# Competition In Passenger Rail Services In Great Britain

A policy document  
You may reuse this information (not including logos or the map of train operators in the Appendix) free of charge in any format or medium, under the terms of the Open Government Licence. 

To view this licence, visit www.nationalarchives.gov.uk/doc/open-governmentlicence/ or write to the Information Policy Team, The National Archives, Kew, London TW9 4DU, or email: psi@nationalarchives.gsi.gov.uk. 

1. Summary .............................................................................................................. 4 
Introduction ........................................................................................................... 4 
Consultation on the discussion document ....................................................... 5 
Independent impact assessment of the four options for greater on-rail 
competition ..................................................................................................... 6 
The rationale for the project .................................................................................. 6 Our goals .............................................................................................................. 8 
Industry background: competition in the rail sector 
............................................... 9 
The potential benefits of greater on-rail competition ........................................... 11 
Potential passenger benefits ......................................................................... 11 Potential efficiency gains ............................................................................... 14 
The feasibility of greater on-rail competition: obstacles and opportunities .......... 16 
Access to infrastructure, network capacity and rolling stock 
.......................... 16 
Funding the network and loss-making services, and the financial  
sustainability of operators 
............................................................................. 18 
Operational issues 
......................................................................................... 21 
Summary of feasibility considerations ........................................................... 23 
Options for greater on-rail competition 
................................................................ 23 
The scope of the options ............................................................................... 24 
The four options 
............................................................................................. 24 
Assessment of the options ............................................................................ 25 
Recommendations and next steps 
...................................................................... 32 
General recommendations: laying the foundations for a dynamic,  
competitive industry 
...................................................................................... 32 
Recommended option: Option 1, a significantly greater role for open  
access on intercity routes ............................................................................. 33 
A vision for the longer term: Option 4, a licensing system for operators on 
main intercity routes ..................................................................................... 35 
Our parallel recommendation: introducing Option 2 where it has the  
potential to deliver benefits on the network .................................................. 36 
Next steps...................................................................................................... 36 
2. Context: industry background ............................................................................. 37 
Structure of the rail sector in Great Britain .......................................................... 37 
Network Rail .................................................................................................. 37 Franchised TOCs .......................................................................................... 38 
Open access operators ................................................................................. 41 Freight operating companies ......................................................................... 42 
Rolling stock leasing companies 
.................................................................... 43 
The role of the regulator and government ..................................................... 44 
Funding of the rail industry 
.................................................................................. 48 
The rail industry's income and expenditure ................................................... 48 The development of competition since privatisation ...................................... 58 
3. Evidence of potential passenger benefits from greater on-rail competition 
......... 66 
Introduction ......................................................................................................... 66 
On-rail competition in Great Britain 
..................................................................... 68 
Competition between open access operators and franchisees 
........................... 71 
First Hull Trains and Virgin East Coast (London to Stevenage, Grantham, 
Retford and Doncaster with one daily overlap to Hull) 
.................................. 72 
Grand Central and Virgin East Coast (London to York, Northallerton and 
Sunderland; London to Doncaster, Wakefield and Bradford) ....................... 75 
Alliance Rail (London to Blackpool from 2018) 
.............................................. 80 
Overlapping and parallel franchises 
.................................................................... 80 
Changes to the level of franchise overlap 
...................................................... 82 
On-rail competition in other European countries 
................................................. 85 
Introduction 
.................................................................................................... 85 
Benefits of on-rail competition in Europe ....................................................... 88 
Differences between open access competition in Great Britain and other 
European countries ...................................................................................... 92 
A trend towards greater rail competition in European countries .................... 98 
Competition in other transport markets ............................................................. 100 
The Great Britain rail freight sector 
.............................................................. 100 
The experience of EU airline deregulation 
................................................... 104 
Dynamic competition: the Gatwick Airport example 
..................................... 105 
Deregulation of local bus services in Great Britain ...................................... 108 
Conclusion on the evidence of potential passenger benefits ............................ 110 
4. Efficiency gains from greater on-rail competition .............................................. 113 
Efficiencies in train operations .......................................................................... 113 
Introduction 
.................................................................................................. 113 
Estimating efficiency 
.................................................................................... 114 
Efficiency of open access operators ............................................................ 115 Sources of efficiency at open access operators .......................................... 118 
Upstream efficiencies 
........................................................................................ 121 
Evidence from open access operators and competing franchisees 
............. 121 
Evidence from the rail freight sector ............................................................ 122 Capacity expansion at Heathrow Airport ..................................................... 123 Airport management .................................................................................... 124 Scottish water sector ................................................................................... 125 
Efficiency gains in the impact assessment 
........................................................ 125 
Conclusion ........................................................................................................ 127 
5. The feasibility of greater on-rail competition: Obstacles and opportunities ....... 128 
Introduction ....................................................................................................... 128 Access to infrastructure, network capacity and rolling stock ............................. 128 
Access to network infrastructure and capacity scarcity ............................... 129 
Incentives to maximise network capacity 
..................................................... 136 
Access to rolling stock ................................................................................. 140 
Financial issues: funding the network and operators' financial viability............. 143 
Introduction: loss-making services and their funding mechanism 
................ 143 
The impact of on-rail competition on government funds .............................. 146 
Fixed access charges and the network grant .............................................. 155 
Franchise scope and service specification .................................................. 158 
Impact of on-rail competition on operators' finances and business 
sustainability 
............................................................................................... 161 
Potential adverse effects of an increased number of operators ........................ 164 
Operational issues 
....................................................................................... 165 
Increased complexity of the system 
............................................................. 173 
Conclusions ...................................................................................................... 178 
6. Options for reform 
............................................................................................. 182 
Introduction ....................................................................................................... 182 
Approach to assessing the options 
.............................................................. 182 
| Addressing potential barriers to competition                                     |  184    |
|----------------------------------------------------------------------------------|---------|
|                                                                                  |         |
| Scope and timing                                                                 | 185     |
|                                                                                  |         |
| Option 1 - existing market structure, but significantly increased open access    |         |
| operations 186                                                                   |         |
|                                                                                  |         |
| Designing a PSO levy or other appropriate funding mechanism 188                  |         |
|                                                                                  |         |
| Option 2 - two franchisees for each franchise 189                                |         |
|                                                                                  |         |
| Option 3 - more overlapping franchises 192                                       |         |
|                                                                                  |         |
| Option 4 - licensing multiple operators, subject to conditions (including public |         |
| service obligations) 193                                                         |         |
|                                                                                  |         |
| Other recommendations to support greater competition                             | 197     |
|                                                                                  |         |
| Detailed specification of operators' obligations                                 | 197     |
|                                                                                  |         |
| Reforming the structure of access charges 198                                    |         |
|                                                                                  |         |
| Network Rail's incentives as system operator 200                                 |         |
|                                                                                  |         |
| Smart ticketing                                                                  | 201     |
|                                                                                  |         |
| Assessment of the options                                                        | 201     |
|                                                                                  |         |
| Passenger and efficiency benefits 202                                            |         |
|                                                                                  |         |
| Funding and risk 207                                                             |         |
|                                                                                  |         |
| Network considerations, including operational issues 212                         |         |
|                                                                                  |         |
| Wider social benefits 215                                                        |         |
|                                                                                  |         |
| Ease of implementation, including legal and technical feasibility                | 216     |
|                                                                                  |         |
| Overall assessment 218                                                           |         |
|                                                                                  |         |
| 7.                                                                               |         |
|                                                                                  |         |
| Recommendations and next steps                                                   | 222     |
|                                                                                  |         |
| Introduction 222                                                                 |         |
|                                                                                  |         |
| General recommendations: laying foundations for a dynamic, competitive           |         |
| industry 222                                                                     |         |
|                                                                                  |         |
| Further reducing the level of detailed specification of franchise contracts      | ... 223 |
|                                                                                  |         |
| Reforming the structure of access charges 223                                    |         |
|                                                                                  |         |
| Improving the 'system operator' function 223                                     |         |
|                                                                                  |         |
| Encouraging the use of smart ticketing                                           | 224     |
|                                                                                  |         |
| Recommended options for reform                                                   | 224     |
|                                                                                  |         |
| Recommended option: Option 1, a significantly greater role for open              |         |
| access on intercity routes 225                                                   |         |
|                                                                                  |         |
| A vision for the longer term: Option 4, a licensing system for operators on      |         |
| main intercity routes 231                                                        |         |
|                                                                                  |         |
| Our parallel recommendation: introducing Option 2 where it has the               |         |
| potential to deliver benefits on the network 233                                 |         |
|                                                                                  |         |
| Conclusions on our recommendations and next steps 235                            |         |
|                                                                                  |         |
| Next steps 235                                                                   |         |
|                                                                                  |         |

## Appendix

A:  Map of train operators in Great Britain B:  List of open access proposals submitted to ORR from 2000 to 2015 C: On-rail competition in Europe D:  EU rail legislation 
E:  Network enhancements F:  Rail capacity and auctions 

## 1. Summary Introduction

1.1 
Great Britain's railway sector has undergone a remarkable renaissance. In the immediate post-war period, there was a sharp decline in rail usage: the number of rail passenger journeys per year in Great Britain had fallen from about 1 billion in 1950 to barely over 600 million by the mid-1980s. Since the mid-1990s, there has been a steady rise. Over the past ten years, passenger numbers have increased by 60% and by 2014–2015, over 1.6 billion rail passenger journeys were being made annually in Great Britain, significantly 
outpacing the growth seen in other major EU countries.1 
1.2 
Passenger satisfaction has also improved in recent years. The National Rail Passenger Survey, conducted by Transport Focus, shows that passenger satisfaction improved from an overall satisfaction rating of 72% in spring 2002 
to a rating of 83% in autumn 2015.2  
1.3 
This suggests that the arrangements for passenger rail services in Great Britain in place since the mid-1990s have yielded broadly successful outcomes, in spite of well-known difficulties such as the collapse of Railtrack 
in 2001–2002, the failure of the private sector East Coast franchisee in 20093 
and the failure of the West Coast franchise letting competition in 2012.  
1.4 
The Competition and Market Authority (CMA)'s statutory duty is to promote 
competition for the benefit of consumers.4 In addition, the government's 
current 'strategic steer' to the CMA, published in December 2015, states that CMA 'should use its knowledge to actively challenge central and local government and encourage the use of effective competition to improve 
delivery and to promote more diversity and choice for UK consumers'.5  
1.5 
In January 2015 we launched a policy project to consider the role of competition in passenger rail services, and the extent to which the broad success of passenger rail services since the mid-1990s might be enhanced - to the benefit of passengers, the industry and the country as a whole - by introducing a greater degree of competition. 
1.6 
Following the launch of the project, we engaged in discussion with a wide range of interested parties and industry experts. We liaised closely with the Office of Rail and Road (ORR). Jointly with ORR we hosted a 'round table' of franchised train operating companies (franchised TOCs) and a separate round table of open access operators (OAOs) and applicants. We also individually met representatives of OAOs, franchised TOCs, Network Rail, the rail freight industry, the consumer representatives Transport Focus and Which?, as well as academics and other experts specialising in the sector. We engaged extensively with the Rail Group at the Department for Transport (DfT) and with officials at Transport Scotland, the Department for Business, Innovation & Skills, HM Treasury and with international rail regulators.  
1.7 
In July 2015, we published a discussion document for consultation.6 The 
discussion document suggested that, while the existing system of competition 'for' the market was working well, a material increase in on-rail competition would result in benefits for passengers and improve efficiency in the sector. 
1.8 
We proposed four options for increasing on-rail competition in passenger rail services, which we considered most likely to deliver benefits on the three main intercity routes in Great Britain - namely the East and West Coast main lines and the Great Western route. To protect against risk for existing and imminent franchises, we stated that we did not envisage any of these options coming into effect until after the end of the current frail franchise terms (or, where new franchise tenders are imminent, after the terms of those franchises about to be tendered), which would mean 2023 at the earliest.   
1.9 
We invited comments on the four options as well as on potential barriers to greater on-rail competition including funding the network and operational impact.   

## Consultation On The Discussion Document

1.10 During the consultation period, we engaged with a wide range of stakeholders 
through bilateral meetings and held an industry-wide 'round table'. We also presented our work at a number of industry forums and conferences.   
1.11 Over 50 consultation responses were received including from the DfT, ORR, 
the Rail Delivery Group, Network Rail, Transport Scotland, franchised TOCs and their owner groups, OAOs, Transport Focus, Which?, regional transport 
partnerships and industry experts. Individual responses are published alongside this policy document. 

## Independent Impact Assessment Of The Four Options For Greater On-Rail Competition

1.12 In order to inform our further assessment of the four options for greater on-rail 
competition set out in our discussion document, ORR commissioned Arup and 
Oxera to undertake an impact assessment of the options.7  
1.13 The impact assessment focused on three main areas: 
 
an assessment of the legal and operational feasibility of each option; 
 
the impact of each option on market outcomes, including the benefits and costs for passengers, social objectives, wider benefits and externalities, industry costs and efficiency; and 
 
the impact of each option on government funding of the rail network.   
1.14 ORR published the impact assessment on 4 January 2016.8 The CMA invited 
any further consultation responses in relation to the four options for greater on-rail competition in light of this impact assessment. Twelve responses were received, including from the DfT, Rail Delivery Group, Network Rail, Transport Scotland, franchised TOCs and OAOs. The responses are published 
alongside this policy document.   

## The Rationale For The Project

1.15 This project is intended as a contribution to public policy debate by an 
independent competition authority that is not a participant in the rail industry. We examined whether it would be desirable and feasible to increase the degree of competition 'in' the market for passenger rail services in Great Britain - that is, competition between operators of passenger rail services, also called 'on-rail' competition. 
1.16 Downward pressure on fares, upward pressure on service quality and 
innovation and greater efficiency are - in theory at least - benefits delivered by competitive markets. As a competition authority, we have explored claims 
made in recent years9 (by regulators, think tanks and commentators) that, in Great Britain's passenger rail sector, these objectives could be better achieved through greater competition between passenger train operators.  

## 1.17 The Following Points Are Important Context For Our Work:

 
In Great Britain we have an established industry structure that enables competition in passenger train operations, with full separation between train operators at the 'downstream' retail level and a wholly independent 'upstream' infrastructure manager, Network Rail. 
 
The franchising process, post-Brown Review10 (ie after 2012), is on a 
firmer footing than before, evidenced by the successful competition to award the East Coast main line franchise in 2014. At the same time, pressure is building on the system as increasingly ambitious open access applications are submitted and ORR must consider whether to accept them in circumstances where (unlike the options proposed in this report) there is no obligation on new entrants to pay fixed track access charges or otherwise compensate for any resultant shortfall in government 
revenues.11   
 
Capacity to accommodate new entry may become available in the future through a combination of incremental enhancements of the existing network but, more significantly, through planned major new build (eg for High Speed 2 (HS2)) and technologies allowing more efficient use of the network (such as on-board digital signalling systems).  
 
The government maintains a central role in the market in order to ensure that the network delivers wider social, economic and environmental benefits. The government also has a key role as a funder of the industry - particularly in relation to socially valuable services and longer-term 
network enhancements that might not otherwise be provided by the market.  

 
An increasing proportion of funding of the industry (now 68%) is, however, made by passengers through fares and other charges rather than by the government. This can be seen as strengthening the case for passengers to have greater choice through on-rail competition - particularly on commercial intercity services.  
 
ORR is reviewing the structure of track access charges, which is an important step in creating a level playing field between franchised TOCs and OAOs, addressing some of the distortions arising in the current funding structure which are impediments to increased competition. 
 
The trend in other major European countries, and the ambition of the European Commission, is for greater on-rail competition. There are examples of on-rail competition on key high-speed routes in countries including Austria, Czech Republic, Germany, Italy and Sweden. New train operators are continuing to enter a number of these markets and significant new on-rail competition is proposed for other key high-speed routes, including between Paris and Brussels, Stuttgart and Berlin, and between Madrid and Valencia.   

## Our Goals

1.18 In undertaking this policy project, we engaged with the industry and 
passenger and consumer groups to identify possible ways to improve the railways in Great Britain, including by: 
 
securing better value for money - for passengers by way of downward pressure on fares, and for the wider economy through efficiencies that lead to lower operating costs of passenger train services; 
 
enhancing service quality and encouraging innovation; and 
 
unlocking efficiencies at the 'upstream' level of infrastructure operations/ management, for example by giving Network Rail greater incentives to use capacity on the network more efficiently and to control costs. 
1.19 In our view, any recommendations to adapt the current industry framework for 
the future must be capable of being implemented: 
 
without disrupting the current and forthcoming rounds of franchise awards;  
 
while maintaining the provision of socially valuable passenger rail services which may not be commercially viable;   
 
without jeopardising current and future investment in the network; and 
 
without any adverse operational impact.  

## Industry Background: Competition In The Rail Sector

1.20 The main features of the passenger rail sector in Great Britain, as currently 
configured, are as follows: 
 
Train services are provided to passengers by train operators - the vast majority of these passenger train operating services (representing some 99% of passenger miles) being provided under regional franchises awarded by the government for a specified period (typically around seven to 15 years), with a competitive bidding process for the award of each franchise. 
 
Franchise contract awards and major network enhancements are managed by the Rail Group at the DfT. Transport Scotland is responsible for managing franchises in Scotland and the Welsh government will take responsibility for the next franchise in Wales. There are plans for further devolution of regional franchises.  
 
The national rail infrastructure (the track, bridges, depots and major rail termini) is provided by an infrastructure operator, Network Rail, which is separate from the train operators. The train operators pay 'access charges' for the track and other infrastructure which are regulated by ORR, the independent economic regulator of rail and road. 
 
Rolling stock is acquired by the train operators, usually by way of lease, from private sector competing rolling stock companies, three of which (the ROSCOs) inherited the rolling stock of the pre-privatisation British Rail. 
1.21 The competitive tendering of franchises is a form of competition 'for' the 
market in passenger rail services. There is also a small degree of competition 'in' the market - ie competition **between** train operators, also called 'on-rail' 
competition. This occurs in three ways: 
 
Overlapping franchises: where two or more franchised TOCs operate on the same route, and therefore compete against each other for passengers on that route. 
 
Parallel franchises: where two or more franchised TOCs operate services between the same city pairs, although on different routes, and so compete 
for passengers travelling between those cities.12  
 
OAOs: these are operators of passenger services authorised by ORR to have access to the network on certain routes for a specified time.  
1.22 The extent of overlapping and parallel franchises has fallen in recent years, 
following a policy decision in 2001 by the then franchising authority, the Strategic Rail Authority, to reduce the number of franchises - a trend that has continued in recent years. 
1.23 There are currently just two OAOs, Grand Central and First Hull Trains, both 
of which are owned by larger companies with franchise operations in Great 
Britain.13 These operate a small number of services on specified routes in 
competition to the franchisee on the East Coast main line. Together they represent less than 1% of passenger miles. In the past, there had been other OAOs, and applications have recently been made to ORR for more 
substantial passenger services on intercity routes.14   
1.24 The scale of 'open access' operations is currently limited by ORR's 
assessment criteria. There is concern that competition from OAOs might pose a risk to the revenue streams of franchisees, which could deter potential franchisees from bidding for franchises or could induce them to submit 'lower' bids, reducing the revenues available to the government for funding the network and for subsidising public service operations.  
1.25 ORR needs to achieve an appropriate balance between its 24 statutory duties, 
which include not only an obligation to promote competition in the provision of railway services for the benefit of users, but also duties to act so as not to render it unduly difficult for network licence holders (ie Network Rail) to finance regulated activities and to have regard to the funds available to the 
government for its functions in relation to railways and railway services.15  
1.26 In practical terms, ORR balances its duties through the application of a 'not 
primarily abstractive' (NPA) test, under which ORR would not expect to 
approve open access applications unless they generate at least 30 pence of new revenue for every £1 abstracted from existing operators.  

1.27 Train operators often face a further degree of competitive constraint from 
other modes of transport, depending on the particular routes they serve. For example, on routes from London to Scotland, train operators face competition from airlines. On many long-distance flows there is competition from coach transport and, on local flows, operators may face competition from local bus services.  
1.28 In contrast to passenger rail services, which are the focus of this report, rail 
freight operations are entirely 'open access', with a number of private sector operators competing freely on the network.   

## The Potential Benefits Of Greater On-Rail Competition

1.29 We have examined whether incremental measures to improve the process of 
competition 'for' the market by way of the competitive award of franchises are the best way to improve services for the passenger - or whether more significant improvements could be achieved on key intercity routes by introducing a greater degree of on-rail competition.  

## Potential Passenger Benefits

1.30 Since on-rail competition does not currently exist on a significant scale in 
Great Britain, we cannot draw definitive conclusions on the magnitude of the benefits that greater on-rail competition would deliver in the future. Nonetheless, we have engaged extensively with industry experts and examined detailed evidence from the current examples of on-rail competition in Great Britain and, by way of analogy, from other markets including on-rail competition in other European countries and other markets where there is inmarket competition, including Great Britain rail freight, the experience of EU airline deregulation and the introduction of new competition between London's airports.  
1.31 The following key points emerge from existing on-rail competition in Great 
Britain and Europe: 
 
On-rail competition in Great Britain from open access shows that OAOs, notwithstanding their current limited role: 
- 
compete with franchised TOCs on price, frequently offering lower 
dedicated fares both for 'walk-up' and advance tickets;16 
- 
have developed improvements to service levels and introduced 
innovations, including selling a wider range of tickets on-board, free wi-fi and new information systems - which is reflected in high passenger satisfaction compared to the majority of franchised TOCs; and 
- 
appear to have generated some growth in the market for rail travel 
and delivered a number of wider economic benefits. 
 
On-rail competition in Great Britain from overlapping and parallel franchises shows that:  
- 
there are examples of on-rail competition between franchised TOCs 
leading to price competition (within the constraints of the ticketing regulation framework), with competing franchised TOCs offering lower fares than the 'lead operator' on many routes across a range of season, 'walk up' and advance tickets - although sometimes for a slower service; and 
- 
Franchised TOCs are generally restricted to competing on price 
because of franchise specifications. However, where franchise agreements are less specified by government (such as the Chiltern Railways franchise), on-rail competition between franchised TOCs 
also appears to have led to improved service quality and innovation. 
 
On-rail competition in other European countries, including Austria, the Czech Republic, Germany, Italy and Sweden shows that, while there are some differences with the market structure in Great Britain: 
- 
on-rail competition has delivered benefits for passengers, including lower fares, increased service frequency and customer service innovations; 
- 
the introduction of on-rail competition has taken place on some of the 
most geographically important routes in each country, indicating the 
trust placed in the ability of on-rail competition to deliver benefits that outweigh the risks;  

 
The trend towards introducing greater on-rail competition is continuing in Europe, with on-rail competition set to be introduced in countries including France, Belgium, Finland and Spain; 
1.32 The following conclusions may be drawn from our assessment of the 
introduction of competition in other transport markets: 
 
In rail freight in Great Britain, competition 'in' the market developed strongly after privatisation, with new entrants successfully winning market share from incumbents. Benefits included improved staff productivity and investment which enables prices to be kept down and service standards to improve. While there are differences between the structure of the freight and passenger rail sectors, the case study illustrates how competition 'in' the market can realise benefits in the rail sector. 
 
The experience of the airline industry in Europe illustrates that a greater degree of competition 'in' the market can lead to a reduction in costs and lower fares, while also leading to improved services, the development of innovative business models and growth in the market overall. 
 
The example of competition between London's Gatwick and Heathrow airports demonstrates that innovation, service quality improvements and lower prices may materialise over a number of years when dynamic competition is increased.   
 
In local bus services, sustained head-to-head competition where it exists 
has delivered benefits to customers, as a result of bus operators competing on the basis of service frequencies, in addition to fares and service quality. The process of competition has sometimes resulted in periods of intense short-lived rivalry, leading to the exit of one operator, and discriminatory behaviour by incumbents against new entrants. However, we do not consider that the issues in the local bus sector are directly relevant to the long-distance intercity rail sector. 
1.33 We recognise that it is not possible to test comprehensively the effects of 
introducing a significantly increased degree of on-rail competition in passenger train services. There are, inevitably, material differences between different transport sectors, and between different operators. However, making due allowances for differences between the structure of the rail sector in Great Britain and other countries, and between transport sectors, we consider that these examples illustrate the significant benefits that could be obtained from 
greater on-rail competition in addition to the benefits delivered by competition 'for' the market.   

## Potential Efficiency Gains

1.34 We considered the potential for greater on-rail competition to deliver efficiency 
gains at both the retail level, where passenger train operators compete, and at the 'upstream' level of infrastructure operations/management. 
1.35 At the retail level, we found that new entrants have achieved operational 
efficiencies in terms of (a) greater operational flexibility, (b) greater use of 
outsourcing, (c) efficiencies in ticketing, and (d) lower staff costs (often 
combined with higher employee engagement and satisfaction). This is supported by a range of empirical evidence: 
 
ORR found in 2011 that OAOs have costs which are 10 to 30% lower than 
franchised TOCs' costs for a given density of operation.17 
 
Empirical work we commissioned from Leeds University's Institute of Transport Studies found that OAOs' input prices were 29% lower than 
those of franchised TOCs operating intercity routes.18 Despite some 
uncertainty regarding the precise magnitude of the efficiencies, we note the following:  
- 
Using an econometric model that makes allowances for differences 
between OAOs and franchised TOCs, the study suggests that efficiency advantages offered by OAOs, which are able to adopt a more efficient business model than franchised TOCs, more than offset any cost disadvantages from the limited scale and density of their 
current operations.19 
- 
Expanding the role of open access has the potential to deliver greater 
efficiencies as operators would benefit from greater economies of scale and density, although the overall cost impact depends on the extent to which the incumbent loses economies of scale and density, and is route-specific.  
- 
The incentives that dynamic competition would create for operators to 
reduce costs may generate further efficiencies over and above those reflected in the model. 
1.36 At the 'upstream' level of infrastructure operations/management, we found 
that greater on-rail competition may create stronger incentives for franchised 
TOCs and OAOs to put pressure on Network Rail to use capacity more efficiently (to accommodate new entry and to control costs), with scope for reformed track access charges to further strengthen these incentives. For example:  
 
London Midland, Virgin West Coast and Chiltern Railways compete on the London to Birmingham route. Competition from other operators was a driver in London Midland undertaking a project to find new capacity to operate additional services. London Midland proposed a method for increasing capacity on the West Coast main line and worked closely with Network Rail to gain approval for its proposal. This led to a material 
increase in passenger seats both into and out of London Euston.20  
 
When Grand Central launched its services from London to York, the additional capacity required by the incumbent franchised TOC to run services from London to York was identified by Network Rail partly as a result of the capacity questions raised by Grand Central in its open access application.  
1.37 Evidence from other sectors also suggests that competition at the retail level 
can incentivise efficiency at the upstream level:  
 
As noted by the DfT in 2012, in the rail freight sector, the competitive environment has forced freight operators to find significant efficiencies 
over recent years, and it has encouraged Network Rail to do the same.21 
 
The air transport regulator, the Civil Aviation Authority, noted the positive impact that liberalisation of airline services had on the 'upstream' management of airports. 
 
In the Scottish water sector, the introduction of downstream retail competition in the past decade substantially increased the efficiency of the upstream wholesale water monopolist.  
1.38 In summary, there is evidence to suggest that greater on-rail competition has 
the potential to deliver benefits for passengers in addition to the benefits delivered by competition 'for' the market. We also found evidence to suggest that greater on-rail competition may have the potential to deliver efficiency gains at both the retail level and at the 'upstream' level of infrastructure operations/management.   

## The Feasibility Of Greater On-Rail Competition: Obstacles And Opportunities

1.39 We considered the potential technical, economic and policy obstacles to 
greater competition in the passenger rail market in Great Britain and possible ways to overcome these obstacles, which fall into three broad categories:  
 
access to infrastructure, network capacity and rolling stock; 
 
funding the network and loss-making services, and the financial sustainability of operators; and 
 
operational issues and greater complexity arising from an increase in the number of operators. 
We consider these potential obstacles in turn. 

## Access To Infrastructure, Network Capacity And Rolling Stock Access To Infrastructure

1.40 In Great Britain, there is vertical separation between passenger train service 
operations and network infrastructure. Network Rail is not permitted to discriminate between train operators and has to consider all applications for access rights in an even-handed way. Therefore, the market fundamentals for on-rail competition are already in place in Great Britain.   

## Network Capacity

1.41 On many parts of the rail network in Great Britain, there is very limited spare 
capacity available, particularly at peak times. In turn, this may limit the opportunity for new entrants to run services in competition with existing franchised TOCs.  
1.42 In the shorter term, a number of capacity enhancements are planned, 
including electrification projects and station upgrades. However, while these projects may generate some increase in network capacity, we did not find that 
these enhancements would generate new capacity on a scale that would facilitate significant new entry on the three main intercity routes.   

1.43 In the longer term, the move from conventional signalling to on-board digital 
signalling as part of the European Rail Traffic Management System (ERTMS) is expected to allow for more trains to run safely over the same length of track. The construction of HS2, which will see high-speed services run between London Euston and Birmingham (and beyond) from 2026, will represent a step change in capacity between London and the North of England.  
1.44 Although it is too soon to know how much capacity on-board signalling and 
HS2 are likely to create, they will clearly add some additional network capacity, helping to create additional opportunities for on-rail competition. ORR also told us that a reformed open access system would, alongside franchising, support the delivery of the government's objective of making the best use of step changes in capacity, such as HS2 and on-board signalling, by responding to changing circumstances and identifying opportunities for new services. 
1.45 More generally, we note that new network capacity is not a prerequisite for 
greater on-rail competition in the future. First, greater on-rail competition could be achieved by reallocating existing capacity between operators at the time of franchise design. Second, even where there is no spare track capacity (ie in terms of train paths), there is still likely to be capacity available on trains - particularly in the off-peak period. Third, even where certain train services are at full capacity, strategies including product differentiation and yield management may enable train operators to compete for particular categories of passenger and to manage demand across their services. 
1.46 Moreover, as discussed in paragraph 1.36, we note that on-rail competition 
has the potential to incentivise the identification of new capacity.   

## Access To Rolling Stock

1.47 We considered whether the availability and cost of rolling stock is a barrier to 
greater on-rail competition. We found that, while there is currently scarcity in the availability of rolling stock, this scarcity is likely to become less problematic in the coming years.  
1.48 As part of the InterCity Express Programme, new rolling stock will enter 
service on the Great Western main line from 2017 and on the East Coast main line from 2018, releasing the trains currently utilised on these lines. If OAOs have an opportunity to access this rolling stock, this could improve 
competitive conditions for re-leased (ie used) rolling stock, supplementing OAOs' ability to procure rolling stock.  

1.49 Furthermore, where operators have sufficiently long access rights, there is 
evidence to suggest that obtaining rolling stock has not represented a barrier to entry. In Great Britain, we note that Alliance Rail is procuring new Pendolino units to operate its open access services from London to Blackpool, which will commence in 2018 under the Great North Western Railway brand. Grand Central and First Hull Trains have also procured new trains. In the international examples of on-rail competition that we have considered, OAOs have purchased new rolling stock and have not cited rolling stock procurement as a barrier to entry.  
1.50 The impact assessment commissioned by ORR noted that the rolling stock 
market seemed to be reverting to operator - and ROSCO - led procurement, which is more compatible with a multi-operator railway.   

## Funding The Network And Loss-Making Services, And The Financial Sustainability Of Operators

1.51 Any consideration of competition in Great Britain's passenger rail services 
must take into account the complex mix of funding. As in other countries, rail services require a significant degree of government funding, reflecting: 
(a) the policy objective of providing socially valuable passenger rail services 
even if they are not commercially profitable (including public service 
obligation (PSO) operations22); and 
(b) the need for very significant ongoing investment in the rail network 
infrastructure, including future construction. 
1.52 In 2013–2014, the industry's total income of £13.3 billion was broken down as 
follows: 
 
Passengers contributed £9.0 billion through fares and other charges. 
 
The government contributed £3.8 billion through: 
- 
£3.7 billion to Network Rail (significantly more than Network Rail 
received in track access charges) - by way of direct subsidy or 'network grant'; and 
- 
£0.1 billion net contribution to franchised TOCs (franchised TOCs 
paid £1.9 billion in premiums to government, while franchised TOCs in receipt of subsidy received £2.0 billion).  
 
