On-Rail Competition in the UK: What now? Where next?

Published on 28th Jan 2016

Competition in rail: what happens now?

The Competition and Markets Authority (the “CMA”) published the findings of its ‘policy project’, examining the state of competition in the passenger rail market in Great Britain in July 2015. The rail industry has had six months to digest the CMA’s findings; so too, has the Office of Rail and Road, the sectoral competition authority for rail, which commissioned joint research by Arup and Oxera to support its own response. This was published on 31 December 2015,  and the CMA consultation on ORR’s response closed on 25 January 2016, with final recommendations expected in March.

In this update we consider: (i) the competition landscape in passenger rail (ii) the options proposed by the CMA last year and ORR’s recent evaluation of them, and (iii) what should happen next.

The current competition landscape

To rehearse some familiar ground, competition in passenger rail takes two forms in Great Britain:

  1. Competition for the market: in other words the franchise model, by which train operators bid for a monopoly (or near monopoly) over the passenger services on a particular route or in a region, with protections and obligations enshrined in a franchise agreement with government; and
  2. Competition in the market (also known as ‘on-rail’ competition): where franchised train operators compete head-to-head to attract passengers, either through overlapping or parallel franchises, or alongside open access operators (who run services on franchised routes on a fully commercial basis and without the protections of a franchise agreement).

The vast majority of passenger rail services are delivered through single-operator franchises, whereas open access services constitute roughly 1% of passenger miles annually. The intention when the industry was privatised was for on-rail competition to play a greater role than it did. Over time, however, policy decisions led to fewer overlapping or parallel franchises. Equally, open access operators struggle to obtain access to the network due to limited capacity and the pervasiveness of franchised services.

The vast majority of passenger rail services are delivered through single-operator franchises, whereas open access services constitute roughly 1% of passenger miles annually. The intention when the industry was privatised was for on-rail competition to play a greater role than it did. Over time, however, policy decisions led to fewer overlapping or parallel franchises. Equally, open access operators struggle to obtain access to the network due to limited capacity and the pervasiveness of franchised services.

A further constraint is that when ORR considers track access applications from open access operators, it is obliged to take into account the extent to which they will take revenue from the franchised operators with whom they compete. Quite sensibly, this protects the taxpayer funds that support franchises, but it greatly limits the scope for open access, even if the economic test applied is perceived as lenient by economists.

In its July 2015 document, the CMA acknowledged that competition for the market via the franchising model delivers genuine benefits, albeit somewhat incrementally, contributing to the marked improvement in passenger numbers since the mid-1990s and improving passenger satisfaction at least over the last decade. Its policy project sought to assess whether more significant benefits for passengers and the wider economy could be achieved with a greater degree of competition in the market.

CMA findings and recommendations – four options for growing on-rail competition

The CMA acknowledged the risk of increased costs to taxpayers posed by greater on-rail competition, in particular the risk of new entrants cherry picking profitable routes, while undermining franchised operators’ ability to finance unprofitable but socially valuable services.

It found that there is nonetheless compelling evidence that greater on-rail competition delivers “downward pressure on fares and upward pressure on service and innovation” citing, among other examples, the impact of Grand Central competing with franchisee Virgin East Coast to bring about cheaper ticket prices and differentiated fare types.

The consultation document therefore proposed four options for the industry to consider:

Option 1: Existing market structure but significantly increased open access: This would require reform of the track access charges system so that open access operators contribute towards Network Rail’s fixed costs (unlike franchised operators they currently only pay towards Network Rail’s variable costs, which are far lower). They would also pay a ‘public service obligation levy’ to fund the shortfall in franchise revenue and hence compensate the taxpayer for the loss of franchise premiums resulting from increased on-rail competition.

Option 2: Two franchisees for each franchise: There would be two successful bidders in each franchise competition, running either 50% of services each or through an asymmetrical allocation, with one ‘anchor’ franchisee being responsible for the unprofitable services and both franchisees competing to run commercially viable services.

