1999-11-05 Statement in response to Rail Regulator's announcement re West Coast Main Line (Railtrack plc)

1999-11-05 SSRA response to Rail Regulator's statement on West Coast Main Line Upgrade (Shadow Strategic Rail Authority)

_______________________________________________________________

date 15 December 1999
source Office of the Rail Regulator
type Press release

note ORR/99/53

The Rail Regulator, Tom Winsor, today published his plans to enable Railtrack
to finance a rail network fit for the 21st Century.

In his periodic review provisional conclusions document, the Regulator sets
out his financial regime for Railtrack - the company responsible for operating
and maintaining the rail network infrastructure for the next charges control
period starting in April 2001. (The Regulator's foreword and the introduction
to the document are attached.)

Tom Winsor also reports on the new incentive framework to be introduced in the
next charges control period. The Regulator is due to publish his final
conclusions on the periodic review as a whole in July 2000.

Introducing his conclusions, Mr Winsor said: 'My objective is to provide
Railtrack with a sound, challenging and above all fair financial settlement
which will enable and incentivise the company to operate the network safely,
efficiently and well and to enhance its capacity through strong and competent
investment.

The Regulator said his conclusions were based on challenging but achievable
assumptions about the scope of the company to improve its efficiency and bring
down its costs. He has published a range of potential scenarios and further
work is required to assess the level of maintenance and renewals which
Railtrack would actually need to undertake over the next control period.

The Regulator's provisional conclusions on Railtrack's revenue requirements
are based on the following assumptions:

(a) efficiency gains of 5 percent per annum (within a range of 3 - 5 percent);
(b) a real pre-tax rate of return of 7 percent (within a range of 7 - 7.5
percent);
(c) an uplift of 10 percent on the first day's trading value of the company's
equity (within a range of 10 - 15 percent) which results an initial Regulatory
Asset Base (RAB) of 2.93 billion pounds in 1998/99 prices;
(d) allowance for 1.14 billion pounds of Railtrack's investment expenditure in
the current period, resulting in a RAB of 4.07 billion pounds before further
investment; and
(e) assumed property income of just under 1 billion pounds over the next
period which would offset Railtrack's expenditure requirements.

Other key proposals on the incentive framework relate to:

(a) the establishment of a framework for enhancements which results in
clearer incentives for Railtrack to invest and sufficient predictability to
give investors the confidence to continue to provide finance;

(b) the identification of clearly defined baseline outputs which are
paid for in the base level of access charges to ensure that Railtrack's
performance can be effectively monitored, incentivised and, where necessary,
enforced.

Tom Winsor said :'The periodic review settlement will provide an opportunity
for a safe, efficient and well managed Railtrack. By discharging its public
interest obligations and responding to the contractual and regulatory
incentives, the company will be able to enlarge and improve the network in a
way which meets the legitimate expectations of both the public and the
company's investors'.

'The periodic review of Railtrack's access charges: provisional conclusions on
revenue requirements' is available from Sue MacSwan, ORR Library, 1 Waterhouse
Square, 138-142 Holborn, London EC1N 2TQ. (Tel: 0207 282 2001; fax: 0207 282
2045; e-mail: orr@dial.pipex.com). The document and three associated
consultants' reports can be found on the ORR web site at
http://www.rail-reg.gov.uk/



Regulator's foreword

1. This document contains my provisional conclusions in relation to the amount
of money which Railtrack is likely to need to operate and maintain its present
network from April 2001, the beginning of the next price control period. These
conclusions are provisional in the sense that they may, in some cases, be
revised if new information is provided or circumstances change and I believe
it is right to make amendments. My final conclusions are due to be published
by the end of July 2000.

2. My objective in the periodic review is to provide Railtrack - and through
them the railway industry and those who fund, use and depend on it - with a
sound, challenging and above all fair financial settlement which will enable
and incentivise the company to operate the network safely, efficiently and
well and to enhance its capacity through strong and competent investment. That
process must of course take account of Railtrack's achievement of the
regulatory objectives which it was given at the beginning of the current price
control period in 1995. But most importantly it must be forward-looking and
take full account of and facilitate the significant investment which the
company needs to make to meet the strong growth in demand for railway
services.

3. In the past the company has faced criticisms of its record and the
condition of its network. Those criticisms have come from several quarters.
Many were deserved, and the company has acknowledged that it needs to improve
in important areas. I acknowledge and recognise the company's stated
determination in these respects. It knows what counts is of course delivery on
its public interest obligations as well as its commercial commitments.

