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 36.

    I don't get it. If it is the model given to the bidders that was flawed did Virgin not bid on the same flawed basis as First? If they did, then why are they crying foul after they lost? If they "corrected" for the flaws in their bid then why did they not point out the flaws before any of the bids were finalised?

  • rate this

    Comment number 35.

    The death throes of the disaster of rail privatisation are ever clearer. Of course a Tory govt obsessed with the idea that govt should not be involved in anything doesn't want to be one the one to finally admit this.

  • rate this

    Comment number 34.

    7- Adolphus Arthuro- The HST's run by First were never 9-10 carriages. They all used to be 8. Then the DfT insisted (not First) that some were shortened to 7. They are now all 8 again, with significantly more seating squeezed in (rightly or wrongly) than before.

  • rate this

    Comment number 33.

    The First Group and Virgin bids were over-optimistic. They knew that but were happy to make false promises because the penalties for failure were nothing compared to the riches flowing from the franchise (note the 20% drop in FG's share price when the contract was cancelled). The performance bonds should be billions, not millions. But then rail privatisation wouldn't work and everyone knows this.

  • rate this

    Comment number 32.

    Excellent article, setting out something I remember trying to explain to "officials" 20 years ago - risk. The other things they still seem to be struggling to understand are cost and performance.

  • rate this

    Comment number 31.

    ..... and in the Guardian 5 August 2012

    Thameslink trains order held up, admits Siemens

  • rate this

    Comment number 30.

    I've just heard the total cost for compensating the bidders could run into the £100's of millions.....I want to know the number of Civil Servants, and their wages, that were involved in putting together and assesing them. It amounts to Gross Incompetence with the worst offender being the Transport Secretary. I'm sick of their excuses, 'professionsl politicians' without any profession/competence.

  • rate this

    Comment number 29.

    I agree with No.4.... If these companies want to make the huge profits available in running such a franchise then they need to suck it up and get on with providing a service to the fare paying public!! If they do sue I would personally call for them to never be allowed to bid for a franchise again.

  • rate this

    Comment number 28.

    Apart from the obvious bidding process flaws, First Group should have been excluded from this anyway on the basis of their incompetence in running previous franchises.

    I agree with others that they should not be entitled to any compensation. Did First Group give the tax payer compensation when they handed back the great western line 3 years early?

  • rate this

    Comment number 27.

    "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."

    An alternative explanation would be that this was deliberately done this way to enable the operator to extricate themselves with minimal financial penalty. Trebles all round afterwards.

  • rate this

    Comment number 26.

    Give us back our railways. I am truly sick of paying my hard-earned money over to private 'enterprises'.

  • rate this

    Comment number 25.

    First of all brilliant reporting (again) by Mr Peston.
    The alarm bells should have rung immediately when Branson raised doubts - he is probably a man who knows a bit about what he is talking about?!
    Secondly why not take this back to be run in public ownership?
    Are the same bunch in government implementing the 'lets hammer the benefits for the most vulnerable in society" really doing a grand job?

  • rate this

    Comment number 24.

    the tories are to blame for the mess when john majors govt rushed the original privatisation process.
    thatcher had her faults but realised that
    railway privatisation was a step too far.

    the labour party said they would reverse the privatisation but reneged on their promise as they did over beeching. it was labour
    who gave dft more power over the railways.

  • rate this

    Comment number 23.

    next time you see a Minister firmly stating that everything is being done properly and under control, remember this fiasco.

    It seems nothing these days is a resigning matter. They take the credit if something happens to go well. If not, they say Ministers cannot be expected to know the minutiae of business.

    Hypocritical parasites. Sack the lot of them.

  • rate this

    Comment number 22.

    ... and the railway franchises were given away because....?

  • rate this

    Comment number 21.

    The whole franchise system is a joke - as taxpayers we spend much more in real terms on the railways than we ever did under BR yet ticket prices are much higher. No wonder Branson loves it!

    Also have DfT ever considered the time wasted by passengers trying to book train tickets under the current complex system - they justify HS2 on time saving yet ignore this disbenefit of the current system.

  • rate this

    Comment number 20.

    Agree with luigi and Oliver S.
    I have worked in large private companies involved in bids for multi million pound projects for nearly ten years and the tender is always at the risk of the bidders. What a scandal to use my tax to pay these companies to bid.
    And has UK PLC never heard of due diligence?
    Shame on money grabbing train companies, shame on the fools who let them get away with it.

  • rate this

    Comment number 19.

    15 years is a long time to be handed a monopoly and opportunity for complacency. Perhaps eight years would add a greater element of competition. I often read complaints about the bad old days of British Rail. High prices, frequent bad customer service and disorganisation demonstrate that the current system of TOCs needs to be challenged; unless you fundamentally do not care about public transport.

  • rate this

    Comment number 18.

    But we can assume that bidders model their own bids as well as using the 'official' version. It is surely possible to game the process to test the risk of 'handing back the contract' and make an offer based on this.

    How are none UK bidders with different ownership structures handled. There were two of them.

  • rate this

    Comment number 17.

    The usual situation here. Those at the top demonstrate, once again, their sheer and utter incompetence. They are not fit to be in employment. Sack them-NOW!


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