A further £0.5 billion of income came from other sources.23 

## Impact Of On-Rail Competition On Government Funds

1.53 The share of industry costs that is not met through passenger fares is 
financed through a mixture of direct government funding of infrastructure and cross-subsidisation between franchised TOCs through the franchise bidding process. An increased level of competition in the market is likely to reduce franchised TOCs' overall revenues, because (a) consumers are partly 
transferred from the franchised operator to the competitor(s) and (b) fares 
decrease due to competition.   
1.54 We recognise that a significant reduction in premium payments could 
threaten: 
(a) the funding of network infrastructure investment (ie new entrants 'freeriding' on incumbents' investments - which could, in turn, undermine the 
business case for the government to make new investments24); and  
(b) the funding of services deemed socially valuable even if uncommercial (ie 
loss-making or of limited profitability), such as PSO operations (ie 'creamskimming').  
1.55 This risk is currently tackled by mapping the franchise area to limit franchise 
overlaps and competition and moderating open access competition, by allowing entry only if it is not expected to be primarily abstractive of revenue from the franchised TOC (ie the NPA test).  
1.56 However, we found that the impact on government funding from greater onrail competition may be mitigated by: 
 
on-rail competition increasing overall passenger volumes by lowering fares, improving service quality and targeting unmet demand. In this 
regard, we note evidence that passenger numbers of East Coast main line routes served by OAOs grew faster than at stations with no competition. Moreover, in most of the European case studies considered, on-rail competition led to significant demand growth; and  

 
efficiencies from greater on-rail competition having the potential to partly offset any reduction in government funds.   
1.57 We are conscious of the importance of government funds in financing network 
infrastructure and socially valuable services and therefore propose mechanisms in our options for greater on-rail competition for addressing the impact on government funds (eg through a levy on OAOs). However, we believe that it is important for policymakers to balance a potential increase in passenger benefits from greater on-rail competition with a potential reduction 
in government funds.25  
1.58 We note that the threat to government funds from on-rail competition is a 
feature of the current framework under which OAOs pay lower track access charges than franchised TOCs, with no mechanism in place to enable the government to recover reductions in franchise premiums. Moreover, the uncertainty created by current and future open access applications may have 
a significant impact on franchise premiums.26 

## Impact Of On-Rail Competition On Investment

1.59 We considered the potential impact of greater on-rail competition on 
investment. We found that on-rail competition has the potential to enhance business cases for investment by generating growth in passenger numbers, developing innovations in the design of investment projects and incentivising private sector investment in the network. However, we note that it is important to ensure that safeguards are in place to avoid undermining public investment cases, including investment cases for schemes such as HS2 and rail electrification schemes.   

## Impact Of On-Rail Competition On Operators' Finances

1.60 We considered the risk that on-rail competition, in driving down fares, would 
threaten the financial viability and sustainability of market participants. We 
found that a number of factors are likely to mitigate this concern. In particular, product differentiation between operators and capacity constraints on the network may limit the extent to which prices would fall. Cost-reflective track access charges paid by incumbents and new entrants would also be likely to act as a 'price floor'.   

## Operational Issues

1.61 Greater on-rail competition would be likely to lead to a higher number of train 
operators (either franchised TOCs or OAOs) using the network. It was put to us that this could create a number of operational issues, including:  
 
inefficient use of capacity as a result of more operators; 
 
reduced interconnectivity; 
 
an adverse impact on performance and greater difficulty in recovery from disruption; and 
 
conflicting slot requests and timetabling issues, which may also affect strategically important changes to facilitate the provision of new services, such as HS2. 
1.62 We also note that an increased number of competing operators could lead to 
greater complexity in the system, in particular in relation to ticketing.   
1.63 We discussed operational issues with a wide range of stakeholders, including 
DfT, ORR, Network Rail, franchised TOCs and OAOs. Operational issues were also considered in the impact assessment commissioned by ORR.  
1.64 **Efficient use of capacity**: Increasing the number of operators on a route may 
affect the total capacity available, although the effect will depend on the journey times and stopping patterns of the operators and the range of rolling stock used. There are already multiple operators on the network and there is a trade-off between the mix of services delivered (eg intercity, regional, 'metro' services and freight) and capacity maximisation. As noted above, on-rail competition has the potential to incentivise the more efficient identification and allocation of capacity and to help to provide the correct signals and information for deciding on trade-offs between capacity maximisation and performance as compared to a centralised process.  
1.65 **Interconnectivity**: In the current framework, there are many thousands of 
possible connections that passengers can make and the degree of interconnectivity that can be achieved is limited. However, interconnectivity is an important characteristic for passengers - particularly on regional routes - and 
it is important that the ability to timetable services to ensure connections are maintained or enhanced is retained. We also note that where operators are competing more intensively for passengers, they may have greater commercial incentives to attract passengers from feeder services by ensuring good connections (and to offer onward connections to their own passengers). 

1.66 **Performance**: We considered whether the complexity of coordinating the 
operations of multiple operators may adversely affect punctuality. We note that empirical evidence on the impact of multiple operators on punctuality is mixed and is dependent on the route and types of operators concerned. There 
is a degree of trade-off between service frequency and performance.27  
1.67 **Recovery from disruption**: The system is already designed to work with 
multiple operators. Network Rail actively manages the response to disruption and current rules provide arrangements for ticket acceptance across operators once a certain disruption threshold is reached. Part H of the Network 
Code28 includes a requirement for operators to comply with the Railway 
Operational Code, which obliges operators to work together to recover from disruption, having regard to the needs of passengers and freight customers. Operators also have a range of obligations to provide passenger information during disruption and ORR is able to deal with inadequate responses to disruption through operators' licences. Network Rail also told us that greater on-rail competition could help performance and service recovery as OAOs are strongly incentivised to perform well in order to attract new customers.   
1.68 **Slot allocation and timetabling**: This would become more complex, but 
evidence from other sectors and from a number of European countries where on-rail competition takes place suggests that it should be feasible. Network 
Rail already manages conflicting slot requests using the criteria set out in Part 
D of the Network Code. ORR is currently undertaking work with a view to 
improving Network Rail's performance as a system operator29 and we note 
that reforms to access rights have increased flexibility in slot allocation and timetabling. Moreover, there is potential to adopt alternative slot allocation mechanisms in the future should this deliver benefits.   
1.69 **Ticketing complexity**: Greater on-rail competition would give operators the 
opportunity to match their ticket offering more closely to passenger preferences, increasing the choice of tickets available to passengers. In the current 
system, the complexity of ticketing can be confusing, but many passengers have also benefited from new types of fare (eg cheaper advance and carnet tickets). We note that these issues are likely to reduce over time as new technology, including smart cards and mobile ticketing, is rolled out. We also note that many passengers purchase their tickets in advance on intercity routes and that operators have more ability to differentiate themselves, which would help to ensure that passengers are able to make informed travel choices.   

## Summary Of Feasibility Considerations

1.70 We concluded that none of the potential barriers considered are insurmountable. This was supported by the legal and operational assessment of the options for greater on-rail competition undertaken in the independent impact assessment commissioned by ORR.   
1.71 We note that greater on-rail competition may create some additional 
operational risks which, given the diversity of the network, may vary on a case-by-case basis. However, we consider that these are manageable and would not be significantly greater than in the current system. In designing the options for greater on-rail competition set out below, we have sought to address the relevant feasibility considerations.   

## Options For Greater On-Rail Competition

1.72 Having concluded that there were likely to be benefits of increased on-rail 
competition, and that there were no insurmountable barriers, we consulted on four options for greater on-rail competition. We summarise these options below and set out the framework that we have used to assess the costs and benefits of each option.   
1.73 Our assessment draws upon evidence obtained through engagement with the 
industry and passenger groups, from consultation responses, the impact assessment commissioned by ORR and the evidence of the benefits of, and potential barriers to, greater on rail competition set out above.   
1.74 The baseline against which we assess the options is a continuation of the 
current system under which franchises are awarded in the framework adopted following the recommendations of the Brown Review, with incremental improvements made by the DfT over the coming years. 

## The Scope Of The Options

1.75 We are mindful of the fact that the industry is continuing to evolve, particularly 
in terms of passenger demand, network enhancements and recent and 
ongoing reviews into the sector.30  
1.76 We have therefore set out some high-level options for increased on-rail 
competition. We have not attempted to set out the exact form which the options would take, nor the precise mechanisms by which the options would be implemented. We recommend that these questions are addressed through further discussions with government, the regulator, the industry and passenger groups.   
1.77 We consider that the options are most likely to deliver benefits on the three 
main commercial intercity routes - namely the East Coast main line, the West Coast main line and the Great Western route. However, the framework could be applied on other parts of the network, with the Midland main line intercity 
route in particular being a potential candidate.31  
1.78 There may be potential for the options to be implemented on HS2 given the 
premium nature of the product, the potential for service differentiation and the fact that many HS2 services will continue onward to different final destinations using the classic network. In this regard, we note that many of the examples of on-rail competition in other European countries are on dedicated highspeed lines.  

## The Four Options

1.79 Option 1 envisages OAOs playing a significantly increased role within the 
current market structure, alongside franchised TOCs. This could be achieved by new capacity being reserved for OAOs, or by reducing the scope of future franchises. The aim of this option is to generate larger-scale on-rail competition between franchised TOCs and OAOs while addressing the 
difficulties that arise in the current model of open access. Franchised TOCs and OAOs would compete on a level playing field, which would entail OAOs making a greater contribution to network costs through higher track access charges in return for more extensive access to the network. OAOs would also contribute to the funding of unprofitable but socially valuable services, which 
would continue to be provided within franchises, through the payment of a PSO levy.  

1.80 Under Option 2, there would be two successful bidders for each franchise. 
Routes currently operated by one franchised TOC would be split so that two franchised TOCs could provide services. This option could be implemented in different ways. Services could be equally split, such that each operator serves many of the same destinations. Alternatively, the two franchised TOCs could be asymmetric, for example with a 60:40 (or greater) division between services. This would reduce the extent of on-rail competition between the franchised TOCs but would reduce the risk of collusive behaviour. Another possibility would be for one of the operators to act as an 'anchor franchisee' with responsibility for the vast majority of unprofitable but socially valuable services, with the other operating primarily profitable services.  
1.81 Option 3, like Option 2, involves increased competition between franchised 
TOCs. Under this option, the franchise map would be redesigned to encourage greater franchise overlaps on specific point-to-point flows for 
franchised TOCs operating on different routes. In contrast to Option 2, the franchises would not need to be tendered simultaneously. Option 3 would effectively reverse a policy decision taken in the early 2000s to reduce the number of overlapping franchises.  
1.82 Option 4 is more radical in its approach, with multiple operators providing rail 
services in a fully commercial environment, subject to a licensing regime which would replace the franchising model in areas where the option was implemented. The licensing regime would include obligations to provide key unprofitable but socially desirable services and could be modelled on regimes 
that already exist in a range of other regulated sectors in the UK such as 
energy, water, telecoms and postal services. Operators could apply for, or bid to obtain, licences in order to offer services which, instead of being centrally specified, would be determined by market forces. There are a number of ways in which train paths could be allocated to operators, including an auction system for small bundles of paths. This would also allow the government to raise revenue in place of franchise premiums.  

## Assessment Of The Options Framework

1.83 In assessing the options, we used a framework which took into account a 
range of quantitative and qualitative measures to compare the options with the baseline of a continuation of the current system. In particular, we took into account passenger benefits, efficiency and wider economic benefits, as well 
as the potential barriers to competition identified by stakeholders, and the degree to which the options can overcome these potential barriers. The framework is summarised in Box 1: 

## Box 1: Options Assessment Framework

1. Passenger and efficiency benefits  
(a)  Lower prices and fares (b) Improved overall passenger experience, including service quality, choice and 
complexity 
(c) Greater cost efficiency at the passenger services level (d) Dynamic or innovation benefits 
2. Funding and risk  
(a) Taxpayer funding - impact on government funds (b) Impact on risk for government and operators (c) Impact on investment incentives 
3. Network considerations, including operational issues 
(a) Impact on coordination and the level of transaction costs (b) Utilisation of capacity and interconnectivity (c) Impact on efficiency at the upstream network management level (d) Impact on safety  
4. Wider social benefits  
(a) Externalities generated: regional economic growth and environmental benefits (b) Impact on social inclusion and connectivity 
5. Ease of implementation, including legal and operational feasibility 
Scale of policy and regulatory changes required 

## Assessment

1.84 In undertaking our assessment, we have taken into account evidence from 
stakeholders, including consultation responses, and the impact assessment commissioned by ORR. The following paragraphs highlight the key points raised by each option.  
Option 1 

1.85 **Passenger, efficiency and wider economic benefits**: Option 1 would 
introduce on-rail competition between two large-scale train operators. The OAO would have more scope to differentiate its service offering than the franchised TOC as it would be free from franchise specification. As discussed above, the OAO may also be able to achieve greater operational efficiencies 
than the franchised TOC, in turn giving it greater scope to reduce fares. Together with the commercial freedom to tailor its service offering to market demand, this may lead to an overall increase in rail demand and its associated economic benefits (including reduced car usage).  

1.86 **Funding and risk**: Option 1 would be expected to lead to some reduction in 
franchise premiums paid by franchised TOCs on the routes where it is implemented. This would be addressed through a combination of (a) a level playing field in the track access charges paid by franchised TOCs and OAOs; (b) a levy to enable OAOs to contribute to the cost of unprofitable but socially valuable services; and (c) reducing uncertainty in the franchise bidding process regarding the future level of on-rail competition.  
1.87 While these mechanisms may not recover all the reduction in franchise 
premium, this risk should be seen in the context of the current system in which there is uncertainty regarding the level of franchise premiums and no mechanism for OAOs to provide a greater contribution to the funding of the network.   
1.88 There is a risk that the PSO levy may unjustifiably deter OAO entry, although 
any levy could potentially be designed to reduce this risk (eg by gradual implementation as new entrants become established). Option 1 could reduce uncertainty for franchised TOCs regarding the future level of on-rail competition during franchise bidding by allocating paths to OAOs in advance of the bidding process. It may also generate additional entry opportunities, helping TOC owner groups to balance their portfolios.  
1.89 **Operational issues**: By introducing an OAO competing with the intercity 
franchised TOC, Option 1 may create some additional operational risk. However, as discussed above, we found that this risk would be manageable and would not be significantly greater than in the current system in which multiple franchised TOCs, OAOs and freight services operate on the network.  
1.90 **Implementation**: Option 1 would require a change to the structure of track 
access charges and the introduction of a PSO levy. The former is already under way but, as considered further below, the PSO levy would be complex 
to design and may possibly require primary legislation. A system for allocating paths to an OAO would also have to be designed. However, we have not received any evidence to suggest that these challenges are insurmountable.  
1.91 **Impact assessment**: The impact assessment found that Option 1 was legally 
and operationally feasible, although further examination of the PSO levy would be required. The increase in competitive pressure was considered likely to lead to lower fares and service quality improvements. The indicative 
quantitative modelling found that, under the central case assumptions,32 
measured in terms of the net present value (NPV) of benefits,33 Option 1 
would generate £489 million of benefits over a 20-year appraisal period on the East Coast main line, £915 million on the West Coast main line and 
£262 million on the Great Western main line.34  
Option 2 

1.92 **Passenger, efficiency and wider economic benefits**: Option 2 would also 
introduce on-rail competition between two large-scale train operators, 
significantly increasing the degree of competition relative to the base case. However, in contrast to Option 1, both operators would be franchised TOCs bound by franchise specification, which would limit their commercial freedom to compete on factors other than fares (eg service quality) and ability to achieve operational efficiencies.   
1.93 **Funding and risk**: Option 2 may be expected to result in some reduction in 
government funds as a result of lower fares, although we note that more costreflective access charges and demand growth induced by greater on-rail competition may mitigate this effect to some degree. By creating smaller franchises, Option 2 would also reduce some of the financial risks associated with franchising.   
1.94 **Operational issues**: In Option 2, the government would, though franchise 
specification, retain operational control over the competing franchised TOCs. As such, there would only be minor implications for operational control and performance.  
1.95 **Implementation**: Option 2 could be delivered within the current legal 
framework, although a change to franchise policy and, potentially, franchise design, would be required.   
under each of the options. Some respondents to the consultation raised questions about the methodology that was adopted. We also note that there are a number of considerations that were not modelled which would be expected to make the net benefits of the options greater, including the dynamic benefits of competition, increased service quality and the potential for improved efficiency of Network Rail as a result of increased pressure from operators. Other aspects which may be expected to have a negative impact were also not modelled. We take these factors into account in our assessment.   

1.96 **Impact assessment**: The impact assessment found that Option 2 could be 
implemented within current industry structures and practices. As for Option 1, this option was expected to deliver net benefits overall. Although the extent of competitive responses would be limited by franchise agreements, the quantitative analysis found that it was possible to configure the option to deliver widespread competition across a route. Under the central case assumptions, Option 2 was modelled as producing £95–£236 million of benefits on the East Coast main line and £151–£166 million on the West 
Coast main line.35 
Option 3 

1.97 **Passenger, efficiency and wider economic benefits**: Option 3 would be 
likely to deliver more marginal benefits from on-rail competition, both due to the more limited extent of overlaps between franchised TOCs compared with Option 2 and the possibility that the franchised TOCs providing overlapping services may be differentiated (eg a regional service and an intercity service).  
1.98 **Funding and risk**: In Option 3, franchise bidders would not be aware of the 
future level of on-rail competition from other franchised TOCs, which may increase uncertainty in the bidding process. Moreover, the application of UK merger control to the award of franchises creates a risk in Option 3 as bidders with overlapping services would face detailed competition scrutiny, possibly reducing their appetite for bidding and, consequently, the intensity of competition for the franchise award.  
1.99 **Operational issues**: In common with Option 2, the government would, though 
franchise specification, retain operational control over the competing franchised TOCs. As such, there would only be minor implications for operational control and performance. 
1.100 **Implementation**: Option 3 could be delivered within the current legal 
framework, although a change to franchise policy and, potentially, franchise design, would be required.   
1.101 **Impact assessment**: The impact assessment found that Option 3 could be 
implemented within current industry structures and practices. The degree of competition created was considered likely to be limited both by the geographic extent of overlaps and the possibility that franchises would serve differentiated markets. This is reflected in the quantitative analysis which suggested that the 
benefits are less significant than under Option 2, with the central case assumptions modelled as producing an NPV on the Great Western main line of £56 million.36   

## Option 4

1.102 **Passenger, efficiency and wider economic benefits**: Option 4 would 
generate the strongest on-rail competition, with three or more operators competing on key flows. This option is therefore likely to deliver the largest reduction in fares of the four options. As each operator would be free from franchise specification, Option 4 is likely to generate the strongest incentives for operators to differentiate their products and to innovate in order to win market share - subject to the licence conditions imposed. Option 4 also provides the greatest scope for operators to achieve operational efficiencies as well as strong incentives for operators to engage with Network Rail to ensure that it delivers performance and enhancements in a cost-effective way.  
1.103 **Funding and risk**: The impact of Option 4 on government funds is more 
difficult to predict given that the auctioning arrangements have not yet been determined. The extent of on-rail competition would act to reduce industry funds by driving fares down, although this would be mitigated to a degree by demand growth. Moreover, the auction of train paths could generate significant revenue for the government. However, there are a number of significant challenges to auctioning paths on the railway that would need to be overcome.    
1.104 We also note that Option 4 may address some of the risks for franchised 
TOCs and government that exist in the base case, which include uncertainty regarding the future level of on-rail competition at the time of bidding for a franchise and the risk of there being an insufficient number of bidders in franchise competitions. 
1.105 **Operational issues**: In Option 4, a strong system operator function would be 
required in order to manage the timetables of multiple intercity train operators. Changes to timetables and licences would have to be coordinated over time and with major projects. However, while the operational risk is higher than in the other options, we do not consider the issues to be insurmountable.  
1.106 **Implementation**: Option 4 would require an overhaul of the current system in 
areas where it was implemented, including the design of licences and a mechanism for auctioning train paths. We summarise these issues below. 
1.107 **Impact assessment**: The impact assessment found that there would be 
significant challenges in implementing Option 4, although these were not considered to be insurmountable. Option 4 was deemed too difficult to model quantitatively in the time available due to the uncertain nature of the service patterns and exact regulatory framework which it would entail. However, a qualitative assessment found that due to the intensity of competition between commercial operators free to adopt their own business models, Option 4 had the potential to offer significant benefits to consumers and should be considered further. Option 4 was also considered likely to drive significant improvements in efficiency.  

## Conclusion

1.108 We summarise our assessment in Box 2 below.37  

 
1 - Greater open access 
2 - Split franchises 
3 - Overlapping franchises 
4 - Licence system 
0 - Base case 
Passenger and efficiency benefits 
 
 
 
 
- 
Funding and risk 
× 
× 
- 
× 
- 
 
- 
- 
 
- 
Considerations within the network, including operational issues Wider social/ economic benefits 
 
 
 
 
- 
Implementation ease 
×× 
× 
× 
××× 
- 
 

1.109 Taking the above assessment into account, we conclude that while Option 4 
has the potential to deliver the greatest passenger and efficiency benefits, it carries significant implementation risks, which have not yet been fully explored. Option 1 would also be likely to deliver significant benefits while 
addressing issues in the current open access model and, given that it retains franchising, raises fewer implementation issues.   
1.110 We also consider that Option 2 could provide benefits by introducing on-rail 
competition on key routes. Although the scope of the benefits - particularly those arising from dynamic competition - may be reduced by both operators 
remaining as franchised TOCs subject to franchise specification, Option 2 is implementable under the current legal framework. Given the diversity of the network in Great Britain, Option 2 may also have the potential to deliver benefits on parts of the network where Option 1 is less suitable. 

1.111 We consider that Option 3 would not be likely to produce significant 
passenger and efficiency benefits given the limited degree of on-rail competition that it would generate.  

## Recommendations And Next Steps

1.112 In setting out next steps, we focus first on general recommendations to lay the 
foundations for a dynamic, competitive industry, and then on the key steps for implementation of our preferred options to introduce greater competition. We then set out the key stages required in implementing our preferred options.  

## General Recommendations: Laying The Foundations For A Dynamic, Competitive Industry

1.113 We make a number of general recommendations that we consider to be key 
to enabling full realisation of the benefits of greater on-rail competition. These may be summarised as follows: 
 
Continuing to reduce the level of specification of franchise contracts on routes where there is on-rail competition - this would allow 
franchised TOCs to compete on factors such as service quality instead of on fares only, therefore helping to realise the dynamic benefits of competition. In Option 1, reducing the specification of the franchised 
TOC's franchise agreement would increase its flexibility to respond to competition from the OAO. 
 
Reforming the structure of track access charges - reforming the structure of access charges would support more effective competition between different types of passenger train operator. As noted above, ORR is already proposing to address this as part of its review of the structure of track access charges. We also welcome the government's decision in 2015 to re-route the network grant paid by government to Network Rail via train operators as it will help to increase pressure from operators on Network Rail to deliver efficiency improvements.  
 
Improving the 'system operator' - a strong system operator is essential to ensuring that track capacity is effectively utilised and is therefore central to implementing greater competition between train operators. We 
note that ORR is already undertaking a review of Network Rail's system operator function. 

 
Encouraging the use of smart ticketing so that real passenger journeys are tracked within the system - by replacing the current 
system which shares revenue between competing operators based on estimates of passenger numbers, this will strengthen the incentives for operators to compete for passengers where there is on-rail competition. We note that there are already positive developments in this area, with smart cards and mobile ticketing being rolled out in a number of areas. 
 
1.114 Building on these general recommendations, we set out our preferred options 
for introducing greater on-rail competition below. 

## Recommended Option: Option 1, A Significantly Greater Role For Open Access On Intercity Routes

1.115 We consider that Option 1 is the lead option for introducing greater on-rail 
competition on key intercity routes for the benefit of passengers and wider society. This option could be piloted in one franchise area before being extended to other areas. The first intercity franchise for which an Invitation to Tender will be issued following the implementation of the new structure of track access charges - and which would allow time for the other necessary implementation steps - is the next East Coast main line franchise, which will commence in 2023. However, as set out below, in order to deliver greater onrail competition in 2023, the implementation steps need to be taken soon.    
1.116 It would also form the first step in any future transition into the licensing model 
proposed under Option 4. The key steps required to implement Option 1 are summarised below. 

## A Level Playing Field In Track Access Charges

1.117 The first stage of this process is already under way. ORR's review of the 
structure of track access charges has identified a potential inability to support effective competition between different types of passenger train operator as a gap in the current system. ORR is therefore consulting on proposals for OAOs to make a greater contribution to network costs, particularly where capacity is scarce and most valuable. In this regard, ORR's consultation notes that such changes might allow for a better allocation of capacity between OAOs and 
franchised TOCs, which may lead funders to be relatively neutral between them in terms of the revenue impacts on the taxpayer.38 

1.118 ORR's review of the structure of track access charges will conclude in 2017 
and the new charges will take effect from the start of the next five-year Network Rail Control Period in 2019. If a level playing field between the charges paid by franchised TOCs and OAOs is achieved, this will also help to address some of the funding risks associated with open access applications made under the current framework from 2019 onwards.   

## Designing And Implementing A Pso Levy

1.119 Primary legislation may be required to implement a PSO levy to mitigate the 
impact of greater on-rail competition on government funds, as the levy would be government imposed and distinct from the track access charges set by ORR. 
1.120 EU legislation provides for member states to employ a levy to compensate for 
PSOs, but its imposition is discretionary, and the government has not 
transposed the relevant legislation into UK law to date.39 Transposing the 
relevant EU legislation would be an alternative to making primary legislation in the UK. The levy would need to be designed carefully to ensure that its fits with EU legislation regardless of whether it is imposed by primary legislation or the transposition of EU legislation. 
1.121 There are a number of questions to address in the design of the levy, 
including the charging mechanism and whether the levy would change over time. While OAOs responding to our consultation stated that they would be willing to pay a levy in return for greater access to the network, care would need to be taken to ensure that the levy did not act as an unjustifiable barrier to entry. It may also be appropriate to consider whether any levy should apply to current OAOs with small-scale operations focused on previously unserved destinations.  
1.122 Any levy would need to be in place as soon as possible so as to inform OAOs' 
entry decisions. Moreover, given the links to the charging regime, the levy would ideally be in place by the time that the new structure of track access charges is implemented in March 2019.   

## Allocating Train Paths To An Oao

1.123 For open access operations to expand on the main intercity routes, the 
required train paths would need to be made available. Prior to the expiry of the current intercity franchises (eg East Coast main line), the DfT would need to reconfigure the franchises to allow capacity for OAOs to operate in 
competition with the intercity franchised TOC on certain routes.40 For Option 1 
to be introduced in 2023, this would need to be achieved in advance of the expression of interest documents being issued for the East Coast main line franchise in 2021.  
1.124 In parallel, a system for allocating train paths to an OAO would need to be 
developed either by the DfT or ORR. There are a number of possibilities for allocating paths, including an economic assessment of OAOs' applications by ORR or a bidding or auction process for paths (in which the level of PSO levy that OAOs were willing to pay could be a factor).  

## A Vision For The Longer Term: Option 4, A Licensing System For Operators On Main Intercity Routes

1.125 Option 1 could be extended towards the model of competition in Option 4 in 
the future. For example, instead of a franchised TOC operating 70% of train paths for intercity services and an OAO the remaining 30%, three OAOs of a similar size could be licensed to operate all the paths. This is an ambitious proposal and would require an overhaul of the current system. In particular: 
 
Licences would need to be designed in such a way that socially valuable services were delivered and minimum service levels were provided, while not being overly prescriptive and unduly restricting commercial decisions.  
 
The structure of the new licensing system would need to be defined in national legislation and also comply with the corresponding EU regulations. 
 
A system would have to be established for allocating paths to operators, which would be likely to involve auctioning capacity.  
 
A strong system operator would need to be in place with sufficient flexibility to coordinate timetables and the response to industry developments, such as major projects.  
1.126 We note that Option 4 was advocated by a major TOC owner group and that 
the impact assessment commissioned by ORR did not consider that the 
challenges were insurmountable. However, given the questions associated with its design, we recommend that more detailed consideration is given to Option 4 once the steps required for Option 1 to be implemented are in place.   

## Our Parallel Recommendation: Introducing Option 2 Where It Has The Potential To Deliver Benefits On The Network

1.127 In parallel to our main recommendations, we also recommend considering the 
introduction of Option 2 on areas of the network where it has potential to deliver greater benefits. This would allow policymakers a choice of tools as to 
how to achieve greater on-rail competition in the future.41 Option 2 would be 
implemented under the existing regulatory framework and no legal issues have been identified.  
1.128 The franchises on which the option was implemented would need to be 
redesigned in order to ensure that there is appropriate competition between the two franchised TOCs on the selected routes, while retaining operational integrity.  

## Next Steps

1.129 The publication of this policy document does not mark the end of our 
engagement in this area. The recommendations we have set out are for the long term and we will continue to engage with policymakers and regulators as appropriate to discuss how the benefits of on-rail competition can be harnessed on the network in the future.   
1.130 We also encourage industry participants and stakeholders to continue to 
consider the benefits that greater on-rail competition could deliver, and to consider further ways in which opportunities to expand on-rail competition for the benefit of passengers and wider UK productivity may be pursued. 

## 2. Context: Industry Background

2.1 
This chapter sets out the current structure of the rail sector in Great Britain42 
and describes the roles of the key industry players, including Network Rail franchised TOCs, OAOs, freight operators, the regulator and government. We set out the process by which franchised TOCs, OAOs and freight operators access the network and outline the complex system of funding the rail network.  

## Structure Of The Rail Sector In Great Britain Network Rail

2.2 
Network Rail owns and manages the main rail network infrastructure in Great Britain, including the track and related infrastructure (eg depots, signalling and electrification systems) and virtually all the stations (Network Rail operates 19 
stations itself and leases all the others to the franchised TOCs).43 For 
management purposes, the network is divided into ten regional operating routes, each constituting a separate business unit with its own accounts to facilitate greater benchmarking of performance between operations. The ten routes are Anglia, Kent, London North East, London North West, East 
Midlands, Scotland, Sussex, Wales, Wessex and Western.44  
2.3 
Network Rail is regulated by ORR under its network licence.45 ORR has a 
range of statutory powers to set the contractual and financial framework within which Network Rail operates. There are six parts to Network Rail's licence covering: network management and timetabling; restrictions on activities; 
effect of the change was that the company's net debt (currently around £30 billion) appeared on the government's balance sheet. 

44 Network Rail also owns the land, rail infrastructure and assets on the Isle of Wight but these have been leased to Stagecoach South Western Trains Limited (under the Island Line brand) for a period of 25 years, commencing on 1 April 1994. This is a vertically integrated operation with Island Line being responsible for all railway operations and infrastructure maintenance. See Network Rail, Network Statement 2016, December 2015-
December 2016.  
dealings with third parties; information requirements; corporate requirements and standard industry obligations.   

2.4 
The level of access charges paid to Network Rail is regulated by ORR through a process of five-yearly periodic reviews and, where appropriate, interim 
reviews.46 ORR assesses what Network Rail must achieve, the money it 
needs to do so and the incentives needed to encourage delivery and outperformance. Each review covers a five-year period, known as a 'control period'. The current period, Control Period 5 (CP5), runs from 2014 to 2019. The outputs and funding for this period were set during the Periodic Review 2013 (PR13). 