4. When I was appointed as Regulator, I said that I did not consider myself
bound by the conclusions on the financial framework which my predecessor
announced in December 1998. I said that I would reconsider all the work which
had been done before I took office and make my own decisions. That is what I
have done. In several areas I have departed from my predecessor's conclusions,
and by doing so I have ensured consistency with other regulators and with the
reasonable expectations of investors. I also consider that it is important to
avoid retrospective clawback of profits arising from the current performance
incentive regime because this would undermine incentives in the future.

5. My provisional conclusions for the future level of expenditure are based on
challenging but achievable assumptions about the scope for the company to
improve its efficiency and bring down its costs. However, these conclusions
have been hindered by difficulties arising from the company's lack of
knowledge about the condition of its assets. I have therefore published a
range of potential scenarios and further work is required to assess the level
of maintenance and renewals which Railtrack will actually need to undertake
over the next period.

6. A major shortcoming of the current regulatory framework is the fact that
the outputs which Railtrack is expected to deliver are not clearly defined or
monitored. The foundations for a robust incentive framework - based on carrots
as well as sticks - are therefore missing. This document begins to address
this issue by attempting to define the outputs. The way in which these outputs
are incentivised will be developed further in Spring 2000.

7. Another difficulty for Railtrack and operators is that there is no clear
understanding of the commercial and regulatory framework for dealing with
enhancements. In conjunction with Railtrack and the SSRA I am therefore
developing a code of practice which should result in clearer incentives for
Railtrack to provide appropriate enhancements and sufficient predictability to
give investors the confidence to continue to provide finance for new
infrastructure projects.

8. The periodic review settlement will provide an opportunity for a safe,
efficient and well managed Railtrack. By discharging its public interest
obligations and responding to the contractual and regulatory incentives, the
company will be able to enlarge and improve the network in a way that meets
the legitimate expectations of both the public and the company's investors.
TOM WINSOR
Rail Regulator

15 December 1999
1. Introduction


Background and purpose

1.1 This is the fifth periodic review document published by the current
Regulator. A full list of all the periodic review documents, related
consultation papers and consultancy reports is contained in Appendix A.

1.2 The August 1999 periodic review document set out the timetable, process
and issues for the remainder of the review. It confirmed the Regulator's
intention to publish provisional conclusions on the overall level of
Railtrack's revenue requirement from access charges for franchised passenger
train services in December 1999. Since then, in October 1999, the Regulator
published a further periodic review document on the incentive framework, and
provisional conclusions on these issues are due to be published in Spring
2000. He has also published two technical consultation papers relating to the
structure of charges. The Regulator's final conclusions on the periodic review
as a whole are due to be published in July 2000.

1.3 The primary purpose of this document is to invite views from interested
parties on the Regulator's provisional conclusions for Railtrack's overall
revenue requirement from access charges for franchised passenger train
services. Part I therefore describes the Regulator's provisional conclusions
on these issues, together with the principal reasons for those conclusions.
Part I also describes the further work which the Regulator plans to undertake
to enable him to reach final conclusions in July 2000.

1.4 Part II of this document provides a progress report on work which the
Regulator has undertaken on the incentive framework since the October 1999
periodic review document. This includes:

- a brief review of progress since the October 1999 periodic review
document on the incentive framework including a summary of the responses to
the associated technical consultation document on electric traction charges;

- provisional conclusions on changes to the property allowance scheme
or PAS (in June 1999 the previous Regulator consulted the industry on the
operation of the current PAS and on whether there should be any changes to the
scheme);

- discussion of the key issues relating to the level and structure of
Railtrack's charges for access to stations (which were not covered in detail
in the October periodic review document);

- definition of the outputs which Railtrack is expected to deliver over
the next price control period, the output measures which the Regulator
presently proposes to monitor and requirements for the March 2000 Network
Management Statement (NMS); and

- proposals for a regulatory framework for dealing with future
enhancement projects which are not included in the baseline (this is an
important part of the periodic review since it aims to provide greater clarity
about the way in which the Regulator would expect to treat future enhancement
expenditure).

1.5 The questions for consultation are summarised in Appendix B. Consultation
responses should be sent to:

Paul Plummer
Chief Economist
Office of the Rail Regulator
1 Waterhouse Square
138-142 Holborn
London
EC1N 2TQ

by 14 February 2000. Respondents should indicate clearly whether they
wish their responses to remain confidential to the Office of the Rail
Regulator (ORR). Otherwise they may be published, placed in the ORR library or
quoted from by the Regulator. Where a response is made in confidence, it
should be accompanied by a statement which can be published, placed in the ORR
library or quoted from by the Regulator, summarising the submission excluding
the confidential information.

