Rail 555: NR’s pretend profit is from artifice not effort

Though not invited to Network Rail’s celebratory press briefing, CHRISTIAN WOLMAR is unsurprised the company made a profit – it’s what Tom Winsor ordained.

The BBC got very excited about Network Rail’s ‘profit’ when the half year figures were announced in early December. All day it ran the news as if it were the best thing to happen on the railways since the opening of the Liverpool & Manchester.

But that merely shows a total lack of understanding amongst its journalists of the bizarre economics of the rail industry where profit and losses are artificial constructs manipulated by the policies of the government and regulators. Railway economics are a world of pretend capitalism where neither profit nor loss mean what they seem.

The BBC’s optimism might have been tempered had I or any other of the known troublemakers in the rail press been invited to Network Rail’s press briefing when these figures were announced. However, according to a Network Rail spokesman, the company wanted to present the figures only to ‘the business and City journos’ because it was a City story and thus ensured no one was at the briefing to ask the awkward questions. (To his credit, John Armitt, the chief executive, was not best pleased at this decision taken by his own spin doctors and was deeply apologetic when I happened to meet him that evening).

So where did Network Rail’s ‘profit’ come from? Well, us actually. Network Rail was always going to go into the black this year for the very simple reason that Tom Winsor, the rail regulator, determined that it would when he set Network Rail’s income for the current control period (which runs from 1 April 2004 to the 31st March 2009). During the first two years of the control period, payment of some of Network Rail’s income from the government was deferred (not, as Network Rail’s chairman Ian McAllister claimed, ‘as a result of the company’s agreement’ but because Winsor agreed to the government’s request to structure the payments in this complex and opaque way).

Inevitably, therefore, NR made significant losses during these first two years, Now though, with an increase of just under £1bn in its income to £2,884m during the first six months compared with just £1,900m last year, the company is happily in the black. None of this rise is due to its own efforts. It is not like a conventional capitalist business boosting its accounts by selling lots more widgets but the rise is simply a result of the increases in government grant (up £523m) and access charges (up £451m) allowed in Winsor’s settlement. So no wonder the company’s pre-tax profits went from a loss of £108m, to a profit of £747m, despite operating costs rising slightly by just under £50m.

Already, the company knows pretty much that it will make similar amounts of ‘profit’ in the next two and a half years because it is not subject to the normal market vagaries which conventional companies face but merely receives what it is being granted by the regulator. The profit, of course, is reinvested because there are no shareholders, so it is all a bit of a daft game, especially as tax has to be paid on these profits which means some of the Exchequer’s money goes on a merry go round.

It is fair to point out that Network Rail has improved its performance by reducing delays (though the mishaps on the West Coast Main Line in the first week of December caused by the storms and other problems may mar the next set of figures) which are now, at last, a couple of percent better than pre-Hatfield. There are plenty of other good figures, such as broken rails being at an all time low and a reduction in accidents (it has been nearly five years since the last rail-caused fatal accident on the railways, Potters Bar in May 2002. And yes, Network Rail is on target to reduce the cost of operating and maintaining the railway by 31 per cent during that five year period, but that is from an extremely high base when spending was allowed to soar during the period of Railtrack’s administration as a result of the mistakes that led to the Hatfield disaster and the chaotic aftermath.

One item rather sticks out in the accounts: Network Rail made a paper loss of £173m on ‘losses on cash flow hedges’ compared with an overall profit of £1m in the 12 month period 2005/6. It is perfectly normal to hedge such items – in other words, attempt to read the future way the market is going in order to reduce risk – but such a big loss suggests that someone was betting the wrong way. These sort of enormous sums tend to get taken for granted in the rail industry but there does seem to have been a rather large sum gone astray. Let’s hope they make it up in the second half!

The whole artifice of Network Rail’s structure makes it rather galling to find that its executives are being paid in the order of £1m per year including bonuses, the sort of amounts they would get if they were running a sizeable public company. It is difficult to see how John Armitt and Ian Coucher, the deputy chief executive, can justify their enormous salaries and bonuses which are now both in the £1m region mark. Yes they may be doing quite a good job in reducing costs, but only in line with what the regulator expected and they are not risk taking entrepreneurs who face possible wrath of their shareholders or have to battle for market share. Network Rail is an infrastructure company with, effectively, a fixed income and as Richard Bowker suggested in the previous issue of Rail, Winsor’s settlement appears to have been far too generous. Now some of his generosity is filtering through in payments to executives of telephone number salaries determined by a supine remuneration committee.

Which brings me to the other part of Network Rail’s structure that is becoming of increasing concern in the industry: its governance structure. In effect, there isn’t one. Notionally, there is a group of around 115 members (the number varies from time to time) who have oversight of the company’s activity. Around half represent companies or organisations and the rest are public members, selected by an independent panel that submits its recommendations to Network Rail. This is in lieu of having shareholders and is all part of the pretence of keeping Network Rail off the government books. But as one former member put it these members do not have the power of shareholders, who really hold a board to account and the twice annual meetings are hardly enlightening: ‘the company members tend to have their own access to the board, so don’t bring their questions to the meetings. And the public members tend to ask rather batty questions like why can’t bikes be carried to Llandudno Junction on a Saturday or why were trains cut back on a particular line, all of which is not within Network Rail’s control, but takes up lots of time at these meetings’.

An attempt to give the members a bit of beef by forming a council of the more active (and brighter) members who would provide the board with a more rigorous intellectual challenge was defeated because some members feared it would compromise their independence. Nor was Network Rail not keen on the idea which might have resulted in board members being given a somewhat harder ride at the meetings.

In truth, then, we have to rely on Network Rail’s managers being competent which, so far, they appear to be so. However, the rail industry would be in a mess if they were not, and, worryingly, there would be precious little that anyone could do about it. With Network Rail spending over £5.5bn per year, there must be a few civil servants and indeed ministers who occasionally wake up in a cold sweat thinking about it. Or at least one would hope so. Just possibly, they should exercise their minds to thinking of ways of boosting the corporate governance issue before the inevitable happens one day and a lunatic gets hold of the asylum.

Wrong again

Mystic Wolmar has really gone off the rails over the past couple of years. After a series of good year, 2005 was bad and this year has been worse. He was far too eager to predict departures and doom and gloom, and therefore scraped one point out of five, less than the law of averages from a mere guess would have suggested. Of his predictions, Mystic said that Mike Mitchell, the head of DfT trail, an unnamed senior exec of Network Rail, Tony Blair and Alistair Darling would no longer be in the same posts – well only the latter turned out to be true. Then he suggested that passenger numbers would not grow as fast because ‘the economy would stutter’ which was completely off the mark as the increase has been a healthy 6 per cent. Worst of all, Mystic suggested that Stagecoach would lose its South West Trains franchise. If he had used his brain instead of his crystal ball, he would have realised that prediction was bound to be wrong because there is something of a golden rule in the franchise process: a company desperate to stay in the market – e.g. National Express for One, GNER for East Coast and now Stagecoach for SWT – will always bid that much higher to ensure victory.

So should Mystic smash his crystal ball – as some readers have none too politely suggested – or keep trucking? Well that is a prediction which will be answered in the next issue….