Railnews 188a

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RUNNING HEAD: West Coast crisis

HEAD: West Coast Q & A

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CAP: Virgin may now continue to operate intercity services on the West Coast after 8 December

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CAP FOR ALL THREE: Other franchises which may now have to be extended as a result of the West Coast problems include c2c, First Capital Connect and First Great Western

Q. What has gone wrong with the award of the Intercity West Coast franchise?
A. The DfT has admitted that its calculations of risk associated with the winning West Coast bid were 'flawed'. Assessments of the losing bids may have been affected as well, of course. A new computer model which was supposed to provide a better assessment of risk was used for the first time, and the DfT has said that not all the necessary figures were provided to it. There may also have been some 'double-counting' by officials.

Q. Does that justify cancelling the award?
A. The DfT (and Virgin Trains) say it does. Although the details have not been fully revealed, we understand that the errors included a failure to take inflation into account, which means that the projected revenue and profits (and expenditure) would have become increasingly inaccurate as the franchise progressed.

Q. If inflation had been taken into account, would the projections have been reliable?
A. Less unreliable, perhaps, but long-term predictions associated with franchises of this length (13 years and 4 months, at least) are always going to be highly approximate, to put it kindly. Disregarding a major factor like inflation only makes matters worse -- possibly much worse.

Q. Doesn't the DfT try to protect itself (in other words, the taxpayer) against rail franchises failing en route?
A. Indeed it does. Bidders are required to provide a financial buffer -- essentially a form of insurance -- which will be called upon in the event of failure. This buffer usually takes the form of a 'subordinated loan'. In the case of FirstGroup, there would have been £10 million of shareholders' capital involved too.

Q. Does this buffer also cover people who pay for travel in advance?
A. No. There are separate bonds which protect money deposited with the franchisee because of advance purchases (for season tickets, in particular).

Q. So is it safe at the moment to buy West Coast tickets for travel after 8 December?
A. Absolutely. The DfT has guaranteed that all tickets will remain valid, no matter who the operator is.

Q. We know that Virgin had started legal proceedings. Had VT discovered that the DfT had disregarded inflation?
A. It is not clear how much Virgin knew about the details. We know it sent 40 questions to the DfT about the process, which it says were ignored, so the court case was launched in a bid for greater 'transparency'. However, Virgin was doubtful about the outcome of the DfT's calculations, even if the cause was not identified.

Q. What alerted Virgin to a possible problem?
A. It seems to have been the relative sizes of the subordinated loans, which become larger as the risk increases. Virgin's bid, worth £4.8 billion at net present values, involved a loan of £40 million. First's, which involved another £700 million in premiums, also assumed roughly 25 per cent more revenue growth. Virgin was cynical about the realism of this forecast, but decided to take action over the size of First's financial buffer, which amounted to £200 million (including the £10 million of capital). Virgin had attempted to calculate the risk associated with First's more optimistic bid, and came up with £600 million. It is only fair to add that First disputed this conclusion.

Q. What about the other bidders?
A. There were two: the international arm of Dutch Railways (NS), which trades as Abellio, and a partnership of French Railways (SNCF) with Keolis. They have not commented on developments since the award was made on 15 August.

Q. The DfT has said the cost of its error will be £40 million. How is that calculated?
A. Again, this is not something the DfT has explained, but presumably it stems from the DfT's announcement that it will refund the costs incurred by the bidders. Virgin said it spent £14 million, but perhaps the other three spent rather less. The figure seems optimistic even so, because it may not take other expenditure into account, such as almost two years of Departmental time. External consultants were also employed, and there will have been some legal costs. Neither do we yet know if First is going to seek damages for the loss of its potential contract. The cancellation was announced just after midnight on 3 October, and shares in FirstGroup fell by 20 per cent during the following day.

Q. The award was made on 15 August, and Virgin started legal action on the 28th. If it had not, the contract could have been signed with First on the following day. But ministers continued to maintain that the calculations were 'robust', and would be defended in court, until just after midnight on 3 October. Were they lying?
A. They say not. Patrick McLoughlin, who became transport secretary as the successor to Justine Greening in the first week of September, has said ministers relied on their officials, who had reassured them consistently that all was well, although it is said that Greening was alerted to a 'minor' problem in late August. If that is true, it was still apparently not enough to justify changing course at that stage.

Q. So it was the fault of civil servants?
A. That is one interpretation, and three officials from the DfT have been suspended ahead of possible disciplinary action. But one of the three has denied that she was even involved in the financial modelling process, and political observers have suggested that there is a blame game in progress within the DfT.

Q. Who will be running West Coast from 9 December?
A. Although it was not an outcome anybody would have predicted during the summer, it could be Virgin. Talks are under way about a management contract, in which Virgin would get a fixed slice of revenue (some observers suggest 2 per cent) for carrying on. Such a contract can be ended at comparatively short notice, and does not involve complex calculations about premiums, subsidies and revenue protection clauses. If Virgin and the DfT do not agree terms, the DfT's Directly Operated Railways must take over, probably via a newly-created operating company – as has been the case on East Coast since November 2009.

Q. Isn't East Coast due to be returned to the private sector in December 2013?
A. Well it was, although the date had already been postponed because the DfT's franchising timetable has been running late for some years. This slippage does not bode well for next year's franchise awards, which are also supposed to include Essex Thameside, Greater Western and Thameslink.

Q. Can these go ahead as planned?
A. It seems fairly unlikely at the moment. The whole franchising process has been suspended (probably until New Year at the earliest) to allow time for two official inquiries to report their findings. We also know that West Coast must be restarted from scratch, and the inevitable conclusion is that something will have to give. It is even possible that rail franchising as we know it has come to an end, and will be replaced by a new system. The role of the DfT will also be questioned, because its management of franchising has not been conspicuously successful. Certainly, opposition MPs (and also the unions) will be baying for the DfT's blood for some time yet.

Q. How soon can West Coast be relet?
A. Nobody knows. It could stay as a management contract (or else directly operated by Government) for quite some time. One problem facing the DfT will be that the essentials of the top two bids are now public knowledge. This makes a straight re-run using the current specification rather difficult. There will also be the competing demands for DfT time from the other franchise competitions, and the continuing distraction (from the DfT’s point of view) of a major public and political debate about the whole issue of rail franchising, which is set to be fuelled even further when the results of the current official inquiries become available.

Q. What will happen between now and 2013?
A. Parliament is still in recess until mid-October, but we can expect a vigorous reaction to the events of the past few days when MPs are back at Westminster. The DfT will also be embroiled in two inquiries, while the ministers (and maybe some officials) involved can expect a fierce grilling from Parliamentary committees. We may hear more about the three suspended civil servants. Watch, too, for announcements of fresh franchise extensions to keep things going for the time being. As they say, this one is set to run and run.

ENDS

© Railnews Ltd 2012