Summary of Part I

Outputs

1.6 The appropriate level of Railtrack's access charges clearly depends on the
outputs which it is expected to deliver in return for these charges. The
outputs covered by the periodic review are referred to as the baseline outputs
since they exclude any new enhancements which might be negotiated (or
otherwise established) for implementation over the next price control period.

1.7 For the purposes of the provisional conclusions, these baseline outputs
are defined in terms of the outputs which are implicit in the 1999 Network
Management Statement (referred to in this document as the sustained network).
They therefore exclude any incremental outputs which the Shadow Strategic Rail
Authority (SSRA) may want to buy as part of the periodic review process. The
SSRA's current view on these incremental outputs is set out in Part II of this
document and these will need to be costed up in the 2000 NMS so that they can
be taken into account in the Regulator's final conclusions.

Activities

1.8 Given these baseline outputs, Railtrack's expenditure requirements depend
primarily on the level of maintenance and renewals activity which is required
in order to sustain the current capability and condition of the network.
However, due to the lack of information on the existing condition of
Railtrack's assets, there is considerable uncertainty about the amount of work
which Railtrack needs to do.

1.9 Because of these uncertainties, the Regulator has examined a range of
scenarios. The base scenario assumes that the current level of maintenance and
renewals activity (excluding backlog) would continue throughout the next
period. However, it may be the case that this is insufficient to sustain the
current capability and condition of the network. The Regulator's provisional
assumption is that these activities might need to increase by around 10%.
However, this does not take account of Railtrack's recent reassessment of the
maintenance and renewal costs associated with the West Coast Main Line, which
could imply a further 12% increase in activity.

1.10 In considering these alternative scenarios, Railtrack will need to
establish that any increase in maintenance and renewals activity is necessary
to sustain the network and that this additional activity can be delivered. In
relation to the West Coast, Railtrack will also need to be able to establish
that these additional costs should not be treated as part of the enhancement
for which they have agreed a fixed-price contract with West Coast Trains
Limited (Virgin).

1.11 The Regulator will also wish to consider whether renewals should continue
to be paid for on a pay-as-you-go basis rather than being included in the
Regulatory Asset Base (RAB). His present view is that the former approach will
generally be preferable. However, this will depend to some extent on the
degree to which he is satisfied that the underlying projections of renewals
expenditure are soundly based.

Efficiency

1.12 For each maintenance and renewal scenario, Railtrack's expenditure
requirements depend on the assumed scope for improved efficiency. In assessing
this issue, the Regulator has examined evidence from a wide range of sources
including Railtrack's efficiency savings to date, detailed analysis of the
impact of specific improvements, benchmarking with other railways, comparisons
with productivity trends in other railways, comparisons with what other
regulators have assumed and comparisons with what other privatised companies
have actually achieved.

1.13 Given the available evidence, the Regulator believes that Railtrack
should be able to achieve savings of 3-5 percent per annum over the next price
control period as a whole (although the profiling of these savings requires
further consideration). For the purposes of his provisional conclusions, he
has assumed savings of 5percent per annum, which is at the top end of the
proposed range. His present view is that these savings will be challenging but
achievable.

Single till income

1.14 Railtrack's expected income from other sources which are within the
so-called single till is deducted from the overall expenditure projections
referred to above. The main source of this income is from property and this is
expected to total just under one billion pounds over the next price control
period. For the purposes of the Regulator's provisional conclusions, freight
income and open access income are assumed to remain flat in real terms.
However, the current freight access agreements are due to be renewed at the
beginning of the next price control period and the Regulator will need to take
account of the likely level of charges in his final conclusions.


Cost of capital

1.15 The Regulator proposes to set the allowed rate of return on a pre-tax
basis. This ensures consistency with the treatment of major enhancements and
will help to minimise the need for detailed regulatory involvement in
Railtrack's tax and financing assumptions.

1.16 The Regulator's approach to assessing the cost of capital has been to
adopt a methodology which is consistent with that used by other regulators and
to focus on the extent to which Railtrack may face greater risks than other
utilities. He has concluded that Railtrack does face some additional risks. In
particular, he recognises that Railtrack's profits are a relatively small
proportion of its revenues/costs and that a given change in revenues/costs
will therefore have a relatively large impact on profits.

1.17 Given these additional risks, the Regulator's provisional conclusion is
that Railtrack should be allowed a real pre-tax rate of return of
7-7.5percent. This compares with 6.5 percent assumed by OFGEM on the same
basis (it is also consistent with the range of 5-6 percent post-tax proposed
by the previous Regulator). For the purposes of his provisional conclusions,
the Regulator has assumed a value of 7 percent pre-tax.

