The Digital Railway – finance now or await the funding?

The Digital Railway (DR) programme is fundamental to the modernisation of the UK’s rail network and its progression towards an intelligent transport system. In April 2017, DfT will begin assessing business cases for the latest pipeline of DR enhancements. While an important step forward for the UK rail technology industry, it is expected that only half may receive funding in the short term. With the level of long-term Government commitments also uncertain, Keir Pimblett takes a look at how private finance might be unlocked to fill the void.

In April 2017, up to eight business cases will be submitted to the Department for Transport (DfT), each aiming for a slice of the £450 million earmarked for the implementation Digital Railway in the 2016 Autumn Statement. These route-specific plans focus on schemes where the introduction of digital technologies will deliver the maximum benefits, particularly in relation to capacity; a new and targeted approach adopted by Network Rail.

However, only half of these projects are expected to receive short-term funding and the level of long-term commitments (the Government’s Control Period 6 (CP6) settlement) are uncertain.

Challenges

A key barrier to funding has been Network Rail’s reclassification as a public body, which prevents it from continuing to raise funds through the issue of corporate bonds. It now relies directly on the DfT and so its funding is subject to government fiscal constraints.

From Train Operating Companies (TOCs) perspective, the delay in the return on their investment is a central concern given the limited durations of their franchises, as well as potential imbalances in risk/reward. On the supplier side, a series of aborted or heavily amended procurements has damaged confidence and investment in technology has slowed. Cuts to Network Rail’s ETCS Cab Fitment fund, have meant that the first-in-class fitments, led by rolling stock operation companies have also suffered delays.

The upshot is that current funding sources are insufficient and private sources of finance are needed. Early market soundings suggest that there are plenty of investors waiting in the wings. We look below at the funding models which might be used and some key challenges.

Private Sector Finance Models

Project Finance

The Transport Select Committee has said that “[i]t is possible that performance-based compensation for traffic management technology providers could improve outcomes by sharing performance risk with technology suppliers.” A refined version of a PPP model – similar to the much maligned PFI (or, as it now known, PF2) – would appear to fit this brief. Suppliers would be appointed to finance, supply and maintain the equipment for the whole of its design life – anywhere up to 25 or 30 years. They would shoulder most or all of the capital investment, take development risk and, once operational, receive an availability payment based on the achievement of KPIs during the term.

Similar models were used in the InterCity Express Programme and Thameslink rolling stock procurement, and any process used in this instance would certainly benefit from implementing the lessons learned from these deals.

However, whole-industry buy-in will be required. The TOCs, especially, will need to be adequately incentivised and allowed commercial and contractual flexibility to mitigate the associated risks. In particular, given the significant financial consequences of late or cancelled trains, the pass-down of risk from the TOC to the supplier for performance failures will be of central importance.

Asset Finance

Asset finance could be used to finance on-board technologies. Equipment would be purchased and owned by financiers and rented to TOCs. This should overcome concerns over a lack of tenure, as the TOC would only pay for the asset while it operates the franchise. Financiers’ concerns around ensuring a guaranteed whole-life lease could be overcome by undertakings (known as “Section 54 Undertakings”) from DfT, although the Department’s enthusiasm for these undertakings has waned in recent years.

Whilst this model could work well for new rolling stock, subject to the correct alignment of procurement programmes, it may be less suitable where equipment is retrofitted, given that the equipment might well outlive the rolling stock on which it is installed.

Franchise bid with residual value mechanism

A recommendation of the Brown Review, we are now seeing residual value mechanisms being used to encourage franchisee investments in projects which have a commercial return beyond the franchise term.

Given that upfront capital investment is still required from the TOC and the appetite for further investment may be scarce, its applicability may be limited.

Conclusion

With a compelling long-term business case and a clear need to reduce the short-term capital burden on the Treasury, the requirement for private finance is clear. Appropriate models are being considered by Network Rail and DfT. In practice, and in common with Network Rail’s approach to the latest business cases, each project will need to be assessed on a route-specific basis. Timetable planning, programme alignment and franchise requirements will all play their part. At the market level, it will be important to ensure stakeholders are incentivised by continuing to rebuild supplier confidence and offer TOCs reasonable contractual and commercial ways to mitigate the impact of the new system.

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