On track to reform: how the ORR intends to incentivise public companies

The chief executive of the Office of Rail and Road explains how regulation can help to deliver value for money for taxpayers. 

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Britain’s railway is in demand, with more than 1.7bn passenger journeys being made in 2016-17. Each journey connects people with jobs, education, family and friends, strengthening our society and economy. Network Rail’s job of operating, maintaining, renewing and enhancing the infrastructure of the mainline railway is vital. The success of the industry as a whole depends on the success of Network Rail.

At the Office of Rail and Road our role is to protect the interests of rail and road users. An important aspect is the economic regulation of Network Rail, holding it to account for delivering high levels of performance and service, as well as good value for money – for passengers, freight customers and taxpayers.

The basis for this regulatory system was set in 1993 as part of the process of privatisation. Since then the infrastructure owner has followed a path from a privatised company – as Railtrack plc – back to the fully publicly owned Network Rail in 2013.

In that time the regulatory model has evolved but has not been radically overhauled. As we approach the next five-year funding settlement for Network Rail, beginning in April 2019, we are undertaking our periodic review of the company. Our aim is to support a more efficient, safer and better used railway, delivering value for passengers, freight customers and taxpayers in CP6 and beyond. So how are we taking this opportunity to reset our regulation of Network Rail?

Economic regulation: incentivising a publicly owned company

Economic regulation was established in response to the privatisation of utilities in the late 1980s. Economic regulation starts with understanding the monopoly’s motivations. In the case of privately owned companies, firms aim to maximise profit and shareholders aim to maximise their return on investment. Put simply, the role of economic regulators was to ensure  that the monopoly did not achieve its profit maximising through the exploitation of its customers.

In a world where the government owns a monopoly, such as Network Rail, a single incentive of profit maximisation no longer exists. Instead, there are two broad incentives at play within the company: enhancing its reputation and an aversion to risk.

People like to work in successful organisations. Success reflects on them directly and indirectly giving them opportunities in the future, both individually and corporately. Pressing against this positive reputational incentive can be a tendency to defer difficult decisions and avoid risk. The motivation of the state as shareholder is also different when compared to the private sector. The shareholder is now political. The role of the shareholder to exert pressure on management or to replace the management remains, but the shareholder’s incentives are more closely linked to the political cycle and narrative.

Route devolution: an opportunity for regulation

This change in the company’s incentives, from profit to reputation maximisation, requires a change in approach to ensure we are still regulating Network Rail effectively. In Network Rail’s case this change is facilitated by the opportunity brought by its transformation into eight devolved geographical route businesses, supported by a national system planning function.

This route-based structure creates opportunities to better use the reputational incentives on Network Rail and its routes to meet the requirements sought by funders on behalf of passengers and freight customers. These routes are smaller, more focussed businesses, which will strengthen the line of sight between them and their customers, the train operators, and ultimately passengers and freight customers. In addition, they will also enable us as regulator to make comparisons between route management teams carrying out comparable activities in different parts of the country.

As a minimum, our periodic review will need to make sure that the routes have their own budgets and clarity around what they are expected to deliver. They also need the opportunity to innovate and do things differently from each other, so we can identify best practice and share it between the routes.

We know anecdotally that this structure is already generating a sense of competition between routes and is used by their managing directors to motivate their teams.

Regulating efficiency

Efficiency is always a priority for taxpayers and governments faced with a wide range of competing demands for resource. The picture in recent years at Network Rail has not been positive with year on year declines in how efficiently it is renewing the network. Network Rail now operates within a fixed funding envelope. To stay within this envelope it has forecast that it will have to defer £3.9bn’s worth of work into future years, in turn requiring more re-planning which in itself can create further inefficiency.

Traditionally utility regulators have not monitored efficiency in the same way that they monitor the quality of service received by customers.

This is because within the profit maximising model there is already a powerful incentive to become efficient, but this is not easily replicated in the reputation maximising model.

Our approach as a regulator to assessing Network Rail’s plans, as well as our ongoing monitoring of efficiency, has had to change. Throughout our periodic review we have placed a strong emphasis on the importance of good quality, bottom-up plans owned by the routes with specific plans to deliver efficiencies.

It is no longer sufficient for us as regulator to report only on what has happened in terms of efficiency. In future we will be reporting on leading indicators which aim to show ahead of time how Network Rail is performing. This future look will enable action to be taken to correct it.

What’s next?

The initial conclusions from our periodic review will be published on 12 June, ahead of our final determination in the Autumn. Then, we will be holding each of Network Rail’s route businesses to account for delivering their £53bn investment plans, which are vital to the success of the whole railway, and the passengers and freight customers who rely on them.