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2000-04-14 ORR-001
Office of the Rail Regulator

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Rail Regulator tackles Railtrack's incentive framework


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Office of the Rail Regulator

Rail Regulator tackles Railtrack's incentive framework
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related documents


1999-12-15 Regulator sets out Railtrack's future financial framework (Office of Rail Regulation)

2000-04-14 Railtrack gives cautious welcome to the regulator's provisional conclusions on the incentive framework (Railtrack plc)

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date
14 April 2000
source Office of the Rail Regulator
type Press release

note ORR/00/11


n a week when it was revealed that Railtrack earned huge bonuses despite rail
passengers suffering ever more delays, the Rail Regulator has taken another
step towards sweeping away the existing financial framework replacing it with
stronger and clearer incentives for delivery.

Tom Winsor said today 'Since I was appointed in July 1999, I have made it
plain publicly that incentive regulation is and always has been preferable to
enforcement action and that the incentive regime established in 1995 was
fundamentally flawed. I want Railtrack to become more imaginative, more creative and more responsive to its customers' needs, giving the railway industry its own vision for growth
and implementing worthwhile plans for sorely needed investment and
improvement. That is what the public and the industry want and expect of the company.'

He said the present structure had been rightly criticised but he now had the
opportunity to put right the shortcomings of the past and that is what he
intended to do. He said: 'Good performance will be rewarded and bad
performance will be penalised.' In particular, he proposes to strengthen and
simplify the contractual incentive for Railtrack to reduce delays.

'However, no regulator should discard enforcement action if commercial
incentives fail for any reason. But I will inject greater clarity and
transparency about the circumstances in which enforcement action may be taken
and the basis on which penalties will be established,' he said.

Mr Winsor said that information about Railtrack, its financial performance and
the nature and condition of its assets was the oxygen of regulation. Having
already announced his intention to modify the company's network licence he
said his plans included draft licence modifications relating to the provision
of information and the appointment of independent reporters to verify the
information.

The plans also include an explanation of how enhancements to the network will
fit into a new financial framework. 'The new enhancement regime will be
important in facilitating the franchise replacement programme, in which train
operators are to be encouraged and may be required to invest considerable sums
themselves in exchange for much longer contracts,' he said.

On the question of third party enhancements, Mr Winsor stressed that it was
essential that neither the safety nor operational integrity of the railway was
prejudiced, and no such risks would be contemplated. 'However, the railway
industry should not be afraid of new ideas which could bring real and sound
improvements earlier than the traditional methods', Mr Winsor added.

The Regulator also announced his intention to publish draft final conclusions
on the review in July 2000 allowing interested parties time to make
representations on the conclusions before he publishes his final review notice
in September 2000. This will allow more time for the Regulator to assess new
information in relation to the West Coast modernisation and the cost of
enhancements included in the Shadow Strategic Rail Authority's Incremental
Output Statement.

'The periodic review of Railtrack's access charges: Provisional conclusions on
the incentive framework' is available from Sue MacSwan, ORR Library, 1
Waterhouse Square, 138-142 Holborn, London EC1N 2TQ. (Tel: 020 7282 2001; fax:
020 7282 2045; e-mail : orr@dial.pipex.com. The document can also be found on
the ORR web site at http://www.rail-reg.gov.uk.

Notes to Editors
1. The Regulator's approach to the periodic review including the incentive
framework was first set out in August 1999 - 'Incentive regulation central to
the Regulator's periodic review of Railtrack' (p/n ORR/99/37).
2. In October 1999 the Regulator consulted further on detailed proposals for
the incentive framework, including the incentive to improve delays -
'Rail Regulator publishes consultation document on incentives' (p/n
ORR/99/45).
3. The December 1999 periodic review document consulted on further aspects of
the incentive framework, including the treatment of enhancements 'Regulator
sets out future financial framework (p/n ORR/99/53).

