Q&A: West Coast Main Line franchise
- 15 October 2012
- From the section Business
The collapse of the West Coast Main Line bidding process - after the government found "significant flaws" - has left the Department for Transport facing questions from many quarters.
FirstGroup had been due to take over the running of the line from current operator Virgin Trains in December, but now the government must look at re-running the competition and keeping the line in operation for an interim period.
So how did the government manage to back-track on its decision, and what does it mean for upcoming rail franchises?
What was the original bid?
On 15 August, the government announced that FirstGroup had won the bid to run the West Coast rail franchise and would take over running the line from Virgin Rail at the beginning of December.
At £5.5bn, FirstGroup had offered considerably more money for the 15-year contract, as well as offering to pay much more in compensation should the firm prove unable to fulfil it.
What concerns were raised?
Virgin immediately called into question the government's decision, arguing that FirstGroup's bid simply did not stack up and represented a far greater risk than its own. At the end of August, Virgin started court proceedings challenging the decision.
It argued that FirstGroup's revenue projections were wildly optimistic - that passenger growth of 6% a year was unlikely given that Virgin had seen growth of 5% a year from a much lower base. This level of passenger growth would have seen FirstGroup's revenue from the franchise grow by more than 10% a year, which was simply unrealistic, Virgin argued.
And it is not alone. "Everybody in the industry thought that this bid was not sustainable and that the risks had not been taken into account by the Department for Transport," says rail industry expert Christian Wolmar.
What risk was the government taking?
If revenue targets are not met, the franchisee doesn't have the money to pay the government the promised fee for the contract, which in FirstGroup's case was back-loaded towards the end of the 15-year term.
The risk of non-payment must be weighed very carefully by the government, because it could result in a hefty bill for the taxpayer.
This is why each bid must include a certain amount of "capital" - in effect a compensation payment to taxpayers should it fail to make its payments, or indeed terminate the contract early.
Virgin argued the £265m compensation offered by FirstGroup was woefully inadequate given the level of risk involved in the bid.
According to Virgin boss Sir Richard Branson, "this is the fourth time that we have lost a competitive tender as the runners-up... on each occasion the winner went bust or they ran into serious financial difficulties".
Why was Virgin's legal challenge significant?
The suggestion has been made that the Department of Transport only reconsidered the bids in preparation to defend its decision in the courts.
This has led some to ask whether the department's mistake would have been uncovered, and therefore whether its decision to award FirstGroup the franchise would have stood, had it not been for Virgin's legal challenge.
What did the Department for Transport get so wrong?
Pretty much everything, it would appear. Or at least everything that matters. Transport Secretary Patrick McLoughlin has described the mistakes as "completely unacceptable", but has given very little detail about exactly what went wrong at his department.
The department was using an entirely new financial model for evaluating bids, a spokesperson has told the BBC.
The BBC has since learned that this financial model - which was provided by the department to all four of the bidders to guide their submissions - was far too optimistic about future inflation and passenger growth.
It could also be that figures were inputted incorrectly.
The model is used by the bidders to calculate how much capital they must promise to provide as potential compensation to protect taxpayers if they fail to deliver on the contract.
But because of its defective assumptions, the model was calculating capital levels that were far too low.
What do the mistakes mean for the bidders?
The revelations do more than just vindicate Virgin's claims that FirstGroup was being too optimistic.
They suggest that all of the bidders were inadvertently being too optimistic.
If so, the entire bidding process needs to be rerun on an entirely new set of assumptions.
Indeed, if the process had been run on the correct assumptions in the first place, it could be FirstGroup would have legitimately won.
What is the department doing about it?
The department has suspended three officials who may face further disciplinary action once an investigation has been completed.
It has announced two independent reviews into the fiasco.
The first will be an "urgent examination into the lessons learned" from awarding the West Coast franchise, which will report by the end of October.
The second will look at the way in which rail franchises are awarded in general, which will report by the end of the year.
A robust system of checks and balances will be considered to ensure mistakes are not made. Clearly the system failed.
How much will the mistakes end up costing?
The government has said it will reimburse the costs incurred by all four bidders for the West Coast franchise. These also include Dutch train operator Nederlandse Spoorwegen, and a joint bid from French companies Keolis and SNCF.
The government says the cost will be about £40m. But with Virgin alone putting the cost of its bid at £14m, the bill will be more than £50m, according to Christian Wolmar.
According to BBC Business Editor Robert Peston, sources close to some of the bidders say they expect the total compensation costs to run into the hundreds of millions.
There is also the possibility that FirstGroup will take legal against the government, for example for loss of profits.
Why does the bidding process cost so much?
Richard Westcott, the BBC's transport correspondent, talked to an "industry insider" who has worked on several bids in the past (but not the West Coast one), who said a team of around 30 experts spent months devoted to winning the contract. "For three months, you don't see your family," the insider said.
The teams are made up of outside consultants and train company staff. There are lawyers, economists, transport modelling experts, all led by a bid manager.
After a relatively easy pre-qualifying process, the team spends weeks crunching numbers, brainstorming scenarios, checking and re-checking that they have got everything right. Then for three months they sit tight while government officials make up their mind.
The level of expertise, the time, money and stress involved are why it can cost more than £10m for a company to bid for a rail contract. The stakes are high - thousands of jobs and billions of pounds are on the line.
What are the implications for other rail franchises being decided in the coming months?
There are four franchises due to be decided next year - Greater Western, East Coast, Thameslink and Essex Thameside - and about 15 due before the next general election. These will inevitably now be pushed back.
In fact, according to Sim Harris, managing editor of Railnews, "not much will happen next year - it's hard to see one franchise go, let alone four. And the government cannot now let them all go before the next election".
The government is likely to begin negotiating with current franchises to extend contracts for the short term, which will prove a lengthy and difficult process. It may also be an expensive one, as subsidies may have to be offered as an incentive - short-term contracts are not an attractive proposition when long-term assurances are needed for things such as leasing rolling stock.
It could also be that the length of franchises may have to be cut. The BBC's business editor Robert Peston has suggested that correcting the department's forecast assumptions could lead to required levels of capital that are simply unaffordable for the bidders.
In that case, the government may be forced to shorten the term of the franchise from 15 years to, say, eight years. But although a shorter term would make the capital requirement cheaper, it would also undermine the incentive for the train operator to invest in long-term improvements in the service they provide.
Are past franchise deals now in doubt?
There is some good news: the Department for Transport says there is no question of looking back at previous franchises, because the mistakes occurred while inputting data into the new model which has not been used before.
What happens next?
From the point of view of rail travellers, West Coast Main Line trains will run to timetable after 9 December - which is when the next franchise was due to begin. The same trains and staff will be used and all tickets and bookings will remain valid.
Virgin Trains will be asked to continue to run services on the West Coast Mainline for at least another nine months after the latest decision on the route franchise was scrapped, according to the Department for Transport.
The "temporary" contract will allow Virgin to remain the West Coast Mainline operator for between nine and 13 months while a competition is run for an interim franchise agreement.
BBC News transport correspondent Richard Westcott says the interim contract will last for two years while the longer franchise will be handed out around the time of the next general election.
That means that a permanent deal for the franchise may not be sealed for several years.