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Beyond the quiet life of a natural monopoly:

Regulatory challenges ahead for Europe’s rail

sector

Issue paper # 3

Towards optimal regulatory structures and practices

for the rail sector

Chris Nash (Institute for Transport Studies,

University of Leeds)

October 2012

121025_CERRE_CES_Rail_IssuePap3_CN

121025_CERRE_CES_Rail_IssuePap3_CN_All 2/33

Table of content

About CERRE ....................................................................................................................... 3

About the author ................................................................................................................ 5

Abstract ............................................................................................................................... 6

Introduction ........................................................................................................................ 7

1. Alternative institutional approaches to rail regulation ............................................... 8

3. Models of rail reform ................................................................................................. 11

4. Incentives in a vertically separated railway............................................................... 13

5. Subsidies from central or local government (for infrastructure and/or operations) 16

6. Track access charges .................................................................................................. 18

7. Performance regimes ................................................................................................ 24

8. Regulation of investment .......................................................................................... 26

9. Alliancing .................................................................................................................... 28

10. Conclusion .............................................................................................................. 31

11. References ............................................................................................................. 33


About CERRE

Providing top quality studies, training and dissemination activities, the Centre on

Regulation in Europe (CERRE) promotes robust and consistent regulation in Europe’s

network industries. CERRE’s members are regulatory authorities and operators in those

industries as well as universities. CERRE’s management team is led by Dr Bruno

Liebhaberg, Professor at the Solvay Brussels School of Economics and Management,

Université Libre de Bruxelles.

CERRE’s added value is based on:

its original, multidisciplinary and cross sector approach;

the widely acknowledged academic credentials and policy experience of its team

and associated staff members;

its scientific independence and impartiality.

CERRE's activities include contributions to the development of norms, standards and

policy recommendations related to the regulation of service providers, to the

specification of market rules and to improvements in the management of infrastructure

in a changing political, economic, technological and social environment. CERRE’s work

also aims at clarifying the respective roles of market operators, governments and

regulatory authorities, as well as at strengthening the expertise of the latter, since in

many member states, regulators are part of a relatively recent profession.

This issue paper has been prepared within the framework of a CERRE Executive Seminar

which has received the financial support of a number of stakeholders in the rail industry

including CERRE members. As provided for in the association's by-laws, it has been

prepared in complete academic independence. Its contents and the opinions expressed


in the document reflect only the author's views and in no way bind either the CERRE

Executive Seminar sponsors or any member of CERRE (www.cerre.eu).

http://www.cerre.eu/


About the author

Prof. Chris Nash is professor of transport economics at Leeds University. In recent years

he has been a visiting professor at the University of Sydney, the Eurasian National

University of Kazakhstan, the University of Las Palmas, the Polytechnic University of

Catalonia in Barcelona and the University College of Molde (Norway). Prof. Nash has

also acted as an advisor to many public institutions, including the European Commission,

the European Union Committee of the House of Lords, the Transport Committee of the

House of Commons and the Railways Group of the European Council. He is also a

member of the Editorial Board of many distinguished academic journals in transport

economics, such as the Journal of Transport Policy and Economics, the International

Journal of Transport Economics and the International Journal of Green Economics.


Abstract

The first railway package of 2001 required establishment of a rail regulator, whose

duties would certainly include ensuring non discrimination on the part of the

infrastructure manager when allocating capacity or charging for its use, but might also

extend to ensuring that the infrastructure manager is efficient and subject to that

adequately funded. Where railways are vertically separated between infrastructure and

operations, it is important to ensure that there are appropriate incentives on both

parties to perform efficiently. Key mechanisms for achieving this are subsidies from

central or local government (for infrastructure and/or operations), track access charges,

performance regimes, and regulation of investment and quality of service. However,

important as they are, all of these mechanisms are subject to shortcomings, leading to

the development of alliances between the infrastructure manager and train operators

as an alternative way of aligning incentives where a single operator has a large share of

the market at a regional level. A similar role may be played by the holding company

where this model is adopted and a single operator has a large share of the market

nationally. But at the end of the day, government still has a major role in European

conditions in the planning and financing of infrastructure investment.