## Franchised Tocs

2.5 
Franchised TOCs operating passenger rail franchises are awarded the right to run specific services within a specified area for a specific period of time, in return for the right to charge fares and, where appropriate, to receive financial 
support from the franchising authority (now the Rail Group in the DfT47). 
Franchised TOCs generally lease stations from Network Rail and earn rental income by subletting parts of them, for example to retailers.  
2.6 
There are currently 16 franchises operating in England and Wales and two in Scotland. Table 1 sets out the current franchises and their operators and a map of train operators in Great Britain is included in the Appendix. 

|                        |                             | Operating name     | Franchisee         |
|------------------------|-----------------------------|--------------------|--------------------|
| Franchise              | (franchised TOC)            | (TOC owner group)  | Duration           |
| England and Wales      |                             |                    |                    |
| Chiltern               | Chiltern Railways           | Arriva             | Mar 2002–Dec 2021  |
| Cross Country          | CrossCountry                | Arriva             | Nov 2007–Oct 2019  |
| East Anglia            | Abellio Greater Anglia      | Abellio            | Feb 2012–Oct 2016  |
| East Coast             | Virgin East Coast           | Stagecoach/Virgin  | Mar 2015–Mar 2023  |
| East Midlands          | East Midlands Trains        | Stagecoach         | Nov 2007–Mar 2018  |
| Essex Thameside        | c2c                         | National Express   | Sep 2014–Nov 2029  |
| Great Western          | First Great Western         | First Group        | Apr 2006–Apr 2019  |
| Northern               | Northern                    | Serco/Abellio      | Dec 2004–Apr 2016  |
| South Eastern          | Southeastern                | Govia              | Apr 2006–Jun 2018  |
| South Western          | South West Trains           | Stagecoach         | Feb 2007–June 2017 |
| Thameslink, Southern & | Thameslink, Great Northern, | GoVia              | Sep 2014–Sep 2021  |
| Great Northern         | Southern, Gatwick Express   |                    |                    |
| TransPennine Express   | First TransPennine Express  | First Group/Keolis | Feb 2004–Apr 2016  |
| West Midlands          | London Midland              | GoVia              | Nov 2007–Oct 2017  |
| West Coast             | Virgin                      | Stagecoach/Virgin  | Mar 1997–Sep 2017  |
| Wales & Borders        | Arriva Trains Wales         | Arriva             | Dec 2003–Oct 2018  |
| Scotland               |                             |                    |                    |
| Caledonian Sleeper     | Caledonian Sleeper          | Serco              | Mar 2015–Mar 2030  |
| ScotRail               | ScotRail                    | Abellio            | Apr 2015–Mar 2025  |

Source: ORR data and House of Commons note (14 December 2015), Railways: passenger franchises. 2.7 
Franchised TOCs bid for franchises on the basis of the amount of funding they would require - or the premium they would be prepared to pay - in order to run the services specified in the franchise. The winner is selected on the basis of a weighted scoring system taking into account factors including the subsidy required or premium offered and initiatives to enhance the quality of service for passengers. This competition 'for' the market, to run a franchise, is currently the principal form of competition in passenger rail services. 
Franchised services cover 99% of passenger rail miles.   
2.8 
In the event that a franchise is terminated or suitable bids are not submitted, the Secretary of State for Transport (in the case of England and Wales) has a responsibility to be the operator of last resort (see section 30 of the Railways 
Act 1993).48 
2.9 
European law specifies that rail franchises may initially be awarded for a term of up to 15 years, but may be extended in certain circumstances for a further 7.5 years. This means that the maximum length of rail franchises cannot 
exceed 22.5 years.49 The independent Brown Review into franchising, which was published in January 2013, recommended that franchise agreements should be concluded for an initial term of seven to ten years with a precontracted extension, in the event that agreed criteria are met, for a further three to five years giving a maximum term of up to 15 years.50  

2.10 Initial franchises were specified by the then Franchising Director, which 
produced a Passenger Service Requirement (PSR) setting out the minimum service levels for train services, based on the timetable historically operated by British Rail. Each PSR was (and, for the Chiltern Railways franchise, is still) specific to a franchise, but generally included requirements relating to first and last trains, frequency, journey time and stopping patterns. The Franchising Director had the responsibility for monitoring each franchisee's performance. If a franchisee did not deliver the proper timetable, the Franchising Director could impose penalties or, as a last resort, terminate the franchise agreement.  
2.11 Under the Transport Act 2000 a body called the Strategic Rail Authority (SRA) 
inherited all the functions, property, rights, and liabilities of the Franchising Director. Under the Railways Act 2005, the functions relating to franchise agreements for England transferred from the SRA to the DfT, responsibility for the Scottish franchise transferred to the Scottish Executive and the Welsh government was granted a direct role for local and regional passenger rail services in Wales. Franchise specification became tighter (eg in relation to the frequency and timing of services and the provision of on-board facilities such as catering and cleaning) through the introduction of Service Level 
Commitments and Train Service Requirements.51  
2.12 The rights and obligations of franchised TOCs are specified through a Train 
Service Requirement as part of the franchise agreement negotiated between 
the franchising authority and the franchisee. The Train Service Requirement includes obligations on franchised TOCs such as the number of daily calls at 
stations and the timing of first and last trains. Each franchise has its own specific Train Service Requirement.  

2.13 Following the problems with the re-let of the West Coast franchise,52 the 
Brown Review examined the wider rail franchising programme, looking in detail at whether changes were needed to the way risk was assessed and to 
the bidding and evaluation process.53 During the hiatus in the bidding process, 
a number of direct awards were made to extend franchises. The nature of these awards varied but, in effect, the government negotiated directly with the incumbent operator and there was no competition for the award. The DfT worked with technical advisers to build a comparator model based on the current and projected performance of the franchise. The submissions from the incumbent for the direct award were then compared with this model. The franchise bidding process restarted in 2013, leading to the subsequent award of the Essex Thameside, Thameslink, Southern & Great Northern and Virgin East Coast main line franchises. 

## Open Access Operators

2.14 Franchised TOCs face a degree of competition 'in' the market from nonfranchised operators, which are granted the right, by ORR, to compete on certain routes as OAOs.  
2.15 OAOs operate on a commercial basis with no subsidy and are required to 
apply to ORR and Network Rail for the necessary access rights to run their proposed service. Network Rail will advise a current or potential rail operator on the likelihood of train paths being available on the relevant part of the network for running a proposed service based on the timetable in operation at the time. Network Rail may then either support an application to ORR under section 18 of the Railways Act 1993 or not, in which case the procedure under section 17 for 'disputed' applications is followed.  
2.16 Fares set by OAOs are not subject to fare regulation.54 However, OAOs have 
the same general ticketing obligations as franchised TOCs, other than with 
respect to ticket offices.55  
2.17 Of a total of 19 proposals for open access services received by ORR between 
2000 and 2014, only four were successful.56 
2.18 There are currently just two OAOs: 
 
First Hull Trains, which commenced services between London and Hull in 2000. Currently, First Hull Trains runs seven services per day between 
London and Hull on weekdays and five on weekends.57 
 
Grand Central Railway, which commenced services from London to Sunderland in 2007 and from London to Bradford in 2010. The company runs five trains per day from London to Sunderland on weekdays/ Saturdays, four on Sundays and four trains per day from London to 
Bradford throughout the week.58 
2.19 Another OAO, Wrexham and Shropshire, used to operate open access 
services between London Marylebone and Wrexham. It commenced operations in April 2008 but was unsuccessful financially and exited the market in January 2011. 

## Freight Operating Companies

2.20 Freight operating companies operate freight train services in Great Britain on 
an entirely open access basis, ie there is full competition 'in' the market, rather than 'for' the market. Services are not specified by government.  
2.21 Freight operators may either own or lease locomotives and wagons. They are 
allocated train paths on the network by Network Rail, alongside franchised TOCs and OAOs. Rail freight operates in sectors including bulk (eg coal, construction and petrochemicals), intermodal (eg shipping containers) and automotive.  
2.22 There are currently seven separate freight operators in Great Britain: Colas 
Rail, DB Schenker, Devon & Cornwall Railways, Direct Rail Services, Europorte, Freightliner and GB Railfreight.  

## Rolling Stock Leasing Companies

2.23 The three major ROSCOs operating in Great Britain are Angel Trains, 
Eversholt and Porterbrook. ROSCOs own fleets of trains and lease them to 
franchised TOCs, OAOs, freight operators and train building companies.59 
When rolling stock is replaced by newer stock on a given route, it is often relet to other routes operated by different companies. The ROSCOs work with train operators to determine the sorts of rolling stock required to deliver the desired customer services. 
2.24 Although constrained by the availability of rolling stock and the rolling stock's 
interoperability with train operators' requirements, there is a degree of competition between ROSCOs. A new competitor, QW Rail Leasing, entered the market in 2008 and currently leases trains to London Overground.  
2.25 In recent years, the government has procured large rolling stock orders 
directly from the train manufacturers, including the rolling stock for schemes such as the InterCity Express Programme (replacing the original diesel InterCity 'High Speed Trains'), Thameslink and Crossrail. The rationale for this was to ensure the delivery of large-scale investment and to align the procurement and delivery of the new rolling stock with the specification and delivery of major infrastructure upgrades to parts of the network on which the new rolling stock will be used.  
2.26 The Competition Commission reviewed the rolling stock leasing market in 
2009 and concluded that competition in the market for the leasing of rolling stock was restricted by the limited number of alternative fleets available to franchised TOCs when bidding for franchises and a number of other factors 
such as the costs and risks involved in switching rolling stock.60 The 
Competition Commission made several recommendations and imposed the Rolling Stock Leasing Market Investigation Order, which placed certain 
obligations on rolling stock lessors.61  

## The Role Of The Regulator And Government

2.27 Unlike many other privatised industries, government plays a major role in all 
aspects of the rail industry from access to the network to the operation of passenger rail services. As described in paragraph 2.45 below, the 
government accounts for 29% of the rail industry's funding. The following paragraphs set out the roles of the key government departments and agencies involved.  

## Office Of Rail And Road, The Industry Regulator

2.28 ORR is an independent regulator, which operates within the framework set by 
UK and EU legislation and is accountable through Parliament and the courts. It is the main safety and economic regulator of railways in Great Britain. In exercising its functions under the principal legislation, the Railways Act 1993, ORR must consider and achieve an appropriate balance between its 24 statutory duties, one of which is to 'promote competition in the provision of railway services for the benefit of users of railway services' and another of which is to 'have regard to the funds available to the Secretary of State for the purposes of his functions in relation to railways or railways services'. 
2.29 ORR's statutory responsibilities include:62 
 
monitoring the efficiency and performance of Network Rail and other main line rail infrastructure providers (including HS1 and the UK end of the Channel Tunnel), to hold them to account on performance for users within a long-term framework;  
 
regulating and enforcing health and safety on the railways, to protect passengers, workers and the public;  
 
regulating access to the rail network for passenger services and freight, to maximise capacity and ensure fair and equal treatment of operating companies and the charges that they pay;  
 
licensing and authorising rail activities and technical standards, to ensure safety, accessibility and interoperability of rail infrastructure and vehicles across the network, and internationally;  
 
ensuring fair and efficient markets for customers and across the sector including the supply chain; and 
 
protecting and promoting passenger interests, including under consumer law.  

## Department For Transport

2.30 The DfT, acting under the authority of the Secretary of State for Transport, is 
responsible for preparing the government's long-term strategy for the rail industry, defining the level of passenger services expected to run and specifying the level of funding required.  
2.31 The DfT is now (through its Rail Group) the franchising authority responsible 
for the majority of franchise agreements entered into with respect to services 
on the rail network in England, Wales and cross-border routes.63 In addition, it 
is responsible for fare regulation and other consumer protection aspects such as safeguarding the provision of services for disabled people. 

## Rail Group

2.32 In 2014, the DfT created a Rail Executive within it to support the drive to 
strengthen its focus on passengers, to build an enhanced culture of commercial expertise and innovation and to ensure greater coordination of improvements to track and trains. The role covers: 
 
passenger rail services, including franchise contract award and franchise management; 
 
major projects, including Crossrail, Thameslink and the InterCity Express Programme for rolling stock procurement; 
 
integrated delivery of projects; 
 
whole industry strategy and funding; and 
 
Network Rail sponsorship. 
2.33 The Rail Executive was renamed the Rail Group in January 2016.  

## Devolution Of Franchises

2.34 As set out below, Transport Scotland is now responsible for managing the 
ScotRail franchise and the Welsh government will take responsibility for 
managing the next Wales & Borders franchise. There are also proposals for further devolution of franchises.  

## Transport Scotland

2.35 Transport Scotland was created in 2006 to carry out the transport functions of 
the Scottish Executive, including responsibility for devolved powers over rail franchising. Transport Scotland carries out appraisals of capital investment projects in the rail sector, advises on rail investment decisions and provides the specification of railway outputs to the Scottish government. 
2.36 Transport Scotland is responsible for managing the ScotRail franchise in 
Scotland, which is worth around £2.5 billion over its ten-year term. FirstGroup ran the ScotRail franchise from 2004. The ten-year franchise was awarded to Abellio in October 2014 and commenced operations on 1 April 2015. At the end of the old ScotRail franchise, the Caledonian Sleeper (which operates overnight services from London to Scotland in both directions), became a separate franchise operated by Serco. The specifications of both franchises were built around a detailed analysis of how rail can support broader 
economic growth and social cohesion across Scotland.64  
2.37 Scotland's rail strategy is determined by Scottish Ministers and includes 
responsibility for defining the level of public expenditure required to support Network Rail's operations and the ScotRail franchise. The DfT is obliged to inform and take full account of the views of the Chief Executive of Transport Scotland prior to approving any new commercial transactions that have a material impact on the Scottish network, while each body has to bring to the attention of the other, as a matter of urgency, any matter which has the potential of materially impacting upon the operation of rail services in Scotland 
or the planned investment programme.65  
2.38 In May 2015, Abellio ScotRail and Network Rail entered into a formal 
agreement to encourage, through an alliance, greater organisational 
integration and operational alignment.66  

## Welsh Government

2.39 The Welsh government was given more powers with respect to passenger 
services in Wales under the Railways Act 2005. In November 2014, 
agreement was reached to devolve rail franchising functions to the Welsh government effective from 2017. This will enable the Welsh government to specify and award the next Wales & Borders franchise, for which the Invitation to Tender will be issued in August 2017 so that the new franchise may commence in October 2018. 

## Proposals For Further Devolution Of Franchises

2.40 A number of regional rail franchises are expected to be devolved in the 
coming years.   
2.41 On 20 March 2015, the Secretary of State for Transport signed a Partnership 
Agreement with Rail North for the management of the Northern and TransPennine Express franchises from 1 April 2016. Rail North is a government body based in Leeds, which was set up to support railways in the North of England and represents 29 Local Transport Authorities from across 
the region.67 Although there remain a number of 'reserved matters' for the 
Secretary of State, the responsibilities of Rail North will include developing the Train Service Requirements and train plan, implementing changes to the train fleet, undertaking performance management and enforcement, while, also, applying fare increases to fare baskets.  
2.42 In addition to this, and as part of the 'Northern Powerhouse' programme,68 the 
government entered into a devolution agreement with Greater Manchester in November 2014, outlining the powers to be transferred to the area as it moves 
towards having a directly elected mayor in 2017.69 The powers and resources 
that the mayor will receive include a devolved transport budget as well as responsibility for franchised bus services, railway stations and 'smart ticketing' 
(following the example of London's Oyster card) in Greater Manchester.70 
Furthermore, Greater Manchester will work closely with the DfT and Rail North 
in order to contribute to rail franchising policy.71 
 

2.43 The *Cities and Local Government Devolution Act 2016* puts in place the legal 
framework to enable other areas to follow the lead of Greater Manchester.72  

## Funding Of The Rail Industry The Rail Industry'S Income And Expenditure

2.44 Figure 1 sets out the rail industry's income and expenditure in 2013–2014. 

Source: ORR (February 2015), GB rail industry financial information 2013-14. 

## Passenger Revenue

2.45 In 2013–2014, the rail industry in Great Britain received £13.3 billion in 
income, of which 68% was from passengers (from fares, car parking and ontrain catering), 29% from government and 4% from other sources such as 
property, retail and freight.73  
2.46 Passenger fares contributed 61% (£8.2 billion) of the industry's total income, 
of which unregulated fares accounted for 64% and regulated fares (ie fares capped under franchise agreements) for 36%. In both categories, discounted fares (eg advance, off peak and super off-peak) accounted for 42% (£3.3 billion). Passengers contributed another £0.8 billion through the 
payment of charges such as car parking and on-train catering.74 
2.47 The proportion of the rail sector's funding paid for by passengers is 
increasing. ORR analysis, adjusted for inflation, shows that:  
 
funding from government sources decreased by 16.4% between 2010 and 2014. This equates to a 28.3% decrease in the government's financial contribution per passenger journey; and  
 
income from passengers increased by 10.8% during the period between 2010 and 2014. This largely reflected the 16.6% increase in passenger journeys with the average fare per passenger journey decreasing by 5.0%. 
2.48 We note that passengers (rather than the government) are now responsible 
for funding the largest share of the industry's costs. This can be seen as strengthening the case for passengers rather than government having an increasing say in services by allowing greater passenger choice through onrail competition - particularly on commercial intercity services.  

## Government Funding

2.49 Different parts of government contributed a total of £3.8 billion (29%) to the 
funding of the network. The main sources of government funding were the DfT (£2.6 billion), Transport Scotland (£0.8 billion) and the Welsh government (£0.15 billion). On a per journey basis, there were higher levels of government funding in Wales and Scotland than in England, varying from £1.88 per 
passenger journey in England to £7.77 per journey in Scotland and £9.18 per journey in Wales.  

2.50 As a whole, the government contributed £3.7 billion to Network Rail through 
the network grant.75 Network Rail also received £2.4 billion in income from 
track access and other charges levied on train operators and £0.5 billion in income from other sources.   

## Franchises

2.51 In 2013–2014, franchised TOCs paid £1.9 billion in premiums to government, 
while TOCs in receipt of subsidy received £2.0 billion. The government 
therefore made a net contribution of £0.1 billion to franchised TOCs.76 In 
effect, for the franchises operated by the DfT, the franchises received a total 
subsidy of 6.8 pence per passenger mile in 2013–2014.77 This includes the 
subsidy paid directly to the franchised TOCs by government and an allocation of the network grant (ie payments made directly to Network Rail).  
2.52 During the period 2013–2014, three franchises (Thameslink, Southern & 
Great Northern, South Western and East Coast) paid government a larger premium than the subsidies they received (ie they had a negative subsidy per passenger mile). Northern Rail received the highest subsidy per passenger mile of 51.5 pence. 
2.53 Franchised TOCs' main costs are the track access charges that they pay to 
Network Rail, the costs of leasing stations and rolling stock and of employing staff. Under the terms of each franchise agreement, the government indemnifies each franchisee, for the duration of the franchise term, against any rise in the rate of track access charges payable by the franchised TOC to Network Rail, typically following a periodic review by ORR (see above, paragraph 2.4), that occurs during the franchise term. Franchised TOCs may do light maintenance work on rolling stock themselves or contract it out to private companies. Heavy maintenance is normally procured for TOCs by ROSCOs, according to the contracts between them. 
2.54 Franchised TOCs' revenues are primarily derived from the sale of tickets but 
also include other income from ancillary activities such as car parking, onboard catering and advertising.78  

## Network Rail

2.55 At present, Network Rail's income is derived from the following sources: 
(a) grants received from the DfT and from Transport Scotland (64% of its income); (b) its commercial property income (10% of its income); and (c) track 
access charges paid by passenger and freight operators (26% of its 
income).79 In addition, funds are received from debt issuance, with Network 
Rail having previously raised bonds in the capital markets supported by a UK government guarantee for the purposes of funding capital expenditure and refinancing existing debt. However, following reclassification, Network Rail will no longer issue bonds but will instead borrow £30.3 billion directly from the government through a loan facility designed to cover funding requirements for 
the period 2014–2019.80  
2.56 In its most recent Periodic Review (PR13) of Network Rail's funding and 
outputs, ORR assumed that for the five-year period from 2014 to 2019 approximately 30% of Network Rail's revenue would be derived from access charges, 60% from the network grant and the remaining 10% from other 
sources.81 Over this period, the government has committed £18 billion, 
including for investments to modernise the network where this is most 
needed.82 
2.57 Network Rail's funding arrangements may change in the coming years 
following the recommendations of the Shaw report on the longer-term future shape and financing of Network Rail (described further in paragraph 2.72).  

## Track Access Charges

2.58 Network Rail levies a number of charges on operators using the rail network. 
The main categories of charges are set out below: 
(a) **Variable track access charge (VTAC)** - this charge is related to the 
short-term cost of running an additional train over the track, reflecting the wear and tear incurred. 
(b) **Capacity charge** - this was introduced in 2002 as a way of reimbursing 
Network Rail for the additional delay costs associated with additional 
traffic as incurred under Schedule 8 of the track access agreements.83 
The charge aims to provide appropriate incentives and price signals to encourage train operators and funders to make efficient use of network capacity. 
(c) **Other charges** - other charges levied by Network Rail include electrification asset usage charge, traction electricity charge and certain freight-only charges (including a freight-specific charge and a coal spillage charge). 
(d) **Fixed track access charge (FTAC)** - this charge recovers Network 
Rail's residual funding requirements after taking into account the charges set out above and the network grant.  
2.59 Different types of operator currently pay different charges. The charges 
payable are set out in the track access agreements that passenger and freight operators enter into with Network Rail. These agreements, which also specify the rights that train operators have to be allocated capacity on those parts of the network for which Network Rail is infrastructure manager, are approved by 
ORR.84 Most track access agreements are entered into for a term of between 
five and ten years. 
performance. See ORR (November 2012), Consultation of Schedules 4 and 8 possessions and performance regimes. 

84 ORR ensures that the framework of access charges set are consistent with EU law, including Directive 
2001/14/EU. Specifically, it has to take into account the provisions of the Railways Infrastructure (Access and Management) Regulations 2005, which require, among others, that track access charges are non-discriminatory and transparent, ensuring on the one hand that train operators are not charged excessively high prices by Network Rail and on the other that the charges paid are sufficient to cover Network Rail's costs of running the network. 

2.60 Figure 2 provides a breakdown of the different sources of Network Rail's 
income during CP5 (ie for the period 2014–2019), including from track access charges described above.  
 
Source: ORR. * The 'Other Single Till Income' referred to in Figure 2 primarily relates to income generated from the commercial exploitation of property owned by Network Rail. The variable and other charges listed are the following: the electricity asset usage charge (EAUC), the traction electricity charge (EC4T), the capacity charge (CC), the variable track access charge (VUC) and the station long-term charge (SLTC), which recovers station building and information and security systems maintenance and repair costs.   

## Charges Paid By Oaos And Franchised Tocs

2.61 Franchised TOCs, OAOs and freight operators pay variable charges, whereas 
only franchised TOCs also pay FTAC. The fact that OAOs do not pay FTAC is often cited as a reason to restrict the entry of OAOs in order to protect the funding of the network.   
2.62 In 2006, the then franchisee on the East Coast main line, GNER, brought a 
judicial review against the open access applications of Grand Central and First Hull Trains in the English High Court on the basis of an alleged illegality in ORR's policy of charging franchised TOCs and OAOs inconsistently. 
2.63 The court noted that there was a critical distinction to be made between the 
circumstances in which franchised TOCs and OAOs access the network 
upstream.85 Franchised TOCs have very considerable advantages, including 
taking over established businesses, protections against variations in access charges and revenue protections such as 'cap and collar' (now replaced by a GDP risk-sharing mechanism).86 The court decided that the different market conditions faced by the OAOs and the franchised TOCs justified different charging regimes and also described FTAC as an 'artificial construct'.  

## Orr Review Of Structure Of Track Access Charges

2.64 The way in which Network Rail charges train operators for their use of the 
network affects decisions made by franchised TOCs, OAOs and freight operators, Network Rail and funders of the network. In its final determination for PR13, ORR therefore committed to working with the industry to conduct a review of Network Rail's structure of access charges in advance of the next Periodic Review (PR18) which will cover Control Period 6 (CP6), which runs from 2019–2024. In undertaking its review, ORR aims to improve the understanding of what drives Network Rail's costs and the link between these costs and charges.  
2.65 In order to help inform ORR's review, the Rail Delivery Group87 conducted a 
review with the industry of the current structure of access charges and considered how Network Rail and operators' incentives could be better aligned to improve industry outcomes. The Rail Delivery Group published a report setting out options for a new and/or updated charges and incentives 
regime in November 2015.88  
2.66 On 10 December 2015, ORR published for consultation a list of options for 
changing the structure of Network Rail's charges.89 In considering the options 
for changes to the structure of charges, ORR identified four gaps in the current charging regime: (a) a limited ability to drive down costs; (b) a lack of specific and strong incentives to provide and allocate capacity most efficiently; (c) a potential inability to support effective competition between different types of passenger train operator; and (d) complexity.   
2.67 ORR proposes to focus its future work on understanding what drives Network 
Rail's costs, considering if this information should be reflected in charges, and improving the existing set of charges.   
2.68 The consultation closed on 4 March 2016 following two workshops (one in 
Glasgow and one in London) where ORR's proposed approach to the review 
of the structure of track access charges was discussed with stakeholders. ORR will start the process for PR18 with the publication of its initial consultation document in April 2016, setting out how it proposes to prioritise and focus the review to address the current and prospective challenges and opportunities.   

2.69 As set out in our consideration of the options for greater on-rail competition in 
Chapter 6, reforming the structure of access charges is an integral part of the CMA's proposals for greater on-rail competition and the CMA will therefore continue to work with ORR as it undertakes its review.   

## Other Recent Reviews

2.70 In June 2015, Sir Peter Hendy was appointed Chairman of Network Rail and 
was asked by the Secretary of State for Transport to develop proposals by autumn 2015 on how the rail upgrade programme (set out in the Appendix 
should be carried out.90 The report concluded that the vast majority of 
programmes and projects should go ahead for delivery by 2019. No projects 
were cancelled and the remaining projects will be delivered after 2019.91  
2.71 At the same time, for the purposes of improving future investment 
programmes, the Secretary of State requested that Dame Colette Bowe, an experienced economist and regulator, examine lessons learned in order to make recommendations for better investment planning. The report was published in November 2015 and concluded that there was no one overarching cause which explains the cost escalation and delays to projects and programmes in the current control period, which if corrected would prevent it from recurring. Instead, a number of issues have combined to 
require this programme to be reviewed and elements to be replanned.92 
2.72 In July 2015, the government appointed Nicola Shaw, Chief Executive of High 
Speed 1, to advise it on how the longer-term future shape and financing of 
Network Rail should be approached.93 The work is to be presented jointly to 
the Secretary of State for Transport and the Chancellor of the Exchequer. A 
scoping study was published in November 201594 and a detailed report with 
implementation proposals is to be prepared by the time of the Budget in spring 2016  

## Fare Regulation

2.73 The Secretary of State has the power to regulate fares through franchise 
agreements where this is in the interests of passengers.95 Historically, 
regulated fares fall into two 'baskets' of fares: commuter fares and other protected fares.  
2.74 Fare baskets are regulated by a cap on annual fare increases. For 2015, the 
amount at which an individual regulated fare can rise has been capped at the retail price index (which in July 2014 was 2.5%). We note that the new government has stated that it will not permit operators to raise regulated fares (the majority of which cover commuter routes) above the rate of retail price 
inflation over the next five years.96  
2.75 Fare baskets may include off-peak or super off-peak returns, 'anytime' day 
singles and returns and some season tickets outside urban areas, longdistance saver fares and shorter distance standard return fares.97 
Approximately 45% of fares are subject to regulation.  
2.76 Advance and first class tickets are not regulated. For long-distance journeys, 
'anytime' single/return fares are usually unregulated as are off-peak day single/return tickets for shorter journeys. TOCs determine unregulated fares on a commercial basis and changes can be made during the franchise agreement provided that the financial effect on the franchisee is neutral within the framework provided by the Ticketing and Settlement Agreement (see paragraph 2.78).  
2.77 In Scotland, all ScotRail season tickets, all ScotRail off-peak returns as well 
as all fares in the Strathclyde area and standard singles, standard day returns and season tickets in the Edinburgh commuter area are currently regulated. These fares are set by Transport Scotland and are defined in the franchise agreement. Other fares for flows in Scotland are unregulated and can be set by the franchisee on a commercial basis. Transport Scotland does not set 
fares for cross-border services; rather these follow the DfT's policy.98 In 2015, 
ScotRail's off-peak tickets remained frozen at 2013 levels and increases in peak fares will be capped to increase in line with inflation.99 

## Other Ticket Regulations

2.78 Train operators are required to comply with arrangements relating to the 
creation of fares, including obligations around the creation of interavailable fares and through tickets. In order to support an integrated ticket retailing system, there are interoperator agreements that enable, for example, agreement on unified systems and the allocation of revenue. The key enabling document is the Ticketing and Settlement Agreement (TSA), which is entered into by all train operators.  
2.79 The fares and retail regime is overseen by train operators who come together 
through various governance arrangements. For example, the Association of Train Operating Companies leads on changes to the TSA on behalf of the train operators and the Rail Settlement Plan facilitates integrated retailing and manages the allocation of revenue between train operators. National Rail Enquiries manages the National Rail Enquiries website and telephone service and manages some central industry data, such as real-time train information.  
2.80 Under the TSA, train operators are obliged to offer at least one interavailable 
fare between each origin and destination point on the network. This fare is valid on any permitted route across multiple operator services. Interavailable fares are set by the lead operator (ie the operator with the greatest commercial interest on a certain route) and must be observed by all train operators selling tickets for that journey or operating a service on some or all of the route. Other operators, other than the lead operator, can set dedicated (ie unregulated) fares for travel only on their own trains at prices which are generally lower than the interavailable fare.  
2.81 ORR is currently conducting a retail market review focused on who sells 
tickets, what tickets are sold, where and how tickets are sold, and the ticket format. ORR is considering the issues from the point of view of the industry regime - in particular, the rules and practices in which retailers (ie both TOCs and third party retailers) operate under when selling tickets in order to ensure that they are working to the benefit of passengers, the industry and taxpayers. 
ORR's consultation on its June 2015 emerging findings100 closed in 
September 2015. ORR is planning to publish its final recommendations with respect to third party retailer arrangements in spring 2016.   

## The Development Of Competition Since Privatisation

2.82 In this section, we consider the development of competition since privatisation 
including the extent to which the original government vision of competition has been achieved, the development of open access operations and the government's reforms to franchising.   

## The Government'S Vision At The Time Of Privatisation

2.83 At the time of privatisation, the government's 1992 White Paper envisaged 
that competition would be instrumental in driving greater efficiency and a wider choice of services that were more closely tailored to customer preferences.101 The government noted that the rail industry was more insulated from 
the demands of the market than other forms of transport - such as the airline, coach and road haulage sectors - and that radical changes were needed.   
2.84 The 1992 White Paper also envisaged that franchises would be designed, 
wherever possible, to provide scope for competition. There would be no universal template for a franchise contract and flexibility would be preserved in all aspects of franchising to take full account of the private sector's views on how it could best bring its skills to bear. Subject to contractual obligations, operators would have the freedom to provide the extent, type and quality of service which they believed best met passenger demands.   
2.85 The DfT published a paper in 1993, in which it explained that 'it is the 
Government's intention that on-track competition in the first generation of franchises will be moderated, but only to the extent necessary to ensure the successful transfer of British Rail's passenger services to the private 
sector'.102 The government envisaged that, after the initial franchises were 
awarded, as the system for gaining access evolved, more services would be provided on the basis of open access and fewer under franchise 
agreements.103 Also, train operators would obtain subsidies for individual lossmaking services rather than packages of services.104 
2.86 Freedom of access was also central to the aims of privatisation, with the 
government seeking the greatest possible development of commercial railway services. Liberalising access was seen as complementary to structural changes by providing the opportunity for new operators to run services, 
encouraging initiative, giving customers a wider choice and rail operators the stimulus of competition to provide better service quality and value for money.  

2.87 Greater on-rail competition has remained a policy objective of the authorities. 
ORR, in its long-term regulatory statement of July 2013, said: 
There is an opportunity for there to be much greater on-rail competition in the future, if governments desire it. The addition of new [network] capacity, including HS2, and the introduction of new signalling technology that allows much more dense use of network capacity, will open up new route paths that allow greater on-rail competition between operators.105 

## Achievement Of Competitive Benefits

2.88 Since privatisation, the system has produced notable successes. Competition 
'for' the market has been intense, with franchise competitions attracting a number of credible bidders. There have been real benefits, evidenced by the reverse over the past two decades of the previous long-term decline in usage of Britain's railways and, over the past decade, a material increase in passenger satisfaction. 
2.89 The system has adapted following a number of major shocks, including the 
Hatfield rail accident and the subsequent overhaul of the network infrastructure and insolvency of the then network operator Railtrack; the exit of the East Coast franchisee; and the failure of the 2012 West Coast franchise auction. The government, balancing the need for stability with the need to make the system more responsive to passenger needs, introduced a number of reforms to facilitate more competitive behaviour including, in the past few years, a commitment to greater flexibility in franchise specification and changes to the mechanism in franchise agreements for sharing risk between the government and franchised TOCs.  
2.90 Nevertheless, for all these very real gains which have enabled franchised 
TOCs to become more responsive to passenger needs, the system has not yielded all of the benefits that were hoped for at the time of privatisation: 
 
the scale of on-rail competition envisaged at privatisation has not materialised; 
 
the post-privatisation period has seen a significant increase in passenger rail expenditure, only part of which can be directly attributed to the increase in outputs; and 
 
franchisee specification and risk sharing may limit the ability and 
incentives of franchised TOCs to respond to customer preferences.106 
2.91 The following paragraphs consider these issues in greater depth. OAOs are limited in scale 

2.92 As described in paragraph 2.18, there are currently just two OAOs operating 
in Great Britain - First Hull Trains and Grand Central. Both OAOs compete against the incumbent franchisee on certain East Coast main line routes. Together, they represent less than 1% of passenger rail miles in Great Britain.  
2.93 In considering applications for track access, ORR must have regard to its 
statutory duties. Although having a duty to promote competition for the benefit of rail users, ORR must balance this with its other statutory duties, as set out in section 4 of the Railways Act 1993, including the requirement to have regard to the funds available to the Secretary of State for Transport for the purposes of his functions in relation to railways or railway services. 
2.94 In the post-privatisation period, on-rail competition was limited by a policy 
referred to as Moderation of Competition. Under this policy, each track access agreement specified those routes on which Network Rail (and previously Railtrack) was prohibited from granting access rights to potential competitors 
of the franchised TOCs.107 The rationale behind this approach was to ensure 
that OAOs could not undermine the viability of the franchise system by 'cherry picking' profitable services. However, in 2004, ORR indicated that it would only approve Moderation of Competition clauses in exceptional circumstances (ie where investments would not otherwise occur). In November 2010, ORR stated that such protection would no longer be approved.  
2.95 Under the current open access regime, new entrants are able to compete 
directly against the franchised TOCs provided that such new entry meets 
ORR's 'not primarily abstractive' test,108 ie the new services would have to 
demonstrate that they can increase the overall market size by generating a 
certain level of new-to-rail business rather than merely abstracting business from existing operators (which, in turn, would have a negative effect on the Secretary of State's funds). The test, commonly known as the 'NPA rule', is currently interpreted to require that the proposal must generate three units of new revenue for every ten units that it abstracts from the franchisee(s) operating on the same routes.  

