it is a ‘net cost’ model – TOCs keep the
revenue, pay their costs, and either seek a subsidy or offer
premium payments for the right to operate services with a
degree of protection from competition.
Secondly, the operating group (eg. Virgin) is distinct from the
TOC (Virgin Trains), with the latter possibly going bankrupt
when the former hasn’t. That situation could EITHER be
referred to as Virgin “handing back the keys” OR Virgin
Trains going bankrupt.

6. Major Problems Facing the
TOCs post-1997
1. There was a crisis of confidence around 2000, epitomised
by the Hatfield crash in 2000, in which the network
provider, Railtrack, realised that it could not meet (or afford
to buy out) the terms of a contact with Virgin Trains and so
went bankrupt, leaving a backlog of maintenance, poor
records of the state of the tracks, and a series of accidents
(leading to an over-reaction in the imposition of speed
limits and renewal works that disrupted rail services).
2. Government spending plans, particularly on new rolling
stock, were halted by the 2007/8 financial crisis,
accompanied by a large fall in GDP (to which rail demand
is strongly positively related).

7. The Original Method of
Franchising, and it’s Outcome
In brief, franchises were awarded solely on the financial bids,
with bidders promising large efficiency gains and revenue
growth over time, leading to reduced subsidies (increased
premia) over time. Essentially, the bidders had a higher test
discount rate than the Treasury.
Possibly due to deliberate overbidding, the Winner’s Curse, or
just the crisis in 2000, one by one nearly all the TOCs asked
for bailouts or to be put on ‘management contracts’.
This has been widely studied, including in a good paper by
Nash and Smith in January 2006, “Passenger Rail
Franchising – British Experience”. Unlike today’s seminar,
that paper concentrates on the evolution of costs and
revenues.

8. Who bears the
macroeconomic risk?
By Macroeconomic Risk, I mean the consequences for TOCs
of the economy performing differently to expectation.
If GDP is higher than expected then TOCs will obtain a
windfall (for up to 25 years!), whilst if GDP is lower than
expected TOC revenues will be insufficient to cover the cost
of providing the services agreed in the Franchise Plan,
unless there is a safety margin priced into the bid.
By always choosing the best financial bid in the first round, the
safety margins were probably inadequate.
If we increase the penalties for bankruptcy, that would force
bidders to play safe, but would cost DfT money, and TOCs
still get to keep the windfalls from higher GDP.

9. The Second Method
For the second round of Franchising, starting in 2003 (most
first round franchises having been let for 7 years) it was
decided that it was inappropriate to leave the TOCs bearing
all the revenue risk.
No attempt was made to distinguish between the sources of
the risk (eg. GDP, delayed services, overcrowded trains),
but a large part of the variability in revenue was to fall on
DfT, via a ‘Cap & Collar’ mechanism.

10. Cap & Collar
• Purpose: To mitigate revenue risk to the franchisee, so that
they will make financially improved bids, with government
better able to cover the risk.
• Operation: From the 5th year of the franchise, large
deviations from the revenue forecast in the franchise plan
would result in risk sharing.
• Method: If actual annual revenue is more than 2% away
from the ‘revenue line’, then the difference begins to be
shared 50/50 with DfT; until the difference reaches 6%
wherefrom the DfT share is 80%.
• Surpluses are “capped” and shortfalls are “collared”.

11. Cap & Collar, worked example
Suppose, the Planned Revenue (the ‘Revenue Line’ in the bid ) in a particular year
is 100, what Revenue Support would be due for various levels of Actual Revenue.
The table shows the Revenue Support to the TOC (-ve is a payment to DfT).
Actual
Revenue
2-6%
support
(50/50)
6+%
support
(80/20)
Total
Support
(-ve is TO
DfT)
Total TOC
Receipts
0 2 75.2 77.2 77.2
90 2 3.2 5.2 95.2
96 1 0 1 97
100 0 0 0 100
104 -1 0 -1 103
110 -2 -3.2 -5.2 104.8
200 -2 -75.2 -77.2 122.8