PRESS INVITATION

To: Transport, City and Business Correspondents

You are invited to send a representative to a press briefing to be hosted by
Tom Winsor, the Rail Regulator, when he will explain his proposals to
incentivise Railtrack to expand the capacity of the railway and improve its
own performance.

The briefing, starting at 11am, will be held today, Friday 14 April, at the
Office of the Rail Regulator, 1 Waterhouse Square, 138-141 Holborn, London
EC1N 2TQ.

Stills photographers are asked to conclude their business in the opening ten
minutes. There will be an opportunity for tv and radio interviews at the end
of the briefing.

Copies of the material are now available for collection from ORR Reception.

Please ring Ian Cooke on 020 7282 2002 or David Davies on 020 7282 2007 to
confirm your attendance.

PRESS ENQUIRIES : ORR Press Office : 020 7282 2002/2007/2089
Out of office hours : pager number 07659 127303


Regulator's foreword

1. This document contains my provisional conclusions on the framework of
incentives which I believe should be established as part of the periodic
review of Railtrack's access charges. I believe that incentive regulation is
and always has been preferable to enforcement action. If Railtrack is allowed
to share in the benefits of the growth of the railway it will be far more
inclined, on its own initiative, to expand its capacity and improve its
performance. That is what the public and the industry want and expect of the
company. This document is about equipping it to do so.

2. I want Railtrack to become more imaginative, more creative and more
responsive to its customers' needs, giving the railway industry its own vision
for growth and implementing worthwhile plans for sorely needed investment and
improvement. Railtrack has the enviable position of being at the heart of an
industry whose customers want more and more of its product. It can and should
meet those demands with enthusiasm, skill and energy.

3. The lack of an adequate incentive structure for Railtrack has been
criticised, and the decisions made in 1995, when the present financial regime
was established, have not served the industry well. The periodic review
provides me with the opportunity to put right this shortcoming of the past,
and that is what I intend to do. However, no regulator should discard or
disregard his right - indeed, in appropriate cases, his obligation - to
consider and take enforcement action if commercial incentives fail for any
reason. I will not do so. But I believe it is far better that there is greater
clarity and transparency about the circumstances in which enforcement action
may be taken and the basis on which any penalties will be established. The
better the company understands these things in advance, the better able it
will be to minimise or eliminate the circumstances in which they may
materialise. And if the company is performing well, it will have no need to be
concerned about penalties and enforcement.

4. Information about the company, its financial performance and the nature and
condition of its assets is the oxygen of regulation. In November 1999 I
announced my intention to modify Railtrack's network licence to provide much
better systems for the provision of this information. Today's document takes
that process to the next stage, with draft licence modifications relating to
the provision of information and the appointment of independent reporters to
verify this information.

5. It is right that Railtrack, its customers and funders understand in advance
how enhancements to the network will be treated in its financial framework.
This document explains the development of the enhancement framework. Once
established, it will reduce the uncertainties which Railtrack has faced in the
past, incentivise the company to improve and enlarge the network and so better
serve the public interest. The new enhancement regime will be important in
facilitating the franchise replacement programme, in which train operators are
to be encouraged and may be required to invest considerable sums themselves in
exchange for much longer contracts.

6. This document also considers the issue of parties other than Railtrack
carrying out work on the network. The SSRA has encouraged those bidding for
new franchises to come forward with different ways of financing and ensuring
delivery of network enhancements. Ensuring that the limits on Railtrack's
resources and capacity - whether of project management or financing - do not
unnecessarily hinder the development of the network is important. It is also
of course essential that neither the safety nor operational integrity of the
railway is prejudiced, and no such risks will be contemplated. The railway
industry should not be afraid of new ideas which could bring real and sound
improvements earlier than the traditional methods.

7. These provisional conclusions take the periodic review of Railtrack's
access charges another important step closer to the establishment of a far
better system of financing and rewarding the railway. The shortcomings of the
past will be swept away as soon as the existing framework will allow.


