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INFORMED SOURCES February 2007

West Coast – Virgin back with a vengeance

Forget the subsidy, it's the implied revenue line that counts

When DfT Rail announced the reinstatement of the West Coast franchise agreement with Virgin Rail Group (VRG) with immediate effect from December 13, what caught everyone's attention was the subsidy (Table 1). With the other inter-city operators paying premia (or failing to, as the case may be), the outcome of 15 months of negotiations between DfT Rail and VRG was perceived as handing yet more money to Virgin Chief Sir Richard Branson, after the original expansive plans for the West Coast had failed.

However, if you read on you will see that far from being subsidised fat cats, VRG are staying true to the Spirit of '97. And VRG don't do Peter the Great franchise bids – draw a straight line on the graph and call it the premium. While their franchise plans incorporate some very sporty revenue growth projections, these are linked to changes on the real-life railway.

Letter Agreement

But let's start at the very beginning, or rather, July 2002, when the then SRA had to rescue the two Virgin franchises under the ‘Letter Agreement'. With the West Coast Route Modernisation (WCRM) running late, and with it the performance enhancements on which the franchise plan was based, VRG could not meet the projected revenue lines.

With the Passenger Up Grade 2 (PUG2) contract making a threatening bulge under Sir Richard's pullover, the Strategic Rail Authority ( SRA ) dared not pull the plug on the two franchises, even if it had wanted to. Hence the Letter Agreement which converted Virgin Cross Country and Virgin West Coast to management contracts, under which Virgin was paid a percentage of revenue to run the franchises to an agreed annual budget while new terms were agreed.

In the case of Cross Country, if a deal could not be achieved, SRA , and subsequently DfT Rail, had the right to re-let the franchise, as is indeed happening. But with PUG 2, inherited from Railtrack by Network Rail, threatening Mutually Assured Destruction, West Coast was inviolate. DfT Rail could either negotiate revised franchise terms or leave continue with the management contract until the franchise expired on 9 March 2012 .

Negotiations

As reported here, DfT Rail, wisely, imposed a pause in negotiations until the commercial impact of the Pendolino service could be quantified. Meetings reconvened in September 2005 and the December 2006 settlement reflects DfT Rail's growing confidence in VRG's ability to deliver budget forecasts.

Table 1

Source DfT Rail

According to DfT Rail, the renegotiated franchise agreement puts the contract on a ‘secure financial footing' and will ensure that the enhancements in the 2008 timetable are delivered. Commenting on the deal Rail Minister Tom Harris said it provided the opportunity ‘to put even more services' in the December 2008 timetable within the contract, and ‘strike a better value deal for the taxpayer'. He added that further capacity enhancements are being examined as part of the development of the High Level Output Specification and the future of the railways White Paper both of which are due to be published in July.

Analysis

Now for some heavy duty analysis, starting with a comparison of the profiles of the three long distance Inter-City franchises (Table 2 and Chart 1). As you can see after the part year to 31 March this year the VWC subsidy increase slightly then starts to reduce from 2009-10.

This reducing trend is triggered by the extra capacity and journey time improvements in the December 2008 timetable. Birmingham-Scotland services are also due to be transferred to VWC after the New Cross Country franchise comes into effect in November 2007

As the chart shows, once the upgrades are completed VWC revenue is expected to grow at around the same rate as GNER and FGW. But, it should be noted that, unlike the others, on ridership, VWC is coming from behind.

Readers may have noted that when Virgin makes a song and dance about growth it always mentions passenger numbers. This hides the West Coast's dirty little secret.

Table 2 Inter-City Ridership - journeys

As Table 2 shows, West Coast has had the lowest growth in passenger journeys of all the Inter-City franchises. Given the disruption during the WCRM this is understandable from what has been effectively a five days a week railway.

But passenger miles is a different matter. And it is passenger miles that generate the revenue.

Table 3 Inter-City Ridership – passenger miles

Passenger miles millions

As Table 3 shows, in the first 11 years following privatisation, Inter-City West Coast passenger miles fell by 12% from an already depressed level due to the recession in 1991. No wonder the business had to be rescued.

Table 3

Premium/(subsidy) payments for inter-city franchises

* Part year for VWC

Access

But that is not the reason for the VWC subsidy when other Inter-City operators are paying premia. The difference is to be found in Track Access Charges ( TAC ).

Under their Franchise Agreements, Train Operators are indemnified against changes in track access charges paid to Network Rail. Since TAC are reviewed every five years by the Office of Rail Regulation, and are outside the Train Operators' control, no one would bid for a franchise unless the risk of such change were mitigated.

