Finance
TAYLOR FERGUSON
Previous cap & collar mechanism
Under the previous franchises, the DfT implemented a cap and collar mechanism, where operators received a share of the revenue shortfall below the revenue target (known as ‘Revenue Support’) and paid a share of any revenue above the revenue target (known as ‘Revenue Share’) as compared to their initial bid. The mechanism captured between 50% - 80% of the difference between actuals and forecast, meaning that when the revenue targets were not achieved the DfT could be responsible for up to 80% of the shortfall and when the operator was performing well they were transferring up to 80% of the excess to the DfT. This mechanism of Revenue Support started in year four of the franchise, providing no cover for operators in the initial years, but the DfT benefited from Revenue Share from day one.
One of the shortfalls of this mechanism, which was highlighted at the start of the current economic downturn when the assumed level of revenue growth, which had been incorporated into certain franchise bids was no longer possible. In some cases operators accepted an element of loss or were able to exercise their ability not to extend their contract to manage their overall exposure.
In a free market Train Operating Companies (TOCs) could maintain their bottom line by implementing measures to increase revenue or reduce costs. However, for franchise operators the ability to reduce costs is made difficult by the fact:
• the same services must be provided regardless of demand, with limited time windows to change timetables;
• elements of key fares are controlled by the DfT;
Bidders face a difficult balancing act to provide real efficiencies through the franchising process to deliver the savings that McNulty and the DfT envisage.
• there is a high level of fixed costs that cannot be controlled by the operator, i.e. track access and to a degree, rolling stock costs.
In order to maintain a robust competition the DfT had to formulate a mechanism to ensure that:
• operators would be responsible for their forecasts on which they would potentially secure the operation of a new franchise;
• there was sufficient funding or parent guarantees available from the operator in the event the risk of financial failure was realised;
• there was an incentive for operators to focus on both increasing revenues and reducing costs, as previously the cap and collar regime led to a focus on revenue maximisation initiatives, as support was available for underperformance of revenue.
New GDP Mechanism
The current DfT proposals, which are detailed in the Inter City West Coast (ICWC) franchise documents, is a GDP mechanism that allows for adjustments to be made to the revenue support or premiums based on the national GDP metric. The logic being that operators cannot influence the macroeconomic conditions they are operating under and therefore should not be held to account for variations in revenue caused by the external economic environment. So for example the DfT will provide bidders for ICWC assumed national GDP figures for each year until the end of the franchise period. It has also created a 5% nil band above and below which the new mechanism will apply. While this approach appears to provide a better linkage upon which to hold bidders to account for their forecasts, the relationship between revenues on any specific franchise and the GDP mechanism will not always be precise, thus creating winners and losers.
The GDP mechanism is linked through the franchise process to:
• the evaluation process, where DfT will assess bidders forecasts under various scenarios to determine the impact of external factors and the robustness of the operators’ bids under various scenarios;
The current DfT proposals, which are detailed in the Inter City West Coast (ICWC) franchise documents, is a GDP mechanism that allows for
adjustments to be made to the revenue support or premiums based on the national GDP metric.
• the financial risk of failure, which will require additional funding from the operator or their parent;
• the revised profit sharing mechanism, which incorporates three bands that bidders are expected to bid back.
Bidders face a difficult balancing act to provide real efficiencies through the franchising process to deliver the savings that McNulty and the DfT envisage. On the one hand, if they are too cautious their financial proposal may not be good enough (notwithstanding the criticism levelled at DfT by the NAO and PAC) as there will still be significant focus on the NPV of such payment. On the other hand, if they are too aggressive, this could lead to either risk/price adjustments being made by the DfT during the evaluation process and/or significantly larger guarantees being required from their parent company.
The market seems to be in general agreement with the approach, and in theory at least, it should provide a cost-effective mechanism for bidders to produce their forecasts and provide a reduced risk of financial failure of an operator for the DfT. It will be interesting to see when the results for ICWC are announced if this mechanism has achieved the desired outcome of better value for money for the taxpayer, or whether the potential requirement for additional guarantees have been highly priced by the private sector in the current capital constrained environment and if such mechanism will continue to be used on subsequent franchises.
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