FINANCE: BROWN REVIEW
as soon as they were past the initial four-year period from when the collar would have been applied. Once in the revenue support mechanism there was little incentive on bidders to increase revenues within the support band, as they would only receive 20% of the additional revenue generated. Following criticism from both the National Audit Office (NAO) and Public Accounts Committee (PAC) for the financial failure of the East Coast Main Line, the DfT moved to a GDP (gross domestic product) mechanism, which aimed to address the points raised in these reports. The GDP mechanism was linked to reducing the probability of failure by requesting potentially large backed subordinated loan facilities (SLFs) from the parent companies to support bidders’ proposals. The SLF was based on adjusting bidders’ revenue forecasts against a baseline, taking into account the margin, to calculate the probability of failure. The SLF was then increased to reduce the probability of failure to the predetermined failure rate. The proposals put forward by Brown would create substantial cost savings for the TOCs as they will no longer require to price for exogenous risk (compared to the cap and collar regime) and will no longer require to provide a large SLF (compared to the GDP mechanism). Under the Brown proposals, bidders will not be required to take any exogenous risk, other than the timing of the cash flow’s adjustments, which will be one year in arrears. Overall this change should generate savings on the proposals put forward by bidders, however the price of this reduction will need to be considered against the additional exogenous risks that are proposed to be transferred to the DfT, who will have to pick up additional costs under poor economic conditions. Clearly separating exogenous and endogenous risk within a bid proposition will be a critical step in the evaluation process.
Capital requirements
As noted above, the first iteration of the GDP mechanism focused on the desire to ensure that there was a low risk of TOC failure. This resulted in a requirement for high value SLFs to ensure that the risk of failure was at an acceptable level. The review takes a softer stance against financial failure
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and states that the government should accept that there could be failure. If the proposals are accepted the capital requirements are likely to be reduced in quantum from the previous mechanism. This reduction in capital requirements is based on a calculated ‘default indemnity’ to the DfT of which between a third and a half should be bonded with a financial institution. The default indemnity would be calculated by using a pre-arranged band, likely to be in the range of 10-15% of the revenue growth proposed by bidder initiatives. These proposals should allow the financial assessment to be undertaken without the requirement to make any revenue risk adjustments to bidders proposals. Franchise bidders, especially the thinly capitalised ones, will be encouraged by these proposals and should create an opportunity to reduce the costs included within their franchise bids. However, these changes will focus the evaluation of risk and deliverability of the bidders’ revenue enhancing proposals to ensure that the appropriate parental support is obtained.
Franchise length
Until the cancellation of the West Coast competition, government policy had focused on longer franchises to incentivise investment. Brown’s recommendation is that franchises should be reduced in length, as forecasting patronage accurately over longer periods is extremely difficult. As a result, the proposal is for franchises with a seven to ten year initial term and a pre-contracted performance-related continuation for three to five years. This proposal has been put forward on the basis that the current residual value mechanisms are more actively used to allow TOCs to invest in assets that have a commercial return beyond their franchise term. These proposals will add cost through investment but reduce on-going revenue costs by more, assuming each investment has a positive payback. Therefore these proposals should reduce the overall cost of TOC bids. Critical in any residual value assessment for the bidders will be the weighting allocated to the NVP of the future benefits.
Costs
Bidders are to be given more freedom to enter into alliancing agreements with
It appears the proposals should
reduce the costs that TOCs will bid. This part of the review could have gone further but may yet be developed through the proposed dialogue period with bidders prior to finalisation of the ITT.
Conclusion In summary, the proposals should reduce the costs of TOCs and therefore the DfT, through bidders having to price less risk, however, the quid pro quo is that DfT will take on extra risk. Furthermore, the final evaluation of quality-versus-price will be a difficult one to value unless there is a high level of transparency around the subjective evaluation of quality and deliverability. That is not to say it cannot be achieved, as many public sector procurement exercises already incorporate quality and price into their evaluation. The driver for the next round of franchises is to reduce the costs to the public purse, while trying to limit fare increases as far as possible; the Brown proposals appear to be another stepping stone in achieving this objective.
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Network Rail to reduce overall industry costs. The residual value mechanism highlighted above would also give an incentive for investment to reduce on- going costs beyond the initial franchise expiry.
The proposals seem to allow an
increasing scope for bidders to specify what franchise outcomes are required to allow bidders the opportunity to reduce costs through, for example, more resource efficient timetables, which should allow for the optimisation of staff and rolling stock. The one area not covered explicitly by Brown is the ability for bidders to use technology to reduce costs and where this may have a knock-on impact to revenue in the short term.
It is proposed that there should be a simplified pre-qualification questionnaire (PQQ), which is backward looking only and would not require a bidder to articulate its vision for the franchise.
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