UK Rail Franchise Risk-Sharing
1. Introduction
This document is intended to explain the contractual mechanisms by which Gross Domestic Product (“GDP”) risk will be shared between the UK Government and the train operating company in relation to new UK rail franchises. The document compares these mechanisms to the revenue risk-sharing mechanisms found in a number of existing UK rail franchises.
2. Cautionary statement
This purpose of this document is, in conjunction with other material, to assist investors, analysts and others in understanding the business of Stagecoach Group plc and the industry in which it operates. This document is not a full description of the contractual terms of any particular UK rail franchise and should not be regarded as a substitute for reading the full franchise documentation.
This document is intended to be a generic explanation of risk-sharing mechanisms in UK rail franchises. Contractual terms vary between franchises and this document should therefore not be regarded as explaining the precise operation of risk-sharing mechanisms in any particular franchise.
This document makes a number of simplifications in describing certain contractual mechanisms to make them easier to understand.
3. Background
The UK train operating market is split into a number of separate franchises, which are awarded by the Government for set time periods to a specification set by the Department for Transport (“DfT”) on the basis of competitive bids. Train operating companies operate passenger trains on the UK rail network. The UK railway infrastructure is owned and operated by Network Rail, a “not for dividend” company that invests any profits into improving the railway. Network Rail runs, maintains and develops tracks, signalling systems, bridges, tunnels, level crossings and key stations.
Each franchise is awarded to a train operating company following a competitive tender process. Each bidder for a UK rail franchise compiles forecasts of the expected revenue and costs of the relevant train operating company over the life of the franchise. Taking account of these forecasts and its required profit, each bidder will offer to pay amounts to the DfT and/or receive amounts from the DfT during the life of the franchise. The successful bidder will then be contractually bound to pay such amounts to the DfT and/or receive such amounts from the DfT1. Stagecoach Group views these payments as a contractual “promise” to pay.
The revenue earned by UK train operating companies is historically correlated with macroeconomic factors such as UK GDP and Central London Employment. Accordingly revenue can vary significantly due to factors outwith the control of the train operating companies. Furthermore, a substantial element of the cost base of a train operating company is essentially fixed because under its franchise agreement the train operating company is obliged to provide a minimum level of train services and is therefore less able to flex supply in response to short-term changes in demand. The payments to/from the DfT referred to above are essentially fixed. In addition, a significant part of the cost base is comprised of payments to the infrastructure provider, Network Rail, and payments under train operating leases which are committed and do not vary with revenue. Accordingly a significant proportion of any change in revenue (for example, arising as a result of the risks described above in respect of the macroeconomy) will impact the profit of the train operating company. In an extreme situation, this could result in a particular train operating company becoming no longer commercially viable.
To reduce the risk to the train operating company, the franchise agreement often contains some form of risk-sharing mechanism which effectively reduces the train operating company’s exposure to (a) revenue falling below the expectations reflected in the original bid for the franchise and/or (b) costs exceeding the expectations reflected in the original bid for the franchise. The precise risk-sharing arrangements vary from franchise to franchise but share some common features.
4. Revenue Share and Revenue Support
Although there have been a variety of contractual risk-sharing mechanisms seen in UK rail franchise agreements, the concepts of “Revenue Share” and “Revenue Support”, as most recently defined, have featured in a number of UK rail franchises with start dates since 2007.
The revenue for each year reflected in the original bid for the franchise becomes the “Target Revenue”2 for that year. The actual revenue for a given year is compared to the Target Revenue and any surplus or shortfall is potentially shared between the DfT and the train operating company3.
For most of the franchises where the concepts apply4, if actual revenue is less than 98% of Target Revenue for a given year, then the train operating company is entitled to receive Revenue Support from the DfT as follows:
- if actual revenue falls below 98% of Target Revenue, the DfT pays support to the train operating company equivalent to 50% of the shortfall between 94% and 98% of Target Revenue and;
- if actual revenue is below 94% of Target Revenue, the DfT provides support of 80% of the shortfall below 94%.
