‘Engines of Extravagance’: The privatised British railway rolling stock industry

Critical Perspectives on Accounting 23 (2012) 153–167

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‘Engines of Extravagance’: The privatised British railway rolling stock industry Sean McCartney a,1 , John Stittle b,∗ a b

School of Business and Management, Queen Mary, University of London, Mile End Road, London E1 4NS, UK Essex Business School, University of Essex, Wivenhoe Park, Colchester CO4 3SQ, Essex, UK

a r t i c l e

i n f o

Article history: Received 8 April 2010 Received in revised form 5 October 2011 Accepted 16 October 2011 Keywords: Railways Leasing Privatisation Transaction Cost Economics

a b s t r a c t The privatisation of Britain’s railways involved not only the transfer to private ownership but also the break-up of a previously integrated industry. Under the government’s plan the railway’s passenger rolling stock was sold to three rolling stock companies (or ‘ROSCOs’). This paper focuses on the role of the ROSCOs in the rail industry and their financial performance, critically examining the available literature and in particular the use that has been made of Transaction Cost Economics (TCE) to analyse the relations between ROSCOs and train operators, as well measuring their profitability from financial statements. The ROSCOs have been able to charge excessively high lease rentals to the train operating companies (TOCs). Analysis based on TCE which argues that ROSCOs have taken on serious risk to justify these returns (of default by a TOC, or of holding rolling stock surplus to requirements) has been misplaced, failing to see the dysfunctional nature of the market and the implicit government guarantee to maintain services. The paper finds that the ROSCOs need to be regulated and more transparent in their dealings with both train operators and the public. © 2011 Elsevier Ltd. All rights reserved.

1. Introduction The privatisation of Britain’s railway industry in the mid-1990s resulted in the overwhelming majority of the passenger locomotives and carriages in use on Britain’s railway network being transferred into the ownership of three rolling stock companies (usually referred to as ‘ROSCOs’). These ROSCOs supply rolling stock to the train operating companies (or ‘TOCs’) under lease agreements normally tailored to the length of their franchises. Despite their importance to the rail industry’s operations (their turnover represents about 20% of the passenger revenue of the TOCs2 ), the ROSCOs have attracted relatively little attention in the academic literature, which has predominantly focused on the TOCs and the infrastructure company (Railtrack and its successor, Network Rail). This literature has been largely critical of the performance of the privatised railway industry (e.g. Bagwell, 2004; Crompton and Jupe, 2002, 2003a, 2003b; Jupe, 2009a, 2009b; Jupe and Crompton, 2006; Shaoul, 2004, 2006) and, where they have been noticed, of the ROSCOs, alleging excessively high lease charges and lack of investment in rolling stock (e.g. Crompton and Jupe, 2002, pp. 43–44; Crompton and Jupe, 2003b, p. 626; Jupe and Crompton, 2006, p. 1057; Shaoul, 2004, p. 33; Shaoul,

∗ Corresponding author. Tel.: +44 1206 874860; fax: +44 1206 873429. E-mail addresses: [email protected] (S. McCartney), [email protected] (J. Stittle). 1 Tel.: +44 020 7882 2705; fax: +44 020 7882 3615. 2 In 2006 the ROSCOs’ turnover was £918m (see Table 3); TOCs’ passenger revenue was £4.8bn (ORR, 2007a, Table 1.3a). 1045-2354/$ – see front matter © 2011 Elsevier Ltd. All rights reserved. doi:10.1016/j.cpa.2011.10.001

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2006, p. 155). However a number of writers (e.g. Gourvish, 2002; Terry, 2001) have argued that the public policy mistake was not privatisation per se, but the resulting government-imposed fragmentation of the industry, exemplified by the creation of the ROSCOs. This fragmentation is dysfunctional and raises overall costs – and some writers have used Transaction Cost Economics (TCE) to analyse the contractual relationships within the privatised industry, including the ROSCOs’ leasing contracts with the train operators. The purpose of this paper is to elucidate and evaluate the role and performance of the ROSCOs, which have been given only limited attention in academic literature. This is attempted by critically reviewing both the literature and government policy, and then establishing the ROSCOs’ financial performance, so as to put in proper context the above-mentioned claims of excessive lease charges. The remainder of the paper is arranged as follows: Section 2 outlines the background to and reasoning behind railway privatisation and the creation of the ROSCOs; Section 3 presents a critical analysis of the structural arrangements for the rolling stock leasing industry created by privatisation and of the relevance and application of Transaction Cost Economics, which has been used by a number of writers to analyse contractual relationships within the privatised industry, and particularly those between ROSCOs and TOCs; Section 4 examines the financial performance of the ROSCOs and widespread concerns about excessive charges, and attempts to assess their profitability; Section 5 contains some conclusions. 2. The structure of the privatised railway industry The railways in Britain were originally constructed and operated, from the 1820s, as almost entirely private enterprise initiatives. The state was permissive (authorising lines through Acts of Parliament) but not pro-active and railway companies were regarded by policy-makers as private profit-making institutions which would be regulated, like others, through competition (Bagwell, 1988; Irving, 1978). Mergers and acquisitions starting in the 1840s extinguished competition in many areas, creating local monopolies, and a Parliamentary Select Committee which enquired into this was forced to conclude that: . . . competition must fail to do for railways what it does for ordinary trade, and . . . no means have yet been devised by which competition can be permanently maintained. However, the Committee added that monopolisation had not brought ‘the evils which were anticipated’ (Joint Select Committee Report, 1872, pp. 18, 49), whereas the benefits of an integrated system were clear, so much so that government policy shifted from promoting competition to direct control of charges. By the 1900s government policy was actually urging further integration on the industry: in 1909, Winston Churchill, then President of the Board of Trade declared ‘there is no real future . . . for British railways apart from amalgamation of one kind or another’ (Cain, 1972, p. 636). Nevertheless, there were still some 120 railway companies in Britain in 1914, although about 1000 had been taken over or merged since 1830 (Simmons and Biddle, 1997, p. 197) when the network was taken over by the state as an emergency war-time measure and effectively run as an integrated system. The results were so salutary, the benefits of an integrated system so apparent, that after the First World War a return to the status quo ante was inconceivable, and the government forced through the further amalgamation it had been urging on the industry before 1914. This came in the form of the Railways Act of 1921 which forcibly amalgamated the existing companies into four large regionally based groups (Aldcroft, 1968). But these companies had only a brief existence: in 1939, at the start of the Second World War, the state took them over again and this time permanently – with formal nationalisation following in 1948. The lesson from this history was that a reversal of this integration would almost certainly be a major policy error. Privatisation did not per se entail the demise of an integrated industry. The state owned, British Rail (BR) could have been privatised en bloc, as indeed was proposed by BR’s own directors, and other structures were certainly discussed after the decision to privatise had been taken in principle.3 The Conservative Party’s manifesto for the UK General Election of May 1992 contained a commitment to privatisation, but in very vague terms, and John MacGregor, appointed Secretary of State for Transport after the Conservative victory, had no experience of his new department. Nevertheless, as part of his party’s privatisation plans, MacGregor announced the significant decision to separate infrastructure from train operations just six weeks after taking up his new office. The drive towards break-up apparently came above all from the Treasury and its Privatisation Unit headed by Steve Robson, with the support of Christopher Foster, MacGregor’s own special adviser. The Treasury was determined to introduce competition wherever possible as well as secure the elimination of the railway industry’s subsidy and vertical separation was a sine qua non of meaningful competition. MacGregor seems to have been rushed into making such a hasty decision on the future structure of the industry, without proper consideration of the alternatives, so that the entire privatisation process could be completed before the following election, due by May 1997 (Gourvish, 2002, p. 390; Pollitt and Smith, 2002, p. 467; Shaw, 2000; Wolmar, 2005).