2.96 For the purpose of the NPA rule, ORR has established a five-stage test which 
applies when a new open access service would compete with franchised services, impacting upon the public sector funder's budget or when a new OAO would compete with an existing open access service.109 As part of this 
test, standard industry models110 are used to estimate the likely level of 
abstraction (as part of stage 1) and estimates are refined using benchmarking 
and survey information from other comparable situations (at stage 3).111  
2.97 In 2013, ORR launched a consultation on whether to relax the NPA rule in 
return for OAOs paying a mark-up as a contribution to Network Rail's fixed costs. Following consultation, however, ORR decided to retain the NPA rule, but said that it would review the operation of the requirement.  
2.98 Although existing OAOs have extended their operations, over the last five 
years no new OAOs have entered the market. ORR received three proposals from Alliance Rail in 2014 to authorise more substantial open access operations that would compete head-on against the franchised TOCs on the 
East Coast and West Coast main lines. Although the application to provide passenger rail services on the West Coast (between London and Blackpool) was rejected in December 2014, ORR approved a revised proposal in August 2015. Alliance Rail expects to operate six daily services between London and 
Blackpool from 2018.112 The separate application by Alliance Rail lodged with 
ORR in early 2014 to operate fast services between London King's Cross and Edinburgh and to Cleethorpes and Bradford on the East Coast main line is still under consideration.  
2.99 In March 2015, ORR received an application from FirstGroup to run services 
on the East Coast main line from 2018. This would add five daily services in 
each direction between London King's Cross and Edinburgh. The application is currently being considered by ORR.   

2.100 A full list of open access proposals submitted from 2000 to 2015 is set out in 
the Appendix.   

## Franchise Overlaps Have Reduced

2.101 The number of franchise overlaps was reduced by the SRA following its 
franchising policy announcement in 2001.113 The SRA argued that having a 
single operator at each major London terminus would have a number of practical advantages including optimising capacity and offering economies of scale. In the subsequent franchising rounds, the number of franchise overlaps 
was significantly reduced.114 This trend has continued although, as set out in 
Chapter 3, a number of franchise overlaps remain. 

## Efficiencies

2.102 The post-privatisation period has seen a significant increase in passenger rail 
expenditure, only part of which can be directly attributed to the increase in the number of passenger rail journeys. Since 1996–1997 passenger rail industry expenditure has increased from more than £8 billion to £12.7 billion in 2013–
2014.115 However, we note that operator margins as a share of revenue have 
fallen since 1997–1998, suggesting that franchising has captured value for the 
taxpayer.116 The efficiency of the sector is considered further in Chapter 4.  

## The Government'S Approach To Franchise Specification And Risk-Sharing Since Privatisation

2.103 The form of franchises has changed several times since privatisation, 
reflecting changing government policies, and attempts to deal with shortcomings of the framework as they emerged.  
2.104 In March 2013, the government announced its intended approach to 
franchising over the medium term.117 The timetable for future franchise 
awards, subsequently revised in April 2014, was published at the same 
time.118 The government also published a revised statement on franchising policy, setting out how the Secretary of State proposed to exercise franchising powers in the future.119  

2.105 In order to mitigate the risk of distorting the commercial incentives of 
franchised TOCs, in more recent franchising models, the 'cap and collar' risksharing mechanism was abandoned and, in some cases, replaced by a mechanism reflecting exogenous risks, such as GDP changes, throughout the 
whole life of the franchise.120  
2.106 Moreover, a number of changes were made to the franchise award 
programme following the Brown Review in order to maximise the benefits of competition 'for' the market. In particular, the DfT emphasised the following: 
 
The new franchise award programme introduced a weighted scoring system against which bids are assessed that reflects the 'quality' of bids. Points in the competition are awarded to bids which include initiatives to enhance the quality of service passengers receive over and above the franchise specification's requirements or which enhance the value of the franchise for the taxpayer that would not generally be expected to provide 
a return within the life of the contract.121 
 
Innovation in bids has been encouraged by making specific funds available to certain franchised TOCs for innovations that can be bid for by 
operators during the life of a franchise.122  
 
The approach to the treatment of the residual value of investments made by franchised TOCs was developed in order to address the risk of investment tailing off towards the end of a franchise. This makes it more likely that new competitive challenges to franchised TOCs will elicit a competitive response. There are also fewer restrictions being placed on franchised TOCs, enabling them to develop additional services and quality enhancements during the lifetime of a franchise.   
2.107 The DfT highlighted the East Anglia Invitation to Tender, issued on 
17 September 2015, as an example of its new approach providing bidders with significant scope for bringing forward innovative approaches to serve 
passengers.123 For example, rather than being specified by the DfT, bidders 
have been invited to make their own proposals for cutting journey times and introducing new rolling stock.  
2.108 We welcome the trend towards reducing the degree of franchise specification 
and consider the level of franchise specification that may be appropriate in an environment of greater on-rail competition in Chapter 6.   

## Potential Limitations To Benefits Arising From Competition 'For' The Market

2.109 In many sectors, competition directly between operators 'in' the market tends 
to be more effective at delivering benefits than competition 'for' the market.  
2.110 We note that a number of conditions need to be met in order for a bidding 
process to fully realise the benefits of competition 'for' the market. These were outlined in a paper by Professor Paul Klemperer on bidding markets as: (a) the winner takes all (ie the winner wins all of the order); *(b)* competition is 
'lumpy' (ie the contract is a large proportion of the supplier's total sales); 
(c) competition begins afresh for each contract and customer (ie there are no 
incumbency advantages); and (d) entry is easy.124  
2.111 We note that some of the conditions for an ideal bidding market might not be 
met by the current competitive tendering system for franchises. In particular, entry is not 'easy' given that the franchise application process is expensive and time-consuming. There might also be an information asymmetry between incumbents and bidders in the franchising process which creates an advantage for incumbents in the bidding process.  
2.112 More generally, ORR's consultation response highlighted a number of 
reasons why competition 'for' the market alone may not fully realise the potential benefits of competition in the sector. ORR noted that franchised TOCs are largely insulated from changes in the charging structure and so have weakened incentives to lower costs on the network. It also noted that most operators face limited competition between franchise bids, which weakens ongoing incentives on pricing and service quality, while the fixed duration of franchises acts to weaken incentives on operators to innovate or invest in areas where there are longer-term payoffs. ORR also suggested that 
the prescriptive nature of some franchise specifications can limit the ability of operators to adapt to passengers' changing demands.  

2.113 We also note that in order to fully realise the benefits of competition 'for' the 
market, there must be sufficient market interest in bids. The National Audit Office (NAO) noted in its review of franchising that the number of bids the DfT has received under the current franchising programme is lower than the 
historic trend.125 For each of the first three competitions in the current 
programme (taking the InterCity East Coast competition to be the first) the DfT has received three bids, which is the minimum that it considers is necessary to ensure good quality bids. The previous ten competitions received four bids on average.   
2.114 The risk of insufficient market interest in bids was also noted by Public 
Accounts Committee in 2016.126 In this regard, the Public Accounts 
Committee stated that there are signs that the level of interest from the market 
in rail franchises is dwindling. It recommended that the DfT should develop alternatives to its current commercial approach so it is well placed to deliver value for money if market interest falls to a level where intense competition 
cannot be guaranteed.127 
2.115 In this regard, as noted above, we recognise that the DfT is trying to 
encourage new entrants to the market and maintain interest from existing operating companies by simplifying the pre-qualification process and 
reviewing the size and number of franchises.128  

## Conclusion

2.116 The system of competition 'for' the market has produced some notable 
successes and recent reforms to the franchising system are welcome. However, the scale of on-rail competition remains limited. In Chapters 3 and 4 we consider the extent to which greater on-rail competition can deliver benefits over and above the current system of competition 'for' the market.   

## 3. Evidence Of Potential Passenger Benefits From Greater On-Rail Competition Introduction

3.1 
Franchised TOCs face strong competition 'for' the market in bidding to run franchises, with franchise competitions attracting a number of credible 
bidders.129   
3.2 
Train operators often face a further degree of competitive constraint from other modes of transport, depending on the particular routes they serve. For example, on routes from London to Scotland, train operators face competition 
from airlines. On many long-distance flows there is competition from coach transport. On local flows, operators may face competition from local bus services. The private car also exerts a competitive constraint on many flows.  
3.3 
The competitive constraint on passenger train operators from other modes of 
transport was highlighted by a number of respondents to the consultation.130 
While we recognise that this constraint is strong on certain flows, it is weaker 
on others.131 In response to our consultation, it was also put to us by some 
franchised TOCs that competition from other modes of transport increases the need for franchised TOCs to be granted commercial freedom to compete effectively with other modes of transport.  
3.4 
However, as described further below, the scale of on-rail competition currently faced by franchised TOCs in Great Britain is limited.   
3.5 
This chapter considers the potential benefits that greater on-rail competition can bring in addition to competition from other modes of transport, examining examples of direct competition 'in' the market in: 
 
on-rail competition in Great Britain from open access;  
 
on-rail competition in Great Britain from overlapping and parallel franchises;  
 
on-rail competition in other European countries, including Austria, the Czech Republic, Germany, Italy and Sweden; 
 
transport markets where there is 'in'-market competition, such as:  
- 
the Great Britain rail freight sector (which, following privatisation, is 
fully open access); 
- 
the experience of EU airline deregulation;  
- 
the introduction of new competition between London's airports; and 
- 
the deregulation of local bus services in Great Britain.   
3.6 
The DfT, while recognising that any comparator is likely to have deficiencies, 
told us in its consultation response that the comparators in other transport markets used by the CMA focused on the benefits of introducing competition to markets where competition was previously significantly restricted. In its view, the comparators were therefore unsuitable for assessing potential customer benefits from further, incremental, competition over and above the benefits of competition already achieved by way of the competitive award of franchises. In relation to the DfT's concern, we note the following: 
 
We consider the incremental benefits that the current degree of on-rail competition from OAOs has delivered relative to the offering of incumbent 
franchised TOCs.  
 
Rail freight in Great Britain, European airlines and London airports all faced a degree of competition before further competition was introduced. 
 
We have undertaken further research into the examples of on-rail 
competition elsewhere in the EU, drawing on the experience of transport regulators and train operators in those countries. We have also considered the degree of competition that operators faced prior to liberalisation. 
3.7 
We recognise that it is not possible to comprehensively test the effects of 
introducing a significantly increased degree of on-rail competition in passenger train services *ex ante*. There are, inevitably, material differences 
between different transport sectors, and between different operators. However, we think that the evidence in this chapter taken together illustrates the significant benefits that could be obtained from greater on-rail competition 
in addition to the benefits delivered by competition 'for' the market.132 We also cross-refer in this, and later chapters, to the independent impact assessment of our options for greater on-rail competition commissioned by ORR.  

## On-Rail Competition In Great Britain

3.8 
The following paragraphs consider evidence regarding the benefits that the existing degree of on-rail competition in Great Britain has delivered by examining: 
 
fares, satisfaction, service quality and innovation on routes where there is competition between OAOs and franchised TOCs; 
 
fare competition where overlapping and parallel franchises operate (the degree of franchise specification restricts the range of factors on which franchised TOCs can compete); and 
 
the impact of changes in the degree of on-rail competition, for example, where changes to the geography of franchises have introduced or eliminated on-rail competition.  
3.9 
In 2014–2015, OAOs accounted for 0.7% of all rail miles in Great Britain and 0.8% of passenger rail miles. Freight operators accounted for 7.3% of rail miles. Table 2 sets out the data on rail miles by category of operator in 2014– 2015. 

Rail miles  
Operator type 
(in millions) 
% of network 
Franchised TOCs 
319.0 
91.96 
OAOs 
2.5 
0.72 
Freight operators 
  25.4 
   7.32 
Total 
346.9 
100.00 

Source: Network Rail data from ORR data portal. 3.10 In addition to competition between OAOs and franchised TOCs, on-rail 
competition also takes place where franchises overlap or run parallel to each other. Overlapping franchises are defined as those where more than one 
competitive constraint on wholesalers' behaviour, it did not necessarily show that it is the most effective form of competitive constraint. OFT1121, Newspaper and magazine distribution in the United Kingdom - Decision not to make a market investigation reference to the Competition Commission, September 2009. 

operator serves passengers on a flow using the same track. Parallel franchises are defined as those where more than one operator serves a flow between an origin and destination, but using a different line (eg London– Birmingham with Chiltern Railways or via the West Coast line).   

3.11 Table 3 below sets out the overlapping and parallel rail franchises in Great 
Britain in March 2016. A map of franchised and open access services is 
included in the Appendix.133 

## Table 3: Overlapping And Parallel Franchises In Great Britain In 2016

| Overlapping and parallel franchises                        | Flows                                                        |
|------------------------------------------------------------|--------------------------------------------------------------|
| Great Northern and Virgin East Coast                       | London to Stevenage and Peterborough                         |
| Great Northern and Abellio Greater Anglia                  | London to Cambridge                                          |
| First Great Western and Chiltern Railways                  | London to Oxford                                             |
| London Midland, Chiltern Railways and Virgin Trains        | London to Birmingham                                         |
| London Midland and Virgin Trains                           | London to Milton Keynes, Coventry, Rugby, Nuneaton,          |
| Tamworth, Lichfield, Stafford, Crewe and Stoke-on-Trent    |                                                              |
| Rugby to Coventry, Birmingham International                |                                                              |
| Thameslink and East Midlands Trains                        | London to Luton and Bedford                                  |
| c2c and Abellio Greater Anglia                             | London to Southend                                           |
| South West Trains and Southern                             | London to Portsmouth                                         |
| London to Southampton                                      |                                                              |
| London to Epsom, Dorking and Guildford                     |                                                              |
| South West Trains and First Great Western                  | London to Reading, Exeter and Bristol                        |
| London to Basingstoke                                      |                                                              |
| Cross Country, First TransPennine and Virgin East Coast    | York to Newcastle (and between Cross Country and Virgin      |
| on services north to Edinburgh)                            |                                                              |
| London Midland, Virgin Trains, Arriva Trains Wales and     |                                                              |
| Cross Country                                              |                                                              |
| Birmingham International to Wolverhampton and              |                                                              |
| Shrewsbury                                                 |                                                              |
| First Great Western and London Midland                     | Worcester to Hereford                                        |
| Govia, Abellio Greater Anglia and Cross Country            | Cambridge to Ely                                             |
| Peterborough to Ely                                        | East Midlands Trains, Cross Country and Abellio Greater      |
| Anglia                                                     |                                                              |
| Cross Country and Abellio Greater Anglia                   | Ely to Norwich                                               |
| Cross Country and First Great Western                      | Bristol Parkway to Tiverton, Exeter and stations to Plymouth |
| and Penzance and between Reading, Oxford and Banbury       |                                                              |
| Reading to Basingstoke                                     |                                                              |
| First TransPennine, East Midlands Trains and Northern Rail | Liverpool to Manchester                                      |
| First TransPennine, Virgin East Coast and Northern Rail    | Manchester to Leeds and York                                 |
| Blackpool and Barrow-in-Furness to Manchester              |                                                              |
| East Midlands Trains, Cross Country and Northern Rail      | Derby to Sheffield and Leeds                                 |
| First TransPennine and Northern Rail                       | Leeds to Scarborough                                         |
| First TransPennine and Northern Rail                       | Leeds to Hull                                                |
| Northern Rail and Virgin East Coast                        | Doncaster to Hull                                            |
| First TransPennine and Virgin Trains                       | Wigan to Preston, Carlisle and Glasgow/Edinburgh             |
| Arriva Trains Wales and Virgin Trains                      | Chester to Holyhead                                          |
| Arriva Trains Wales and First Great Western                | Newport to Cardiff, Swansea and Carmarthen                   |
| Virgin East Coast, Cross Country and ScotRail              | Edinburgh to Glasgow                                         |
| Virgin East Coast, Cross Country and ScotRail              | Edinburgh to Aberdeen                                        |
| Virgin East Coast and ScotRail                             | Edinburgh to Aberdeen and Inverness                          |
| South West Trains and Cross Country                        | Basingstoke to Winchester, Southampton and Bournemouth       |
| Abellio Greater Anglia and Cross Country                   | Cambridge to Stansted Airport                                |
| First Great Western and Southern                           | Brighton to Southampton                                      |
| London Midland, Cross Country and Virgin Trains            | Wolverhampton to Stafford                                    |
| London Midland and Chiltern                                | (Leamington and) Birmingham to Kidderminster                 |

Source: CMA analysis.  

3.12 The extent of competition on overlapping and parallel franchises varies 
significantly according to the frequency of the overlapping services and the extent of journey time differentials between operators.  
3.13 The following paragraphs consider the passenger benefits that the relatively 
limited extent of on-rail competition in Great Britain from OAOs and competing franchises has delivered.   

## Competition Between Open Access Operators And Franchisees

3.14 As described in Chapter 2, First Hull Trains and Grand Central currently 
compete with Virgin East Coast on the East Coast main line.  
3.15 The current limited scale of on-rail competition in Great Britain constrains the 
extent to which one can draw conclusions about what would happen if the scale of on-rail competition were to increase materially. Nevertheless, there are a number of concrete examples of the benefits of current open access rail competition in Great Britain, including in relation to fares, service quality and 
innovation.134   
3.16 In its consultation response, ORR cited potential benefits that OAOs bring in 
terms of: 
 
different business models, with the potential for greater cost reduction than could be achieved through franchising; 
 
stronger incentives to compete on price and service quality, reflecting their greater exposure to costs and revenue risk in the absence of a timelimited franchise; and 
 
combining these factors to support greater innovation in service offering and pricing and the ability to find new, underserved markets.   
3.17 The following paragraphs consider the benefits arising from competition 
between OAOs and franchised TOCs in the current model of (limited) open access operations. Further evidence of the impact of the current level of onrail competition in Great Britain is presented in section 5 of the impact assessment commissioned by ORR. 

## First Hull Trains And Virgin East Coast (London To Stevenage, Grantham, Retford And Doncaster With One Daily Overlap To Hull)

3.18 First Hull Trains is now a joint venture between FirstGroup (as 80% 
shareholder), which operates franchises in Great Britain including the Greater Western franchise and (through a joint venture) the TransPennine Express (see Chapter 2, Table 1) and Renaissance Trains. It was the first OAO in Great Britain, entering the sector with direct services between London and Hull in 2000. FirstGroup acquired its interest in Hull Trains in 2003 and the company was rebranded in 2008 as First Hull Trains. 
3.19 First Hull Trains competes with Virgin East Coast on a number of flows on the 
East Coast main line. First Hull Trains also competes with Grand Central on the flows from London to Doncaster. 

## Impact On Fares

3.20 First Hull Trains offers dedicated fares in competition with Virgin East Coast. 
In addition to offering a range of advance tickets, First Hull Trains offers super off-peak, off-peak and anytime 'walk-up' tickets which are generally priced 
below the fare set by the lead operator (with respect to interavailable fares).135 
For example, from London to Doncaster, the off-peak single offered by First Hull Trains is priced at £64.00 against an interavailable off-peak single priced at £82.10. From London to Hull, the same ticket types cost £79.00 and £96.80, respectively. On the London–Grantham flow, the operators also compete on price. For example, First Hull Trains offers the dedicated anytime single ticket at a price of £51.50 against the corresponding interavailable 
ticket, which is priced at £60.00.136  
3.21 Although the dedicated fares sold by First Hull Trains are only valid on their 
own services (which are less frequent), passengers benefit from the availability of cheaper fares which, in turn, may also constrain the fare set by the lead operator in the case of interavailable tickets.  
3.22 First Hull Trains also competes with Virgin East Coast on the price of 
dedicated advance purchase tickets. Passengers booking advance tickets 
with either operator are restricted to travelling on a specific train but benefit from lower prices as a result of on-rail competition.  

3.23 First Hull Trains introduced a 'carnet' ticket for business passengers in 2013 
that it claims offers savings of up to 50%. ORR noted in the emerging findings of its retail market review that OAOs offering such products may also encourage competing franchised TOCs to offer similar products, citing the 2014 example of Virgin East Cost offering carnet tickets to business 
passengers through its website.137  
3.24 We note that price competition between First Hull Trains and the incumbent 
franchised TOC would be expected both because First Hull Trains needs to win passengers by undercutting the incumbent in order to ensure that its services remain commercially viable (as an OAO service it would not be subsidised if it entered financial difficulty) and because, as an OAO, First Hull Trains has lower costs (including through paying lower access charges than the franchised TOC). Further examples of fare competition between First Hull Trains and the incumbent franchised TOC are set out in Table 3 of the impact assessment commissioned by ORR.   

## Impact On Service Levels And Innovation

3.25 First Hull Trains also competes on service and innovation. First Hull Trains 
identified a number of examples, including: 
 
a passenger information system (incorporating information from the official industry real-time train running information system and GPS tracking) which provides real-time information on board the train, including the progress of the service, expected arrival times at stations and information on connecting trains. First Hull Trains cited its freedom from the need to amend a franchise agreement as facilitating this innovation in response to on-rail competition; 
 
privately funding new rolling stock with 125mph capability (the current maximum permitted line speed), more seats and higher specification; 
 
free 4G Single Sign Up wi-fi on all trains; and 
 
access to a selection of ITV programmes on board. 
3.26 First Hull Trains is also pursuing a project to electrify the line from Selby to 
Hull using predominantly private sector finance (discussed further in 
paragraphs 4.36 and 4.37).  
3.27 Passenger surveys consistently rank First Hull Trains as one of the leading 
rail operators in terms of overall passenger satisfaction. The National Rail Passenger Survey published in autumn 2015 indicated that 97% of passengers were satisfied with First Hull Trains, the highest score across all operators (followed by Grand Central and Heathrow Express - which both 
operate on an open access basis).138 The Which? 2016 Trains Satisfaction 
Survey ranked First Hull Trains as the operator with the second highest customer score in Great Britain, taking into account factors including the availability of seating, cleanliness, frequency, punctuality, reliability and value 
for money.139   

## Impact On Passenger Usage

3.28 Analysis of on-rail competition by Ove Arup for ORR in 2009140 found that the 
number of journeys from stations served by both the incumbent and First Hull 
Trains increased at a faster rate than most of the control stations.141 The 
increase in revenue yield (ie the increase in average fare per passenger) was 
also smaller at stations with competition (Grantham, Doncaster and Hull) than on the control flows. Arup also cited a number of softer benefits of competition in its study, including additional car parks.  

## Wider Economic Impact

3.29 In terms of the wider economic benefits of the service, Arup (2009) notes that 
prior to the introduction of First Hull Trains, the Hull and Humber Ports City Region was one of the few major urban areas in Great Britain that was not served by direct connections to London. The new services created major opportunities for business in London, with people able to arrive in the capital before 0930 and to travel back in the evening.  

## Grand Central And Virgin East Coast (London To York, Northallerton And Sunderland; London To Doncaster, Wakefield And Bradford)

3.30 Grand Central is a subsidiary of Arriva UK Trains (which is itself a subsidiary 
of the main German national rail operator Deutsche Bahn); Arriva also operates franchised services in Great Britain (see Chapter 2, Table 1). Grand Central competes with Virgin East Coast on a number of flows on the East Coast main line and serves stations, such as Sunderland, which  previously 
had no direct services to London.142  

## Impact On Fares

3.31 Grand Central offers dedicated fares as part of its strategy of competing with 
Virgin East Coast.   
 
For example, Grand Central offers a dedicated anytime single fare from London to York for £83.10, whereas the interavailable fare set by the lead 
operator is £112.00.143 Although the dedicated fares limit the number of 
services on which a passenger may travel (to five per day in the York example), Grand Central told us that the majority of its passengers travel using dedicated tickets. The availability of cheaper dedicated tickets may also constrain the interavailable fare set by the lead operator, although Virgin observed that as the lead operator on the route, fare regulations prevent it from offering dedicated walk-up fares.  
 
For travel from London to York, both Grand Central and Virgin East Coast compete on the prices of their dedicated advance single tickets. 
 
We observed that the cheapest advance single tickets for travel between London to York available for departures between 0700 and 0859 cost from £20.90, whereas for travel from London to Manchester on the West Coast main line, a similar distance as from London to York but without on-rail competition, the cheapest advance single available for departures 
between 0700 and 0859 cost £110.00.144 While differences in demand 
and operating cost are likely to exist between the East and West Coast main lines, the magnitude of the fare differential appears significant.   
 
Which? also considered the fare differentials on the London–York flow, finding that that Grand Central's 'walk-up' tickets are cheaper than those 
of Virgin East Coast.145 For example, Grand Central also sells a dedicated 
off-peak single valid in the peak period. The cheapest walk-up ticket for the 0802 Grand Central London to York service is therefore only £55.40, whereas the cheapest walk-up single valid on the 0800 Virgin East Coast service costs £124.50.   
 
As set out above in relation to First Hull Trains operating on the East Coast main line, price competition between the OAO and the incumbent franchised TOC may be expected as the OAO needs to win business by undercutting the incumbent in order to remain commercially viable and due to the fact that the OAO has lower costs (including through paying lower access charges than the franchised TOC). Further examples of fare 
competition between First Hull Trains and the incumbent franchised TOC are set out in Table 4 of the impact assessment commissioned by ORR.   

## Impact On Service Levels And Innovation

3.32 Grand Central also competes with Virgin East Coast on service quality and 
innovation. The following examples were cited by Grand Central: 
 
Grand Central told us that it was the first train operator in Great Britain to offer free wi-fi to all passengers. The incumbent lead operator at the time, GNER, responded by offering wi-fi (although, in contrast to Grand Central, it charged passengers in standard class to use wi-fi). 
 
Grand Central introduced a 'carnet' ticket offer where a book of 20 fully 
flexible tickets is sold at a 25% discount. GNER responded by offering its 
own carnet. 
 
GNER increased the number of advance tickets that it sold on the East Coast main line. Grand Central responded by increasing the number of advance tickets that it offered for sale. 
 
When Grand Central launched its services from London to York, the incumbent responded by adding additional services to York. We were told that the capacity required to run the additional services was identified 
partly as a result of the increased competitive pressure on the route.146 
The additional capacity has generated benefits for all passengers on the route both in terms of increased frequency and crowding relief.  
 
Grand Central makes its full range of walk-up tickets available for sale on the train. In contrast, Grand Central told us that it is common for franchised TOCs to sell only the most expensive tickets available for a given journey if passengers do not purchase a ticket before boarding.  
 
Grand Central's service to Bradford is, itself, an example of innovation. The introduction of the service acted as a catalyst for the refurbishment of Wakefield Kirkgate station, from which Grand Central offered the first 
direct trains to London for 32 years.147 The service also utilises a former 
freight-only line to Bradford.  
3.33 Passenger surveys consistently rank Grand Central as one of the leading rail 
operators in terms of overall passenger satisfaction. The National Rail Passenger Survey published in autumn 2015 indicated that 93% of passengers were satisfied with Grand Central, the third highest score across all operators (following First Hull Trains and Heathrow Express - which both 
operate on an open access basis).148 The Which? 2016 Trains Satisfaction 
Survey ranked Grand Central as the operator with the highest customer score in Great Britain, taking into account factors including the availability of seating, 
cleanliness, frequency, punctuality, reliability and value for money.149 

## Impact On Passenger Usage

3.34 Grand Central commissioned AECOM to examine the impact of on-rail 
competition on market growth between 2007–2008 and 2011–2012. Passenger journeys, revenue and yield at stations with competition (namely Peterborough, Grantham, Retford, Doncaster, Wakefield, York and Northallerton) were compared with the corresponding data at stations without competition (namely Newark, Leeds, Darlington, Durham, Newcastle, 
Berwick-upon-Tweed and Edinburgh).150 We recognise that analysis of this 
kind can be sensitive to the methodology used, and that ORR and AECOM 
have had some analytical differences regarding this to date.151 We comment 
on the implications of this when outlining AECOM's key findings below. We 
also note that ORR has commissioned new work to establish the volume of new passenger growth generated by OAOs on the East Coast main line. 

3.35 AECOM's analysis found that, on average: 
 
passenger journeys grew by 42% at stations with competition compared with 27% at stations without competition;   
 
over the same period, revenue increased by 57% at stations with competition compared with 48% at stations without competition; and   
 
revenue yield (ie average fare per passenger) therefore rose more slowly at stations with competition, increasing by 11% over the period, as compared with stations without competition where revenue yields rose by 17%.  
We note that these figures may slightly overstate the benefits competition has brought in this area if, for example, some of this growth in passenger numbers was abstracted from other stations which are not included in the sample.  

3.36 It should also be noted that AECOM compiles data which could be used as a 
control to account for the impact of changes in demand, namely employment and population growth, but does not use this in its analysis. Virgin also observed that its own analysis of East Coast revenue trends indicated that flows with competition outperformed in passenger numbers compared to other flows, but significantly underperformed in revenue, suggesting that passenger volumes increased and fares fell.   
3.37 In conclusion, however, we consider that the general direction of these effects 
found by AECOM are likely to be correct for three reasons. First, the results are in line with those found by Arup (2009) using a somewhat different methodology, as discussed below. Second, these figures are based on averages from a number of stations, and so passenger growth caused by abstraction from one station to another station would be more likely to be cancelled out and so not have an overly positive effect on the average values. Finally, they are in line with economic theory, which would normally suggest that introducing competition lowers prices and raises passenger numbers. 
3.38 AECOM also compared revenue yield trends at Northallerton and York for the 
financial years ending April 2008 and April 2012. The results indicated that Grand Central entered the market at a higher average fare than East Coast on journeys from London to York and Northallerton as it did not offer heavily discounted advance purchase tickets (although its walk-up dedicated fares were cheaper than those of East Coast). However, competition led to yields on both operators' services falling over the period. In constant prices, overall 
average yield fell by 10% at York and by 13% at Northallerton. This contrasts with increasing average fares at East Coast main line stations where there was no competition.  

3.39 In order to examine the extent to which OAOs could grow the market through 
introducing new direct services, AECOM examined revenue growth at Thirsk, Eaglescliffe, Hartlepool and Sunderland. Over the period from 2007 to 2014, revenue grew by 552% from £1.4 million to £9.1 million. While this success is remarkable, we are aware that there may have been particular circumstances which led to success in this area (namely a large underserved population, with no previous direct service to London, and, at Eaglescliffe in particular, good car parking facilities allowing passengers from a large new catchment area to be attracted). Therefore, while it seems that introducing competition can have positive effects in terms of growing the market, this may not be of the same magnitude as the results at these four stations. 
3.40 In 2009, Arup examined the impact of the launch of Grand Central's services 
between London and Sunderland in December 2007 (the work predated the increase in Grand Central's frequency and the launch of its services to Bradford). Arup's analysis, commissioned by ORR, was consistent with the results of the AECOM work, finding that passenger growth from Northallerton and York to London (where Grand Central competed with the incumbent operator) significantly outperformed control flows despite similar levels of regional economic growth. The improvements could not be fully explained by 
a reduction in generalised journey time.152 Lower fares enabled Grand Central 
to grow its market share, while extra capacity offered by Grand Central offered benefits to customers.  

## Wider Economic Impact

3.41 In terms of the wider economic benefits of the introduction of the Grand 
Central service, Arup (2009) notes that new journey opportunities were created from Sunderland, Hartlepool, Eaglescliffe and Thirsk to London. Since the Arup report was published in 2009, Grand Central launched services to other stations that were not previously served directly from London, including 
Pontefract, Mirfield, Brighouse, Halifax and Bradford.153  

## Alliance Rail (London To Blackpool From 2018)

3.42 The new operation, running under the GNWR brand, will increase the number 
of direct services between London and Blackpool from one to six or seven each way per day.   
3.43 The new services are expected to call at Milton Keynes, Nuneaton, Tamworth, 
Lichfield Trent Valley, Crewe, Preston, Kirkham & Wesham and Poulton-le-
Fylde. At a number of these stations, the new operator will compete for passengers against Virgin and London Midland. It will also create new direct services between London and Poulton-le-Fylde and Kirkham & Wesham. 
There will be an increase in direct travel options from some other stations and some journey times will be improved including from London to Tamworth and Lichfield Trent Valley (which will also benefit from the higher service quality offered by intercity services). 
3.44 The services will be operated by four new six-car tilting 125mph Pendolino 
trains built and paid for by the operator. ORR stated in its approval decision that these will have similar or better traction characteristics to the Pendolinos 
using the route today.154 GNWR will also invest £1.5 million in station 
improvements.   

