Oral evidence: Intercity East Coast rail franchise inquiry, HC 891

Oral evidence, 16 July 2018.

Witnesses

Martin Griffiths, Neil Micklethwaite, Jo Kaye and Rob McIntosh.

Chair

Welcome and thank you for coming along this afternoon. For the record of our proceedings, can you introduce yourselves?

Jo Kaye

I am Jo Kaye. I am the managing director of the system operator part of Network Rail.

Neil Micklethwaite

I am Neil Micklethwaite. I am the commercial and business development director for the rail division within Stagecoach Group.

Rob McIntosh

I am Rob McIntosh. I am the Network Rail route managing director for the London north eastern and east midlands route.

Martin Griffiths

I am Martin Griffiths. I am the chief executive of Stagecoach Group.

Chair

Thank you. This is a question to Martin and Neil. We know that the east coast franchise has failed three times. I know it was not Stagecoach each time, but there seems to be a theme of overbidding in each of the cases. Do you accept that you, Stagecoach, with Virgin, overbid for the franchise?

Martin Griffiths

It is disappointing that the franchise terminated early in the circumstances that it did. We put together what we thought was an ambitious plan. It was ambitious. It was about transformation for the east coast main line, driven by more passengers and more revenue to deliver additional premium to the Government. Operationally, I am proud of all the things we have done, but clearly it is disappointing. The bid was put together at the back end of 2013 and 2014, and we regret that the passenger numbers we forecast have not materialised. Hindsight of course is a wonderful thing, and if we had our time again, given everything that we know now, we would look at it differently. We used the best economic indicators that were available to us and Government at the time; a wide array of experts were available to us and we have a track record of 20 years of operating railways in the UK. In partnership with Virgin, we have transformed the west coast main line, with the sort of passenger and revenue growth that we have seen there.

Chair

Do you think there was a failure to understand that east coast and west coast are fundamentally different markets, different sorts of franchise?

Martin Griffiths

No. There was always a recognition that they were different markets. A whole series of factors have come together since the bid was put in that, with hindsight, we did not see, and that has been disappointing, but I do not think it was just that they were different markets. Clearly, that was understood. A whole lot of sensitivities were run, and the Department for Transport, as well as complimenting me individually and the team corporately for the best bid they had ever seen, evaluated it as a financially low‑risk bid at the time.

Chair

It might have been a good bid, but you did not deliver on what you promised. Would you ever realistically have been able to deliver the nearly £3 billion in premiums that you set out in your bid?

Martin Griffiths

When the bid was put together, Madam Chair, it was with the intention of doing that. There is absolutely no incentive at all to overbid or to overestimate. Reputationally and financially, it has been very disappointing for us as a group, and for Virgin as our partner; absolutely. Of course, it was a bid predicated on a number of assumptions that were to drive the premium. Indeed, the way the bid was put together and the way the franchise was specified, the Government could have got more than that. They could also have got less. Actually, the one thing that was probably sure is that they would not have got £3.3 million, because, in a contract that should have gone on for eight years, a number of things were going to change, and the contract had the ability to vary that depending on those changed circumstances. We find ourselves now in a position that is, as I said, not what was envisaged at the start.

Chair

Let me clarify. You are saying you do not think you overbid. You think it was realistic to deliver £3 billion of premiums over the life of the contract.

Martin Griffiths

We are now in 2018. Back then, in 2013‑14, when we put it together, there was no incentive to overbid. It was put together in good faith, but at high cost, with some of the best advisers around and our own experience of bidding. Clearly, with the benefit of hindsight, I am disappointed at the way things worked out, but I do not think we can sit here now and say we would have made a different decision back then. At the time, we were confident in the projections, based on everything we knew at that time.

Chair

If you had put in a more conservative bid, do you think you would still have won the franchise competition?

Martin Griffiths

The franchises are competitively tendered. It would be for the Department for Transport to look at the bids they received and the evaluation of those. I cannot comment on that.

Chair

Did the way the Department structured the franchise, or the ITT, encourage you to make over‑ambitious bids?

Martin Griffiths

Clearly, there was an element of understanding their evaluation process, and the premium that was offered was an important part of that, but I go back to my statement that there is no incentive to overbid. The reputational and financial damage to our group has been very significant. On this one contract, Stagecoach Group will have lost about £200 million. To put that into context for the Committee, that is about a fifth of our current market capitalisation. The penalty has been very significant for us.

Chair

You have only been held to delivering the premiums you promised, and actually, because you left the contract early, you will not have delivered taxpayers the full premiums they were expecting to receive.

Martin Griffiths

If I could correct you, we did not leave the contract early. That was a decision for the Government.

Chair

The contract has ended early.

Martin Griffiths

It was the Government’s choice to do that, with us having satisfied the contract operationally and financially, and I am very comfortable that we did; we fulfilled all the obligations that were set. When the Government passed transfer of risk at the time of the contract, they knew what risks they were taking. We accepted those risks. It did not work out for us as we had hoped, but we honoured our contract in full.

Chair

But you would not have been able to honour your contract in full through to the original date set, would you? You would not have been able to pay the £3 billion-worth of premiums.

Martin Griffiths

That is what I am saying. The Government understood the risks that they were transferring to us. That is the model. The Government accepted that, in circumstances where the bid did not materialise—we regret that it did not; clearly, that is disappointing—to the extent that there was a shortfall, on this particular contract, there was no risk-sharing of downside, macroeconomic or any other, so the operator took the financial risk, but that risk was capped at an agreed amount when the contract was signed. They have not always done it that way and they will not do it that way in the future, I suspect, but we have honoured our contractual obligation in full.

Chair

No question. We will ask more questions about why you did not get your sums right.

Iain Stewart

Again, the questions are to Martin and Neil. You said that you based your projections, in good faith, on the best advice on assumptions you made about the duration of the franchise. Can you tell me a bit more about what assumptions were wrong, in the light of day?

Martin Griffiths

In the light of day, the thing that did not materialise was the growth in passenger numbers and therefore the growth in revenue. The big intercity franchises in this country have a very high fixed cost, and there is a very regulated service and output that you have to deliver. Everybody understands that when they bid, so on a franchise like this you have to deliver the revenue line. We have done extremely well, actually; we have outperformed the long-distance market, but we just have not made the sort of revenue and passenger numbers that we had assumed we would make when we put the bid together. There are a whole range of factors. We have a very different economic and political outlook right now. We went into, and are still in, periods of the lowest fuel prices we have seen in a long time. We are seeing structural changes in the market, in terms of people’s propensity to travel both for employment and for social purposes. I am encouraged to see that the Department is recognising that as well. In Peter Wilkinson’s evidence to the Public Accounts Committee, he acknowledged that; we are seeing the lowest rail revenue growth since the period of privatisation, for a whole lot of factors that have come together, and that is impacting the whole industry, so it needs to be looked at. Fundamentally, our revenue projections and our passenger numbers were lower than we had hoped.

Iain Stewart

Was there one particular causal factor for that lower number? Also, to clarify, you had growth in both passenger numbers and revenue; it just was not as much as you were anticipating.

Martin Griffiths

Yes.

Iain Stewart

Of all the factors, was there one in particular?

Martin Griffiths

No. It was all the factors I have said. The infrastructure was also a contributing factor, which I am sure we will come to. What we had assumed on the performance of Network Rail in that period was less than had been assumed as well, but that was dealt with through normal industry mechanisms. It was all of those factors. It is difficult to pinpoint one, but I am confident that the majority of the things that happened were outwith our control. All the things we said we would do, all of those that were bid, were put in: the management initiatives, the product itself, the upgrade of first class, the upgrade of standard class, the upgrade of the food offering, the extra seats and the extra destinations. What gave me great encouragement as we left the franchise in the last few weeks was that the revenue growth, while still below what we had assumed, is coming through strongly, and I am confident that the benefit of those initiatives will be there for the future franchisee.

Iain Stewart

What steps did the Department take to challenge the robustness of your assumptions when awarding the franchise?

Martin Griffiths

That is probably a question you have to ask them in terms of their approach to their evaluation, but, based on my experience over many years, they have a robust review process; they have highly paid and qualified advisers to help them; they clearly have the benefit of other franchises and what they are seeing in the industry; and, as I said, they evaluated our bid as financially low risk as part of that process.

Iain Stewart

You would say they have to take an equal share of the blame for the numbers being wrong.

Martin Griffiths

It is not a question of blame. At the end of the day, the numbers did not come through. That is disappointing. Rather than use the word blame, I think they have to accept the portion of the risk that was for them. To the extent that those numbers did not come through, they understood, or should have understood, the risk that that left with them.

