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Protecting the long term public interest in Melbourne’s rail franchise Issues Paper No. 8, February 2017

About Melbourne Sustainable Society Institute (MSSI) Issues Papers MSSI strives to inform and stimulate public conversation about key sustainability questions facing our society. Our Issues Papers provide information and trigger discussion about these issues. Each paper encapsulates the insights of a thinker or practitioner in sustainability. Although material is often closely informed by peer-reviewed academic research, the papers themselves are presented in a clear, discursive style that appeals to a broad readership. The views and opinions contained within MSSI publications are solely those of the author/s and do not reflect those held by MSSI, the University of Melbourne or any other relevant party. While MSSI endeavours to provide reliable analysis and believes the material it presents is accurate, it will not be liable for any claim by any party acting on the information in this paper. © Copyright protects this material.

Authors Dr John Stone is a Senior Lecturer in Transport Planning in the Faculty of Architecture, Building and Planning at the University of Melbourne. David Ashmore is a transport policy and regulatory specialist with over twenty years of international experience and is currently based at the University of Melbourne. Yvonne Kirk is a researcher in transport planning and policy at the University of Melbourne with a special interest in the structures of governance and management required to improve public transport performance. For further information, or to provide com-ments or feedback, please contact Dr John Stone at stoneja@unimelb.edu.au.

Acknowledgments This paper focuses almost exclusively on the train franchise currently held by the Metro Trains Melbourne consor-tium. A similar franchise also exists for tram services, but for reasons of space and clarity, we have concentrated our analysis on the train franchise. Thanks to staff at Metro Trains Melbourne and Public Transport Victoria for making valuable data available and for very useful comments on previous drafts. Thanks also to Professor David Hayward and Eric Keys for constructive reviews, and to the Melbourne School of Design for support through the Transport, Health and Urban Design Research Hub. Thanks to Professor Brendan Gleeson and Melbourne Sustainable Society Institute for the opportunity to make this paper publicly available.

Citing this paper Please cite this paper as Stone, J., Ashmore, D. & Kirk, Y. 2017 ‘Protecting the long term public interest in Mel-bourne’s rail franchise’, MSSI Issues Paper No. 8, Melbourne Sustainable Society Institute, The University of Melbourne.

ISBN: 978 0 7340 4949 0

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IntroductionIt is nearly 30 years since the wave of neoliberalism swept through the government institutions that had managed Victoria’s public utilities with varying degrees of success over many decades. The pri-vatisation of Melbourne’s train and tram systems, begun in 1999, is currently unique within Australia as it represents the only outsourced urban rail system in the country. In Europe and North America it is also unusual - public sector delivery of complex urban rail systems tends to be the norm (Mees 2010).

For some supporters of neoliberalism, the Melbourne tram and train franchises, by keeping track and rolling stock in state ownership, may be seen as a sophisticated attempt to address some of the problems that followed from more radical assets sales and deregulation in the rail systems of New Zealand and the UK (Abbott and Cohen 2016, Clark 2011). For the sceptics, even this lighter touch, in which only the operations and maintenance of complex urban transport systems are contracted to a private consortium, is a recipe for regulatory capture and erosion of the public good (Mees 2005).1

Locally, the performance of the Melbourne model is under scrutiny for two reasons. First, some are suggesting the expansion of the Melbourne franchising model to the Sydney and regional NSW passenger rail services (Clayton Utz 2016), systems currently provided by the public sector. Second, Melbourne’s existing rail franchisee has now entered sole negotiations with the State Government, for a seven-year extension on contracts first signed in 2009.

This paper aims to identify the issues at stake in these negotiations and to suggest improvements to existing contracts to protect the public interest. It begins by setting the Melbourne franchise model in an international context and describing the key features of the current contracts. We then highlight major issues of concern that emerge from an analysis of publicly available data, and suggest possible solutions. We explore ways in which the current contracting model provides incentives for the par-ties to act in particular ways that do not always produce beneficial outcomes for users of the system, and where change is needed to better serve the public good.

