A recent report from the rail regulator will significantly change the revenue levels of Railtrack plc, owner of Britain’s tracks, signals and stations. Unfortunately, many of the regulator’s generous reforms may not necessarily improve the company’s abysmal record of performance and safety.
At the end of last month, the government-appointed rail regulator, Tom Winsor, announced new financial controls that will increase Railtrack’s £2.5bn revenue stream. The regulator’s financing framework will determine the level of Railtrack’s track access charges for the next five years.
The charges are critical to the company’s financial fortunes since they amount to nearly 90% of Railtrack’s revenues. In the aftermath of the Hatfield disaster the regulator’s revised financial structure takes on far greater significance.
- Railtrack’s current pricing framework is due to expire early next year.
- The method of determining the track charges has not impressed the regulator.
- He believes the current regime is ‘shaky and not fit for its purpose’.
The track charging methodology is, at best, imprecise and, at times, wholly inaccurate. Additionally, there are few financial incentives in the track charges to encourage Railtrack to improve efficiency.
Although the changes are an attempt to remove some of the worst anomalies of the current regime, it is by no means certain that the new framework will be a significant improvement. The revised charges have simply introduced another batch of accounting problems and some weak regulatory controls.
The new regime is hideously complex. But on virtually every issue the regulator has taken a lenient and generous approach toward Railtrack.
Overall, the key control mechanism of the revised charging framework is centred on determining a rate of return applied to the so called Regulatory Asset Base (RAB).
The return on Railtrack’s capital employed is not based upon the conventional definition of a company’s net assets. The practical difficulties involved in identifying and valuing Railtrack’s assets have proved insurmountable.
The company’s asset register is notoriously inaccurate and incomplete.
Instead, a proxy measure is used to determine the asset values. The regulator has calculated the RAB on the market value of Railtrack’s debt and equity on the first day of trading. The value of the equity and debt is then subject to an ‘uplift’ to compensate for an artificially low flotation valuation. It was claimed the depressed flotation price arose because of political and economic uncertainty and did not reflect the value the company.
The amount of this uplift has caused considerable dissension between the regulator and Railtrack. The method by which the regulator calculates the uplift is weak and contentious. Essentially, the regulator examined different periods of time over which the political risks ‘unwound’ after privatisation. Eventually, a 15% uplift was selected – when it was deemed that the privatisation process was fully completed.
Even this 15% uplift is at the top end of expectations. In his earlier consultative report, the regulator suggested a much lower and more realistic uplift of 10%. Railtrack has even disagreed with the regulator’s generously high 15% uplift. The company has demanded an excessive, and rather arbitrary, 23% uplift. At one stage, Railtrack wanted a farcical 60%.
There are also major difficulties in deciding the extent to which backlog expenditure, future renewals and enhancement of assets should be added back to the RAB. In an enormous concession to Railtrack, the regulator has permitted an additional £2.5bn to be included in Railtrack’s RAB.
In total, after allowing for equity uplift, debt, backlog spending, renewals and improvements the RAB is set to rise from £5.5bn in 2001 up staggeringly high £7bn in 2006. This increase represents over a £1bn more than the regulator’s draft proposals earlier this year.
The second key component in determining the overall level of charges is the company’s cost of capital. The weighted cost of capital is used to determine the rate of return on the RAB. In a similar approach used with other utilities, the regulator has used the Capital Asset Pricing Model to calculate the cost of equity. The regulator has finally set the company’s pre-tax cost of capital to be eight per cent. Winsor needed to ensure the rate of return was sufficient to enable Railtrack to raise finance ‘without undue difficulty’. Even so, the eight per cent is unduly high. Considering the risks, and compared to other utilities, this return is excessive.
The regulator had initially considered a return of around 7 to 7.5% to be adequate. But Winsor has conceded to some of Railtrack’s more exaggerated demands for the eight per cent return. Compared with other privatised utilities, eight per cent remains too high. Others, such as the electricity industry, are regulated on a return of 0.5% to 1% less than Railtrack.
The new controls will impose tighter efficiency targets. But Winsor has accepted Railtrack’s arguments that efficiency savings should be at the lower end of the initial range of three to five per cent. The net target savings will amount to a 3.1% over the next five years.
Generally, most of the efficiency savings are woefully lax. These targets are undemanding and unchallenging. Other privatised utilities have achieved far greater efficiency gains at a faster rate. There is no reason why Railtrack cannot be set a more ambitious target – even up to five per cent per year for the next five years.
Overall, the net impact of the regulator’s charges has lead to an immediate 35% increase next year in Railtrack’s revenue, followed by further real increases of five per cent pa for the four subsequent years.
Most of the increased revenue will come from the TOCs who will pay higher track charges. The government is also channelling in #4.7bn of government subsidies over the next five years. This is nearly #900m more than anticipated in the regulator’s earlier discussions. To help ensure these funds find their target, the Treasury will allocate this directly to the Strategic Rail Authority (instead of the TOCs). The SRA will then distribute the subsidies to Railtrack.
In almost all areas Winsor has treated Railtrack extremely leniently.
More of the sources of funding will now be dependent on the taxpayer and passenger. The shareholders have escaped very lightly. Threats of an emergency rights issue have subsided in the face of substantial government support.
In revising Railtrack’s track charges, the regulator was presented with an opportunity to reform a rather inept, complacent and poorly motivated company. Admittedly, the regulator’s revised charging methodology is some improvement on his predecessor’s calculation of track charges, but there are still considerable weaknesses. The RAB and the permitted rate of return are excessively high and the efficiency targets are too modest.
Railtrack’s shareholders have been given undeserved priority at the expense of the taxpayer and passenger. The Hatfield accident must be a watershed. Never again must safety become subordinated to profit and performance.
The regulator’s undemanding reforms on return on capital should permit the company to raise more capital funds. This investment opportunity must not be wasted. Railtrack has run out of chances; the public will accept no more excuses.
John Stittle is senior lecturer in accountancy at Anglia UniversityCorporate killing: What price a life?