TOM WINSOR
Rail Regulator
14 April 2000


1. Introduction and summary

1.1 The October 1999 periodic review document set out the key aspects of the
incentive framework which are covered by this review:

- incentives to use and develop the network, arising from the structure
of charges and the form of control;

- longer term incentives to develop the network including the regulatory
treatment of enhancements in the next control period and beyond;

- incentives to enhance the performance of the network which are
provided by the contractual performance and possessions regimes supported by
regulatory targets and incentives;

- incentives to maintain and improve the underlying long-term health of
the network through appropriate monitoring of the serviceability and condition
of Railtrack's assets; and

- incentives to improve efficiency derived from the fixed price nature
of RPI-X incentive-based regulation and the interaction with the periodic
review process.

1.2 The key elements of this framework have already been discussed in the
preceding periodic review documents. The October 1999 document invited
comments on the main options relating to the structure of charges and the
incentives relating to performance and possessions. Further aspects of charges
for electric traction and usage were discussed in technical consultation
documents in September 1999 and November 1999 respectively. The December 1999
document contained the Regulator's provisional conclusions on changes to the
Property Allowance Scheme or PAS (Chapter 10). It also invited comments on
options for changing the basis for station access charges (Chapter 11), the
definition and measurement of baseline outputs (Chapter 12) and the framework
for enhancement expenditure (Chapter 13).

1.3 A list of respondents to these consultations is contained in Appendix A
and those responses which are not marked confidential have now been placed in
the Office of the Rail Regulator's (ORR) library and will be placed on its
website.

1.4 The Regulator also held an industry seminar on specific elements of the
structure of charges on 28 February 2000. The transcript of this seminar has
been placed on the ORR's website and in the ORR library.

Purpose

1.5 The purpose of this document is to invite views on the Regulator's
provisional conclusions on the main elements of the incentive framework:

- Part I describes the proposed structure of charges, including usage
charges, electric traction charges, capacity charges, volume incentive and
fixed charges;

- Part II discusses the proposed arrangements for incentivising and
monitoring delivery of the periodic review settlement. This includes the
performance and possessions regimes, the incentives for delivery of other
baseline outputs, general guidelines on penalties, the enhancement framework
and information reporting arrangements (including regulatory accounts and the
role of reporters); and

- Part III sets out the proposed timetable for the remainder of the
review and the way in which the final conclusions will be implemented.

1.6 This document therefore relates primarily to services provided to
franchised passenger train operators and excludes several aspects of the
incentive framework which will be developed over the next few months. For
example, it excludes the treatment of the Incremental Output Statement (IOS)
enhancements and West Coast Route Modernisation (WCRM) costs, as well as the
development of the Regulator's charging policy for freight, stations and
depots.

1.7 It should be noted, however, that some elements of the proposed incentive
framework for franchised passenger operators (e.g. the structure of charges)
may also have implications for the Regulator's approach to freight charging.
The Regulator will be consulting on his criteria for the approval of
Railtrack's access charges for freight services during May 2000. In developing
this policy he commissioned NERA to look at the effect of charging structure
on freight revenues (the executive summary of their report can be found on the
ORR website). More recently, he appointed Symonds and NERA to undertake a
review of the efficient cost of providing a stand-alone freight network.
Railtrack has also been asked to provide information on its avoidable costs.

1.8 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 26 May 2000. Respondents should indicate clearly whether they wish all or
part of their responses to remain confidential to the ORR. Otherwise they may
be published, placed in the ORR library and its website and 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 and its website
and quoted from by the Regulator, summarising the submission excluding the
confidential information.

Summary of Part I: Structure of charges

1.9 The structure of Railtrack's access charges has already been subject to
considerable discussion involving the Regulator, Railtrack, operators and
funders. The Regulator's provisional conclusion is that the existing structure
is no longer appropriate since:

- the existing charges are below the incremental cost of providing
additional services and therefore penalise Railtrack for promoting growth on
its network; and

- the case-by-case negotiation of congestion costs and the share of net
benefit (as part of the fixed charge for additional access rights) reduces the
transparency and predictability of Railtrack's charges.

