PR18 review of charges and incentives

This is the fifth article in our series on the 2018 Periodic Review of Network Rail, covering the Office of Rail and Road (ORR)'s latest consultation on charges and contractual incentives that came out in December 2016. The consultation is open until 9 March.

In PR18 the ORR are concentrating on route level regulation and how they will regulate Network Rail's new National System Operator role. There isn't the time or the resource to focus on a wholesale reform of the charging and incentives regime and so the ORR are targeting their proposed changes on areas where there is a strong case for reform or those which they can simplify.

Fixed cost charges for open access operators

Network Rail currently recovers the fixed costs of running the rail network (the costs that do not vary with use in the short term) through a combination of direct grant from Government, mark-ups paid by freight operators and fixed charges from franchised passenger services.

One of the main changes proposed is to apply fixed cost charges to all operators, including open access operators.

At the moment, franchised passenger services pay a fixed track access charge (FTAC) as an annual lump sum, based on forecast traffic levels. Open access operators (OAOs) only pay short-run variable charges and do not contribute towards the fixed costs. Freight operators pay two charges (as a mark-up on trains carrying electricity supply industry coal, iron ore and spent nuclear fuel):

the freight only line charge (FOL), which recovers the fixed costs of freight-only lines; and
the freight specific charge (FSL), which recovers freight avoidable costs, that is, costs that Network Rail could avoid if freight services did not use its infrastructure.

The ORR and the Competition and Markets Authority (CMA) both think that charging OAOs for the fixed costs of running the network, along with introducing a PSO levy on OAOs (which the DfT are also considering) would facilitate competition on the network. This follows a review which the CMA carried out in 2016 where they considered a range of options for enhancing on-rail competition and, in particular, the role of OAOs (see here).

The way of allocating the fixed costs between operators will also change. The ORR propose to use the methodology adopted in Brockley Consulting's 2015 study of the Wales route for Network Rail and roll this out nationally. At a recent workshop on charges and incentives, various stakeholders voiced their concerns with this and claim the methodology is flawed.

The cost allocation would be based on a "market can bear" test for all operators (at the moment, only freight operators are subject to such a test, which for them is based on the type of commodities carried). It would involve developing a market segmentation approach for passenger operators so the end result would be that all operators would pay a mark-up, to the extent that they can bear this. The ORR are at an early stage in developing a "market can bear" test and they will develop it over the course of 2017 in consultation with stakeholders.

Finally, the two existing freight charges (FOL and FSL) will be combined into one and the coal spillage charge (one of the short-run variable charges) will be abolished.

Capacity charge

In general, the various short-run variable charges that train operators have to pay will remain largely unchanged, with the exception of the capacity charge. The ORR have been considering three options for this, which are explained in more detail in this draft Impact assessment:

Option 1 – keep the capacity charge but remove the caps (applied through the wash-up mechanism) for open access, charter and freight. The ORR think that the current caps in PR13 have to be removed to comply with the Railways (Access, Management and Licensing of Railway Undertakings) Regulations 2016, and in particular the Commission Implementing Regulation 2015/909 on the modalities for the calculation of the cost that is directly incurred as a result of operating the train service. This would mean capacity charges would go up quite significantly in PR18, which the ORR are worried would impact on competition. We are not convinced that the ORR's interpretation that the caps have to be removed is correct so it will be interesting to see if others agree when they respond to this consultation.

Option 2 – replace the capacity charge with adjustments to the Schedule 8 benchmarks. The ORR have discounted this as being too difficult to implement in time, although the industry still appears to be broadly in favour of this, so it will be interesting to see what comes out of the consultation.

Option 3 – Remove the capacity charge altogether and recover the lost revenue through higher fixed charges (see above). From the impact assessment, this seems to be the ORR's preferred option.

Schedule 8 performance regime

The ORR are not making significant changes to the Schedule 8 regime but are prioritising four key areas:

Passenger compensation

If a train service's reliability gets worse, then over time passengers will use it less, which means lower revenues for the operator. Schedule 8 payments compensate the operator for this, but they do not marry up with the compensation payments that the operators make to passengers. The ORR are considering two options:

Allow operators to recover the passenger compensation they have paid where this is due to a Schedule 8 event. This could be either a formulaic recovery (although the ORR have ruled this out for PR18 as too complicated to work out a formula in time) or on an actual costs basis (but Network Rail could end up compensating both the operator and their passengers and also the franchise payments would need adjusting so that the operator is not compensated twice); or
Publish passenger compensation levels and the attribution of these costs between operators and Network Rail. No sums would actually change hands but there would be a reputational incentive on Network Rail to address the causes of delay.

Setting benchmarks

The ORR propose not to link benchmarks to past performance, as this may be a disincentive on passenger operators and on Network Rail in the freight sector to improve their own performance. If this proposal goes ahead, the ORR will work with industry in 2017 to establish a new methodology for setting these benchmarks.

Measuring TOC performance

The ORR state that one of the purposes of Schedule 8 is to incentivise operators to minimise the delay they cause to other operators (and not to incentivise Network Rail to handle better the delay caused to operators). It's fair to say that the industry does not all agree with this interpretation. Based on this stated purpose, however, the ORR want to change the way TOC performance is measured in Schedule 8 so that it is based on the minutes of delay caused to other TOCs rather than on the minutes of delay which a TOC causes themselves. This begs the question of who bears the risk if the way an incident is handled by Network Rail causes more delay to other TOCs.

Sustained poor performance

At the moment, if performance is 10% worse than the benchmark for a sustained period, an operator can claim its additional costs and lost revenue over and above the Schedule 8 payments. However, in practice such claims are rarely made because of the difficulty in proving revenue losses. The ORR suggest that if the claims are restricted to costs only, rather than revenue, it would be easier to claim and the number of claims might increase, giving Network Rail more incentive to reduce sustained poor performance.

Schedule 4 possessions regime

The ORR's thinking on Schedule 4 is more high-level and less advanced than on Schedule 8 at this stage. They are looking at incremental change rather than fundamental reform. Following an RDG review of charges and a consultation in November 2015 they have decided to prioritise three areas:

the incentives created by notification discount factors (NDFs) - do the notice periods need to be as long as they currently are in the age of smart phones?
the way the access charge supplement (ACS) is calculated - there are various suggestions on how to make it more accurate; and
negotiated compensation arrangements - lowering the threshold and making the process simpler.

Financial incentives

The ORR are considering several options for the route-level efficiency benefit sharing mechanism (REBS) including its removal, redesign or replacement. They will publish their plans for REBS as part of their consultation on remaining charging issues in September 2017.

Next steps

According to the latest PR18 timetable (version 1.3, 26 January 2017), look out for these key dates in 2017:

June – results of this consultation
June/July – "mini" consultation on Schedules 4 and 8
July – Network Rail will publish its own charges and incentives consultation (going into more detail on the methodology)
September/October – Further ORR consultation on remaining charges and incentives issues (if required).