Introduction

Alongside measures to require a degree of vertical separation and open access for new

entrants, the first railway package of 2001 required establishment of a rail regulator,

independent of the infrastructure manager or any railway undertaking. Clearly the main

task of the regulator was to ensure non-discrimination on the part of the infrastructure

manager when allocating capacity or charging for its use. However, the legislation also

made governments responsible for ensuring that a plan existed which put pressure on

the infrastructure manager to be cost effective but subject to this ensured financial

equilibrium. This plan could take the form of a multi-annual contract between the state

and the infrastructure manager, or be achieved by a periodic review of the

infrastructure manager’s finances by the regulator with a duty on the regulator to

ensure that the infrastructure manager had adequate finance. So the regulator also had

a potential role in ensuring that the infrastructure manager was efficient, and

adequately financed.

In the next section, we consider the alternative institutional approaches to regulation

that have been adopted in Europe. We then consider alternative models of rail reform

and the issue of incentives in a vertically separated railway. We discuss the main

mechanisms for providing those incentives - subsidies from central or local government

(for infrastructure and/or operations), track access charges, performance regimes,

regulation of investment and quality of service and alliancing – and the role of the

regulator in them before reaching our conclusions.


1. Alternative institutional approaches to rail regulation

In terms of how this requirement for a rail regulator is implemented, there are at least

three different approaches (IBM, 2006). Some countries, such as Britain, have a specific

rail regulator, with wide ranging powers and responsibilities. In Britain these include

overseeing not just charges and capacity allocation but also whether the infrastructure

manager meets the reasonable needs of its customers in terms of capacity and quality

of service, and conducting a periodic review of the financial needs of the infrastructure

manager, alongside benchmarking to determine the degree to which it can reduce those

needs by increased efficiency. The British regulator is not subject to government

direction, although it must consider guidance given by the Department for Transport

and in particular it must pay attention to the financial implications of its decisions for

government. It has substantial powers to demand data when these are necessary to

fulfil its role. In Britain the regulator is also responsible for regulating safety, whereas in

many countries this is a separate body. It also shares responsibility with the Competition

Commission for examining competition issues in the rail sector; again this is often the

responsibility of a separate body.

In other countries, such as Germany and the Netherlands, regulation of the rail sector

has passed to a sector regulator, responsible also for – for instance - air transport and

telecommunications. A third solution is for the regulator to be within the Ministry. Many

countries, including France and Italy, initially adopted this model, in which the regulator

was largely advising the government, but they are gradually moving away from it to a

more independent body.

It is clear that having the regulator still within the ministry raises fears that it will not be

independent in terms of decisions which affect the infrastructure manager and the main

train operator, which are usually still owned by the government. It is also the case in

practice that regulators located in ministries have typically had few powers and limited


resources. Their function has been largely to consider complaints of discrimination

rather than a broader role in terms of competition and efficiency. The arguments

between a rail specific regulator and a more general regulator are more finely balanced.

A rail specific regulator may be too inward looking and not sufficiently open to ideas

from elsewhere, and ultimately more subject to regulatory capture whilst a regulator

with a broader remit may be more able to transfer experiences from one sector to

another. On the other hand there is much about the rail industry that is very different

from other regulated industries, and in particular the level of interaction between

railway undertakings and infrastructure managers. Running trains involves having a

precise path through junctions and stations, calling at them at the correct times, using

rolling stock which imposes differential wear and tear on the infrastructure according to

its characteristics. Coordinating this is a more demanding task than that facing, for

instance the electricity or telecommunications industry and requires specialist

knowledge for its regulation. It also means a level of day to day contact between the

infrastructure manager and major railway undertakings that is not found in other

industries and may raise fears of discrimination against smaller operators.

Merkert et al (2012) undertook interviews with 46 infrastructure managers and railway

undertakings in Germany, Sweden and Britain to understand and estimate the

transactions costs of vertical separation. They found there was significant interaction

between railway undertakings and infrastructure managers in seven different areas:

- Market entry;

- Investment;

- Access conditions;

- Timetabling;

- Day to day operations;

- Reporting and billing;


- Safety.

Of these, by far the most time consuming were timetabling and day to day operations.


3. Models of rail reform

At least three models of rail reform have come into being in Europe. The first is the

holding company model, as in Germany, Austria and Italy, where a holding company has

separate subsidiaries responsible for freight operations, passenger operations and

infrastructure. Given the legal requirement for open access for freight and international

passenger services, such countries will usually have other operators on the system.

Moreover, in some countries, domestic passenger operations are also open to

competition, mainly through competitive tendering for the franchise to run regional

services.

