A “fresh start” or the “worst of all worlds”? A critical financial analysis of the performance and regulation of Network Rail in Britain’s privatised railway system

Critical Perspectives on Accounting 20 (2009) 175–204

A “fresh start” or the “worst of all worlds”? A critical financial analysis of the performance and regulation of Network Rail in Britain’s privatised railway system Robert Jupe Kent Business School, The University, Canterbury, Kent CT2 7PE, UK Received 7 June 2007; received in revised form 22 April 2008; accepted 5 May 2008

Abstract The purpose of this paper is to examine the degree to which Network Rail, the new not-for-profit infrastructure company owned by members, has provided a “fresh start” for Britain’s privatised railway system. Rail privatisation was predicated on the belief that surplus value could be created through redundancies and deskilling in a loss-making subsidy-dependent industry. Network Rail’s predecessor, Railtrack, followed a profit-maximising agenda and collapsed into insolvency in 2001, after several years of poor performance. Unlike Railtrack, Network Rail is not under pressure to pay dividends to shareholders, and so in theory can focus on the maintenance and renewal of the infrastructure. However, its reliance on debt rather than equity finance, combined with escalating infrastructure costs, means that its annual borrowing costs have reached £1 billion. Thus, the nominally private company is only viable because of substantial subsidy and explicit government support for its borrowing. Further, the bulk of its expenditure is on renewals work which is outsourced to contractors aiming to maximise surplus value. The paper uses critical financial analysis to show the extensive and continuing transfers from the taxpayers and passengers to the financial elite, highlighting distribution issues which have been largely missing from the policy debate over Network Rail’s creation. © 2008 Elsevier Ltd. All rights reserved. Keywords: Railway privatisation; Corporate governance; Network Rail; Performance indicators; Regulation; Risk transfer

E-mail address: [email protected]. 1045-2354/$ – see front matter © 2008 Elsevier Ltd. All rights reserved. doi:10.1016/j.cpa.2008.05.002

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1. Introduction Privatisation was conspicuous by its absence from the successful 1979 Conservative election manifesto, which focused on issues such as deregulation, monetary discipline, and reductions in income tax and bureaucracy (Marsh, 1990, p. 2). Buoyed up by their triumph in the 1983 general election, the Conservatives led by Prime Minister Margaret Thatcher then developed incrementally a wide-ranging privatisation programme in Britain. Amongst the more prominent privatisations, nationalised monopoly utilities such as gas and electricity were sold into private ownership through share flotations. Various motives lay behind the privatisation policy. Early debate was dominated by economic arguments about promoting efficiency through private ownership and market disciplines (Flemming and Mayer, 1997; Goodman and Loveman, 1991; Letza and Smallman, 2001; Ogden, 1997; Shaoul, 1997). Later arguments focused on privatisation’s role in reducing the role of government and raising revenue to reduce public sector borrowing (Letza and Smallman, 2001, p. 66; Ogden, 1997, pp. 529–530; Shaoul, 1997, p. 480; Vass, 1992). Additional arguments wielded by Conservatives in support of privatisation included extending share ownership (Shaoul, 1997), and weakening the power of public sector trade unions (Letza and Smallman, 2001). This paper focuses on the performance and regulation of the last industry to be privatised by the Conservatives: rail. In particular, it examines the performance and regulation of the railway infrastructure provider, Network Rail, which replaced the original infrastructure owner, Railtrack, in 2002. The key element in the fragmentation and privatisation of the nationalised rail industry, British Rail (BR), was the vertical separation of infrastructure and train operations. This principle had encountered severe criticism even in circles sympathetic to privatisation. At a Centre for Policy Studies conference in 1988 it was pointed out that the track authority would occupy a monopoly position, would be remote from customers and that investment might prove difficult to attract (Murray, 2001, p. 11). Despite these implicit risks, the Major Government adopted this fragmented model. It was defended on the grounds that a separate infrastructure authority was needed in order to take the sunk cost element out of rail provision, and so facilitate the franchising of the train operators (Jupe and Crompton, 2006, pp. 1036–1037). Rail privatisation was only completed in early 1997, shortly before the general election which swept the Major Government from office. Privatisation meant that the integrated railway industry was broken up into various constituent parts: infrastructure, train operations, rolling stock, and engineering and maintenance. The new system allocated a central role to a regulated public limited company, Railtrack, which was the industry’s monopoly infrastructure provider. Despite the fact that it was the regulator’s duty to ensure Railtrack could finance its activities, the company collapsed into insolvency in 2001, after several years of poor performance. Railtrack’s collapse offered the Labour Government, led by Tony Blair, “an unprecedented opportunity to reassert its socialist credentials” by renationalising the company (Whitehouse p. 234). However, Railtrack’s replacement was another private sector company – Network Rail. The key differences between it and Railtrack were in its financial and corporate governance structures. Network Rail was established as a debt-financed, notfor-profit private company limited by guarantee, which was accountable to members rather than to shareholders. Two years after its creation, the National Audit Office (NAO) argued,

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although not uncritically, that the company was making a “fresh start” in the privatised rail industry (2004). This paper analyses the extent to which Network Rail’s new corporate governance, financial and regulatory structures have provided a genuine “fresh start” for the privatised rail industry, or whether Blair Government’s attempt to avoid renationalising the rail industry has resulted in the “worst of all worlds”, where the company is financed by private borrowing but there is no risk transfer to the private sector (Glaister, 2004, p. 55). The paper employs critical financial analysis, drawing extensively upon rail company accounts, in order to evaluate these judgements. It presents accounting data in order to analyse Network Rail’s costs, revenue and cash leakages, and also draws upon non-financial performance indicators. This analysis sets the problems of creating and regulating Network Rail within a political economy framework, and identifies the private sector interests it benefits. This paper is organised into five further sections. The second section examines the development of public ownership, the ideological shift in the 1970s from nationalisation to privatisation, and the efficiency arguments for privatisation. The third section then examines rail privatisation, analysing key features of the industry including its complex structure and Railtrack’s collapse. The fourth analyses Network Rail’s corporate governance structure. The fifth section draws on critical financial analysis and non-financial performance indicators to evaluate Network Rail’s performance and regulation. The final section concludes by considering the implications of the company’s creation for the stakeholders in the privatised rail industry, including the Labour Government, and highlighting the fact that the key beneficiaries of Network Rail’s funding are the capital markets and private sector firms.

2. The development of privatisation ideology 2.1. Development of public ownership A belief in the importance of state regulation and public ownership developed in Britain during the nineteenth century. As far back as the 1830s, for example, the Duke of Wellington publicly expressed his concern over the dangers of monopoly and mismanagement in Britain’s emergent rail companies and suggested public ownership. Some private companies were brought into public ownership, and public services established, at the municipal level in the nineteenth century, but it was not until the twentieth century that major industries were nationalised in countries such as Britain and France. These changes occurred largely either between the two World Wars or shortly after World War II. In Britain, the Labour Governments of 1945–1951 brought important industries, including coal, rail, steel, gas and electricity within the public sector and established the welfare state. Public ownership was justified on several grounds. In the face of market failures, arising from inadequate investment by, for example, private transport companies, public enterprise was held to be the only way of developing an efficient industry which would benefit capital. Public ownership also enhanced the ability of governments to implement Keynesian demand management techniques to ensure economic growth and full employment (Letza et al., 2004, p. 161). The spread of public ownership benefited capital in several ways. Nationalisation, combined with the development of the welfare state, provided “a means of containing and regulating the very bitter class