The Melbourne model in an international contextProponents of neoliberalism hold that private sector delivery of public services is inherently more ef-ficient than direct state control from both an ideological perspective (Amos 2004) and from a political perspective (European Commission 2013). Others, like former advocate, Australian Competition and Consumer Commission Chair Rod Sims, may support the principle but observe that the promise has not been fulfilled, ‘governments have created private monopolies without sufficient regulation to stop those monopolies from overcharging users’ (Hutchens 2016, Hatch 2016). In the transport sector, the most radical moves to deregulate urban and regional rail and bus services took place in Britain and New Zealand in the 1980s and 1990s.2 Bowman et al. (2013, pp.14) suggest that:

Rail privatisation created a situation whereby risk and investment averse private companies positioned themselves as value extractors, thanks to high public subsidies. Government effec-tively took the operating risk, covering operating deficits and supplying investment funds.

Nevertheless unpicking the complex web of contracts makes reversing privatisation a daunting task for any politician, even if the problems are deep-seated and there is some popular support as appears to be the case for the Labour party’s renationalisation position in the UK. It is also worth noting that it took decades to implement a reform package for the New Zealand privatised bus market to address problems of concentration of services on well patronised routes and to establish a greater degree of market contestability (Ashmore and Mellor 2010, Auckland Transport 2016).

Counter to the faith in the market is research that explores the institutional arrangements underpin-ning public transport systems in the developed cities that have done the most to provide effective

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alternatives to the private car. In these cities, in continental Europe and Canada, strong public organisations have managed the operation, maintenance and capital development of complex urban rail systems, while the private sector, if present at all, is restricted to delivery of some bus services within publicly planned intermodal networks (Mees 2010). This empirical perspective suggests that reform of public transport management in Australian cities requires strong public sector capacity and robust public control of strategic and tactical policy decisions.

In an international context, Melbourne’s current franchising model is a seemingly modest one; operations and maintenance have been contracted to a private consortium for an initial period of eight years, with a rollover provision for a further seven years, subject to meeting pre-determined performance benchmarks. The intention is to let new tenders at the expiry of the franchise in 2023. Strategic planning responsibility remains, with the state. The roles of the parties are documented in the franchise contracts (Public Transport Victoria 2012).

This model differs from other nations such as the UK by keeping the assets in state ownership, something that is designed to ensure lower barriers to the entry of competitors at tender points. In Melbourne, assets are owned by the state through VicTrack and leased to Public Transport Victoria (PTV), who then sub-leases them for the life of the franchise. During this period, the franchisee is responsible for operating trains to a stipulated timetable and level of performance, maintaining the assets as detailed in an ongoing asset management plan for both rolling stock and fixed infrastruc-ture, and providing capital works as needed. The government shares with the franchisee the revenue risk associated with fluctuations in patronage due to extraneous circumstances such as economic downturns. This is done via a ‘cap and collar’ arrangement: the franchisee is guaranteed a minimum level of revenue but the state can take back a percentage of revenues if these grow above an agreed threshold (PTV 2012).

The first period of the current franchise began in 2009 when the Metro Trains Melbourne (MTM) consortium replaced the previous operator, Connex, after a period of heightened political contro-versy due to over-crowding and poor service performance following unexpected patronage growth (Stone 2010). The MTM consortium comprises Mass Transit Railway (Hong Kong), 60 percent equity; construction company, John Holland (whose parent company is now the state-owned China Communications Construction Company), 20 percent equity; and rolling stock construction and maintenance company, UGL Rail (formerly Alstom), 20 percent equity. Reflecting the growing glo-balisation of infrastructure businesses in recent years, the two maintenance and construction compa-nies have undergone rapid internationalisation since the formation of the consortium in 2009.

MTM have three contracts with the government: a franchise agreement for service operations and rolling stock maintenance (said to be at a fixed cost of $500 million per year); an infrastructure lease to provide track maintenance (said to be at a fixed cost of $270 million per year); and a projects agreement which offers capital works and renewal on a per project basis (said to be a variable-cost contract with a negotiated profit margin, $400 million per year). These contracts, tendered as a package, are shown in Table 1.

Table 1: MTM’s contracts with the PTV. (Source: email from MTM to the authors, 9 August 2016; reproduced with permission from MTM).

