Railway Funding and Financing: The System Works – Keep It

In this piece I want to focus on the funding and financing of railways in Great Britain (shorthand, GB Rail) and where we might be headed with it all.

Funding and financing are two concepts often confused, but distinctly different : the simplistic explanation is to think of financing as ‘borrowing and lending’ and funding as ‘giving’.

GB Rail has seen an important change in this area in recent times : the reclassification of Network Rail to the public sector in 2013, an accounting move which took effect the following year. This recognised the reality that Network Rail had previously funded its activities – approaching some £40bn worth between 2014 and 2019 alone - in part by systematically increasing its debt but that, sooner or later, most of that debt will only ever be repaid out of taxation.

So what had previously been presented as financing debt (‘borrowing and lending’) was in reality taxpayer funding (‘giving’).

Network Rail’s reclassification also reinforced the perception that the railway is run, in some detail, by the UK Department for Transport with oversight by the Treasury.   The latter’s involvement is, not least, because there is a great deal of public money at stake –  some £100bn, if all the projects in plan or under way over the next twenty years are accounted for.

Control Periods – a tried and trusted system

Rail funding periods generally (though not always) run in five year cycles known as ‘control periods’.  We are currently in Control Period 5 which began in 2014 and runs to 2019.

ORR is responsible for determining in consultation the funding we consider is necessary during each five year period for GB Rail to operate effectively, maintain its network efficiently, carry out the renewals necessary and enhance the network progressively to meet growing demand.

That demand, incidentally, is rising at a significant rate as people have greater and greater expectations of mobility.   There are twice as many people using the railway today than twenty years ago and forecasts continue to show at least similar rates of growth.

The ‘control period’ system, which is common to the regulated utilities, has worked well for the railways.   During any control period, Network Rail - as system operator - knows what it is expected to deliver and it is assured that, if efficient, it should have sufficient funds to do the job.

This mitigates the problem of funding volatility and political uncertainty in a system which might otherwise run only from year to year; an issue well recognised in government as an impediment to economic and efficient procurement in an infrastructure industry where lead and committal times are especially long.

It follows also that the system should impose a discipline on government ministers to prevent them from intervening at irregular moments to specify new, unplanned activities which may (or may not) fit with agreed plans, and for which there may (or may not) be corresponding funding available.

The 2005 Railways Act and was created to deal with the absence of normal commercial disciplines following the demise of the privately-owned Railtrack in 2002, as well as to furnish the industry with a degree of stability.

The Act requires that the Secretary of State for Transport set out to the ORR a High Level Output Specification (or ‘HLOS’) of what s/he wants to be achieved by rail activities during the railway control period and of the public funds (the Statement of Funds Available or ‘SoFA’) that are or are likely to be available to secure delivery of those activities.

In turn, it is the ORR’s role to assure what we believe the efficient cost of those activities should be.  We do this in consultation with the industry – a two-year exercise we have just begun (called periodic review 2018 or ‘PR18’) for the control period beginning in 2019.

It is important that the HLOS and SoFA disciplines are adhered to.  Departure from this contributed to the difficulties that emerged in 2015 over funding of major works, and precipitated the various reviews into the industry (Nicola Shaw's report, and the Bowe Review to name two, plus an internal review of the ORR’s functions by the Department for Transport which nevertheless led to a clear endorsement from the industry for our purpose and activity).

So HLOS and SoFA is a good system, and unless and until the legislation is changed it should remain a pillar of relative stability for the rail industry.

devolving power – what about the funding?

Whatever the longer term outcome of the current turmoil in UK politics, I assume it likely the new government will wish to continue devolving powers—and specifically, transport responsibilities—to sub-national transport bodies like Transport for the North; the 39 Local Enterprise Partnerships (LEPs); and combined authorities such as that of the West Midlands.

This raises a number of issues in relation to funding because, for sure, whatever devolution there is to the local tax bases, these authorities will not have sufficient funding to meet all their aspirations for road and rail operations, or for infrastructure investments.

So they will have to consider how much they are willing to afford, and how they make the choices that have often been dictated in the past by central Government in Whitehall.

Any devolution taking place must also do so against a backdrop of continuing technological innovation.  This comes at a price, and digital investment in rail is but one illustration of the funding and financing conundrum.

In the long run, digital will undoubtedly reduce operating costs and generate additional revenues from users. But all this will require up-front investment.

It may be the case that some digital investments are self-funding: over time they will pay for themselves. If not, however, and assuming they are judged worthwhile investments, the gap will have to be funded (that is, paid for) by some form of taxation or external financial contribution.

borrow now, pay later

Either way, investments have to be financed.  Which will mean some way of borrowing money to pay for the initial investment, to be repaid later.

