Premiums and subsidies: how they work
topic ref. 34567890
Premiums and subsidies: how they work
A passenger rail franchise is a contract between government 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.
The costs of doing this are never neutral. A particular franchise will either return a profit or run at a loss.
If the franchise is expected to run at a profit, then government will want a share of the returns, known as premiums. The operator will be expected to pay the premiums due under the contract to the Department for Transport at regular intervals. Failure to do so would be a breach of contract, and could be followed by termination.
If the specified services will cost more to provide than they will earn in fares, then the franchise will attract subsidies. These will be paid by the Department for Transport to the operator, again at agreed intervals during the contract.
(It has yet to happen, but in theory the revenue from fares could just match the costs of running the service. In such an unlikely case the franchise concerned would still attract subsidy, or else the operator would make no profit and would have no incentive to take the inevitable commercial risk which is inherent in rail franchising.)
Would-be operators compete for each franchise when it is advertised. The usual process is (1) An general invitation for interested parties to make themselves known, followed by (2) the identification of prequalified bidders (usually at least three) and (3) a formal Invitation to Tender. Prospective franchisees responding to an ITT will then be given access to confidential information about the economics of the franchise concerned so that they may draw up realistic ‘best and final’ offers.
Stage (4) is usually the announcement of a preferred bidder, followed by final negotiations. If all is well, Stage (5) is the handover itself. The date of the handover is usually known from the start, because it will be the day that the previous contract ends. The precise transfer of control is customarily at 02.00 on the handover day, when traffic levels are at their lowest and in some cases no trains are moving at all.
The scale of payments, one way or the other, is set out in the franchise profile, which is theoretically published but rarely highlighted in detail nor always readily traceable in official sources after the event. A profile may not consist entirely of premiums or subsidies. Some franchise profiles have started with subsidy but moved into premium in the later years of the contract.
Cap and collar
Although a franchisee takes significant commercial risk (and some have failed) there has been a level of protection in more recent contracts, known as the cap and collar clause. If revenue exceeds a certain amount, the government can claim some of this as an additional profit share (the cap): on the other hand, if revenue is lower than expected, even though the franchisee has run the specified service to agreed performance criteria, then the government will make good some of the shortfall (the collar). Although each contract stands alone, typical values either way have been as much as 80%, and the cap and collar arrangements have normally become ‘live’ in Year 4. Therefore, in the early years, the franchisee may keep all additional profits but also assumes a greater commercial risk. In early 2011, the government abandoned the cap and collar clauses in future contracts, substituting a simple profit share provision in the event of higher than expected revenue. In other words, this retains the cap but exclude the collar.
How cap and collar works
For example, if after four years revenue falls between 98% and 94% of the target set out in the franchise contract, then the DfT will pay 50% of the shortfall to the franchisee. If it falls below 94%, then the DfT will pay 80% of the further shortfall. However, if actual revenue is between 102% and 106% of target revenue, then 50% of the excess between 102% and 106% will be shared with the DfT. If it goes above 106%, then 80% of the further excess will be payable to the DfT. These are typical figures only, and may vary.
The Department for Transport has indicated that it does not necessarily simply accept the ‘best’ bid – that is, one which promises the highest premium or claims the lowest subsidy. All bids are subjected to a ‘deliverability’ test during the later part of Stage (3) above, and exceptionally optimistic offers are likely to be eliminated.
The franchises which have been terminated early on financial or performance grounds so far have been Connex South Central, Connex South Eastern, GNER (second contract), National Express East Coast and Virgin Trains East Coast.
last updated: 2018-07-13