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Melbourne’s contract performance is measured through outputs. Output-based contracts (as de-scribed in UK Department for Transport 2012) are concerned with what a contract produces, not how the outputs are actually produced. The Melbourne contract contains various output measures includ-ing on-time running, cancellations, and asset availability. If operators exceed the contractual targets they are offered a bonus, failure to meet them incurs symmetrical penalties. Performance against these targets is a significant consideration in decisions over contract extensions.

A key assumption of procurement models of this type is that maintenance risk can be passed to the private sector when it is taking operational performance risk. For this to work in practice, the opera-tor must be motivated by the risk of penalties for poor on-time running to a sufficient extent that they will maintain the assets to a sufficient standard. This may hold true over the life of a 15-year contract, but an operator arguably has less incentive to consider the life of assets beyond the contract period. The Victorian Auditor-General’s Office (VAGO) has recently identified this as an important issue in Melbourne:

We found significant weaknesses in how PTV oversees the maintenance and renewal of assets leased to its franchisees under the current agreements. In particular, PTV does not have adequate medium to long-term asset strategies for its train and tram network assets. PTV also does not know enough about the condition of the assets used across both the tram and train networks. The lack of meaningful information about asset condition reduces PTV’s capacity to appropriately plan, budget and prioritise maintenance and renewal work. (VAGO 2016, pp. ix)

Railway asset maintenance backlogs can run to hundreds of years of deferred investment, and so long-term asset condition must remain a responsibility for the state. Given this is the case, how can this responsibility be fulfilled under a short-term franchise? Despite its importance, this question has received scant research attention. The only reference the authors could find on the topic came from Balfour Beatty’s (2016) submission to the Shaw Report on Network Rail in the UK, which identified a tension between short term franchises and long term asset management incentives without suggest-ing a solution.

Scant public information on rollover criteria We understand that MTM was informed in December 2015 that relevant performance benchmarks had been met and that negotiations on conditions for a contract rollover for a second term of seven years would begin late in 2016. In order to meet the rollover criteria, the franchisee was required to meet five performance benchmarks each year, two for reliability and customer service, three oth-ers agreed between PTV and the franchisee annually. On 30 September 2016, the State issued an invitation to negotiate (ITN). The ITN document, though not in the public realm, apparently lays out the timetable for the negotiation process, and any changes PTV wishes to make to the contract in the second term. Negotiations will be on an ‘open book’ basis comparing the submitted bid to an efficient operator comparator costing model.

The PTV franchise negotiations team have informed us ‘they are not at liberty’ to reveal either details of the three variable performance benchmarks, or communications documenting the rollover. The recent report from the VAGO states:

The current agreements give franchisees an exclusive right to negotiate a seven-year extension of their agreement with the state, as long as they meet certain performance benchmarks. In December 2015, PTV assessed that both franchisees met the required benchmarks. However, PTV could not provide evidence to demonstrate the rationale for some of the benchmarks and how they were assessed. (VAGO 2016, pp. ix)

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Operating performance and legacy assetsMTM suggest that their operating performance has improved over the life of the franchise (Figure 1), an assertion which is corroborated in PTV’s public performance reports, Track Record (PTV 2016).

Figure 1: On-time running 2004-2015. (Source: Metro Key Statistics, provided by MTM to the authors in January 2016. Reproduced with permission from MTM).

This may indeed be the case for the overall summary figure for on-time performance, but the picture seems more complex than this. This is because according to Carey (2015a, 2015b) the on-time per-formance has been achieved through running incomplete services and maximising performance in the less crowded off peak periods rather than the all-important peak periods when the trains are full:

In the 18 months to September 2015, MTM received $16.7 million in incentive bonuses… achieved in part by… running hundreds of incomplete services……Metro ran just 85 per cent of trains on time in the morning peak and 89 per cent of af-ternoon peak services were punctual… By contrast, it ran 95 per cent of trains on time on Saturdays and Sundays when patronage is lower and services are less frequent… helping the company to avoid paying out customer compensation to monthly and yearly Myki pass holders. (Carey 2015a, 2015b).

The contracts do include complicated formulae for Passenger Weighted Minutes: an attempt to relate delays to the number of passengers affected. These are not part of the publicly reported performance measures. MTM get bonuses for exceeding targets, and incur a penalty for failing to meet targets.