By contrast, other countries, such as Sweden and Britain, have gone for complete

separation of infrastructure from operations. In Sweden, the government still owns the

largest passenger and freight railway undertakings, whereas in Britain it owns none. The

third model is a hybrid, as in France, where there is a separate infrastructure manager

for some purposes (in France this includes planning and investment as well as charging

and allocation of capacity) but the main railway undertaking retains some

responsibilities (in France, these include all infrastructure maintenance and operation).

The obvious attraction of a complete vertical separation is that it removes the incentive

for the infrastructure manager to favour its own sister train operating companies and

thus makes discrimination less likely (although even in a vertically separated railway

there may be a tendency for the infrastructure manager to favour large operators over

small, particularly when the large operator, like the infrastructure manager, is state

owned).

Table 1 shows that by 2012, a majority of EU countries had implemented complete

vertical separation, although five had holding companies and six some form of hybrid

involving separation of key powers. However, there is no evidence that on average


railways with complete vertical separation experience more competition in the freight

market then holding companies or hybrid systems.

In a vertically integrated company, it may be assumed that senior management have the

aim of optimising the performance of the company; even if individual divisions have

their own budgets and targets, senior management will intervene if they see sub

optimising behaviour or disputes between them. A holding company may provide

something of the same role, although this varies with the degree to which the holding

company intervenes in the decisions of its subsidiaries. With open access, there will be

at least some operators who are not part of the same company as the infrastructure

manager, and with complete separation none will be. The regulator must then give a lot

of thought to how to ensure appropriate incentives for systems optimisation are in

place. This includes incentives for cost minimisation, appropriate quality of service,

efficient use of the infrastructure and investment.

Table 1 Rail Freight Market New Entry by Railway Structure (%)

Vertically separated Hybrid Holding Company

Britain 51 Estonia 43 Austria 15 Bulgaria 27 France 20 Belgium 12 Czech Rep n.a. Hungary 19 Germany 25 Denmark 25 Latvia 23 Italy n.a. Finland 0 Luxemburg 0 Poland 36 Greece n.a. Slovenia n.a. Lithuania 0 Netherlands 33 Portugal n.a. Romania 41 Slovakia 2 Spain 8 Sweden n.a. Mean 21 21 22

Source: European Commission (2012) Rail Market Monitoring Study 2011. Annex 4. Brussels.


4. Incentives in a vertically separated railway

In the absence of regulation, a commercial infrastructure manager will seek to attract

market entry and invest in capacity and performance where it is profitable to do so.

Profitability will rule timetabling and priorities in day to day operation. It will charge

negotiated rates according to what the market will bear subject to that covering at least

marginal cost. It will concern itself with safety inasmuch as accidents are costly both

directly and in terms of reputation and therefore future traffic prospects.

There are a number of respects in which this approach may fall short of achieving a

social optimum. Firstly, the profitability of particular services may not reflect their social

benefits, in terms of consumer surplus or externalities (particularly reduced externalities

by attracting traffic from roads. These will be particularly significant for freight and

commuter traffic, whose external costs are usually not fully reflected in charges for the

use of roads). This generally leads to a case for government subsidy of certain types of

service.

Secondly there may be market failure because of fear of being locked in. Investment

particularly in infrastructure but also to some degree rolling stock, is often very specific

in location and use. There may be fear that if one party makes the investment, the other

may be able to capture its benefits through renegotiation of access charges. The

solution to this is generally long run access agreements embodying rules regarding the

allocation of capacity and price, but achieving complete contracts which cover any

eventuality is impossible, and usually even long run contracts will be much shorter than

the lives of the assets concerned.

Thirdly, as a monopoly supplier of infrastructure, the infrastructure manager will have

an incentive to restrict capacity and force up price, and perhaps also to restrict quality of


service. This incentive may be limited if the Infrastructure Manager can practice

complete price discrimination.

Fourthly, ensuring non-discrimination in such an infrastructure manager would be

extremely difficult, to the extent that access, capacity allocation, investment and

charging were the subject of individual negotiation.

For this reason, European legislation rules out this approach to the relationship between

infrastructure manager and railway undertaking. It requires published rules regarding

access and the allocation of infrastructure capacity, and published tariffs based on short

run marginal social cost (with non-discriminatory mark ups where necessary for financial

reasons). In doing so, it removes many of the possibilities for normal commercial

contracts to work. Published tariffs will not usually relate charges to quality of service,

whilst the degree to which attracting extra traffic is profitable depends on which traffic

attracts a mark-up and by how much. An infrastructure manager charging according to

short run marginal social cost has no commercial incentive to attract additional traffic at

all.

