News Desk

End of the line for East Coast

1st July 2009

When news broke that National Express had handed back the keys to its East Coast rail franchise there was some confusion. National Express insisted that it had not in fact done anything of the kind and that it was still firmly in control. The Department for Transport (DfT) made a not wholly helpful announcement that East Coast had hit the buffers and that it had set up a company to take it over, in the public interest, until the franchise could be re-let. The facts are actually spelled out in a National Express trading statement which indicated that it was still attempting to engage in negotiations with the DfT but was not prepared to put additional funds aside to cover huge losses on the franchise.

The long and short of this is that if the DfT and National Express do not change their respective stances then East Coast will run out of money during the latter part of 2009. Anticipating this event, the DfT has drawn down one of their off-the-shelf companies held precisely for such an eventuality and will transfer control of East Coast to this government-controlled entity at the point of insolvency. The companies are known as operators of last resort and can be mobilized very quickly - the only other such company so far deployed was to take over the franchise operated by unloved Connex South East. Professional railway managers already pre-qualified by government (presently contractors First Class Partnerships) will take over day to day management of East Coast. An orderly handover can be expected.

It wasn’t a complete surprise. Perhaps the departure of maverick Richard Bowker, National Express’s Chief Executive to the sandy foothills of the United Arab Emirates is more to be regretted as he was a railwayman by inclination and passionate about customer service, even if he had been overtaken by events at National Express. Bowker is to leave National Express in August to become Chief Executive of Union Railway in the UAE, a matter which has obviously been planned for a while so we can perhaps assume that he received some encouragement to find something new to do by NX shareholders a while back.

Timing is all, and it is easy to see that had events gone differently East Coast might have been a huge success. The UK economy had been growing, and with it passenger numbers using the UK rail network had been rising at an unprecedented level. The East Coast franchise bid was predicated on that growth continuing and producing vast year on year profits that were to be hoovered back into the Department for Transport through the aggressive medium of premium payments. Early results looked good and NXEC, NX’s railway jewel in the crown, looked as though it was going to be a tremendous success.

Then the economy collapsed. Growth continued to rise but hugely more slowly than predicted. The new cash trajectory was clearly going to fall short of the premium payments required to pay government from year two. Even if the economy subsequently recovered the cash hit so early in the franchise was going to leave National Express seriously out of pocket. But National Express is a private company and is required by its shareholders to make a profit – indeed if it were not to make healthy profits then it could not afford to invest. With East Coast haemorrhaging money something had to be done. Huge effort was made to strip out remaining cost (doing little to improve customer service) but East Coast is not a large franchise, with only a dozen or so stations and under fifty train sets. Most costs (track access charges, train leasing and government premia) are fixed. The only ‘flex’ was thought to be in renegotiating the franchise deal. The government for reasons of its own has been intransigent: doubtless it was very worried about any compromise opening the floodgates for other franchises presently suffering pain, for there are some. The outcome is the present impasse with the government posturing to run the franchise. Let us see if they can do better. Elaine Holt (late of First Capital Connect) has been selected as the managing director when the time comes, and compared with the horrors of First Capital Connect, East Coast should be straightforward.

The problem of course is that in the idiosyncratic world of UK rail franchises the bidders are largely (though not entirely) assessed on the basis of the financial benefits they generate for the taxpayer, so the amount of money on the table, providing it is plausibly justified, speaks volumes. Each successive bid for the same franchise effectively squeezes the franchise harder. Cost reductions made such efficiency improvements as there were over five years ago so the only thing that can be done is to improve marketing efforts and take ever more robust views about the overall economic conditions of the country. If these assumptions are wrong (and who could tell), then disaster. East Coast was expecting year on year growth of around 10 per cent so it could afford to pay the government a premium of £1.4 billion over the franchise term. In fact growth has shrunk to just one per cent and the franchise is making a loss. The franchise will fail when the £42m loan commitment is reached (current losses stand at £20m).

Matters were not helped by the profiling of the premium payments. The East Coast bid ramped up payments quickly, before cap and collar relief became available. Franchise bids are often, however, back-ended. This means not only that failure matters less as possible franchise loss will only impact on the last year or so, but also cap and collar protection means that in practice the DfT has to absorb up to 50 per cent of most of any revenue shortfall, significantly reducing risk to the operator. Having said that, premium payments ran lower than that of its failed predecessor, GNER, until 2012 when it leaped ahead. Had things gone wrong at that stage, not only would cap and collar have been in play, but either party could walk away in 2013 when there was a break opportunity. In either case NX would have been well protected and would have retained its reputation. Recession wasn't supposed to happen so soon.

It is open to question whether rail franchisees should be allowed to gamble over macro-economic conditions over which they have no control, and some franchisees are much more cautious. The DfT (caught twice by East Coast franchise problems) should have asked what would happen if things changed. Perhaps they did, but were seduced by the huge premia on offer (well above nearest competitor) and hoped they would get away with it. On longer franchises the DfT’s cap and collar arrangements would offer protection to franchises where revenues differed from targets through no fault of the franchisee. In the case of East Coast the franchise was new and cap and collar was not available. As already stated, the timing was dreadful.

A complication in all this is that franchise agreements made in respect of any one franchise contain 'cross fault' clauses allowing DfT to cancel any other franchises a large owning group may hold. The DfT has been rattling sabres about this and doing nothing to dispel myths that it may strip National Express of its East Anglia and C2C franchises, even though they are performing satisfactorily. National Express has sought legal opinion about this which suggests they are confident these clauses cannot be invoked when the nature of the failure has no implications for the other franchises and is keen to rebut suggestions that early termination is possible in practice. In turn the DfT has made it clear that National Express is unlikely to prequalify for new franchises coming up, and the implication that it will be applying this mantra as a kind of penalty is likely to create some hostile reaction from National Express. The difficulty in attracting good bids for rail franchises is evident enough without excluding credible players out of pique.

Personally we feel sorry for the staff, who do a good job under difficult conditions. Although they are protected to an extent it is hardly a source of comfort and satisfaction to have this revolving door of managers wandering in telling them how to do things ‘better’, and then breaking their railway. We wish Bowker well in whatever he does for the Arabs, but suspect he’ll be back in the UK one day and hope he has a better chance to prove himself next time.