Rail 691: Politicians fail to understand risk of risk

We need to talk about risk. That’s because the assessment and allocation of risk informs virtually every decision made in the rail industry. And the tragedy is that the politicians repeatedly fail to understand the concept and therefore as a result make decisions that are completely wrong-headed.

It is the current round of franchises coming up for renewal which prompts me to write about this subject, but the Intercity Express Programme – IEP – is another all too relevant example and countless mistaken decisions on safety are also made on the basis of a failure to properly assess risks.

Let’s though, for the moment focus on franchising. This is not just to restate the unanswered Wolmar question of ‘what are franchises for?’ but to try to work out what is government thinking on an issue that may land taxpayers with hundreds of millions in unnecessary franchising costs and undermine the railway’s ability to meet the targets set in last year’s McNulty report on the finances of the industry. To say that the franchising programme is a dog’s breakfast is to be unkind to Winalot. It is not surprising that the publication of the franchise review has been postponed several times, given the difficulties of creating a coherent policy.

The basic problem is this: ministers and their civil servants, with no understanding of business , always seek to allocate as much risk as possible to the private sector. They can then say that they are acting in the most prudent way as the state becomes immune to any future variations and uncertainties. However, they never seem to understand the basic way that the private sector operates which that any risk that it takes on will, quite understandably, need to be priced.

The usual mantra from ministers – if they are ever forced to respond to questions on risk, which is rare – is that they understand that, but risk is best located where it can be best controlled by the party concerned. However, this is plainly untrue. When it comes to the franchise programme, there is no such question that risks are being allocated sensibly. There are a whole host of risks in the Thameslink and Great Western franchises, both scheduled to start next year, and even in the West Coast process which is further down the line and due to start in the autumn, there are risks which are unquantifiable and therefore likely to be the cause of excess payments or greatly reduced subsidy.

Probably the worst example is the 15 year franchise for Great Western, but it’s a close call with Thameslink. The Great Western franchise process is underway with calls for prequalification but just look at the range of uncertainties which surround the franchise. There is the reorganisation of Reading station; the electrification programme and the related introduction of new stock, probably the IEP; Crossrail stretching out to Maidenhead and possibly further which will be a separate arrangement but undoubtedly abstract some revenue; new or cascaded trains for suburban and regional services out of Paddington; and possible new arrangements linking Heathrow – and that’s just to name the specific risks. There will, too, be performance requirements which will also need to be priced in.

There is a new one on the horizon, too  in the shape of heightened regulatory risks which all franchises will now face. The Office of Rail Regulation has recently been baring its teeth by, for example, seeking to make the provision of up to date information into a condition of the franchise, rather than just a voluntary code of practice. This is good for the passenger, but it will place an added risk on the train operator which in turn could lead to, again, reduced premiums or higher subsidies. Now the ORR which is seeking increased powers over franchises in the review of policy taking place at the moment, might decide that station facilities should be provided to a higher standard, or that more efforts should be made by TOCs to reduce train delays under their control. Another of the ORR’s policies, its encouragement of open access poses a risk to franchise bidders, too.

Thameslink, which is actually going to become the country’s biggest franchise in terms of passenger numbers, too, is replete with ‘unknowns’ of both kinds. Let alone the need to take on new trains, whose order has not been finalised, cope with the ongoing refurbishment of the line, especially at London Bridge and  bed in a new signalling system, amazingly, the franchise route has not even been determined: the OJEU (Official Journal of the European Union) document put out by the Department states that ‘at some point between April and December 2014 the franchise would include some services currently operated by SouthEastern’, as well as all of Southern services. All this for just a seven year franchise, with perhaps a two year extension.

Given this huge number of what Donald Rumsfeld famously called ‘unknown unknowns’, as well as ‘known unknowns’, any sensible bidder for these franchises ought to be cautious. This is where it gets the bidding process turns into a poker game, with everyone holding their hands close to their chest: if all the bidders are conservative, then premiums – let’s assume it will be a profitable franchise, leaving aside the direct payment to Network Rail – will be reduced. However, say one bidder goes out of line and simply discounts some of these risks, and wins the franchise. Fine if the risk does not materialise, but disastrous if it does. But disastrous to whom? On past experience, when franchisees have thrown the towel in, the taxpayer has simply lost out. Given that bidding will probably be dominated by foreign state-owned enterprises, it is unlikely that the Department could take any sanction against them that would really hurt.