Iain Stewart

It was fairly clear that in the period between the franchise being awarded to you and you taking over the franchise the numbers were going to be wrong from day one. Did you at any point seek to rebase the contract?

Martin Griffiths

It has been very clear for a number of years—probably going back to when franchises did not have as long a gap from bid and award to actual commencement—that the Department’s policy is that they do not rebase. We see it in other jurisdictions, but the Department for Transport’s policy is not to rebase, and we understood that.

Iain Stewart

You did not even attempt to approach them about it.

Martin Griffiths

It was raised with them by us and by the wider industry, and it was part of the discussion on Richard Brown’s review on franchising back in 2012‑13, but the Department’s position is that it does not rebase. As a bidder, you understand that. You have to accept that risk.

Iain Stewart

You do not even say, “It is worth our while to do this on a one‑off basis.”

Martin Griffiths

That would not get traction under their current policy.

Iain Stewart

Moving forward, do you think there should be processes for renegotiating contracts mid‑period? When changes have happened in the basic economy or the market, do you think there should be that flexibility in the franchise?

Martin Griffiths

I am on record as saying that I think the bid should be rebased to the start point. I think you should start with the actual revenues, but, again, that is not Department policy. I am encouraged, as we go forward, that the Department is now looking at the sharing of macroeconomic risk, and I go back to the fact that they did not do that to any meaningful extent on this franchise. We knew that when we signed it, so we accept our contractual responsibilities for that, and we have honoured them. But, if you go back to Richard Brown’s review on franchising, he made it very clear that risks should best sit with those able to manage or absorb them. In terms of macroeconomic risk, his firm view was that that should sit with Government. We took all of the risk—macroeconomic, management initiative and everything else on this franchise. As we go forward, I would expect to see that change.

Chair

Can I check this? You just said those numbers did not come through—revenue and passenger numbers. It almost sounds like you do not accept any responsibility for the outcome. Surely, as the franchisee, you were responsible for meeting the revenue and the passenger growth. That is why it is in the private sector.

Martin Griffiths

Yes. I did not want to give that impression. I am very disappointed and regret that our numbers did not come through. It was our bid; we put it together. I was trying to explain to you the background. You asked me why it had happened. There is no debate. It was our bid, and we stood by it at the time, as I said. It was ambitious, and it was all about fundamental transformation of the east coast main line. It was our bid, so I am not trying to not have responsibility for it. I was trying to give you an explanation of some of the reasons why it did not come through.

Chair

What were the assumptions you made that changed? You made reference to Network Rail’s part of what they delivered over the period you were running the franchise.

Martin Griffiths

There is a point of principle for me. I want to be very clear. At no time have I or, to my knowledge, anyone else said that any failure of Network Rail’s infrastructure upgrade or capability is responsible for the early termination of this franchise. That is not true.

Chair

What I said was that, in your evidence—

Graham Stringer

But Richard Branson said that.

Martin Griffiths

No, he did not say that.

Graham Stringer

I have the quotes in front of me. Branson said that.

Martin Griffiths

What Richard said it would come to was that there would be changes going forward that the infrastructure was not going to be delivered around what we had assumed in our bid for changes that would impact from 2019 onwards, but I want to be absolutely clear: the performance—

Chair

I was not asking you about that. Earlier, when you were answering Iain’s questions, you made some reference to Network Rail’s performance, and obviously you would have received compensation from Network Rail when the infrastructure was not available, as is normal. Can I check whether you believe that Network Rail’s performance over the period when you were running the franchise impacted on your revenue or passenger numbers?

Martin Griffiths

Yes, it did, significantly.

Chair

How significantly?

Martin Griffiths

As we exited the franchise, we had a claim against Network Rail for £72 million. My understanding is that liability was accepted, but the quantum was not accepted, for what we call sustained poor performance. That sustained poor performance dated back to a period even before we took over the franchise, when it was previously operated by DOR. We had an obligation, from a taxpayer and a Government point of view, to pursue that claim. That claim has passed on to the new operator and it will be for them to decide what to do with it.

Chair

Do you believe that Network Rail’s poor performance, in terms of delivering the day‑to‑day operation of its infrastructure, impacted on your revenue or passenger growth, other than the part that is compensated for in the normal way from Network Rail—that £72 million? Do you think that you had greater costs as a result of its poor performance than the amount you are due in compensation?

Martin Griffiths

No. That claim was to try to put right what we thought was due to us during that period.

Chair

The amount that you would have lost as a result of Network Rail’s poor performance in delivering the infrastructure, or when things went wrong, has been covered by the compensation that is payable in the normal way.

Martin Griffiths

Yes. There are three mechanisms—schedule 4, schedule 8 and sustained poor performance. Schedule 4 and schedule 8 are settled in the normal industry course. There can be a dispute at any point in time, but, as the franchise went on, we got better at agreeing those. Sustained poor performance, as I said, is in addition to that and was liability-accepted, in terms of my discussion with the chief executive of Network Rail, but the quantum was not accepted. That £72 million was outstanding when the franchise ended.

Chair

If you had received the £72 million, would you still have used up your parent guarantee or not?

Martin Griffiths

We would have gone on for a bit longer but the parent guarantee—that is the point I was making, I am sorry, when I interrupted you—was only a factor in the whole range of issues that meant the franchise terminated earlier, but we would have gone on longer.

Ronnie Cowan

I want to come back to the point you made about macroeconomic risk. You stated that the Brown review recommended that franchises should only be responsible for the risks they can manage. Do you agree with that?

Martin Griffiths

As a principle, yes.

Ronnie Cowan

In the real world, do you agree with that?

Martin Griffiths

Yes. This type of contract has a fixed‑cost base and therefore you are very revenue dependent, so it is very difficult for us to take responsibility for all the macro factors that impact the revenue base. That is what Richard Brown was saying.

Ronnie Cowan

In the process of this franchise, where was that macroeconomic risk spread? Did you say you took it all on?

Martin Griffiths

We took it all, yes. There was no risk-sharing of any downside with the Department from the bid on this franchise—none.

Ronnie Cowan

How was that split between yourselves and Virgin?

Martin Griffiths

Between ourselves and Virgin, we took 90% of it and Virgin took 10% of the parent company guarantee. That was, effectively, the way we did it. That was the Government’s protection for their downside. In other franchises, they have risks shared where it has been a macroeconomic risk, and we used to have things called cap and collar and revenue support. They did not have that on this franchise.

Ronnie Cowan

Does anyone have anything to add?

Neil Micklethwaite

On the macroeconomic risk, since we put the bid in nearly five years ago, a number of things have changed, as Mr Griffiths said. This is a very discretionary-based franchise in terms of the travel; only about 3% of it is season-ticket based. At the time we put the bid in, car fuel prices were about £1.40 at the pump and not long after they were closer to £1, so the car became more attractive. We have also seen that GDP did not do what we expected it to do at the time. A lot of highly skilled consultants and professionals were part of the process of not predicting how GDP would turn out, and how average weekly earnings have not grown as we expected, due to a lot of political and economic uncertainty.

Ronnie Cowan

You said that when you bid for the contract you did not overbid, but, in taking on that macroeconomic risk, were you not in fact loading the bid?

Martin Griffiths

It was our bid. We made assumptions at the time that of course we thought were deliverable, but clearly we also took into account that the risk transferred to us was capped at a certain amount. That was how the Government structured this particular contract. That is how they wanted to do it on the east coast main line franchise that they let at that time. Yes, we knew that potentially there was downside risk, but that risk contractually for us was set at our parent company guarantee plus some bonding that we had to put up.

Ronnie Cowan

I am a bit confused, to be honest with you. You are saying that you did not think the risk should be transferred to you in the first place but you then took on the risk as part of the bid.

Martin Griffiths

No. Let me be clear. There would be no point in having the private sector there in the first place if we did not take risk. We should take risk, absolutely. We are taking risk and we took a lot of risk—significant risk. I have highlighted what the impact has been on our group. I think you were asking where the different baskets of risk are that would impact a railway like this. The majority of passenger and revenue growth on a franchise like this is impacted heavily by what is happening in the economy, GDP, the wider political outlook, and, as Neil said, what is happening to wages. On this particular franchise, we have seen the lowest period of low fuel prices in over a decade, which I do not think people saw. Those things impact significantly on a discretionary travel railway like this one.

Ronnie Cowan

Surely any private business is taking on those same risks.