## Overlapping And Parallel Franchises

3.45 This section considers the degree of on-rail competition on overlapping and 
parallel franchises, the extent of which varies significantly according to the frequency of the overlapping services and the extent of journey time differentials between operators.  
3.46 In contrast to OAOs, which are free from franchise specification, the factors on 
which franchised TOCs are able to compete is restricted due to the detail of the franchise specification which, for example, defines service frequency and other service characteristics. Franchised TOCs are, however, free to compete on fares, although the lead operator providing interavailable tickets may only offer permanent dedicated advance fares in addition to those that are interavailable (ie it cannot offer dedicated anytime or off-peak 'walk-up' fares).   
3.47 In Appendix C of our discussion document published in July, we examined the 
extent of competitive interaction between overlapping and parallel franchises 
across each of the overlaps.155 A number of themes emerged from this analysis:  

 
The degree of price competition between franchised TOCs on overlapping and parallel franchises appears to depend on journey distance, relative journey times, frequency of services, the nature of the franchised TOCs (eg whether they are long-distance or regional operators) and the extent of franchise specification.   
 
Where franchised TOCs compete on shorter distance flows, such as between London and Cambridge and London and Peterborough, the franchised TOC competing with the lead operator typically offers a lower dedicated walk-up fare in competition with the lead operator's interavailable fare. This offers passengers a greater range of fare and service options, including a number of cheaper fares, and may also constrain the lead operator's unregulated fares. In the London to Cambridge and Peterborough examples, commuters benefit from cheaper season ticket options.  
 
In a number of cases, franchised TOCs competing with the lead operators operate a slower service than the lead operator (with the lead operator sometimes running an intercity service and the competitor a metro or regional service). In some of these examples, the franchised TOC with the slower service appears to offer deep discounts, particularly on advance tickets. Where there is competition on parallel franchises, for some passengers, the franchised TOC with the longer journey time may still offer a shorter overall journey time given the location of the stations relative to the passenger's ultimate origin and destination. 
 
Long-distance intercity franchised TOCs competing on overlapping flows appear to primarily compete on the price of their dedicated advance tickets, particularly where journey times are similar on both operators. This appears to generate passenger benefits by way of lower fares.   
 
Competition between franchised TOCs on overlapping and parallel franchises appears to be most intense where the franchises are loosely specified or where significant changes in franchises and/or access rights were permitted. For example:  
(a) Chiltern Railways has a relatively loose franchise specification 
compared with other franchises and was incentivised to invest in new 
rolling stock, launch free wi-fi, introduce new timetables and improve line speeds in order to compete with Virgin Trains on the London– Birmingham route in response to the introduction of Virgin's new 'very high frequency' high-speed timetable following the West Coast main line upgrade.156 Chiltern Railways' customers benefited from lower fares, refurbished rolling stock, improved services (branded as 'Mainline') and faster journey times (cut by 20%). The total market for rail traffic between London and Birmingham grew, as did the premium paid to government.  

(b) London Midland increased its service frequency on services from 
London to Birmingham and North West England through changes to its access rights and enhancements to its rolling stock to allow 110mph running. The new rolling stock also offered tables and power sockets throughout. Competition from Virgin Trains and Chiltern 
Railways was one driver for the enhancements.157 
 
The frequency of overlapping services is likely to have an impact on the intensity of price competition. Competition between franchised TOCs appears to be less intense where one of them runs only an infrequent service. 

## Changes To The Level Of Franchise Overlap

3.48 There have been a number of changes to the degree of on-rail competition in 
recent years as the geographic reach of franchises has changed and as OAOs have introduced new services. Although the previous section highlights that there remain a number of franchise overlaps on which operators compete, the number is less than in previous years following a policy introduced by the SRA to simplify the franchise map and to seek to have a single franchise operator at each London terminus station (see paragraph 2.101). This allows us to examine the impact of removing on-rail competition.  

## Arup 2009 Analysis Of Changes To Franchise Overlaps

3.49 The effect of some of these changes in overlap is considered by Arup (2009) 
in the study referred to above. The three case studies are considered below. 

## Ipswich To London: Anglia Railways And National Express East Anglia

3.50 Prior to the formation of the London and Eastern Railways ('One') franchise, 
Anglia Railways and First Great Eastern competed on flows between London, Colchester and Ipswich. Evidence from Arup's analysis found that the timetable changes resulting from the introduction of a single operator meant that service characteristics deteriorated for passengers. In particular, service frequencies reduced and journey times were extended and the number of seats per hour reduced. Passenger growth at Ipswich and Colchester was lower compared with control flows and revenue yields (ie average fare per passenger) increased at a faster rate compared with Norwich and 
Stowmarket. Passenger satisfaction scores158 slightly deteriorated and some 
softer measures delivered by one operator before competition was removed 
were affected. However, service performance levels159 improved, which - as 
set out in paragraph 2.101 - was the rationale for the reducing the number of 
operators. 
Reading to London: First Great Western and South West Trains 

3.51 The extent of on-rail competition on this flow was reduced following the 
merger of Thames Trains into the Great Western franchise in 2004, first as First Great Western Link and then as part of the enlarged Greater Western franchise. Prior to the changes, First Great Western was the dominant operator, with Thames Trains attracting about a third of the total revenue on the flow. The revenue allocated to South West Trains, which ran a much slower service, was negligible. Arup's analysis is inconclusive as to the impact of the changes following the removal of competition. Service frequencies did not change and the overall change in revenue yield affecting Reading was similar to that at Maidenhead (a control flow). There was an improvement in service performance levels, although there was a deterioration in passenger satisfaction.  
Gatwick Airport to London: Thameslink and Southern 

3.52 Arup (2009) examined the lessening of on-rail competition brought about by 
the amalgamation of Gatwick Express services within the Southern Railway franchise in June 2008. While there were no significant changes to the timetable or passenger growth trends, subsuming Gatwick Express into 
Southern led to a large increase in yield (ie average passenger fares) between 2008 and 2009 affecting Gatwick Airport, significantly larger than on the control flows. Service performance increased although passenger satisfaction reduced.  

## Summary

3.53 Arup (2009) examined only three of the many changes in franchise overlaps 
that resulted from the SRA's policy decision to reduce the number of franchises. Two case studies suggested that average fares (measured as overall revenue yield) increased after the franchise overlaps were removed, while the other did not find an overall change compared with the control flow. 
Service performance increased in the three examples, although passenger satisfaction decreased.  

## Recent Changes To Overlapping Franchises

3.54 There have been a number of further changes to the degree of on-rail competition in recent years. One example is the award of the new Thameslink, Southern & Great Northern franchise to Govia in September 2014. 
3.55 The new franchise removed on-rail competition between First Capital Connect 
and Southern including between London and Gatwick Airport, Three Bridges, Haywards Heath and Brighton. However, we were told by the DfT that a deliberate decision was taken to have only one operator running through the Thameslink cross-London section during the Thameslink upgrade programme in order to reduce the risk to the delivery of the project. We were also told that the new franchise is designed in such a way that it could be split again in the future following the completion of the upgrade work.  
3.56 In terms of the impact on fares, we note that, following the award of the new 
combined franchise, cheaper fares offered by Thameslink (the operator replacing First Capital Connect) will rise over time to harmonise with Southern's fares.  
3.57 Which? noted that Thameslink offered a London–Brighton off-peak ticket at 
£17.10 against £26.70 on Southern and that the cheaper fare may be lost 
after harmonisation.160 An annual season ticket between Brighton and London 
cost £4,304 after the cheaper dedicated £3,640 season ticket was withdrawn, 
while from Three Bridges to London, the cheapest season ticket was £3,392 per year, an increase of £436 on the dedicated fare.   
3.58 The DfT told us that, notwithstanding the impact on fares, the legacy of 
multiple competing operators on the Brighton main line resulted in an inefficient timetable and poor performance. However, ORR told us that performance had declined since the franchises were combined - although it is not clear the extent to which this is due to the upgrade works at London 
Bridge station.161 The DfT also suggested that the historical fare structure was 
complex and, in some respects, confusing. We consider the relationship between on-rail competition and operational performance and ticketing complexity in detail in Chapter 5.   

## On-Rail Competition In Other European Countries Introduction

3.59 On-rail competition has developed in a number of other European countries, 
in particular in Austria, the Czech Republic, Germany, Italy and Sweden. This trend is continuing in a number of other European countries, with proposals for greater competition being developed in countries including Finland, France and Spain.   
3.60 The EU is also focusing on developing a strong and competitive rail transport 
industry through a number of packages aimed at restructuring the European rail transport market. The 'market pillar' of the Fourth Railway package, which focuses on liberalising domestic passenger railway services, is currently being enacted. An overview of the EU railway packages is set out in the Appendix.   
3.61 While we note a number of differences between on-rail competition in Great 
Britain and other European countries, examining the European experience offers valuable insights as to the benefits and costs of on-rail competition on a greater scale than currently exists in Great Britain.  
3.62 The intensity of on-rail competition is different in each country and depends on 
a number of variables defined by policymakers, such as the degree of 
liberalisation, the scope of public service contracts (PSCs) and PSOs,162 the 
manner in which PSCs are awarded (ie competitive tendering versus direct 
operator, if it were considering its own commercial interests would not assume or would not assume to the same extent or under the same conditions without reward'. A PSC is defined as 'one or more legally binding acts confirming the agreement between a competent authority and a public service operator to entrust to that public service operator the management and operation of public passenger transport services subject to public service obligations'. 

awards), the structure of the market (ie vertical integration or separation) and the presence of an independent economic regulator.  

3.63 In summary, as set out in Table 4 below and described in further detail in the 
Appendix, the level of open access on-rail competition is relatively low in 
Germany, but is higher in Austria, the Czech Republic, Italy and Sweden (although subject to different legal and market constraints). 
3.64 As discussed further below, efficient open access entry, signalled by the 
sustainability of the OAO's business and its share of the relevant market segment, has had a positive impact on those markets in terms of price, quality of service, demand growth and, sometimes, efficiency. There have also been some pitfalls (described further in Chapter 5), including uncertainty regarding financial stability and impact on public funds.  
3.65 Table 4 and Figure 3 show the OAOs active in the EU in 2015 and provide a 
direct comparison of the main policy factors affecting the rail market design in European countries with on-rail competition. 

Market share (%) 
OAO in relevant 
Incumbent 
Country 
Main OAOs 
Service 
Entry date 
segments/routes 
country overall 
Austria 
Westbahn 
LD 
2011 
[20–25]* 
88 


Czech Republic 
RegioJet 
LD 
2011 
[35–40]† 
95 
Leo Express 
LD 
2012 
[25–30]† 


Germany 
HKX 
LD 
2012 
[5–10]‡ 
88 


Great Britain 
Grand Central 
LD 
2007 
[0–5]§ 
- 
First Hull Trains 
LD 
2002 
[0–5]§ 


Italy 
NTV 
HS 
2012 
[20–25]# 
83 


Sweden 
Veolia/SkandJern/TAG 
LD 
2011 
N/A 
68 
MTR 
LD 
2015 
[25-30]~ 

Source: Based on 2013 data (passenger miles) available in the Staff Working Document accompanying the European Commission's Fourth report on monitoring development of the rail market (SWD (2014) 186 final) and from interviews conducted with national authorities and OAOs in Austria, the Czech Republic, Germany, Italy and Sweden. * Market share estimate relating to the Vienna–Salzburg route. † Market share estimate relating to the Prague–Ostrava route. ‡ Market share estimate relating to the Hamburg–Cologne route. § Market share estimate relating to long-distance services on the East Coast main line. # Market share estimate on the overall national high-speed services market. ~ Market share estimate relating to the Stockholm-Gothenburg route.  
 
 
Source: Elaboration on data from EU Commission RMMS questionnaires - Annex 15 of SWD (2014) 186. * In Great Britain, franchise contracts include bundles of both profitable and unprofitable services. 

3.66 It is also relevant to note that there is considerable variation in the track 
access charges paid by train operators across Europe. Figure 4 presents the track access charges for intercity/long-distance services. 
 

3.67 A more detailed description of the evolution of on-rail competition in Austria, 
the Czech Republic, Germany, Italy and Sweden is set out in the Appendix.   

## Benefits Of On-Rail Competition In Europe

3.68 This section considers the benefits that on-rail competition has generated in 
continental Europe, including in relation to fares, service quality and 
innovation, passenger usage and efficiencies.   

## Fares

3.69 The European case studies offer evidence of how open access competition 
has affected fares.  
3.70 In Austria, the OAO's entry generated intense price competition with the 
incumbent163 and in the Czech Republic the three operators have engaged in intense price competition.164  
3.71 In Italy, the incumbent reacted to competition from the OAO, NTV, by offering 
frequent discounts, exerting downward pressure on fares for high-speed services. As a result, the fares for high-speed services are now similar to the fares for those non-high-speed long-distance services that are operated on a 
commercial basis but which are not subject to competitive pressure.165  
3.72 In Sweden, the early new entrants (eg Veolia) often focused on the low price 
segment of the market and did not therefore compete strongly with the incumbent. However, the entry of a new OAO, MTR, which competes head-tohead with the incumbent has generated an extensive discounted tickets 
campaign from the incumbent on the Stockholm–Gothenburg route.166 
3.73 In Germany, the OAO, HKX, focused on offering low fares with the aim of 
attracting custom from lower income groups, including students and the 
retired. In contrast to its routes with no competition, Deutsche Bahn (DB) 
decreased by 50%. 

165 The data compares price/km on the incumbent Trenitalia high-speed services ('Frecciarossa'), eg the Florence to Rome route with that on the incumbent non-high-speed long-distance services ('Frecciabianca'), eg on the Adriatic route from Pescara to Bologna. 

166 The incumbent reduced its fares by 10 to 15% following MTR's entry. Currently, according to MTR, its cheapest fares are 10-15% lower than the incumbent. 

responded by freezing its fares on the Hamburg–Cologne route and by introducing refurbished rolling stock. 

3.74 Figure 5 presents the estimated average return fares (in terms of €/km) on the 
main long-distance European commercial routes. Fares on routes with on-rail competition (eg Prague–Ostrava) are some of the lowest in Europe, and often lower than other routes in the same country.  
 

## Service Quality And Innovation

3.75 In Austria, the OAO introduced free wi-fi and the incumbent followed this 
innovative offer. Moreover, the Austrian OAO introduced ticketing innovations 
such as online retailing, on-board ticketing services offered by stewards167 
and the sale of discounted tickets at tobacco kiosks. The OAO's five-stop service also achieves the same journey time as the incumbent three-stop service due to its more technologically advanced rolling stock. The Austrian OAO has reported very high overall customer satisfaction and punctuality 
rates,168 which are higher than those of the incumbent. The OAO told us that 
the incumbent has now responded to this competitive pressure by enhancing the quality of its service, leading to higher customer satisfaction.  

3.76 In the Czech Republic, service quality improvements have also been generated. For example, the OAOs introduced higher quality standards in their services than that of the incumbent (such as wi-fi and lower-floor trains to facilitate access) and also offered complimentary parking and taxi services upon departure and arrival. 
3.77 In Italy, the OAO explicitly started competing with the incumbent on service 
quality and innovation, including by introducing new rolling stock which offers more comfortable seating, a greater range of dining options and a cinema car. The incumbent reacted with a service differentiation strategy and increased frequency (especially in the off-peak hours) and also by investing in new highspeed rolling stock, which will enter service in 2017.  
3.78 In Sweden, one OAO introduced sophisticated restaurant services and the 
new OAO, MTR, has started competing with the incumbent on the Stockholm– Gothenburg route in terms of price and quality of service in order to win passengers from rail, car and air. MTR has introduced new trains, complying with more advanced environmental requirements (which are perceived to be a relevant component of service quality in Sweden) and high-quality service onboard. MTR has scored very highly in customer satisfaction surveys.  
3.79 In summary, these case studies indicate that, in addition to generating lower 
fares, on-rail competition in Europe has resulted in improvements in service quality, innovation and service frequency, leading to higher customer satisfaction.  

## Passenger Usage

3.80 In the Czech Republic, we were told that the customers of the new entrants 
(which currently have a combined market share of 55 to 60%) were largely new to the rail market and, therefore, demand was not significantly abstracted from the incumbent. The new entrants told us that overall demand for rail travel on the Prague–Ostrava increased by 40% since on-rail competition was introduced. In Italy, when the OAO commenced its high-speed operations, rail demand grew by 10 to 15% and the overall frequency of services was increased, mainly due to the transfer of passengers from air transport services 
on the Milan–Rome route.169 In Austria, overall demand for rail travel on the 
Vienna–Salzburg route has been growing by 10% per year since on-rail competition started, with passengers attracted from road transport. As a result, the initial reduction in the incumbent's share of the passenger rail market was only about 1.5%, despite the growth of the OAO.170 In Sweden, the explicit aim of the new OAO, MTR, is to target competing modes of transport rather than the incumbent rail operator.171 Overall demand for passenger rail services has grown since MTR entered the sector and MTR estimates that about 20% of this demand has been abstracted from air transport services. 

3.81 In summary, on-rail competition generated market growth on almost all the 
routes involved. The new services often served previously unmet demand and also resulted in the transfer of passengers from other modes of transport, particularly from road and, in some cases, from air.  

## Efficiencies

3.82 There is limited information available on the costs of OAOs in other European 
countries and it is therefore difficult to assess the extent to which OAOs are 
able to achieve lower costs than incumbents.172  
3.83 We were told by the Austrian regulator that the OAO in Austria is understood 
to have lower overheads and lower staff costs than the incumbent, which allows it to compete effectively despite it having lower economies of scale and density. Moreover, the new Swedish OAO, MTR, told us that it is able to keep costs down by exploiting synergies with MTR Stockholm (the Stockholm metro network operations, which MTR took over in 2009). We were also told that a 
number of the OAO entrants in other European countries173 have sophisticated yield management systems which allow them to generate additional 
revenue.174  

## Conclusion On The Benefits Of On-Rail Competition Across Europe

3.84 The evidence indicates that, in these examples, on-rail competition across 
Europe has delivered significant benefits to passengers in terms of exerting a downward pressure on fares, improving service quality and encouraging innovation, while also generating new rail demand and market growth.  
3.85 However, there have also been some pitfalls, including concerns regarding 
financial sustainability and the impact of competition on public funds, which we consider and address in Chapter 5.   

## Differences Between Open Access Competition In Great Britain And Other European Countries

3.86 There are a number of differences between open access competition in Great 
Britain and other European countries including vertical integration, capacity constraints and PSOs (see the Appendix for an overview of the market structure in each country). These differences are considered below in order to put both the benefits and costs of greater on-rail competition in other European countries in context when considering the potential benefits that greater on-rail competition would be likely to deliver in Great Britain.  

## Vertical Integration

3.87 As described in the Appendix, a major difference between most European 
systems and Great Britain is the level of integration in the market, both at the vertical and horizontal level. Continental European incumbents are typically 
vertically integrated companies175 yet subject to obligations of functional and 
accounting separation imposed by the EU legislation (which does not impose 
a full vertical separation as there is in Great Britain).176  
3.88 Therefore in Austria, the Czech Republic, Germany and Italy, the OAOs 
compete against a vertically integrated incumbent operator, which can act as an entry barrier. In particular, there have been concerns that OAOs may not be able to compete on a level playing field, and that incumbents may raise competitors' operating costs, through price and non-price discrimination or by engaging in other exclusionary practices, such as predatory pricing.  
3.89 The problems arising from vertical integration and the lack of a level playing 
field arose in Italy prior to the establishment of the independent regulator in 
government; Czech Republic (in 2009) for insufficient separation between the infrastructure manager and the incumbent train operator company.   
2013. Issues arising included margin squeeze177 and non-price discrimination.178 In Germany, there have been problems in terms of access to ticket distribution, stations and the DB Energie electricity network. Action was taken by the sector regulator.179 Complaints by the OAO in Austria have concerned both discriminatory path allocations and the exclusion of the OAOs' 
train services from the timetable published by the incumbent.180 However, the OAO in Austria told us that OAOs are now able to compete on a more level playing field. The Czech OAOs filed complaints before the national and EU competition authorities about exclusionary practices (namely predatory pricing sustained by cross-subsidisation), undertaken by the Czech incumbent.181 

3.90 In contrast, in Sweden, long-term vertical separation has allowed a more level 
playing field.  

## Capacity Constraints

3.91 Capacity constraints in other European countries are often less severe than in 
Great Britain. Figure 6 illustrates the intensity of the use of network in various European countries. 
required that DB Energie reduce the fee by 23% compared with its proposed amount. Complaints regarding ticket selling were made to the Swedish competition authority signalling that the main selling platform is the incumbent's website which sets price and access conditions. However, the Swedish competition authority stated that the ticket platform was not an essential facility and thus refusal to supply access did not represent abusive conduct. 

180 Complaints from the OAO about discriminatory treatment by the incumbent were addressed by the sector regulator, Schienen-control, either by facilitating a negotiated agreement between the parties or via a formal decision. Some complaints were also brought before the Austrian Competition Court. 

 

Source: Elaboration on data from IRG-Rail Annual Market Monitoring Report 2015 and Eurostat 2014. * This intensity measure is calculated by dividing the total train kilometres by the route length and number of days to give the average number of trains per route kilometre per day. 
 
3.92 We also note that in a number of the case studies considered, competition 
takes place on dedicated high-speed networks with spare capacity. In contrast, open access competition in Great Britain is on conventional (albeit intercity) lines with limited capacity available to new entrants, which limits the 
scale of on-rail competition.182  

## Passenger Service Contract Scope, Award And Pso Definition

3.93 Another relevant difference between Great Britain and the other European 
countries examined is the ratio between services included in PSCs and services not included in PSCs. This is particularly true for high-speed and long-distance services, while for the regional/suburban services it is more similar (see Figures 7 and 8 below). Moreover, in most of the European countries where open access competition has developed, there is a clear definition of PSO services and a clear separation between PSO and 
commercial services,183 while franchise contracts in Great Britain generally 
include bundles of profitable and unprofitable services.184 
 
Source: EU Commission RMMS questionnaires - Annex 15 of SWD (2014) 186. 


Source: Elaboration on data from EU Commission RMMS questionnaires - Annex 15 of SWD (2014) 186. 3.94 Furthermore, the system in Great Britain differs from many other European 
countries (with the exception of Sweden) in terms of the scope of the competition for the market. In Britain, PSO services are generally awarded by way of a competitive bidding process rather than direct awards, while the percentage of tendered PSOs is very low in Austria and the Czech 
Republic,185 low and slowly increasing in Italy186 and increasing to a greater degree during last few years in Germany (currently at about 60%).187  

## Network Investments And Unprofitable Service Funding

3.95 There are also different approaches to financing the network in Great Britain 
than in other European countries. As noted above, in Great Britain, PSOs and commercial services are bundled together in franchises, with profitable services, in effect, cross-subsidising unprofitable services. In other European countries, the non-PSO routes are often separately defined. In addition, as set out in Chapter 2, in Great Britain, a greater proportion of revenue is derived from passengers than from general taxation. This is reflected in higher average passenger fares (Figure 9) and lower average public subsidies (Figure 10) in the UK relative to many other European countries. 
 
Source: IRG-Rail Annual Market Monitoring Report 2015. 

 
 
Source: EU Commission RMMS questionnaires - Annex 15 of SWD (2014) 186. The incremental benefits of on-rail competition 

3.96 The DfT noted in its consultation response that where competition in the 
market has been introduced in other EU countries, this has tended to be the first introduction of any form of competition to the relevant network (or part thereof), whereas in Great Britain, there is already strong competition 'for' the market.   
3.97 In this regard, we note that in Sweden, which was the first country in Europe 
to introduce vertical separation, most services included in PSCs are awarded 
through a competitive tender, as in Great Britain.188 We also note that in a 
number of European countries in which on-rail competition has taken place for some years, the entry of additional operators (such as in Sweden and the Czech Republic) has still led to incremental benefits for passengers. 
3.98 It is also relevant to note that in countries in which on-rail competition represented the first significant intra-mode competition faced by train operators, the resulting passenger benefits were often achieved in the absence of a level playing field given the presence of vertically integrated incumbents. In contrast, Great Britain's vertically separated rail sector offers a level playing field for in-market competition between train operators. Therefore, although the introduction of competition to the rail sector for the first time in countries such as Austria and Italy might have delivered greater incremental benefits 
than the expansion of on-rail competition in an environment of strong competition 'for' the market, the benefits achieved in these countries to date may be lower than the benefits that could be achievable through greater onrail competition in Great Britain.   

## A Trend Towards Greater Rail Competition In European Countries

3.99 The trend towards greater competition in the rail sector is continuing, with a 
number of other European countries planning to open their services to competition. This trend is expected to continue as the market pillar of the EU's Fourth Railway Package is enacted. 

## France And Belgium

3.100 In France, Thello (a joint venture of Veolia Transdev and Trenitalia) began 
operating overnight services between Paris and Venice in 2011. The service was the first open access operation in France. In December 2014, Thello launched open access services between Marseille and Milan, following approval by the French rail regulator, competing with SNCF on certain flows.   
3.101 In October 2015, Trenitalia announced that it was holding preliminary discussions with its suppliers and relevant regulatory bodies regarding the possible launch of an open access high-speed service between Paris and Brussels in 
direct competition with the Thalys service.189 If taken forward, this would result 
in significant head-to-head competition on one of Europe's most important routes.  

## Finland

3.102 In Finland, the Transport Minister announced in October 2015 that work to 
open up the rail sector to competition would commence, with a report aiming to identify the possible options for competition planned for publication in spring 2016. The incumbent state operator, VR, currently has an exclusive agreement which runs until 2024. However, the Transport Ministry has raised concerns about the cost-effectiveness and quality of this arrangement, which it is now considering terminating early. The Finnish domestic rail freight market was opened to competition in 2007.  

## Germany

3.103 In Germany, a new OAO, Locomore, is planning to operate open access 
services between Stuttgart and Berlin from September 2016.190 The current 
OAO, HKX, expanded its network in December 2015, when it extended its Hamburg to Cologne services to Bonn, Frankfurt and Koblenz. In July 2015, the German Monopolies Commission published a special report on 
competition in the rail sector191 concluding that the majority of travellers would 
benefit from functioning competition and urged policymakers to be more active in advancing competition in the sector.  

## Spain

3.104 In Spain, on-rail competition is being introduced on long-distance high-speed 
services. Legislation has now been passed that will lead to the gradual introduction of duopolies on high-speed routes, on which the incumbent RENFE is currently the only operator. The first route to be opened to competition will be that from Madrid to Valencia and Alicante. A tender process has been designed to select an operator to compete with RENFE for a seven-year period, after which full on-rail competition may be introduced. The tender is expected to take place in 2016. 
3.105 We were told that the rationale for introducing duopoly competition is to 
increase efficiency, to facilitate a more dynamic industry and to increase the volume of passengers on the new high-speed network on which there is 
currently spare capacity.192 Duopoly competition was chosen as the mechanism by which to introduce competition in order to offer some protection to the incumbent for a transitory period while it adapts to competition. The asymmetry between the positions of the incumbent and new entrant is considered sufficient to reduce the risk of collusion.   
3.106 We note that this has some analogies with our proposed 'Option 2' for 
introducing greater on-rail competition, which is discussed in Chapter 6.   

## International

3.107 Eurostar services are expected to face competition from Deutsche Bahn from 
2017.193  

## Competition In Other Transport Markets The Great Britain Rail Freight Sector

3.108 As set out in Chapter 2, freight train services in Great Britain operate on an 
entirely open access basis, ie there is full competition 'in' the market, rather than 'for' the market. There are currently seven separate rail freight operators in Great Britain. Services are not specified by government and freight operators are not subsidised, other than indirectly through lower track access 
charges and taxpayer funded enhancements.194 
3.109 In common with OAOs, freight operators pay variable charges, but not FTAC. 
The McNulty Report observed that 'by paying its wear and tear costs, rail freight ensures that the network provider is no worse off from the existence of 
freight than from its absence'.195 However, the fixed costs of the network are 
still essentially paid for by taxpayers (through the network grant) and passengers (through franchised TOCs' FTAC payments) rather than by freight 
operators.196 In addition, for the purpose of recovering freight avoidable 
costs197 (not recovered by other charges) and fixed costs of freight-only lines, 
certain segments of the rail freight industry pay the freight-specific charge 
(FSC) and freight-only line (FOL) charge.198   

## Competition Between Freight Operators

3.110 The rail freight sector is characterised by high levels of competition between 
freight operating companies (but also between rail freight and road haulage). 
Since on-rail competition was introduced at privatisation, the industry has achieved growth of over 70% with the revenue of rail freight operators 
increasing by 44%.199   
3.111 The increase in rail's share of land freight, from about 8% in 1995 to 11% in 
2013 was achieved against the backdrop of decline in heavy industry200 and 
ongoing competition from road freight. In contrast, the nationalised French 
and Spanish rail freight sectors have seen relative modal share decline since the late 1990s.201 

3.112 Forecasts indicate that rail freight is expected to grow by a further 30% in the 
five years from 2014.202 In the longer term, Network Rail forecasts that rail 
freight volumes could more than double over the next 30 years.203  
3.113 The market shares of rail freight operators have changed significantly as a 
result of competition and new entry since privatisation. New entrants, such as GB Railfreight, have won market share from DB Schenker (formerly known as EWS), which has been active in Great Britain since privatisation. For example, in 2005–2006, DB Schenker had a market share of 67.8%, which fell to 46.7% by 2014–2015 primarily as a result of competition from other freight 
operators.204  
3.114 The success of new entrants is often attributed to their focus on providing 
customer care at competitive prices. It was suggested to us that flexible working practices among drivers, including flexibility in rostering and drivers taking on additional duties (including dealing with customers), was a key part of the strategy to deliver an efficient service that is competitive on price.   

## The Efficiency Of The Rail Freight Sector

3.115 The competitive environment has forced rail freight to find significant efficiencies over recent years and it has encouraged Network Rail to do the same. The DfT's 2012 report entitled Reforming our Railways: Putting the Customer First highlights the fact that, unlike franchised TOCs, freight operators are subject to access charge variations at regulatory reviews. As a result, freight operators engaged considerably with ORR and Network Rail during periodic 
reviews in 2003 and 2008, pushing hard to challenge Network Rail's costs.205 
The DfT's report goes on to state that, in an industry that has had difficulty in reducing costs, freight has made good progress and that the government seeks to repeat this approach with similar success for passenger services.  
3.116 The McNulty Report also considered the efficiency of the rail freight sector 
and highlighted the fact that, since 1997, rail freight traffic increased and unit costs fell as freight operating companies invested in new rolling stock and 
entered different market segments.206 Freight operators increased their load usage. For example, GB Railfreight increased its load usage from 667 million gross tonne miles during 2005–2006 to 3,142 million gross tonne miles by 
2013–2014.207 

3.117 According to the McNulty Report, staff productivity increased in rail freight 
while, as illustrated in Figure 11 below, in the rail passenger sector staff 
productivity has slightly decreased.208 The McNulty Report notes that this may 
be due to the greater effect of competition on freight operating companies.   
3.118 Lodge (2013) also highlights the efficiencies achieved by the rail freight 
sector, pointing to data indicating that freight operating companies reduced their unit costs by 35% between 1998–1999 and 2008–2009 as a result of competition, whereas in the rail passenger sector costs increased by 10% 
over the same period.209 Rail freight traffic increased by 50% since 
privatisation with half the number of locomotives and two-thirds of the wagons 
used at the time moving a greater volume of goods.210  
3.119 Freight operators have striven to minimise costs in order to ensure the 
competitive pricing of rail freight distribution compared with road, given that rail freight customers are price-sensitive and there are low switching costs 
between certain modes.211 
3.120 Competition also appears to have spurred investment. Rail freight operators 
have continued to invest in the sector, investing £2 billion in new locomotives, 
wagons and other capital equipment since privatisation.212 During CP4 (2009–
2014), Network Rail and government made investments of over £500 million to improve freight capacity and performance.   

## Conclusion

3.121 The rail freight sector is an example of a fully open access rail environment. 
Competition 'in' the market developed strongly after privatisation, with new entrants successfully winning market share from incumbents. This competition appears to have generated benefits over and above those resulting from intense intermodal competition, including improved staff productivity and investment which enables prices to be kept down and service standards to 
improve.213 In common with OAOs, freight operators determine their timetables, subject to securing access to the network, and are free from franchise specification.  
3.122 Although we were told that freight is less subject to the constraints of 
timetabling than passenger services, it was also put to us that rail freight is subject to strict commercial and contractual requirements requiring the goods be delivered 'just in time'. For example, supermarkets transport fresh and frozen goods by rail and, in the intermodal market segment (eg shipping containers), services run to a regular timetable.  
3.123 While there are clearly differences between the structure of the freight and 
passenger rail sectors, the case study of the rail freight sector provides a valuable illustration of how competition 'in' the market can realise benefits in the rail sector.   
Rail Performance: Quality and Methodology Report. 