12. TOC Recipts as a function of
Bid Revenue Levels
TOC TOTAL
RECEPTS
************ BID REVENUE LEVEL *******
ACTUAL
REVENUE
(YEAR 10) 50 100 110 120 150 200 400
400 121.4 162.8 171.08 179.36 204.2 245.6 400
150 71.4 112.8 121.08 129.36 150 184.4 338.8
120 65.4 106.8 115.08 120 139.8 178.4 332.8
110 63.4 104.8 110 114.64 137.8 176.4 330.8
100 61.4 100 104.92 112.64 135.8 174.4 328.8
90 59.4 95.2 102.92 110.64 133.8 172.4 326.8
60 53.4 89.2 96.92 104.64 127.8 166.4 320.8
0 38.6 77.2 84.92 92.64 115.8 154.4 308.8
AR400-AR0 82.8 85.6 86.16 86.72 88.4 91.2 91.2

13. Collar Support in 2011/12
7 TOCs RECEIVED
COLLAR SUPPORT IN
2011/12
REVENUE SUPPORT AS
PERCENTAGE OF
REVENUE
REVENUE AS % OF
TOC RECEIPTS
CROSS COUNTRY 4.6 95.6
VIRGIN WEST COAST 5.1 95.1
FIRST CAPITAL
6.2 94.1
CONNECT
EAST MIDLANDS
TRAINS
7.5 93.0
SOUTH EASTERN 7.8 92.8
SOUTH WEST TRAINS 10.0 90.9
Source: Roger Ford, MODERN RAILWAYS, Dec. 2012

14. Collar Support in 2011/12
7 TOCs RECEIVED
COLLAR SUPPORT IN
2011/12
REVENUE SUPPORT AS
PERCENTAGE OF
REVENUE
REVENUE AS % OF
TOC RECEIPTS
CROSS COUNTRY 4.6 95.6
VIRGIN WEST COAST 5.1 95.1
FIRST CAPITAL
6.2 94.1
CONNECT
EAST MIDLANDS
TRAINS
7.5 93.0
SOUTH EASTERN 7.8 92.8
SOUTH WEST TRAINS 10.0 90.9
FIRST GREAT
25.7 79.6
WESTERN
Source: Roger Ford, MODERN RAILWAYS, Dec. 2012

15. First Great Western 2011/12
That 25.7% shown on the previous slide equates to £209.4M,
relative to Revenue of £813.5M.
What does that imply the Revenue Line was in the Plan?
Answer: £1114.25M.
94% of 1114.25 is 1047.4, and 98% is 1092.
50% of (1092 – 1047.4) is 22.3
80% of (1047.4 – 813.5) is 187.1
Total Revenue Support is 209.4M.

16. Capped Revenue Share in
2011/12
Only one TOC paid a capped revenue share to DfT in
2011/12.
Northern paid £12.5 million to DfT, this equating to 4.8% of
their Revenue.

17. An Actual Bidding
Competition: South Western
The NPV of the winning bid is made public, but the range of
other bids is not. However, following a Freedom of
Information request in 2009, the following anonymised NPV
bid premia were published relating to the South Western
franchise:
(a) £501M, (b) £513M, (c) £636M
I do not know whose bids any of (a-c) are.
So, bearing in mind everything I have said, how large an NPV
did the winning bid have?

18. An Actual Bidding
Competition: South Western
The NPV of the winning bid is made public, but the range of
other bids is not. However, following a Freedom of
Information request in 2009, the following anonymised NPV
bid premia were published relating to the South Western
franchise:
(a) £501M, (b) £513M, (c) £636M
I do not know whose bids any of (a-c) are.
So, bearing in mind everything I have said, how large an NPV
did the winning bid have?
Answer: (d) Stagecoach, £1191M

19. The ICWC Franchise Process:
Definition of Terms.
ICWC: InterCity West Coast. This, or just “West Coast”, is
the official name of the franchise in question, covering the
tilting train services from London Euston to Birmingham,
Manchester, Liverpool, and Glasgow.
ITT is the DfT Invitation to Tender, issued 20/1/12.
The Contract Award Committee (CAC) is a committee of
senior DfT officials tasked with recommending which bid to
accept. Reported to RRPB.
The Rail Refranchising Programme Board (RRPB).
Reported to BICC.
DfT Board Investment and Commercial Sub-Committee
(BICC).