Martin Griffiths

Yes, but remember that this is a very specific contract. The point I was making is that this is a highly regulated, output‑based contract. Let me make it simple for you. In theory, if I carried one passenger or 100,000 passengers, my costs are the same. It is exactly your point. I remember sitting down with a very significant politician explaining this about the rail franchise. If you are in the real world—if you want to call it that—and you are a house builder and demand drops away, what do you do? You cut the supply. On these types of contracts, you cannot; the supply is fixed, so the revenue is extremely important. That is why, on some of these contracts, the Government have shared in the macro risk. On this particular one, they decided not to. They went for a parental guarantee to protect what they saw as their downside. That is how they structured it.

Ronnie Cowan

Were they right to do that?

Martin Griffiths

That is a question you should ask them. My view is that they have done exactly what they were entitled to do under the contract. They have enforced the contract absolutely to the letter. I have to respect that.

Ronnie Cowan

If you had not taken on the macroeconomic risk, would the franchise have failed?

Martin Griffiths

That would depend, but if, hypothetically, we had the FRM that is now being suggested, it is likely that the franchise would not have failed.

Daniel Zeichner

When you were making the bid, what did you think you were bringing to the franchise that would make it work better?

Martin Griffiths

We brought 20 years of experience, a transformation on both South West Trains and Virgin West Coast where I think we are all extremely proud of what we have done—the product, new trains, staff, development and brand. All those things were part of a vision for a pretty old and tired railway, but which had incredible staff. One of my biggest disappointments is that I promised them a vision; I promised them an eight to 10‑year vision because they needed that. This will be their fourth change of ownership, and I think the vision is still sound. It will happen. This will be a fantastic railway. It is all set up for that. The new trains will come in over the next two years and they will deliver big time on that. It is disappointing that we will not be there to do it. We brought all of that to bear.

Daniel Zeichner

But that was not enough to make the difference. The reason I ask is that one of my colleagues raised a point that the previous operator ran very popular loyalty schemes and that kind of thing. You changed those things, and that may not have worked.

Martin Griffiths

I am aware of the previous loyalty scheme. We had a different loyalty scheme, but I believe that we were doing all the right things. Our passenger satisfaction was at an all‑time high for that railway and outperforming the rest of the sector at 92%. That is not me; that is independently judged. Our customers thought we were doing something right, and that was before we got to the transformational stage of the railway with the new trains that will come in from 2019.

Chair

Jo, you have just heard in the evidence about the complaint of sustained poor performance from Network Rail, and that there was a claim for £72 million. Can you give us your take on that? Why was there a dispute about the quantum that Network Rail owed Virgin Trains?

Jo Kaye

Apologies, Chair, but I think my colleague Rob is best placed to answer your question on sustained poor performance.

Rob McIntosh

Yes. That is within my part of the organisation rather than Jo’s. First, the sustained poor performance threshold is a mechanistic trigger, which is the breach, and therefore why Mark Carne, our CEO, would agree in principle that there is an entitlement. You then move into a discussion about how you quantify that entitlement. The entitlement is in two parts: any cost incurred by the operator over and above what was not recompensed through schedule 8 is one aspect; the second aspect is any consequential loss in revenue. We have been working with colleagues in Virgin Trains for the best part of a year and a half to try to agree what we think is a reasonable valuation. We are obliged to do that under our obligations for managing taxpayers’ money. Colleagues in Virgin Trains East Coast provided us with the information in so far as they could, to allow us to form a quantum. We could never get to the point of agreeing what that quantum would be. We, therefore, had to take steps to refer it to adjudication.

Chair

Who is it being adjudicated by?

Rob McIntosh

It is being adjudicated by an independent QC.

Neil Micklethwaite

But that claim has now transferred from Virgin Trains East Coast as part of the transition to London and North Eastern Railway.

Martin Griffiths

On all of that, any value goes back to the Department and the taxpayer.

Chair

We are going to look a little further at infrastructure enhancements and Network Rail performance.

Graham Stringer

Going back to your projected profits, I understand you made some growth—4% over the period of the franchise and you had projected 10%. Isn’t 10% rather a heroic assumption?

Martin Griffiths

Are you talking about revenue growth?

Graham Stringer

Yes.

Martin Griffiths

I go back to my comments to the Chair at the beginning. Clearly, with the benefit of hindsight, we can all sit here and say that looks aggressive now. Back then, based on how the industry had been performing, what we had seen in the past and what we had done on Virgin West Coast over many years, and with all the initiatives that were there to back it up, we were all comfortable as a management team, our advisers and the Department that it was deliverable. Actually, the growth we got outperformed the market, which is great testament to the team we had and the things we did. As we were coming out of the franchise, that revenue growth had been accelerating over the last three or four months, so there were a lot of really positive things that had come through. It is just disappointing that what we had assumed in the bid was a higher number.

Graham Stringer

Going back to the little exchange we had before, I have a quote here from Richard Branson on 5 January, in essence, blaming Network Rail for a loss of £100 million. He said that Network Rail had cost his business £100 million because they had failed to upgrade.

Martin Griffiths

I am not sure of the precise context, or Richard’s wording. I have tried to explain my position on it. I hope I have made that clear. There was a claim about sustained poor performance that related to the period we have been in, but that was only part of a whole range of issues that meant this contract terminated early. Richard is right though. We contend very strongly that, going forward, had we still been there, the contract would have had to change, because a lot of the revenue growth and passenger numbers from 2019 onward assumed there was to be infrastructure that would drive new services, new destinations and faster trains. Some of that either will not happen or will be delayed. He may have been mixing the two, but I am very clear on the distinction.

Graham Stringer

You are clear on it, but I think he was talking in the past tense and explaining why things had gone wrong. He also talked, as you have talked, about the improvements and investment you have made. He put a figure of £140 million on that. Is that accurate for the investment in trains and other improvements?

Martin Griffiths

The £140 million was the commitment at the outset of the franchise. When the contact was terminated early, we had invested £75 million of that £140 million.

Graham Stringer

So that figure he was using was not accurate either. In the written submissions we have had from you and Network Rail, there is a slight difference in what has come through. Can you tell us what had not been delivered, if anything, to the date that the franchise was terminated?

Martin Griffiths

Again, just to establish the principle, we have never said that anything material had not been delivered to that point. We could split hairs and say that there were one or two things that were either slightly late or had not happened, but, in the scheme of it, everything that was due to be delivered to the point of termination had been. Our issues were about the future.

Graham Stringer

But you had some difficulties with Network Rail that were not about investment. They were about performance over that period of time.

Martin Griffiths

Day-to-day performance, yes.

Graham Stringer

Would one of the two Network Rail representatives like to comment on your performance over the period of the franchise?

Jo Kaye

In terms of enhancements?

Graham Stringer

No; just basic performance and running the railway.

Rob McIntosh

I use the line myself and have done for a number of years. I am very acutely aware of some of the performance issues that we have had and the effects on passengers and the travelling public. We work very closely with all operators on the east coast main line to try to improve our performance every day. The way we measure performance, as I am sure you are aware, is a composite measure in the industry—PPM—as we go through this control period. It is a complex matter. Network Rail’s performance over the duration of the franchise, from when it started until autumn 2016, began to get worse. We saw that our performance was degrading. We took steps to turn that around and we have seen a continued period of improved Network Rail performance from autumn 2016 right through until about February this year, when we were badly affected by the quite harsh end to the winter. Since then, we have seen performance decline again, but in recent periods I am pleased to say that we have begun to see performance, in terms of Network Rail infrastructure, stabilise and improve. Over the last year, the Network Rail contribution to the performance gap has been 55%, with the operators taking 45%. That is operators, not just LNER, or VTEC as was. Within that, 66% of the delay causes are associated with our infrastructure and 34% to external events, of which we have seen a particularly difficult upturn in recent months.

Graham Stringer

You said you did not sign off or validate the infrastructure assumptions in the bid process. Is that unusual?

Rob McIntosh

That was the norm at the time. We would not sign off the infrastructure assumptions.

Graham Stringer

Do you think that was a major failing? It seems to me that, if the Department, which effectively owns Network Rail, even though it is a different structure, is agreeing to a bid with certain assumptions in it, the people who are going to make that investment should be involved. It strikes me as very odd.

Rob McIntosh

I completely agree. If you are dependent on significant infrastructure interventions and commercial dependence in a tender, the entity accountable for delivering those should endorse them. Why it was not done at the time is probably a question best put to the Department. What I can say is that going forward, and working closely with colleagues on franchises on this and the east midlands franchise, we are very much more sighted on what is going into the franchise specifications before they go out to tender. We will be sighted on what goes into them when the franchisee bidders respond.

Graham Stringer

And the Secretary of State has guaranteed that for all future franchises, has he?

Rob McIntosh

I have a letter from one of his officials saying that I will be invited along to the investment committee hearing when they determine who is going to win the east midlands franchise. I expect the Department to look at me as the Network Rail responsible person and say, “Can you agree to and sign off the assumptions for Network Rail in this franchise?”