Sensibly, the Department for Transport is moving towards allaying what is called GDP risk – in other words, the fact that in a downturn fewer people are likely to use the railways and vice versa. This will replace the cap and collar arrangements which have previously protected bidders. Nevertheless bidders will still be taking a punt on whether passenger numbers will rise irrespective of the economic situation. What, for example, if a decision is taken to move London’s main airport to the mooted Boris Island – unlikely, I feel, but nevertheless a risk in a 15 year time frame?

Quantifying these risks is a virtually impossible task.  For ministers unaware of how bidders approach the issue of risk, here is a frank assessment  from a contact who has been involved in the process numerous times: ‘All bidders for franchises make an evaluation of the number of level of risks they are exposed to in the bid. This is then reflected in the margin they will factor in. Put crudely, more risk equals a higher margin equals less premium/more subsidy. Uncertainty is essentially another form of risk, and gets priced in accordingly.’ Therefore the bidder wins either way. If the risk does not materialise, then its more profit. If it does, it is already factored in. Simples.

Here’s the views of another experienced railway manager: ‘The whole idea seems to be on the basis of maximising the cost of the rail industry with far too tight a specification in all areas including performance.  For the West Coast, the timetable is basically prewritten with a max 10 percent stop variation so innovation is pre-empted. Everything is valued and priced in by the bidders.‘

So, before trying to pretend every time a franchise is let that ‘this is a good deal for taxpayers and a good deal for passengers’ when the contract is stacked full of risk, ministers should think about whether it is worth paying to offset many of these risks. And if so, how much are they paying for it. That would require a level of transparency in bids which, from talking to those involved, is not currently required. The London Overground model of a simple management contract with no revenue risk has worked fantastically well, suggesting a perfectly workable alternative if ministers continue to be wedded to the bizarre notion of franchising.

Oyster cracked open

While we are on the subject of failings of the Department for Transport, the shenanigans over the Oyster card are ridiculous and damaging to passengers. The franchising muddle means that some franchisees are required to accept Oyster cards on some of their Pay As You Go while others are prevented from doing so. This was made clear recently when, in January, the Department turned down a request from First Capital Connect to extend Oyster to St Albans, Welwyn Garden City and Welwyn North. This came after no fewer than 15 months of negotiation!

The Department rejected the idea on the basis that it wants its own card, currently being developed – ITSO as it is known – to become the national norm. Oyster is non ITSO compliant though there is the potential of merging the two systems by adapting the Oyster readers to the ITSO system and therefore there is an element of ‘not invented here’ in the Department’s decision. Theresa Villiers, in her recent speech to the Railway Studies Association annual dinner, stressed the value of the recent extension of Oyster on Abellio’s new Greater Anglia franchise and then quickly used the more general term ‘smartcard’ when talking about other franchises. That’s because when the Abellio award was announced, Ms Villiers specifically gave the go-ahead for its extension but other companies such as Southern and First Great Western which are also seeking extensions of the scheme have slipped into the Department’s ITSO trap.

Oyster is a fantastic scheme and its extension – after much negotiation and delay – to National Rail stations in London in January 2010 has boosted travel and benefitted passengers. Anything that encourages seamless travel encourages public transport use. Clearly, in a sensible world, Oyster would gradually be extended to various other commuter services but unfortunately, as the DfT’s recent decisions suggests, we do not live in one. One possibly for a rethink, Ms Greening?

  • Completely agree. It is a myth (believed by both this and the last administration) that the private sector is full of risk takers. Corporations are understandably extremely risk averse and if risk is unavoidable they will need a huge price incentive to take it on.

    In contrast, the Government is well placed to take on risks. I’ve recently been reading through some documents from the 1960s when British Railways was developing a whole rash of innovative products and services for freight and passengers (only a few of whch were completely insane). There seems to be less scope for innovation in the present set up, rather we are in an era of careful fine tuning. 

    Of course there are risk takers in the private sector, but as the dotcom boom and credit crisis showed, they are usually taking risks with other people’s money.

  • Greg Tingey

    DafT is not fit for purpose
    The farce over Oyster is one example.
    The unbelievably horrible determination to have an over-expensive utterly useless train, the IEP is another.
    The IEP programme MUST be stopped before we get saddled with these camels

  • Keith

    My oyster was ‘checked’ on a London Midland to Watford Junction, which is part of the scheme. The guy looked at it but he had no way of electronically reading it. It’s also amazing the number of people who go through gates with oyster and get on longer distance trains safe in the knowledge there won’t be a ticket check.

  • Christian Wolmar

    Keith that’s hilarious — completely pointless

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