Why all the West Coast bids were wrong

 
trains

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, economics editor Article written by Robert Peston Robert Peston Economics editor

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  • rate this
    0

    Comment number 196.

    15 year franchises weren't made up by civil servants. They were recommended by McNulty in his report into creating efficiency in the railway, which was commissioned by Labour when in government.

  • rate this
    0

    Comment number 195.

    One point everyone is missing is that if DOR do take the franchise on for the short term all the people currently working for Virgin (except may be the Directors who they Headhunting replacements for currently according to the press) would Tupee across.

    If the government gives the extension to Virgin they have to offer extensions to all the others. That will cost the tax payer millions.

  • rate this
    0

    Comment number 194.

    I don't think a company with such an appalling Environmental Policy of sending mountains of unsolicited junk mail deliberately addressed to 'The Householder' or 'The Occupier' in order to circumvent Direct Mail marketing rules should be put in charge of a railway.

  • rate this
    0

    Comment number 193.

    It might be worth considering if there is any connection between the fiasco of this franchise award and the effort Virgin is putting into taking over services of the NHS.

  • rate this
    0

    Comment number 192.

    187.Jovian
    9th Ooctober 2012 - 22:58
    My immediate reaction to the fiasco was to try and find out who the financial advisors
    ----
    Jovian you're looking in the right direction, but will not find much. Since 2009 the DfT hired contractors to do the evaluation of bids. they had previously used a well known management consultancy.

  • rate this
    0

    Comment number 191.

    I 86 - "Of course it was (cheaper) - it was run on the cheap and it showed. Why do you think the modernisation cost so much?

    Underinvestment yes - but a more comprehensive network, safer, more reliable, and run on 1/3 of the subsidy. Now we have more expense in every regard for a poorer service and the profits go overseas.

    Its a RACKET

  • rate this
    0

    Comment number 190.

    Don't agree Virgin is bect TOC. It doesn't own trains track or stations and the taxpayer paid £8billion of West Coast upgrade to enable him run a fast modern service. What have we paid Branson £1.0 billion for over the last 15 years? His logo? Ditch him but keep his staff.
    East Coast is good also and this is publicly operated with much older equipment.

  • rate this
    0

    Comment number 189.

    Don't agree that British Rail was run badly. BR managers did a damn good job with the money available. Relatively speaking, fares were much cheaper and affordable on the day of travel.

  • rate this
    0

    Comment number 188.

    FT told that "much of the blame lay with Francis Maude, cabinet office minister"
    This certainly rings true. Nothing wrong with reducing waste on consultancy, but if franchises are to be at the mercy of financial engineering, you'd better have some financial engineers on your side.
    Apparently £1m "saved"; loss £40m+

    FT: http://www.ft.com/cms/s/0/be4df682-1086-11e2-87cc-00144feabdc0.html

  • rate this
    0

    Comment number 187.

    My immediate reaction to the fiasco was to try and find out who the financial advisors - my experience from the sidelines of a number of large PFI procurements is it would be unprecedented not to have specialist city input. However, the FT had a story that there was no such advice. So, was this hubris by DOT or was appointment blocked by Cabinet Office to save money as FT story implied?

  • rate this
    0

    Comment number 186.

    71.
    FauxGeordie " ... It was CHEAPER to a really staggering degree."
    Of course it was - it was run on the cheap and it showed. Why do you think the modernisation cost so much?

    Re-nationalisation is far from being the panacea people think it will be. BR was poorly run and managed for years. It needs professional management which is completely insulated from interfering know-nothing politicians

  • rate this
    0

    Comment number 185.

    "Are we, the public, prepared to pay those wages to save money long term or not?"

    God here we go again. Pay peanuts get monkeys? OR - as things work nowadays - pay colossal fortunes, get mayhem, then get stung for the cost of bonuses too.

    Trebles all round!

    Idiot Tory ministers in a hurry wrecked the railways. They will collapse now under the weight of supporting myriad lawyers and fat cats

  • rate this
    0

    Comment number 184.

    169

    Actually, no - HS2 is being dealt with by HS2 Limited, not the DfT direct. This is a company set up for the purpose which has recruited specialist staff, not just ended up with passing caeer civil servants with no specialist knowledge headed by a minister with even less. If you want to see more DfT "efficiency", look at the IEP!

  • rate this
    +1

    Comment number 183.

    I understand why the government wants First Group to run the WCML and not let Virgin Train continue. The government believes that the public are fed up of using Virgin Trains and want a different train operator to operate that route. But that said, Virgin trains are by far the best train operator in the country and it would be common sense to allow them to operate on the WCML for the future.

  • rate this
    0

    Comment number 182.

    Little_Old_Me
    11 Hours ago
    Procurment officials in the private sector earn many times more than in the public sector (as with so many jobs). It is a very skilled role reuquiring much legal knowledge.

    Are we, the public, prepared to pay those wages to save money long term or not?
    =
    So we didn't pay Bankers enough?

  • rate this
    0

    Comment number 181.

    It seems to me that the model did not discount future possible income streams to take account of BOTH inflation and uncertainty in order to obtain a present value of all future forecast returns to compare with the present capital capability of the TOC.
    In other words they didn't discount at a 5% interest rate per annum but perhaps used 3%.
    If so, a rather obvious technical error.
    Alan

  • rate this
    0

    Comment number 180.

    @ 177

    Most listed business are driven by making more profit year on year (10-12%) or else are punished by "the market" which demands short term profits in order to make traders, fund managers etc. their bonuses.

    There's no incentive for public or private sector to decision makers to think long term.

    Asset strip, outsource, a pound today and bust tom. instead of a steady £10 over 10 years.

  • rate this
    0

    Comment number 179.

    @adc82140 - Hmm, I'm sure some were longer at one point - might be thinking of when it was still intercity. I know some on the Swansea routes are still short (7 coaches) because I was on one the other week! And it wasn't the DFT who told them to shorten some of the sets, all they wanted was for timings to improve. So to shave off a minute or two, First took out a coach to save weight..considerate.

  • rate this
    0

    Comment number 178.

    7 Secretaries of State for Transport in 7 years - almost like transport isn't seen as important to the country:

    D Alexander 2006
    R Kelly 2007
    G Hoon 2008
    Lord Adonis 2009
    P Hammond 2010
    J Greening 2011
    P McLoughlin 2012

    Short-term doesn't work for infrastructure.

  • rate this
    +1

    Comment number 177.

    There does seem to be a lack of genuine ability at Directorial/ senior managerment levels in the Private and Public sector.
    You have Rail firms prepared to say anything for a subsidised operators franchise, and then Banks, who have done so much to stop fraud, creating a new fruadsters loophole ! (Get Cash App and Emergency Cash) No Apps, have a computer in Branch to allow online withdrawals..

 

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