20. The ICWC Franchise Process:
Definition of Terms (cont).
The Subordinated Loan Facility (SLF) is an amount of risk
capital owning groups would be required to provide in order
to reduce the risk of TOC bankruptcy to an acceptable level.
DfT sometimes referred to it as “insurance”.
The GDP Mechanism varies the amount of the annual
franchise payment, to the extent that actual GDP varies
outside of a +/- 5% range around forescast GDP. The ITT
implies that 80% of this GDP risk would be borne by DfT.
The DfT Model is the DfT GDP Resilience Model, used to
calibrate the GDP Mechanism. It contains 500 economic
scenarios, with associated probabilities. “Apparently around
the time” the ITT was published, it was decided to use this
model ALSO for the determining the required level of SLF.

21. ICWC: Franchise details.
The franchise was to be for a maximum of 15 years (with the
last 2 at DfT’s discretion) from 9/12/12 to 12/12/27.
Bids had to be submitted in Excel model form, complete with
Operating Manuals etc.
Monetary figures were to be in Nominal Terms, but with a
deflation “switch” to convert into Real Terms (at 2012/13
prices), and NPV was to be discounted back to 9/12/12.
Bidders were invited to offer “profit share”, and there was to
be automatic sharing of the GDP risk.
DfT supplied default values of RPI and GDP for bidders to
use.

22. ICWC: Financial Risk
The ITT explained that the bid evaluation process would
include a consideration of whether the risk-adjusted revenue
and costs of each bid produced too high a risk of franchise
insolvency, possibly requiring bidders to inject additional
funds, potentially via an SLF.
The maximum permissible risk of default was set at 4.4%,
over the 15 years of the franchise. With roughly 16
franchises, that implies that one franchise would default
about every 10 years. Previous defaults had been a
nuisance for government, with financial loss and plans
knocked off course, but passenger interests had been
protected. So ... was 4.4% too low?

23. Technical Modelling Flaws
The following Modelling Flaws were documented in the
Laidlaw Report of 2012, and much of what I say here follows
that report closely.
1.It was not realised that the outputs from the DfT Model were
in real terms, with the result that the SLF figures resulting
“were understated by nearly 50%”. I believe he meant that
50% needed to be added.
2.There was confusion regarding the GDP elasticity to be
used (per capita or not, PDFH v4.1 or v5, the latter only
adopted that August). Laidlaw thought, quite possibly
wrongly, that this also led to the DfT Model SLF figures
being too low.
Since bidders were unaware of these problems, they could not
sensibly choose how much risk to build into their bids.

24. Administrative Flaws
1. The DfT model was not provided to bidders (as it would
have been obvious that it was not designed to generate
SLF requirements, and therefore open to challenge).
2. As of 23.02.12, DfT was advised that, as things stood, the
material given to bidders allowed DfT to take its own view
on SLF, not constrained by any particular methodology.
3. In order to mitigate this lack of transparency, on 24.02.12,
the SLF Guidance document was issued. This said that
increasing SLF levels would be input into the DfT model
until the maximum default risk (4.4%) was reached. It
suggested that no SLF would be required if a bid’s default
risk was below the maximum level. A Ready Reckoner
was included, but this was incredibly rough & ready.

25. Administrative Flaws (cont).
The bidders continued to raise concerns regarding the lack of
transparency regarding the determination of SLFs.
On 13/3/12, the ICWC Project Team Leader asked
colleagues, by email, “Is the exposure so great that we
should dispense with the solvency test/subordinated loan
requirement?”
On 21/3/12, a meeting of the RRPB decided to press on and
give no more guidance.
In answers to questions, DfT said it had no policy of requiring
a minimum level of SLF, and that it would not impose one on
a bid with a risk-adjusted profit margin over 5%.

26. In early May, DfT received 4 bids, all except Virgin’s including
an SLF. First’s SLF was £50M, plus £10M of equity.
In mid-June, Atkins provided “first-pass” risk adjustments, that
were run thru the bidder’s models to generate re-profiled
revenues and costs, which were in turn modelled with the
DfT model against the 4.4% maximum default rate to
determine any additional SLF requirements. The Virgin SLF
(all additional) was £90M, but the others are secret.
DfT also used its Ready Reckoner gave “materially different”
figures, the Virgin figure being £72M.

27. A CAC meeting on 19/6/14 decided, in an unminuted meeting,
with anonymised figures, to use the Ready Reckoner
numbers, since that was all the bidders had, in oral
communication with bidders. Virgin wrote back to challenge
the £72M.
Atkins included further adjustments, including taking some
account of a suggestion from First, which resulted in Atkins
advising DfT to make further risk adjustments to all bids. On
both the full model and the Ready Reckoner, First’s SLF
rose (to £252M on the RR, and the DfT model figure would
have been £355M if the “real terms” mistake had not been
made), but Virgin’s fell to zero (due to First’s suggestion).

