Why all the West Coast bids were wrong


I have learned a bit more about the mistakes made by the Department for Transport in overseeing the contest to win West Coast Main Line rail franchise.

As I understand it, the entire bidding process was flawed - and that all four of the bidders were given erroneous information by civil servants when preparing their bids.

The nature of the mistake, which I describe below, carries all sorts of implications.

One consequence is that all the bidders were offering far too little protection to taxpayers against the risks of collapse by a franchise holder. In other words, if the mistake had not been picked up, taxpayers would have been excessively exposed to potential losses at some point during the 15-year life of the franchise.

The nature of the department's errors, with all the bidders given flawed data, explains why the Department for Transport has said that it cannot be certain that the outcome of the bidding process would have been different if the process had been robust. In other words, FirstGroup might still have won.

That might make FirstGroup marginally less hostile to the idea that Virgin may be asked to keep running the service for an additional 18 months to two years, until a new tendering process can be completed and the new franchise holder can be in place - because there is no evidence that Virgin as the incumbent would have had an advantage if the last contest had been run properly.

A decision on whether the franchise will stay with Virgin for an interim period, or go into temporary public ownership, will be taken in the next few days.

That said, FirstGroup is considering suing the government for substantial damages resulting from the way it was first awarded and then stripped of the franchise. As it happens, those close to a number of the failed bidders tell me they expect the compensation payments from taxpayers to run to hundreds of millions of pounds, far more than the £40m that has been widely reported.

I am told that ministers and officials are desperately anxious to somehow dissuade FirstGroup from suing, although it is not clear why it would be in the interests of FirstGroup's shareholders to settle without the threat of legal action.

Robert Peston: "I think it does have actually quite big implications for taxpayers"

But back to what went wrong. All this is slightly technical and complicated, so bear with me.

When there are contests to award complicated long-term contracts such as this one, civil servants construct their own financial model. This contains certain assumptions about what is likely to happen to important economic variables, such as inflation and passenger numbers, over the contract period.

The model serves two purposes.

It helps civil servants and ministers evaluate bids against their own benchmarks, when those bids are submitted.

But perhaps more importantly, it helps the bidders to submit bids on a basis that allows them to be compared. It creates a level playing field for the bidders.

What happens is that the model produces what is known as a "ready reckoner" which is given to the bidders. This ready reckoner tells each bidder the financial implications of their respective forecasts of how much they think they can increase revenues.

In particular, it tells a bidder how much capital its so-called Train Operating Company (TOC) would have to hold as a protection for taxpayers against the risk that in the course of operating the franchise the TOC went bust or risked going bust.

The point is that any bidder could submit wildly optimistic and unrealistic forecasts for how much its TOC could increase its revenues in order to win the bid, and then get into lethal financial difficulties when actually operating the franchise on that basis.

So to minimise that risk, all the bidders are told that they have to endow the TOC with sufficient capital to protect taxpayers from potential losses.

In the case of FirstGroup, for example, its winning bid endowed its new TOC with £10m of capital from day one, and there was also a £190m subordinated loan from FirstGroup to the TOC and a £45m "performance bond".

All of which may sound like a fair amount of money to absorb the costs of an abrupt termination of the franchise.

But what the Department for Transport discovered in the last few days is that the capital protection being offered was far too little. That was not FirstGroup's fault. It was because of assumptions in the department's own model about what would happen to inflation and passenger numbers - which in turn meant that the ready reckoner given to bidders was wrong.

In fact, the department's mistakes meant that all the bids were offering far too little protection to taxpayers against the possibility of a franchise holder being unable to hold the franchise for the full 15 years.

The implications are serious for the whole process of tendering for rail franchises. It explains why the department has suspended the competitions to run the Great Western, Essex Thameside and Thameslink services, just in case the financial models underpinning those contests are flawed in a similar way.

One very interesting question is how much extra capital First Group and the other bidders would have been forced to hold if the department's model and ready reckoner had been correct.

Here is the big point. It is very expensive for companies to raise capital. It is theoretically possible that FirstGroup - or indeed any of the four bidders - would not have been able to afford the correct amount of capital.

That raises a further question - whether the government will have to revert to awarding eight-year franchises, rather than 15-year franchises, because in theory the capital required to underpin an eight-year contract should be much less.

UPDATE 16:50

Here is a tidbit which will add to the government's misery over the West Coast rail debacle.

Virgin tells me that they received the erroneous data from the Department for Transport's flawed ready reckoner and concluded that it was wrong - so they ignored it when submitting their own bid.

The current West Coast encumbent even went so far as to tell the Department for Transport that its numbers were awry.

But apparently the Department ignored Virgin and pressed ahead with the bidding contest.

For what it's worth, Virgin insists that the bid it submitted has a robust financial basis - and it believes it would have submitted the same bid, even if the department had got its own numbers correct.