Option 3: More overlapping franchises: This option involves redrawing the franchise map to create more flows on which franchisees compete with one another.

Option 4: Licensing multiple operators, subject to conditions: This would replace the franchise model with something closer to total open access competition. Operators would be fettered by a licensing regime to impose obligations and restrict activities in order to ensure that unprofitable but socially valuable services were still operated. The licence would be less prescriptive than a franchise agreement to allow market forces to determine which operators are best placed to offer particular services.

Office of Rail and Road evaluation of the four options

The Arup and Oxera research commissioned by ORR was based on case studies that simulated the effect of increased competition on the three mainline routes (Great Western Mainline, West Coast Mainline and East Coast Mainline). The four options were compared to a ‘do nothing’ base case.

Option 1: Existing market structure but significantly increased open access: For this option to work, government would have to specify fewer train paths in franchises so that there is capacity left on the network for open access to fill.

An expansion in the number of train operators would increase complexity and have performance impacts, but these effects are likely to be manageable. Benefits of this option include increased competition on fares and service quality, and potential for new business models to cater for a wider range of consumer preferences.

A heightened risk is the likelihood of government needing to step in as operator of last resort if an open access operator exited the market and ceased operating on a particular route or set of train paths. Overall this option was likely to deliver a very high level of benefits, although the net effect will not be positive for all routes, and the impact will depend on the increase in market share afforded to open access operators.

Option 2: Two franchisees for each franchise: This option is quite easy to implement through franchise remapping. It can be done either by splitting a franchise or by separating it into the profitable and unprofitable parts. It is anticipated that competition would increase less than in Option 1, because both operators on a route will be constrained by the requirements of their franchise agreements.

However, this option will still deliver benefits to passengers on fares and quality. The quantitative research in respect of the East Coast Mainline suggested that depending on how that route was divided between two operators, the reduction in fares could be similar to or even greater than in Option 1. There was a heightened risk for government under this option as increased competition reduces profitability for operators which would be passed on to government via lower premium payments. Government can retain control of that risk, however, through franchise agreements.

Option 3: More overlapping franchises: The impact of this option depends on the extent to which the overlapping franchises create direct competition. Nonetheless this option is likely to have less impact than splitting franchises into two (per Option 2) because the overlaps will be limited in geographical extent and also because operators will often be serving different markets. As with Option 2, any loss of franchise profitability will be passed to government, but can be managed in the same way.

Option 4: Licensing multiple operators, subject to conditions: This option renders it very difficult to secure continuity of unprofitable but socially valuable services. The licensing regime would need to be designed so that operators were still required to run a minimum level of service for non-commercial times, stations or routes.

As it is the most radical of the four options there would be significant legal and operational challenges in its implementation, for example establishing the auction system for train paths. However, it is acknowledged that this option would generate the largest increase in competition because multiple operators would compete with each other and with minimal restrictions under their licences. Operators would be more exposed to changes in Network Rail’s access charges and be incentivised to work with it to reduce costs (unlike in a franchise scenario where operators are largely shielded from such changes). ORR was not able to undertake a quantitative assessment of Option 4 until the CMA develops the option further.

What next?

The CMA does not envisage the outcome of its policy project being implemented until 2023 at the earliest, noting that recommendations should be phased in as current franchise agreements expire. Aside from this realistic approach to the timeline, we believe the recommendations cannot be considered in isolation from current government reviews looking at the shape and financing of Network Rail (the Shaw Review) and at the role of rail regulation.

The outcome of these reviews will shape the landscape of the sector for many years to come, and will surely have an impact on the suitability or otherwise of the CMA’s proposals for increasing competition.

These reviews publish their conclusions at around the same time as the CMA, in March 2016. We strongly suggest that the CMA leaves open the possibility of revisiting its own conclusions once the outcome of the two other reviews is settled.

For a simple chronological guide on the reports, reviews, policy projects and studies, recently published or concluded in this area please click here.

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* This article is current as of the date of its publication and does not necessarily reflect the present state of the law or relevant regulation.

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