The practice of skipping stops to meet punctuality targets has received considerable media attention in Melbourne. Standard practice in German-speaking Europe is for adherence to the timetable to be measured at every scheduled stop, although vehicle location systems make measurement a less costly exercise than it would probably be in Melbourne.3

The State Government has already indicated in many media reports that tighter performance stan-dards will be pursued in the current negotiations.

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EscalationThe nature of the subsidy payments to Melbourne’s rail operators has changed noticeably over time and often lacks consistency in reporting. Figure 2 shows the variation in reporting categories and their often opaque and shifting labels.

Figure 2: Payments to train franchise operators 2000-2014 (PTV 2016).

Figure 2 also shows the three distinct phases of franchising. In the first phase, from 2000-2003, the system was divided into two with separate contracts awarded to National Express and Connex under net cost arrangements. Revenue risk remained with operators and they bid on a ‘net subsidy’ basis: fare revenues went straight to the operators and so were not included in the publicly reported payments. These early bids were based on ambitious patronage growth projections and consequent reductions in subsidy payments as can be seen in the 2003 data (Mees 2005). Faced with loom-ing losses, National Express cancelled the contract, and the government, faced with the prospect of severe disruptions to services, felt that it had no option but to enter new contracts with Connex (2004-2009). In this second phase, the revenue payments were adjusted to reflect actual levels. The franchise was operated on a ‘cost plus’ basis (the ‘plus’ being performance bonus incentives). Ticket-ing revenue was added back into the publicly available data, allowing the full payment stream to be captured.

After a tender process in 2009, the franchise was transferred from Connex to MTM and a ‘cap and collar’ was introduced. Under this arrangement, a revenue ‘cap and collar’ insulates the operators from significant drops in fare revenue, and ensures that the government benefits from significant growth. In addition, over the period of the introduction of the Myki smartcard ticketing system, revenues were guaranteed by the state (shown in the light red and orange bars on the graph). This guarantee was in place until 2013. Since 2013, ticketing revenue has been paid direct to the operator

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and is no longer reported quarterly by PTV. A total revenue payment from Myki to operators is now reported in PTV’s Annual Report, but this payment is not broken down by individual operators (PTV 2015). This change makes it impossible to draw conclusions about payment trends to individual franchises since 2014, and into the future.

Beyond inconsistency in reporting categories, it is clear that costs have been rising, primarily in maintenance and capital works. It may be easy, given the obvious age of Melbourne’s rail infra-structure and evidence of many years of under-investment, to provide a summary justification for the increase in spending; however there is no publicly available evidence of improvements in operating performance or reduced asset maintenance backlog. It would be interesting to discover if evidence of long-term benefit through increased maintenance renewal expenditure is one of the commercially confidential performance benchmarks considered in making the contract-rollover decisions.

It is also of concern that the capital asset renewal and maintenance spending have been merged into a single public reporting category since 2013. This is made clear in Figure 3. This goes against transparent and accountable book-keeping practice.

More importantly, the blurring of asset renewal and maintenance payments may be obscuring cross-subsidies between the three contracts under which MTM operates. As described earlier, two of these contracts are ‘fixed price’: one for service operations and rolling stock maintenance, and a second for infrastructure maintenance (track, power supply, signals), including some aspects of renewal. The third is a contract for capital works on the network on an ‘as needed’ basis (at pre-agreed rates) through discussions between PTV and MTM.

MTM assert that the greatest single contribution to their overall profit margin is made from these projects (Figure 4). This raises the issue of cross subsidisation between service provider contracts and its potential impact on market contestability. Some argue that cross subsidisation allows flex-ibility within a contract, an ability to extract best value from a contractor. Copley (2016) for exam-ple, sees cross subsidies as an essential benefit of the London social housing market. Others believe there is a risk an incumbent may be in a position to allocate costs advantageously in future bids to distort market mechanisms which are supposed to protect the public interest. O’Connell (1995) sees cross subsidisation in multi-product firms directly affecting market contestability as each product may not be offered at true marginal cost so affects optimal allocation. Heald (1996) stresses the need for clarity in the analysis of franchisee costs by the contracting agency. The PTV have informed us that they make a rigorous assessment of an ‘efficient’ operator price model during the bidding phase.

