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Franchises and concessions

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Premiums and subsidies: how they work




Franchises and concessions
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Premiums and subsidies: how they work

Most passenger operating contracts in the British railway industry are known as 'franchises'.

A passenger rail franchise is a contract between a government body (often but not necessarily the Department for Transport) and a train operator, to run services on specified routes, calling at named stations, using specified rolling stock and observing a minimum timetable, for an agreed period.

However, a further – and essential – feature of a rail franchise in Britain is that most of the commercial risk rests with the franchisee. This transfer of risk from Government was one of the reasons for railway privatisation between 1993 and 1997, which for a while was broader than it is now because the infrastructure was also owned by a private sector company – Railtrack plc – between 1996 and 2001/02.

Railtrack did not survive and was replaced by Network Rail in late 2002. NR was a 'not for dividend' company but became a government body in the public sector on 1 September 2014. Its debts are the responsibility of Government.

Passenger franchises continue, however, although some details of the contracts have changed in the light of experience since the first were awarded in late 1995.

The core of a franchise agreement is the 'profile' of premium or subsidy payments.

The franchisee must earn enough revenue to fund its operation, including such payments as may be required to government (premiums), rolling stock leasing companies (leasing charges) and Network Rail (track access charges). Until recently, some franchises have included a safety net – the 'cap and collar' clauses – which are intended to compensate for lower-than-expected revenues or capture a share of excess profits. (This mechanism is described in detail in Premiums and subsidies: how they work.)

In return for taking much of the commercial risk, a franchisee has some freedom as well, being able to apply its own branding, offer special tariffs and make other marketing decisions within a framework of limitations which, for example, control certain ('regulated') fares.

The degree of freedom has arguably narrowed over the past decade, with the Department for Transport having been accused in recent times of 'micro-managing' such matters as timetable details and rolling stock characteristics. Current government policy is to move towards longer franchises (thus providing better incentives for franchisees to invest), accompanied by greater commercial flexibility.

A concession also involves a partnership between a private sector operator and a public authority, but on more rigid terms. There is also considerably less commercial risk.

A concessionaire is essentially paid agreed fees to provide a service which is tightly specified in the contract. Concessionaire's branding, for example, is likely to be minimal and may be virtually absent; fares will probably be precisely controlled (sometimes to maintain consistency with related modes of transport), as will be timetables and the fleet which is to be used. Indeed, most passengers may not realise that the service is being operated by a third party at all.

The reduction of commercial risk does not mean that the contract cannot contain incentives for exceptional performance or penalties for missed targets, but in general the concessionaire can calculate the returns with a fair degree of certainty. There may well be other minor variables: for example, the London Overground concession contract shares farebox revenue between the concessionaire and Transport for London with a split of 10:90.

There are a number of concessions in existence, although none are awarded by the Department for Transport. Transport for London favours this approach: apart from London Overground, another TfL concession – now in its third term – is Docklands Light Railway, and TfL announced on 12 March 2013 that Crossrail will also be operated via a concession (which has since been awarded). Most British tram systems involve similar contracts, as does Tyne & Wear Metro.

Although Crossrail lies in the future, one heavy rail concession has already been awarded. This is the 25-year operating contract for Merseyrail awarded by Merseyside PTE to Serco/NedRail (now Abellio), which started in 2003.

Concession v. management contract

There is also some resemblance between a concession and a management contract, although the two are distinct. A management contract has usually been introduced in the past because a franchise has entered a period of unacceptable uncertainty, but in its announcement of a greatly revised franchise programme on 26 March 2013 the Government revealed that the next Thameslink and Great Western contracts would be let as management contracts from the outset.

In the event, the Thameslink franchise has been let as a hybrid: the franchisee takes responsibility for costs but does not share the revenue risk.

Examples of previous management contracts include both the Virgin franchises as they existed in 2002. The original terms – including the payment of premiums or subsidies as well as a considerable degree of commercial risk – were suspended in favour of payments to the operator calculated as a fixed percentage of farebox revenue. This was because the seriously-delayed West Coast Main Line upgrade had made the original Business Plans unachievable. (The West Coast contract was resumed on new terms in late 2006, but agreement over a revised contract could not be reached in the case of CrossCountry, which was relet.)

Summary

Franchise: significant commercial risk for franchisee but also some commercial freedom; potentially greater profits
Concession: comparatively minor risk for contractor (in most cases, but see Merseyrail for an exception); minimal/no commercial freedom; some incentives/penalties likely, but revenue reasonably predictable
Management contract: something of a compromise. Reduced risk for contractor but some degree of commercial flexibility may be permitted. Some incentives/penalties may be included, and revenue is likely to have a closer relationship with actual turnover than is often the case with a concession.

Note
Open access operators are outwith all these arrangements, operating instead via an operating licence from the Office of Rail Regulation. Commercial risk is high, and there is no possibility of subsidy.

British rail passenger franchises (infographic)




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