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struggles that arose in the aftermath of World War I” (Shaoul, 2005, p. 467). Further, the cost of investment was shifted to taxpayers while the often generous compensation paid to shareholders could be reinvested elsewhere (Shaoul, 2005, p. 467). Capital also benefited as nationalised industries were often run in ways which constituted a subsidy to private industry (Shaoul, 2005, p. 467). For example, prices to industry were often held artificially low. 2.2. Development of privatisation For three decades after 1945, there was a postwar consensus over the extent and the importance of the public sector in many countries such as Britain and France. Nationalised industries were widely accepted as constituting an important part of the economy. In Britain, for example, at the end of the 1970s nationalised industries contributed over 10% of the GDP and employed 8% of the workforce. That decade witnessed a significant ideological change, however, as the oil price shock was followed by an international economic depression. These problems “profoundly challenged Keynesian economics and the ideology of nationalisation” (Letza et al., 2004, p. 162), and gave ammunition to the monetarist critics of public enterprise and public expenditure, led by Milton Friedman. The development of the New Right Agenda, which encompassed deregulation and privatisation in order to extend the capitalist mentality into many new areas, lies in these key economic changes. Marx argued that capitalism emerged from feudalism, providing the insight that “the essential difference between the feudal and capitalist modes of production is their way of extracting surplus value from labour” (Bryer, 2000, p. 136). The modern capitalist aims to extract surplus value in order to maximise the rate of return, measured as “profit divided by the capital employed in production” (Bryer, 2000, p. 136). The 1970s saw a falling rate of return, in the form of profit relative to the amount of capital employed (Shaoul, 2005, p. 467), and so capital required new policies in order to boost the rate of return. Within private industry, these policies included replacing labour by new technology, and outsourcing both manufacturing and services to overseas suppliers with much lower labour costs in countries such as India and China. Capital also required support from the state in order to access new sources of profit, and so in many countries the public sector was opened up to private enterprise through privatisation, the outsourcing of public services, and the development of schemes such as the Private Finance Initiative and Public Private Partnerships (Shaoul, 2005, p. 468). In Britain in particular, and in many other countries, privatisation and its variants “transformed the public sector and public life in general”, and the neo-liberal mantra became “private sector good, public sector bad” (Letza et al., 2004, p. 160). Further, the neo-liberal agenda is now being vigorously promoted around the world, in countries such as Ghana, particularly in respect of crucial public services such as water (Rahaman et al., 2007). As Veblen argued, in a prescient analysis, countries become “richer in money-values and poorer in use-values” and captains of “big business rule the affairs of the nation, civil and political” (1924, pp. 220, 118). 2.3. Privatisation and efficiency As in their previous privatisations, such as gas and electricity, the Conservatives’ arguments for transferring rail to the private sector focused on “abstract economic models”

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(Shaoul, 1997, p. 480). Competitive market forces, it was argued, would allocate resources more efficiently than bureaucratic structures. Privatisation would, it was claimed, provide greater incentives for cost minimisation; encourage more effective management; and stimulate greater employee effort (Jackson and Price, 1994, p. 7). John Moore who, as Financial Secretary to the Treasury in the mid-1980s was in charge of the privatisation programme, proclaimed triumphantly that “Privatisation is bringing about a fundamental change in the operation and efficiency of key sections of the UK economy. Its success is self-evident. Privatisation liberates managers and employees and allows them to reach their full potential” (Dick, 1987, p. 14). The economic models used to justify such claims were the public choice and property rights theories. Public choice theorists (see, for example, Mitchell, 1988; Niskanen, 1971) argue that public services become inefficient as they tend to be run in the interests of employees, and other special interests, rather than in the public interest. Property rights theory complements this public choice model, focusing on the inefficiency in the public sector which stems from the weakness of property rights. Its advocates, such as Alchian (1995) and Furubotn and Pejovich (1974), argue that managerial efficiency is encouraged by the ability of shareholders to sell their shares if a company’s performance is poor. Economic models may provide a theoretical justification for privatisation in terms of enhanced efficiency, but various empirical studies of privatisation have produced mixed results. Some studies have been highly sceptical about the success of privatisation (see, for example, Curwen, 1986; Jackson and Price, 1994; Shaoul, 1997). Martin and Parker examined 11 privatised organisations, concluding that it was “difficult to sustain the hypothesis that private ownership is unequivocally more efficient than nationalisation” (1995, p. 225). Kay and Thompson (1986) found that in practice there are efficient and inefficient enterprises in both the public and the private sectors. A meta-analysis of 158 studies from around the world found 98 supportive of the hypothesis that private ownership is more efficient than public, while 60 either rejected the hypothesis or found no significant difference (Villalonga, 2000). Some studies of particular privatisations have been critical of the alleged benefits. Shaoul’s study of the water industry, for example, “refuted the claim that private ownership would increase the efficiency of the industry and that ownership is the most important factor in determining performance” (1997, p. 500). Much of the privatisation literature accepts that simply changing the ownership of assets is neither a necessary, nor a sufficient, condition for improving efficiency (Jackson and Price, 1994, p. 16). This was demonstrated in the 1980s when performance gains in the nationalised BR exceeded those in the privatised British Telecom and British Gas industries, as Conservative Governments imposed rigorous financial targets on the railways (Bishop and Thompson, 1992). While economic models and efficiency arguments were employed to legitimise all privatisations, the underlying method used to achieve “efficiency” was to increase surplus value through redundancies, and the underlying purpose was to benefit capitalism by “transferring wealth from the public at large to a relatively few individuals and corporate entities” (Shaoul, 1997, p. 479). Many privatised utilities “operated in mature domestic markets”, subject to price capping by regulators (Shaoul, 1998, p. 243), and so sought cost reductions through redundancies in order to boost surplus value and, therefore, profits. Both British

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Gas and British Telecom, for example, reduced their workforce by 38% between 1987 and 1995, with the amount saved on labour costs “approximately equal to the amount paid out in dividends” (Shaoul, 1998, p. 244). The British water industry provides a contrasting example of a privatisation which was far less successful in these terms. Water, like rail, is a capital-intensive industry with substantial infrastructure costs. The water industry made very significant productivity gains in the 1980s, reducing its workforce by over 30% by 1989 (Shaoul, 1997, p. 491). Thus, there was much less scope for increasing surplus value through redundancies when water was privatised in 1989. The water industry, like rail, had to find substantial sums for investment, and so there was a conflict between the shareholders’ demands for dividends and the needs of the consumers. This dilemma was resolved at the very considerable expense of the consumers as the economic regulator, the Office of Water Services (OFWAT), permitted companies substantial above-inflation rises in water prices. Thus, in the 9 years after privatisation water companies raised prices by an average of 46% in real terms (Shaoul, 1998, p. 244).

3. Railway privatisation 3.1. The privatisation model It was Margaret Thatcher’s supposedly more “moderate” replacement as Prime Minister, John Major, who introduced rail privatisation. Citing the need to raise revenue from BR’s sale, to reduce rail’s subsidy, and to introduce on-rail competition, the Major Government embarked on the riskiest and most ideological privatisation to date (Gourvish, 2002, pp. 390, 439; Wolmar, 2005, pp. 48–98). Rail was a very unpopular privatisation, opposed by a majority of the public and many members of Parliament, including some Conservatives. It had even been condemned by a former Conservative Transport Minister as “such a silly scheme” (Crompton and Jupe, 2003a, p. 620). During preparations for rail privatisation, the Major Government spent a “staggering” £450 million on consultants, often from the Big 5 accounting firms, many of whom had no prior knowledge of the industry (Wolmar, 2005, p. 68). In this way, the state used accounting’s legitimacy to “depoliticise” its deeply unpopular and highly ideological activities (Catchpowle et al., 2004, p. 1053). Despite the huge amount spent on consultants, the resulting 1992 Rail Privatisation White Paper was only 20 pages in length and very short on empirical evidence. It simply asserted, in optimistic terms, that privatisation would lead to a more efficient allocation of resources through market forces and to the harnessing of “the management skills” of the private sector (Department of Transport, 1992, foreword). Despite conceding BR’s “significant improvements” in efficiency and productivity made in the 1980s, the White Paper did not provide any empirical evidence to support the claim that “greater efficiency” would result from privatisation (Department of Transport, 1992, paras 3 and 6). A full analysis of BR’s performance in the 1980s would have revealed that it was perhaps the most financially successful railway in Europe, with a subsidy of only 0.16% of GDP compared to the European average of 0.52% (Harris and Godward, 1997, p. 52). BR’s productivity improvements stemmed from a combination of organisational reforms and a substantial reduction in the workforce, which declined by around one third in the 1980s (Gourvish,

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2002, pp. 374–383; 291–294). This substantial cut in employee numbers was to be ignored in the privatisation process, which aimed to create surplus value through the traditional process of reducing the workforce. A very thin White Paper led, in 1993, to an equally slim Railways Act. The deeply flawed Act, which was predicated on the naive belief that a loss-making subsidy-dependent industry would somehow produce surplus value after fragmentation and privatisation, separated train services from the infrastructure, composed of 19,000 miles of track, 2500 stations and connections to 1000 freight terminals. Thus, the ideologically driven privatisation fragmented the vertically integrated structure common to railways throughout the world (Bradshaw, 1998, p. 179). The justification was that a separate infrastructure company was necessary in order to eliminate the problem of sunk costs for operators (Baumol et al., 1982), and so ensure “fair treatment” between competing train operators wanting track access (Department of Transport, 1992, para 12). Railtrack was privatised in May 1996, and by the next year all the rail businesses had been sold and an “unparalleled” degree of fragmentation had been introduced into the industry (Nash, 2000, p. 166). The system was divided into around 100 components, which included: Railtrack, the infrastructure owner; 25 passenger operating companies (TOCs); three rolling stock companies (ROSCOs); 13 infrastructure companies (INFRACOs), who were employed by Railtrack; six freight companies (soon reduced to two); and some support companies. Fig. 1 shows the structure of the rail industry after privatisation. Further fragmentation developed after privatisation as the INFRACOs were mostly purchased by construction companies, which employed extensive subcontracting in order to make savings on employee costs in their fixed price contracts. The number of permanently employed infrastructure maintenance workers fell from 31,000 in 1994 to a maximum of 19,000 in 2000 (Murray, 2001, p. 71). The loss of permanent maintenance staff was partly compensated for by recruiting untrained, or poorly trained, casual workers. Thus, the total number of firms involved in the rail industry rose to at least 2000 (Murray, 2001, p. 71), a

Fig. 1. Britain’s privatised rail industry in 1997.