Thus, under Schedule 18 of Franchise Agreements, if access charges rise, subsidy is increased, or premium reduced, and vice versa. For Train Operators changes in TAC are cash neutral.

Under the 2004 Access Charge Review, Network Rail's income increased, but the Government chose to keep track access charges down and increase Network Rail's direct grants. On top of that Network Rail received only part of its increased revenue in the first two years of the new Control Period 3 (CP3), so that DfT could balance its books. The diference was made up by borrowing.

Network Rail's income was then reprofiled for the remaining three years, so that over the five years of CP3 it received the Regulatory determination in full. You can see how subsidy and TAC drop at the start CP3 in 2004-05 and rise again in 2006-07. You can see this in qction in Table 4.

Chart 1

Compariso of inter-city premium/subsidy profiles

Table 4

Virgin West Coast subsidies and track access charges

(- denotes premium payment)

All figures £1000.

•  start of letter agreement

•  Subsidy for part year December 13 2006-March 31 2007

(3) Includes transfer of half class 221 fleet from November 2007 but excludes increased Pendolino mileage

Table 5 shows the effect of reprofiling on GNER and VWC. But, more importantly, it highlights the effects of a another change of policy. When track access charges were introduced in 1996, Railtrack's fixed income was ‘jam spread' equally across all franchises. But for CP2, starting in 2001, the allocation was changed to reflect investment in infrastructure.

This increased the VWC and VCC TACs, but reduced TAC for investment free operators including GNER and FGW. VWC pays nearly three times as much as GNER.

Table 5 Comparison of fixed track access charges for CP3

£million

Missing Pendolino

So far, the numbers shown have been fixed TAC determined by ORR. These cover the cost of providing and operating the infrastructure. In addition TOCs and open access operators pay variable TAC which reflect the wear and tear of running trains. ORR publishes a ‘price list' of variable TAC , giving the cost in pence per mile of all passenger and freight traction and rolling stock.

But, and, you may detect a faint small of rotting fish, the only rolling stock not in the price list is the Class 390 Pendolino. So in February 2005 I asked ORR for the Class 390 Variable TAC under the Freedom of Information Act. This request, and a subsequent appeal, were was rejected on grounds of commercial confidentially.

But I was assured that the information would be published in the 2006 update of the ‘price list'. When I checked at the end of last year, the Class 390 still wasn't listed. ORR attributes omission to the ongoing franchise negotiations, and the information will now feature in the autumn 2007 revision.

But we can estimate the VWC variable TAC by using the Class 221 tilting Super Voyager as a surrogate for the Class 390 Pendolino. Vehicle for vehicle, Pendolino should be cheaper.

But based on the Class 221 I reckon that VWC's variable TAC for the current Pendolino timetable is around £32m a year. As a back check, the GNER variable TAC is around £20m a year with fewer train miles.

Some time after November 2007, VWC will take over approximately half the Class 221 fleet under the Central Trains/VWC franchise remapping. I estimate that this will add £6m a year to the VWC variable TAC charge. Finally, when the new December 2008 timetable comes in VWC reckon that Class 390 mileage will increase by around one third – equivalent to a further £10m a year.

So in round numbers from 2009-10 the VWC variable TAC could be £50m a year, bringing total access charges to around £400m a year. Virgin told me that TAC for the remaining five full years of the franchise will total £2.2 billion.

TAC to rise?

Fixed TAC from 2009 onwards are a known unknown because they will depend on the outcome of current Periodic Review and how much money is in the SoFA. But we do know that the £2.2 billion represents the best guess of VRG and DfT Rail in the course of their negotiations. And DfT Rail's best guess ought to be pretty well-informed.

So, subtracting the ‘known' two year's TAC from the £2.2 billion total and dividing the remainder by three gives total annual TAC for the last three years of the franchise of around £490 million, an implied increase of around £100 million. So, in a steady state franchise you would expect subsidy to rise by the same amount under Schedule 18,

But, instead, the VWC subsidy is due to fall in 2009-10, reflecting the increased service frequency. So with access costs rising by £100 million and subsidy falling by £50 million, the implication is that VWC is looking to the new timetable to increase revenue by £150 million in the first year. Sporty, or what?

Now, I suspect that this may be an over-estimate, but not by an order of magnitude. Looking back to Table 4 we see that under the original franchise plan, completion of the first stage of the WCRM in 2003-04 was due to increase the premium by £60 million (at 2005-06) and by a further £70 million with PUG 2 in 2006-07.

Continues.........