Figure 3: Merging of capital grant and maintenance payments from 2013 (PTV 2016).

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However, on publicly available evidence, we do not know if each of the three current contracts are profitable in isolation, or if the capital works contract is helping to prop up the others. In general, railway capital works contracts of this type are vulnerable to exploitation through contract variations after the initial bid (Alexandersson and Hulten 2003).

Figure 4: MTM profit breakdown. (Source: Metro Key Statistics, provided by MTM to the authors in January 2016. Reproduced with permission from MTM).

Note: OPR = Operational Performance Regime, bonuses for exceeding contract specifications in train operations; it is not clear what activities make up Business Development.

Protecting the public interest?There are many components of the planning, management and operation of a complex rail system that can be contracted to the private sector (Gomez-Ibañez 2003). The more that planning and man-agement is contracted out, the greater the dangers of installing a private monopoly and thus reducing the ability of the state to protect the public interest. This is because railways are a clear example of a natural monopoly. Figure 5 illustrates a hierarchy of attributes that can be contracted out.

Figure 5: The continuum of functions in the management of complex rail systems.

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There is some consensus in the literature that it is difficult to avoid monopolistic or other so-called distortions in the market if assets and other attributes below this on the hierarchy are taken out of state control. Often governments opt for negotiated solutions with incumbent operators, rather than tender services in areas where operators control strategic assets (Myers and Ashmore 2007). Under the Melbourne franchise model, assets have been retained by the state and leased to the operator, and revenue risk is shared under the ‘cap and collar’ arrangement. The red line in Figure 5 indicates this.

This would appear to indicate that Melbourne has adopted only a light-touch arrangement through which one operator can be exchanged for another if the public interest is not being served. However, for the public interest to be protected, the theory requires that the market will be contestable at future tender points. A non-contestable market is one in which few, if any, credible companies offer up competitive bids against an incumbent. If this eventuates, the market in effect becomes a private monopoly with all the consequences of inefficiency and loss of mechanisms to protect the public interest.

Franchise bids cost millions of dollars to produce, so potential competitors will not enter a tender process if they perceive it to be a waste of time and money because the incumbent is unlikely to be usurped. This might occur under several illustrative scenarios as set out below.

1. The incumbent being able to shift overheads from one contract to another. The incumbent may then be able to offer a superficially attractive bid for one contract while receiving payment to cover its costs from another contract. Although PTV staff assure us that this is not the case, the public information on the structure of the three contracts held by MTM, as described earlier, is not sufficiently transparent for us to be certain that opportuni-ties for ‘cost shifting’ do not exist.

2. State agencies losing skills or them being captured by the incumbent private operator. Loss of skills often follows periods of instability or restructuring of the state agency that manages a contract. Capabilities in service procurement, performance management, plan-ning and engineering can drift to the franchisee, placing them at an advantage in their knowledge of the system. Regulatory capture is a process through which the state agency ends up looking after the interests of the franchisee over the travelling public. It is a func-tion of a government’s need to dissuade an operator from walking away, as well as an almost inevitable outcome of the professional relationships between purchaser and provider (Flinders and Buller 2006, Otáhal 2010). PTV did not have a clear mandate or an independent structure when it was set up by the State Government in 2011. It went through a long re-structure in 2015, and is now facing a new reorganisation with the creation of Transport for Victoria, which will take the strategic functions of PTV and VicRoads back into the Department of Economic Development, Jobs Transport and Resources (DEDJTR). Such processes are destabilising and have contributed to a loss of skills and corporate memory. Certainty over the structure and purpose of the state’s public transport agencies is prerequisite for re-building rail management capability.