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vast increase compared to BR which did all its own maintenance work and only employed a handful of contractors on major renewal projects. The loss of experienced staff, which was to prove so damaging to the rail industry, was welcomed by the new managers. Railtrack’s senior management set out to repudiate much of the industry’s past, making targeted attacks on the older stakeholder culture and encouraging redundancies amongst experienced workers, particularly engineers. The accumulated railway knowledge of the nationalisation era was used to symbolise failure and so “delegitimised” (Strangleman, 2004, p. 143). One senior Railtrack employee graphically likened the process to the Khmer Rouge takeover of Cambodia, arguing that it was like “Year Zero. Anything that happened before that, they don’t want to know” (Strangleman, 2004, p. 144). In a widespread deskilling process, “employees with expert and tacit knowledge were being offered redundancy packages throughout the industry as the various employers realised that every penny spent on something they felt they could do without knowledge was a penny spent on something less distributed in dividends or executive compensation” (Cole and Cooper, 2006, p. 621). This deskilling process was pursued in other privatisations, such as electricity, in Britain and elsewhere. In New Zealand, for example, skilled cable maintenance staff were made redundant when the electricity industry was privatised. Thus, in 1998 when the Auckland central business district was hit by a power blackout, which lasted 4 weeks, staff had to be flown in from overseas to retrieve the situation. 3.2. Regulation of privatised industries Privatised industries, such as gas, often constituted “natural” monopolies and retained significant elements of monopoly power after privatisation. Thus because of public fears of poor service or overcharging, by “a rapacious monopoly supplier” (Shaoul, 1997, p. 484), regulators were established for privatised industries. Most regulators were given three main objectives by the relevant legislation, the most important of which was to ensure that the industry was able to finance its activities; additional objectives included protecting the interests of consumers, and enabling or promoting competition in the industry (Beesley and Littlechild, 1989). In practice, regulation often focused on setting prices based on inflation and adjusted by an efficiency target, the Retail Price Index (RPI)-X formula devised by Stephen Littlechild for the first major privatisation, British Telecom (1984). Littlechild, an academic economist with a strong belief in the merits of free markets, was very influential in the development of regulation. His RPI-X formula was adopted by many regulators, and he was head of the Office of Electricity Regulation from 1989 to 1998. The RPI-X price capping formula, which was intended to promote “efficiency”, encouraged privatised companies to boost surplus value by pursuing redundancies. Regulation is a strongly contested territory, and it is not just the widespread application of the RPI-X formula which has been heavily criticised. OFWAT, for example, has been attacked for its very generous approach towards the water companies. In 1991, just 2 years after privatisation, OFWAT decided that the water companies deserved 10 years advance notice if their operating licences were to be terminated. This made it very difficult for a future

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British government to consider water renationalisation. OFWAT has also been criticised for not referring any of the takeovers in the industry to the Competition Commission, as huge sums are now being made from buying and selling water companies. In 2007, for example, Royal Bank of Scotland, which together with the French company Veolia had purchased Southern Water for £2 billion in 2003, sold it for £4.2 billion to a consortium led by Australia’s Challenger Investment. In rail’s case, regulation was seen as especially important because of two factors: the continued dependence on public subsidy and, the need for effective guarantees of service provision (Crompton and Jupe, 2003b, p. 403). The separation of the infrastructure from train operations provided the basis for rail regulation. Two new regulatory bodies supervised, in broad terms, economic and quality issues. The key economic regulator was the Office of the Rail Regulator (ORR) (later renamed the Office of Rail Regulation) which supervised Railtrack. The key quality regulator was the Office of Passenger Rail Franchising (OPRAF), which allocated franchises and then monitored the TOCs’ performance. The ORR was independent of government, and regulated Railtrack through the company’s operating licence, in order to assure investors of impartiality. OPRAF regulated by contract, and was subject to a set of Objectives, Instructions and Guidance by government. Government control of OPRAF was seen as necessary given its role in dispensing subsidies. The ORR’s key regulatory task was periodically to set the level of access charges, which would be paid to Railtrack by the TOCs. These charges, which were largely fixed costs for the TOCs, were intended to incentivise Railtrack by providing it with a stable and predictable income of over £2 billion per year. The determination of access charges required the establishment of a Regulatory Asset Base and a permitted rate of return on capital. Rate of return regulation, which has been widely used in the USA, can be problematic. It can lead to overcapitalisation in a regulated industry as the industry undertakes unnecessary investment in order to justify an increase in the Regulatory Asset Base (Averch and Johnson, 1962). Another possible consequence is that the industry may produce substantial investment plans in order to justify increased expenditure, but the investment “is subsequently slow to be delivered” once the regulator has settled the revenue requirement (Welsby and Nichols, 1999, p. 73). This adverse consequence applied to Railtrack which focused on profit maximisation, and the preparation of a succession of increasingly grandiose and unrealistic investment plans. The level of access charges was crucial both for Railtrack’s profitability and for the viability of the TOCs. Most TOCs were unprofitable, and so heavily dependent on subsidy, the bulk of which was paid to the companies by OPRAF and subsequently by the Strategic Rail Authority (SRA), which absorbed OPRAF in 1999. Subsidy payments thus represented substantial indirect public support to the ostensibly private infrastructure owner. In 1999/2000, for example, the TOCs received £1.4 billion in subsidy, which underpinned their payment to Railtrack of £2.2 billion in access charges. 3.3. Railtrack’s collapse Consistent with its private sector profit-maximising status, Railtrack’s initial focus was on shareholders, and so infrastructure expenditure was neglected as part of “a squeezing of the assets” (Cole and Cooper, 2006, p. 605). All maintenance and renewals work was

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outsourced to infrastructure companies, which applied the practices of the building site and employed extensive subcontracting. Despite the complexity of Railtrack’s operations, and the diversity and quantity of its infrastructure assets, there was no comprehensive asset register showing the network’s condition. Such a register was regarded as essential both for the company’s safe and efficient management of assets, and for the ORR’s monitoring of Railtrack’s stewardship. It was urgently needed as Railtrack had implemented “Project Destiny”. This was based on the concept of saving on renewal expenditure by replacing assets only when needed, rather than the traditional policy followed by BR and other European railways of replacing assets at fixed time intervals (Wolmar, 2005, p. 170). The adverse consequences of this policy were detailed in a major NAO investigation into Railtrack’s infrastructure expenditure. This report highlighted the fact that the establishment of the access charge regime was not accompanied by an “agreed baseline” for maintenance and renewal work, and that a comprehensive asset register was urgently needed (NAO, 2000, para 17). The report emphasised the consequences of the low track renewals rate with, for example, the number of broken rails increasing by almost 25% to 937 in 1998/1999, compared with 755 in 1997/1998 and Railtrack’s forecast of 600 (NAO, 2000, para 17). Railtrack’s neglect of its core function, the maintenance and renewal of the network, led, as the NAO predicted, to a decline in the “health of the network” (2000, para 17), as demonstrated by the Hatfield accident in October 2000. A train, travelling from London King’s Cross to Leeds, was derailed by a broken rail, resulting in four people being killed and 70 injured. According to Wolmar, at Hatfield “the part played by the fragmentation and sale of the railways is very clear. The whole ghastly tale of mismanagement, greed, and incompetence that caused the Hatfield crash was a result of the crazy structure for the railways created by John Major and his ministers. . .Hatfield was the epitome of the failings created by rail privatisation” (Wolmar, 2005, p. 156). The accident highlighted both Railtrack’s lack of knowledge of the infrastructure’s confition and its very poor management of contractors, as the crash occurred on a stretch of line where a fault had been discovered 21 months earlier and which had been earmarked for renewal. Tragically, although the defects were discovered by the maintenance contractor, Balfour Beatty, and reported to Railtrack, work on renewal was fatally delayed with the result that 90 m of rail fractured into 300 pieces. Railtrack, grossly hampered by the lack of an asset register, was unable to establish whether there were more broken rails in the system. Its alternative, which plunged the company into what proved to be a terminal crisis, was to introduce over 1000 speed restrictions in an attempt to remedy the accumulated maintenance and renewals deficit (Crompton and Jupe, 2003a, p. 636). In addition to Railtrack’s neglect of its core business, which resulted in the Hatfield crash, its “poor project management” skills were exemplified by the fiasco of the flagship investment project, the upgrading of the West Coast Main Line (WCML) route (NAO, 2004, paras 1.10, 1.11). The WCML project’s initial budget in 1997 was £2.1 billion, but the project was “poorly scoped and managed, with outputs that were not clearly defined and costs that escalated substantially” (NAO, 2004, 1.11). Railtrack appealed for Government support as its costs escalated, and was granted £1.5 billion in subsidy in April 2001. Despite declaring a loss of £445 million in March 2001, Railtrack recycled £138 million of the subsidy to

