News Desk

New Start for East Coast

20th November 2009

Our piece on 1st July explained that National express was in trouble—rather more trouble than other companies that had been knocked about by the present financial climate. Some heroic decisions taken by former Chief Executive Richard Bowker had been a risk too far. That they might have worked out had the economy kept growing is a matter about which it is only possible to speculate. The debt taken on was sustainable only as long as the economy kept growing and brought more passengers to its bus, coach and rail services which, according to the models, could generate all the cash needed to service, and one day pay off, its debts.

The National Express East Coast passenger franchise was perhaps a text book example of not only the prevailing National Express philosophy but also of the position that modern rail franchises feel obliged to adopt, to varying degrees. National Express was once the UK’s largest train operator, with nine franchises. The majority of these came from acquisitions and in fact the Group had difficulty in winning new work, with only East Anglia to its credit, in 2004. It was rapidly becoming the smallest train operating Group. This may have been a factor in its bidding strategy for East Coast when it unexpectedly became available in 2006 following its collapse under troubled Sea Containers’ ownership when growth failed to meet expectations even before recession hit.

Rail franchise bidding is difficult anyway. Unavoidable fixed costs are high and most waste has long been stripped out, so franchise bids are inevitably forced to focus on revenue growth, which is a function of fares charged and usage. Many fares are regulated by the government so real growth is a function of unregulated fares (typically cheap offers subject to restrictions and available only on that operator’s services) and passenger growth which is heavily influenced by macroeconomic behaviour whatever marketing effort is made. If the only factor influencing selection of a winning bid were the revenue promised, then in essence this would be the number arrived at after estimating the sales and marketing effect one can bring to bear and guessing how the economy will behave, how wages and prices will change (especially fuel prices), and if any open access train operator will turn up and ‘steal’ some of the traffic. All these factors constitute risk (and risk against which it is hard to mitigate). The risk is factored into the overall price that a franchisee is prepared to offer to run the franchise. The final element is to offer an overall number that is likely to pass muster with the government as representing best value for money, but profiling the premium payments in a way which minimises exposure. In particular it is a good thing not to extend oneself too much before the oft-discussed ‘cap and collar’ clauses kick in where, after usually five years the government will underwrite some of the revenue risk. Another good thing to do is to put as much of the premium payment towards the back end of the franchise so it comes in after the usual break clauses can be deployed, allowing the operator to get out if things look too hot. For these and other reasons the oft-quoted £1.4 billion premiums that National Express promised the government from East Coast is a complete nonsense, since if the worst had happened when it was supposed to have happened the actual exposure would have been vastly less than this.

However the government is not as silly as people like to think and perfectly well realize (though it took a while) that people could stick any old numbers into a bid. This happened in the early days of franchising when several bus operators obtained rail franchises on the basis that they were ‘just like bus companies’ with simple operations and loads of costs that could be stripped out. Anyone remember MTL, running North Western? In consequence, bids are now poured over to check that they are deliverable. Astonishingly, the National Express bid was by some way not the largest cash contributor, but the largest bid was thought too risky; this offered £150m more and is thought to have been made by Arriva. Even so, nobody (at least, nobody who mattered) saw the recession coming. The East Coast bid was predicated upon year-on-year growth of around ten per cent. They did their best and traffic did grow briefly, but when recession hit it declined slightly instead. This meant that the carefully modelled sums did not work out in practice and could not meet the premium payments that were required. The government refused to renegotiate and National Express found itself supporting the franchise to the tune of more than a million pounds a week with little prospect of being able ever to recover its position (because that is how franchise models behave). The Group adhered to its contractual requirement to support the franchise to the tune of £40 million but once that was gone it was under no requirement to do any more. The government stepped in as operator of last resort in order to maintain services.

The 13th December was widely tipped as the date the government would step in, but in fact the franchise was taken away just before midnight on 13th November and passed to government-owned East Coast Main Line Ltd, whose management team had already been put in place and includes some familiar faces. In turn, East Coast Main Line is a subsidiary of Directly Operated Railways Ltd, which acts as a holding company. Such a structure isn’t essential, but would be convenient in the event that any other franchises need to be taken under government control.

National Express Group was required to agree to something called cross-default termination where in theory defaulting on any one franchise would make it liable to be stripped of any others it held, in this case, c2c and East Anglia. Having taken advice, the Group strenuously denies that the clauses could be exercised in these circumstances but the DfT seems keen to keep its options open. c2c only has until 2011 to run, is not profitable, and would seem pointless to terminate early, but East Anglia is worth keeping and is the area around which there may be concern. This franchise can also terminate in March 2011 but is subject to automatic 3-year renewal providing certain circumstances are met as on or by 14th November 2009. Loss of East Coast the previous day means that this extension is no longer automatic (and see our News in Brief which suggest this move was carefully planned).

Meanwhile East Coast is enduring its latest rebranding and management changes while attempting to maintain its creditable service improvements under a new team. The railway will remain under government ownership for about two years while the lengthy refranchising process is embarked upon; a prior information notice was issued on 24th November indicating that the process would begin early in 2010 and will take at least a year (the c2c franchise is being re-let in parallel). Others in the industry point to the failure of the franchising system in encouraging behaviours that are unduly risky. A different model would be worth considering, or perhaps longer franchises where short term ‘blips’, even big ones, are not so devastating. Simply repeating more of the same does seem questionable. We also have a general election looming, where sensible options will be coloured by perhaps hastily and inexpertly-devised election commitments. However, to begin refranchising so soon perhaps suggests that more of the same is exactly what is going to happen. More immediately will be the concern that the network is not returning to government the expected revenues that have been built into the Statement of Funds Available and which are required to deliver the outputs required. National Express East Coast may have failed as an entity, providing clear evidence that their revenues were considered undeliverable, but other franchises are suffering too, and even if none of them fail there will still be less money being delivered.