Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Rail franchise margins European Transport Conference 2014 Andrew Meaney, Partner Christopher Davis, Consultant 30 September Purpose To better understand the link between contract design, the size of rail franchise margins and value for money To outline a framework that public authorities can use to design passenger rail contracts such that the margin required by railway undertakings offers value for money 30 September 2014 2 Overview Background on franchising Some observations A framework for delivering value for money 30 September 2014 3 Background (I) What is a franchise? • the right to operate rail services on a given collection of rail routes • formal contract with government • franchises broadly split by region or mainline • awarded by competitive tender to private companies • competition for the market • passenger-facing part of the rail service • day-to-day management of the train services 30 September 2014 4 Background (II) What are the aims of franchising? • increased efficiency and innovation • an improved service offering for passengers • reduced government subsidy • enhanced certainty on future public expenditure by contractually underpinning premium/subsidy payments • flexible tool with which to vary the specification of rail services across different areas of the country 30 September 2014 5 Background (III) Rail margins • TOCs require a margin (compensation) for providing rail services • margin assumption incorporated in franchise bid • affects size of the premium or subsidy required to operate the franchise • link between the level of risk and the level of return (i.e. the margin) • franchises have different cost and revenue characteristics that may affect owning groups’ risk exposure HIGHER RISK HIGHER RETURN 30 September 2014 6 Overview Background on franchising Some observations A framework for delivering value for money 30 September 2014 7 1. Rail franchises are asset-light businesses... • required profit margins will decrease as assets decrease (relative to revenues) • required margins lower than the market average 40% 35% Average operating margin (2008–12) • investors in asset-light businesses require a return on the risks they take from running the business and/or the intangible assets created over time 30% 25% 20% 15% 10% 5% 0% 0 -5% 1 International Consolidated Airlines Group 2 3 5 Capital intensity (2012) Required profit Assets Required profit Assets Revenue Revenue 30 September 2014 4 8 2. ...but margins are non-zero • finance theory is based on the assumption of a ‘return on investment’ • franchises require little or no direct asset investment • does this mean any profits are unnecessary? Asset owner Franchisee Upfront investment Commitment to provide capital Risk of loss Target profit (capital * return) Required return on investment Risk of loss Required return on investment 30 September 2014 9 3. Observed margins across TOCs vary widely 0.16 Lower interquartile range 0.14 Density of UK TOCs 0.12 There is a clustering of EBIT margins at or below the 5% level Upper interquartile range GB franchise average 0.10 0.08 There is significant variation in the profitability of different franchises 0.06 0.04 0.02 0.00 -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% Total operating profits across the GB passenger rail industry were around £250m in 2013 30 September 2014 10 4. Margins are driven by cost risk, revenue risk and operational leverage... Type of rolling stock Input costs The critical driver of required returns Hedging policy Cost risk Volatility of net cash flows Initiatives Results in potential losses for investors where capital is committed Operational leverage Capacity utilisation Transition of revenue volatility in the volatility of net cash flows Structure of contracts with the ROSCOs and Network Rail Revenue risk Revenue support mechanisms Proportion of business passengers Underlying volatility of demand Open access regime 30 September 2014 Subsidies or premium payments 11 5. ...which will vary across franchises Revenue risk Cost risk Inter-modal competition Wages GDP City employment Materials Power Disposable income Premium or subsidy Schedule 4 Schedule 8 Open access Initiatives Operational leverage and capital structure • utilisation of available capacity • premium or subsidy payments • structure of lease contracts • capital requirements 30 September 2014 12 6. Rail franchise design will affect risk exposure and thus the required margin • franchise term • risk-sharing mechanisms • only at risk for controllable factors? • within period changes • profit share arrangements • two-sided? symmetric? • exposure to cost shocks • e.g. energy costs, track access charges • exposure to open access operators • timetable flexibility • bid assessment criteria • capital requirements (bonds and parent company