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shareholders as dividends, thus placing itself in an “indefensible position” (Wolmar, 2005, p. 187). In October 2001, faced with costs on the WCML spiralling towards £10 billion and increasing demands for additional subsidy, Transport Secretary Byers obtained a court order placing an insolvent Railtrack in administration. Byers’ actions in placing the ailing company in administration, and in announcing that no taxpayers’ money would be used to compensate shareholders, were heavily criticised by the Conservative Opposition, commentators and the City. The Conservatives accused Byers of “assassinating” Railtrack, and there were widespread calls in the media for his resignation (Wolmar, 2005, p. 197). One Financial Times commentator (Dickson, 2001) exemplified this mood, attacking Byers and drawing attention to the problems which upsetting the City could cause the Labour Government in future “When Railtrack went under he declared with relish that no taxpayer money would be used to bail out shareholders. He has as much sensitivity to the capital markets as a pantomime dame. . .raising equity capital or debt for government-related entities, including the public–private partnership meant to run the London Underground and Railtrack’s putative not-for-profit successor, will be significantly more expensive because the risk premium has risen sharply”. Under pressure, in March 2002 Byers announced that Railtrack’s assets would be used to pay compensation of £2.55 per share to shareholders, a figure close to the £2.80 share value when Railtrack went into administration. This provided “a fig leaf for the government to protect Byers’s assertion that there would be no compensation for shareholders” (Wolmar, 2005, p. 214). City institutions accepted the compensation figure, but 48,000 individual shareholders formed an action group and brought a case to the High Court in 2005 claiming additional compensation. The claimants accused Byers of “misfeasance in public office”, alleging that he engineered Railtrack’s collapse into administration. The judge dismissed the case against the Byers and the government, arguing that “The government can be said to have failed to avert Railtrack’s insolvency but that cannot be said to be a fault in the government unless one can postulate a duty on government to have funded Railtrack without limit and without condition, a hopeless proposition” (Milner, 2005).

4. Network Rail’s corporate governance structure Railtrack was placed in administration for 1 year. This was at considerable cost, as the administrators, Ernst and Young, charged £755,000 per week and, being risk-averse, added substantially to the costs of running the infrastructure (Wolmar, 2005, p. 213). In October 2002, the Blair Government handed over control to Railtrack’s replacement, Network Rail, after paying out £1.3 billion in cash to Railtrack’s parent company which ultimately went to compensate shareholders (Shaoul, 2004, p. 35). The problems arising from Railtrack’s overriding concern with maximising profits ensured that Network Rail was established as a not-for-profit “public interest company” limited by guarantee. Byers explained the rationale behind Network Rail’s creation in a speech to the House of Commons on the 25 March 2002

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“. . .Getting Railtrack out of administration must be done on a basis that it will produce a viable, financially sound company – one that takes a long-term perspective, and that puts the emphasis first and foremost on operating a safe, efficient and reliable rail network” (Byers, 2002). One strong supporter of Network Rail’s creation as a nonprofit organisation was Grayling, a senior research fellow at the Institute of Public Policy Research. He argued, in terms consonant with New Labour’s “third way” philosophy (Giddens, 2002), that an evolutionary approach was needed which both removed shareholder influence and avoided renationalisation (Grayling, 2001). Grayling was invited to present his ideas to Cabinet Ministers at 10 Downing Street. Other influential figures in Network Rail’s creation were Shriti Vadera, a former investment banker, who was special adviser to the Chancellor of the Exchequer Gordon Brown, and Dan Corry, special adviser to Stephen Byers (Wolmar, 2005, p. 212). Supporters of the new rail infrastructure model cited the recent example of Glas Cymru in Wales (Wolmar, 2005, p. 213). Glas Cymru, a not-for-profit company limited by guarantee, was established to take over the assets of a privatised water company, Welsh Water, in May 2000. A key argument in favour of this change was that Welsh Water’s combination of debt and equity finance would be replaced by Glas Cmyru’s complete reliance on debt finance, and so savings would occur as interest payments on the bonds issued would be cheaper than dividend payments. Another model which had been recommended to the Labour Government, in a different context, was that of NavCanada, the Canadian air traffic control service. This was suggested by the House of Commons Select Committee on Environment, Transport and Regional Affairs in preference to the Government’s plan to part privatise Britain’s National Air Traffic Services (NATS). The Select Committee raised serious objections to the plan, which proved to be entirely justified when NATS had to be rescued from its financial difficulties by the Government just 3 months after its partial privatisation in 2001. The Select Committee recommended that NATS could be established as a non-share-capital corporation, similar to NavCanada, with members rather than shareholders (House of Commons, 2000, para 83). The Government’s response in April 2000 to the Select Committee’s proposal was quite bizarre, particularly when analysed in the context of Railtrack’s collapse and replacement by Network Rail. The Government argued that NATS needed partial privatisation to bring “shareholder scrutiny to bear on NATS’ operational efficiency” and to provide “incentives to improve its performance” (Department for Transport (DfT), 2000, para 32). Further, the Government argued that the corporate governance structure of members rather than shareholders meant that NavCanada’s board was not “accountable to anyone” (Department for Transport, 2000, para 30). These responses suggest that the influence of the privatisation ideology in the capitalist state is so strong that it can produce delusional, even schizophrenic, attitudes within government. The claim that privatisation encouraged “shareholder scrutiny” was made less than 6 months before the Hatfield crash in October 2000, which dramatically confirmed earlier criticisms of Railtrack’s very poor performance made by the NAO. Moreover, the NavCanada model which was dismissed for lacking accountability was very similar to that adopted for Network Rail 2 years later. As well as the reliance on debt finance, Network Rail’s governance structure drew on the models of NavCanada and Glas Cmyru, both of which have members rather than sharehold-

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ers. NavCanada has a board of 15, supervised by an advisory committee of 18 members. Glas Cmyru was established with a board of nine, which included a non-executive majority, and a membership of about 50 people chosen by an independent selection panel. Network Rail’s board of twelve also has a non-executive majority, including one director appointed by the Government. The key difference between Network Rail and both NavCanada and Glas Cmyru is in the size of the membership. Network Rail has between 110 and 120 industry and public members, rather than shareholders, with public members forming the majority. Industry members include representatives of rail industry companies, principally the TOCs, the freight companies and some rail contractors. Public members are drawn from a cross-section of the public, appointed on the basis of application forms submitted to a selection panel, which is established by and answerable to the twelve-strong board of Network Rail. Members “technically own the company” and are expected to perform a corporate governance role “similar to that of shareholders in a publicly limited company” (Network Rail, 2006a, p. 1), which includes appointing eleven of the directors. Serious questions have been raised about the role and effectiveness of members, however, as they do not have “any direct say in the strategy of the rail industry” and “are not liable for the activities or finances of Network Rail” (Network Rail, 2006a, pp. 6, 9). Further, there are only two formal meetings per year for members. The director of the New Economics Foundation argued that there was “a closed loop of accountability. The directors are accountable to members who are effectively chosen by the directors. What we’ve got here is a kind of crazy hybrid” (Clark, 2002). Birchall argued that a much more appropriate form of accountability would involve the “direct election of consumer representatives” to the board of Network Rail (2002, p. 27). This policy had also been advocated by Grayling, who argued that the Government should include other stakeholder representatives on the board of directors notably “passengers and the workforce” (2001, p. 6). Having been subject to widespread criticism for placing Railtrack in administration, however, Transport Secretary Byers was concerned to reassure “financial constituencies” nervous at the prospect of “diverse stakeholders being given a strong governing role in the new body” (Leam, 2002, p. 10). Hence, just 2 weeks after Railtrack was put into administration, when the plans for the corporate governance structure of its replacement were only at an embryonic stage, it was notable but unsurprising that Byers pronounced in an interview that the successor company’s members would only play a “very limited role” in decision-making (Newman, 2001). Byers’s confident prediction about the limited influence of members has been amply demonstrated in practice. The difficulties members can have in contesting the dominant managerialist interests were illustrated at Network Rail’s July 2004 meeting, when the chairman gave a robust defence of the award of £437,000 of bonuses to the executive directors despite the company missing its punctuality target. One public member argued that the public would think a fair bonus in the circumstances was zero. The chairman’s trenchant reply was: “You may be a public member but you were appointed to act in the best interests of Network Rail. What other members of the public think about it or tell you is irrelevant” (Osborne, 2004). Clearly moved by this rhetoric, 80% of the members voted for the executive bonuses. The Transport Select Committee drew attention to Network Rail’s lack of accountability to its members, arguing that: “Network Rail did not convince us that the members of the company were exercising an effective control of the company. We were

