Identifying the benefits Office of Rail Regulation of an improved understanding of Network Rail's costs and cost drivers Final Report Our ref: P22781801 May 2015 Client ref: ORR/CT/14-58 Identifying the benefits Office of Rail Regulation of an improved understanding of Network Rail's costs and cost drivers Final Report Our ref: P22781801 May 2015 Client ref: ORR/CT/14-58 Prepared by: Prepared for: Steer Davies Gleave Office of Rail Regulation 28-32 Upper Ground One Kemble Street London SE1 9PD London WC2B 4AN +44 20 7910 5000 www.steerdaviesgleave.com Steer Davies Gleave has prepared this work for Office of Rail Regulation. This work may only be used within the context and scope of work for which Steer Davies Gleave was commissioned and may not be relied upon in part or whole by any third party or be used for any other purpose. Any person choosing to use any part of this work without the express and written permission of Steer Davies Gleave shall be deemed to confirm their agreement to indemnify Steer Davies Gleave for all loss or damage resulting therefrom. Steer Davies Gleave has prepared this work using professional practices and procedures using information available to it at the time and as such any new information could alter the validity of the results and conclusions made. Contents Executive Summary ....................................................................................................................... i Introduction ................................................................................................................................... i Decisions and decision-makers ...................................................................................................... i Transmission mechanisms .............................................................................................................ii Rail sector case studies ................................................................................................................. iii Experience in other sectors .......................................................................................................... vi Future scenarios ........................................................................................................................... ix 1 Introduction ....................................................................................................................... 1 Background ................................................................................................................................... 1 Our approach ................................................................................................................................ 1 2 Decision-making in the rail industry .................................................................................... 3 How costs inform decisions .......................................................................................................... 3 Transmission mechanisms ............................................................................................................ 7 3 Case studies of decision-making in the rail industry ........................................................... 12 Overview ..................................................................................................................................... 12 Network enhancement: electrification of Great Western Mainline branches ........................... 13 Network enhancement: Northern Hub and Northwest Electrification ...................................... 16 Capacity enhancement: Reading station .................................................................................... 18 Capacity enhancement: Oxford station ...................................................................................... 19 Rolling stock procurement: Class 444/450s on Wessex routes .................................................. 22 Rolling stock deployment, Mk III and Mk IV stock on ECML ...................................................... 26 Service enhancements: Knottingley to Wakefield Kirkgate ....................................................... 28 Summary ..................................................................................................................................... 31 4 Improving cost information in other sectors ...................................................................... 33 Introduction ................................................................................................................................ 33 Implications for ORR ................................................................................................................... 33 Case Study A: understanding demand-side in the water industry ............................................. 36 Case Study E: constructive engagement in the Australian rail industry ..................................... 37 Case Study F: unit costs in Healthcare ........................................................................................ 39 Case Study L: Long Run Avoidable Costs in ports ....................................................................... 45 May 2015 Implications for funders.............................................................................................................. 46 Implications for Network Rail ..................................................................................................... 46 Case Study R: transfer pricing in German firms .......................................................................... 47 Implications for investors and creditors ..................................................................................... 47 The costs of obtaining better information ................................................................................. 48 Conclusion .................................................................................................................................. 49 5 Opportunities for improving the understanding of Network Rail’s costs ............................. 52 Introduction ................................................................................................................................ 52 The benefits of a better understanding of costs ........................................................................ 53 Opportunities for improving cost information ........................................................................... 55 Future scenarios ......................................................................................................................... 62 Figures Figure 2.1: ORR’s Final Determinations for CP5 ........................................................................... 5 Figure 2.2: Network Rail’s forecast revenue from charges for 2014-15 (2013-14 prices) ........... 7 Figure 2.3: Passenger franchise welfare gains .............................................................................. 9 Figure 3.1: Great Western electrification plans ......................................................................... 13 Figure 3.2: Inefficient investment through poor attribution of costs and benefits ................... 14 Figure 3.3: Oxford station: Evergreen 3, Great Western IEP, East West Rail and Electric Spine 20 Figure 3.4: Mark I and replacement stock: comparative EC4T charges ..................................... 24 Figure 3.5: Mark I and replacement stock: comparative variable charges ................................ 24 Figure 3.6: The “Pontefract Line” from Knottingley to Wakefield Kirkgate ............................... 29 Figure 4.1: Approach to case study analysis ............................................................................... 33 Figure 4.2: Regulated companies’ views on regulators’ information requirements .................. 48 Tables Table 2.1: Principal opportunities to make use of an understanding of costs ............................. 4 Table 2.2: Examples of service reductions and their impact on Network Rail costs .................... 6 Table 2.3: Allocation of the costs of the Hitchin flyover ............................................................ 10 Table 3.1: Selection of rail case studies ...................................................................................... 12 Table 3.2: Enhancements planned, committed or under construction affecting Oxford .......... 21 Table 3.3: CP5 variable usage charges (VUC) for Mark III and Mark IV formations ................... 27 May 2015 Table 3.4: Impact of improved understanding of costs on rail industry activity ........................ 32 Table 4.1: Case studies of charges which vary with geography and/or time ............................. 43 Table 4.2: Case studies of charges using LRMC approaches ...................................................... 44 Table 4.3: Summary of key experience from other sectors ....................................................... 50 Table 5.1: Weaknesses in current understanding of costs ......................................................... 52 Table 5.2: Case studies: potential benefits of better understanding of Network Rail costs ...... 54 Table 5.3: Opportunities for improving cost information .......................................................... 56 Appendices A Experience of understanding costs in other sectors B Welfare analysis of fixed and variable access charges C Future scenarios D Information sources May 2015 Identifying the benefits of an improved understanding of Network Rail's costs