Graham Stringer

Can I ask Stagecoach whether the Department validated your infrastructure assumptions in the bid?

Neil Micklethwaite

We signed a franchise agreement openly with the Department for Transport in December 2014 that was in accord with the invitation to tender that had been put out much earlier that year. That contract had a transformational timetable for May 2019 that was predicated on a number of infrastructure enhancements being delivered by the end of 2019. Those infrastructure enhancements were in the Office of Rail and Road’s final determination for control period five, so we were entitled to rely upon that information in that regulated document. It enabled us to develop a timetable that was in accord with the invitation to tender that was then subsequently contracted on. The transformational timetable was only capable of being delivered by all those enhancements being fulfilled.

Graham Stringer

I think I understand that. Are you saying that, in effect, it was a validation of your assumptions that there was a draft timetable, as opposed to the Department explicitly saying, “This investment is going to take place”?

Neil Micklethwaite

We had a contracted timetable in the franchise agreement that was in accordance with the official invitation to tender, so as far as we were concerned we had a contract to deliver that particular timetable. That could only be delivered with enhancements that would have been fulfilled.

Graham Stringer

I just want to be clear. It might be splitting hairs, but they did not actually validate the assumptions of the investment. It was an assumption made because there was a timetable.

Neil Micklethwaite

You would have to ask the Department that particular question, but we have a contract that said the timetable would be operated from May 2019.

Chair

Can I check one of the issues with you, Neil? In making your assumptions about the infrastructure enhancements, you were looking at what was in control period five. Is that right?

Neil Micklethwaite

That is correct; yes. We had an obligation under the invitation to tender to look at the enhancements that were going to be delivered at the end of control period four, and those that were going to be delivered in control period five.

Chair

Fairly early in control period 5, we saw the Department get into all sorts of bother and we had the Hendy review, which led to a significant scaling back of a number of things in control period five. Did you have any discussions with the Department at that point, because you knew that enhancements had been cut back?

Neil Micklethwaite

At the time we submitted our bid, in June 2014, according to the East Coast Programme Board, which was the board established to determine the priorities and the deliverability of the enhancement schemes, they were still on time. We took over the franchise in March 2015 and the Hendy review started in November 2015, if I recall, with the final enhancement delivery plan in March 2016. We started conversations with the Department around the future in terms of the infrastructure enhancements not being as we expected them to be at the time of the Hendy review, late 2015 or early 2016.

Chair

You started having discussions with the Department at that point about the fact that you would not be able to deliver all the things that you had promised in your bid, because the underlying assumptions had then changed. Is that right?

Neil Micklethwaite

That is correct.

Chair

For the future—not specific to this line—obviously we are not going to have enhancements within the five-year control period process. They are going to be in the new pipeline. How will you, as an operator, know what enhancements are going to happen, given that they are not set for five years ahead but are dealt with in the pipeline process?

Neil Micklethwaite

Rob mentioned the early infrastructure assumptions document that we are now seeing as part of the franchise bidding process. They are formal documents that will be part of the competition of which we choose to be part. That will give us much more clarity. However, one of the key things we want to continue to see is much closer alignment between the invitation to tender in the franchise agreement and Network Rail’s planned enhancements, so that they are all fully transparent and in alignment. The infrastructure assumptions documents that we are starting to see are a step towards that.

Chair

If you are doing a bid, say, for the east midlands franchise, how many years does that franchise run for?

Neil Micklethwaite

It will be eight years.

Chair

Would you know what enhancements are planned in the whole of that eight-year period? Would you have some idea? How does it work?

Neil Micklethwaite

We have sight of what is in the document. Rob mentioned the infrastructure enhancement document. We have sight of that documentation, which is part of the suite of documents we will see as part of the competition of what the planned enhancements are over the forthcoming years.

Chair

Rob and Jo, if they have sight of what is in the next eight years, how realistic is that? Presumably, those things will not all be agreed, knowing how your new enhancements pipeline works. On what basis are bidders bidding?

Jo Kaye

As you rightly said, the separation of enhancements from the rest of Network Rail’s funding means that there is a difference in how that will need to be managed going forward. My expectation is that enhancements that are committed to delivery, and have passed through that final stage gate we talked about in the pipeline process, will be very clearly obvious to bidders in the infrastructure assumptions document. There will need to be a change mechanism in franchises to deal with enhancements committed for delivery after the franchise has been let. That is a natural consequence of adopting a pipeline approach. There will be a mix of certainty in the short term for things that are committed, but for things that are much earlier in the pipeline process there will need to be a mechanism by which outputs of franchises are amended to take account of them.

Chair

We can ask the DFT later about how they are going to deal with that. We want to look at what is happening now on east coast and what is going to happen in the future.

Paul Girvan

The Secretary of State announced that the management of the east coast franchise would be transferring to the operator of last resort. I do not necessarily like that term, but it says an awful lot. He said that it would be until the new introduction in 2020. According to what you have already stated, passengers seem to be very happy with what has been happening—the improvements. There are reports stating that there is a high level of satisfaction with what is going on. Is there going to be an impact on that? Was there consideration when it was going forward of how it would impact on the passengers? Ultimately, that is who we really care about—the passengers in this operation. How is the management going to be dealt with?

Martin Griffiths

I am on the record as saying that I was both surprised and clearly very disappointed with his decision. I felt that we had put forward a compelling case for continuity for passengers. That is really what matters. However, the Secretary of State made a different choice. I have no option but to respect his decision on that. It is a question for him and his officials to make sure the passengers are protected.

Paul Girvan

Do you think that the Department properly accounted for those risks when removing operational control from the franchise, from VTEC?

Martin Griffiths

I think you will have to ask them that. I assume they have done a full evaluation process of the two options. He was very transparent. He said there were two options available to him—to go with a continuity non-profit position with us, or to go with the operator of last resort, and he chose to do that. I have to respect that decision. It is probably best to ask them what the basis was for them being comfortable that that was the right decision.

Paul Girvan

When does the transition take place?

Martin Griffiths

It has happened.

Paul Girvan

It has already happened.

Martin Griffiths

Yes, it happened on 24 June.

Paul Girvan

It is too early in the process to evaluate how it is going to run out.

Martin Griffiths

Yes. If it gives you comfort, I am very confident in the staff we had and the team we left behind. They will do a good job. They worked very hard to do a seamless handover. The passengers were at the forefront of what we did, so I am confident it will be all right. I travelled on it this morning and they were very good.

Paul Girvan

You would say that. Thank you.

Huw Merriman

From 2020, the partnership will see Network Rail and the franchisee operating under one roof. We had expert witnesses who came before us saying that this would be the last network where you attempt a model such as the one I have just described. I understand that both Stagecoach and Network Rail are supportive of that partnership proposal. Can I ask both organisations why you support the proposal?

Martin Griffiths

I believe, and have passionately believed for a long time, in the management of a joined-up railway. We tried to do that with South West Trains and the alliance. I cannot comment on this proposal because I do not know what it is, but as a principle do I believe in a strong partnership and a joined-up management team between train operations and infrastructure and signalling? Yes, I do. It is the right thing to do.

Rob McIntosh

Martin is absolutely right. It is the right decision to put track and train under single leadership and provide a single point of accountability for passengers and the stakeholder. The reason people say the east coast is not the best place to do that is the multi-operator nature of it. It is a large piece of railway that we have to operate, and I have a large number of customers. What people are concerned about is that the day-to-day operations become affected by this, and what would be called regulating policy—whose train gets to go first, on a particular day in a particular situation—starts to get clouded by that. That can be addressed by work we already have in place. We have policies agreed with all operators on the route as to whose train will go in front of whose train in a particular set of circumstances. We have those in place. We have had to work very hard on those for the timetable changes that took place quite recently. The answer to this problem is that we have very clear and robust regulation policies to which the industry has to adhere when my staff on the ground have to make the decisions day in, day out.

Huw Merriman

How will you deal with the conflict of interest point? I understand that the Wessex route is a previous example. That fell apart because of segregation of finances, but, as you say, for this particular line you have a whole series of customers with open access, yet you will also be part of the operator structure. How will you deliver for your customers?

Rob McIntosh

The east coast partnership proposals would not allow Network Rail to deviate from the track access codes and the codes that are in place in the industry. They are enshrined in how we work. We already have rules in place that do not allow Network Rail to show any prejudicial behaviours, and that will be baked into the east coast partnership.

Huw Merriman

That leads to the obvious question, which is that, apart from looking like the right thing to do—we hear a lot about the joined-up approach—what more is this going to do that is not currently already being done on the other routes? As you say, by your very nature you are unable to favour one operator over another. What more can you do beyond what you already do with all the other operators?