This may be government borrowing, borrowing on the markets, or an equipment supplier may itself raise capital and service the equity and debt out of annual charges levied under a long term service contract.

The latter is the essence of Private Finance Initiative and Public Private Partnership (PFI/PPP) arrangements, but in the past there has been confusion here that has led to disappointment or bad decisions.

Private investors (often representing pension funds or sovereign wealth funds) will finance deals, but only for a return.  It is wrong to think that the private investor would ‘step in’ to fund public investments that the taxpayer ‘cannot afford.   Why should any private investor want to do that?

This means that if an investment is not commercially viable the taxpayer will have to fund some of it later, if not sooner.

It should not, for example, have come as a surprise that the UK health service would have a substantial burden on its annual budgets from contractual commitments made years ago to procure new hospital facilities under the PFI.

Don’t get me wrong, there is merit in PFI/PPP deals – but only if appropriately applied.  And there is considerable experience of both appropriate and inappropriate application in the railway context.

At the point where the PPPs for London Underground were signed there were pre-existing, long term PFI agreements in place for the Northern Line trains, the ticketing system, the electrical power supply and the radio communications system.

None of these ran smoothly and all except the communications PFI were terminated prematurely. The London Underground PPP contracts themselves then failed and were terminated about one quarter of the way through their terms.

These agreements are typically for 20 to 30 years—long, so that the investors can recover their capital out of annual service charges set at a manageable level. So for these deals to be successful for both parties I believe there are two fundamental requirements:

• the procuring body must be able to write down, in a commercial contract, a specification of what it expects to be delivered and to what standard, over the term of the agreement; and
• the contract must be capable of being enforced, in practice, and it must actually be positively managed and enforced.

The first requirement can be problematic because the demographic, economic and political environments can change rapidly and unpredictably.

In the case of large public services and long term contracts, the second requirement can also become problematic if it is difficult  to ensure that there is a credible threat that another party would be available to take over provision of service should the contract be terminated for inadequate performance.

Without this threat it can then become difficult to defend against sub-standard level of service and demands for extra funds.

complications for the future

All the above are live considerations as Network Rail seeks to generate an extra £1.8bn, mostly through the sale of property assets, where continued Network Rail ownership is not essential to running the railway.

This extra funding requirement is to meet its remaining commitments within the remainder of Control Period 5 and help fund Network Rail’s Railway Upgrade Plan.

And as noted in the ORR’s ‘PR18’ consultation document (open for comments until 10th August), funding Control Period 6 is then likely to be demanding.

There is already a backlog of maintenance expenditure, estimated at £2.5bn, which will be deferred from Control Period 5 and a further £9.5bn in deferred enhancements (that is, new parts to underpin growth of the railway).

Further, rental income from commercial property will not be available if it has been capitalised as described above to help pay for CP5.

And if the High Level Output Specification and Statement of Funds Available is to be put in place for railways in relation to Control Period 6, this commitment will be required around mid 2017 for the five year expenditure programme which would comprise CP6, starting in 2019.

It’s not all about the railways either - a similar commitment will be sought from the UK Government, at a similar time, to the funding for the strategic road network under the second, five year Road Investment Strategy (RIS2) due to begin in 2020.

Before the UK Referendum result on leaving EU membership, it was thought that the Treasury was likely to operate a particularly tight policy on public spending around the end of the decade, because this was the date at which the deficit was targeted for elimination.  While this requirement has now changed following the Referendum result, there is still a lack of clarity.

Needless to say, the earlier this is resolved, the better and any extension of uncertainty into 2017 will frustrate the essential long-term financial planning of the railway.

innovative financial engineering

So we may be in for some choppy water ahead.  There seems little doubt that funding the remainder of CP5, and then CP6, is going to be difficult and the prizes may go to those more able to provide innovative financial engineering.

For sure, we will need realism and clarity about the distinction between financing and funding, and to avoid the mistakes made in the past with PFI/PPP contracts.  But the current arrangements have proven their worth in the past and will do so again for the future.

ORR has a direct interest how the remainder of CP5, and then CP6, are funded. Our duties are very clear in relation to long term stewardship of GB Rail, and ensuring fair access by train operators to reliably functioning railway assets.

As the independent regulator, ORR can help provide a stable platform for funding and financing of the railway for its long term future, as well as an environment for successful technical innovation.

We stand ready to do what we can to promote a stable system of governance and the long-term view in these more uncertain times.