guarantees) 30 September 2014 13 7. Franchise contracts can take a number of different forms • High risk • Stronger incentives TOC takes cost risk, client body takes revenue risk Management contract ‘Cap and collar’ TOC takes all risk Exogenous risk-sharing mechanisms • Low risk • Weaker incentives Source: Adapted from English. K-L. (2014), ‘Overview of the UK rail market’, Department for Transport, 19 May. 30 September 2014 14 8. It is generally agreed that TOCs should only bear the risks they can manage Endogenous risk Marketing initiatives Revenue from unregulated fares Exogenous risk Track access charges Service quality Local GDP National GDP Unemployment Inflation Brand / reputation Exposure to exogenous risks reduced through revenue risk-sharing mechanisms (e.g. GDP mechanism) and inflation-linked changes in regulated fares 30 September 2014 15 9. Inappropriate risk transfer can lead to higher subsidy than is necessary • leaving TOCs exposed to too much risk can lead to higher than necessary franchise margins • removing all risk can dampen incentives and lead to overbidding • potential negative impact on alignment of incentives across industry if TOCs fully protected from changes in track access charges • balance needs to be struck • risk transfer should be tailored to each franchise 30 September 2014 16 Overview Background on franchising Some observations A framework for delivering value for money 30 September 2014 17 A framework for ensuring value for money Ensure that rail franchise design reflects policy objectives—i.e. what is the tender or direct award meant to achieve? Find ways in which the contract also aligns incentives between the railway undertaking and the infrastructure manager Balance risk transfer such that the operator faces appropriate growth incentives but limited exposure to events that are outside its control Reflecting step 1, require that the contract includes incentives for efficiency, innovation and service quality improvements 30 September 2014 18 Contact: Name Tel email www.oxera.com Follow us on Twitter @OxeraConsulting Oxera Consulting LLP is a limited liability partnership registered in England No. OC392464, registered office: Park Central, 40/41 Park End Street, Oxford, OX1 1JD, UK. The Brussels office, trading as Oxera Brussels, is registered in Belgium, SETR Oxera Consulting Limited 0883 432 547, registered office: Stephanie Square Centre, Avenue Louise 65, Box 11, 1050 Brussels, Belgium. Oxera Consulting GmbH is registered in Germany, no. HRB 148781 B (Local Court of Charlottenburg), registered office: Torstraße 138, Berlin 10119, Germany. Although every effort has been made to ensure the accuracy of the material and the integrity of the analysis presented herein, the Company accepts no liability for any actions taken on the basis of its contents. No Oxera entity is either authorised or regulated by the Financial Conduct Authority or the Prudential Regulation Authority. Anyone considering a specific investment should consult their own broker or other investment adviser. We accept no liability for any specific investment decision, which must be at the investor’s own risk. © Oxera, 2014. All rights reserved. Except for the quotation of short passages for the purposes of criticism or review, no part may be used or reproduced without permission. Revenue risk sharing mechanisms Brown Review’s recommended approach Agree appropriate (franchise-specific) mix of exogenous risk drivers (e.g. national/regional GDP, CLE) and the elasticity of demand to them ITT includes base forecasts for national GDP, regional GDP and CLE to give exogenous revenue growth assumption (which feeds directly into bid) Bids are on endogenous revenue growth (i.e. companies’ own initiatives) with proposed costs, margins and resulting payments Contracted premia or support payments are adjusted for the outturn level of the indices relative to the base forecast 30 September 2014 20 Case studies Recent prospectuses Thameslink Northern • seven-year management contract • 8–10 years • DfT takes full revenue risk • bidders will take full revenue risk • Govia takes cost risk • profit-sharing arrangement including a profit cap • operating costs plus 3% margin (4% cash margin) • no sharing arrangement where operator incurs losses East Coast • 8–9 years • GDP indexation mechanism • based on national GDP • covers 90% of difference in revenue resulting from outturn GDP • symmetrical with nil band (±2%) • elasticity of 1.2–1.4 • profit share with profit cap 30 September 2014 21 Further reading • Oxera (2014), ‘Something for nothing? Returns in low-asset industries’, Agenda, March. • Oxera (2012), ‘Chuffing hell: is the British model of rail franchising dead?’, Agenda, November. • Oxera (2012), ‘Sold to the slyest bidder: optimism bias, strategy and overbidding’, Agenda, September. 30 September 2014 22