3. The franchisee holding significant related contracts that extend beyond the franchise period. This can create barriers to competition because the incumbent has the advantage not only in a strategic or tactical sense from close and on-going relationships with the state agencies, but also because of a commercial advantage from having already invested in rel-evant plant and equipment. MTM has already made moves in this direction with its ‘market-led proposal’ in 2014, which could have given it significant long-term control of capital works and maintenance of large sections of the Cranbourne-Pakenham lines (Carey and Millar 2014). The ‘unsolicited’ or ‘market-led’ proposal is a new form of infrastructure project development through which

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Australian state governments seek proposals from the private sector and give favoured projects an accelerated path through formal planning processes.4 The MTM proposal was encouraged by the previous government but rejected by the current government soon after its re-election in 2014 (Cole 2014). More recently, John Holland–the large construction firm in the MTM consortium–has been awarded contracts for preliminary works on the Melbourne Metro Rail tunnel. They will have plant, skills, and knowledge ‘on the ground’ beyond the end of the franchise period of tenure, potentially adding up to a competitive advantage. Moreover, John Holland has only a few local competitors in the race for major works in this $11 billion project that will still be under construction when the current franchise contracts end in 2023. (Hepworth 2013, offers the view that the Australian construction industry does not encourage international bidders to compete for major infrastructure contracts.)

There is a risk that MTM’s $400 million per year ‘projects’ contract, and John Holland’s role in the Melbourne Metro Rail Tunnel, could play a role in lessening the contestability of future rail franchis-es, due to the incumbent having plant equipment, manpower, and system knowledge ‘on the ground’, at the time of tendering. If this was the case, then there could be an asset barrier (contrary to the assumptions of the model shown in Figure 5) and therefore the Melbourne model would appear less of a ‘light touch’ and more like a path to a potential private monopoly.

ConclusionRequirements for new contract negotiations and long-term protection of public interest

In this paper, we have set out some clear requirements for the current contract negotiations and posed questions for which further research is needed. These are summarised below.

First, despite the views expressed by PTV staff, we believe that issues of cost-shifting, cross subsidi-sation, and market contestability remain unresolved, and require further research. The risks associ-ated with cost-shifting can be countered by cost transparency in contract negotiations. We recom-mend clear and credible separation of the accounts for the operations, maintenance and capital works contracts, so that there can be no cross subsidisation between contracts and so create potential for MTM to under-bid future potential competitors.

Overall, the state will need to build confidence in the strength of its negotiating position by getting appropriate advice and support, but most notably by making the process and content of its agree-ments with MTM more publicly available.

Second, there is the much more complex issue of establishing greater state control of maintenance and asset renewal within the current franchise model. The first step is for the government to develop a clear strategy that articulates long-term goals for renewal of legacy assets, and then links this to clear, measurable and publicly reported short-term objectives and outputs stipulated in franchise contracts. For example, how many speed restrictions are there on the track and when can they be lifted? A similar objective is included in the infrastructure condition and development reports of the German Federal Railways Authority (EBA).5

More broadly, there are some fundamental problems with any attempt to manage and protect as-sets with working lives of 50 or 100 years through short-term franchises. A franchisee has contracts with typical spans of 10 to 15 years. It would be naive to imagine that a franchisee would give equal weight to considerations beyond their period of guaranteed tenure. A franchisee will seek to maxi-mise profits over a contract term and to do what it can to strengthen its position against potential competitors at future tender points; to do otherwise would be to neglect the interests of their share-holders. The question of how best to maintain legacy assets within short term franchise agreements

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requires further research.

Third, there is a need to strengthen public-sector skills in the management of complex rail systems. This is not just because it is necessary to make the changes to contract arrangements as described above, but it is also necessary because an alternative to a private monopoly future for Melbourne’s railways is the re-establishment of state control in 2023. If such an alternative was to be viable, the political and institutional task of creating the conditions for such a change will need to start now.

1 While it is important to understand the historical development of the Melbourne rail franchise through its three clear iterations since 1999, we have not given a detailed chronology here. This can be found in Stone (2010) and Stone et al. (2015).2 For an overview of global developments in rail privatisation and deregulation see Alexandersson and Rigas (2013), Beria et al. (2012), Nikitinas and Dailydka (2016), and Nash (2010).3 For details of the publicly available performance requirements in the MTM contracts see www.ptv.vic.gov.au/about-ptv/victoria-s-pt-network/performance-monitoring/.4 For the current Victorian process see http://www.dtf.vic.gov.au/Infrastructure-Delivery/Market-led-proposals.5 See www.eba.bund.de/DE/HauptNavi/Finanzierung/LuFV/Infrastrukturzustandsbericht/izb_node.html (in German)

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