The risks of Railtrack


Lessons can be learnt from Railtrack’s failure. The government should re-appraise how projects should be financed and managed in the future.

The last regulatory review of Railtrack was based on the principles applied to all privatised monopoly utilities – gas transmission, electricity distribution, water supply. The Rail Regulator valued the assets of the business by reference to their sale price. He then allowed the company to charge prices that would cover its operating costs and yield a rate of return on these regulatory assets.

For Railtrack, the agreed rate of return was 8% in real terms. This is about six points higher than the rate at which the government can borrow – the difference reflects the additional costs of private sector financing and the risks associated with equity investment.

In a regulated utility, the most important of these risks is that costs will be higher than assumed in the calculations agreed between the company and the regulator. And the regulator may be less generous the next time around. These are in essence the only risks assumed by the management and shareholders of a regulated utility. It is hoped that the efficiency of private sector management, and pressures on management from its investors, will more than compensate for the substantial additional cost of equity capital.

For Railtrack this hope has proved unfounded. Costs are higher than foreseen and were expected to be much higher in future – not because of extraneous unforeseeable events, but as a result of matters which were directly under the management of Railtrack itself. In consequence, shareholders have not made the hoped for 8% real return but have lost a large part of their investment.

In these circumstances, it is hard to see what Fidelity Investments and other institutional holders of Railtrack shares are complaining about. Meeting the regulator’s cost targets has been easy for most utilities. That is why there has been downward pressure on the amount the companies have been allowed to earn in respect of the risk. Railways were, perhaps, harder. The 8% figure allowed Railtrack was the highest award made in any regulatory review.

It is easier to have sympathy for private investors in Railtrack. Individual shares whose performance is likely to be buffeted by political events and complex regulatory negotiations are not suitable investments for people with few disposable assets. Yet small shareholders were strongly encouraged to buy privatised businesses. Do you remember Sid, or the billboards showing the Loch Ness monster and the Forth Bridge? There was nothing there about the intricacies of regulatory asset value or the weighted average cost of capital. There used to be rules against promoting shares this way and there still should be.

But even small shareholders were told that shares might go down, although their experience was often different. The government has been paying a lot of money – not just in its privatisations but through the private finance initiative and other private-public partnerships – for the private sector to assume risk. It is in the nature of risks that they sometimes go the wrong way.

The Treasury alone has taken seriously the notion that you can earn yields substantially above the government bond rate only in return for accepting greater risk. For some time, Treasury insistence that the transfer of risk to the private sector should be real ensured that few private financing deals happened. But public sector managers were anxious to go ahead with their pet schemes. More important banks and their lengthy gravy trains of advisers wanted to be in on the act. They persuaded politicians that the Treasury approach was a bureaucratic curb on their freedom to earn margins and fees.

Increasingly, private finance became off balance sheet financing for the government. The underlying assumption has been that whatever the various parties said, the government would pay out in the end. The lesson of Railtrack is that this expectation is both widely held and unjustified. The government may bail out projects, but not necessarily the participants.

That lesson will prove costly. It would almost certainly have been cheaper to keep Railtrack going than to pay the extra that public private partnerships will cost now that the investors know their money may really be on the line. And the cost of genuine risk capital is likely to be too high for many of these schemes to make sense.

The trade-offs have already been illustrated in the water industry. The regulator’s allowance for the risks associated with the boring and stable businesses of water supply and sewage disposal is enough to be a substantial component of water bills but not enough to satisfy the expectations of stock market investors. That is why Welsh Water has turned itself into a not for profit company and other businesses – not just in the water sector – are looking at similar routes.

But Glas Cymru is only one of many other organisations which are neither plc nor branch of government. The BBC, schools, universities, NHS trusts, Channel 4, Equitable Life, museums and galleries. Transport for London, East of Scotland Water. Policy for every one of these is determined independently. There is no attempt to read across and see what works and what doesn’t, and there is little clarity about the capital structures of these businesses or the relationship between their public functions, their financial performance, and their external accountability.

It is time for joined up government. In developing New Railtrack, there is an opportunity to develop a model relevant not just for modernising the rail network but for the whole range of activities which are intermediate between the public and private sectors.


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