3 See e.g. Bradshaw, 1997, p. 96; Gourvish, 2002, p. 365–400; Wolmar, 2005, p. 50–9. The then Prime Minister John Major even talked of recreating the four (integrated) regional railway companies of the inter-war period (Welsby and Nichols, 1999, p. 59).

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Introducing competition turned the privatisation of the rail industry into the most complex carried out by the Conservative administrations of 1979–97. Under the Railways Act 1993, BR was broken up into more than 100 separate businesses (ironically about the same number of companies as had operated the railways in Britain in 1914) that were then sold over a period of several years (see Davies, 2000), producing a fragmented structure ‘unique for a rail system anywhere in the world’ (Nash, 2003, p. 242). Passenger services were initially reorganised into 25 TOCs which were awarded fixed-period and largely geographically based franchises and sold to 14 private bidders between October 1995 and February 1997 (Curwen, 1997, pp. 55–56). Franchise periods were limited, typically to seven years, to allow ‘more frequent exposure to the market’ and so maintain competitive pressures on the TOCs4 (DoT, 1993, para 14). Such short franchises were only possible because a major underlying principle of the privatisation process was the separation of the railway infrastructure (track, signalling and stations) from train operations. The TOCs do not own the tracks and stations but pay ‘track access charges’ to the infrastructure provider, Network Rail (formerly Railtrack). Moreover the TOCs, as established under the Railways Act 1993, did not even own their rolling stock (locomotive engines and passenger carriages),5 but leased it from one of the three privatised (ROSCOs) to which BR’s passenger rolling stock had been transferred. This arrangement would, it was believed, lower barriers to entry by reducing the capital commitment required by franchisees, making it ‘easier to transfer operations at subsequent franchise awards’. In addition, the initial leases placed responsibility for ‘heavy’ maintenance on the ROSCOs, which worked in the same direction, although in practice this work was outsourced6 (ORR, 1998a, para 2.4). A key factor behind these arrangements was that the expected useful life of passenger rolling stock, typically 25–40 years, was far greater than that of the awarded franchises. In addition, it was often difficult (for technical and engineering reasons) to transfer rolling stock between routes operated by differing franchisees. Given this, it was recognised that the TOCs would be unwilling to invest in new rolling stock when there was no guarantee that franchises would be renewed, and, at least initially, would experience a severely restricted second-hand market. Three separate ROSCOs were established and then privatised early in 1996 to create a competitive leasing industry – and in theory, franchisees could in any case buy additional rolling stock if they wished, or lease it elsewhere.7 Investment in the industry would be made on commercial grounds and privately financed, so that ‘ultimately there [would] be no public sector intervention in [what would be a] fully competitive market for the provision of new and second-hand rolling stock’ (DoT, 1993, paras 2–4, 19). In the light of this forecast, the government considered it unnecessary to provide for any regulation of the ROSCOs beyond an inevitable transitional period. The Railways Act 1993 created the Office of Rail Regulation (ORR) to monitor the rate of return and performance of the infrastructure company (Railtrack) and the Office of Passenger Rail Franchising (OPRAF) – later subsumed into the Strategic Rail Authority8 – to award and regulate train franchises and supervise the quality of train operations. In contrast, the ROSCOs were outside this state regulatory regime and ‘subject only to general competition law’ (ORR, 1998a, Forward). The franchising director (initially OPRAF) was given legislative powers to intervene in certain circumstances. If a train operator defaulted on a lease rental to a ROSCO, the regulator was empowered to take on the lease on the same terms and require future franchisees ‘to take on existing rolling stock to operate the train service’ in order to ensure operational continuity and encourage investment in rolling stock (see Railways Act 1993, sec. 54; Wolmar, 2005, p. 291).9 Apart from these rather limited provisions, the ROSCOs were omitted from the railways’ regulatory framework, despite the fact that the industry was heavily dependent indirectly on public subsidy channelled through the TOCs. This was thought to be a temporary situation: the initial TOC franchises assumed a reduction in overall subsidy to the railways from £2.1bn in 1996/97 to less than half that figure by 2002/03 (at constant prices) with complete elimination planned for around 2012. Operators of profitable lines would increasingly ‘make payments to the government’ to acquire their franchises, covering subsidies that might be necessary elsewhere (Davies, 2000; DoT, 1992, para 21; OPRAF, 1997). However, as can be seen from the figures in Table 1, from a low point of £1.2bn in 2000/01 support soared to over £6.3bn in 2006/7, then falling back to £4.6bn in 2009/10. Passenger fares currently only account for about half the cost of running the railways (ATOC, 2010). The railway industry from which the ROSCOs derive their revenue will be heavily dependent on public subsidy for many years to come.

4

The Treasury had wanted even shorter franchises (3–5 years) for this reason (Jupe and Crompton, 2006, p. 1043). This paper is concerned with the arrangements for BR’s passenger rolling stock. The much smaller fleet of freight rolling stock was sold to the three freight-operating companies. 6 ‘Heavy’ maintenance was not clearly defined but has typically been taken to mean ‘work required less than once a year’ (Shaoul, 2007, p. 196). 7 Licences from the Office of Rail Regulation must be obtained by those who operate railway assets, but not for those who merely own and lease such assets (ORR, 1998a, p. 5). 8 The Strategic Rail Authority was created by the Transport Act 2000 to implement greater strategic direction in Britain’s train services. It was wound up in 2005 and most of its functions were transferred to the Department for Transport. 9 For example, when Connex SE, a train operating company in south London was deprived of its franchise in 2003, the SRA took over the running of train services and also took control of its leased rolling stock. 5

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Table 1 Government support to the railways. Year

Current prices (£m)

2010/11 prices (£m)

1993–94 1994–95 1995–96 1996–97 1997–98 1998–99 1999–00 2000–01 2001–02 2002–03 2003–04 2004–05 2005–06 2006–07 2007–08 2008–09 2009–10 2010–11

1627 1697 431 1056 1829 1586 1418 1214 1826 2588 3622 3791 4602 6308 5293 5213 4619 3960

2604 2644 650 1556 2608 2193 1931 1605 2378 3302 4495 4563 5397 7132 5747 5497 4848 3960

Sources: ORR (2006b, p. 70, Table 6.2a; 2011, p. 99, Table 6.2a). Notes: (i) Support includes grants to Passenger Transport Executives (PTEs). (ii) Uprating to 2009/10 prices by the UK Retail Price Index.

