How might franchising change the UK bus industry?

In its recent report, the Competition Commission concludes that local bus markets aren’t quite as competitive as was once envisaged by the architects of deregulation. This is no bad thing in itself – I expect few of us would advocate a return to the bus wars of the 1980s. The problem is that without the discipline of a competitive market larger operators are able to take home a little too much profit, largely at the expense of passengers and, often, smaller operators. So how could we introduce greater competitive pressures in the market without more wasteful competition? The Commission offers franchising as a potential solution. Indeed, this approach is now the norm across the developed world and the evidence shows it can be a powerful tool in delivering both cost savings and patronage growth. But how might franchising change local bus markets? This article tries to draw some lessons from the experience in London, the Netherlands and Scandinavia.

Lessons from London

London hybrid bus near the Houses of ParliamentOne of the most interesting examples of bus franchising is in London, where TfL is fully responsible for designing the network and tenders out around a fifth of all routes every year, with several bidding rounds each year. This steady flow of contracts has helped keep the market alive and avoids peaks of activity. TfL also takes revenue risk, thereby removing the biggest advantage held by the incumbent at re-tendering, a common problem in recently de-registered services elsewhere in the country. There are now seven medium-sized operators and two smaller ones, with an average of three bids per tender. With controls at the tendering stage to prevent any single operator from dominating this is likely to remain fairly stable in years to come. Another key feature in London is the use of quality incentives since 2000, which has reversed the decline in reliability and service quality observed in the 1990s.

Lessons from the Netherlands

Outside the UK, the Netherlands provide a contrasting model to London with large area-based contracts as the norm. The province of Limburg is at one extreme, having awarded a long term multi-modal net cost contract to Veolia in 2006 covering both rail, bus and taxi. Despite some teething problem as a result of deviations from cost and patronage forecasts, this integrated network approach has delivered both huge cost savings and substantial growth in demand. Few other franchising authorities have been quite as bold though, most of which preferring to adopt gross cost contracts subject to minimum service levels and quality incentives. However, some degree of negotiation over network design issues appears to be commonplace at the tendering stage. Overall, the Dutch approach has been effective in the difficult task of moving some large public monopolies into private ownership.

Lessons from Scandanavia

A slightly less conventional model has been developed in Norway, where reasonably efficient incumbents in some parts of the country are allowed to maintain their monopoly position but with all public subsidy awarded through highly incentivised contracts. These are typically a combination of unit payments per bus-km, per passenger and per passenger-km, varying based on local priorities (for example, with more emphasis on bus-kms in rural areas and passengers in urban areas). The objective is to ensure operators’ decisions are well aligned with public sector objectives. Underperforming operators can be replaced through competitive tendering by default, a more credible threat than Quality Contracts at present. In a way, this model is not dissimilar to Statutory Quality Partnerships with the key difference that UK transport authorities directly control little more than 10% of industry revenues, compared to over 50% in Scandinavia. Changes in subsidy flows could certainly make this a more viable model.

What does this mean for the UK?

In general, international experience suggests that there is more than one way to improve the functioning of local transport markets, with all-out deregulation possibly one of the worst models around  both for passengers (as demonstrated by the contrasting faith of London and the metropolitan areas over the past 25 years) and for smaller operators. The precise model that each UK local market ends up with in the future will depend not only on the Competition Commission but, crucially, on the current market structure, LTAs’ funding and attitude to risk. It is conceivable that some areas could end up with a Limburg-style model while others will prefer to develop something closer to current partnership arrangements. On the whole, these are very exciting times which offer the potential to deliver a more sustainable market structure, increasingly attractive bus services but, above all, long term passenger growth.

Pedro Abrantes

This article was first published in Coach and Bus Week.

The end of bus deregulation red in tooth and claw?

Bus wars could be consigned to history

The Competition Commission is a black box that sucks masses of data and information in but what’s going to come out of it you don’t know until the lid suddenly opens. Or half opens in the case of the interim report. And the interim report is paradoxically both more and less radical than might have been reasonably anticipated. First things first. The CC, in an understated but definitive way, says there is a problem with the market and that profits are higher than there would be if the market was working properly. However the CC firmly eschewed the options of divestment or seeking to trigger the spectacle of bus wars on the streets. This is the kind of competition that traditionally would have sent the OFT and CC  home from the office at night with a smile on the face and a song in their heart. Happy that all was now well in the world as perfect consumers could delight in making sophisticated judgements on which service to choose as they glumly stood in the rain at their bus stops waiting to get home. This is highly significant as a free market red in tooth and claw was what the 1985 Act was all about. Goodbye to all that.