In practice, no European infrastructure manager is privately owned (although Network

Rail is constituted as a private company, it has no shareholders and its debts are

underwritten by the government) and few behave like commercial organisations. Most

receive much of their funding from government, as opposed to train operators, and

undertake investment on social cost-benefit rather than commercial grounds. This raises

some fundamental issues regarding the effectiveness of financial incentives. There are

no shareholders to suffer as a result of financial penalties: indeed, what may suffer is

investment and therefore the rail industry itself. Nevertheless, it is generally assumed

that, since managers’ reputations and future careers (and perhaps also their salaries and

bonuses) rest on their meeting financial as well as other targets, and indeed financial


targets are typically seen by governments as the most important, financial incentives are

still seen in this context as effective.

The key measures which may be used to incentivise vertically separated infrastructure

managers and train operators to achieve social optimality are:

- Subsidies from central or local government (for infrastructure and/or

operations);

- Track access charges;

- Performance regimes;

- Regulation of investment;

- Alliancing.

We will consider each of these in turn.


5. Subsidies from central or local government (for infrastructure

and/or operations)

Rail operations and infrastructure are generally subject to economies of traffic density,

leading to marginal cost being substantially below average cost (Caves et al, 1987;

Wheat and Smith, 2010). Government subsidies may help economic efficiency by

enabling charges to be more closely aligned to marginal costs, whilst there are many

other arguments for subsidies (e.g. second best arguments to reduce traffic on other

modes where there are external costs of congestion, pollution and accidents not

reflected in price, and social arguments to provide transport for those who would

otherwise be disadvantaged in terms of access to jobs, education and services).

Typically governments subsidise both infrastructure and services. Subsidies to services

may be compatible with incentives for train operators to be efficient if they are awarded

by competitive tender; whilst this has worked well in many countries, the experience of

this has not been entirely positive (see for example Smith, Nash and Wheat, 2009).

There is an increasing tendency for such subsidies to be awarded by regional or local

governments as they are best placed to determine local needs. Such subsidies raise

particular issues of how to incentivise regional authorities to make efficient use of

infrastructure which is provided by central government. We return to this issue under

track access charges.

Usually, subsidies to the infrastructure manager will be part of a multi annual contract,

but Britain has an alternative approach where the regulator conducts an independent

periodic review. Either way, there is a problem of how best to ensure that such subsidies

are used efficiently, given that they are paid to a monopoly infrastructure manager. In

Britain, it is the regulator who conducts top down international benchmarking studies as

well as comparisons with trends in other industries and bottom up studies of working


practices to determine to what extent the infrastructure manager could provide the

desired outputs at lower cost.

Decentralisation of many of the activities of the infrastructure manager into regional

units, as is now happening in Britain, add to the ability of the regulator to conduct

benchmarking studies without all the added complications of international studies.

More importantly, they may make other incentives more effective, by making the

financial consequences of their actions bear more directly on regional managers

responsible for the actual decisions leading to them. A further step would be to

introduce an element of competition into the provision of rail infrastructure by

concessioning those regional infrastructure companies, whilst leaving issues that must

be set on a system wide basis at headquarters.


6. Track access charges

Current EU policy requires track access charges to be based on short run marginal social

cost, with non-discriminatory mark-ups as necessary to meet financial requirements.

(Nash, 2005). These charges should take account of marginal wear and tear costs,

environmental costs where charged on other modes, and may include charges for

congestion and scarcity (congestion is where running an additional train increases the

risk of delays to others, scarcity is where it actually prevents another operator from

getting the path it wants). There is now plenty of evidence on the various costs involved

(Wheat et al, 2009; Anderson et al, 2012). Wear and tear costs differ with the

characteristics of the vehicles and the characteristics of the track. Britain has an

unusually complex charging system which currently identified several hundred different

types of vehicle for this purpose; it does not currently differentiate by type of track. If a

simpler system is desired, it appears that gross tonne kilometres is the best simple

indicator of wear and tear, although at least some differentiation by type of rolling stock

would be desirable. Britain also charges for the increased congestion caused by running

additional trains. It differentiates this charge by the train service group, although ideally

it would be more finely differentiated in terms of location and time of day. Of course,

congestion charges should be levied per train kilometre.