Rob McIntosh

We are still working closely with colleagues in the Department about what the future partnership should look like. There has been some conversation today about where commercial risk, and so on, would lie. It is at the heart of what we do in the east coast partnership that commercial risk needs to lie with the entity in the partnership best placed to take that risk, and for that risk and that commercial construct to deliver the best possible outputs for the passengers. That is what needs to be different for the east coast partnership. We also need to use it as an opportunity to better integrate the planning and execution of the service changes that are planned over the short term in the franchise, and the long term of the east coast main line.

Huw Merriman

Do you think there will be enough time to implement it by 2020? It sounds to me as if the announcement has occurred before the detail has been set out, which is not unusual for this place. What you have just described sounds as if that is the case. Do you think there will be enough time to bottom out the detail by 2020?

Rob McIntosh

The aspect that will take time is the actual procurement of the franchise, whatever it looks like. It is important that we spend time now getting the model right, to make sure that we get the right result. The procurement duration, which the DFT will manage, will determine whether 2020 is achievable or not.

Huw Merriman

Would Stagecoach be looking to bid for this new east coast partnership?

Martin Griffiths

I do not think it is a question we can answer today. I do not even know what the proposition is. Let’s wait and see what emerges in franchising policy more generally and the east coast partnership. I cannot answer that.

Huw Merriman

There is nothing at the moment such that you would say, “There is absolutely no way we would bid.” Perhaps I should reverse the question. Is there anything that you know now which would stop you bidding?

Martin Griffiths

There are some of the things we talked about earlier about what is going to happen with franchising. Risk allocation is equally as relevant to something on the east coast partnership as to other opportunities. We just need to wait and see what emerges. It has all been a bit raw, and it is not a question for today.

Huw Merriman

In a way, that takes me to a few more questions on franchising.

Chair

Luke has a couple of extra questions.

Luke Pollard

Following up Huw’s point, do you think that past performance on a specific franchise should be taken into account if you are rebidding on that franchise? Do you think that the fact it was taken off you should count as part of the marking scheme on any future franchise, should you bid for it?

Martin Griffiths

We have been running railways in this country for 20 years. I think I can confidently say that every railway we have run, we have handed back in a better state than we inherited it, and we have done a lot with it. This railway had a contractual issue, which we have talked about; it was nothing to do with the staff or the operation. All of that came through. Although it is disappointing, I am very clear that at no point did we walk away or hand in the keys. We honoured our contractual obligations in full. When the Secretary of State made his decision, we respected that. If people want to judge, that is the message I will give. We have run railways really well. We ran this one really well. We honoured our obligations in full. I have explained what the model was and the risk transfer. People should look at that. If you have operational challenges on railways, yes, I would expect people who are awarding franchises to look at that.

Luke Pollard

That sounds like a very good example. In a new franchise, the staff TUPE over anyway. It is effectively the management that changes with any change in franchise. As you have had the franchise taken off you by the DFT due to failure to deliver what was promised, do you think the validity of previous bids should be taken into account on this franchise and future franchises if the DFT is giving them out?

Martin Griffiths

I stand by what I said. We have honoured in full our contractual obligations. There is a process that the DFT goes through. You have to have a passport to bid for franchises, to make you a good and valid operator. We are that; we continue to be that; and I fully expect us to continue to participate in UK rail going forward.

Luke Pollard

There will be an awful lot of people watching this who will be slightly confused by your answer. It seems to me, from your answer, that you are claiming that nothing has been done wrong, when in fact yet another franchise on the east coast has failed. You yourself say that as a company you have lost £200 million, yet you seem to not be apologetic or to rule out a future bid for this franchise. An awful lot of people who travel on that train service want to see an operating railway, and will be flabbergasted by the fact that you do not seem to reflect the enormity of the failure of the franchise and how that should rule you out of any future franchise on that line.

Martin Griffiths

There are two things. There is an operational issue, where we have performed extremely well. As we said, customer satisfaction is high. We delivered on all the new services that we put in. We have dramatically changed the product. The railway is all set up for the future. I am genuinely disappointed and sorry that we will not be there to see it through, but the Government let a contract with risk. They transferred risk to the private sector. We accepted that risk, for better or for worse, as did the Government. For a whole lot of circumstances that we have gone through, we are in a different place than we were. That is disappointing but it happens. I believe we have acted with integrity in honouring what we were asked to do in terms of passing that contractual risk to us and then accepting it. The Government knew what they were doing when they did that too. The Government have taken £200 million of private shareholder capital. Until the point of termination, we were delivering 35% more premium payments on a monthly basis than before we inherited it. That is the model. People might not like it—they might not even agree with it—but on this franchise that was what we were asked to do, and the Government understood the risks that they were taking. The staff did a great job, and the passengers told us that we were doing a really good job. That has been measured in the passenger satisfaction that we got.

Chair

I have a couple of questions about the partnership that is going to operate from 2020. Martin, you said that you did not know what the partnership was going to look like. In relation to the deep alliance or the joined-up railway on South West Trains, what did that deliver in terms of a better railway?

Martin Griffiths

It actually did a lot of good things. We got a single chain of command. There was one management team. We took a lot of day-to-day disruption and incident management down significantly. One of the questions was about conflict of interest. We managed that; there was no conflict of interest. We managed the other customers on the line well. What happened subsequently with South West Trains has been disappointing, but it was a railway that was performing well for such a big, complicated business. It was an alliance that we broke up for different reasons. What we were asked to do at the time was difficult to integrate completely, financially. That was to be part of a new franchise bid. There were many positives that came out of the joined-up management approach to South West Trains.

Chair

You think it was very positive, but it was still scrapped.

Martin Griffiths

Because we could not agree some of the financial sharing. It is back in history. The new management of Network Rail at that time had a different view from the previous management. That is on the record. David Higgins was a massive supporter of it. Mark Carne was less supportive of it. If the chief executive does not support it, it is more difficult to take it forward.

Chair

Do you know how the issues that you found on South West Trains are going to be resolved on the new east coast partnership?

Martin Griffiths

Not at the moment, no.

Chair

Rob, do you know how those issues will be resolved? There are a whole load of other issues because obviously the east coast main line has a lot more operators on it than the Wessex route.

Rob McIntosh

I do not think we have got to the point of understanding how they are going to be resolved. We absolutely understand what those issues are though. We have not got through the detailed work of what the partnership will do. I am very pleased with the way the Department have listened to the feedback from guys on the South West Trains alliance who came to the expert advisory group and shared some of the stuff that Martin has just talked us through about what needed to be put right. At the heart of this is the extent to which you align the balance sheets of the two organisations, how deep you want to take that and therefore how you commercially incentivise them to work together. Those are some of the discussions that are still ongoing with the Department.

Chair

How can we know whether this is the right option for the east coast main line when we do not know what it looks like?

Jo Kaye

I am afraid we cannot answer that. That is a question best directed to departmental colleagues. As Rob has said, we have been involved in picking up the lessons from previous arrangements and being clear about the important issues from Network Rail’s perspective, but we are not yet at the point of having a complete partnership model to talk about.

Chair

So we cannot know at this point. It might be.

Jo Kaye

I am afraid you will have to ask departmental colleagues.

Chair

Huw, you wanted to ask some wider questions.

Huw Merriman

On franchising, I would like to get the views of the team— from Stagecoach in particular. Obviously, there have been a number of changes. There is perhaps a bit more rigour in the franchising system in terms of Network Rail’s review and so on, but we also see fewer bidders coming forward. Mr Griffiths, do you think franchising is in a better place now than perhaps where it was when the Brown review reported in 2012?

Martin Griffiths

The private sector and franchising has delivered many positive things over the years, but it is not perfect. The very fact that we are sitting here again tells us that not everything is right. Sometimes a franchise will fail. I said earlier that I took comfort from the evidence that the Department gave to the Public Accounts Committee that it is considering 50 or so different areas to look at the franchise model to try to improve it and take it forward. We must learn lessons, the east coast being one of them, but equally with what is going on in other parts of the railway at the moment, and we are not short of issues that I know you have been debating. I would hope that out of that will come a model that can continue to evolve, be sustainable and deliver the benefits that passengers rightly expect and deliver good value for the taxpayer. We have some work to do. It is important that we go back and look at some of the principles Richard Brown raised and challenge ourselves, and we are starting to see some of those emerge in new contracts that are being tendered.

Huw Merriman

Lord Adonis, who came before us as part of this inquiry, took the view that, with the exception of this particular route, the rest of the franchising system operated well. Do you share that view?