3. The rolling stock leasing industry after privatisation 3.1. Transaction Cost Economics Transaction Cost Economics (TCE) regards the transaction as the basic unit of economic analysis and focuses attention on ‘the organisation of transactions – where a transaction occurs when a good or service is traded across a technologically separable interface’ (Williamson, 1996, p. 58). Whilst the market mechanism may be the most efficient means of co-ordinating economic activity, the necessity of contracts between actors in a market, and the arranging (and enforcing) of such contracts imposes transaction costs (the costs of making exchanges) which may be so high that some form of non-market co-ordination may be more efficient; indeed ‘the main purpose and effect of economic organisation is economizing on transaction costs’ (Williamson, 1996, p. 5). Thus Coase (1937) explained the existence of firms, as units of organisation, by their ability to eliminate or reduce the transaction costs that would be incurred in their absence. TCE is particularly interested in the costs that arise where there are ‘ongoing contractual relations for which continuity of the relationship is a source of value’ (Williamson, 2005, p. 2) such as those between ROSCOs and train operators. These costs should not be thought of as merely those of administration or bureaucracy (although these may be real): more important are the costs of the ‘hazards of contracting’ of which the most important are that (1) contracts, if at all complex, will inevitably be incomplete due to uncertainty as well as the limited memory and cognitive processing ability of the individuals involved and hence need renegotiation, incurring further costs; and (2) contractors may well fail to be honest and open about their intentions and behave in a self-interested, opportunist fashion, imposing costs on the other party (Williamson, 2005, p. 8). These hazards pose particular problems when one or both of the parties have made investments in assets specific to the contract whose value cannot be fully recovered elsewhere: a specialised piece of machinery is a standard example. Such asset specificity leaves the investor vulnerable to opportunist behaviour and creates a risk (of non-recovery) for which parties making the investment will require appropriate compensation and a key governance problem in TCE is to secure the return on such an investment. Contracting parties will seek to arrive at agreements that minimise costs of transactions by ensuring that institutional or governance structures are aligned with transaction characteristics and safeguard their own positions e.g. through verification or arbitration procedures and the like (see e.g. Rindfleisch and Heide, 1997; Silverman et al., 1997). The ultimate safeguard of course is vertical integration, internalising the transaction, especially where ‘the investment decision in the relationship by one party is much more important than the other’s investment decision’ (Hendrikse, 1996, p. 140). In the case of rolling stock the ROSCOs are making investments with a high degree of ‘asset specificity’ (for instance some rolling stock can only be operated on certain lines) where asset lives are much longer than their leases with the TOCs (which will be the length of the franchises) apparently exposing them not only to default risk but also to residual risk of a loss of asset value when leases expire. 3.2. Asset specificity and the duration of leasing contracts TCE was paradoxically used as a rationale by Christopher Foster, MacGregor’s own special adviser on railway privatisation. He argued that the historical lesson of the benefit of an integrated industry had been nullified by ‘modern management methods, accounting systems and computers’ which now made it possible to replace the command structure of BR with

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Table 2 Interoperability of ROSCOs rolling stock at privatisation. Train type

Proportion of fleet composed of this type [Total <100% as carriages are excluded] (%)

Usability [percentage of rail network on which these can be used] (%)

Electric locomotives Electric multiple units (EMUs) DC Diesel locomotives EMUs AC EMUs dual (can use AC or DC) Diesel multiple units (DMUs)

2 31 3 20 5 16

9 14 15 24 38 62

Source: Yvrande-Billon and Ménard (2005).

‘contractual relationships between free-standing autonomous bodies’ which would previously have been prohibitively expensive, and the market thus created would arrive at optimal solutions. This, he argued, would be in line with a ‘general shift’ in industry ‘from command to contract’ for the aforementioned reasons (Foster, 2003, pp. 6–7; see also Foster, 2005). However, Foster implied that the transaction costs arising were largely administrative ones – through ticketing and the like, referring to the ‘army of up to 3000 clerks in the Railway Clearing House’ (2003, p. 7) who dealt with such issues before nationalisation. More commonly the opposing argument to Foster’s views has been made: Crompton and Jupe (2003a) argue that privatisation has led to a substantial increase in overall costs in two ways: first, there are ‘cash leakages’ inasmuch as all the firms involved require a return on capital; second, and far more importantly, ‘[i]nterface costs arise because many companies are involved in a supply chain’.10 The first is a result of privatisation per se, the second and far more important, aptly characterised as ‘friction at the interfaces’, is a product of its disintegrated structure (pp. 399, 413). Thus more than half the overall cost of station redevelopments carried out by Railtrack was subsumed in project management. Despite their use of the term ‘friction’,11 Crompton and Jupe make no explicit reference to the TCE literature or transaction costs, and although they identify leasing charges for rolling stock (along with track access charges) as ‘key interface costs’ they actually say very little about the ROSCOs (2003a, p. 400). Others (e.g. Newbery, 2004; Parker, 2003) suggest that the flaw in railway privatisation was the model not the principle,12 as does Tyrrall (2003), who uses an analysis explicitly based on TCE to argue that the fragmentation of the industry drove up operating costs after privatisation. TCE has also been utilised to examine the nature of the contracts between the TOCs and the ROSCOs, focusing on the transaction-specific nature of the ROSCOs’ investment and the short (relative to asset life) duration of the lease contracts, which creates ‘transaction costs that could have been avoided if contracts [had] been designed differently’ (Yvrande-Billon, 2003, p. 4). Some writers (e.g. Affuso and Newbery, 2002; Yvrande-Billon and Ménard, 2005) have stressed the physical specificity of the rolling stock bequeathed by BR. For example, ‘electric trains cannot operate on routes which have not been electrified’; some electrified routes use a third rail system others use overhead lines (ironically a result of decisions made by private sector railway companies before 1948), and so forth (ORR, 1998b, p. 16; see also NAO, 1998, para 3.39). One estimate of the degree of interoperability of the rolling stock (excluding carriages) the ROSCOs inherited is given in Table 2. As noted above, a TOC will contract to ensure supply for the whole franchise period, but not beyond it, so a lease contract will be considerably shorter than the useful life of the rolling stock concerned (NAO, 1998; Prideaux, 2000). Thus there is a ‘misalignment13 between the short duration of the rolling stock leasing agreements . . . and the high level of specificity of the assets these contracts are supposed to monitor. This misalignment affects the level of transaction costs actors have to bear and thus deteriorates their profits’ (Yvrande-Billon, 2003, p. 4). Specifically, the ROSCOs carry a ‘residual risk’ that they will be left holding assets they cannot profitably employ when the lease contract expires, and for which they will require compensation. Yvrande-Billon argues that the performance of TOCs in 1996–2001 was negatively correlated with the degree of misalignment and argues that their (and the ROSCOs’) performance would be improved if ‘the contractual agreements [being entered into] with trading partners match the characteristics of [their] transactions’ (2003, p. 6). Misalignment would be reduced by longer franchises and lease periods, closer to rolling stock life. At privatisation most franchises were ‘short contracts of around 7 years’; more recently they have been for ‘8–10 years with a break clause before the final 2–3 years’ (Transport Committee, 2006, para 84). Many have argued, from the earliest days of privatisation, that longer franchise periods were needed to encourage TOCs to make longer term investments: Alastair Morton, Chair of the Shadow Strategic Rail Authority (SSRA) suggested franchises of 10–20 years for this reason as early as June 1999 (Gourvish, 2008, p. 43; Poole and Dyer, 1999, p. 16) and a similar argument was made by the last

10 The Chairman of freight operator English, Scottish and Welsh Railway put it more simply, ‘separation of infrastructure from operations is a poor idea which only drives up costs. I’ve never appreciated an integrated railway so much as by having to deal with one that isn’t!’ (Burkhardt, 1997, p. 24). 11 ‘Transaction costs are the economic equivalent of friction in physical systems’ (Williamson, 1986, p. 176). 12 Christopher Foster does not agree, blaming poor and hurried implementation of privatisation (Foster, 2005). 13 ‘[A]n arrangement in which the characteristics of the mode of organisation adopted do not fit the attributes of transaction it has to organise’ (YvrandeBillon and Ménard, 2005, p. 680).

