Many of us will be familiar with the rail franchising system that has been in place for the past 25 years. That private system was brought in to replace the old nationalised British Rail. The intricacies of how the franchise system worked may be less well known. In very simple terms the Train Operating Companies (“TOCs”) made payments to the Department for Transport based on a forecast of ticket revenue. With train use at all time high levels that was a workable model.
Of course in March 2020 when the COVID-19 pandemic hit and national lockdowns were imposed, rail use suddenly dropped from 100% capacity pre-COVID to around 5%. TOCs were left in the position of having to make payments to the state based on the 100% capacity revenue projections when in reality actual revenue income had dropped off the proverbial cliff.
The government had to swiftly step in. It introduced Emergency Measures Agreements which resulted in the Department for Transport forking out around £3.5 billion to assume the commercial risk the TOCs could no longer bear.
That level of government support could not continue indefinitely, so in September 2020 new Emergency Recovery Management Agreements (“ERMAs”) were introduced. Under these agreements the performance requirements were tightened and the fee payable to the operators reduced by 25%. So while the TOCs can earn less under the ERMAs, the continued support from the DfT means trains are still able to run even with low passenger numbers.
The ERMAs last for 6 to 18 months, depending on how long was left on the original franchise agreement. Under the ERMAs, the TOCs and the DfT need to agree on a “termination sum” to end the pre-existing franchise agreement. The idea being that TOCs who operated franchises that were losing money before the pandemic, still owe money to the DfT from those contracts. The amounts owed will be based on the financial status of each franchise prior to the pandemic and the DfT’s assessment of their trajectory but for the pandemic.
If the termination sums cannot be agreed then the DfT has the right to terminate the ERMA early. That would result in the TOC reverting to substantially all of the pre-existing franchise terms from mid-January 2021. This would leave the TOC exposed to having to make payments to the state based on pre-COVID revenue projections while actual revenue remains well below that level. Clearly that is not a commercially attractive option, especially in the midst of a third national lockdown.
Initially the plan was that the termination sums would need to be agreed by mid-December 2020. However many TOCs expressed concern about the lack of transparency over the calculation of the termination sum and the lack of mechanism for challenging it. TOCs were then given until mid-December to make their final representations and the DfT is due to notify the franchises of the termination sum by 22 January 2021. There is talk of judicial review if the TOCs are presented with a bill that they do not accept is a fair estimate of the sum they owe, though we shall have to wait and see.
There is a general consensus within the industry and within government that these transitional agreements should be used as a stepping stone to much wider reform of how the railways are run. This would be in conjunction with the Williams Review which is looking at the structure of the whole rail industry and has been further pushed back in light of the pandemic and the changes it has forced on the industry.
Last month it was announced that the former Avanti West Coast and South Western Railway franchises are negotiating new directly awarded management contracts with the DfT, which will come into effect when the present ERMAs comes to an end. That followed an agreement with the DfT that the termination sum of £33.2 million was payable for SWR and no termination sum was required for Avanti. Matthew Gregory, the chief executive of FirstGroup (the majority shareholder in both contracts) said “These new directly awarded management contracts will focus on passengers and operational performance, with a more appropriate balance of risk and reward”.
The future of the franchise system still remains unclear for many though. Speaking to Rail Technology Magazine at the start of December 2020, Steve White (Chief Operating Officer at Govia Thameslink Railway) noted they were carrying around 25% of the number of customers they were carrying before the pandemic hit. Even before the second lockdown in November 2020 they were only back up to around 40%. As Steve identified, the biggest challenge for the rail industry now is to win back customers and close the revenue shortfall. It is no doubt hoped that a reinvigorated approach to the franchise system will help to achieve that goal.