Martin Griffiths

I can look across my own portfolio; I look at 20 years of history. Most of them have been successful. The east coast, unfortunately, has had three difficult changes of ownership, but, generally, franchising has delivered. We need to look at it and evolve, and work with the Department, Network Rail and other stakeholders to make sure we come up with the best model that we can.

Huw Merriman

As to that evolution, do you think the Department has the right mix of skills required to evolve in a positive manner? I recognise that is quite a difficult question for you to answer.

Martin Griffiths

I am sure you will also ask the Department how it feels about that. I have been doing this for more years than I care to remember. I think the Department’s skill set, process and capability has evolved over a long period of time. I think it is in its interest to make sure we get to the right place as well, so I am sure it will be challenging itself to do that.

Huw Merriman

One observation I have noted myself is that often we see people move from one part of the industry to another. Is there enough fresh challenge and thinking going in? Is that unfair to the Department? Has it brought people in from the outside who can really challenge existing views?

Neil Micklethwaite

If we look at Virgin Trains East Coast, that business attracted a whole bunch of new people to the industry. You can say that some were attracted to brand, but they were also attracted to some of the transformation that we wanted to achieve. For the first time in my experience of doing this for longer than I can remember, we had people coming from media and the tech sector to work in the rail industry. That is a big plus for us, hence why we have seen some of the customer transformations there. Two hundred and fifty thousand people work in this industry, on and off, throughout the whole supply chain. It is about making sure that we are open to as diverse a range as possible across the whole gamut of the industry, whether it is an operator, Network Rail, the Department or other parts of the supply chain. It is about things like the apprenticeship scheme, of which our Network Rail colleagues and operators are big champions, to make sure we attract as many new types of people as possible so that we have as good and broad a range of skills, experience, background and diversity to reflect the customers we are serving. I think we are seeing that.

Huw Merriman

We have talked about some of the challenges and the macroeconomic side of things, but could you give us one or two key areas of reform that you think could boost the franchise system and make it sustainable for the long term?

Martin Griffiths

We have talked about risk allocation, which is fundamental. What is the model, who bears what risk, and who is best placed to take and manage those risks? We also touched on the question of resetting it, which is relevant now. If we look at the west coast partnership, there could be 13, 15 or 17 months between a bid going in and a franchise being awarded. An awful lot of things can happen in that period. In the early days, when that was the policy, franchises were turning over much more quickly so there was much less of a gap. Those two things can definitely be looked at. For me, the final factor, on which we have also touched, is that between infrastructure, franchise and operator we need to be much more joined up so that, if the Department is letting a franchise based on a particular specification that is dependent on certain infrastructure that is going to happen, and the operator is planning its bid around that, everybody has sight of that and is agreed on that. If for any reason that does not happen, which could have been the case here, there is then a clear methodology for making sure it can be changed and accommodated within the contractual framework so that we do not end up in dispute, or having to go “legal”, or there is a default, because people disagree. If we did those three things, they would take us a long way forward.

Huw Merriman

We talked about the 2020 partnership proposal and the fact that it is not yet in place. Would you expect the Department to come to you, seeing that you have had the experience of South West Trains and also this route, to put your model of how this would work? Has it come to you yet?

Martin Griffiths

It has not yet, although it is speaking to the wider industry. Some of our people have been involved in discussion with it. As part of the exit from the alliance, South West Trains shared with it a blueprint document and the findings for that. Absolutely, it is in the interests of a company such as ours for me and my colleagues to make this right, whatever discussions and dialogue the Department has. I would hope that it would do that, because the industry on our side of the table has a lot of collective experience that I hope would be very relevant in framing whatever emerges on the east coast partnership and beyond.

Graham Stringer

I have two very quick questions. I put a very simple question to Mr Griffiths. Did the £200 million that you lost include your bidding costs, and what were your bidding costs?

Martin Griffiths

Our bidding costs, which would have been in addition to that, were £8 million or £9 million.

Graham Stringer

Was that in the £200 million?

Martin Griffiths

No; that is in addition to it.

Graham Stringer

That is on top of the £200 million. Let me ask Network Rail a question that Stagecoach may also want to answer. You have said that in the process of putting track and different operators together you can deal with the conflicts. I would like you to explain that. If you have two train companies that want to bid for the same train pathway, apart from wishing for the best, I do not see how you can say that the conflict is resolved.

Jo Kaye

That is dealt with by the fact that the allocation of train paths will not be done within the partnership but within the system operator part of Network Rail, which is distinct. The allocation of train paths is already subject to a set of rules laid out in the network code. We make a transparent decision if there are competing interests and there is an opportunity for people to challenge our decision.

Graham Stringer

You do not actually get rid of the conflict; it is just dealt with independently.

Jo Kaye

There are existing rules to deal with that conflict; it will be done within the system operator and not in the part of Network Rail that would be inside that tight partnership.

Graham Stringer

That applies to goods trains as well as passenger trains.

Jo Kaye

That is correct.

Chair

I want to return to the question of the partnership approach. Perhaps Mr McIntosh is best placed to describe it. What is the advantage of being in some sort of partnership with one of the multiplicity of operators on the east coast main line? Given what you said earlier about the fact that there is a code on access that sets out whose train should go first, what is the benefit of being in partnership with just one of those operators?

Rob McIntosh

Albeit it is one of those operators, the east coast franchise—let us call it that—that carries a lot of passengers on the route. The new trains that are coming are transformative for a lot of aspects of the route of the east coast main line. One of the major benefits of the partnership is that it will allow us, finally, to align the management incentivisation of both management teams. Balanced score card and performance targets that are matched both within Network Rail and the train operator will give us greater benefit for teams working together. It will allow us to do some much better long-term planning for what the future of the route could be potentially in lieu of HS2 arriving.

Chair

Can you give me an example of the sorts of things that you might be doing in partnership with the intercity operator that you would not be doing in partnership with other users of the route?

Rob McIntosh

The east coast partnership that the DFT is seeking to put in place has a duration approaching 15 years. At the moment our investment planning on the east coast is limited to pretty much 2021, and we will be able to work with the east coast partnership beyond that to look at the investment opportunities there might be to provide a better service between that date and when HS2 arrives on the east coast main line sometime in the early 2030s.

Chair

Doesn’t that partnership give an unfair advantage to one operator compared with other users of the line?

Rob McIntosh

No, because that is what Jo’s organisation, the system operator, will protect against. The network code will also protect against any kind of preferential treatment about the allocation of those paths.

Chair

In thinking about what is going to happen on that line in future, it sounds like you are having a discussion with only one body when there are other open access operators.

Jo Kaye

We certainly would not be having long-term discussion with just this partnership operator; we would continue to do long-term strategic planning for the route with all operators there. The difference is that this one operator with whom we were in partnership would also have a longer perspective, whereas many franchises are much shorter term than that currently.

Daniel Zeichner

Mr Griffiths, when I asked the Rail Minister a few weeks ago who was in charge of the railways he struggled with that question. When you had this franchise who did you feel was in charge? Was it you?

Martin Griffiths

Of this franchise?

Daniel Zeichner

Overall.

Martin Griffiths

I ultimately was responsible and in charge of Virgin Trains East Coast franchise.

Daniel Zeichner

That is the franchise, but what about the whole operation? This seems to me to go to the nub of the problem we are having in trying to discuss these partnerships and all the rest of it. I think that in the end most people would imagine that somebody would be in overall charge. The problem is that it seems like responsibilities are shared between various competing groups, which means that ultimately you, as the boss of that group, could not actually take a decision because you would have to consider a range of others.

Martin Griffiths

That is one of the reasons I have believed in and lobbied—as has our group, for more than 20 years—to have a joined‑up railway, where you have one management team and one leader who is responsible for everything in that franchise. That was what we set out to try to do under Tim Shoveller’s leadership in South West Trains. As the Chair asked me, we did a lot of very good things, which, for other reasons, we did not take further, but there are some very good and pertinent points from that that I hope will be taken forward as part of whatever emerges on the east coast partnership and beyond.

Chair

Thank you. That concludes our questions for the first panel of witnesses today. Examination of witnesses

Witnesses

Polly Payne, Beatrice Filkin and Simon Smith.

Chair

Welcome and thank you for being here this afternoon. For the record of our proceedings, would you like to introduce yourselves? Perhaps we can start at your end, Polly.

Polly Payne

I am Polly Payne, director general of rail group in the Department for Transport. In case there is any confusion, we have two directors general of rail group because I job share with Ruth Hannant.

Simon Smith

I am Simon Smith. I am the director in rail passenger services in the Department for Transport.

Beatrice Filkin

I am Beatrice Filkin. I am the intercity market lead for passenger services.