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Labour government’s ten-year Transport Plan (DETR, 2000). Ten years later the Transport Select Committee argued that the ‘current length of franchises does not encourage train operators to plan on a long term basis’, discourages investment and permits operators to take ‘short term cost cutting measures that reduce passenger service quality’; it argues for longer franchise periods, but with pre-defined break points at which franchises could be terminated if specified targets were not met (Transport Committee, 2009, para 19). The Conservative/Liberal Democrat Coalition government, in power since May 2010, has now announced its intention, inter alia, to institute longer franchise periods (from 15 to 22 years), subject to operators meeting specified performance criteria, to encourage them to make investments which might only be justifiable over a longer time scale (DfT, 2011a, paras 2.9–10). There is some force in this argument for longer franchises, but short franchises were adopted precisely to ensure competition, the raison d’être of the disintegration of the industry at privatisation. Franchise periods in excess of 20 years are not, to put it mildly, maintaining competitive pressure on operators and could even be argued to constitute an admission that in the sphere of train operations at least ‘competition must fail to do for railways what it does for ordinary trade’ and be replaced by direct regulation. After a change to longer franchises, TCE predicts ‘vertical integration of the supplier by the client’ as the simplest way of eliminating transaction costs and the acquisition of Porterbrook by Stagecoach (which held two franchises) was interpreted as a move in this direction by Yvrande (2000a, p. 9), although subsequently the ‘[r]egulatory authorities [have] discouraged further vertical integration’ (Affuso and Newbery, 2002, p. 84). These circumstances would appear to greatly enhance the residual risk faced by the ROSCOs, which will consequently ‘lease costly non-redeployable equipment to TOCs . . . only at prices including high premiums’ to compensate (Yvrande-Billon and Ménard, 2005, fn. 45, p. 693). These risks would be reduced if rolling stock were more redeployable i.e. more standardised (Berdugo, 1998). It has been argued that TOCs also have an incentive to favour standardisation, to reduce dependency on a particular supplier. If rolling stock were fully redeployable, then it could be regarded as consisting of ‘dedicated assets’14 as claimed by Yvrande (2000a, p. 9) who also argues that asset specificity did fall after privatisation as design culture shifted from one of ‘made-to-measure’, with designs specified by BR for particular routes, to one of ‘off-the-shelf’ with standard but flexible designs being produced by manufacturers e.g. electric multiple units that operate on either the third rail or overhead cables (Yvrande, 2000b, p. 10). More recently the DfT has pushed in the same direction, for instance its ‘Rolling Stock Plan’ envisages a new generation of bi-modal intercity trains that could be used on both electrified and non-electrified lines and on a wide variety of rail routes (2008, paras 34–43). The ROSCOs’ residual risk was certainly taken seriously at the time of privatisation. The tenders made for the ROSCOs in 1996 reflected such ‘high degrees of risk relating [to their] ability to re-let the rolling stock at the end of the initial leases’ – co-terminous with the initial leases – that they effectively assumed a residual valuation of zero, although the National Audit Office estimated this at about £900m (NAO, 1998, para 4.2). Potential investors in the ROSCOs concerned with the risk of default by TOCs were reassured by a government guarantee of 80% of the ROSCOs’ cash flow from their initial leases (NAO, 1998, para 4.2) making these largely risk-free, but also undermining one of the government’s key privatisation objectives of transferring risk from the state to the private sector. Moreover, the TCE analysis discussed is seriously flawed, as the next section will demonstrate. 3.3. Transferring risk to a competitive market A number of conditions would have to obtain before the government achieved its aim of a competitive market for rolling stock in which the private sector took ‘the key decisions and accepted the risks and rewards that flow from them’ (DoT, 1993, para 2). To begin with there would have to be not only a reasonable degree of mobility of rolling stock (i.e. stock can be, and is moved fairly freely between operators) but also a surplus of rolling stock over requirements – a condition that was absent at the beginning of the privatised regime (Curwen, 1997, p. 59). In other words, competition could only arise if such a surplus was created by speculative investment or a fall in demand (Welsby and Nichols, 1999, p. 70). This was not a shortterm problem: in 1998 the National Audit Office noted ‘evidence of some shortages of surplus serviceable vehicles’ and the concern of OPRAF that ‘future bidders for franchises . . . will have little alternative but to lease the majority of rolling stock already used’, concluding that competition between the ROSCOs ‘for the supply of existing vehicles is likely to be limited over approximately the next ten years [i.e. until 2008]’ (NAO, 1998, paras 3.33–3.39, emphasis added). In fact a decade later, ‘[t]he size of the total rolling stock had increased by only 5% since privatisation but the fleet was running 20% more train mileage. . .. [T]he investment in rolling stock that had occurred since privatisation had largely replaced existing vehicles rather than increased the size of the fleet’ (Competition Commission, 2007, para 10). In practice, train operators normally continue with the same rolling stock and renew the lease on expiry, or else the rolling stock is transferred to the successor franchisee: alternative rolling stock (either second hand or new) is not readily available. Train operators see ‘limited substitutability’ and often have ‘few realistic alternatives as to what rolling stock they would be able to use’ whilst the DfT is ‘increasingly prescriptive’ about the rolling stock to be used on a given franchise: ‘in many of the recent competitions [for franchises] bidders have been instructed by DfT to factor in a high percentage of

14

Defined as ‘discrete investments in general purpose plant made at the behest of a particular customer’ (Williamson, 1996, p. 105–6).