But just because they have rejected what was their default response in the past, that’s not to say there isn’t a problem to be solved. In a definitive and understated way the CC is very clear that there is a problem with the bus market – and that profits are higher than they would be if the market was working properly. Instead of short term bus wars what it wants to see is a more civilised and structured format for competition. In large urban areas this could well mean franchising. If not franchising then there should be more gentlemanly competition for markets. It should take place within the framework of attractive multi-operator fares and without the aggressive or defensive flooding of key routes with excess services, or sudden fares reductions. The Traffic Commissioners are identified as those that would oversee this squeaky clean competitive environment. But this seems highly unlikely given the retrenchment of the Traffic Commissioners recently in favour of VOSA, as well as the mismatch between the TC’s traditional focus on safety and performance rather than the tricky and localised issues around what’s fair competition and what isn’t. So if it’s not the Traffic Commissioners then is there a role for Local Transport Authorities, or some form of independent regulation, in moderating competition? Deep waters for the Competition Authorities – but then again the logical outcome of their own findings and the objectives they’ve said they want to achieve.

The future is smart and integrated

A further significant aspect of the report is that it offers the opportunity to build on the three ways to improved bus services offered by the Local Transport Act 2008: more comprehensive and effective voluntary partnerships, statutory quality partnerships and quality contracts. Unless there’s a big change in the final report the idea of scrapping key sections of the Act – in particular the provisions on quality contracts – looks to be closed off. That’s good news as it creates stability, and in my view, the Local Transport Act 2008 was about 75% there in making the voluntary partnership, SQP and QC options fully effective. The way the interim report is going leaves a lot of options for Norman Baker to build on the Local Transport Act 2008 to craft a new bus policy that knocks the rough edges off some of the detail of the legislation, that focuses on key objectives (not least of which is simpler, smarter ticketing) and uses BSOG to incentivise those outcomes. There’s a big opportunity here for everyone to move on and accept that the future is about a more structured format for competition in the bus market; where smart and integrated is central to what public transport is providing; and where the three options in the Local Transport Act are the ways to achieve these outcomes (depending on local circumstances). But given some of the boorish condescension that is being directed at the CC via the bus press, it looks like the past can be a more comforting place to be!

Jonathan Bray

This article was originally published in Coach and Bus Week.

Higher profits or better regulation – what would really get bus markets moving?

 A report recently published by the Department for Transport  robustly demonstrates what we have long known but many in the bus industry regularly attempt to discredit – the deregulated bus market has effectively become a set of local monopolies which large operators are able to exploit to their advantage. This is nowhere more true than in PTE areas where large operators are making profits, on average, double of those that would be expected in a truly competitive environment.

But let’s focus on the fundamental question of what drives successful local bus markets. Some have argued that it is lack of profitability rather than lack of regulation, that is holding back the development of a more competitive and efficient bus sector. They contend that operators’ strong desire for growth would tempt them away from reaping excess profits even in what have effectively become monopolies of local bus markets. This is at the core of the recent TAS submission to the Competition Commission, which suggests that it is the inherently low level of profitability in the industry, rather than incumbents’ market power, which has led to limited competition.

pteg is sceptical about this argument – which is in danger of becoming received wisdom in some quarters. Instead we would argue that bus operations in the PTE areas have maintained relatively high profit margins, largely at the expense of patronage growth, whilst being supported by significant levels of public sector funding. We would further contend that far from being the distraction that some claim it is, improved regulation could lead to some of that profit being better channelled towards improving the quality and coverage of bus networks.