Such a well differentiated charging system should encourage the railway undertaking

only to bid for paths where the marginal benefit to it covers the costs imposed on the

infrastructure manager and other train operators. It should also give appropriate

incentives to acquire track friendly rolling stock. What it will not do is prevent the

operator requesting paths where there is inadequate capacity to meet all requirements,

and where the path could be used in a better way by another operator. This is the

purpose of scarcity charges (Johnson and Nash, 2008).


Scarcity charges have been more controversial than the other elements of track access

charges, although they are used in a number of countries including Denmark and Austria.

They should be based on the opportunity cost of the path in question – i.e. its value in

its best other use. Calculating this accurately requires a great deal of knowledge, and it

has been suggested that the best way of acquiring this knowledge is by auctioning the

path, as this would force train operators to reveal their values. This has been seen as too

complex in practice, however, and has yet to be used. In the meantime those countries

which use scarcity charges do so on the basis of simpler ‘trial and error’ approaches.

It should be noted that scarcity charges should logically be levied as a reservation fee, as

it is the process of reserving a path which makes it unavailable for other railway

undertakings. Such a reservation fee would give operators an incentive not to reserve

paths just in case they need them, a practice common particularly amongst freight

operators, who are often unsure of their exact day to day requirements.

The traditional alternative way of managing capacity shortages has been to simply

define priorities in terms of types of train (inter city passenger, container, bulk freight,

commuter etc). A more sophisticated approach would be to use cost benefit analysis to

resolve conflicts, although that again poses the issue of obtaining the relevant

information.

As noted above, mark-ups are permitted where needed for financial reasons, and –

given that public funds have a shadow price greater than one – it has been argued that

some degree of mark-up is always appropriate (Crozet, 2007). In principle such mark-ups

should be proportional to the inverse of the elasticity of demand for paths. In practice

the degree of differentiation open to the infrastructure manager is limited; they can

differentiate by type of train (high speed , regional passenger, bulk freight, container),

location and time of day, but do not generally have precise information on what the

train is carrying (journey purpose of passengers, commodity in the case of freight).


Fig 1 Typical Freight Access Charges € per train-km in 2008

Source: International Transport Forum (2008), Charges for the Use of Rail Infrastructure, OECD, Paris.

Fig 2 Typical Access Charges for high speed passenger trains € per train-km in 2008

Source: International Transport Forum (2008), Charges for the Use of Rail Infrastructure, OECD, Paris.


In practice there is a wide variety both of structures and levels of charges to be found in

Europe. Fig 1 shows typical freight charges as in 2008. It will be seen that whilst some

countries of Western Europe just charge short run marginal cost (or less), others,

typically in Eastern Europe, impose large mark-ups in order recover total cost. There are

similar differences in charges for passenger trains, particularly for high speed trains (fig

2).

So far we have discussed how track access charges may be used to give appropriate

incentives to railway undertakings. How far can they also be used to give appropriate

incentives to the infrastructure manager, in terms of the quality and capacity of the

infrastructure it should deliver? The answer is, if based on the principles outlined above

and which are embodied in European legislation, not much. Where some traffics carry a

mark-up on short run marginal cost, that might give some incentive to attract more

traffic of the type in question. Where charges are simply based on short run marginal

social cost, there is no incentive to improve capacity or quality at all.

It is sometimes argued that therefore charges would be better based on long run

marginal cost, with the infrastructure manager being reimbursed for the capital cost of

expanding capacity or improving quality of service. It is difficult however to specify this

as a price per path, as infrastructure changes are subject to major indivisibilities and

joint costs. Moreover, charges based on long run marginal cost would not encourage the

use of spare capacity, which might exist for prolonged periods of time after an

enhancement or before renewal on a smaller scale, or assist in rationing capacity where

it was scarce even at long run marginal cost prices. What would make more sense is for

access contracts to be based on a two part tariff, with a fixed part negotiated to cover

the avoidable costs of the capacity ordered and a variable charge reflecting the short

run marginal cost of actually running the trains. This would give the railway undertaking

the right incentives both in terms of the quality and capacity of the infrastructure it


ordered and in terms of the services to actually operate. A similar approach might be

taken to charging for the use of national infrastructure by regional authorities. However,

it is problematic where there is more than one operator competing for the same traffic

– what share of the fixed charge should each operator pay – and is generally regarded

under EU legislation as discriminating in favour of the larger operator. Thus such a two

part tariff is only to be found for franchised passenger services in Britain, where (almost)

all services are franchised and the fixed part of the tariff is not negotiated but is the

same whoever wins the franchise.

