ROSCOs were ostensibly created, as with so much else in privatised rail, to increase competition and reduce barriers to entry in the operating franchises. Trains typically have a lifespan of more than 25 years and franchises have typically lasted for less than ten years. TOCs would surely refuse to bid for franchises if they had to make a substantial up-front investment in rolling stock which then had to be disposed of in a distress sale at end of franchise. So, separate rolling stock companies would take the risk on instead and lease to successive franchisees over the lifespan of the vehicles.
How the system should work, was summed up by the Competition Commission in their 2009 report on the ROSCOs (discussed further below):
| Public Interest Report 61 61 THE GREAT TRAIN ROBBERY: rail privatisation and after
In a well-functioning market, TOCs would have the ability to choose between a variety of different fleets, and they would be able to switch freely between them or to invest in new rolling stock, depending on relative rentals, operating costs, and revenue-earning capacity. This process of TOCs choosing between fleets on the basis of perceived value for money would create competition on rental rates between different fleets, including existing and new rolling stock, taking account of each fleet’s relative utility, i.e. their costs and revenue-earning capabilities. Lease rates would be determined by the balance of supply and demand for particular types of fleet but we would expect that in the long term as older rolling stock was retired from service, or if demand for rolling stock increased, rental rates would increase due to demand exceeding supply until a point where new rolling stock became a viable alternative, as new rolling stock is the only potential source of additional supply.74
The imaginary is of an efficient market where supply and demand balances, prices accurately reflect values, choice is unlimited, information is perfect and everyone gets the best deal possible. This kind of generic vision of how the market should work underpins most government promises about the privatised rail system, but the outcome, as the Competition Commission found, is very different. The ‘market’ for rolling stock does not work as in the world of textbook economics because of the characteristics of the rail industry.
On privatisation, the 11,250 trains, with an average age of 16 years, which comprised the British Rail rolling stock were divided up and sold off to three leasing companies. It was hoped that a surge of capital market investment in new rolling stock would follow as the ROSCOs competed to offer the best vehicles possible to demanding TOCs.75 The sector was to be run entirely by private finance, with no state responsibility for funding new rolling stock, and thus ROSCOs would be un- regulated aside from competition law.
Train leasing is much less hazardous than aircraft or auto leasing. Ordinary commercial losses arising from lessee default are a significant problem in aircraft leasing. But lessor risk on trains was limited by state guarantee. If a franchise holder abandoned the lease, the government, via the rail regulator, would – as it acted to keep the trains running – take the franchisee’s place, guaranteeing 80% of their cash flow from the lease.76 In auto leasing of new cars lease rates are set on ex ante assumptions about the resale value of used stock so that optimistic predictions about resale values can crystallise in large losses. This risk on second hand values was again irrelevant in train leasing. From the very start it was clear that rolling stock was to be a low risk leasing activity, but the privatisation auction of rolling stock did not raise as much as might have been hoped. The stock had a book value of £2.93bn but its sale in November 1995 raised just £1.8bn from three management buyouts that were later criticised by the National Audit Office (NAO) for underestimating the ROSCOs revenues. As in the case of TOC buy outs, the ROSCO buy out companies were quickly sold
74
Competition Commission (2009), Rolling Stock Leasing Market Investigation, p.6. Available at
http://www.competition-commission.org.uk/our-work/directory-of-all-inquiries/rolling-stock-leasing-market- investigation
75
Shaoul, J. (2007) ‘Leasing passenger trains: the British experience’ Transport Reviews, Vol. 27, No 2, 192
76
McCartney, S. and Stittle, J. (2012), ‘Engines of Extravagance’: The privatised British railway and the rolling stock industry’ Critical Perspectives on Accounting 23 (2012), 155-8. Office of Rail Regulation (1998), Review of the rolling stock market: report to the deputy prime minister. Available at http://www.rail-reg.gov.uk/upload/pdf/64.pdf
| Public Interest Report 62
on as management cashed out and took more than £750 million in profit. All three leasing companies had been re-sold by December 1997 for £2.6bn – costing the taxpayer £1.1bn in lost proceeds according to the NAO.