28. CAC met on 27/6/12 to review all the figures, and their final
decision on SLF was £200M for First (ie. £140M additional)
and £40M for Virgin (all additional).
The Laidlaw Inquiry team interviewed all 14 attendees at the
27/6/12 meeting but “There remains a significant lack of
clarity and a large degree of inconsistency in the evidence
as to the discussions and decisions taken at the meeting.
This is surprising, not least because it was an important and
fairly recent meeting attended by some senior DfT
officials. ... “Unhelpfully, ... the short draft minutes circulated
following the meeting were replaced with even shorter final
minutes.”

29. Laidlaw concluded that the 27/6/12, meeting had:
1.Taken account of extraneous factors in a way that treated
First and Virgin inconsistently;
2.Paid no regard to the SLF Guidance, which did not mention
the use of discretion;
3.Imposed a minimum level of SLF, contrary to previous
advice to bidders, and done so in a way that favoured one
bidder over the other;
4.Baulked at asking First for a significantly higher SLF than
previously advised (even though that was a “first pass” using
Ready Reckoner numbers rather than DfT Model numbers.

30. Both remaining bidders were given their SLF numbers and
quickly agreed to provide the SLFs requested, though First
told the Transport Select Ctte that their figure was reduced
by £15M in negotiation/clarification.
Between 29/6/14 and 2/7/14, DfT’s external advisors
Eversheds raised concerns regarding the SLF
determination, but Laidlaw finds that their concerns were not
formally escalated within DfT.
On 16/7/14, CAC agreed to hold final negotiations with First.
Around 20/7/14, Virgin was told it was not the preferred
bidder, and R. Branson wrote on 23/7/12 to the PM and
others, claiming First had overbid, but not mentioning SLF.

31. On 30/7/12, Virgin wrote to the DfT DG responsible for
refranchising, asking what First’s SLF was and how it had
been calculated (refused on 9/8/12), and mentioning a
judicial review.
On 31/7/12 BICC met to agree to seek authority for franchise
signature. Virgin’s objections were raised, and it was agreed
that “BICC fully satisfied itself on these issues”. It decided it
needed further information, and requested a paper for a
follow-up meeting on 2/8/12.
That paper contained the untrue statement that “The SLF
required is calculated by reference to the 500 macro-economic
scenarios ..., to ensure that the calculated
probability of default ... is no higher than 4.4%”

32. Clearly, the chosen SLF values were chosen not to be higher
than the “first-pass” figures already given to bidders, so did
not satisfy the 4.4% maximum in the case of First. Those
figures, in turn, were based on the Ready Reckoner and not
the DfT model, as had been specified in the SLF Guidance,
and so had not been run over the 500 scenarios.
The major influence on the choice of SLF numbers was the
desire for a minimum SLF, expressly against previous
advice to bidders, and the fear that an SLF meeting the
4.4% test would have been too high for First to stand, and
even if they managed it they would not have wanted to bid
for other franchises on that basis. These matters were not
even raised in the 2/8/12 meeting, even though some of
those in the 27/6/12 meeting were present on 2/8/12 too.

33. The 2/8/12 meeting decided to proceed. The Secretary of
State having learned of the identities of the bidders,
ministerial approval was obtained from the Minister of State.
On 15/8/12, the award of the ICWC franchise to First was
announced.

34. Conclusions
The method used for the ICWC Franchise exercise:
1.Was not based on a defendable/publishable model, and so
failed the test of transparency, which led to large errors
being made.
2.Put DfT in the position of having bids each good in one key
respect but bad in another, since bidders did not know what
weight DfT would place on each and so could not make an
intelligent bid.
3.Required successful bidders to carry a larger share of the
risk than was conducive to having numerous bidders, some
of whom held several franchises.
Hence, a fourth method is being tried .........

35. References
Ford, R. (2012), Cap & Collar hitting DfT’s budget, Modern
Railways, December.
Laidlaw(2012), Report of the Laidlaw Inquiry, TSO, London.
Nash, C. A. and Smith, A. S. J. (2006), Passenger Rail
Franchising – British Experience.