In the absence of such a two part tariff there may be a serious problem of misalignment

of incentives regarding investment. The infrastructure manager has no incentive to

invest in increasing capacity unless it receives a share of the resulting revenue. We will

consider other ways of incentivising the infrastructure manager to invest in section 6

below. On the other hand with much investment paid for by government, to both the

infrastructure manager and the railway undertaking it is a free good and they will have

an incentive to argue for the best infrastructure possible, regardless of whether the

benefits exceed the costs. We return to this issue in discussing the McNulty report and

alliancing in section 8 below.

It will be apparent from this discussion that the efficient setting of infrastructure

charges is a complex matter. To the extent that the regulator is simply concerned with

ensuring that charges are non-discriminatory, this may not be too big a problem,

although it is possible for discrimination to occur indirectly in complex ways, for instance

if the charges favour traffics where the incumbent is strong rather than where it is weak

and serve to block entry in the latter case. But if the regulator has a wider remit in terms

of promoting efficiency then their concern with track access charges will be much

greater. They will need access to detailed information about how charges are

determined and the data on which they are based, and they may need to do


independent studies to verify the appropriateness of the level and structure of charges

proposed by the infrastructure manager.


7. Performance regimes

An appropriately calibrated performance regime, with penalties for delays according to

their attribution, and with equivalent measures regarding track closures for

maintenance work, should do much in terms of incentives. For the infrastructure

manager, it gives appropriate incentives about maintenance and investment in order to

ensure reliability (including dealing with growth in demand in a way which avoids

increased unreliability), and about how and when to do the work (long closures versus

short, day versus night etc). For the train operator, it gives appropriate incentives

regarding its own maintenance and investment policies to achieve reliability.

But it does have some problems as well. Firstly, really to give the right incentives, it

needs to be very detailed. The cost of delays varies, in particular with train loads but

also with the mix of journey purposes or commodities, so different values are need by

route and time of day as well as type of train. The cost of track closures leading to

diversion or bus substitution is of course even more variable. As often in financial

incentives, there is a trade-off between accuracy and complexity. Moreover, there is a

conflict between compensating the train operator, for which the charge should be based

on the lost net revenue, and giving the correct incentive from the point of view of social

optimisation, in which case the charge should also reflect social costs such as the

external cost involved in diverting traffic to car.

Secondly, if the track access charging regime gives no incentive to the infrastructure

manager to expand services, the performance regime may actually discourage

expansion. This is because operating at a higher level of capacity utilisation is likely to

reduce performance.

The other major issue with performance regimes was raised in Britain by the McNulty

study (2011). If the non-responsible party is fully compensated for delays caused by


another party, what is the incentive for them to work with that party to minimise

delays? For this reason, Britain is considering moving away from full compensation.

It is apparent from the above discussion that bespoke performance regimes for different

types of traffic may make sense. Again these will be relatively difficult in terms of

ensuring non-discrimination.


8. Regulation of investment

If it is the case that the infrastructure charging regime gives no incentives to the

infrastructure manager to invest in improving capacity or quality, then other regulatory

regimes are needed to do this. In some countries, such as Germany, this is achieved by a

multi-annual agreement between the government and the infrastructure manager,

under which the government provides funding, but in turn requires various outputs in

terms of quality and capacity. In others, such as Britain, this is part of the regulatory

regime.

In Britain, the regulator has imposed a licence condition on the infrastructure manager

that it must ‘meet the reasonable needs’ of its customers. In monitoring and enforcing

this condition, the regulator examines the adequacy of the infrastructure manager’s

investment plans and their implementation, and its performance in terms of punctuality

and reliability. The regulator also has an obligation to ensure that the infrastructure

manager has sufficient finance to fulfill its obligations provided that it does so efficiently,

and undertakes a periodic review of Network Rail’s costs and finances every 5 years (or

more frequently if required by unexpected changes in circumstances). Since the

government is the source of much of the funding, and also responsible to a considerable

extent for specifying the services that should run over the network via a comprehensive

passenger franchising system, the government is also heavily involved in this process. At

the start of the process, the government specifies what it requires of the rail network

(the High Level Output Specification) and the funding it is willing to make available (the

Statement of Funds Available). The regulator then determines the financial

requirements of Network Rail, considering what it might achieve in terms of improved

efficiency over the period in question, using top down benchmarking studies both

comparing Network Rail with infrastructure managers elsewhere in Europe and with

other industries, and also bottom up studies of actual working practices. Again, this


imposes the need for data, not just on the home country but also on peer group

railways, and is thus an area where cooperation between regulators across Europe is

important. Ultimately, the British Regulator is responsible for ensuring that the specified

outputs and the funding are consistent, if necessary by reducing the specified outputs.