Chair

Thank you very much. I am delighted to hear that we have job share high up in the civil service; that is very positive. I noticed that you heard some of the previous evidence. On the east coast main line, three operators have now walked away or been forced off the franchise. Is there something inherently wrong with this franchise that makes it vulnerable to default?

Polly Payne

I do not think there is anything inherently wrong with the franchise. I think it is fair to say that this is a franchise that has a much smaller proportion of its revenue coming from commuters than other franchises, which means that possibly it has a more volatile revenue stream. I think the three circumstances in which this franchise has finished early have been quite different.

Chair

What responsibility does DFT accept for this third failure on the east coast main line?

Polly Payne

I think DFT’s primary goal when letting this franchise was to look after both the taxpayer and passengers. I would say that we managed to achieve that. We had parent company support of £165 million as well as a performance bond of £21 million. They are relatively high levels. The point of having those is to ensure that, if we get into the kind of circumstances that we did get into, passengers and the taxpayer are protected, and we believe they were.

Chair

The Secretary of State has said that he thinks Virgin overbid for this franchise. Did the Department actively encourage over-ambitious bids for this franchise?

Polly Payne

The Department did not actively encourage over-bidding. The Department does encourage ambitious bids to get maximum revenue for the taxpayer and to deliver ambitious increases in services for passengers. When we do franchises, we look at the balance between that ambition and protecting taxpayers and passengers from the risks. That is what we are looking at. As the Brown review said in 2013, it would not be a good franchise system if we never had franchises running into problems. That would probably show we were being under-ambitious and not delivering for the taxpayer and passengers, so it is a difficult trade‑off. It is probably worth saying that since franchising began we have had 52 franchises, of which four have ended early.

Chair

But three have ended early on this line. Do you not feel that within DFT this is a failure when the franchise collapsed within three years of its start date?

Polly Payne

We would rather that had not happened, and with hindsight the bid was probably too ambitious. However, we feel that we managed to protect taxpayers and passengers, as Martin said. I think Virgin and Stagecoach have worked very well during the handover. The handover went smoothly; it happened on 24 June. Martin travelled on it today. As he said, I think passengers are seeing a really good service. Another point, on which I totally agree with Martin, is that VTEC did run this service well; it did have high passenger satisfaction—it was 90% or so—and produced additional services for passengers.

Chair

But it is not going to be able to continue to run the service and deliver the level of premiums anticipated. Do you not think that the Department must have failed in its analysis of the bid for it to collapse within three years? What went wrong in that stress-testing within the Department?

Polly Payne

With hindsight, absolutely, the forecast premiums were not achieved. In particular, passenger revenues and numbers have been lower across the railway than we and industry predicted, and that led to the forecast premiums not being achieved.

Chair

Why do you think they have not been able to achieve the premiums they promised just four years ago?

Polly Payne

It is a combination of factors. In part, we think that something structural is happening, so that passenger numbers have not been increasing as fast as they had been in the previous decade. That is due to a number of different factors. We have been analysing it. There are macroeconomic factors, fuel prices, and changing work patterns and passenger habits.

Chair

Do you think changing work patterns had a major impact on this franchise, as opposed to on commuter franchises?

Polly Payne

That is very fair. The impact is less on this franchise, although there are some commuters on it, than on others.

Chair

Looking at the key reasons why this franchise has not performed as well as anticipated and the DFT did not pick that up, what are the factors that not only the operators failed to anticipate in their bid but the DFT failed to pick up in terms of its sensitivity? For example, one of the issues raised was about changes in macroeconomic performance of the wider economy. When National Express had to hand back the keys, we went from GDP growth of about 2.4% to a massive slump and recession. In the past three years we have seen a fall in GDP growth, but certainly not negative GDP. Did you not anticipate that things might change slightly?

Polly Payne

The forecasts are only as good as the assumptions and modelling on which they are based. We definitely anticipated that we would not be coming out with exactly the numbers we had. Probably one of the main factors that changed was our assumption about fuel prices. Mr Smith may be able to add to that.

Simon Smith

We have done some analyses to try to look at what revenue was expected to be in Stagecoach’s bid and how it has turned out. There are three roughly similar-sized areas in that. We thought Virgin and Stagecoach’s bid was quite ambitious at the time we received it, so we expected at the time we evaluated it that revenue would be lower than they forecast. They had attributed quite ambitious growth to certain initiatives, including things like their marketing and pricing strategy and so on. We thought they would get some of that, but we did not think they would get all of it. There have been some macroeconomic changes, of which the largest by quite a significant margin is fuel prices. Current fuel retail prices have declined by 41% since 2014 when the bid was submitted. That is a really significant decline in real terms. That was not projected at the time. That has been driven mostly by a reduction in global oil prices. There is a third part, but it is not clear to us what drove that. There may be wider changes so that economic growth is not feeding through to additional rail demand growth in quite the same way as in the past. We have a lot of ongoing work to establish better and make sure we fully understand the relationship between rail revenue and economic growth.

Chair

Government can obviously have an influence on car fuel prices. Was concern raised by DFT with colleagues in Treasury that this change would impact people’s propensity to choose to use public transport rather than private car?

Simon Smith

The largest driver of the decline in retail car fuel prices, although a part of that comes from the fuel duty freeze, is the drop in global oil prices rather than Government policy.

Chair

But Government policy can respond to things outside their control. Is that a conversation that you are aware is happening with officials in the Treasury?

Simon Smith

I am not aware of that, but obviously Government have wider objectives in terms of setting fuel duty than simply the impact on rail revenue.

Chair

Sure; absolutely. We are going to come on to other questions.

Ronnie Cowan

Picking up the last point, surely fuel prices are dropping across the United Kingdom, so why are the other franchises not failing as well?

Polly Payne

It probably had more impact on east coast and possibly west coast, because, if you are a commuter coming into central London, the fuel price might not make a huge difference to whether you bring in your car, whereas if you are travelling from London to Edinburgh it might make a bigger difference. I think there is more movement when it is long-distance travel.

Ronnie Cowan

I move to a different topic. The Department in its submission said that franchise failure does not necessarily matter provided it is managed in the right way. Is that not saying that it got the wrong messages?

Polly Payne

I do not think so. If you go back to the Brown review—and we would agree with this—Richard Brown was very clear that in a well-functioning, good franchise system you sometimes have failure. We would not want to have failure too often, but the key thing is to make sure that both passengers and the taxpayer are protected in the event of failure, and we think that in this case that happened.

Ronnie Cowan

So we are planning to fail.

Polly Payne

No. In any competitive private market you are planning that sometimes there is failure, but it is not something you want to have too much of; you want to protect against the consequences of it.

Ronnie Cowan

Earlier Mr Smith said he thought that the bid for the franchise was ambitious and the revenue would be lower. It seems that you are already in a situation where you think it could potentially fail, but you have a back-up plan anyway, so it doesn’t really matter.

Polly Payne

It is not so much that it doesn’t matter; it is more that we want ambitious bids because they maximise the revenue we get for the taxpayer, but we also want to ensure that, if things don’t work out as we and the franchisee hope, both passengers and the taxpayer are looked after.

Simon Smith

Could I clarify what I said? We expected when we evaluated the bid that revenue growth might be lower than the bidder had assumed. We expected that possibly it might need to draw on its parent company support. We did not expect the bid to fail; we expected it to pay the contracted premium for the full term.

Ronnie Cowan

Does not the franchise failure and reletting process eat into your staff considerably in terms of time and numbers?

Polly Payne

Our staff spend a certain amount of additional time on this. The main cost is standing up the OLR and the additional consultants. That is what the £21 million performance bond is designed to cover. The costs of the change of franchise are covered by that performance bond and come out of Stagecoach’s money.

Ronnie Cowan

What about the cost in terms of the staffing of this? Have your staff members now been drawn in to help to run this?

Polly Payne

We have a standing team that looks after the operator of last resort, and we have various directors and consultants on call‑down contracts. The additional costs of those consultants and directors have been covered by the performance bonds. There has also been some additional pressure and workload on our staff, and I suppose that the extra money from the performance bond that we have not spent on consultants indirectly pays for that, so, yes, they are also paid for.

Ronnie Cowan

I get the fact it is paid for, but it is the additional pressure on your workforce that bothers me. What happens if another franchise goes down next week?

Polly Payne

We have about 530 staff in rail group; about 250 work in passenger services and the different areas of the franchises—whether we do a direct award. The overall work programme is constantly changing. We recruit new staff and bring people in on secondment where needed; we get additional consultancy support where needed. We try not to over-burden them but at the same time give them challenging jobs.