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also concerned that industry members were virtually self-appointing” (House of Commons, 2004, para 59). The NAO was equally unimpressed by the members’ role, arguing that: “In the absence of direct exposure to financial risk and in view of different interests, Network Rail members may not always be motivated to act swiftly to deal with problems” (2004, para 3.3). Even the Conservative Party’s Shadow Transport Secretary delivered a withering critique of the company’s governance structure, arguing that “Network Rail is not really accountable to anybody” (Osborne, 2007). The foregoing analysis has established that Network Rail’s corporate governance structure is weak, and that members have little influence on the company or on rail industry strategy. Given this weak internal governance structure, the next section examines the extent to which the new external financial and regulatory arrangements for Network Rail have provided a “fresh start” for the rail industry.

5. Network Rail’s finances, regulation and performance 5.1. Impact of privatisation on cost Network Rail’s finances will be analysed by first establishing the context of rail privatisation’s impact on railway costs. The Major Government claimed that privatisation would benefit the public, as the resulting competition and introduction of business efficiency would produce greater opportunities to “reduce costs” (Department of Transport, 1992, para 19). Privatisation was expected to eliminate public subsidy in the long run, and then to produce net payments to the government from franchisees operating “profitable services” (Department of Transport, 1992, para 21). This position was expected to arise by 2005/2006. In practice, however, privatisation led to a very substantial increase in both costs and subsidy. The combined subsidy to the TOCs and Network Rail in 2005/2006 totalled £3 billion, and is expected to be above £4 billion per year for the rest of the decade (ORR, 2007). The key additional costs may be summarised as interface costs and cash leakages (Harris and Godward, 1997, p. 107). Interface costs arise as a result of many companies being involved in a supply chain, which creates an upward pressure on prices as each company seeks surplus value in the form of profit. Cash leakages arise as interest payments and dividends are required to finance debt and equity, respectively. The key interface costs introduced by privatisation were track access charges and leasing charges for trains. The two represented the bulk of the costs of the TOCs, and constituted most of the revenue of Railtrack and the ROSCOs, respectively. These interface items alone added £3 billion per year to the costs of the privatised railway. In addition, the outsourcing of Railtrack’s maintenance and renewals work meant it was necessary to reward layers of contractors. The dramatic increase in rail costs since privatisation can be demonstrated by comparing BR’s revenue, before privatisation, with the total revenue of the railway companies in the fragmented network. BR’s revenue in 1993/1994, the year before its reconstitution as an infrastructure provider, was £3.6 billion (British Rail, 1994), which broadly equated with the cost of running both the infrastructure and passenger services. In comparison with this figure, as Table 1 reveals, total revenue of the privatised rail companies more than doubled, reaching £9.2 billion in 1999/2000.

Before privatisation

BR reconstituted as infrastructure company (£m)

After privatisation (£m)

1993/1994

1994/1995

1995/1996

1996/1997

1997/1998

1998/1999

1999/2000

2000/2001

2275 3000 800

2300 3602 794 244

2483 4455 821 760

2485 5005 797 666

2573 5083 747 663

2547 5126 864 673

2476 4918 804 682

6075

6940

8519

8953

9066

9210

8880

BR Railtrack TOCs ROSCOs Freight companies

3645

Totals

3645

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Table 1 Revenue of rail industry before and after privatisation. Sources: Annual report and accounts of British Rail, Railtrack, 25 TOCs and two freight companies. Nominal values, unadjusted for inflation.

189

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Despite the very substantial revenue increase since privatisation, there is still an underlying deficit in the industry which has been disguised by increased private sector borrowing. Table 2 shows the increased cash leakages and debt of the infrastructure provider since privatisation. Total leakages of dividends and interest over the period 1995/1996 to 2006/2007 totalled £4.4 billion. Railtrack distributed dividends totalling £709 million between 1995/1996 and 2000/2001, equivalent to 41% of the total operating profits of £1.7 billion generated over the period (Railtrack Group plc, 1995/1996 to 2000/2001). The most significant leakages are interest payments, however, which have risen by £700 million since privatisation. This reflects the fact that total debt has increased by £16 billion since privatisation, reaching £18.4 billion by 2006/2007. Railtrack increased borrowing from £1 billion in 1996/1997 to almost £4 billion in 2000/2001 to raise funds to maintain and improve the network and to finance dividends and interest. Although borrowing continued to increase while Railtrack was in administration, the most significant increase in debt has occurred under Network Rail’s stewardship of the network. Indeed, Network Rail’s £2.6 billion increase in debt during 2005/2006 was greater than BR’s total borrowing of £2.5 billion in 1993/1994 to fund all aspects of its operations. The need for both Railtrack and Network Rail to increase borrowing is shown in Table 3, which summarises the companies’ expenditure plans for the first, second and third financial control periods. The infrastructure operator’s expenditure needs were assessed by the regulator for each financial control period, in order to determine the revenue stream necessary for the company to finance its activities. Railtrack’s flotation prospectus envisaged that its maintenance and renewals expenditure would be £10.5 billion in the first financial control period (1995–2001). This figure increased substantially over the next few years as Railtrack revised its total expenditure needs for the second financial control period (2001–2006) from £13 billion at the end of 1999 to £16 billion in late 2000 and then, shortly before its collapse, £20 billion in 2001. The escalating expenditure plans, which largely reflected increased maintenance and renewal costs, particularly of track and signalling, rather than new projects, led ultimately to Railtrack’s demise and to its replacement by Network Rail. As the table demonstrates, however, the cost escalation has continued under the new infrastructure provider. Although Network Rail’s initial bids to the regulator for funding were regarded as completely unrealistic and so scaled down, the revised funding settlement in October 2003 of £22.7 billion was 50% higher than Railtrack’s financial settlement in October 2000. The significance of the increased rail costs is highlighted by Smith’s work on high-speed replacement railway lines for the UK. He calculated that a new high-speed rail infrastructure would cost, depending on the complexity of the terrain, between £11 billion and £27 billion (Smith, 2003, p. 37). Hence, sums which have been used ineffectively to prop “up the present, poorly performing system, could have paid for a large proportion of a new rail network” (House of Commons, 2004, para 15). The dramatic increase in annual costs and revenue of the infrastructure provider since privatisation is shown in Table 4. Costs rose substantially as BR was privatised and its infrastructure role replaced by Railtrack. In 1997/1998, for example, Railtrack’s costs of £2.4 billion were two thirds of BR’s costs of £3.6 billion in 1993/1994, but the company only had responsibility for half of its predecessor’s activities. There was a further significant increase in costs, however, as Network Rail took over from Railtrack. In 2006/2007, Network Rail’s costs of £4.8 bil-

Table 2 Rail debt and cash leakages before and after privatisation. Sources: Annual report and accounts of British Rail, Railtrack and Network Rail. Nominal values, unadjusted for inflation.