On the other issue, of whether Virgin will continue to run the franchise for the two years before a new contact can come into force, or whether the West Coast line will go into temporary public ownership, my sense from talking to sources in government and among the bidders is that Virgin will prevail.

The main reason is that there are 150 West Coast contracts that are up for renewal between now and 9 December, when Virgin's current tenure expires. It would be quite a challenge for civil servants, with only a cursory knowledge of the business, to suddenly take over responsibility for those contracts.

Robert Peston Article written by Robert Peston Robert Peston Economics editor

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  • rate this

    Comment number 16.

    HMG will be paying out compensation because of breach of contract. They awarded a contract, shares in the company which won the contract rose, investors bought shares on the strength of a long term contract with the British Government, who promptly breached the contract within weeks. A class action by First Group shareholders is due, regardless of any legal action by FG for loss of costs.

  • rate this

    Comment number 15.

    I cannot help but wonder if the existing franchises are providing the best value for money for the tax payer.

  • rate this

    Comment number 14.

    The important question that has not been answered yet is...
    Would this series of incredible screw ups have been exposed had Virgin/Richard Branson not kicked up a fuss about losing? I suspect the answer is no, and we would have only found out when it was already too late.

  • rate this

    Comment number 13.

    I agree with 4.Oliver S I have worked for an IT company bidding for very large contracts, and yes we have NEVER asked for compensation from a private company because they changed the bidding process or cancelled or something. If we had we would never have to provide IT services anymore just live of compensation. This is a joke !

  • rate this

    Comment number 12.

    The private sector trousers the profits,the taxpayer covers the losses. Where have we heard that before?

    You might think that a government whose stated purpose is reducing the deficit would show a keen interest in the risk to the public purse. Apparently not. What is the point of being a Minister if you don't ask even the most basic of questions? This incompetence has cost £40 milion. So far.

  • rate this

    Comment number 11.

    Whatever happens now, this will cost taxpayers tens of millions of pounds in compensation. Whichever company then goes on to win the contract will then make tens or hundreds of millions of pounds more over the life of the contract. This is a disgusting and completely avoidable waste of public money at a time when there is supposed to be no money left in the country. Heads at the top should roll

  • rate this

    Comment number 10.

    How long has this flawed model been used? Were previous auctions also flawed in this way?

  • rate this

    Comment number 9.

    Justine Greening saying this was a good deal for tax payers, obviouly her good education forgot to teach her to pay attention to detail. Too complacement in the job and like all the great and the good don't take responsiblility when things go wrong and she still remains within the government.

  • rate this

    Comment number 8.

    Both First and Virgin have seen (to some extent) each others bid values now, so it should be interesting to see what figures they submit the second time around.

  • rate this

    Comment number 7.

    The bidding process has been flawed from the very beginning of privatisation, not only financially but also in terms of how customer's (who are taxpayers too let's not forget and therefore pay twice!) rights and standards of service are protected. Passengers on FGW frequently have to stand or cram into airline style seats because First shortened all the HST sets from 9-10 coaches to 8 or less.

  • rate this

    Comment number 6.

    If there is a need to hold a large amount of capital, presumably the companies owned by the German, Dutch, French, Italian etc state railways will be in a better financial position than the domestic private companies, due to the implied government guarantees and therefore lower borrowing costs?

  • rate this

    Comment number 5.

    So is the Dept looking for bids on a 'risk free' basis? If so then the costs of the 'insurance' bonds will be enormous. We pay those costs in the long term anyway, so where is the gain? Surely the bids should be on the basis that the risk to the bidder is enough to keep them honest, whilst the risk to the taxpayer is reasonable, at the beneft of lower costs. No risk, no reward, for both parties.

  • rate this

    Comment number 4.

    "....they expect the compensation payments from taxpayers to run to hundreds of millions of pounds...."

    Bidding for commercial contracts is "at your risk". It's a numbers game, you win some, you lose some. If the bid process is flawed, you do it again if your interested in winning.

    Why tax payers have to cover the bidding costs is beyond me...???

  • rate this

    Comment number 3.

    Even if the ready reckoner is "fixed" there is still a major weakness if bidders are allowed to back-end their payments. It might still be worthwhile for a company to quit in say year 10, having picked up the subsidy for ten years, forfeit say £700m billion to save several billion. If Virgin/Stagecoach profits were so high then perhaps a limit on profit levels (eg can't exceed % of subsidy)

  • rate this

    Comment number 2.

    It gets worse! Bur where's the obvious question- if First Group had the East AND West coast routes, where's the competition? That ALONE should be counted against them, just as if Virgin had bid for the East Coast, when it came/comes up. And, if the DoT hadn't allowed for inflation, then neither had the bidder, so their bid was rubbish and unworkable and thats THEIR fault, so why compensate?

  • rate this

    Comment number 1.

    RE: "...if the department's model and ready reckoner had been correct."
    It is a "model" surely a model is not going to be correct, it is going to be a best estimate of the future with certain assumptions. How many predictions about the future end up being correct?


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