1.18 If OFGEM or OFWAT are forced to refer these matters to the Competition
Commission, the Regulator would expect to take account of this in reaching his
final conclusions on the cost of capital.

Regulatory Asset Base

1.19 In assessing the appropriate value for the RAB, the Regulator believes
that it is important to ensure that this is consistent with the reasonable
expectations of investors at the time of privatisation. Otherwise, investors'
perception of regulatory risk may be increased and this could impact on
Railtrack's cost of finance. Given the likely scale of the enhancement
programme, this is unlikely to be in the interests of passengers, operators or
funders.

1.20 The initial RAB is based on the value of equity plus debt at around the
time of privatisation. The Regulator presently intends to include an uplift of
10-15 percent on the first day's trading value of equity for consistency with
relevant precedents and to provide reasonable compensation for the risks which
investors took at privatisation. The provisional conclusions assume an uplift
of 10 percent which results in an initial RAB of 2.93 billion pounds in
1998/99 prices.

1.21 The Regulator presently proposes to roll forward the RAB by making the
following adjustments:

- 0.48 billion pounds of backlog spending is included in the RAB on the
basis that this was the understanding when the current price controls were set
at privatisation;

- the RAB includes 0.32 billion pounds of the additional 1.9 billion
pounds which Railtrack will have spent during the current price control period
over and above the assumptions underlying the current price controls (the
remainder is not included since this was either offset by other changes which
were made at the time of privatisation or because this represents inefficiency
or risks which investors were expected to bear);

- 0.46 billion pounds of enhancement expenditure in the current period
is included in the RAB (although this has not yet been fully assessed) but,
for the purposes of the provisional conclusions, further enhancement
expenditure in the current period (0.72 billion pounds based on Railtrack's
estimates) and network downgrades have not been reflected in the RAB;

- some specifically identified items of expenditure have been disallowed
on the basis that these outputs should have been delivered in the current
period. There is also strong evidence that Railtrack has underdelivered in a
number of other areas. Due to the absence of any clear definition of what
Railtrack was expected to deliver in the current period and the Regulator's
proposed disallowance of most of Railtrack's additional renewals, the
Regulator does not consider that it would be appropriate to make substantial
further adjustments for this under-delivery. However, he is consulting on
whether it would be appropriate to reduce the RAB by up to 120 million pounds
(around 1percent of turnover in the period since privatisation) in line with
the approach adopted by OFWAT and OFGEM; and

- given the potential adverse implications for future incentives and
perceived regulatory risks, the Regulator does not consider that it would be
appropriate to claw back the profits which Railtrack has earned from the
performance regime (through a further reduction in the RAB) even though there
is some evidence that most of the improvement in performance was achieved in
the first year and may have been due to slack targets rather than efficiency.

1.22 A related issue is whether Railtrack's charges should be set to achieve a
rate of return in line with the assumed cost of capital (so that efficiency
savings are passed on immediately following the review), or whether there
should be some form of glide path which would allow the company to earn a
higher return for a period of years (to provide a stronger incentive to
improve efficiency). The Regulator does not presently believe that it would be
appropriate to provide for a glide path as part of the current review. He
intends to consider how to strengthen the incentive for improved efficiency in
his Spring 2000 provisional conclusions on the incentive framework.

1.23 By comparison, the previous Regulator proposed that there should be no
uplift on the first day's trading value, that none of the (then 1.3 billion
pounds) additional renewals should be included in the RAB, and that some of
the profits from the performance regime should be clawed back. However, the
question of a glide path was left open and other issues relating to the way in
which the RAB is rolled forward were not addressed in detail.

1.24 The Regulator believes that the proposed ranges are consistent with the
relevant precedents and the expectations of investors at the time of
privatisation. Where he has departed from the approach adopted by the previous
Regulator, he believes that this will be in the longer-term interests of
passengers, operators and funders since it is likely to reduce Railtrack's
cost of finance, thereby facilitating further investment in the railway.

Baseline revenues

1.25 Given the preceding assumptions, the charges required to finance the
delivery of the baseline outputs which are implicit in the 1999 NMS would fall
by around 17 percent at the beginning of the next period; for the remainder of
the period, there would be no real change in charges (i.e. X equals 0). The
Regulator's provisional assumption of the possible need for additional
maintenance and renewals activity reduces the initial cut in baseline revenues
to 8 percent. If Railtrack's reassessment of the costs associated with the
West Coast Main Line is taken into account, charges would increase by around 2
percent in real terms. By comparison, Railtrack's own projections imply an
initial increase of 31percent (again with X equals 0).