Interest payments BR Railtrack Railtrack/Network Network Rail

BR reconstituted as After privatisation (£m) infrastructure company (£m)

1993/ 1994

1994/ 1995

1995/ 1996

1996/ 1997

1997/ 1998

1998/ 1999

1999/ 2000

2000/ 2001

2001/ 2002

2,192

701

1,009

1,456

2,384

3,333

3,967

6,895

2002/ 2003

2003/ 2004

2004/ 2005

2005/ 2006

2006/ 2007

2,484 Rail

9,744 12,935 15,678 18,201 18,394

121 141

181

39

40

81

132

150

318

Rail

361

Dividends BR Railtrack Network Rail Total dividends and interest

121

141

69

111

121

133

137

138

250

150

161

214

269

288

318

361

428

505

669

822

428

505

669

822

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Debt BR Railtrack Railtrack/Network Network Rail

Before privatisation (£m)

191

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Table 3 Estimates of Railtrack’s and Network Rail’s expenditure needs for the first, second and third control periods. Notes: (i) Estimates for the first control period are for maintenance and renewals expenditure in constant 1994/1995 prices. (ii) Estimates for the second control period are for total expenditure in constant 1998/1999 prices. (iii) Estimates for the third control period are for total expenditure in constant 2002/2003 prices. Sources: House of Commons (2004), NAO (2000), ORR (2000, 2005), Strategic Rail Authority (2001a, 2001b). Estimate date

Source

Amount (£ billion)

First: 1995–2001 (i) 1995 1996 1999

ORR Railtrack prospectus Booz et al. (1999a, 1999b)

9.2 10.5 10.5

Second: 2001–2006 (ii) May 1999 November 1999 December 1999 July 2000 September 2000 October 2000 April 2001 June 2001

Railtrack Railtrack Booz et al. (1999a, 1999b) ORR Railtrack ORR ORR Railtrack

12.34 13.07 10.73 14.256 16.069 14.874 16.374 20

Third: 2004–2009 (iii) March 2003 June 2003 September 2003 October 2003

Network Rail Network Rail Network Rail ORR

35 29.5 24.5 22.7

lion exceeded BR’s infrastructure costs of £1.8 billion in 1993/1994 by £3 billion. Thus, infrastructure costs have effectively more than doubled since privatisation, and a very substantial subsidy to Network Rail is required. While part of the increase is explained by the need to remedy the previous neglect of the infrastructure, there was also cost escalation due to the “inefficiencies” of privatisation (Department for Transport (DfT), 2004, para 2.2.2). The foregoing discussion has established that rail privatisation, far from bringing a reduction in costs and subsidy as the Major Government had predicted, led to a very substantial increase in costs, subsidy and borrowing. This analysis sets the context for the discussion in the next sections of the extent to which the new financial and regulatory arrangements for Network Rail have provided a “fresh start” for the rail industry. 5.2. Network Rail’s 2004/2009 funding settlement Network Rail’s corporate governance structure means that the company is not under pressure to make dividend payments. However, costs continued to escalate under Railtrack’s replacement and total expenditure on the network has risen very substantially, especially when compared to the generous funding settlement of £15 billion negotiated with the ORR for Railtrack over the period 2000–2001 (Crompton and Jupe, 2003a, pp. 410–412). The overspend, when actual infrastructure expenditure is compared with the amount authorised by the ORR in the period 2001–2004, was the “huge sum” of £5.5 billion (House of

Railtrack (£m)

Network Rail (£m)

1996/1997 1997/1998 1998/1999 1999/2000 2000/2001 2001/2002 April–October 2002 2002/2003 2003/2004 2004/2005 2005/2006 2006/2007 Revenue 2483 (less subsidy) Subsidy – Total revenue 2483 Total costs 2302 Net profit/(loss)

181

2485

2573

2547

2476

2413

1025

944

2154

1742

1853

2397

– 2485 2408

– 2573 2281

– 2547 2389

– 2476 2921

499 2912 3981

497 1522 2167

499 1443 1559

452 2606 3340

2058 3800 3829

1984 3837 4090

3398 5795 4760

77

292

158

(445)

(1069)

(645)

(116)

(734)

(29)

(253)

1035

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Table 4 Increase in costs and revenue of Railtrack and Network Rail under privatisation. Note: The figures for Network Rail for 2002/2003 are for a 6-month period. Sources: Annual report and accounts of Railtrack and Network Rail. Nominal values, unadjusted for inflation.

193

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Commons, 2004, para 78). This overspend was largely financed by increased borrowing by Railtrack/Network Rail, which was revealed in Table 2. Regulator Winsor stated that he was “minded” to allow for the overspend “on the grounds that he did not want Network Rail to be held responsible for the inefficiencies of its predecessor” (NAO, 2004, para 1.23). The ORR’s fundamental responsibility is to ensure that the infrastructure provider can finance its activities without undue difficulty. Thus, the ORR authorised a 50% increase in funding for Network Rail over the period 2004–2009. The ORR agreed that Network Rail’s revenue requirement, net of station income of £3.7 billion, would be £22.7 billion over that period. This disaggregated as £9.9 billion from grants, £9.5 billion from track access charges, and £3.3 billion from additional borrowing (ORR, 2005, para 1.18). Thus, the combined direct and indirect public funding for Network Rail now represents 85% of its net revenue requirement. This represents a “dramatic move away from the original privatisation model, where an unsubsidised Railtrack was intended to be funded and incentivised” by track access charges (Jupe, 2005, p. 190). This is unsurprising as the replacement of Railtrack by Network Rail did not solve the fundamental problems of a flawed privatisation, which included the industry’s fragmentation and cost escalation. Network Rail’s high expenditure has already led to a large increase in debt, as shown in Table 2. In the year 2005/2006, it made a loss of £253 million, after accounting for interest charges of £875 million, and net debt increased by £2.6 billion to £18.2 billion (Network Rail, 2005/2006). In 2007, much publicity was given to the profit of £1 billion made by Network Rail in the financial year 2006/2007. Despite the favourable publicity, this transformation into “profit” was not due to Network Rail’s efforts but, as Table 4 reveals, resulted from an increase in government subsidy that year of £1.2 billion and increased track access charges of £700 million, stemming from the 2004 regulatory settlement. Publicity was not given to the increase in finance costs, of over £250 million, which brought the annual debt interest for 2006/2007 to £1.13 billion (Network Rail, 2006/2007). It is the very significant private debt and interest burden carried by Network Rail which undermines its newly found “profitable” status. Over the current financing period, 2004 to 2009, interest payments are expected to total £4.7 billion, which represents 48% of the total subsidy for Network Rail over this period (Network Rail, 2006b, p. 43). Thus, not only are interest payments an increasing burden on the company, but also almost half of its subsidy payments are leaking out of the rail industry to the providers of capital. The Labour Government expects Network Rail’s borrowing to increase by £6 billion to £28 billion over the period 2009 to 2014, with interest payments rising from £1.6 billion to £1.8 billion (DfT, 2007, p. 128). Interest payments as a proportion of subsidies will then vary between 106% in 2009 and 75% in 2014. Thus, over the next control period most of the subsidies will leak out of the rail industry to the providers of capital. In order to make Network Rail appear to be viable, there was a blatant manipulation of its first set of accounts for political and economic reasons. The Labour Government needed its “third way” alternative to nationalisation to succeed, and City institutions wanted wealth transfers in the form of interest payments, underpinned by subsidy, to continue. Thus, the company changed from historical cost accounting to a form of current cost accounting, depreciated replacement cost accounting, in 2002/2003. The result, which is summarised in Table 5, was both to reduce the loss for the first accounting period, and to make a company with net liabilities appear to be solvent and show net assets.

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Table 5 The effect of Network Rail’s adoption of depreciated replacement cost accounting in 2002/2003 compared to historical cost accounting results. Source: Annual report and accounts for Network Rail 2002/2003. Nominal values, unadjusted for inflation. ( ) = loss/liability. £m Profit and loss account Loss for the period under replacement cost accounting Additional depreciation charge on an historical cost basis Historical cost loss for the period

(116) (729) (845)

Balance sheet Net assets under replacement cost accounting Revaluation reserve Net liabilities under historical cost accounting (582–698–729)

582 698 (845)

The company’s loss, as the table shows, was reduced from £845 million under historical cost accounting to £116 million, and net liabilities of almost £0.9 billion became net assets of £582 million. It is not possible to calculate the effects of the departure from historical cost accounting in subsequent years as, according to Network Rail, “the information is not available” (2003/2004, p. 50). The level of debt means that Byers’s aim of making Network Rail a “viable, financially sound company” has not been achieved. Network Rail’s nominal private sector status and dependence on Government support has been subject to substantial criticism. The Transport Select Committee argued that the Government “added another fudge by creating Network Rail, a private company without any private sector disciplines, seemingly set up simply to keep the enormous costs of the railway infrastructure away from the Government’s balance sheet” (House of Commons, 2004, para 13). In 2005, following the abolition of the SRA, the Government was obliged to make explicit guarantees for Network Rail’s debt. The Public Accounts Committee argued that the company’s borrowing was “still more expensive than direct public sector financing, and emphasised that it “is not clear how private sector lenders can provide the necessary discipline on the company to offset the extra cost of private finance” (House of Commons, 2005, para 5, p. 5). 5.3. Network Rail’s infrastructure and operating costs The most recent funding settlement envisaged the reduction of Network Rail’s annual operating, maintenance and renewal costs of around 30% by 2008/2009 (NAO, 2004, para 2.8). If this is achieved, however, it will still leave its annual costs “over 30% above preHatfield levels” (NAO, 2004, para 2.9). The NAO argued that the “challenge for Network Rail will be to cut costs rather than purely to cut back on the work it carries out” (2004, para 2.1). Under Railtrack’s stewardship, capital investment in the network was neglected in the early years after privatisation, as Table 6 reveals, as the company focused on a profitmaximising agenda to benefit shareholders. Under Network Rail, capital investment in the form of renewals and enhancement expenditure has grown to record levels of over £3 billion per year. Major questions have been

