A Vertical Shift

1 February 2017 Transport Secretary Chris Grayling has plans to open up the rail industry and allow greater private investment. But there are many bumps in the track to realising the vision, reports Paul Jarvis

The days of Network Rail operating the country’s track are numbered. Transport Secretary Chris Grayling announced in December his intention to bring more vertical integration into the way the UK’s rail system is maintained and run, essentially creating the potential for franchises in which the same private team will not only operate the trains along a route, but also the track on which those trains run.

Grayling said the first new franchises to be let from 2018 will have “integrated operating teams between train services and infrastructure”.

In many ways, this is finally bringing to fruition the recommendations made over five years ago by Sir Roy McNulty in his wide ranging review of the way in which the rail system operates in the UK. And many in the market suggest that the changes announced by Grayling fall a long way short of a revolution of the rail industry.

“The change is in emphasis to a greater degree. It is picking up some of the recommendations of McNulty,” says Chris Nash, research professor at Leeds University’s Institute for Transport Studies. “It might indicate a lack of confidence in Network Rail, but it doesn’t seem a radical change of direction.”

Tammy Samuel, partner at law firm Stephenson Harwood, agrees. “The plans are not as exciting as we first thought they might be.”

In truth, of course, Network Rail does not operate the whole of the UK’s track. There are already examples, such as HS1 or Crossrail, where the network is outside Network Rail’s control.

But Grayling’s plans do go much further than these isolated examples, and could yet provide new opportunities for investors and contractors with a strong PPP background.

As well as this new approach to franchising – which will begin with the South Eastern and East Midlands franchises in 2018 – Grayling also unveiled plans to implement vertical integration on a wholly new line: the East West Rail line creating a commuter route along the Oxford-Cambridge corridor.

“Its main task will be to secure private sector involvement to design, build and operate the route as an integrated organisation,” said Grayling. He also refused to rule out the potential for a PPP approach to the initiative, suggesting that all options are currently on the table.

Growing competition

The market may well be in a stronger position to respond to these opportunities today than when McNulty published his report in 2011.

“Six or seven years ago, there was probably only one company interested in a vertical franchise option in the UK, with everyone else looking for operator only contracts,” says James Stewart, global chair of infrastructure at KPMG. “As such, if you put out a contract you would have got a very narrow field of bidders.”

Stewart and others agree that today, there is a range of potential investors, particularly from China and Japan, who are willing and able to invest.

And it is not just the typical rail companies that are showing signs of interest. Samuel points to Wales, where she says bidders are all talking to investors or construction experts.

“I am sure that many entities will be interested in joint venture opportunities to take on infrastructure and track,” she explains. “The government will definitely get interest from all the types of companies that have previously been working with Network Rail, for example on maintenance and renewal projects.

“Lots of financiers are interested in rolling stock, but would be even more interested in getting involved in the track. If it gets the model and structure right, the government could end up with a lot of competition.”

So could that structure look something like a PPP? Transport academic and current chair of independent regulator the Office of Rail and Road (ORR), Stephen Glaister, has suggested that there could be “some merit” in using a PPP structure, “but only if properly applied”.

He argues that for PPPs to be successful in rail, two fundamental issues are required. First, that the procuring body write into the contract “a specification of what it expects to be delivered and to what standard”; and second that the contract must be positively managed and enforced in practice.

“The first requirement can be problematic because the demographic, economic and political environments can change rapidly and unpredictably,” he explains, referring to the 20-30 year length of a standard PPP deal.

He also warns that the second issue may be difficult to overcome because it can be “difficult to ensure that there is a credible threat” that another private partner could take on a failing contract should that be required.

“Without this threat it can then become difficult to defend against sub-standard level of service and demands for extra funds,” he says.

Whether the increased number of potential players in the market today might change that dynamic remains to be seen.

Interface issues

Samuel is also uncertain that a traditional PPP approach is the best solution. She suggests that the East West Rail project could provide a perfect opportunity for the government to develop a model for the future of franchising across the country – as long as the work is not considered in isolation.

“Trying out an integrated approach on a small trial basis to see what works is fine, provided it is a basis for rolling out the same approach elsewhere,” she explains. “PPP may work on a completely separable line such as this, but it may not work on all parts of the network.”

This point also drives towards another problem facing the government as it considers moving towards a structure in favour of vertical integration: how to deal with the points at which different franchise owners are operating along a line owned by a rival.

“How do you deal with somewhere like London Bridge, for example, with different franchises coming in,” asks Stewart. “Who gets priority?”

“The interface remains one of the key issues,” agrees Samuel. “By reducing the interface between wheel and rail, you are then creating other interfaces between vertically integrated entities which can also be challenging to manage.”

There are already some examples of this happening in practice, most recently with London’s Crossrail project, where Transport for London, through Crossrail Infrastructure, is looking after the central piece of the new line, but must interface with Network Rail on both the east and west of the line.

Samuel points out that it is not just an issue of who looks after the signalling or maintains the electrical supply – it is also about how services are prioritised; how the knock-on effects of problems on one provider’s service are managed by another, and so on.

Then there is the regulatory issue. “The ORR was set up to regulate Railtrack and then Network Rail – a sole infrastructure manager,” says Samuel. “There needs to be root and branch review and potential reform of how the regulations work when there is more than one entity; how periodic reviews work; how appeals from different networks are dealt with, etc.

“So you need to have physical certainty regarding the infrastructure, but also regulatory certainty.”

Nash suggests that it may not be a sensible approach for all parts of the line, particularly in and around the main stations in cities such as London, where several different operators will be converging. The only way to untangle that knotty problem would be to redraw the franchise boundaries – something that most agree would not be an appetising prospect for the government, and not something that Grayling and ministers have given any suggestion that they are keen to do.

Given all these potential headaches facing the government, it may well be tempted to see the East West Rail line as a stand-alone entity, eschewing any idea of using it as a test bed for the future of the entire network.

But one thing means that the government is in greater need than in the past to do something more fundamental: Network Rail is now on the government’s balance sheet.

“The direct funding of Network Rail is going to be increasingly difficult now that it is on the government’s balance sheet, so I can see some areas will need to be privatised, possibly through a concession arrangement,” concludes Samuel.

“None of this is impossible to overcome, but the government needs to make sure there are going to be benefits in doing it, and that the changes it makes work (both structurally and regulatory), and are not going to be changed again down the line.”

This page was last updated on:
1 March 2017.

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