There is a symmetrical system for Revenue Share if actual revenue exceeds the Target Revenue, whereby if revenue is more than 102% of Target Revenue then the train operating company is committed to pay Revenue Share to the DfT.
For most of the franchises where the concepts apply, Revenue Share is payable in respect of any year where revenue is more than 2% more than Target Revenue but Revenue Support is only receivable from the fifth year of the franchise onwards5.
More detail on the particular Revenue Share and Revenue Support mechanisms can be found in the publically available National Rail Franchise Terms as they apply to the relevant franchise. For example, in the case of the East Midlands Trains franchise, refer to Schedule 8.1 of the National Rail Franchise terms, available at:
http://assets.dft.gov.uk/publications/rail-passenger-franchise-agreement-east-midland-trains/east-midlands-terms-2012.pdf
The accompanying spreadsheet illustrates the calculation of Revenue Share and Revenue Support.
5. Criticisms of Revenue Share and Revenue Support
The Revenue Share and Revenue Support mechanisms described in section 4 of this document offer a number of advantages to Government, train operators and passengers, but have also been criticised as follows:
- When a train operating company is in receipt of Revenue Support, it may have less incentive to grow revenue. Consider where it is receiving Revenue Support at the 80% level. If it generates £100,000 more revenue, the amount of Revenue Support receivable would be £80,000 less and so the net benefit would be £20,000. Therefore, unless the cost of delivering an additional £100,000 of revenue is less than £20,000, there is no financial incentive to deliver the additional revenue. This could discourage specific initiatives (for example, expenditure on marketing) to grow revenue and could result in the DfT having to pay more Revenue Support than would otherwise be necessary.
- Some have questioned why the train operating company should be supported for revenue shortfalls regardless of the cause. If, for example, revenue falls short of expectations due to the failure of the train operating company to deliver an effective marketing campaign, some would question why the Government should compensate for that.
- Given that the macroeconomy can change quickly, there is an argument that not having Revenue Support for the first four years of the franchise leaves the train operating company with too great an exposure to macroeconomic risk.
6. GDP Risk-Sharing
The DfT has devised a GDP risk-sharing mechanism that is intended to share GDP risk throughout the whole life of the franchise. The mechanism is intended to share only national UK GDP risk (based on the argument that GDP is outwith the train operating company’s control) and provides no other protection against revenue falling short of expectations.
The West Coast franchise commencing December 2012 will be the first franchise to incorporate the new GDP risk-sharing mechanism but the DfT intends that subsequent UK rail franchises will incorporate a similar mechanism.
The key features of the GDP risk-sharing mechanism are:
- The DfT provides bidders with a forecast of national UK GDP for each year of the franchise;
- The DfT specifies a GDP calibration factor (the expected relationship between GDP and revenue) to be applied to the national GDP metric. In the case of the West Coast franchise commencing December 2012, the GDP calibration factor is 1.25 in each year. In other words, all other things being equal, revenue is expected to change by {(1 + percentage change in UK national GDP) ^ 1.25} -1 and so if GDP were to increase by 2.5%, revenue would be expected to increase by 3.1%. A less precise approximation can be obtained by multiplying the change in GDP by the calibration factor of 1.25;
- A “nil band” of 5 percentage points on the GDP compensation index (being the index for revenue from a given level of GDP) above and below the DfT’s forecast GDP applies;
- A financial adjustment will occur in relation to each year (starting with the first full franchise year to 31 March) of the franchise for which actual GDP varies from the Department’s forecast by an amount in excess of the nil band. The revenue element of this adjustment will be weighted by 80%.