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rolling stock that would already be operating in that franchise’ (Competition Commission, 2007, para 1; First Group, 2007, para 2.1). Thus, technical ‘interoperability’, whether (or not) particular rolling stock could be widely used on the railway network, is largely beside the point, and the concentration on the question by Yvrande-Billon et al. misconceived. In theory, contracts for rolling stock, like those for aircraft or buses, are operating leases: a ROSCO will let a given asset on a series of relatively short-term leases, albeit to the same TOC if its franchise is renewed. In reality, in many cases, certain categories and types of locomotive engines and carriages cannot be easily moved between operators: they often stay on the same routes, and so, as the Association of Train Operating Companies (ATOC) argues, they more closely resemble finance leases, which are simply inherited by the new TOC if the franchise changes hands15 (Competition Commission, 2007, para 5). New rolling stock for a particular franchise is prescribed by the DfT, acquired by a ROSCO, and then leased to the successful bidder and its successors: if this is the case then the mismatch (‘misalignment’) between the lease period and asset life is more apparent than real, as is the residual risk that allegedly flows from it. TOCs are running ‘essential public services [that] cannot be allowed to fail . . . the government must step in should they become insolvent’ (Shaoul et al., 2008, pp. 8–9). Only if the government decided, let us say when a franchise was due for renewal, to terminate or severely curtail its services (and this would be a political decision) would such risk exist. The contrary decision, to support existing services, constitutes a de facto government underwriting of the demand for rolling stock. In turn, this undermines the argument that TOCs have an incentive to vertically integrate the ROSCOs, although in any case, TOCs could affect this, if they want to, by simply acquiring rolling stock directly – they have no obligation to lease from the ROSCOs. In reality, however, the TOCs have little incentive to purchase rolling stock. As noted above the rationale for the creation of the ROSCOs was that useful life of rolling stock far exceeded the planned franchise periods, kept relatively short to maintain competitive pressure on the operators, who in turn would be unwilling to acquire rolling stock and incur the residual risk that would result when franchises expired. The availability of leased assets would not only reduce capital commitments of would-be franchisees but also barriers to entry, encouraging more bidders to come forward. However, reducing barriers to entry also reduces barriers to exit. A franchise is invariably operated through a ‘special purpose vehicle’ (SPV), a wholly-owned subsidiary of the bidder, an arrangement that offers substantial legal and financial ‘ring-fencing’ protection to the parent undertaking. The SPV pays Network Rail for access to the track and to ROSCOs for access to rolling stock: it may have very little in the way of assets. Profits generated by the franchise can be paid as dividends to the parent, but if the franchise becomes loss-making, the parent may decide not to support the SPV and simply abandon it. Thus the successful tender for the East Coast Main Line franchise in 2005 undertook to make premium payments to the government of £1.9bn over ten years (McCartney and Stittle, 2011) yet the balance sheet of the SPV operating the franchise (Great North Eastern Railway) showed net assets of only £5.5m (GNER, 2006). When GNER began to make losses, due to shortfalls in revenue, the franchise was surrendered and GNER subsequently went into liquidation, but with only a trivial impact on its parent undertaking. Train operators have every incentive to preserve their ‘option to exit’ from a franchise: it is not clear why they should want to make this option more expensive by avoidable investments in rolling stock. Longer franchise periods such as those currently being proposed would not alter this logic.

3.4. The market power of the ROSCOs and barriers to entry TOCs may be unwilling to purchase rolling stock, but they are not obliged to lease it from an existing ROSCO, although in practice they almost invariably do. The Strategic Rail Authority calculated that the three leading ROSCOs had been responsible for 92% of vehicles ordered up to the end of 2002, and argued that this domination would probably increase rather than erode (SRA, 2003a, para 3.26; 2004, p. 15) and in 2007 it was estimated they owned 96% of the passenger rolling stock ‘more or less evenly distributed between them’ (ORR, 2007, p. 40). Only two years after privatisation the Rail Regulator highlighted that he ‘entirely rejected the proposition that the ROSCOs do not have, and may not be expected to have, market power’ (ORR, 1998b, Forward, para 3) and the SRA conceded that significant barriers to entry in the rolling stock market (2003b, para 7.6) meant that ‘there has been no challenge to the power of the ROSCOs’ and so, contrary to the expectations of the government, and the assumptions of analysts using TCE, there is still ‘no real market in trains’ (SRA, 2003b, paras 7.6–7.8; SRA, 2003a, para. 3.26; Wolmar, 2005, pp. 289–90. See also SRA, 2004). Indeed the Competition Commission (2007, para 6.164) also noted that ‘there is no market for the purchase of used rolling stock, and we found very few examples of rolling stock being sold mid-life’. And not only was there a highly limited market for obtaining rolling stock in the UK, the Competition Commission notes that there is an even more restricted market for second hand trading within Europe because of ‘a lack of interoperability with European rolling stock as a result of physical and technical differences’ (2007, para 4.35).

15

A finance lease is usually defined as one ‘that transfers substantially all the risks and rewards incidental to ownership of an asset’ (IASB, 2003, para 4).

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3.5. Governmental and legal concerns The Conservative Government had been successful in completing the privatisation process before the Labour victory in the election of May 1997. The Labour Party had voted against privatisation whilst in opposition, but the new Prime Minister Tony Blair quickly made it clear that he would make no attempt to reverse it and instead committed the new government to making their inheritance work. Despite this, serious concerns began to be expressed about the ROSCOs almost immediately. In January 1998, John Prescott, Deputy Prime Minister who also had Departmental responsibility for Transport, instructed the ORR to conduct ‘a wide-ranging inquiry looking at whether the railway rolling stock market needs stronger controls’ due to ‘widespread concern about lack of proper regulation over the rolling stock companies’ (ORR, 1998b, p. 77) but this only produced a recommendation that the ROSCOs should produce Codes of Practice covering their dealings with the TOCs (DETR, 1998, Chap. 4). The Regulator gave ‘a cautious reception to the publication of the codes’ whilst warning that he ‘expected the commercial behaviour (of the ROSCOs) to reflect [their] spirit as well as the letter’ (ORR, 2000). The codes were initially drawn up in 1997 and reviewed in light of the ORR’s recommendations. But examination of individual codes of practice does not reveal evidence of any meaningful or substantial change of policy (Angel Trains, 2002; HSBC Rail, 2002; Porterbrook Leasing, 2002).16 The government’s 2004 White Paper (‘Future of Rail’) expressed concern that: the markets in rolling stock financing and maintenance established at privatisation are not working in the way they were expected to, and that there is a case for looking to see how the operation of those markets can be improved (DfT, 2004, para 4.3.30). In 2007 the DfT expressed concern that rolling stock provision by the existing ROSCOs may not have ‘achieved an optimum in terms of flexibility or. . . made advances that rely on infrastructure change or reflect likely costs over the whole life of the assets concerned’. Without directly criticising the ROSCOs, the DfT argued that the current mix of trains made it difficult to ‘make optimum use of scarce network [i.e. rolling stock] capacity17 ’ (DfT, 2007b, paras 1.4, 2.1). Meanwhile the ORR was sufficiently concerned about the operation of the market for the leasing of passenger rolling stock to make a reference18 to the Competition Commission, which was particularly concerned to establish whether there were any features of the market that prevent, restrict or distort competition (Competition Commission, 2009, App. 1.1). Such features, the Commission concluded, do exist. Effectively ‘the stock of existing vehicles is fixed’ with ‘little surplus rolling stock available’ to TOCs (Competition Commission, 2009, para 8.13) and no second-hand market (‘we found very few examples of rolling stock being sold mid-life’) (Competition Commission, 2009, para 6.162) whilst acquisition of used stock from abroad is also hampered due to a ‘lack of interoperability with European rolling stock as a result of physical and technical differences’ (Competition Commission, 2009, para 4.35). On the other hand acquisition of new stock involves lengthy lead times. Bidders for franchises have ‘a restricted choice of rolling stock . . . arising partly from operational and technical restrictions on substitutability, but also because of direct or indirect specification of rolling stock in franchise. . .agreements’ (Competition Commission, 2009, Summ., para 43) which is often exacerbated by the lack of inter-operability of rolling stock and the relatively short length of many franchises.19 Existing franchisees are deterred from switching to alternative rolling stock by ‘the costs and risks involved . . . and the operation of the franchise system which reduces opportunities for competition’ (Competition Commission, 2009) In addition, a TOC’s scope to negotiate with the ROSCOs over lease rentals is restricted by the anti-discrimination requirements of ROSCOs’ codes of practice: if a TOC negotiates favourable terms with a ROSCO, such terms must then be offered to all potential franchisees. Overall, the Commission concluded that whilst there may be ‘active rivalry between ROSCOs in the provision of new rolling stock at first lease’ (Competition Commission, 2009, para 5.58) there is little competition subsequently and that given the constraints they mention ‘the incentives on ROSCOs to compete with each other are lower than in a well-functioning market’ (Competition Commission, 2009, Summ., para 43). The Commission’s rather low-key conclusions did not support price controls, favouring instead measures to encourage competition, and merely called for train operators to receive more specific information on rolling stock; increases in the length of some franchises and removal of non-discrimination requirements from the ROSCOs’ Codes of Practice, which taken together would ‘give TOCs the ability to negotiate more effectively’ (DBIS, 2009, para 27). However, in its response to the Commission’s findings, the government only supported the provision of more detailed rolling stock specifications to franchise bidders whilst continuing to favour franchises of around seven years to allow ‘regular testing of the market’ (paras 14–15) – a position subsequently reversed after the 2010 Election, as already noted. The

