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Letting the regulator take the strain

30 June 2003

The government is letting commercial public service providers budget for a profit while its own regulator is doing all the sums that matter. So why shouldn't a state-owned contractor pitch for the work?

The news that Connex South Eastern is to be stripped of its railway operating franchise and replaced temporarily by a not for profit company established by the Strategic Railway Authority caused a flurry of excitement in the circles inhabited by those who thought the railways should never have been privatised in the first place. Following on from the demise of Railtrack it began to look as if the free market model was discredited and a new form of public ownership for these essential and costly services was on its way.

That's probably true, although no one in authority will admit it. And the reason they won't is because they don't yet know that it's true. It suits their purpose to continue to endorse the market-led solution, but that does nothing to alter the fact that the nature of the relationship between the state and its railways means that the operating environment is not, in fact, a free market at all.

The reason is straightforward - in the case of railway operators it is the state rather than the traveller who is the commercial client. This is especially true of the busy and essential commuter routes that bring people into the large cities every morning. There may be more than one way of getting from London to Manchester ('plane, car, train, even 'bus if you're desperate) and consequently some sort of competitive environment for passengers, but if you have x thousand people in Maidstone who all want to get to London at roughly the same time the train is actually the only way.

Not everyone can move in and lay on a rail service. Even when the railways started an Act of Parliament was needed to set up a line. Between Maidstone and London there is only room for one operator. Consequently the only competitive "market" moment comes when the prospective operators make their pitch to the government-inspired authority. Since the service is a public necessity the pitch is not really about how much the prospective operator is going to pay for the privilege of the monopoly concession. The real question is how much the government will have to pay them to run this essential service at controlled prices.

Applying truthful language to this relationship one would have to describe the train operators as subcontractors to the government. Like all subbies their job is to provide a skill at a pre-determined price, the great advantage of which to the main contractor is to offload the risk onto somebody else who may be better qualified to assess it.

For example, a house builder agrees to build a house for a competitive fixed price. He plans for a profit but he is still taking a risk because building always throws up problems you can't foresee. The brick-work is a big part of the job. By subbing it to a specialist brickie for a fixed amount, rather than employing him at a rate per hour, the contractor is passing up a bit of potential profit but also spreading the risk. If the bricklaying takes longer than it should it is the sub-contractor who will pay.

In principle the specialist bricklayer know better that the general builder how long the bricklaying will take. So, not only is the risk for this part of the contract passed to the bricklayer, but the risk of the price of it being miscalculated is reduced by having it calculated by a specialist in bricks. This is important, because if the cost of the bricklaying is underestimated there is no guarantee that the bricklayer will actually roll over and take the hit.

What happens if he can't afford to? If he's bought the bricks with the client's money and now can't complete the work? One way or another the loss is now spread between the subbie, the main contractor and the client. One thing that's absolutely certain is that the building of the house will be delayed.

Since the Thatcher revolution trashed the idea of directly-employed labour, governments have sub-contracted more and more of their work. not only governments, either. Throughout commerce and industry the trend is towards buying-in services and skills. The reason is usually the same - to avoid the establishment cost of direct labour and to maintain flexibility for when things change.

In the commercial world the risk of sub-contractor failure is offset by the reduced establishment costs and the spreading of the pricing risk. If the sub-contractor fails it may be costly and frustrating but it is not usually the end of the world. In government, however, it's not quite like that. Where the public is the client, the government the main contractor and the privately owned service provider is the subcontractor, the government is not normally in a position to tell the client that the service is on hold while the subcontractor sorts out his problems. The subbies have the government over a barrel; they ask for more money and they get it, because if they don't the 7.23 to Victoria won't run the following day.

So conscious are the government of this predicament that it looks as if they may be weighting PFI contracts in the subbies' favour in order to avoid failure. But they don't need to do that. What they need to do is to buy in to the subcontracting market directly. They need to recognise that in setting up the regulatory infrastructure to dictate service levels and fares, calculate costs, investment and subsidy, they have done essentially all the work and that it really doesn't matter what entity does the actual labour. The SRA have proved this by announcing blithely that they are going to run the former Connex services for a while. They promise that no one will actually notice - only the senior bosses will change. The only difference is that Connex's legitimate profit margin will not actually leave the public purse.

The reason public ownership got a bad name was because there was no framework. Like interest rates, the government made up the rules for British Rail as it went along. But private involvement, like an independent Bank of England, demanded a regulatory framework. If the framework is wrong the public purse gets stuffed, anyway. But if the framework is right, it is no more difficult for a public or not-for-profit entity to do the business and for the public purse to keep the loot.