Healthy levels of profitability in the industry were clearly demonstrated in research carried out by NERA in 2006 which showed average profitability amongst the five largest groups to be above the national average for non-financial businesses, and higher still within PTE areas. Bearing in mind the relatively low proportion of actual capital expenditure and the growing volume of public sector funding (more than 40%), the return on capital from deregulated bus operations has been and continues to look highly attractive to investors. This conclusion is strongly supported by the recent L.E.K. report to the DfT, which shows that PTE bus subsidiaries of large groups are earning profits well above those expected from a competitive market.

Indeed, this view seems to be reflected in the stock market performance of the largest UK operators. The graph below shows the price to earnings ratio (P/E) of the five quoted groups over the past 5 years, using the BT Group and Barclays as benchmarks. All four groups which have UK bus as their core business have been well regarded by investors even through the recession. Interestingly, the greatest drop in investor confidence was linked to National Express’s forfeit of its East Coast rail franchise rather than any event taking place in the bus market. And despite the recession, a recent analysis by UBS  (UBS Investment Research – UK Bus and Rail, 14 April 2010) was remarkably upbeat about the profitability prospects for deregulated bus operations, upgrading its recommendation to ‘buy’ for two of the five groups.

As the table shows, deregulated bus operations appear to be the workhorse of the large groups, having generally delivered year on year revenue growth (and profit) for most of the past 10 years. Interestingly, analysis by NERA and TAS shows profitability to be highest within PTE areas which should naturally make this market highly attractive to both new entrants and investors. If we then acknowledge that incumbent operators are making respectable profits on what are fairly large and heterogeneous networks, this suggests there are likely to be core sections of their networks where much higher profit levels are being achieved. The small number of significant new entrants in PTE areas along with the rapid decline of smaller groups and management or employee-owned operators constitutes a clear sign of the degree of market power held by incumbents. Curiously, a number of significant new entrants have emerged not in the deregulated PTE areas, but rather in the more tightly regulated London bus market (for example, Abellio and Comfort Delgro)

So if, as TAS and others appear to believe, profitability equals patronage growth, then the levels of profitability we are seeing should be resulting in that patronage growth. However, in many areas this is clearly not the case. This is because there are other ways in which operators can achieve attractive levels of profitability – including utilising available public subsidy and increasing fare levels (see table).

To understand how this works it is important to acknowledge that there is inherently some degree of cross-subsidy within commercial networks as incumbents avoid leaving gaps for new entrants whereas only small savings will result from cutting marginal services (such as early morning services). But when profit targets are hit by falling demand a low risk strategy is to de-register such marginal services since the danger of entry is small and the incumbent will often be best placed to win back the service if tendered . There are also examples where the incumbent started operating commercially again following the loss of a tender. It is no surprise that tenders for such services typically receive a small number of bids. Another obvious strategy is to increase fares so as to extract maximum revenue from lower elasticity passengers on profitable routes . The recent growth in the free travel market, which now typically represent over one quarter of PTE bus demand, has made this strategy increasingly attractive for operators. This is because a growing proportion of passengers (in some cases the majority) are insensitive to the adult cash fare.

The argument that bus regulation is a distraction from more central issues of bus profitability levels is also false. There is clearly potential for increased regulation (such as through the introduction of Quality Contracts) to grow the bus market. For one, it could help remove some of the existing barriers to entry therefore unlocking the full benefits from effective and healthy competition. But more critically perhaps it would allow passengers to reap a greater proportion of the benefits currently flowing directly to operators (and their shareholders) by using profits from commercial routes to support a fully comprehensive and high quality public transport network. Also important is that it would do this in a context of greater network stability and with the explicit objective of achieving long term patronage growth while maintaining affordability. Greater regulation would also remove barriers to the roll-out of smartcard ticketing, enabling significant operational and time savings and greater value integrated tickets, all key to sustained passenger growth.

So, the argument that inadequate profitability in the bus sector is the main obstacle to better bus markets is not supported by the evidence – particularly in PTE areas. The evidence that operators are motivated primarily by passenger growth is also weak. Even in relatively closed markets operators are achieving good rates of return in declining markets through fares increases, service reductions and effective utilisation of public subsidy. Far from being a distraction better regulation offers the prospect of reasonable returns for operators as well as creating a more competitive market for the provision of bus services with better outcomes for passengers and taxpayers.

 

Pedro Abrantes

A version of this article originally appeared in Transit magazine.