16 Angel’s Code merely states that it ‘will continue to adopt a flexible and customer-driven approach to all aspects of lease terms [and] offer prices and other terms which reflect the value of services provided and risks assumed [and] will negotiate prices in good faith and in a non-discriminatory manner’ (ATL, 2002, paras 2.1, 2.21). 17 In practice, expanding traffic flow capacity was restricted by the varied mix of types of rolling stock which hampered using the network infrastructure to maximum capacity of train operations. Engineering and technical operating issues meant that some types of rolling stock were limited to operating on only certain railway lines. In order to overcome this restriction, the IEP was designed to produce rolling stock that was operational on far more railway lines. 18 Under Section 131 of the Enterprise Act 2002 (see ORR, 2006a, para 1.1). 19 After the DfT took responsibility for awarding franchises in 2005/6 these were typically ‘8–10 years with a break clause before the final 2–3 years.’ (Transport Committee, 2006, para 84).

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government did also undertake to ‘closely monitor the rentals proposed when rolling stock is re-leased’ and ‘keep under review the option of seeking new powers to control prices should it prove necessary’ implying that this had not been the case in the past (para 35). In fact the DfT had already been so concerned at the cost of rolling stock, particularly given that the railway network would ‘continue to require significant support’ from state funds, that it decided, in 2007, after making the reference to the Competition Commission, to initiate the Intercity Express Programme (IEP) without necessarily involving the existing ROSCOs. The IEP, described as ‘potentially the most significant rolling stock investment programme in the UK for over 30 years’ envisages the procurement of up to 2000 vehicles at a cost of about £7.5bn through a newly created consortium, Agility Trains20 (DfT, 2007b, Preface, para 1.2). The Invitation to Tender issued by DfT21 was structured ‘to encourage nonROSCO financiers to participate whilst not precluding ROSCO participation’ and whilst a consortium including Angel Trains also tendered for the IEP contact, none of the existing ROSCOs was selected to play any role in the Programme (ATOC, 2009, p. 2; DfT, 2007c, 2009) which is structured as a Public Private Partnership (PPP) inasmuch as the DfT specifies the type and quantity of the rolling stock procured whilst finance is provided by Agility (Foster, 2010). 4. The financial performance of the ROSCOs 4.1. Allegations of overcharging Concerns over the market power of the ROSCOs have led to suggestions that their lease charges to the TOCs (and ultimately the government) are excessive. Researchers have described the ROSCOs as ‘the most profitable part of the railway industry’ (Shaoul, 2007, p. 204), ‘phenomenally lucrative’ (Jupe and Crompton, 2006, p. 1057), and ‘virtually a licence to print money’ (Wolmar, 2005, p. 277). They have also pointed out that there ‘was no requirement [to reinvest these profits] in new stock’ (Wolmar, 2005, p. 276), ‘no regulation or ring-fencing of their finances’ to ensure such investment took place (Shaoul, 2004, p. 33) and that the increased investment in new rolling stock that the government had predicted failed to materialise, especially in the early years of privatisation (Crompton and Jupe, 2002, pp. 44–45).22 Government bodies have made more measured criticisms along the same lines. Thus the Treasury considered that rolling stock leases ‘were poor value for money and that might be due to lack of competition in the market’ (DfT, 2004, para 4.3.30; 2007a, para 9) and more specifically the DfT believed that the ROSCOs were over-charging, particularly on older rolling stock inherited from BR, estimating the excess at between £34m and £177m annually – and a total, on the rolling stock transferred at privatisation, of ‘between £764m and £1.9bn to the consumer (in NPV terms at 6% discount) over [its] remaining economic life’ (DfT, 2007a, para 10). In response these arguments the Competition Commission (in its above-mentioned Report) made the extraordinary claim that whilst the lack of choice means that TOCs might be facing excessive costs, the unusual nature of the market means that is not possible to make a robust estimate of the returns made by the ROSCOs or of the extent of overcharging (Competition Commission, 2009, App. 8.1) although it had access to lease contracts as well as the ROSCOs’ (publicly available) financial statements. The DfT itself did not go into details, but support for its position has been forthcoming from other writers who have given examples of extraordinary cash flows generated by the ROSCOs from older, already heavily amortised stock. It was reported in 2004 that Wessex Trains was paying £630,000 per year for the lease of a particular type of train acquired by BR in the 1980s for only £1m at current prices; on the Isle of Wight Stagecoach was being charged £121,117 per year for a two-carriage train that was all of sixty-seven years old: but ‘since there [was] no alternative source of supply; and since the money comes from the government there [was] little incentive for Stagecoach to dispute it’ (factors which, it could be observed, apply generally to train operators) (Irwin, 2004, pp. 6–7; Wolmar, 2005, pp. 277–280; see also Shaoul, 2007, p. 196). Evidence is necessarily anecdotal as the details of leasing contracts between the ROSCOs and the TOCs are ‘commercially confidential’, whilst the TOCs’ franchises are in the public domain, which explains why Yvrande-Billon (2003) and Affuso and Newbery (2002) have conducted empirical work on the TOCs, but not on the ROSCOs, although TCE is just as relevant to the latter. However, although all three ROSCOs have been absorbed by large banking groups, each has maintained a continuous legal existence since incorporation, albeit with changes of owner and, in one case, several changes of name. Their income consists almost entirely of lease charges for rolling stock paid by the TOCs. It is therefore possible to estimate their financial performance from published accounts, which is the subject of the following section (see Table 3).

