Background and Challenge

The UK Department for Transport (DfT) was commissioned by Sir Roy McNulty to examine the overall cost and structure of all railway network elements in Great Britain (GB) and identify options for improving value for money to rail passengers and the taxpayer, while continuing to expand rail capacity and improve passenger satisfaction.

As part of this study, McNulty appointed L.E.K. Consulting to develop and evaluate three alternative railway industry structures:

  • Horizontal separation: splitting the national infrastructure manager, Network Rail (NR), into regional units, some or all of which could be sold to alternative owners
  • Vertical integration: integrating train operation and infrastructure management on a regional basis
  • Vertical alignment: establishing an alliance between a regional infrastructure manager and the dominant train operator in the region

The GB rail industry is a complex system. It comprises a wide range of different types of organizations performing a wide range of functions, using a variety of different assets and systems, in different geographies. Along with this, GB is governed through a wide range of contractual arrangements, license conditions, and regulation. Identifying the right industry structure was far from simple.

Approach and Recommendations

Approach

L.E.K. followed a structured process which involved:

  • Identifying the full range of options together with their advantages and disadvantages
  • Filtering options to obtain a shortlist
  • Developing shortlisted options into more detailed proposals
  • Conducting detailed option evaluation, including cost-benefit analysis

L.E.K.’s process was informed by a broad program of research and analysis that included:

  • A review of alliancing and supply chain best practices in other industries
  • Secondary research into the pros and cons of railway industry structures used in other countries and those previously used in GB. In particular, L.E.K. analyzed the impact of previous industry structure changes
  • A review of regulatory regimes used in other asset intensive industries (e.g. utilities)
  • Analysis of the current GB rail industry to understand the impact of interfaces, incentives and economies of scale / scope
  • Regional case studies to identify how the options could work in practice in different types of geography (e.g. relatively self contained parts of the network vs. multi-user routes
  • Stakeholder consultation

L.E.K.’s stakeholder consultation program included one-to-one interviews and industry workshops with a very wide range of organizations, including passenger train operators (incumbents and potential new entrants), freight train operators, infrastructure managers, regulators, and regional and national government. The workshops included “brainstorming” sessions to capture a broad spectrum of ideas and opinions early in the process, and “dragon’s den” sessions to challenge the emerging recommendations to ensure that they were practical and widely accepted in the industry. Throughout the project, L.E.K. worked on the principle that changes to the industry structure will only succeed if they are embraced by the key industry participants.

Recommendations

The key issue was how to address the disadvantages of having NR in its current form without losing the corresponding advantages. The main disadvantages are as follows:

  • NR has a monopoly position and does not have any close comparators. As a result, it does not face sufficient external pressure
  • Further issues result from its current highly centralized management approach
  • Misalignment of incentives between NR and train operators
  • Cost of interface between NR and train operators

L.E.K. recommended horizontal separation of NR into regional units, some of which should be sold to alternative owners. This would enable comparative regulation of the Regional Infrastructure Managers (Regional IMs). There is a body of evidence to show that this brings a number of important benefits:

  • Indirect competition between Regional IMs – this would significantly increase the level of external pressure
  • Greater scope for regional managers to innovate and respond to local issues
  • Improves regulator’s ability to set challenging, but realistic targets, and reduce the risk of gaming

L.E.K. recommended three key mechanisms to mitigate the potential negative impacts of horizontal separation, including any loss of network-wide benefits:

  • Separately owned Regional IMs should only be created in relatively self-contained parts of the network, at least in the short / medium term
  • A number of key functions should remain centralized
  • Introduce appropriate incentives to ensure the network continues to meet the requirements of all stakeholders

L.E.K.’s research and analysis also showed that there would very likely be incremental benefit in taking the further step from horizontal separation to vertical integration (VI) in relatively self-contained parts of the network with a dominant train operator and with limited prospect for “in the market” competition. VI is the structure that achieves the best alignment of incentives between infrastructure managers and train operators.

However, given the complexity of the GB rail industry, there will always be significant uncertainty regarding the outcome of structural changes. As such, L.E.K. recommended a phased, evolutionary approach to implementing the changes. This approach will facilitate changes to the ex-ante plans to take account of emerging information obtained from implementing the earlier phases of the change program.

Results

L.E.K.’s recommendations were widely reported in the trade press and were well-received by the industry.

"Sir Roy McNulty's Rail Value for Money (RVfM) study has commissioned supporting work from a number of consultancies covering various aspects of his broad remit. One of the most important, and potentially most radical, is the study into industry restructuring carried out by L.E.K. … While it likes the idea of regulating Network Rail piecemeal on a regional basis, L.E.K. has an even better idea. Managements would be under even more pressure to drive down costs if a number of independently-owned Regional Infrastructure Managers (RIM) were in the comparative regulatory mix." Modern Railways, March 2011

L.E.K.’s report was very influential in shaping McNulty’s own recommendations to the Secretary of State. McNulty’s report was published on May 19, 2011.  L.E.K.'s report for the McNulty Value for Money study can be found here (http://www.rail-reg.gov.uk/server/show/ConWebDoc.10420)

The Secretary of State will now chair a high-level group that will consider McNulty’s recommendations in detail, with a view to publishing the DfT’s proposals for industry reform by November 2011.

Network Rail has already started to implement a more devolved approach in which its regions are given greater autonomy.