The operation of the GDP risk-sharing mechanism might not be immediately clear and might be better understood by the simplified example below:
Target real revenue for year 1 (being first full franchise year to 31 March) = £1,000m
Target GDP growth in year 1 as specified by the DfT = 2.5%
Multiplier used for GDP share as specified by the DfT = 1.25
Target GDP index = 1 * (1 + Target GDP growth of 2.5%) =1.025
Target share/support index = (Target GDP index of 1.025) ^ (Multiplier used of 1.25) = 1.0313
Actual GDP growth in year 1 = -4.5%
Actual GDP index = 1 * (1 + Actual GDP growth of -4.5%) = 0.955
Actual share/support index = (Actual GDP index of 0.955) ^ (Multiplier used of 1.25) = 0.9441
Actual share/support index - Target share/support index = 0.9441 - 1.0313 = -0.0872
Element eligible for support is more than the nil band of 0.05 so = 0.0872 - 0.05 = 0.0372
Shortfall (0.0372) as a % of target share index (1.0313) = 3.61% or 0.0361
Actual RPI for year 1 = 3% and so RPI index would be 1.03
80% sharing so GDP support receivable in year 1 would be = 0.8 * 0.0361 * £1,000m * 1.03 = £29.8m
It should be noted that the actual share/support calculation uses only the Target real revenue and that actual revenue is completely excluded from the calculation.
The accompanying spreadsheet illustrates the calculation of GDP Share.
7. How the mechanisms compare
From the perspective of the train operating company, Stagecoach Group’s view is that the train operating company has more downside risk under the new GDP sharing mechanism than it did under the old Revenue Share and Revenue Support mechanisms.
The advantages for the train operating company of the new mechanism compared to the old mechanisms is that the train operating company is incentivised throughout the franchise to grow revenue and support is available for the full duration of the franchise rather than from the fifth year only.
The disadvantages are:
- The new mechanism only compensates for differences in actual UK GDP versus the GDP forecast set by the DfT and so:
- The train operating company bears the risk that the relationship between revenue and UK GDP is not consistent with that specified by the DfT.
- The train operating company bears other macroeconomic risks such that for any given level of UK GDP, revenue might vary due to changes in regional GDP, regional employment levels, changes in disposable incomes etc.
- The train operating company bears the risk that revenue might vary due to factors other than UK GDP, some of which might be under the train operating company’s control (e.g. marketing, revenue protection and other specific initiatives designed to increase revenues) and some of which might not (e.g. terrorism, national industrial relations disputes, Network Rail’s operational performance).
- The 5% “nil band” means that there is no protection for a significant proportion of any GDP shortfall. A large franchise commencing now for a fifteen year franchise term could have annual revenue comfortably in excess of £2 billion by its expiry. Even using a 1.25 multiplier, on £2 billion of revenue, revenue would need to fall short by around £100m before any support was receivable.
8. Profit share
Certain UK rail franchises also include a profit sharing mechanism. The West Coast franchise commencing December 2012 is expected to have a mechanism whereby a proportion of profit in excess of certain specified thresholds is payable by the train operating company to the DfT. The franchise is not expected to include a profit support mechanism and therefore, under the profit share mechanism, the train operating company has no entitlement to receive amounts from the DfT. The DfT intends that subsequent UK rail franchises will incorporate a similar mechanism, limiting upside potential for the train operating company.
1 The amounts payable to or receivable from the DfT are stated in the relevant franchise agreement for each franchise year within the franchise term, together with any potential extension periods. The amounts are stated in real terms (that is, excluding the effects of inflation). The amounts are subject to adjustment for (a) various inflation measures (b) risks borne by the DfT (c) called options and (d) changes in regulated Network Rail charges.
2 The annual Target Revenue figures are specified in the relevant franchise agreement. The amounts are stated in real terms (that is, excluding the effects of inflation). The amounts are subject to adjustment for (a) changes in the UK Retail Prices Index (“RPI”) (b) risks borne by the DfT (c) called options and (d) changes in regulated Network Rail charges.
3 The components of actual revenue for the purposes of calculating Revenue Share and/or Revenue Support are specified in the relevant franchise agreement.
4 The thresholds and percentages for determining Revenue Share and/or Revenue Support are generally as stated here but certain franchise agreements may use different thresholds and percentages.
5 Certain franchises were entitled to Revenue Support earlier than the fifth year of the franchise, notably Stagecoach South Western and First Great Western.