Ronnie Cowan

I am not trying to be a prophet of doom here, but what happens if another franchise goes under?

Polly Payne

If we were in a similar situation with another franchise, we would mobilise the OLR in the same way that we did with VTEC. We would bring in additional consultancy support and move some people internally to support the team from other projects that had a lower priority at the time.

Ronnie Cowan

Is the cost of that additional consultancy support already met by the failing franchise?

Polly Payne

Assuming it has an adequate performance bond, which I hope would be in place, yes.

Chair

I think we are going to look at what has happened in the past.

Iain Stewart

I would like to return to the adequacy of the stress-testing that you did against the assumptions that Stagecoach and Virgin put forward. When National Express failed in 2009, the National Audit Office recommended that robust stress-testing against significant economic shocks should be carried out. In your stress-testing of east coast, to take the oil price as an example, talk me through the range of scenarios against which you tested the bid. If you look back over the past 40 years of oil prices, they have oscillated significantly. What band of probability did you cover in stress-testing the bids?

Simon Smith

At the time of the east coast franchise competition the evaluation of the risk in the bid was based on one central case scenario. We also did a number of downside tests to understand the impact on the franchise’s financial robustness. We were aware that if revenue growth turned out to be lower there was a risk that the franchise could terminate early, but the actual evaluation decision at that point was based on the one central case. For the more recent franchise competitions that are now under way we have revised our approach to evaluation. The evaluation looks at both a central case and a downside scenario, but that was not the approach at the time.

Iain Stewart

We have been talking about this being a franchise that has a highly discretionary element: passengers can choose other rail operators or other modes of transport. To be clear, are you telling me that you did not factor in, in your stress-testing, the kind of decline in oil price that was seen?

Simon Smith

The franchise proposition at the time was designed around the principle set out in the Brown review, which was that Government should tolerate a risk of franchise default and not seek to insure against it. As to the commercial model at the time, there was sufficient confidence in a central case scenario that the franchise would be robust, but not in a downside. The mechanisms set up for the franchise included a GDP mechanism. Therefore, in the event of economic shocks, if there had been a recession in the early years, the franchise would have been protected through the GDP mechanism, and there was not something like that covering oil prices.

Iain Stewart

I appreciate that you are now reassessing the risks for current and future franchise awards, but, reading between the lines of what you have said, you are admitting that the stress-testing was not sufficiently adequate.

Simon Smith

It was undertaken in accordance with the rules of that competition at the time.

Iain Stewart

I am saying that the rules of the competition did not include a sufficient stress-testing of risk—that is my question—and we are now learning the lessons from that.

Polly Payne

I think the focus at the time was more on ensuring that we had the proper protections in place if something were to go wrong rather than looking at the great wide range of things that could have gone wrong. That is why we had a considerable amount of PCS—parent company support—on this franchise. Arguably, we could have looked at other factors in more detail in addition to the stress-testing we did, but we focused our effort more on ensuring that we looked after passengers and the taxpayer, which is the other way of doing this.

Iain Stewart

I accept looking forward that that will now happen, but I can only conclude—other members of the Committee can form their own views—that there was a failure on the part of the Department that this stress‑testing was not done in the way it should have been.

Polly Payne

With hindsight, we might have focused more on fuel prices.

Iain Stewart

I use fuel prices as one example; there were other considerations. It was also clear that in the period between the franchise being awarded and Virgin and Stagecoach starting operations the numbers had gone awry. They were basically starting on day one from a position behind and would have to play catch-up. Do you accept that?

Polly Payne

That was a risk the franchisee would have been aware of and would have taken and priced in.

Iain Stewart

But you accept that from day one they had to start from a basis that was not factored into the franchise.

Polly Payne

On day one they were starting from a different place from the one they had forecast, but that was a risk they were aware of.

Iain Stewart

If you accept that you knew from day one that the numbers were wrong, why were you not more proactive in managing the situation?

Polly Payne

I think we were proactive in managing the situation. We talked to Virgin from the beginning about their financial situation; we continued to review that throughout the franchise. We ensured that the OLR was ready. We did due diligence and were sure that we had time to mobilise it, should it be needed. We were also very clear throughout with VTEC about the different roles and responsibilities and where we were. That was the role we had at that point.

Iain Stewart

But you were not at any point considering rebasing the franchise. We were told very clearly by the previous panel—I do not know whether you were present to hear it—that that was never an option available.

Polly Payne

That was not the basis on which the franchise was tendered, and that would have been a big and significant change to the franchise. The other bidders might have been unhappy had we made that much of a change to the franchise that early on.

Iain Stewart

But did no one say, “Hang on. The changes are outwith the parameters of risk that we assessed”? No one had the foresight to say, “Hang on. We might need to rethink this.” Was that conversation ever had with Ministers or other officials?

Polly Payne

I do not think the changes were outwith the parameters of risk; I think they were within it. From the moment the franchise started, Ministers were aware that the forecasts were not being met and that was a risk, and we continued those discussions with Ministers all the way up until the end of the franchise.

Iain Stewart

Did you consider any other options for changing the scope of it without changing the franchise itself, or any other means by which you could have tried to keep this franchise on track, if you pardon the pun?

Polly Payne

We did not consider changing the terms of the franchise. I think I would have seen it as letting VTEC off its contractual obligations. We ensured that it stuck to those contractual obligations. It had signed a contract in full knowledge of the risks it was taking on. As Martin said, it knew the risks it was taking on; we knew the risks we were taking on. We had a limited liability contract in which it was very clear who would pay what in those circumstances; Stagecoach and Virgin had £165 million of parent company support and we ensured that they paid that.

Iain Stewart

At what point did you evaluate that the parent company bond would not be sufficient?

Polly Payne

It was a slow process; we kept an eye on it and we were hoping that the revenues would pick up, as did Stagecoach. We knew when it took on the franchise in March 2015 that the revenue was lower than it had expected. In June 2017 Stagecoach made a statement and set out its expected losses. In November 2017 the Secretary of State made his statement in which he first talked about the east coast partnership. On 5 January 2018 the last PCS was drawn down, and on 30 January 2018 there was an event of default and at that point we knew that it was months until the franchise would probably fail.

Iain Stewart

I am trying to get a clearer picture. On day one of this franchise you knew that revenues were significantly lower than had been expected when the franchise was awarded. At that point did you think there was a significant risk that the parent bond would not be enough?

Polly Payne

We thought that might be the case.

Iain Stewart

But no one at that point said, “Hang on. We need to rethink this.”

Polly Payne

No. At that point we thought we had the right mechanisms in place such that if we continued in this way and the parent company support got used up, which we thought was a risk, we would deal with that in a way that looked after both taxpayers and passengers. We did not feel that we should be going outwith the contract and give VTEC easier terms, no.

Luke Pollard

To continue the theme of Iain’s questions about what the Department’s impression was of this bid on day one, we heard some positive feedback from Mr Griffiths on the first panel about the Department’s feeding back to Stagecoach about the quality of the bid. I think the phrase he used was “the best bid they had ever seen.” You are now telling us that on day one of the bid you had serious concerns about elements of it and you were expecting them to be lower than the bid had said. The Secretary of State at the time Virgin and Stagecoach were awarded this contract said, “I believe Stagecoach and Virgin will not only deliver for customers but for the British taxpayer as well.” It seems that we have a very mixed picture here of very positive feedback, inflated PR and a lot of very official behind-the-scenes concern about the bid. Could you help clear that up, because it seems that what the public are being told is a very different story from what officials had concerns about?

Polly Payne

I do not know exactly when that comment was made to Mr Griffiths, or by whom, but I think that when VTEC won the franchise in 2014 it was nine months before it started.

Simon Smith

It submitted the bid in June 2014 and won at the end of November of that year.

Polly Payne

It took over the franchise in March 2015. I think the deterioration in the revenue had happened over that period, so, when the positive statements you are talking about were made, that was at the point it won the bid rather than the point at which it took over the franchise, and by that point we had seen that the revenues had declined.

Luke Pollard

This is a familiar story that we have heard from a number of train operating companies across franchising in general. Having regard to the difference in the state of play between when bids are made and the reality when franchises are taken over—for instance, not having enough drivers, which was something that GTR spoke about when it first took over the franchise—do you think that the period between bids being won and bids being delivered upon when the company takes over is too long, with too much potential for macroeconomic change, differences in operating procedure and different staffing levels kicking in, and that that is a structural flaw in how franchises are awarded?

Polly Payne

We are letting franchises for seven to 10 years and you are talking about a period of months. So, if you are letting a franchise that could go up to 10 years-plus, having too great a focus on what happens in that initial six to nine months would possibly be unbalanced.