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Table 6 Capital investment under Railtrack and Network Rail. Note: The figures for Network Rail for 2002/2003 are for a 6-month period. Source: Annual report and accounts of Railtrack and Network Rail. Nominal values, unadjusted for inflation. Renewals and enhancement expenditure (£m) Railtrack Year 1996/1997 1997/1998 1998/1999 1999/2000 2000/2001 2001/2002 April–October 2002

484 599 1653 1847 2535 1557 1500

Network Rail Year 2002/2003 2003/2004 2004/2005 2005/2006 2006/2007

1654 3858 3598 3151 3326

raised, however, about the quality of this investment and the extent to which it represents value for money or excessive payments to profit-maximising contractors. One of Network Rail’s principal methods for making efficiency savings in infrastructure expenditure involved bringing maintenance work in-house. This has led to estimated annual cost savings of £100 million, representing around 7% of the outsourced 2003/2004 maintenance expenditure of £1.4 billion (Network Rail, 2005, p. 26). Despite these savings, the company has refused to treat renewals and enhancement expenditure in this way. Thus, over 70% of infrastructure expenditure is still outsourced, incurring annual interface costs in the form of contract profit margins of over £200 million, and so the Transport Select Committee urged Network Rail to “reconsider” its decision to continue to outsource renewals work (House of Commons, 2004, para 95). Further problems have arisen from the lack of an asset register, the compilation of which was made a licence condition for Railtrack in 2001. The ORR’s stewardship report argued that the failure to complete the asset register meant that the regulator was considering whether the company was “in breach of its licence” (ORR, 2004, para 12.9). It was only in 2006, however, that the ORR imposed its first financial penalty. The company was fined £250,000 for a licence breach, as it had failed to provide “accurate information on infrastructure capability” to freight operators (ORR, 2006a, p. 11). Such fines are trivial when compared with the government subsidies and borrowing guarantees for Network Rail. The importance of the company’s lack of infrastructure information was highlighted by a consultants’ report for the ORR which, in a credible and comprehensive analysis, examined 798 renewal projects across the seven Network Rail regions. The consultants found that on average only just over 60% of the jobs were fully justified on the basis of available information. In the case of plain track renewals, only 57% of jobs were fully

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justified and 16% were not justified at all. With signalling, merely 62% of the work was fully justified, while the figure for station renewal projects had the lowest proportion of fully justified jobs at 43% (LEK et al., 2003, para 1.4.2). The report emphasised that the “review of maintenance activities was made difficult by the absence of detailed information currently within Network Rail on the condition and maintenance needs of much of the asset base”, and argued that “little evidence was found of a considered linkage at the planning stage between decisions made on the timing, extent and scope of renewal activity and that on future maintenance activity” (LEK et al., 2003, paras 1.4.3, 5.7.4). The ORR concluded that the consultants’ evidence was valid and argued that Network Rail should be able to spend between 15% and 25% less on renewals than the amount set out in the company’s initial 2003 Business Plan, and thus reduce substantially its bid for £35 billion of expenditure (ORR, 2003, para 5.24). Even though Network Rail’s March 2003 expenditure bid was scaled down by the ORR, evidence has continued to emerge of its poor cost control, wasted expenditure, and lack of financial disciplines. Executives of the TOCs were very critical of the scale of the company’s costs at a hearing of the Transport Select Committee in July 2006. David Franks, Chief Executive of the National Express train division, argued that Network Rail’s battles with the ORR over costs were nowhere near as demanding as the disciplines applied when TOCs bid for franchises. He claimed, therefore, that over the 5-year control period savings of “hundreds of millions and possibly billions of pounds” in infrastructure expenditure were feasible. Further, the Commercial Director of First Group TOC argued that Network Rail always increased estimates by 35% when considering costs, thus adding up to £100 million to the budget on any infrastructure project (Clement, 2006). Such criticisms were similar in kind to those made to the Select Committee about Railtrack 5 years earlier. One witness then, for example, criticised Railtrack’s project management costs, arguing that they added 54% to the costs of station development schemes (House of Commons, 2001, paras 506–508). 5.4. Network Rail’s performance indicators The 2004 Rail White Paper allocated Network Rail the “lead role” for “operational management of the network”, including “driving up” performance (DfT, 2004, paras 4.3.10, 4.3.11). The Labour Government’s third attempt to reform the railways introduced a form of regulation unique to privatised industries, in that “one private company, Network Rail, is being made accountable for the overall performance of the network, which depends on the performance of the private TOCs” (Jupe, 2005, p. 189). In order to improve performance, Network Rail is subject to a number of performance measures, both external and internal. The key external measure set by the ORR is the reduction in the minutes of delays attributable solely to Network Rail. In 1999/2000, before the Hatfield accident, the total of the delays on the railway attributable to the infrastructure, through for example faulty track, was 7.7 million minutes. In 2001/2002, after Hatfield, there were 13.4 million minutes of delays, and in 2002/2003 Network Rail was responsible for 14.7 million minutes of delays, a performance condemned as “scandalous” by the Transport Select Committee (House of Commons, 2004, paras 64, 65). Network Rail now has the target of progressively reducing delay minutes to 9.1 million by 2008/2009. This figure, if achieved, will still be 18% higher than before Hatfield, however, and the Transport Committee argued that it is “most unlikely”

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Table 7 Public performance measure: percentage of trains arriving on time 1997/1998 to 2006/2007. Sources: SRA National rail trends 2003–2004 and ORR National rail trends yearbook 2006–2007. Year

Long distance operators % London and SE operators % Regional operators % All operators %

1997/1998 1998/1999 1999/2000 2000/2001 2001/2002 2002/2003 2003/2004 2004/2005 2005/2006 2006/2007

81.7 80.6 83.8 69.1 70.2 74.1 73.4 79.1 82.2 84.8

89.6 87.9 87.1 77.6 77.8 78.9 80.5 84.7 87.9 88.8

90.6 88.6 89.1 81.7 79.1 80.5 82.8 82.6 85.0 86.1

89.7 87.9 87.8 79.1 78.0 79.2 81.2 83.6 86.4 88.1

that the targets will be met fully because of the “fragmented state of the railways” (House of Commons, 2004, para 69). In 2005/2006, Network Rail achieved an outturn of 10.5 million minutes for attributable delays, compared with a regulatory target of 11.3 million minutes. The ORR, however, noted that “the rate of improvement was not uniform” and “expressed concern about performance on two parts of the network in particular – in Scotland and on the Great Western Main Line” (2006a, p. 10). Alongside the attributable delays target, the company sets its own internal targets and their weighting, subject to the approval of the remuneration committee which is composed of Network Rail’s non-executive directors. Three Key Performance Indicators (KPIs), currently equally weighted, are used to calculate annual bonuses. These are: the Public Performance Measure, which measures the percentage of trains arriving on time; the Asset Stewardship Index, which measures the condition of the network; and the Financial Efficiency Index, which rewards the company’s ability to set attainable budgets (NAO, 2004, para 2.32a). Achieving targets triggers annual bonuses for 30 senior executives of between 18% and 60% of salary. In addition, there is a rolling long-term bonus, based on performance over 3-year periods, which is intended to replace the role of share options in an equity-financed company. In 2005/2006, the executives received an annual bonus of 47.7% of salary, and a long-term bonus of 22.3% of salary. For the Chief Executive, John Armitt, this represented bonuses of £240,408 and £112,320, respectively, on top of £504,000 in salary. There is a notable contrast between the bonuses for senior executives and the much more modest bonus for the workforce of £954, representing around 4% of average pay (Network Rail, 2005/2006). Further, as with any targets, there are several problems with the KPIs themselves which are examined below. Punctuality has improved in recent years, as shown in Table 7, with the percentage of trains on time increasing from 83.6% in 2004/2005 to 88.1% in 2006/2007. There are significant variations within the overall measure, with the performance of long distance operators lagging behind that of regional operators. Thus, it may become increasingly difficult to reach, or improve on, the pre-privatisation performance level of 90% of trains arriving on time in 1993/1994 (Gourvish, 2002, p. 504). Furthermore, achievement of punctuality improvements is heavily dependent on the performance of the TOCs. It is possible for the TOCs to achieve “improvements” in punctuality by providing a worse