## The Experience Of Eu Airline Deregulation

3.124 The airline industry in Europe was deregulated in the 1990s. Before deregulation, airline competition in the EU primarily took place between legacy national carriers, such as British Airways, British Midland, Air France, Lufthansa and KLM. Coles (2004) found that deregulation led to a major reduction in fares as well as an increase in the number of routes and choice of 
carrier.214 Low-cost airlines emerged and, by 2003, they accounted for 24% of 
the UK international market and 32% of the domestic market, leading to an average reduction in fares of 75% and contributing to an increase of 78% in 
the number of flights.215 The emergence of low-cost airlines has led to many 
passengers travelling from their local airports, increasing the range of flights 
available from regional airports.216,217 
3.125 Low-cost airlines can sustain cheaper fares as their costs are lower than 
those of traditional airlines.218 Costs are minimised by paying staff lower 
wages, performing ticket sales and issuing boarding passes online, requiring passengers to pay separately for food and beverages and using secondary airports. In order to compete with low-cost airlines, traditional airlines have also cut costs by adopting some of these practices and this has led to a fall in average one-way fares paid by UK-based passengers for both business and 
leisure travel, as shown in Figure 12 below.219  
 
Source: International Passenger Survey, ONS. 

## Conclusion

3.126 The experience of the airline industry in Europe illustrates that a greater 
degree of competition 'in' the market can lead to a reduction in costs and lower fares, while also leading to improved services, the development of 
innovative business models and growth in the market overall.220,221 

## Dynamic Competition: The Gatwick Airport Example

3.127 Across numerous industries exposed to a significant increase in competitive 
pressures, the benefits of competition in terms of innovation, service quality improvements and lower prices have materialised over a number of years as 
incumbents and new entrants compete to win customers.222 The benefits of 
this dynamic competition are difficult to forecast in advance of market opening and are generated by firms adopting new strategies in order to win market share, with competitors responding by improving their offering.  

3.128 A further example of dynamic competition being introduced in a transport 
market is the introduction of competition between London's Gatwick and 
Heathrow airports following the break-up of BAA.223 The key developments 
are summarised below.  
3.129 Gatwick Airport was owned by BAA until its divestiture was ordered by the 
Competition Commission in March 2009 following a market investigation into 
the supply of airport services by BAA in the UK.224 At the time, BAA also 
owned Heathrow, Stansted and some other UK airports. Gatwick Airport was acquired in 2009 by Global Infrastructure Partners. The sale of Gatwick Airport was part of a package of remedies devised to address the adverse effects on competition found by the Competition Commission to arise from BAA's common ownership of airports in the South East of England and lowland Scotland. The CMA is currently evaluating the impact of the Competition Commission's remedies arising from the 2009 BAA airports market investigation and the evidence presented here was gathered prior to 
the evaluation.225   
3.130 Following its sale to Global Infrastructure Partners, Gatwick Airport developed 
its offering226 and there is also evidence that Heathrow Airport was 
incentivised to improve its own offering:  
 
New routes and customers - in targeting Heathrow Airport's full-service 
long-haul airlines, Global Infrastructure Partners focused on developing its performance, capacity utilisation and facilities to accommodate new aircraft types such as the A380. Gatwick Airport developed new international 
routes and attracted new carriers.  
 
New transfer service - in order to assist airlines to establish new longhaul services from Gatwick Airport, a new commercial strategy was devised which included developing a transfer service called 'Gatwick 
Connect' in order to allow passengers to transfer between flights more easily.  

 
Improved resilience - Global Infrastructure Partners also invested in facilities to minimise closure time following natural events.  
 
Improved services and new innovations - other benefits to service 
quality deriving from greater competition include Gatwick Airport's introduction of new services for passengers with reduced mobility, improved security and search procedures, a premium area security lane, an airport welcome service and a new commercial retail strategy to attract high-value customers from Heathrow Airport. 
 
New infrastructure - Gatwick Airport invested in infrastructure including the station, new terminal floors and toilets.  
3.131 Heathrow's service offering also developed following the break-up of BAA. 
Heathrow Airport invested a total of £5.9 billion to improve quality of passenger services, enhance resilience and provide additional capacity and improve overall airport efficiency.  
3.132 Heathrow Airport's passenger satisfaction continued to increase following the 
new investment (having started to rise following the opening of Terminal 5). 
3.133 In addition to making new investments, Heathrow Airport adopted a new 
commercial strategy, which included improvements to:  
 
the cleanliness and security of the airport's terminals; 
 
the departure lounge at Terminal 3 and improvements to the security screening process; and 
 
departure punctuality and baggage handling, in coordination with the airlines (see annex for chart of rates). 
3.134 Finally, a new Terminal 2 opened at Heathrow Airport in 2014, replacing the 
old terminal. In addition to improving the quality of service, the new terminal enhanced connectivity by co-locating Star Alliance members that fly from Heathrow Airport. Although the new terminal was in the pipeline prior to the break-up of BAA, we note that competitive pressure may have enhanced its final product and service offering.  

## Conclusion

3.135 The example of competition between London's Gatwick and Heathrow airports 
demonstrates that innovation, service quality improvements and lower prices may materialise over a number of years when dynamic competition is significantly increased and incumbents and new entrants compete to win customers.   

## Deregulation Of Local Bus Services In Great Britain

3.136 In the 1980s, long-distance coach services in Great Britain and local bus 
services outside London were deregulated and offered largely on a commercial basis.227 As a result, there was a degree of competition 'in' the market 
where local bus services overlapped. Passengers benefited from improved services and lower fares on main routes but, in some cases, reduced frequencies, higher fares and a loss of services on the lower density routes. In London, bus services were also privatised through introducing competition 'for' the market with all routes being contracted out by means of competitive tendering.  
3.137 In 2009, the OFT examined the local bus sector (excluding Northern Ireland 
and London) - ie the deregulated sector where there is competition 'in' the market. The study found some evidence that market liberalisation and competition led to lower average fares in the sector. However, the OFT identified a number of competition concerns and made a market investigation 
reference to the Competition Commission in January 2010.  
3.138 The Competition Commission found that head-to-head competition in the 
supply of local bus services was uncommon and most local markets were 
highly concentrated.228 It found that sustained head-to-head competition 
where it exists could deliver significant benefits to customers, as a result of bus operators competing on the basis of service frequencies, in addition to 
fares and service quality.229  
reliability of bus services has improved, investment has continued, fares offer good value for money and customer satisfaction is high. The response also suggested that customers pay more for franchised services in London compared with non-franchised systems in the rest of England and that customers in London are less satisfied with services.  

3.139 However, it also found that the process of competition could result in periods 
of intense short-lived rivalry, leading to the exit of one operator. The anticipation of costly rivalry was found to create a barrier to entry and expansion.230 
Along with other barriers to entry and expansion, this was found to reduce the competitive constraint from potential competition and new entry. 
3.140 We also note that, in recent years, concerns have been identified regarding 
strategic behaviour by incumbent operators, including aggressive scheduling 
in response to new entry.231  
3.141 However, ORR has previously observed that competition concerns identified 
in the local bus sector have limited application to the case of passenger rail where similar concerns relating to the impact of head-to-head competition on 
service frequency are unlikely to arise.232 Track paths are allocated in 
advance and frequencies cannot be quickly adjusted. Moreover, service timings cannot be altered easily, making it difficult to run trains just ahead of 
competitors in order to win customers.233 'Hit and run' entry (ie where an 
undertaking enters a market temporarily and then exits when extra profits are exhausted) is also not possible in the rail sector given that the barriers to entry and exit are higher than those in the bus sector. 

## Conclusion

3.142 The local bus sector provides an example of the adoption of models of both 
competition 'for' and 'in' the market. The evidence regarding passenger benefits and efficiencies resulting from the two modes of competition is mixed. While in-market competition has led to some concerns regarding the behaviour of incumbent operators in certain areas of Great Britain, we do not consider that the issues that have arisen in the local bus sector are directly 
relevant to the long-distance intercity rail sector.234 
in advance, with operators often differentiating their services on price and quality. Moreover, neither OAOs nor franchised TOCs raised this as a concern. We also note that timetabling must be agreed through Part D of the Network Code, reducing the likelihood of suboptimal timetabling.  

## Conclusion On The Evidence Of Potential Passenger Benefits

3.143 This chapter demonstrates the benefits that greater on-rail competition can 
bring through on-rail competition examples as well as in other transport markets. The following key points emerge:  
 
On-rail competition in Great Britain from open access shows that OAOs, notwithstanding their current limited role: 
- 
compete with franchised TOCs on price, frequently offering lower 
dedicated fares both for 'walk-up' and advance fares; 
- 
have developed improvements to service levels and introduced 
innovations, including selling a wider range of tickets on-board, free wi-fi and new information systems (this is reflected in high passenger satisfaction); and 
- 
have generated growth in the market for rail travel and delivered wider 
economic benefits. 
 
On-rail competition in Great Britain from overlapping and parallel franchises shows that:  
- 
there are examples of on-rail competition between franchised TOCs 
leading to price competition, with other franchisees offering lower fares than the lead operator across a range of season tickets, 'walk up' fares and advance fares; and 
- 
franchised TOCs are generally able to compete mainly on price given 
that service quality, timetables and innovation are determined through franchise specification. However, where franchise agreements are less specified (such as the Chiltern Railways franchise), there is evidence that on-rail competition between franchised TOCs has also led to improved service quality and innovation. 
 
On-rail competition in other European countries, including Austria, the Czech Republic, Germany, Italy and Sweden shows that: 
- 
on-rail competition has delivered significant benefits for passengers, including lower fares, increased service frequency and customer service innovations; 
- 
the introduction of on-rail competition has taken place on some of the 
most geographically important routes in each country, indicating the 
trust placed in the ability of on-rail competition to deliver benefits that outweigh any risks;  

- 
due to differences between the structure of the rail sector in Great 
Britain and many other European countries, we consider the evidence of on-rail competition in other European countries to be relevant and informative but not determinative; and  
- 
we note that the trend towards introducing greater on-rail competition 
is continuing in Europe. 
3.144 The following conclusions may be drawn from our assessment of the 
introduction of competition in other transport markets: 
 
In rail freight in Great Britain,  
- 
Competition 'in' the market developed strongly after privatisation, with 
new entrants successfully winning market share from incumbents. Benefits included improved staff productivity and investment which enables prices to be kept down and service standards to improve. 
- 
While there are clearly differences between the structure of the freight 
and passenger rail sectors, the case study of the rail freight sector provides a valuable illustration of how competition 'in' the market can realise benefits in the rail sector.   
 
The experience of the airline industry in Europe illustrates that a greater degree of competition 'in' the market can lead to a reduction in costs and lower fares, while also leading to improved services, the development of 
innovative business models and growth in the market overall. 
 
The example of competition between London's Gatwick and Heathrow airports demonstrates that innovation, service quality improvements and lower prices may materialise over a number of years when dynamic competition is increased and incumbents and new entrants compete to win customers.   
 
In local bus services: 
- 
Sustained head-to-head competition where it exists has delivered 
significant benefits to customers, as a result of bus operators competing on the basis of service frequencies, in addition to fares and service quality.  
- 
However, it also found that the process of competition could result in 
periods of intense short-lived rivalry, leading to the exit of one operator.  
- 
We do not consider that the issues in the local bus sector are directly 
relevant to the long-distance intercity rail sector. 
3.145 Making due allowances for differences between transport sectors, we think 
that the evidence in this chapter taken together illustrates the significant benefits that could be obtained from greater on-rail competition in addition to the benefits delivered by competition 'for' the market. 

## 4. Efficiency Gains From Greater On-Rail Competition

4.1 
In addition to generating benefits for passengers, on-rail competition may also result in greater efficiency at both the train operator level and the 'upstream' network management/operation level. This chapter considers the evidence available regarding the potential for greater on-rail competition to lead to efficiency savings. 

## Efficiencies In Train Operations Introduction

4.2 
Competition is an important way to drive improvements in efficiency. If firms are competing to win or retain customers in a competitive environment, they typically have greater incentives to adapt their operations in order to minimise their costs, use resources where they are valued most and to innovate to find 
better ways of delivering services.235  
4.3 
We examine the extent to which these incentives would be likely to result from greater on-rail competition in Great Britain and the impact that this might have on the cost of train operations.  
4.4 
Open access operations in Great Britain provide an indication of the potential for on-rail competition to lead to efficiencies as OAOs are exposed to on-rail competition from incumbent franchised TOCs and are free from franchise specification.  
4.5 
There are number of specific aspects of OAOs in Great Britain that make 
them better able than franchised TOCs to operate efficiently:236 
 
OAOs operating in Great Britain are free from franchise specification and have greater flexibility to change their price and service offering as part of their strategy, whereas franchised TOCs are less able to control their costs as a result of their franchise agreements.  
 
OAOs can make their own staffing and procurement decisions.  
 
Franchised TOCs may have less of an incentive to challenge certain costs (particularly staff costs) given the cost of potential disruption through industrial disputes, etc as compared with the benefit that would be accrued over the limited term of their franchise, and the effect that such disruption could have on a bid to renew the franchise.  
 
Franchise agreements that include revenue-sharing features such as cap and collar mechanisms (described in Chapter 2) or franchise operations that are run on the basis of management agreements typically result in even lower incentives to achieve efficiencies once the franchise is under way.  
4.6 
In addition to efficiency savings at the train operating level, we consider that train operators who are not indemnified against increases in track access charges (such as OAOs) are more likely to take a strong interest in Network Rail's efficiency and to drive demands for: 
 
more efficient use of network capacity to accommodate new paths; and 
 
more efficient spending on the network.  

## Estimating Efficiency

4.7 
Efficiency is conventionally measured as units of input per unit of output, or through costs per unit of output. For example, a franchised TOC's efficiency could be assessed by its cost to provide a passenger mile, or how many staff and how much rolling stock it requires to do so. Efficiency may also be measured in terms of train-hours (ie the hourly cost of operating services) to reflect time-driven costs such as staff costs and rolling stock leasing costs.  
4.8 
As set out in Chapter 2, there is some evidence to suggest that the passenger rail sector in Great Britain could still achieve greater efficiency. The McNulty Report commissioned by the DfT and ORR found an efficiency gap when comparing the system in Great Britain with four European comparator 
railways.237 It concluded that Great Britain's passenger rail sector should aim 
to achieve a 30% reduction from the 2008–2009 level of industry costs by 
2018–2019. Other studies, such as Smith, Nash and Wheat (2009)238 and 
Smith and Wheat (2011)239 find that, respectively, franchised TOC costs were the same in 2006 as in 1997, or had actually increased.240  

4.9 
In order to determine whether on-rail competition has the potential to generate efficiencies, the unit costs or productivity of sections of the rail network where there is on-rail competition could be compared to sections of the network where there is no competition (controlling for any differences in characteristics of the network which affect costs and which differ between these areas). As passenger railway operations involve multiple outputs and multiple inputs, these outputs and inputs would ideally be assessed together, and there are a 
number of sophisticated means to do this.241 However, such methodologies 
require a large amount of data, including comprehensive data on franchised 
TOC and OAO outputs, inputs and costs at a greater degree of granularity than is currently readily available.  
4.10 As an alternative, it is possible to examine the costs of OAOs, which face onrail competition for the majority of their flows, relative to franchised TOCs, 
which face more limited on-rail competition (and which are unable to adjust much of their competitive offering due to franchise specification). It is important to consider whether comparisons of this nature are drawn on the basis of providing 'like-for-like' services. We consider that this is broadly the case in the examples we consider below, as the comparisons are drawn for the provision of intercity services.  
4.11 A second approach would be to draw comparisons between passenger rail 
services and other sectors in Great Britain with in-market competition that have similar characteristics. A third approach would be to compare results in comparable markets which experienced changes in the degree of competition 
they faced. In respect of these latter two approaches, we focus on the rail 
freight and the airport sectors, which are discussed in Chapter 3 above.  

## Efficiency Of Open Access Operators

4.12 OAOs, which currently compete on the East Coast main line, face strong 
competition from franchised TOCs on the routes on which they operate. Previous work has found that OAOs may achieve significant efficiencies. In its 2011 consultation, MVA consultancy, on behalf of the ORR found it 
appropriate to use an assumption that OAOs have costs which are 10 to 30% 
lower than franchised TOCs' costs for a given density of operation.242  

4.13 This figure was based on a study prepared by Leeds University's Institute of 
Transport Studies and included in work conducted by the MVA consultancy for the 2011 ORR consultation. The Institute of Transport Studies generated its estimate based on a number of approaches including: econometric papers by 
Smith, Nash and Wheat (2009)243 and Smith and Wheat (2011);244 estimates 
of the efficiency gains experienced in Sweden and Germany since privatisation through successful competition for the market; and sense-checking against the savings achieved through bus and airline deregulation in the UK (which were considerably higher at 40 to 50%).  
4.14 In this regard, we were informed by a transport company which operates both 
franchised and open access services that its unit costs in 2014 (per vehicle mile) were in the region of 10% lower for its open access operations than for its franchised operation with similar characteristics.  
4.15 In assessing the efficiencies achieved by OAOs, it is important to note that the 
evidence relates only to the efficiencies delivered by OAOs in the current model of marginal open access operations. In some of the proposed options 
for reform set out in Chapter 6, OAOs would compete on key commercial 
routes (closer to the model adopted in other European countries with on-rail competition).  
4.16 This may generate additional costs, but potentially much larger efficiencies as 
OAOs benefit from economies of scale and density and as greater dynamic competition between operators increases incentives on all operators to achieve efficiencies. Moreover, as noted in the impact assessment commissioned by ORR, the effect of cost reductions due to greater on-rail competition on particular routes may lead to impacts beyond the routes that are affected as the efficiency gains may be implemented across the entire operator's business.   
4.17 As well as these efficiencies and benefits, there are a number of potential 
risks, which we consider further in our assessment of options in Chapter 6. 
We also note that OAOs may face additional track access charges under a regime where they have a significantly expanded role on the network, although we consider charges to be a separate issue from operator efficiency as the level of charges paid are not under the operator's control.245 

## Econometric Analysis By Rasmussen, Wheat And Smith

4.18 The CMA commissioned Wheat and Smith (with Rasmussen) from Leeds 
University's Institute of Transport Studies to undertake research comparing the costs of OAOs with franchised TOCs after controlling for a number of 
factors. The analysis is based on the model of Wheat and Smith (2015)246 
which is currently thought to be the most sophisticated modelling of the cost structure of train operators in Great Britain.  
4.19 The study found that OAOs' input prices are 29% lower than those of 
franchised TOCs operating intercity routes.247  
4.20 In the next step, the study utilised an econometric model that makes allowances for differences between OAOs and franchised TOCs (including differential access charges, density, scale, heterogeneity and input prices). 
This analysis suggests that the efficiency advantages offered by OAOs, which are able to adopt a more efficient business model than franchised TOCs, more than offset any cost disadvantages from the limited scale and density of their current operations - although, as the study notes, there is a degree of uncertainty regarding the precise magnitude of the efficiencies. 
4.21 The analysis in the paper also suggests that expanding the role of OAOs has 
the potential to deliver greater efficiencies as operators would benefit from greater economies of scale and density, although the overall cost impact depends on the extent to which the incumbent loses economies of scale and density as OAOs gain market share, and is route-specific. The paper also acknowledges that the incentives that dynamic competition would create for operators to reduce costs may be expected to generate further efficiencies over and above those reflected in the model.  
4.22 In this regard, the DfT told us in its consultation response that it would expect 
efficiencies associated with OAOs' business models to decline as they grew larger and that, in its view, it was unlikely OAOs' input prices would remain much lower than franchised TOCs' costs if the former expanded their 
operations considerably.248 While this cannot be ruled out, we note that OAOs 
could still remain smaller businesses than the larger TOCs in an environment of greater on-rail competition and might be dedicated to serving a particular route. OAOs would also remain free from franchise specification, allowing them to retain some of the fundamental principles of their alternative business models. As noted above, OAOs would also benefit from economies of scale and density as their operations grew. As such, we consider that there may still be scope for OAOs to generate efficiency benefits as they grow in scale. We also note that the impact assessment commissioned by ORR did not choose 
to model OAO efficiencies which declined with OAO size.249  

## Sources Of Efficiency At Open Access Operators

4.23 We have further explored, through industry engagement and round tables, the 
efficiencies that OAOs have been able to achieve and how these have been attained. 

## Staff Costs

4.24 Staff costs represent one of the industry's most significant costs, accounting 
for 29% of TOC costs in 2013/14.250 The franchising system has had limited 
success in controlling staff costs as is noted, for example, in the McNulty 
Report.251 In the same publication, Leeds University's Institute of Transport 
Studies is reported as having found that historical OAO staff costs were 6 to 18% lower than franchised TOC staff costs, while there is evidence that staff satisfaction levels may be higher in OAOs than in franchised TOCs.  
4.25 This is widely considered to be because OAOs recruit their own staff upon 
entry to the market. By contrast, franchised TOCs inherit staff from their predecessor under TUPE arrangements on the same terms and conditions: the duration of the new franchise is then typically insufficient to risk harming 
industrial relations through introducing changes to pay and conditions.252  
4.26 We were told by OAOs that they were able to achieve cost savings by 
allocating staff more efficiently, for example through flexible and efficient rostering of staff. A number of employees at OAOs also undertake multiple roles. For example, OAOs use on-board staff to despatch trains rather than paying station staff to undertake the task. We were also told that working practices at OAOs were more flexible than those under many historical agreements in the rail industry.  
4.27 We have also seen evidence that the different terms and conditions under 
which staff at OAOs are employed has not led to lower staff satisfaction. On the contrary, we were told that staff at OAOs demonstrate higher levels of engagement with their employer than staff at franchised TOCs. A company operating both franchised and OAO services told us that the staff on its open access services had the highest employee engagement and staff satisfaction within its operating group, because of greater staff involvement in decisionmaking and strategy and a stronger relationship between company performance and pay.  

## Other Sources Of Train Operator Efficiencies

4.28 OAOs told us that they are able to achieve a number of additional efficiencies 
over franchised TOCs: 
 
Outsourcing - one operator told us it had achieved efficiencies by outsourcing maintenance, retail and cleaning activities. Local procurement was identified as a source of cost savings in certain areas. OAOs told us that they benefited from sharing some of the services of larger owning groups, for example in terms of legal, property and safety advice.  
 
In-house provision - vertical separation in the rail industry in Great Britain means that OAOs can access stations and train depots on an equal basis with larger franchised TOCs. This is not to say OAOs are wholly reliant on buying in upstream services; they have told us they are free to undertake services themselves when they see inefficiencies. One operator told us that it prefers to uncouple and despatch its own trains at stations as it can do it faster than if it uses the services provided by the franchisee at the station. We have also been told that they have achieved efficiencies in terms of faster passenger embarkation and disembarkation 
at stations.253  
 
Freedom from franchise specification - we were told by OAOs that they have achieved a number of operational efficiencies. These include faster turnarounds of train units at stations, running services that are more closely tailored to demand and adjusting the rolling stock formation accordingly. OAOs are also free to adjust services to changing demand. A number of TOC owner groups also noted that prescriptive franchise arrangements and costs prevent them from achieving further efficiencies. The impact assessment commissioned by ORR also stated that there is no evidence to suggest that franchised TOCs would have the ability to reduce unit costs of staff given the constraints of a franchise agreement.  
 
The franchise process - OAOs avoid the cost of the franchise bidding process and the ongoing costs of running franchises such as contract management services required to demonstrate that franchised TOCs are appropriately fulfilling their franchise duties. This point is also made in the 
2011 ORR consultation and associated MVA report.254  
 
Ticket retailing - OAOs may have a greater incentive to chase every pound of revenue compared with franchised TOCs whose franchise contracts contain revenue-sharing mechanisms. This has led to efficiencies in terms of ticketing and pricing innovations. Key factors include early introduction of yield management systems (where advance ticket prices change over time towards the point of departure, maximising revenue for the operator). We were told that one OAO implemented this system well before its franchised rival. We have also been told that OAOs more frequently sell tickets on board trains and have a greater incentive to prevent revenue leakage than some franchised TOCs (eg through fare evasion). These customer-facing innovations are aimed at attracting the maximum number of passengers to their services. Other pricing innovations have included loyalty schemes and carnet tickets, where passengers can buy journeys in bulk 'books', for example of 20 tickets, at a discounted price.  
4.29 Moreover, as discussed above, OAOs may have the potential to achieve 
further efficiencies if they were permitted to expand their service offering - eg along the lines of some of the options considered in Chapter 6.  

## Upstream Efficiencies

4.30 The network is currently owned, operated and managed by Network Rail. The 
operation of the network makes up 52% of total industry expenditure.255 
Efficiency gains at this upstream level therefore have significant potential to reduce the cost of the network to both passengers and taxpayers. 
4.31 We consider that on-rail competition has significant potential to enhance 
capacity allocation and to reduce upstream costs. First, there is potential for greater on-rail competition to increase the incentives for train operators to put pressure on Network Rail to use capacity more efficiently. Second, greater onrail competition may incentivise train operators to encourage Network Rail to reduce costs where possible (in discussions we have had in the course of preparing this document, network costs were often cited as a major source of inefficiency within the current system).  
4.32 The potential for greater on-rail competition to generate upstream efficiencies 
would be strengthened if the structure of charges within the industry were reformed so that access charges paid by train operators were truly costreflective, rather than covered partly through the current mixture of infrastructure funding (ie FTAC, variable charges and the network grant). The current structure does not incentivise franchised TOCs to encourage efficiency from Network Rail as they factor in the cost of access charges to their franchise premiums or subsidy requirements, and are indemnified in their franchise agreements from increases in access charges at ORR periodic reviews. Similarly, while OAOs are fully exposed to variable charges (that reflect their direct impact on the network), they do not face any fixed access charges and, therefore, are not exposed to charges relating to the cost of providing and expanding the network. In this regard, we note that ORR's review of the structure of track access charges has identified improving cost reflectivity and supporting efficient use and provision of network capacity as objectives.  

## Evidence From Open Access Operators And Competing Franchisees

4.33 There is evidence to suggest that new entrants and competing franchised 
TOCs have incentives to put pressure on Network Rail to use capacity more efficiently (ie to accommodate new entry and to control costs).  
4.34 For example, as highlighted in Chapter 3, in response to competition from 
Virgin Trains on the West Coast main line and from the parallel Chiltern 
Railways franchise, London Midland found that it was possible to operate two services in a single train path, allowing an additional service to be added into each off-peak hour in 2012 and two additional morning peak services and five evening peak services to be added in December 2014. This example is discussed further in paragraphs 5.54 to 5.56. 

4.35 In addition, we were told that when Grand Central launched its services from 
London to York, the additional capacity required by the incumbent franchised TOC to run services from London to York was identified by Network Rail partly as a result of the capacity questions raised by Grand Central in its open access application.  
4.36 There are also examples of OAOs encouraging Network Rail to undertake 
projects to increase network capacity. First Hull Trains persuaded the DfT to back its plans to electrify the line between Selby and Hull, securing £3.3 million in public funds to support the scheme which is predominantly 
privately financed.256 The scheme will allow for the introduction of new electric 
trains which would reduce journey times. Once completed it is expected that Network Rail would take over maintenance with the special purpose company that funded and delivered the upgrade being paid an access fee by First Hull Trains and the other operators on the route to recoup its investment. 
4.37 In a report published in March 2015 by the Electrification Task Force, which 
was established by the Secretary of State for Transport to advise him on the next steps for electrification in the North of England, the project to electrify the line between Selby and Hull was identified as one of the government's priorities, which would lead to the provision of faster rail services, while also alleviating problems of overcrowding on routes. The Secretary of State for Transport has indicated that 'Network Rail will take the task force's findings into account as it develops its nationwide plan to improve the nation's 
railways'.257  
4.38 The potential for on-rail competition to drive private sector investment in the 
network is considered further in Chapter 5.  

## Evidence From The Rail Freight Sector

4.39 As noted by the DfT in its 2012 report entitled Reforming our Railways: Putting 
the Customer First, the competitive environment has also generated significant efficiencies in the rail freight sector over recent years, and this has 
encouraged Network Rail to achieve efficiencies.258 Specifically, freight operators which, unlike franchised TOCs, are subject to access charge variations and regulatory reviews, have engaged extensively with ORR and Network Rail during periodic reviews in 2003 and 2008 (to a greater degree than franchised TOCs), in order to challenge Network Rail's costs.  

4.40 We also set out below examples from other industries which help illustrate the 
point that competition can generate efficiencies at the upstream level of a value chain. 

## Capacity Expansion At Heathrow Airport

4.41 NATS is the provider of air navigation and traffic control services in the UK. In 
2012, NATS was successful in London's Heathrow Airport tender process to develop a system to address the short- and long-term capacity and 
operational constraints at the airport.259 
4.42 Heathrow Airport faces competition from other airports, including Gatwick 
Airport and European airports such as Frankfurt, Amsterdam Schiphol and Paris Charles de Gaulle. It is therefore incentivised to create additional capacity in order to satisfy airline demand. The airlines themselves compete to attract passengers and require additional capacity in order to satisfy demand, expand their businesses and increase the reliability of their services. At the same time, NATS is a commercial business which is paid partly upon the number of movements that it facilitates into and out of Heathrow Airport. 
4.43 This competitive environment led to an alignment of incentives between the 
airlines, the airport and NATS, which encouraged collaboration between the various stakeholders in order to address the capacity and operational constraints at Heathrow Airport. The solution found involved using 'big data' to provide decision support to air traffic controllers in order to enable more dynamic management of the network to improve capacity.  
4.44 As in the rail industry, capacity constraints mean that demand for services can 
exceed available capacity on parts of the network. Moreover, both the aviation and rail sectors have access to rich data which can be used to model passenger demand. The example illustrates that cooperation by a downstream transport service provider and an upstream infrastructure provider, both with 
an incentive to increase capacity, was able to find an innovative solution to improve capacity.  

## Airport Management

4.45 Another interesting example from the air transport services sector concerns 
the 'upstream' pressure and positive impact that airline deregulation has had on the management of airports.  
4.46 The air transport regulator, the Civil Aviation Authority (CAA), has described 
the 'virtuous circle' generated by greater competition between airlines (and low-cost airlines in particular) seeking to exploit new business opportunities (see Figure 13 below). In this context, airports have moved from a 'passive role' to a more commercially oriented approach in the management of their 
operations.260 
4.47 In response to airline deregulation, airports began to change the way they 
viewed their operations. Although this may have also been due to a move from the public to private sector, and in part due to the break-up of BAA (described in more detail in Chapter 3), even where still publicly owned, airports started to reduce costs, price more competitively and seek out new air services. 

## Scottish Water Sector

4.48 Another example of competitive downstream market participants encouraging 
efficiencies in upstream markets comes from the experience of the introduction of competition into the non-household water and wastewater market in Scotland in 2008. The reforms saw the separation of the previous incumbent's 'upstream' water supply and wastewater treatment wholesale arm from its 'downstream' arm, and the opening of the retail market to competition.  
4.49 The Water Industry Commission for Scotland (WICS) in its 2011 analysis with 
the consultancy Oxera,261 assumed that vertical separation and retail 
competition in the downstream market would lead to efficiencies of at least 0.05% per year, giving a total NPV of savings of £110 million per year. We understand the savings were realised and delivered a year ahead of schedule.  
4.50 WICS considered this efficiency to have been generated as a result of the 
retailers taking up the role of 'customer champion', and putting pressure on the upstream operator to deliver services and investments tailored to the preferences of their own customers, namely downstream consumers. In the rail context, this would equate to train operators in an environment of on-rail competition putting pressure on Network Rail to minimise costs and to improve service quality in terms of reliability and punctuality, and to develop the network better in the interests of passengers.  
4.51 Although it is difficult to identify the precise effect the introduction of retail 
competition has had, Scottish Water has achieved remarkable gains in efficiency in recent years. WICS told us it considers that the introduction of retail competition has played a significant part in this. 

## Efficiency Gains In The Impact Assessment

4.52 The impact assessment commissioned by ORR reviewed evidence regarding 
the potential for on-rail competition to generate efficiencies, including from the Great Britain rail sector, examples of European on-rail competition, the UK bus and coach travel market, airlines' buyer power with respect to airports and the entry of low-cost carriers in the air travel market.  
4.53 In its modelling, the impact assessment made a number of assumptions 
regarding efficiencies. 
4.54 In relation to staff costs, the impact assessment cited the McNulty Report and 
Leeds Institute of Transport Studies estimates, as well as estimates from 
Smith and Wheat (2015). The authors concluded it was appropriate to assume reductions in staff costs for OAOs of 5 to 15% relative to the 'do nothing' 
counterfactual.262 

4.55 In relation to rolling stock costs, the impact assessment assumed a range of 
possible efficiencies of between 0 and 10% savings, again citing evidence from Smith and Wheat (2015). 
4.56 The impact assessment also included an 'own costs efficiency' for OAOs of 
between 10 to 30% savings per train km, based on estimates of 'open access operator business model effects' in Smith and Wheat (2015), and a 20 to 30% range used by MVA in its 2011 report. 
4.57 In addition, the impact assessment assumes an own cost efficiency of 0 to 
10% for franchised TOCs competing against an OAO, and an own cost 
efficiency of 0 to 5% for franchised TOCs when competing against another franchisee, based on economic theory and evidence from other transport 
sectors such as the bus market.263  
4.58 In all the scenarios modelled in the impact assessment, economies of density, 
which imply reduced efficiency when services are divided up between operators, are assumed in the range of 0.95 to 0.85. 
4.59 The impact assessment applied these assumptions to scenarios in which 
service patterns were redesigned to model the indicative impact of the options 
for greater on-rail competition on operating costs.264 Under Option 1, where 
OAOs expand, total industry costs fell under most of the scenarios.265 The 
results for Options 2 and 3, in which greater on-rail competition between 
franchised TOCs is introduced, were more mixed.266 These findings are 
discussed in more detail in Chapter 6.  
266 For Option 2, total industry costs were higher in the low scenarios for the East Coast and West Coast main lines, higher in the central scenario for the East Coast main line and did not change on the West Coast main line under the central case scenario. Costs fell under the high scenarios for the East Coast and West Coast main lines. For Option 3, which was modelled only on the Great Western main line, total industry costs rose in the low scenario, fell marginally in the central scenario, and fell slightly in the high scenario. 