The advantage of this over a negotiated contract is that the regulator is there as an

‘honest broker’, ensuring that neither party can pressurise the other into an agreement

which is not sustainable.


9. Alliancing

In Britain, the McNulty study (McNulty, 2011) was set up jointly by the Department for

Transport and the Rail Regulator to examine why rail costs in Britain have risen so much

in recent years and why they are so high relative to European best practice. Overall

McNulty concluded that the costs of the British rail system should be reduced by 30% by

2018/9 by comparison with European best practice. Of this some 2% might be achieved

by reduced transactions costs, and 2-20% (according to different case studies) by better

aligned incentives. The key point here is that, whilst charges to train operators in Britain

are designed to reflect the wear and tear caused by different types of vehicle and (very

roughly) the contribution trains make to congestion on the system, train operators do

not pay directly for the quality and capacity of the infrastructure they use. Moreover,

the franchising system protects franchised operators from any increase in Network Rail

costs in that any change in track access charges leads to an equal change in franchise

payments from or to the government. Thus they have no incentive to help or pressure

Network Rail to deliver capacity in the most cost effective way. The solution to this

problem was seen as closer arrangements between Network Rail routes and franchised

train operating companies, taking the form of alliances, joint ventures or even the

leasing of infrastructure to the franchisee. Different solutions were seen as appropriate

for different circumstances; for instance, the latter was only seen as appropriate were

there was a single dominant train operator, as there are in some parts of Britain given

the comprehensive franchising system and the dominance of passenger services.

The first step of this reform has been the devolution of many responsibilities within

Network Rail to a series of routes, with their own management teams and their own

accounts. The routes align as closely as possible with franchise boundaries and permit

much closer working relationships between infrastructure manager and train operators.

One quoted result of the benefit of this is that in one case Network Rail is helping to


finance the training of a train operator’s drivers on a diversionary route, which will

reduce delays and in turn reduce the compensation Network Rail has to pay the

operator for maintenance possessions. It is argued that, without close working

relationships in the field and the availability of a local budget such an arrangement

would have been unlikely.

Post McNulty, Britain is now experimenting with various forms of alliances to try to

optimise incentives. Such alliances might deal solely with particular issues, such as track

or station maintenance, or might be broader, ultimately covering all the activities of the

train operator and infrastructure manager within the stated area. The deepest alliance

so far negotiated in Britain is that of South West Trains, where a single management

team is responsible for both infrastructure and operators, although each party remains

a separate organization and retains responsibility for its own staff. South West Trains

and the Network Rail Wessex route have identical boundaries and the alliance covers all

the staff of both. A single alliance board brings together all the functions of both

infrastructure manager and train operator, so that issues are discussed with all points of

view represented. The Board and the Managing Director are responsible to both

Network Rail and Stagecoach (the owner of the franchise). A baseline forecast of costs

and revenues was agreed, and all differences from the baseline are shared equally

between the two parties. The result is already showing in better cooperation and faster

decision taking. For instance, South West Trains has agreed to change its timetable to

give Network Rail longer night time possessions in order to maintain the track in a more

cost effective way. Since both parties will share both the benefits and the costs of this,

incentives are now correctly aligned. Thus the correct alignment of incentives has been

achieved, without the difficulties of full vertical integration, in terms of compliance with

EC legislation (and also without the opposition of trade unions to what they would see

as privatisation of the infrastructure).


Although South West Trains runs by far the majority of the trains over the Wessex route,

there are other operators, both freight (Freightliner) and passenger (First Great Western,

Southern and Cross Country) using the route. If these were disadvantaged in any way by

the alliance then the regulator would have to intervene. In practice, timetabling and

allocation of capacity, network change (i.e. investment or disinvestment) and track

access charges, are determined by Network Rail centrally and are not formally part of

the alliance. So a separation of essential functions is achieved. This does not mean that

the joint management team will not discuss such issues, but that ultimately the decision

is taken elsewhere. Both parties are fully aware that if there were any suspicion of

discrimination against other operators, the future of the alliance would be threatened.