1.26 As noted above, however, these charges do not include the cost of any
enhancements which might be negotiated over the next period or the cost of any
incremental outputs which the SSRA may wish to buy as part of the periodic
review process. The enhancement plans in Railtrack's November 1999 submission,
for example, would increase the RAB from 4.07 billion pounds to 11.30 billion
pounds by March 2006 and 15.69 billion pounds by March 2011. Given the three
maintenance and renewal scenarios described above, this implies price
increases of up to 18 percent and Railtrack's own projections imply initial
increases of 47 percent (with X equals 0 in each case).

Financing implications

1.27 The financing implications of these potential outcomes have also been
considered. It is clear that the range of scenarios examined by the Regulator
would not make it unduly difficult for Railtrack to finance the delivery of
the sustained network outputs alone. The scope for Railtrack to finance
investment through additional debt will be considered further in conjunction
with the Regulator's final conclusions. However, depending on the scale of
the investment programme which Railtrack is expected to finance, it may wish
to raise new equity as well. The proposed framework for enhancements
(summarised below) is therefore an important element of the periodic review.

Summary of Part II

Progress on the incentive framework

1.28 Since the October 1999 periodic review document on the incentive
framework, the Regulator has published two technical consultations relating to
the structure of charges (on electric traction charges and usage charges). He
does not, however, intend to consult further on the possibility of a capacity
reservation fee until after the responses to the October 1999 document have
been reviewed. The Regulator is also considering the appropriate timing of any
changes to the structure of charges and the possibility that some aspects of
these charges might be subject to further review during the next price control
period (without reopening the overall level of charges).

Property allowance scheme

1.29 The Regulator's present view is that the property allowance scheme (PAS)
should remain broadly unchanged. His current view is that the baseline income
(which is deducted from Railtrack's expenditure projections as described
above) should be towards the upper end of the range of income projected by his
consultants. In addition, he presently considers that out-performance should
continue to be shared 75:25 between Railtrack and franchised passenger
operators/funders.

Stations

1.30 Since station access charges represent a relatively small proportion of
Railtrack's overall charges and there are many individual station access
agreements, the Regulator does not presently envisage changing the methodology
for setting individual stations charges. Instead he plans to propose
high-level adjustments to the level of these charges.

1.31 The Regulator does, however, believe that it is important for the station
access charges to be structured to provide a stronger and clearer incentive
for Railtrack to improve performance and to deliver the enhancements required
by operators/funders.

Baseline outputs

1.32 For the next price control period, the Regulator will want to ensure that
there is a very clear definition of the baseline outputs which are being paid
for in the base level of access charges. This is necessary to ensure that
Railtrack's performance can be effectively monitored, incentivised and where
necessary enforced.

1.33 The Regulator is therefore proposing a number of output measures which he
would expect to monitor over the next price control period. These will need to
be reflected in the 2000 NMS. In the first instance, the Regulator expects
Railtrack to take major steps towards establishing an asset register and
populating this so that the current condition of the network is clearly
understood.

Enhancement framework

1.34 As noted above, most enhancements are outside the scope of the periodic
review. However, the Regulator believes that this review should provide a
clear framework within which these enhancements can be negotiated (or
otherwise established) and approved by the Regulator. In particular, he
considers that the proposed framework should provide sufficient transparency
and predictability to give investors the confidence to provide finance for new
infrastructure projects at an appropriate cost. It should also help to ensure
that Railtrack has sufficient incentive to provide worthwhile network
enhancements and help to minimise the transaction costs associated with the
applicable processes.

1.35 The proposed framework would incorporate a clearer definition of the
boundary between the baseline outputs which are paid for by the base level of
access charges and additional enhancements which would need to be paid for by
operators/funders. It would also set out the issues which the Regulator
expects to take into consideration when assessing the appropriate level of
charges in new or revised access agreements (including the appropriate rates
of return). Finally, it would establish a transparent process for establishing
how enhancement expenditure should be reflected in the RAB at subsequent
reviews.

Next steps

1.36 As indicated in the August 1999 periodic review document, the Regulator
plans to publish provisional conclusions on the incentive framework in Spring
2000. His final conclusions on the periodic review as a whole are due to be
published in July 2000. These final conclusions will take account of responses
to this document as well as further discussions with Railtrack and other
interested parties.

1.37 As well as the specific issues identified in this document, consultees
are invited to comment on other aspects of the periodic review.

Railhub Archive ::: 1999-12-15 ORR-001