## Conclusion

4.60 We consider that the evidence in this chapter suggests that greater on-rail 
competition has the potential to generate efficiency savings - particularly where operators are free from franchise specification.  
4.61 Analysis by Rasmussen, Wheat and Smith (2015) found that OAO input costs 
were 29% lower than those of franchised TOCs operating intercity routes. This 
analysis also found further efficiency benefits for OAOs, although it noted there is a degree of uncertainty regarding the precise magnitude of the efficiencies and whether these would change if OAOs grew in scale.  
4.62 There is also evidence to suggest that greater on-rail competition may reduce 
upstream costs in network and infrastructure provision and put pressure on Network Rail to use network capacity more efficiently. Evidence from other UK sectors such as the rail freight sector, capacity expansion at Heathrow Airport, airport management and the Scottish water sector also lead us to consider that increased on-rail competition may lead to increased upstream efficiencies. 

## 5. The Feasibility Of Greater On-Rail Competition: Obstacles And Opportunities Introduction

5.1 
This chapter considers the potential technical, economic and policy obstacles to greater competition in the passenger rail market in Great Britain and describes possible ways to overcome these obstacles.  
5.2 
In particular, we consider issues that are relevant to assess in an environment of greater on-rail competition relating to: 
 
access to infrastructure, network capacity and rolling stock (paragraphs 5.4 to 5.68); 
 
funding the network and loss-making services, and the financial sustainability of operators (5.69 to 5.155); and 
 
an increase in the number of operators, which might lead to operational issues and to greater complexity of the system (5.158 to 5.2061). 
5.3 
We cross-refer to our analysis of these issues in discussing the design of options for greater on-rail competition in Chapter 6.   

## Access To Infrastructure, Network Capacity And Rolling Stock

5.4 
The structure of the value chain in the rail industry is complex. As described in Chapter 2, after the privatisation of British Rail, a model of vertical separation 
was chosen in Great Britain.267  
5.5 
Therefore, the market fundamentals required for greater on-rail competition in terms of a level playing field and non-discriminatory access arrangements are already in place in Great Britain. 
5.6 
Nevertheless, technical and economic constraints at the upstream network management level could result in obstacles to greater on-rail competition. In the following paragraphs we set out these potential obstacles, consider mitigating factors and discuss the regulatory and policy tools designed to overcome the obstacles. 

## Non-Discriminatory Access And Level Playing Field

5.7 
A vertically integrated market structure may be a barrier to increasing downstream competition in the rail market (whether by way of competition 'for' 
or 'in' the market). 268 As described in Chapter 3, vertical integration has 
impeded competition in a number of European countries. 
5.8 
In Great Britain, there is full vertical separation between Network Rail and the TOCs on one side and between TOCs and ROSCOs on the other. Although on-rail competition remains limited in scale, the unbundling of the rail network has created the prerequisite for a level playing field and the conditions for open downstream competition in the market.  
5.9 
Network Rail is not permitted to discriminate unduly between train operators and has to consider all applications for access rights in an even-handed way, ie franchised TOCs will not automatically be prioritised over non-franchised 
TOCs. We note that franchised TOCs are committed to run the services that 
they bid to operate as part of the competitive process during the life of a franchise, unless there is a significant change in circumstances, although 
additional franchised services may be specified.269  
5.10 Network Rail's Sale of Access Rights Panel oversees Network Rail's 
approach to access applications, in particular considering carefully where selling rights to access network capacity may involve a trade-off with other Network Rail objectives (ie deliverability and performance of services and optimising network efficiency).  
5.11 However, all new agreements to access Network Rail infrastructure and all 
amendments to existing agreements are subject to ORR approval and direction. Similarly, where Network Rail has multiple requests to access the same network capacity that cannot all be accommodated, ORR will determine who, if anyone, should be given access.  
269 For example, we were told that the June 2015 Train Service Requirement under the new East Coast main line franchise is for 199 weekday services at London King's Cross, compared with 186 in March 2014 under the previous franchise. Moreover, the current services to Middlesbrough, Thornaby, Sunderland and Stirling were not included in the March 2014 Train Service Requirement.  

5.12 In assessing an application for track access, ORR does not discriminate 
between operators. ORR has discretion as to the weight it places on each of its statutory duties according to the circumstances of a particular 
application.270 Where the duties point in opposite directions, ORR seeks to 
balance the duties in order to reach a decision. As set out in Chapter 2, ORR balances its duties through the application of the NPA test, which has 
moderated the scale of open access operations.271  
5.13 Moreover, as noted in Chapter 2, ORR is reviewing the structure of charges 
paid to Network Rail, in preparation for the next five-year control period for access charges (CP6) which starts in 2019. One objective of the review identified by ORR is to create a more level playing field supporting effective competition between different types of passenger operators, eg in terms of the 
risks and charges that franchised TOCs and OAOs face.272  
5.14 In addition, we note that the system in Great Britain benefits from the 
impartiality obligations that feature in the TSA and the franchise agreements, which require incumbent operators to sell OAOs' tickets on an impartial basis. We discuss the current arrangements that are in place that enable the allocation of revenue between operators in paragraph 5.204 below. 

## Capacity Scarcity And The Potential For Capacity Expansion On The Network

5.15 Many parts of the rail network in Great Britain are characterised by physical 
and technical constraints which limit the network capacity available and which, in turn, might limit the opportunity for train operators to compete for passengers by running additional services. Indeed, as described in Chapter 3, capacity constraints in Great Britain are more severe that those in many 
enable operators to plan their businesses with a reasonable degree of assurance.   
European countries, particularly on parts of the network where demand is high and entry might be commercially viable.273  

5.16 A number of respondents to the consultation told us that capacity scarcity and 
network congestion currently (and in the near future) represent a barrier to 
greater on-rail competition.274 
5.17 However, ORR pointed to the potential for network capacity to increase 
following technological enhancements. As further described in the Appendix, these technological enhancements include the introduction of on-board digital signalling as part of the move from conventional signalling to the European 
Rail Traffic Management System (ERTMS) electrification programmes275 and 
investment in the rail network (eg the development of HS2 and upgrading of 
station facilities).276  
Shorter-term capacity enhancements 

5.18 In relation to capacity enhancements in the shorter term, the Secretary of 
State for Transport issued a statement on High Level Output Specification (HLOS) in 2012 setting out to ORR what should be achieved on the rail network in Great Britain during CP5 (see the Appendix). Moreover, the ORR's CP5 periodic review (2014–2019) assessed options for Network Rail to improve the capability of the whole system by, for example, the use of new technology. As a result, Network Rail has planned short-term (ie by the end of CP5) enhancement works (budgeted at £6 billion) aimed at improving capacity and capability. The intention is to deliver 20% more morning peak seats into central London and 32% more peak seats into major regional cities.  
5.19 ORR told us that there is potential for capacity increases in the shorter term, 
which may help to facilitate on-rail competition, as highlighted in ORR's most 
recent long-term regulatory statement.277 Examples cited included lengthening 
trains and innovation in rolling stock design to permit faster acceleration and 
shorter dwell times at stations.278  We also note that electrification projects 
including those planned for the Great Western and Midland main lines may lead to some additional capacity in the shorter term through greater reliability and better rolling stock performance. ORR also told us that a strengthened system operator would be better incentivised to find new capacity on the existing network.  

5.20 However, a number of respondents to the consultation, told us that sufficient 
capacity to sustain increased on-rail competition would be achieved only as a 
result of major investments in the network.279 The impact assessment 
commissioned by ORR concluded that, in the short and medium term, for the three key main line intercity routes, a significant increase in the scale of open access competition would be likely to require government to allocate some train paths that are currently being used by franchised TOCs to OAOs in the 
future.280 
Longer-term capacity enhancements - digital signalling and HS2 

5.21 In the longer term, as described in the Appendix, the move from conventional 
signalling to on-board digital signalling as part of the ERTMS is expected to allow for more trains to be safely run over the same length of track. Network Rail told us that digital train control will enable an increase in capacity on the 
existing rail network by up to 40%.281 ORR stated in its consultation response 
that the move to digital signalling will increase capability of the network, albeit in ways that are difficult to predict.  
5.22 Certain consultation respondents questioned the potential for on-board 
signalling to increase capacity,282 while others have indicated that capacity 
created by such technological developments will only ease current 
overcrowding283 and that sufficient capacity to sustain increased on-rail 
competition would be achieved only as a result of major investments in the 
network, such as HS2.284   
by capacity at London termini. 

5.23 In particular, certain consultation respondents stated that, although line 
capacity could increase following the introduction of on-board signalling, this 
new technology is unlikely to alleviate problems of capacity at stations.285  
FirstGroup told us that such technological innovations will undoubtedly have a positive impact, but it is unlikely that they will have a significant impact on major stations which are already operating at or near maximum capacity (eg London) or 'bottlenecks', where physical constraints (eg the number of 
platforms available or capacity at junctions) will remain.286  
5.24 On balance, there is evidence - including from ORR and Network Rail - to 
suggest that the introduction of on-board digital signalling as part of ERTMS will lead to greater capacity on parts of the network. However, we observe that the extent of capacity increases are difficult to predict at this stage and that a number of barriers, including capacity constraints at stations, may restrict the eventual capacity increase.  
5.25 The other major longer-term change to capacity on the network is likely to 
arise from the construction of HS2, which is planned to create approximately 352 miles of new track and increase the number of passenger seats on trains from the North into London (and vice versa).  
5.26 Phase 1 of HS2, which is expected to open in 2026, will see high-speed 
services run between London Euston and Birmingham, many of which will continue to other destinations using the 'classic' rail network. Phase 2 is planned to form a 'Y' shape from the West Midlands up towards Manchester and the North West with proposed stations at Manchester Airport and Manchester Piccadilly; and up towards Leeds and the North East with proposed stations in Leeds, the East Midlands and Sheffield Meadowhall. 
Further details of HS2 are set out in the Appendix.   
5.27 A number of consultation respondents indicated that the opportunity for 
greater competition would only arise after completion of HS2, which is likely to 
significantly expand capacity on the 'classic' West Coast main line.287 In this 
trains and train sectioning). Professor Chris Nash stated that HS2 may reverse capacity constraints for limited parts of the network. Regional respondents in Wales (Powys County Council and Mid Wales Transportation Partnership) stated that they do not want any changes implemented until after HS2, while the Scottish Association for Public Transport expressed concern that future infrastructure investments like HS2 are likely to be compromised by increased on-rail competition.  
regard, ORR told us that HS2 will add a significant amount of new capacity, potentially freeing up capacity on the West Coast main line.  

5.28 However, the DfT told us that although HS2 will release capacity on the 
'classic' West Coast main line, some of this capacity will be specified to remove duplication between classic and HS2 services, to ensure that HS2 and classic rail services are fully integrated and to make use of the capacity freed up by the introduction of HS2 to improve the rail services to certain 
locations.288 These principles are considered by the DfT to be fundamental to 
the HS2 business case. However, we note that there are many options for future service specifications and that decisions on future services will not be taken until much nearer the time.  
5.29 As considered in Chapter 6, the HS2 high-speed line may itself be a candidate 
for on-rail competition. We are, however, conscious of the need for policymakers to ensure that HS2 delivers the maximum economic and social benefits envisaged in its business case for its construction and that a variety of objectives must be balanced in making operational decisions regarding the nature of services that will run on HS2.   
5.30 In summary, in the longer term, on-board digital signalling and HS2 are likely 
to create some additional capacity on the network, helping to create the flexibility to increase on-rail competition on parts of the network, should policymakers be minded to do so. ORR also told us that a reformed open access system would, alongside franchising, support the delivery of the government's objective of making the best use of step changes in capability, such as HS2 and on-board signalling, by responding to changing circumstances and identifying opportunities for new services. 
5.31 Moreover, as considered in the next section, we do not consider that the 
existence of spare capacity on the network is a strict prerequisite for greater on-rail competition. 

## Competition Under Capacity Constraints

5.32 Although new capacity would create opportunities for greater on-rail competition in the future by allowing new entrants to run services in addition to those operated by incumbents today, we consider that on-rail competition could take place under today's capacity constraints.   
5.33 First, while barriers to capacity expansion may represent an obstacle to the 
expansion of on-rail competition from its current marginal scale through the 
introduction of new services in addition to those run by incumbents, greater on-rail competition could be introduced by reallocating existing capacity between operators. For example, the size of certain franchises could be reduced in order to allow greater open access operations or there could be two successful bidders for some franchises.  

5.34 Second, even when there is no additional track capacity (ie in terms of train 
paths), there is still likely to be capacity available on trains, which will incentivise operators to compete to win additional passengers. We were told by a number of stakeholders that there is considerable spare capacity on many off-peak services on the long-distance intercity routes. We were also told that there may be spare capacity on certain peak-time services on intercity routes, as more price-sensitive passengers typically avoid travelling 
on these services.289 We also understand that even when capacity on 
services is limited on certain flows on a long-distance intercity route, spare capacity may still exist on a number of other flows on the route.  
5.35 Third, even where certain train services are at full capacity, eg in peak 
services, this does not, in itself, imply that on-rail competition cannot be effective in a long-distance intercity environment. We note that: (a) many long distance operators use yield management systems which 
(subject to restrictions from fare regulation) enable them to manage demand across services; and 
(b) operators are still able to compete under capacity constraints by 
differentiating their services to attract passengers with different preferences and budget constraints (for example, we note that the open access applications by Alliance Rail and FirstGroup seek to compete with 
the incumbent in different ways).290 
5.36 Finally, we note that there are also examples of on-rail competition leading to 
the identification of greater capacity on the network, suggesting that greater on-rail competition has the potential to incentivise the development of solutions to capacity scarcity. 

## Incentives To Maximise Network Capacity Misalignment Of Incentives And Network Rail'S Access Rights Policy

5.37 In addition to network enhancement works and investments, a number of 
ORR reports have noted that the capacity identification process undertaken by Network Rail could be improved in order to maximise and manage the network capacity more efficiently, allowing more services to operate on the existing 
network.291  
5.38 We were told by a number of train operators and other stakeholders that there 
is currently little incentive for Network Rail to maximise capacity utilisation, with its primary focus being on operational performance. For example, in its 
final determination of Network Rail's outputs and funding for 2014–2019,292 
ORR noted Chiltern Railways' view that Network Rail is 'programmed' to prioritise performance results over sale of capacity. Chiltern Railways also noted that there are many ways of creating additional capacity without embarking upon major schemes but that Network Rail is not currently incentivised to do this. 
5.39 This alignment of incentives may be due to a number of reasons:  
 
Most variable charges are cost-oriented but cover only short-run marginal costs, so Network Rail has no financial incentive to sell more of its 
network capacity;293 moreover, fixed track access charges are not fully 
cost-reflective and are independent of the quantity of services provided.294  
 
Performance incentives and targets have been significant in Network Rail's regulation, which have provided a disincentive for Network Rail to make additional capacity available because of the trade-off between punctuality/reliability and capacity maximisation.  
 
Lack of incentives could also result from (a) Network Rail's ownership 
structure (ie it is a 'for profit' but not 'for dividend' company295); and 
(b) Network Rail's incentive schemes applied to its senior management. 
5.40 In its system operation consultation document on making better use of the 
railway network,296 ORR identifies the current trade-offs between the level of 
capacity, performance and cost. ORR also highlights that while cost and performance are currently measured and regularly reported, this is not the case for the capacity of the system.  
5.41 In order to take steps to improve the existing alignment of incentives, ORR 
undertook a recalibration of variable charges for CP5 resulting in: 
 
a substantial increase in the capacity charge297 paid by train companies to Network Rail, which now grows exponentially in congested areas and 
therefore encourages Network Rail to make further capacity available; and 
 
an enhanced volume incentive mechanism,298 designed to encourage 
Network Rail to make commercially oriented trade-offs when deciding whether to meet unexpected demand.  
5.42 In addition, ORR is considering further how to introduce more cost-reflective 
charging schemes in order to incentivise Network Rail to manage the network capacity, and to incentivise its customers to use that capacity, more 
efficiently.299  
5.43 In its response to our consultation Network Rail stated that we should be 
seeking ways to make best use of the available network capacity and to provide the best service to end users through on-rail competition. In this regard, Network Rail stated that capacity optimisation is one of the best ways to deliver value for money for funders and end users.   
5.44 Network Rail considers that neither a purely market-based approach nor a 
completely planned system is likely to achieve this. In Network Rail's view, the optimal solution would be a 'reasonably' planned system which still provides opportunities for operators to innovate. In an environment with greater on-rail 
the baseline. ORR introduced a payment floor of –£300 million and a ceiling of +£300 million in order to balance the risk of the incentive becoming inactive, against affordability concerns for both government and Network Rail. 

299 Cost-reflective charges would allow Network Rail to levy higher charges on parts of the network where capacity is scarce. In its December 2015 structure of track access charges consultation, ORR stated that improving the cost-reflectivity of charges has the potential to improve outcomes by reducing costs and improving the use of the network. At this stage, ORR proposes to continue work with Network Rail to understand the drivers of costs that are fixed in the medium to long term and then to consider separately whether and how to pass any improved understanding of costs into charges.  
competition, the system operator role is seen by Network Rail as key to maximising capacity through timetabling and allocating train paths to operators in a non-discriminatory way. 

5.45 Some stakeholders told us that inefficiencies in the optimisation of capacity 
have been a consequence of the lack of flexibility resulting from the detailed specification of franchise agreements and access rights. Access rights were originally prescriptive in nature in order to satisfy the concerns of train operators at the time of privatisation that protection was required against potential network degradation.  
5.46 Network Rail observes that these original concerns have not been realised 
and supports a greater degree of flexibility in access rights as a way to achieve more efficient timetabling and, consequently, to free up additional capacity, recognising that different approaches may be appropriate for different parts of the network. ORR and the DfT are also supportive of the principle of more flexibility around the sale of access rights.  
5.47 More flexible access rights may make it easier to optimise the use of network 
capacity by allowing Network Rail flexibility to optimise the timetable, particularly as the network becomes even more intensively used and infrastructure projects come to fruition. As highlighted below, this could also support greater flexibility in franchise specification. The counterargument is that new entrants require certainty regarding access rights and FirstGroup noted that this would be important in a framework of increased competition.  
5.48 In September 2015, Network Rail published its sale of access rights policy,300 
which sets out how Network Rail will deal with requests for the sale of access rights from those who seek to use the network. The new strategy follows extensive debate in the industry under the auspices of the Rail Delivery Group's Contractual and Regulatory Reform Working Group.   
5.49 In relation to passenger rail services, the policy states that where parts of the 
network are predominantly used by a single operator, Network Rail will usually only agree 'quantum rights' for that operator in order to provide maximum 
flexibility in the construction of timetables.301 Where parts of the network are 
predominantly used by more than one operator, Network Rail will consider agreeing additional specification, which may include journey time or interval protection, in order to provide greater certainty and avoid suboptimal timetable adjustments. We note that this approach balances certainty for operators with 
flexibility and therefore has the potential to facilitate on-rail competition. The access rights policy will remain under review and will be updated, as necessary, to reflect wider industry developments and experience.302  

5.50 In summary, the role of the system operator in identifying and allocating 
capacity is a key component in introducing greater on-rail competition. We welcome ORR's system operation review and the development of an access rights policy that helps to facilitate on-rail competition in the future.   

## Impact Of On-Rail Competition On Capacity Identification And Network Enhancements

5.51 On-rail competition can have, and has had, a positive impact on the capacity 
identification and maximisation process, because of the strong incentives of new entrants to identify additional capacity.  
5.52 The open access applications proposed to Network Rail have often identified 
additional capacity in the network - allowing more services on the network - and led to efficient path allocation solutions. In general, one of the benefits of competition 'in' the market is that it provides incentives for the efficient use of available resources.  
5.53 Competition between overlapping and parallel franchises has also provided 
incentives to innovate and invest in the network. For example, on the London– West Midlands route, Chiltern Railways undertook major upgrade work on the network in partnership with Network Rail, in response to faster and more frequent services launched by Virgin Trains. 
5.54 As highlighted in paragraphs 3.47 and 4.34, competition from Virgin Trains on 
the West Coast main line and from the parallel Chiltern Railways franchise was one driver in London Midland investing in new capacity in order to grow its revenue and to limit the opportunity for scarce paths to be consumed by 
competitors (which would, in turn, limit its ability to expand in the future).303 
The timing of London Midland's proposal to increase capacity coincided with the end of Virgin Trains' moderation of competition clause in 2012 and was only made possible by the lifting of the restrictions. 
5.55 London Midland minimised the requirement for new rolling stock by focusing 
on a modification to existing units. Services operating on key flows from Euston were accelerated from 100mph to 110mph through rolling stock modifications and a small procurement to fulfil the additional requirement at 
peak times. London Midland's project team found that this allowed it to operate two services in a single train path, as opposed to the original two. This allowed an additional service to be added into each off-peak hour in 2012 and two additional morning peak services and five evening peak services to be added from December 2014. This produced around 4,000 extra seats in the morning peak and around 8,000 in the evening peak. 

5.56 In this example, competition was a driver for the capacity increase in two ways 
- the incentives from competition between train operators and, during the options evaluation process, competition to produce the best solution and be granted access rights.  
5.57 However, as discussed in Chapter 2, under many of the current franchise 
agreements, franchised TOCs have limited incentives to maximise the use of capacity on routes where they operate. In particular, once a franchise agreement is under way, there may be limited incentives to increase the number of services. This disincentive is most likely where franchised TOCs have a cap and collar risk-sharing mechanism with the government or where the franchised TOC operates under a management contract with the government bearing full revenue risk (such as in the Thameslink, Southern & Great Northern franchise). Franchised TOCs that are exposed to the full revenue risk of the franchise (such as Chiltern Railways) and those with new 
risk-sharing mechanisms will have greater incentives to run more trains.304  
5.58 We welcome the DfT's reforms to the franchising system in order to develop 
franchised TOCs' incentives to innovate responsively to passenger demand and to reform the mechanism for sharing risk between franchised TOCs and government. We note that additional flexibility is important in allowing 
franchised TOCs to respond to on-rail competition and, in turn, to allow the 
dynamic benefits of greater on-rail competition to be realised.   

## Access To Rolling Stock Rolling Stock Scarcity

5.59 The ROSCOs own rolling stock and lease them to TOCs on a commercial 
basis. This upstream market was created in 1993 in order to promote 
competition and remove entry barriers.305  
5.60 However, in 2009, the Competition Commission found that there was:  
a restricted choice of rolling stock available to TOCs, arising partly from operational and technical restrictions on substitutability, but also because of direct or indirect specification of rolling stock in Invitations to Tender for franchises, the costs and risks involved in switching to alternative used or new stock, and the operation of the franchise system which reduces opportunities for 
competition.306 
5.61 We understand that, currently, the availability and cost of rolling stock is still a 
concern and may be a barrier to entry. This seems to be a particular concern 
for certain rolling stock types307 and for OAOs, which have a shorter horizon 
and less certainty over the length of their track access rights. 
5.62 However, in the near future, rolling stock is likely to become less scarce. As 
part of the InterCity Express Programme, new rolling stock (known as IEP units) will enter service on the East Coast main line from 2018 and on the Great Western main line from 2017. As a result, High Speed Trains 
(commonly known as 'InterCity 125' trains308) currently utilised on the Great Western route and Mk4 electric trains309 currently utilised on the East Coast 
main line will become available when new trains are introduced on these routes. If OAOs have an opportunity to access this rolling stock, this has the potential to improve competitive conditions for re-leased rolling stock, 
supplementing OAOs' ability to procure new rolling stock.310  
5.63 ORR noted in its consultation response that recent investment in rolling stock 
and electrification is likely to free up existing rolling stock, reducing this potential barrier to entry.  
5.64 Furthermore, where operators have sufficiently long access rights, there is 
evidence to suggest that obtaining rolling stock is not a barrier to entry. This 
currently used by Grand Central and First Hull Trains and that this constitutes a barrier to entry. the market, as the release of old stock might not be a viable option due to costs associated with extending their life cycle and bringing them up to the standards required for their continued operation. However, we note that Virgin/Stagecoach are proposing to use Mk4 intercity rolling stock in their application to run fast services from London to Edinburgh and that ScotRail is to start using High Speed Trains to improve services on longer-distance intercity routes, partly due to their popularity with passengers on the competing services operated by Virgin East Coast.   
has been the case in the international examples of on-rail competition that we considered in Chapter 3. In Great Britain, we also note that Alliance Rail is procuring new Pendolino units to operate its services from London to Blackpool under the Great North Western Railway brand.311 

5.65 In relation to the potential impact on delivering government-led rolling stock 
renewals, such as IEP, where both franchised TOCs and OAOs are active on a route, the impact assessment commissioned by ORR also noted that the rolling stock market seemed to be reverting to operator - and ROSCO - led procurement, which is more compatible with a multi-operator railway. Moreover, we note that First Hull Trains, an OAO on the East Coast main line, has ordered five IEP units and will therefore operate the same rolling stock as the incumbent franchised TOC (which will continue to operate older Mk4 trains). 

## Demand Uncertainty

5.66 Rolling stock lease costs represent one of the main cost drivers faced by train 
operators.312 We therefore considered whether increased competition could 
lead to greater uncertainty in the demand for rolling stock, leading to a price increase.  
5.67 However, in our view, if the overall effects of greater competition are 
considered, demand for rolling stock should not be negatively affected as a result of greater on-rail competition. As described in paragraph 5.85, on-rail 
competition is likely to lead to growth in passenger volumes. Therefore, despite potential shifts in franchised TOCs' market shares, we consider there to be only a low risk that there will be a drop in demand for rolling stock. Moreover, in a more dynamic market for passenger services, the possibility of rolling stock 'secondary trading' taking place between operators could further insulate against any such perceived risk. This potential risk was not highlighted as a concern in any of the consultation responses received.   
5.68 Furthermore, we note that increased on-rail competition could indirectly 
benefit the competitiveness of the rolling stock leasing market: (a) more commercially driven behaviours by train operators would support greater competition in the used/re-leased segment of the rolling stock market; (b) as 
seen from the recent open access applications on the East and West Coast main line services, OAOs are potential new entrants in the rolling stock market 
(whereas franchised TOCs are not), and this could serve to discipline incumbent ROSCOs. Recent open access applications made by Alliance, Grand Central and East Coast Trains Limited for the East Coast and West Coast main lines were all predicated on ordering new rolling stock fleets. 

## Financial Issues: Funding The Network And Operators' Financial Viability Introduction: Loss-Making Services And Their Funding Mechanism

5.69 As set out in our discussion document, the rail sector is fundamental to the 
economy of Great Britain.313 This point was emphasised by the DfT, Transport 
Scotland, ORR and a range of respondents to the consultation, including several regional transport partnerships. In particular, a number of respondents highlighted the importance of providing services which meet social and economic needs, but which would not be commercially viable without a 
subsidy.314  
5.70 The unprofitable element of a train service operated on a route could concern: 
 
the entire route;  
 
specific stopping patterns, ie only certain stops on a route could be lossmaking; or  
 
services operated at a particular time of day (for example, the first and last train services may be loss-making). 
5.71 In order to fund unprofitable elements of services, a system of cross-subsidies 
has been put in place: loss-making and profitable services are often bundled together in a single franchise, so that the franchised TOC finances unprofitable services to some extent through cross-subsidy from its profitable services.  
5.72 As described in Chapter 2, in 2013–2014 the government made an overall net 
contribution to franchised operators of £0.1 billion (as a result of £2.0 billion paid as subsidies and £1.9 billion received as premium payments). In addition, 
over the same period, the government contributed a total of £3.7 billion to the funding of the network in all franchise areas via the network grant.315  

5.73 From an economic point of view, in order to identify and quantify loss-making 
services, it is necessary to consider the industry value chain as a whole. Therefore, in addition to the revenues and costs associated with running the trains, the relevant portion of expenditure and revenues associated with the management of the upstream assets, ie track, stations and other essential facilities, should be identified.   
5.74 Figure 14 below provides a simplified description of the premiums paid 
(negative figures) or subsidies received (positive figures) by franchised TOCs (dark blue bars), as well as notional allocation of the government's funding of the network infrastructure for each operator (light blue bars). The net government funding per operator is illustrated by combining these two components 
(red bars).316  
 

Source: Analysis of data from ORR, GB rail industry financial information 2013–2014. 5.75 The figure shows that there are relatively few operators paying premiums to 
the government (negative dark blue bars). In absolute terms, as described above, these premiums initially offset the subsidies. However, taking into account the allocation of government infrastructure funding, there are only two franchised TOCs which receive no subsidy, ie East Coast and South West Trains (negative red bars).  

## The Impact Of On-Rail Competition On Government Funds

How on-rail competition may threaten government funds 

5.76 As set out above, the share of industry costs that is not met through 
passenger fares is financed through a mixture of direct government funding of infrastructure and cross-subsidisation between franchised TOCs through the franchise bidding process.  
5.77 In the absence of suitable restructuring of the current charging arrangements, 
a consequence of greater on-rail competition could be to increase the level of government subsidy required. This section considers the degree to which this 
might happen and provides the context to our proposed approach to managing this risk as part of any implementation of greater on-rail competition.  
5.78 Within the franchise bidding procedure, participants mainly compete for the 
market in terms of the level of subsidies (positive or negative) needed from the government to operate the rail services. An increased level of competition in the market is likely to reduce franchised TOCs' overall revenues, because (a) consumers are partly transferred from the franchised operator to the 
competitor(s), and (b) prices decrease due to competition.317 
5.79 Any significant reduction in premium payments could threaten: 
(a) the funding of network infrastructure investment (ie new entrants 'freeriding' on incumbents' investments - which could, in turn, undermine the 
business case for the government to make new investments318); and  
(b) the funding of services deemed socially valuable even if uncommercial (ie 
loss-making or of limited profitability), such as PSO operations (ie 'creamskimming').  
5.80 This risk is currently tackled by: (a) re-mapping the franchise area to limit 
franchise overlaps and competition;319 and (b) moderating open access 
competition, by allowing entry only if it is not expected to be primarily 
abstractive of revenue from the franchised TOC (ie the NPA test).320  
5.81 Before considering the impact of greater on-rail competition on government 
funds, we note that there is a trade-off between the delivery of passenger benefits and the impact on government funds. 
5.82 Some consultation respondents told us that our primary concern should not be 
to ensure that there is no impact on taxpayer funds, but that any impact is compensated by greater passenger benefits and efficiency in the rail sector. For example, Which? told us that the goal of the regulatory system for rail should be to deliver the quality of service that consumers are willing to pay for at the lowest possible combined cost, whether that cost is funded by passengers or taxpayers.   
5.83 However, given that government funds are used for financing a range of social 
objectives, including investment and unprofitable but socially valuable services, we consider the impact of on-rail competition on government funds in greater detail below.   
Impact of on-rail competition on fares, costs and demand 

5.84 Increased on-rail competition would be expected to exert downward pressure 
on fares and therefore reduce the level of cross-subsidy to unprofitable services from profitable services (on which competition would be likely to emerge). This would therefore increase the amount of government funds that are necessary to finance the system - although it would also generate a 
positive impact in the form of passenger benefits.321  
5.85 The magnitude of the impact may be mitigated by greater on-rail competition 
incentivising franchised TOCs to become more efficient (as discussed in 
Chapter 4). We also note that the impact may be further mitigated by greater on-rail competition generating demand growth. This could occur in two ways: 
 
OAOs targeting previously unmet but existing demand; and 
 
on-rail competition improving the quality of service, lowering fares and growing the market by leading to a transfer of passengers to rail from other transport modes.   
In Chapter 3, we present evidence from Great Britain and other European countries, which suggests that greater on-rail competition can generate growth in demand.  

5.86 We also note that our options for reform, set out in Chapter 6, seek to address 
the impact on government funds resulting from on-rail competition. The impact of our options for greater on-rail competition on government funds was also considered in the impact assessment commissioned by the ORR, details of which are set out in the assessment of each option considered in Chapter 6.   