20 The consortium members are Hitachi (who will manufacture the rolling stock), John Laing, and Barclays Private Equity. The arrangement was suspended by the (Labour) Government in February 2010, given the imminence of a General Election (which took place in May), but the new administration has now confirmed it (Foster, 2010, p. 3; DfT, 2011b). 21 “Following the DfT’s referral of the Rolling Stock Companies (ROSCOs) to the Competition Commission, the DfT decided it was best placed to lead this programme towards a whole-life, whole-cost solution.” As they initiated the project, the DfT would also ensure that “. . .the interests of the funder and the ¨ 2010, p. 10). knowledge of the operator could be brought together in order to achieve effective decisions.(Foster, 22 It is also argued that government seriously undersold the ROSCOs: their ‘flawed sale . . . was the greatest scandal of [rail] privatisation in terms of cost to the taxpayer’ who was ‘robbed of £900 million to the advantage of a handful of BR managers and some large financial institutions’ (Murray, 2001, p. 34; Wolmar, 2005, p. 71). For an account of the sale, see McCartney and Stittle (2008).

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Year to 31 December Turnover PBIT Opening capital ROCE (%) Acquisitions

1996 (£m) 798 442 1743 25.3 143

1997 (£m) 797 405 2041 19.8 69

1998 (£m) 788 459 1816 25.3 104

1999 (£m) 802 503 1885 26.7 205

2000 (£m) 794 421 2215 19.0 459

2001 (£m) 826 422 2515 16.8 927

2002 (£m) 832 424 3091 13.7 693

2003 (£m) 844 399 3582 11.1 848

2004 (£m) 864 394 3957 10.0 847

2005 (£m) 942 418 4357 9.1 602

2006 (£m) 918 408 4321 9.4 370

Sources: Angel Trains Limited (ATL). Financial statements 1995-2006. HSBC Rail (UK) Limited. Financial statements 1995–2006. Porterbrook Leasing Company Limited. Financial statements 1995–2006.

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Table 3 Summary of financial performance of the ROSCOs, 1996–2006.

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4.2. Profitability The three main ROSCOs were incorporated as wholly owned subsidiaries of British Rail and vested with the latter’s passenger rolling stock on 1 April 1994. They passed into direct government ownership in August 1995 and were sold in January/February 1996: ROSCO

Proceeds (£m)

Porterbrook Leasing Company Limited (PLCL) Angel Trains Contracts Limited (ATC) Eversholt Leasing Limited (ELC) Total

528.3 696.3 518.3 1742.9

Profitability has been measured using Return on Capital Employed (ROCE), defined here as profit before interest and tax (PBIT) as a proportion of total investment in the ROSCO, which in turn is defined as the initial cost of acquiring the ROSCO at privatisation plus retained profits thereafter, plus intra-group debt less intra-group advances, plus long-term extra-group debt. This measure abstracts from the capital structure of the ROSCOs, and calculates the return that would have been made by the original acquirer if no subsequent resale had taken place. For the purposes of comparative analysis, the calculation of a consistent figure for PBIT involves a number of adjustments to the published figures. The most important of these arise from the revaluations of rolling stock undertaken by Angel Trains and Porterbrook which enhanced subsequent depreciation charges. For the purpose of this analysis the impact of these revaluations has been reversed, resulting in additional profits of more than £600m in 1996–2006. In 2007 HSBC Rail (UK) disposed of the majority of its rolling stock assets to another member of the HSBC Group: consequently a consistent analysis of the profitability of the three original ROSCOs can only be made up to the end of 2006. A summary of the information extracted from the ROSCOs’ accounts is given in Table 3; and figures for ROCE acquisitions of new rolling stock are shown in Fig. 2. As illustrated in Table 3, both profits and rates of return have been impressive, and in the early years indeed spectacular. Profits before interest and tax have largely remained constant (in nominal terms) over the period from 1996 to 2006, whilst Return on Capital Employed peaked at over 26% in 1999, and then fell back to 9% in 2005–06. It is unclear why this decline has taken place, but a possible explanation is that profits in the early years were inflated by the extraordinarily high lease charges apparently being made for some old and heavily amortised stock, presumably acquired at very low valuations, instanced above, and very little was being invested in new assets. As this old stock has been withdrawn and replaced by newly acquired stock, overall returns have tended to fall. As Fig. 1 demonstrates, profits accounted for a significant proportion of the (declining) government subsidy in the 1990s (fully 1/3rd in 2000), becoming less so thereafter as government support to the railway industry increased from 2000; subsidies peaked at £6.3bn in 2006–07, and declining in subsequent years (see Table 1). From the public’s point of view, the extravagant profitability of the ROSCOs in the early years of privatisation might have been justified if they had been reinvested in the industry. However, as Fig. 2 shows, this did not happen: the years of highest profitability are also the years of relatively low level of rolling stock acquisition. Then from 2000 the level of acquisitions increases for a few years before falling again, whilst the ROSCOs’ return on capital falls away (see Fig. 2). Since 2006 the

7,000 6,000

£ millions

5,000 4,000 3,000 2,000 1,000 0 1996

1997

1998

1999

2000

2001

2002

Government Support

2003

2004

Profits

Fig. 1. ROSCOs’ profits and government support, 1996–2006.

2005

2006

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1,000

30.0

900 25.0

800 700 600 500

15.0

£m

Percentage

20.0

400 10.0

300 200

5.0

100 0.0

1996

1997

1998

1999

2000

2001

PBIT/Opening Capital

2002

2003

2004

2005

2006

0

Acquisions

Fig. 2. ROSCOs’ profitability and investment, 1996–2006.

level of investment has slowly declined, albeit erratically, and the figure for 2010/11, at £274m, is the lowest since 1999 (see Table 4). It is worth noting that investment in the three years from 2008/09 to 2010/11 has averaged only £347m – compared to a yearly average of £471m in the period from 1991/92 to 1993/94 (ORR, 2006b, p. 75, Table 6.4), a fall of 25% in nominal terms, and more than half in inflation-adjusted terms. 4.3. Investment in new rolling stock The initial impact of the privatisation process was to inhibit investment: in ‘the lead up to privatisation, British Rail was forbidden to invest in rolling stock and so no new stock was ordered in the 1000 days before privatisation’ (Crompton and Jupe, 2002, p. 44). It was expected that the sale of the ROSCOs would lead to considerably enhanced investment in new rolling stock as private sources of finance could be exploited, but despite their high profits, the sought after increase in investment did not happen. The Rail Franchising Director ‘reported in 1998 that only £18m worth of new rolling stock (about 20 new coaches) was in use 2 years after privatisation’ (Crompton and Jupe, 2003b, p. 634). There was simply ‘no mechanism’ to ensure that the enormous surpluses the ROSCOs generated were reinvested in rolling stock (Wolmar, 2001, p. 78). This lack of investment was not due to any lack of cash flow either: the ROSCOs generated substantial cash surpluses for their new owners very quickly, as is shown by the example of Angel Trains Limited (ATL). GRS Holding Company Limited (‘GRSH’), the vehicle of the acquiring consortium, purchased ATL for £696.3m on 17 January 1996. On the same day ATL secured a commercial loan of £549.3m on its government-guaranteed lease income. Further borrowings of £193.1m were made on 3 April. Most of this cash was simply lent to its parent GRSH – by 3 April net cash transfers to GRSH totalled £733.6m, comfortably exceeding the £696.3m which GRSH had paid for the company, just 11 weeks earlier. On the other hand spending on new rolling stock in the Year to 31 March 1996 was just £4.9m, and in the Year to 31 March 1997 a mere £1.3m (ATL Financial Statements, 1995–7). The profits generated by the ROSCOs have been reflected in the enormously enhanced values subsequently placed on them. Porterbrook, privatised for £528.3m by a management buyout, was acquired just six months later for £826m by Stagecoach, who in turn sold it on to Abbey National plc in April 2000 for £1.4bn. In 2008, Banco Santander, the Spanish banking Table 4 Investment in rolling stock since 2006. Year

