Are Longer Franchises the Solution to Under-Investment in Trains

Neither horizontal consolidation nor longer franchises in the privatised rail industry in Britain promote investment. These surprising conclusions emerge in a paper by Luisa Affuso and David Newbery of the Department of Economics at Cambridge University, published by the Centre for Economic Policy Research.

The two economists note that the background to the privatisation of British Rail and subsequent restructuring was one of static or declining traffic and a history of under-investment, together with a steady drain on the exchequer. After 1995 freight and passenger demand increased rapidly, reversing the decline of many decades. But ‘the collapse in rolling stock investment was quite dramatic, suggesting that fears about the loss of co-ordination between different parts of the rail system were well founded’.

It was hoped that rolling stock leasing companies (ROSCOs) would provide a competitive framework for rolling stock purchase whilst providing long-term ownership. But, ‘the ROSCOs enjoy a strong oligopolistic position, and face little entry threat. [They] also face considerable uncertainty about the demand for new rolling stock, as they have to decide whether the recent growth in demand represents a change in a long-term static trend’. The risk of hold-up when franchises are to be replaced or renewed because rolling stock is both specific and durable might also discourage ROSCO and/or train company investment.

The Strategic Rail Authority (SRA) has responded to concerns over under-investment by extending contract lengths so that the new franchise contracts will have a minimum duration of 15-20 years, and offers longer franchises at re-procurement. It will also procure new rolling stock (to replace old slam door trains) to transfer to the successful franchisee. Much of this is based on the assumption that the prospect of longer-term contracts will encourage investment. But Affuso and Newbery find ‘that discretionary investment is stimulated by shorter rather than longer contracts, casting some doubt on the view that longer contracts are needed to address the under-investment problem’. One reason may be that the regulator will be impressed by such commitment. In addition, ‘Investing just before the end of the franchise contract enhances the incumbent’s probability of having the contract re-awarded and provides it with a first-mover advantage, while raising the entry cost for other potential bidders’. These conclusions suggest that ‘longer franchise contracts are not the correct solution for under-investment in British railways’ and that investment responds better to the incentive of periodic competition for new franchises.

The authors also note that, contrary to expectations, horizontal consolidation of franchises does not seem to result in higher investment. Horizontal mergers and contractual arrangements may be valuable in obtaining economies of scale and scope, though apparently not for increasing the amount of overall investment. The logic of offering larger franchises must therefore also be questioned.

Finally, Newbery and Affuso find that investment in new rolling stock responds to commercial incentives (passengers’ demand and profitability), also casting some doubt on the need for market intervention by the SRA in rolling stock orders.

Notes for Editors:

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The Authors:

David Newbery is Professor of Economics at the University of Cambridge and is a Research Fellow in CEPR’s Industrial Organization, Public Policy and Transition Economics research programmes. Luisa Affuso is in the Department of Economics at the University of Cambridge.  

INVESTMENT, REPROCUREMENT AND FRANCHISE CONTRACT LENGTH IN THE BRITISH RAILWAY INDUSTRY  
Luisa Affuso and David Newbery  

 
CEPR Discussion Paper  No 2619