The three ROSCOs have since changed hands several times and ended up under the ownership of major banks.77 They have, as Christian Wolmar has argued, ‘a license to print money’.78 And they are certainly the single most profitable part of the railway with 40% or higher operating profit margins for much of their existence. The story of the ROSCOs is about how bad state decisions and the specifics of the sector came together to deliver not new rolling stock but a great opportunity for value extraction through contract.
Competition between the ROSCOs was stymied from the start by the lack of interoperability. Trains could not be switched seamlessly between franchises because of the patchwork nature of twentieth century electrification and nineteenth century loading gauge variation in clearance under bridges and around corners. At worst, electric locomotives were suitable for use on only 9% of the network. Even if some trains were interoperable, there was not enough surplus stock to generate competition – as noted by the NAOs 1998 report into the market.79
Matters were then made worse by the state’s choice of leasing model where the government rejected the aircraft industry practice of cheap leases for obsolescent and fully depreciated older units. The initial lease charges – which paved the way for future pricing models - were inflated due to the government choosing to value the rolling stock using modern equivalent asset pricing rather than depreciated book value, thereby increasing the nominal capital base and ROSCO requirements for profit and lease rates. The government also initially set charges for old trains at only a small discount to new trains in order to encourage TOCs to use newer trains rather than renting older ones cheaply.80
The ROSCOs were now to supply new trains but these were to be predominantly funded not from the capital markets but from hefty lease revenues paid by the TOCs on all their rolling stock including clapped-out ex British Rail units. The revenue to buy new trains would come from TOCs which, particularly in the early years of privatisation (before subsidy was redirected through Network Rail) were heavily dependent on state hand-outs. Thus, the taxpayer and fare-payer was once again footing the bill.81 And, as we argue below, the inflow of capital from the markets never happened because the ROSCOs had a cost plus (extravagant mark-up) relation to the state.
High lease charges could yet have generated a substantial investment fund for new rolling stock (albeit at taxpayer expense) if the ROSCOs had reinvested their profits. But fatally, the ROSCOs were completely unregulated in terms of any obligation to reinvest profits. So the result was a
77
Shaoul, J. (2007), ‘Leasing passenger trains, p.193, McCartney, S. and Stittle, J. (2012), ‘Engines of Extravagance’, p. 164-5.
78
McCartney, S. and Stittle, J. (2012), ‘Engines of Extravagance’, 162-3; and Crompton G. and Jupe, R. (2004), ‘’A Deficient Performance?’ The Regulation of the Train Operating Companies in Britain’s Privatised Railway System’ Canterbury Business School Working paper number 66.
79
Yvrande-Billon and Menard, 2005, in McCartney , S. and Stittle, J. (2012), ‘Engines of Extravagance’, p. 157, National Audit Office (1998) Privatisation of the rolling stock leasing companies. Available at http://www.official- documents.gov.uk/document/hc9798/hc05/0576/0576.pdf
80
Shaoul, J. (2007), ‘Leasing passenger trains, p.195.
81
| Public Interest Report 63 63 THE GREAT TRAIN ROBBERY: rail privatisation and after
classic value extraction three-step at the expense of the contracting state: in step one, government subsidy goes into one company such as a TOC; in step two, the subsidy is transferred to a second company via a quasi-market transaction such as a lease payment to a ROSCO: in step three, the second company takes a substantial part of the lease payment as profit so that state subsidy can be distributed to private shareholders.
Just as predictably, if the chain comes apart (e.g. through failure or withdrawal of a TOC) the lease company’s value extraction is guaranteed by the state. As the operator of last resort under the 1993 Railways Act, the government provides a guarantee that the lease will be fulfilled. In this world of politically constructed profit, the risk on train leasing is thus a political risk rather than a commercial risk of default such as arises in aircraft or a residual value risk as in auto leasing. Even if a TOC halted operations overnight, the lease would be fully abandoned only if the state decided to halt services on a particular route and renege on its role of operator of last resort. As the failures of the National Express East Coast and Connex show, the state will always step in because the wider economic and political damage caused by a closure of the line would (in almost all circumstances) be too great to bear.