Investment (£m)

2006/07 2007/08 2008/09 2009/10 2010/11

326 400 345 423 274

Source: ORR (2011) (p. 104, Table 6.3).

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concern (which had acquired Abby National in 2004) sold Porterbrook to a consortium of European banks led by Deutsche Bank for about £2bn (Inman and Milmo, 2008). Angel Trains Contracts Limited (ATC) was disposed of for £696.3m. In December 1997 the business was acquired for £1085m by the Royal Bank of Scotland, which in turn sold ATC to a consortium led by Australian fund manager Babcock and Brown for £3.6bn in June 2008 (Jameson, 2008). Those who have recently acquired the ROSCOs, at an enormous mark-up over the proceeds of the original privatisation, are obviously confident of recovering their investment from the train operators, and so ultimately from the government which funds them, and on past evidence of the profitability of the ROSCOs this confidence seems entirely justified. 5. Conclusion The (largely critical) literature on the privatisation of British railways has tended to focus on the train operators and the infrastructure companies (Railtrack and Network Rail) whilst the ROSCOs have ‘remained largely invisible’ (Shaoul, 2007, p. 190), possibly because their identity and role are largely ‘hidden’ from view by the other industry players. Ironically, government bodies such as the Department for Transport have been far more vocal, alleging failure in the workings of the market for trains and excessive charges by the ROSCOs. The absence of an effective functioning market for passenger rolling stock, despite confident predictions at privatisation, has enabled the three ROSCOs to maintain a dominant position in the industry. The government has made no significant moves to challenge this, or to revisit its original decision to exclude the ROSCOs from the rail industry’s regulatory régime, although this was predicated on assumption that such a market would come into existence. Instead the DfT is simply bypassing the ROSCOs in initiating and arranging procurement for the Intercity Express Programme – a government-organised venture which makes a mockery of the pre-privatisation government promises to delegate decisions on the level and nature of future investment in rolling stock to the private sector with ‘no public sector intervention’ (DoT, 1993, p. 5; see also Foster, 1994, pp. 9–10). The unregulated ROSCOs have been able to exploit their secure market position to deliver exceptional returns to their investors, particularly so in the first few years after privatisation. However, the investment boom predicted once the railways were freed from the constraints of Treasury Cash Limits was very slow in coming. In 1992/3, investment in passenger rolling stock was £537m: this figure collapsed to £47m in 1996/97 (the first full year after privatisation), and was not exceeded until 2000/01, despite astonishing levels of profitability over that period. In fact, much of the impetus for new investment has actually come from the government via franchise requirements – the Intercity Express Programme is the logical outcome of this trend. The profits generated by the ROSCOs are all the more remarkable given that their business has a very low level of risk – contrary to what some writers (and the government at the time of privatisation) may have thought. Some analysis has used Transaction Cost Economics (TCE) to highlight the risks imposed on the parties to lease contracts for such durable and relationship-specific assets as rolling stock: the ROSCOs allegedly face a serious risk of holding unproductive assets as a result of speculative acquisition, the expiry of a given franchise or default by the Train Operating Company. In reality, the ROSCOs have avoided the first by the simple device of not making speculative acquisitions, whilst the residual and default risks are in reality non-existent so long as the government remains committed to maintaining the existing railway network. This appears to have been overlooked by those using TCE, who seem to have focused exclusively on legal contractual relations and ignored the political context. However, the ROSCOs are the beneficiaries, not merely of an implicit government guarantee, but also, albeit indirectly, of the considerable government subsidy to the rail industry, inasmuch as their revenues come from the TOCs, most of which are in receipt of state support. But whilst the TOCs are subject to regulation, the ROSCOs to whom this support is (in part) passed on, are not, with the malign effect that whilst the ROSCOs have every incentive (and opportunity) to maximise their revenues, the TOCs do not have the same incentive to minimise their lease charges. Under their codes of conduct ROSCOs must offer the same terms to all operators. The rolling stock to be used on a franchise will be prescribed by the DfT, so leasing costs will be a given for all bidders. And the funding comes from the government. In a certain sense this privatisation structure is the worst of all worlds: if train operations were still state-owned, the operator would have every reason to try to bargain down the cost of leases from private providers, as would TOCs if the industry were entirely private and unsubsidised. In the latter case the absence of any requirement on the ROSCOs to disclose the profitability of their leases, either individually or in aggregate, and the confidentiality of lease contracts, would simply be normal commercial practice. The problem is that the TOCs are contracted by the State to provide a vital public service, which the State has to underwrite, inasmuch as the service in question cannot be allowed to fail. This consideration means that normal commercial rules may not apply. This model of public service provision, and so the issues discussed in this paper, is becoming increasingly widespread, and not just in the UK. In the UK itself, the increasing role envisaged for the private sector as contractors for the National Health Service under government plans is a case where similar issues could arise. As far as the British rail industry is concerned, the overall government subsidy to the UK rail industry is not only far greater than that required by British Rail before privatisation, it also appears to be a permanent feature of the industry. Despite this higher level of funding, and the ROSCOs’ impressive record of profitability, investment in rolling stock since privatisation has been, to put it mildly, disappointing. Apart from a surge between 2001 and 2005, it has usually been below that of British Rail, and is currently less than half the pre-privatisation level, in real terms. All of which makes the unregulated

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status of the ROSCOs even more unacceptable. There is surely also a case for greater transparency by ending the commercial confidentiality of leasing contracts, given that the state is paying half the costs incurred by train operators. The fragmentation of rail transport at privatisation has driven up its overall costs – not least due to the profits of the ROSCOs, which would not exist in an integrated industry. Re-integrating the railways would make them redundant. Since this would in practice almost certainly mean state ownership it may be a political impossibility: absent that, the least the public interest requires is that the ROSCOs’ are forced to be more transparent and accountable, and brought within the ambit of state regulation. Acknowledgements The authors would like to thank the two anonymous referees for their very helpful (and exhaustive) comments on earlier drafts, and the editor, Prof. Marcia Annisette, for her advice and support. References Affuso L, Newbery D. 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