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Monday essay: How can operators make a profit now?

Social distancing on trains will come at a price, says Sim Harris.

IT has been reported over the last few days that rail timetables could be restored to around two-thirds of the normal pre-pandemic service on 18 May, particularly on urban commuter lines.

But even though up to 70 per cent of trains might be running again as soon as next week (up from 50 per cent or so at the moment), that does not mean that capacity will also be restored to 70 per cent of the old days.

This is because social distancing seems likely to be with us for some time – some months at least – and that can only be achieved on trains if they carry a fraction (a small fraction) of their usual loads.

Public transport has never been designed for social distancing: the nearest example was probably the former compartments on British passenger trains, because it is possible to imagine an ‘only two passengers in each compartment’ rule. We can imagine the rule, but even then it would have been hard to make it work in practice.

In reality, the last trains to be built with compartments (apart from sleepers) were the Class 442s which British Rail introduced on the Wessex Electric services from London Waterloo in 1988.

These had open saloons for Standard and part of First Class, but there were just a few compartments in First Class as well.

Even these were abolished when the 442s were refurbished for Gatwick Express around 2008, and since then the open saloon has been standard on all daytime National Rail trains.

The general tendency in recent times has been to provide more seats, in response to growing demand, but this has usually meant less space for each seat and also fewer tables, especially in Standard. In fact tables almost disappeared from Standard when Mk3 trailers on Great Western HSTs were modified to increase capacity as much as possible in the mid-2000s.

Now everything has changed, at least for the time being. Passengers can only travel two metres apart if the seating area is very generous, or if not all seats are occupied. Even then, the rows of seats are also often quite close together, which means the person sitting behind you might also be less than two metres away.

If enough seats are to be cordoned off to maintain two metres in all directions, capacity would indeed fall drastically. More than one source has spoken of no more than 15 per cent, or less than one in six of pre-pandemic loads. Standing passengers, not being confined to specific ‘mini-quarantine’ areas, would presumably not be permitted at all.

We will leave aside the problems of imposing and controlling such restrictions for now, and move on to the effects on revenue. They would, of course, be dramatic, and operators’ income would also fall to around 15 per cent of what it was before.

No franchise business plan could survive such a fall without assistance. One Railnews reader put it like this: ‘Will operators even bother to run trains if they can carry so few passengers there is no hope of any profit?’

This perfectly reasonable question masks a common but erroneous assumption, that franchised rail operators have been making profits in any case. They haven’t. In the last couple of years not one of the Department for Transport franchises has made a single penny by itself.

You might ask (also very reasonably) why any franchises exist at all in that case? Why should transport groups bother to bid for profitless enterprises?

The answer is that the franchise owners do expect to make money, but almost always this is because the business plans submitted with bids allow them to scoop a surplus.

It goes something like this. The bidder calculates that the cost of running the franchise will be £120 a day, and that the income will be £85. That would be a non-starter in the usual world of business, but we are in a special dimension –  without realising it, you have entered the Franchise Zone.

Start with track access charges – a major part of the costs. There are several kinds, but the two main types are fixed and variable. Taking variable charges first, these are calculated on the number of trains run each day, and the total kilometres they cover. Other factors are maximum speed, axle count and axle weight, which all of which plainly have an effect on track wear.

In practice, this means a heavy intercity passenger train – an 11-car Class 390 Pendolino, perhaps, running at up to 125mph (200km/h) between London and Manchester – is going to cost more in variable charges than a 2-car Class 150 diesel unit pottering along a branch line in Devon at no more than 50mph (80km/h). The 390 also draws power from the overhead, for which there is a separate charge.

Fixed charges, like the variable ones, are set by the Office of Rail and Road, and the ORR has calculated from time to time that no franchise could afford to pay the full ‘market rate’ charges (those which would balance Network Rail’s own books) without a subsidy somewhere along the line.

Sure enough, there is one. Network Rail has received a Direct Grant from the DfT for many years which has the effect of subsidising the access charges it levies on operators.

Although it looks like a grant to Network Rail its true effect is a grant to operators, placing Network Rail in the unedifying position of being a virtual money launderer. (In 2015-16 alone, the DfT-awarded franchises ‘shared’ access charge subsidies made possible by the Direct Grant worth £3,252 million, offset by £1,201 million paid in premiums. One result was that every passenger kilometre travelled was subsidised on average by 3.54p.)

With track access charges artificially reduced, a franchise can start to show a ‘profit’. You, too, could probably run a corner shop profitably if a kind auntie paid your rent, business rates and utility bills.

But some franchises still won’t be in the black, even with auntie’s help.

Such franchises might, say, calculate in their bids that income will be £65 a day, and the costs £120. The effect of the Network Rail Direct Grant eases the costs down to £90, but the DfT will still need to find at least £25 a day in direct subsidy to the operator, just to make ends meet. That won’t quite do: no-one runs a business just to make ends meet. And so the bid from such an operator will include a ‘reasonable’ profit of 2 per cent, which as a proportion of turnover is £1.30. So the bid might ask for a daily subsidy of £25.00 + £1.30, or £26.30.

This is vastly oversimplified but is, essentially, how revenue is still vital to a franchise-holder. If the revenue falls by just £2 a day the business is now running in the red, and the DfT is notorious for not amending franchise terms later on. (If revenue is higher than forecast there are various profit sharing deals, while the DfT will subsidise lower than expected revenue but only in certain circumstances, such as when a franchise has managed to survive the first four years without extra help.)

We might be dealing with a more prosperous franchise, which has forecast gross costs of £120 a day and revenue of the same amount. Because the track access charges are still being subsidised (bringing the costs down to £90), there appears to be a profit of £30 a day. But don’t celebrate too soon. Such a franchise will be expected to pay premiums, which will take most of that £30 and leave just a couple of pounds for the franchise-holder to keep.

Again, you can see how this can go wrong if revenue is lower than expected — £110 a day, say. That’s a daily deficit of £10, and the DfT will still demand the same premiums, so the business will be £8 in the red, not £2 in the black. Franchises in this position have managed to hold on for a while by introducing more capital into the business, but in the end some have had to give up (the most recent example was Arriva’s Northern [the agreed subsidies were not enough], and before that there was Virgin Trains East Coast [the agreed premiums were too much]).

If the number of passengers and the income they provide falls to 15 per cent, is that the edge of the cliff for franchise holders? Without government intervention, it would have been.

This is why the DfT offered all its franchise-holders management contracts to start from 23 March, removing the risk completely until September at least.

The DfT pays the bills and also collects such revenue as there is.

For now, the operators are simply providers of train services for Her Majesty’s Government.

You may not be too surprised to learn that their management fees will be around 2 per cent as well.

What happens later on, given that the Williams Review is expected, in any case, to signal fundamental changes to the traditional franchise structure, will be a story for another day.

Copies of the current (May) or recent editions of the print edition of Railnews can be obtained by calling 01438 281200 from UK numbers or +44 (0)1438 281200 internationally, and selecting Option 2.

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