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service to passengers; for example, some journey times have been lengthened to make punctuality easier to achieve. The NAO has argued that the KPIs are “complex to calculate and do not always focus on overall longer term operational and financial performance” (2004, para 2.30). For example, there is a danger that the Financial Efficiency Index will not “encourage an appropriate balance of. . .spending and reduction of costs over time” (NAO, 2004, para 2.32a). Further, the value of the Asset Stewardship Index has been questioned after the crash at Grayrigg in Cumbria, in February 2007, when a train derailment killed one person and injured 22 others. In 2006, the ORR reported that the index “confirms that improvements to the condition of the network continued”, but prophetically warned that in some cases such as points failures “reliability has barely improved at all” (ORR, 2006b, p. 3). The initial report into the derailment by the Rail Accident Investigation Branch (RAIB) blamed a faulty set of points maintained by Network Rail for the derailment. At Grayrigg, one of three stretcher bars used to keep rails apart at a points intersection was missing and two were fractured; furthermore, “bolts that secured the lock bar and another stretcher bar were not in place” (RAIB, 2007, para 27). Thus, the crash appeared to be worse than a similar incident at Potters Bar in 2002, when Railtrack was in administration and maintenance work was outsourced, which was caused by a set of faulty points moving between a train “because nuts on two stretcher bars were detached” (Health and Safety Executive, 2002, para 3). Simply bringing maintenance work in-house, however, could not restore the engineering culture that was deliberately destroyed by rail privatisation in a myopic attempt to create surplus value in a loss-making industry. It would take a generation to rebuild such a culture, even if renewals work were to be brought back in-house. The continuing problems caused by the damage inflicted on railway culture were revealed in another very critical ORR report, published in February 2008, on the disruption caused to 300,000 passengers over Christmas/New Year in 2007/2008. Overruns of engineering works in three areas were judged to be a serious breach of Network Rail’s operating licence, stemming from factors such as “fundamentally flawed” risk assessments and “excessive” reliance on self-certification of work by contractors (ORR, 2008, paras 5.10, 5.15). On 28 February 2008, the ORR announced that it would levy its largest ever fine on Network Rail, £14 million, which actually represented less than 1% of the company’s annual subsidy. In a delicious irony, this was the same day that Network Rail’s Chair, Ian McAllister, was awarded a knighthood for “services to transport”. A more accurate citation would, perhaps, have read for “services to capital”.

6. Conclusions Railtrack’s replacement by Network Rail had several implications for the privatised rail industry and for public policy. Firstly, although Railtrack was meant to be incentivised by the track access regime, it was impossible for the infrastructure supplier to maximise both effective investment in the network and surplus value. Thus, Network Rail’s position as a debt-financed company limited by guarantee represented a “fresh start” in the narrow sense that it has new senior management whose priority is not to maximise profits in order to reward shareholders. Any profits made are meant to be reinvested in the network, and there is no pressure from members for dividends. However, the new corporate governance

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structure has not fulfilled the hopes of those who advocated increased accountability to stakeholders, such as passengers and employees, through a membership system. While Network Rail does not have to pay dividends, it still faces the major problem of cost escalation experienced by Railtrack. The increased borrowing necessary to cover the underlying deficit in the rail industry has meant very substantial increases in leakages from the infrastructure provider in the form of borrowing costs, which now exceed £1 billion per year. Far from being a “fresh start”, therefore, there is a strong argument that there is now “worst of all worlds”, with the company paying private “rates of interest on large debts without achieving any real risk transfer from the public sector”, as the Government has explicitly guaranteed borrowing of up to £21 billion (Glaister, 2004, p. 55). In addition, the bulk of Network Rail’s expenditure is on renewals work carried out by contractors aiming to maximise surplus value, and the damage inflicted on the engineering culture will take a generation to restore. The fundamental underlying implication for public policy is the extent to which the capitalist mentality has permeated the British state. The Major Government claimed that passengers and taxpayers would benefit from rail privatisation, which would improve efficiency, reduce costs and eventually eliminate subsidy. Despite the failure of privatisation to achieve these key objectives (Crompton and Jupe, 2003b), the Blair Government has strongly opposed rail renationalisation. Instead, New Labour followed the “third way” approach, arguing that the privatised rail system needed stronger regulation, and an element of strategic leadership, and so created the SRA (Blair, 1999). Railtrack’s collapse provided the Labour Government with the perfect opportunity to renationalise rail, but its preference was to reconstitute Railtrack as a “public interest company”. The failure of the “third way” in rail soon became apparent when the government published its Railway Industry White Paper in 2004, which represented its third attempt to reform the rail system since 1997. The White Paper contained a damning indictment of rail privatisation which, it argued, had resulted in “an inefficient and dysfunctional” organisation and “a failure to control costs” (DfT, 2004, foreword). The White Paper reflected governmental “ambivalence and lack of conviction”, however, as it ruled out any vertical integration of the industry or renationalisation and retained private rail companies (Bartle, 2004, p. 58). Further, despite the abundant evidence of the failure of rail privatisation, and warnings from the Transport Select Committee amongst others, the Labour Government in 2003 applied the fragmentation and privatisation principle to the London Underground tube system. In 2007, Metronet, the consortium responsible for nine out of 12 tube lines, collapsed into administration. In 2008, the Government agreed to pay £2 billion to cover cost overruns and administration expenses as Metronet was brought back into the public sector. The House of Commons Transport Select Committee published a scathing report on this “spectacular failure” (2008, para 93). It warned that “If the Government is again tempted by a seemingly good deal from the private sector, it should recall Metronet’s pathetic under-delivery. . .the model itself was flawed and probably inferior to traditional public-sector management” (2008, paras 97, 98). It is instructive to compare New Labour’s continuing ambivalence over rail, and its extension of privatisation to the London Underground, with its decision to nationalise the Northern Rock bank. Northern Rock’s directors pursued a reckless lending policy in 2007, and increased the bank’s proportion of new mortgages that year from 1% to 20%. The

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mortgages were not financed by increased deposits, but by short-term borrowing from the capital markets. The credit crunch which began in August 2007 destroyed Northern Rock’s source of finance, and it was forced to seek government support. The Labour Government, led by Gordon Brown, was faced with the first run on a bank in Britain since 1866. Thus, it guaranteed all Northern Rock deposits, and lent the bank the huge sum of £26 billion. After attempts to find a private buyer proved fruitless, the Government nationalised Northern Rock in February 2008 in order, as Brown made clear, to safeguard the deposits, the financial sector, and taxpayers’ money (Elliot, 2008, p. 2). Leaving aside the hypocritical complaints of some institutional shareholders, whose shares would have been worthless without government support, criticism mainly focused on the time taken to make the decision. The President of the Confederation of British Industry, for example, argued that the decision “ought to have been reached long before it was” (Eaglesham, 2008). The Financial Times made a fascinating judgement, arguing that the Government had “made a sensible, hardheaded, non-ideological choice” (Editorial, 2008). In other words, nationalisation which benefits capitalism is non-ideological, whereas nationalisation in the public interest would be ideological and, therefore, wrong. Network Rail does not represent a true “fresh start” for the rail industry. More has been spent on the infrastructure than under Railtrack, but costs have escalated and some renewals expenditure has been unjustified. The company is, in effect, a very expensive mechanism for channelling large sums of public money to the private sector. The key beneficiaries of its £9.9 billion in grants, and its £21 billion in guaranteed borrowing, are the capital markets, financial institutions and contractors for renewals work. Its creation “changed little, did little to address whatever were diagnosed to be the fundamental failings of the structure of the railway after privatisation” (Glaister, 2004, p. 40). Fundamental problems will persist as both Network Rail and the TOCs remain in private ownership. This means that the “systemic” problems that the industry cannot meet the “financial dictates of private ownership” without subsidy (Shaoul, 2004, p. 36), and the “poor” private sector record in running trains (House of Commons, 2004, para 130) will remain. Further, the Government is imposing annual above-inflation fare increases on passengers, in an attempt to reduce the inflated subsidies which enable private companies to extract surplus value from the industry. Critical financial analysis, as this paper and others have demonstrated, can be used to “evaluate public policy decisions in terms of the distribution of resources to different social groups” as well as the “ostensible objectives set by government” (Shaoul, 2005, p. 468). Thus, accounting can be used to provide accountability to rail’s public stakeholders, the taxpayers and passengers, in order to demonstrate that capital is the key beneficiary of the public support for rail. In this way, accounting can play an essential educative role in demonstrating the need for a planned public transport system which is run in the interests of the nation rather than the financial elite.

Acknowledgements I am grateful to David Cooper, Warwick Funnell and to the referees for their very helpful comments on an earlier draft of this paper.

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