Other alliances are being negotiated around the country. Although none goes as far as

the South West one, they all have a binding legal agreement, sharing of costs, revenues

and risks, and shared resources. However, it is clear that this approach will not work for

all operators. For instance, the services over the Thameslink connection between north

and south London (currently operated by First Capital Connect) are a very important

part of the London commuter network and will grow in importance when many services

are added to them as a result of the current upgrading. But no sensible geographical

devolution of Network Rail could make these align with a single Network Rail route.

Similarly the Cross Country franchise inevitably cuts across a whole series of Network

Rail routes.


10. Conclusion

The first duty of a regulator in the rail sector is clearly to ensure non-discriminatory

access to the infrastructure for competitors. This is easier to achieve, although still

requires regulatory supervision, in a vertically separated system than an integrated one

of holding company. But a second duty of some regulators is to ensure efficiency in the

development and use of the rail system. This is actually rendered more difficult by

vertical separation, and careful thought needs to be given to the design of incentives to

achieve this.

A well designed track access charging system and performance regime can achieve

much. They can lead to appropriate incentives to the train operator regarding the design

of timetables and the rolling stock to use. They can also give appropriate incentives to

the infrastructure manager regarding punctuality and the efficient planning of

maintenance and renewals. However, they will need to be very detailed to achieve this

as well as a vertical integrated company can.

In this process the role of government will be crucial. By funding infrastructure, it can

ensure that necessary investment takes place, whilst allowing charges for its use to be

based on short run marginal social cost. By funding services, it can ensure that social

benefits over and above the revenue earned by train operators are taken into account.

But as we have noted, what remains missing in all this is a clear incentive for the

infrastructure manager and the train operating companies to work together to optimise

the system for the output they desire. Much of the cost of this rests with the

government. Solutions such as alliancing may assist in ensuring that all parties have an

incentive to play their part in achieving system optimality, and the example of the South

West Alliance is a very exciting development, in finding a way of aligning incentives

which does not require full vertical integration with the problems that would bring in


terms of European legislation. But such alliances can only work where a single operator

runs the majority of the trains on the route. Where a single operator has a major share

of the market nationally, the holding company model can achieve a similar alignment of

incentives provided that the holding company itself plays a sufficiently prominent role to

ensure that its infrastructure and operating subsidiaries do pursue the efficiency of the

system as a whole rather their own separate financial goals. It remains the case that

ultimately it is the government who, either through the negotiation of a multi-annual

contract or through regulatory supervision must ensure efficient design of investment

and delivery of operations. Thus benchmarking studies are crucial in this process.


11. References

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Caves, D.W., L.R. Christensen, M. Tretheway and R.J. Windle (1987) ‘Network effects and the

measurement of returns to scale and d1ensity for US railroads’, in: A.F. Daugherty, ed.,

Analytical studies in transport economics. Cambridge: Cambridge University Press, 97–120.

Crozet, Y., 2007. Infrastructure charging within the French railways sector: a new challenge’’.

Presented at the 11th World Conference on Transportation Research, Berkeley, June 2007.

IBM (2006) Rail Regulation in Europe: Comparison of the status quo of the regulation of rail

network access in the EU-25 countries, Switzerland, and Norway, IBM, Zurich.

Johnson, D.H.and Nash, C.A.(2008), Charging for Scarce Capacity: A Case Study of Britain's East

Coast Main Line, Review of Network Economics, Vol.7, issue 1, March 2008, pp53-76.

McNulty, Sir R (2011) Realising the potential of GB Rail: final independent report of the Rail

Value for Money study. Department for Transport and Office of Rail Regulation, London

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Nash, C (2005) Rail Infrastructure Charges in Europe, Journal of Transport Economics and Policy

39(3) 259-278.

* Swedish National Road and Transport Research Institute, Department of Transport Economics,

Box 920, 781 29 Borlänge, Sweden. ** Institute for Transport Studies, University of Leeds, Leeds

LS2 9JT, UK.

Smith, A., Nash CA and Wheat P (2009) ‘Passenger rail franchising in Britain: has it been a

success?’, International Journal of Transport Economics, 36 (1) 33-62

Wheat, P, Smith A and Nash C (2009) Rail Cost Allocation for Europe. CATRIN Project Deliverable

D8, VTI, Stockholm.

Wheat, P.E. and Smith, A.S.J. (2010). ‘Econometric Evidence on Train Operating Company Size’,

Report for ORR, Institute for Transport Studies, University of Leeds.

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