1.10 Given this, the Regulator's present view is that the following changes
should be made to the structure of charges:

- usage charges should be increased to reflect the estimated incremental
maintenance and renewal cost for wear and tear caused by additional trains;

- electric traction charges should be refined to increase their cost
reflectivity, to promote metering of consumption, and to allow the Regulator
to introduce the possibility of competitive supplies of electricity after
April 2002;

- the current negotiation over the additional congestion costs
associated with supplemental access agreements should be replaced with a
tariff-based capacity charge which would be a simplified version of
Railtrack's proposed capacity reservation fee;

- the negotiated share of net benefit would be replaced with a simple
volume incentive which would give rise to a transitory increase (or decrease)
in profits as a result of additional (or less) growth - this incentive should
be expressed as a percentage of the relevant usage and capacity charge for the
year in question; and

- the fixed charge should allocate Railtrack's residual revenue
requirement between operators (i.e. after deducting expected income from other
single till items and variable charges) in proportion to their access rights
(or proxies for those rights).

1.11 The Regulator's final conclusions on the structure of charges would be
reflected in all existing agreements as part of the periodic review process.
The Regulator would also expect this to be reflected in any supplemental
access agreements which are submitted to him for approval over the following
period. The scope for negotiation over supplementals would therefore be
confined primarily to the specification and costing of any enhancements.

1.12 Figure 1.1 below illustrates the relationship between the current
structure of charges and the Regulator's provisional conclusions on the future
structure of charges. The main change is to replace existing negotiated
charges with predetermined tariffs which should make it easier for Railtrack
and operators to plan their businesses and ease the process of negotiating
enhancements. This would also provide greater consistency between the
treatment of new and existing rights. In addition, with higher, more cost
reflective usage charges, the overall variability of charges would be
increased.

Operational performance

1.13 The Regulator has reviewed the incentives on Railtrack to improve and
maintain operational performance (i.e. the amount of delay). This includes
both the contractual incentive regime in Schedule 8 of the franchised
passenger track access agreements and the regulatory enforcement of
operational performance targets under Condition 7 of its network licence. The
Regulator's provisional conclusions as a result of this review include a
number of changes to the template Schedule 8 regimes:

- removal of the higher and lower thresholds so that the same marginal
incentive rate applies at all levels of performance;

- setting the benchmark based on SSRA's proposed benchmarks for train
operators (although this does not have any impact on marginal incentives);

- increasing the incentive rates to reflect changes in both the marginal
revenue effect and the societal elements of the current rates;

- retention of the star model so that Railtrack is incentivised to
manage network delay; and

- removal of certain non-core elements of the existing regime and
simplification of the drafting to provide clearer incentives for Railtrack and
train operators.

1.14 The Regulator would expect the template regime to be adopted by most
operators. In some cases, however, they may wish to retain or negotiate
bespoke arrangements and the Regulator has clarified his view of the criteria
which he would expect to use in assessing these arrangements.

1.15 In the light of the responses to the October 1999 periodic review
document, the Regulator remains of the view that the contractual incentives
discussed above should be supported by enforceable targets. He proposes to
establish (non-enforceable) monitoring targets based on the expected level of
performance and to define an enforceable target which permits a fixed
percentage more delay minutes per train mile than the monitoring target. If
Railtrack fails to meet this target in a single year it would be required to
provide an explanation and a detailed recovery plan. Failure to meet the
target in two consecutive years would be expected to result in financial
penalties which would normally be established in advance as part of the
periodic review.

Possessions

1.16 The Regulator has proposed a number of changes to the possessions regime
to avoid unnecessary complexity and to achieve a more consistent approach to
compensation regardless of the reason for the possession. His present view is
that the free possessions allowance should be removed and that the Schedule 4
rates should be used to determine the level of compensation for disruptive
enhancements under Part G of the Track Access Conditions. The Schedule 4 rates
will of course rise as a result of the proposed increases in the Schedule 8
incentive rates.

Sustained network outputs

1.17 Considerable progress has been made with Railtrack in defining the
relevant measures of asset condition and serviceability. Railtrack has also
made progress towards establishing a baseline position for 31 March 2001.
Although there are differences in emphasis, there is a large measure of
agreement between the Regulator, Railtrack, operators and funders on the
appropriate measures and the way in which they should be monitored and
incentivised.

General guidelines on penalties

1.18 Where the Regulator takes enforcement action under section 55 of the
Railways Act 1993, he may impose a monetary penalty on the relevant operator.
Although the Regulator hopes that it will not prove necessary for him to use
these powers, he considers that the process should be as transparent as
possible.

1.19 The Regulator therefore proposes to publish general guidelines on the
factors to which he would expect to have regard when deciding whether to
impose a monetary penalty and the amount of the penalty. Having regard to his
section 4 duties, the Regulator's policy objective in setting these penalties
would be to incentivise compliance with the relevant condition or requirement
without introducing unnecessary risks for the relevant operator. Any further
guidance on this policy would be designed to increase transparency by setting
out the steps which the Regulator expects to follow when calculating the
amount of the penalty. He proposes to develop the draft guidelines contained
in this document in conjunction with the periodic review.

Enhancement framework

1.20 Since the December 1999 periodic review document, the Regulator has been
developing the framework for enhancements in conjunction with Railtrack and
the SSRA. The Regulator's current thinking in relation to his proposed policy
statement on this issue is set out in this document. This describes in more
detail the Regulator's proposed criteria for the approval of access charges
relating to enhancements and the way in which he expects to treat enhancement
expenditure at future periodic reviews. In particular:

- in the light of responses to the previous document, the Regulator
confirms his view that the allowed rate of return on enhancements should be
the same as for the sustained network (unless Railtrack takes genuine demand
risk) but that any asymmetric cost or delivery risks should be reflected in
the expected capital cost;

- the Regulator's views in relation to the role of third party
enhancement projects (and Special Purpose Vehicles or SPVs) is discussed in
more detail, including the contractual arrangements necessary to ensure
responsibility for safety is clear and to avoid unnecessary complexity or risk
leaving assets unregulated.

1.21 Although some further work is required, the key principles are now well
established and the Regulator would expect to see these reflected in any
enhancement projects which are currently under consideration. The Regulator is
considering whether the arrangements in relation to enhancement should be
incorporated into a single licence condition or included in a number of other
relevant licence conditions which he plans to introduce in conjunction with
the periodic review.

Information reporting requirements

1.22 The Regulator considers that the current information reporting
arrangements, which have evolved over a period of years, are inadequate.
Following discussion with Railtrack, he has therefore developed proposed
modifications to Railtrack's network licence and associated guidelines which
would require it to:

- prepare more detailed regulatory accounts which are consistent with
the basis on which the price controls are established;

- ensure that enhancement expenditure is logged up on a basis which is
consistent with the enhancement framework discussed above;

- appoint reporters (chosen by the Regulator in consultation with
Railtrack) to provide an independent assessment of the robustness of
Railtrack's information submissions; and

- provide an annual return (together with monthly returns for some
information) which reports data for the previous year and compares this with
both historical data and assumptions underlying the periodic review (this
would consolidate and add to existing information submissions and would allow
the NMS to be more focussed on the future requirements of operators and
funders).

Part III: Timetable and implementation

The Regulator proposes to extend the date for publication of his review notice
in accordance with the provisions in Part 8 of Schedule 7 of each franchised
passenger track access agreement. His present intention is to publish draft
conclusions in July 2000 and to allow interested parties to make
representations on these conclusions before he publishes his final review
notice in early September 2000. This will also allow more time for the
Regulator to assess new information in relation to the West Coast Route
Modernisation (WCRM) and the cost of the enhancements included in the SSRA's
Incremental Output Statement (IOS).


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