## The Impact Of On-Rail Competition On Recent Franchise Awards

5.87 We considered the impact of on-rail competition on historical franchise bids. 
We found limited empirical evidence that on-rail competition had a negative impact on franchise awards, since in a number of recent tenders for franchises, bids have increased in value notwithstanding the presence of actual or potential on-rail competition.  
5.88 As an example, we note that on the East Coast main line franchise premiums 
increased on routes with significant current and prospective open access operations. GNER, the winner of the 1996 franchise competition, bid on the basis of an average premium of £130 million per year. In 2007, National Express won the franchise competition, bidding on the basis of an average premium of £190 million per year despite First Hull Trains having launched services in competition with the franchised TOC in 2000 and the award of access rights in 2006 for Grand Central to offer services from London to 
Sunderland.322  
5.89 In the 2014 East Coast franchise competition, Stagecoach and Virgin bid on 
the basis of an average premium of £410 million per year, despite the growth of First Hull Trains and Grand Central since 2007 (including Grand Central's introduction of services to Bradford in 2010). However, in the 2014 competition, bidders were indemnified against 80% of any revenue loss from failing to obtain sufficient train paths on the network to deliver the franchisee's key specified services, eg as a result of new open access services commencing during the period of the franchise. 
5.90 We note that it is extremely difficult to assess how high bids would have been 
absent on-rail competition. For example, the West Coast main line franchise has not been re-let and the East Midlands and Greater Western franchises changed in size when they were re-let. 
5.91 There are also a number of examples of on-rail competition leading to 
franchised TOCs increasing the number of services they run, including Chiltern Railways' main line services from London to Birmingham and London 
Midland's West Coast main line services, thus growing the value of the franchises. Moreover, we note that the most recent East Coast franchise specifies new services to destinations originally identified and made commercially viable by OAOs, such as Sunderland, again growing the value of the franchise.323 

5.92 We have had some indication from the DfT of the potential impact that the 
approval of recent open access applications would have on the finances of the franchise holder for East Coast main line routes which, as noted in paragraph 
5.89, would be indemnified for a proportion of the revenue loss should it be 
unable to secure the necessary train paths to deliver the key services specified in its franchise - and note that the financial impact would be 
significant.324   
5.93 However, we note that this financial impact is largely a consequence of the 
current open access regime in which: (a) franchise bidders face uncertainty 
about the future level of open access operations at the time of bidding; (b) OAOs pay only variable track access charges; and (c) there is no mechanism for the government to levy a charge on OAOs to contribute to the cost of unprofitable but socially valuable services. The options that we propose for greater on-rail competition involving open access in Chapter 6 are specifically designed to overcome these current issues.  
5.94 In this regard, Virgin/Stagecoach, the incumbent operator on the East Coast 
main line, told us that it was particularly concerned about the impact of greater on-rail competition in the current system in which there was no visibility at the time of franchise bidding of the level of on-rail competition that would be faced during the life of the franchise and in which there was limited ability to respond to on-rail competition given the specification of the franchise. As set out in its consultation response, Virgin/Stagecoach therefore support a greater degree of on-rail competition on long-distance routes if the current system is 
reformed.325   
5.95 ORR stated in its consultation response that the current system carries risks 
for the taxpayer in that open access has an uncertain set of revenue impacts, including the potential for open access to abstract some revenue from franchised TOCs and affect revenue streams to the government. However, ORR also noted that this abstraction risk may be offset by the extent to which 
competition from OAOs improves the performance of franchise operators and/or highlights opportunities for further market growth.  

5.96 In summary, we note that the DfT, ORR and a range of train operators have 
highlighted concerns regarding the way in which the current system of open access is operated, particularly in relation to the uncertainty regarding the future level of open access competition at the time of franchise bidding and a limited ability to respond to such competition given franchise specification. We have therefore sought to address these concerns in designing the options for greater on-rail competition set out in Chapter 6.  

## The Effect Of Greater On-Rail Competition On Investment Business Cases

5.97 The business cases for new investment in infrastructure are based on the 
expected costs and economic benefits of the investment. It was put to us that having multiple operators on a route may undermine the business case for investment as the government is less able to forecast the utilisation of the new infrastructure (as it will not be fully specified and not operated solely by a 
franchised TOC).326  
5.98 In particular, DfT noted that when making an investment decision, it takes 
account of the potential for the new revenue generated to offset, to some extent the investment costs. If an OAO enters and captures this revenue, it can have a dramatically negative impact on the investment case. The DfT also noted that it considers a variety of non-revenue related benefits which, in its view, an OAO will ignore. The DfT also stated that it tends to have a longerterm outlook than a commercial operator when considering the case for investment.   
5.99 We recognise the importance of investment in the network and rolling stock in 
ensuring that the railway is able to meet the needs of passengers and society in the future, particularly as passenger demand continues to grow. We have therefore considered how major investment projects would be safeguarded in an environment where there is more on-rail competition and we have also considered the potential for on-rail competition to drive greater private sector investment.  

## Safeguarding Investment

5.100 A key element of safeguarding investment in the railway is to ensure that the 
business cases for major projects are not adversely affected by on-rail 
competition. In theory, if the business case is economically credible and the demand forecasts accurate, the investment is likely to be fully utilised on commercial intercity routes regardless of the identity of the operators.  

5.101 As set out above, there is evidence that greater on-rail competition leads to 
growth in passenger numbers, and to more efficient discovery and use of capacity, which should boost the business case for investment. In this regard, 
we note the example, cited above at paragraph 4.36, of First Hull Trains 
seeking private sector finance to electrify the line from Selby to Hull - an 
initiative that both it and franchised TOCs would benefit from.327 Moreover, the 
wider economic case for investment, including socio-economic benefits, should not be adversely affected by on-rail competition.  
5.102 In Chapter 6, we consider a number of safeguards and mechanisms for 
ensuring that greater on-rail competition does not undermine investment business cases. In summary:  
 
First, we note that ORR would continue to have a role in determining open access applications, including the rolling stock used. As an example, if an OAO applied to use diesel rolling stock on a route undergoing electrification upgrade work, a mechanism would be in place to prevent this. 
 
Secondly, there are a number of mechanisms through which the cost of investment could be recouped for the taxpayer from competing operators. For example, Arriva told us that investment costs could be recouped through rebate payments made by operators who utilise the infrastructure and who benefit from the enhancement (this was the approach taken in the Chiltern route enhancements, as discussed below at paragraph 5.106).   
Driving greater private sector investment 

5.103 It is important to consider the distinction between privately and publicly funded 
investments. Some consultation respondents argued that private investment in the railway network, under the current framework, is low relative to some 
other sectors.328 
5.104 Arriva also told us that if industry arrangements were developed to reduce 
constraints on operator business planning timescales, there would be significant opportunity to leverage genuine third party investment into the industry, with larger-scale open access acting as the catalyst for moving away from reliance on infrastructure funding by government to operators with 
longer-term access rights.329   
5.105 Figure 15 shows that a net total of £647 million was invested by private 
companies (excluding Network Rail) in the rail industry during 2014–2015 
(green line). This represents an increase of 53% from the previous year (51% in real terms). However, private investment in network infrastructure (ie in stations, track and signalling) is much lower and declining (brown line). In 2014–2015, less than £1 million of net private investment was made in track 
and signalling; in addition there was a net sale of £128 million of station assets (exceeding station investment) which made the overall private investments in the railways network negative in 2014–2015 (ie –£127 million). 
 

Source: ORR. Rail Finance 2014-15 Annual Statistical Release. 5.106 We note that increased on-rail competition could drive greater private sector 
investment, especially on the commercially attractive intercity routes where operators have strong commercial incentives. Moreover, greater certainty in the open access application process and the possibility of longer access rights would allow operators to have a longer business planning timescale, possibly 
allowing a fair return on larger investments. There could be a number of mechanisms in a competitive environment in order to recover the costs of investment in infrastructure, for example it would be possible to charge a fee to train operators using new infrastructure. This approach was adopted in order to finance the Chiltern Railways 'Evergreen 3' project which enhanced capacity between London and Birmingham.330 A similar mechanism is proposed in the plan by First Hull Trains to electrify the line from Hull to Selby 
(see paragraph 4.36).  

5.107 In addition to undertaking major upgrade work on the London–West Midlands 
route in partnership with Network Rail in response to on-rail competition, Chiltern Railways has planned new services that will run from London Marylebone to Oxford for the first time, starting in late 2016 (with services running as far as Oxford Parkway since September 2015).  
5.108 This project involved constructing new track and stations at Oxford Parkway 
and Bicester Village.331 Chiltern Railways invested £130 million of the total 
£320 million cost of the new line and stations, with Network Rail contributing 
the remainder.332 A number of innovations are planned on the new route, 
including free 4G wi-fi contactless payment for services between London and Oxford Parkway. As noted in Chapter 3, the new line introduces on-rail competition between Chiltern Railways and the parallel route from London Paddington to Oxford operated by First Great Western.  
5.109 A further example is Grand Central's investment in stations. Following the 
extension of its operating licence in 2014, Grand Central pledged additional capital investment in order to further improve passenger facilities (ie upgrading the station building, parking facilities and waiting rooms) at 
Wakefield Kirkgate and Northallerton stations, in cooperation with Network 
Rail, local authorities and station facility owners. 

## Impact Of On-Rail Competition On Public Funds Identified From Other European Experiences

5.110 We considered the impact of on-rail competition on public funds identified 
from other European experience. As described in Chapter 3, on-rail competition has developed in a number of other European countries, ie to a limited 
extent in Germany and, more extensively, in Austria, the Czech Republic, Italy and Sweden.  

5.111 In most of those countries, there is a clear separation between commercial 
and PSO services and competition 'in' the market takes place exclusively on 
purely commercial routes (see Chapter 3).333 Therefore, in these cases, the 
development of open access competition has only had an indirect impact on PSOs and government funds, which cannot be easily assessed. Public subsidies and funds allocated to rail passenger services directly depend on policy decisions in individual countries as to which public services to provide and how these should be financed.  
5.112 For example, in some European countries (eg in Germany and Italy), a policy 
choice has been made to sustain the development and complete liberalisation of high-speed services with public funds (implying lower passenger fares) due to the overall positive impact on the economy this is likely to have. In Italy, the scope of PSOs has been redefined at regional and intercity level for services other than high-speed so that, effectively, the requirement to stop at certain 
stations has been eliminated and some prices have increased.334 However, 
the OAO in Italy told us that some regional and intercity services, traditionally covered by PSOs and subsidised by the government, could be run as commercial services, should legal barriers to open access entry be removed.   
5.113 In Sweden, liberalisation and competition have been expressly supported by 
government. In order to sustain a greater level of competition in the market, commercial services can be modified by commercial operators agreeing with regional public authorities to run certain PSOs, applying a licensing system of 'voluntary obligations'. 
5.114 In the Czech Republic, the impact of open access competition on the revenue 
of incumbent operator - and, therefore, on the subsidies and public funds required to support its operation on services included in PSCs - appears to be low. Specifically, despite the high market share of OAOs operating on the route, competition has not resulted in a significant demand abstraction from 
the incumbent operator due to the significant generation of new demand and the increased connectivity that OAOs have created (see paragraph 3.80). 

## Fixed Access Charges And The Network Grant

5.115 In this section, we consider the contribution of OAOs to fixed network costs in 
the current framework and the potential for OAOs to pay more cost-reflective access charges.   
The contribution of OAOs to fixed network costs 

5.116 The current access charge framework scheme was not primarily designed to 
sustain or promote a high level of competition in the market, especially from OAOs.  
5.117 As described in paragraph 2.58, OAOs currently pay only variable charges, 
not contributing (or contributing to a smaller extent)335 to the fixed costs of the 
network. This reflects the risk involved in building a commercially viable OAO 
operation and incentivises the efficient use of otherwise underused capacity. Moreover, compared with franchised TOCs, OAOs have marginal and limited 
access to the network.336  
5.118 However, within a scenario of increased open access competition where 
OAOs enjoy access rights similar to franchised TOCs, OAOs could be asked to pay an increased contribution to network costs through increased track access charges, as considered in our options for reform set out in Chapter 6. Within a proper time frame and adopting a cost-reflective approach to setting access charges, OAOs could contribute to the fixed costs of the network 
through some form of mark-up. 
5.119 As described in Chapter 2, ORR is currently considering as part of its 
structure of charges review whether OAOs should pay cost-reflective charges, which would also cover some of the fixed costs of the infrastructure they use (especially where network capacity is scarce). In order not to impose an excessive burden on OAOs, ORR is also considering possible adjustments and transitional arrangements in order to take into account the existing market differences and long-term business decision taken by OAOs which are 
already in the market.337  
5.120 Moreover, although in general terms the franchise premiums and subsidies 
approximately net off each other, franchised services are still in receipt of an indirect subsidy through the network grant. Consequently, across the whole network, revenues from passengers using a franchised service do not cover the costs of providing the network.  
5.121 However, the netting-off conceals the fact that profitable franchised services 
cross-subsidise unprofitable ones. In so far as OAOs would reduce premiums paid to government, there is a case for OAOs to contribute to loss-making 
services.338 Furthermore, an OAO running an equivalent service to a 
franchised TOC would not currently pay FTAC and so would not make as great a contribution from ticket revenues to network costs as a franchised service.  
5.122 In principle, as we discuss in Chapters 6 and 7, different compensation mechanisms could be adopted, eg a universal service levy339 or some obligations to 
operate unprofitable but socially valuable services being imposed on new 
entrants340 as well as incumbents or a combination of these mechanisms.  
5.123 We are conscious that higher access charges and any PSO levy should not 
act as an unjustifiable economic barrier to entry and specifically sought the views of potential entrants on this question in our consultation. In Chapter 6, we therefore consider how access charge reform and the payment of levies 
could be introduced without acting as a disincentive to entry.341  
5.124 We consider the potential for OAOs to make a greater contribution to the cost 
of the network through a level playing field in track access charges with franchised TOCs and the payment of a PSO levy in Chapters 6 and 7.   
support for this solution, envisaged by Article 12 of Recast Directive 2012/34. On the other hand, a consultation respondent - REGUTRAIN - suggested there could be a risk that a PSO levy might not work as an effective substitute for cross-subsidisation, if the necessary PSO funds are a large proportion of the overall industry turnover. 

340 This solution has been adopted in Sweden (see paragraph 5.113). The Railways Consultancy Ltd, in its consultation response, was of the view that OAOs could negotiate the provision of PSOs with the DfT. As a general point, the allocation of PSOs to OAOs could increase the general profitability of those services and lead to savings of public funds to the extent that the new entrants are more cost-efficient than the franchised TOCs. 

341 FirstGroup focused on the different impact that changes to access charges would have on OAOs compared with franchised TOCs, given that franchised TOCs are currently indemnified for any such changes during the franchise period. As a general point, an increase in charges would be reflected by franchised TOCs in the bidding process and most likely passed on to the government in terms of higher subsidies requested or lower premium paid. 

5.125 In the current funding and charging model, access charges reflect the shortterm variable costs imposed by operating trains on the network, but recover fixed costs from franchised operators in a way that does not closely reflect the longer-term costs of their use, or the scarcity of capacity.  
5.126 As described in Figure 1, the total costs of operating the network are currently 
much higher than the amount raised each year through FTAC, with the differential mostly covered by direct government subsidy to Network Rail, ie 
via the network grant.342 Since the network grant is not directly linked to costs, 
almost 70% of Network Rail's income comes from sources which are not costreflective (ie 62% from the network grant and 7% from FTAC).343   
5.127 The existing charging structure therefore has limited ability and incentive to 
reduce costs and to encourage efficient decision-making both for franchised 
TOCs and new entrant OAOs. In particular, since the charges for using the 
network are not fully cost-reflective, if new entrants were to face these costs, they would not receive the right signals as to whether the benefits of running their services outweigh the (actual) costs. If charges were more costreflective, eg if they distinguished more between areas with higher demand/cost and lower demand/cost, this could send more effective and informative signals to new entrants. 
5.128 In CP5, ORR embraced a more cost-reflective approach to access charge 
definition. ORR substantially increased the capacity charge, in order to ensure the recovery of network costs according to network performance. ORR also undertook a general recalibration of all charges in order to improve the extent to which charges reflect underlying infrastructure costs. ORR used up-to-date 
estimates on costs (eg on the electricity asset usage charge344 and coal 
spillage charge345) and improved its cost models (eg on the traction electricity 
charge346 and the variable usage charge347). Moreover, ORR considered 
some avoidable network costs which were not previously recovered by other 
charges and reflected those costs in the charging scheme (eg a new freightspecific charge348 was introduced). 

5.129 In addition, as outlined above, ORR is working with the industry to implement 
a comprehensive review of Network Rail's structure of charges aimed at removing some of the distortions in the current funding structure. The new structure of charges should be in place by the start of CP6 in 2019, before any of the changes we are proposing would come into effect.  

## Franchise Scope And Service Specification Scope Of Franchises And Public Service Contracts

5.130 In Great Britain, franchises often include a bundle of profitable, potentially 
competitive, routes and loss-making routes. The adoption of this funding approach has resulted in the majority of passenger rail services - around 99% 
- being included in franchises,349 covered by PSCs (franchise agreements), 
and therefore potentially considered PSOs.  
5.131 A number of stakeholders are supportive of PSOs being more clearly defined 
in PSCs and distinguished from commercial services, as a prerequisite for 
introducing a higher level of on-rail competition in the market.350 In this regard, 
some consultation respondents are of the view that the government could be less involved in the commercial parts of the industry with the DfT limited to franchising PSOs.  
5.132 This extensive designation and allocation of unprofitable but socially valuable 
services, including PSOs, represents an obstacle to greater on-rail competition351 because it allocates the great majority of the available capacity (which is a scarce resource)352 to franchised TOCs and creates exclusive rights (and 
obligations), limiting market-oriented behaviour.  
5.133 Due in part to the need to protect profitable services from competition, franchise overlaps have been progressively reduced in recent years. Moreover, 
additional commercially driven services would be likely to abstract revenue from franchised TOCs on both profitable and unprofitable services. 

5.134 In most European cases considered where on-rail competition has developed, 
the percentage of PSO services over total services is much lower, especially on high-speed and long-distance routes where the average is around 30% 
against more than 80% for Great Britain (see paragraph 3.93).353 Furthermore, in those cases, there is often a clear-cut distinction between commercial and PSO services, ie the PSO services are more clearly defined to cover unprofitable but socially valuable services and open access competition focuses only on non-subsidised areas. 
5.135 Some train operators told us that on routes such as the East Coast main line 
there would be very few, if any, PSO services. However, the majority of regional services may, in the view of operators, be classified as PSOs. We were told by operators that the data required to identify which services are PSOs and those which are not is already available. Given that the definition is a key component of introducing any levy on commercial services to fund PSOs, we consider the point further in the design of our options for greater on-rail competition in Chapter 6. 

## Franchise Agreement Specification

5.136 As described in Chapter 2, many franchise agreements in Great Britain have 
historically been tightly specified, even in those areas where the market could provide the right signals. A number of changes were made to the franchising programme following the Brown Review in order to maximise the benefits of competition 'for' the market, including allowing franchised TOCs more commercial freedom in areas such as rolling stock procurement.  
5.137 However, the prescriptive nature of some franchise specifications can limit the 
ability of operators to adapt to passengers' changing demands. A number of consultation respondents highlighted that the current degree of rail passenger service specification restricts the freedom of franchised TOCs to respond to 
competition.354   
5.138 In addition to limiting the potential for competition, this approach implies some 
hidden costs which should be considered in a broader cost/benefit analysis. These costs arise due to the lack of transparency in market dynamics and signals, the limited ability for operators to respond to market evolution and 
consumers' preferences and, finally, the high risk of regulatory failure associated with a highly centralised approach to market design. 

5.139 While franchise specification has the potential to limit the extent to which new 
operators can develop commercial strategies in response to passenger demand - and the extent to which incumbent operators can respond to competition - we note the important rationale for including a degree of specification in franchise agreements. In this regard, some regional 
representative groups355 expressed concerns about the impact of greater onrail competition on the provision of non-profitable but socially valuable services interconnectivity, especially in the event that franchise service specification is relaxed.  
5.140 Franchise specification has a particularly important role in ensuring the 
provision of unprofitable but socially valuable services and in safeguarding service and quality levels of routes facing little competition, such as commuter services. Services that are not commercially viable but which are socially valuable often require more intervention in order to secure the desired social benefits. On commuter routes, operators may have less incentive to deliver service quality and innovation given inelastic demand, crowding and fare regulation, meaning that greater specification is required. Nevertheless, as some industry stakeholders have indicated, there is potential for more dynamic service specification to allow service offerings to evolve in line with passengers' preferences.   
5.141 On longer-distance intercity routes, it is important to balance the need for 
some specification (such as first and last trains) with the need to ensure that operators are able to respond to passenger demand and, where there is onrail competition, to respond to the strategies of other operators. We consider 
this balance in more detail in our design of options for greater on-rail competition in Chapter 6. More generally, as stated in Chapter 2, we recognise that the franchising programme is already moving towards less tightly specified franchises.  

## Sustainability 'Price War' And Operators' Financial Viability

5.142 We considered the risk that on-rail competition, in driving down prices, would 
threaten the financial viability and sustainability of operators.  
5.143 In particular, we have considered the risk that once the core franchise 
payment schedule had been agreed at the start of the franchise, on-rail competition could drive prices down as low as the marginal cost of providing a 
service.356 This would mean that ticket prices would not cover relevant fixed 
costs, possibly leading to an operator ceasing to be financially viable and exiting the market. 
5.144 However, there are a number of factors that mitigate this concern: 
 
First, we note that the cost-reflective track access charges that we propose would be paid by both new entrants and incumbents (set out in further detail in the Chapter 6) would constitute a 'price floor' for all 
operators. 357 
 
Second, TOCs do not compete only on price but also on quality and there is some degree of product differentiation in the passenger rail market, eg high-speed/traditional services; 'no frills' solutions and services combined with bus tickets or car rental. This may limit the intensity of price competition. 
 
Third, capacity constraints exist on a number of rail routes in Great Britain. This may prevent prices from falling to marginal cost as, if a price war started and more passengers were attracted to services, some trains would become full and operators would find it difficult to attract additional passengers by lowering prices.  
 
Finally, as discussed in the next section, we note that financial viability 
concerns have not forced any OAOs in Europe to exit the market.358  
5.145 This potential concern was set out in our consultation document but was not 
raised by respondents to the consultation. 

## Financial Viability Of Open Access Operation In Continental Europe

5.146 Some consultation respondents told us that the European experience of open 
access competition, described in Chapter 3, has led to uncertainty regarding the financial sustainability of operators and that several OAOs have faced financial difficulties.  
5.147 In the European examples considered, where few entry restrictions and no 
PSO obligations were in place, open access competition has resulted in downward pressure on prices in a number of European countries. This has benefited passengers but in some cases it has also created concerns about the longer-term viability of some operators.  
5.148 In the Czech Republic, open access competition on the completely liberalised 
Prague–Ostrava route put intense downward pressure on prices and led to concerns regarding the long-term sustainability of three operators competing on the same route.  
5.149 After nearly four years of operations, one of the Czech Republic's OAOs has 
not yet achieved profitability, although their financial performance is improving 
both in terms of EBITDA and overall losses.359 The other OAO reported a 
profit for the first time in 2015.360 In order to put this in context, it is important 
to note that, in contrast to Great Britain, on the Prague–Ostrava route all three operators (the two OAOs and the incumbent) run services on a purely commercial basis (ie no direct public subsidies or premiums are paid), and the incumbent is vertically integrated with all its other services being directly awarded. The competent public authority is considering a number of policy solutions, including establishing a licensing regime accompanied by licence obligations and/or defining basic essential services to be awarded through a 
competitive tendering process.361 
5.150 Separately to this, both Czech Republic OAOs allege that the incumbent 
operator has abused its dominant position to undercut its competitors by 
adopting a predatory pricing strategy, sustained by cross-subsidisation and that this distortionary practice has had an impact upon their profitability.362  

5.151 In Italy, the OAO experienced financial difficulties during its start-up period;363 
however, the operator told us that it is expecting to generate profits in 2016 and, for this reason, its share capital was substantially increased in 2015. The Italian OAO also told us that its financial performance was negatively affected by what it considered to be a disproportionate level of access charges (later decreased by the newly established sector regulator) and the lack of level 
playing field due to the presence of a vertically integrated incumbent.364  
5.152 Similar problems characterised the start-up period of the Austrian OAO's 
operation, which achieved low unit revenues due to intense price competition 
with the incumbent, which the OAO alleged to have been predatory.365 
However, the OAO managed to adapt its business model in response and, 
after four years in operation, it is currently meeting its operating costs.366  
5.153 In contrast, in Sweden, where long-term vertical separation has allowed a 
more level playing field and PSO services have been generally awarded by way of a competitive bidding process, open access competition does not seem to have created serious concerns about the longer-term viability of competing operators.  
5.154 MTR, which recently commenced services on the Stockholm–Gothenburg 
route, told us that its revenues are showing a positive trend and are growing in line with its business plan. As set out in Chapter 3, because of the competitive pressure exerted by the new OAO, fares on the Stockholm–Gothenburg route have decreased. However, while MTR and the incumbent have offered fare discounts, they also compete on factors including service quality, and there does not appear to be any evidence of a 'race to the bottom' in fares. Another example relates to the incumbent, which terminated its Gothenburg–Malmö service in 2012 after an OAO introduced high-frequency services. However, after two years, the incumbent re-entered the high-speed services market, matching the new OAO's on-board service quality (eg with free wi-fi).  
5.155 We note that, in each of these countries, OAOs commenced their activities 
relatively recently and that new entrants in capital-intensive sectors (such as 
railways, but also telecoms or energy) often experience losses during their start-up period. The capital-intensive investments and entry costs that a number of European OAOs have incurred (eg the purchase of new rolling stock in the Czech Republic, Italy and Sweden) may signal the medium- to long-term business objectives of these OAOs. This approach in their business model appears contrary to a 'hit and run' strategy, which might risk the financial stability and sustainability of the industry.  

5.156 Moreover, in the countries examined, the market entry costs of OAOs have - 
in contrast to the system in Great Britain - been influenced by the presence of vertically integrated incumbent holding companies. 
5.157 In summary, the experience of the European OAOs shows that there have 
been some financial sustainability issues. However, we note that these operators are still in the early years of operation and that some of the issues may be due to the presence of vertically integrated incumbents. In Chapter 6, we have considered the potential impact of access charges and levies on financial sustainability in designing our options for greater on-rail competition.   

## Potential Adverse Effects Of An Increased Number Of Operators

5.158 Greater on-rail competition would be likely to lead to a higher number of train 
operators (either franchised TOCs or OAOs) using the network. It has been put to us that this could create a number of operational issues, including:  
 
inefficient use of capacity as a result of more operators, with varied journey times and stopping patterns and using a wider range of rolling stock with different performance and reliability characteristics (see 
paragraphs 5.160 to 5.165); 
 
interconnectivity problems (paragraphs 5.166 to 5.177); 
 
adverse impact on performance and greater difficulty in recovery from disruption (paragraphs 5.178 to 5.183); and 
 
conflicting slot requests and timetabling issues, which may also affect strategically important changes to facilitate the provision of new services, such as HS2 (paragraphs 5.184 to 5.191). 
These operational issues have also been considered in the impact assessment commissioned by ORR.367 The operational impact of each option for greater on-rail competition is set out in Chapter 6. 

5.159 We also note that an additional potential adverse effect of an increased 
number of competing operators could be the creation of a greater complexity 
in the system, in particular by creating: 
 
higher transaction and coordination costs for the industry players (paragraphs 5.196 to 5.197); and  
 
a negative impact on rail passengers, by a way of a more complicated ticketing structure, or by making the provision of interavailable fares more complex (paragraphs 5.198 to 5.206). 

## Operational Issues

Suboptimal use of capacity as a result of an increased mixed use of the network 

5.160 A number of consultation respondents368  expressed the view that having a 
multiplicity of operators on the network, with varied journey times and stopping patterns, using a wider range of rolling stock with different performance and reliability characteristics could lead to a suboptimal use of the existing capacity.  
5.161 We are conscious that a multiplicity of operators on the network (including 
freight, commuter, regional and intercity services), while delivering important social objectives, reduces the number of services that can be operated relative to a theoretical maximum network capacity. We note that on two of the long-distance routes on which we are considering options for greater on-rail competition, there are already a significant number of operators. On the East Coast main line, for example, there are currently nine major operators.   
5.162 However, greater on-rail competition on intercity routes would not be expected 
to lead to a significant increase in the complexity of operations as new operators would run intercity services using rolling stock that was approved by the ORR as having performance characteristics which would not adversely affect the timetable. There would be no change envisaged in the mix of service types (ie freight, intercity, commuter). It is therefore important that operational issues are judged on a case-by-case basis.  
5.163 Network Rail told us that it did not consider that a greater number of operators 
would increase the costs of running the network or result in adverse performance issues (for example, in comparing the East Coast main line with the Great Western route). Nevertheless, Network Rail suggested in its consultation response that a greater mix of different services on the network would make it more important to have the right information and incentives to achieve the right balance between different types of trains and services.  
5.164 In addition, Network Rail told us that increased on-rail competition should not 
result in less network capacity being granted to freight operators, which it highlights are of great importance in terms of both economic and social benefits generated. The need to ensure sufficient capacity for freight was also 
noted in the responses of some passenger train operators.369 A number of 
consultation respondents370 noted that trade-offs between ensuring the variety 
of the network's use and capacity optimisation exist; nevertheless, a mixed use of the network was feasible, in order to serve wider economic and social objectives.  
5.165 Other respondents, particularly regional transport partnerships, expressed 
concern that more intercity services could interfere with commuter and regional services. However, our options for greater on-rail competition set out in Chapter 6 envisage competing services using existing intercity paths and, potentially, new paths that become available from capacity enhancements. Therefore, while we are conscious of the need for a mix of services to be operated in order to ensure that the railway delivers its wider objectives, our recommendations are designed to facilitate greater on-rail competition without adversely affecting non-intercity passenger services and freight services. 

## Interconnectivity

5.166 Rail services competing on a larger scale would require an increased focus on 
interconnectivity, ie ensuring that different train operators' service paths efficiently interconnect with each other at stations in order to exploit the full value of the network and the possible growth in demand and service frequencies. This task becomes more challenging when competing operators are different 
in scale.371  
5.167 A number of regional bodies expressed concerns that increasing competition 
would undermine the integrated nature of the transport networks which underpin the economic growth of their regions (eg Wales and Greater 
Manchester).372 Interconnectivity is an important characteristic for regional 
routes and one local transport group mentioned in its consultation response that connections (including those with buses) are already inflexible under the current framework, suggesting that the problem is compounded when there is 
more than one operator on a route.373  
5.168 Transport Scotland stressed that any arrangements to introduce greater 
competition on the East and West Coast main lines should not have an adverse impact on connectivity, frequency, service reach or quality within Scotland. A local transport group told us that whichever model of competition is used, connectivity should be maintained and enhanced for the benefit of the rail system, passengers and the nation as a whole, given that connectivity 
drives economic growth.374  
5.169 Network Rail told us that, in the current framework, although consideration is 
given to connectivity in the timetabling process, there are many thousands of possible connections that passengers can make on the network and that the degree of interconnectivity that can be achieved is limited. We also note that in all our recommended options for greater on-rail competition detailed in Chapter 6, Network Rail (or the system operator responsible for the timetabling process) would retain the ability to timetable services to ensure connections are maintained.  
5.170 Moreover, passenger train operators told us that, in practice, the timetable is 
designed by the industry on its own in a decentralised way and is driven by the access rights of the individual operators. In this framework, it is not evident that a greater number of operators would harm connectivity. We also note that where operators are competing more intensively for passengers, they may have greater commercial incentives to attract passengers from feeder services by ensuring good connections (and to offer onward connections to their own passengers). 

## Performance

5.171 Operating additional rail services on an already congested network could 
affect network performance (in terms of punctuality and reliability), as the 
network would be more intensively used. This is more likely to occur if no additional capacity were made available as a result of network enhancements (ie using new technology) or improved network capacity identification and management.  

5.172 It was suggested to us by a TOC owner group (without open access 
operations) that greater on-rail competition may have an adverse effect on punctuality by increasing the difficulty of coordinating traffic on the network. Moreover, with a greater variety of services operating within a more complex timetable, any deviation from on-time operation could have a wider knock-on effect on other services and on overall punctuality. Indeed, concern about the potential for overlapping franchises creating operational conflicts formed part of the rationale behind the franchise re-mapping and simplification carried out by the SRA in the early 2000s.  
5.173 We found relatively limited empirical evidence in relation to this concern. Arup 
(2009) examined evidence on the Public Performance Measure (PPM), which reflects punctuality, finding that some franchise re-mappings which reduced franchise overlaps may have resulted in improved punctuality. However, Arup (2009) also found that punctuality on the East Coast main line improved in the 
period in which open access was introduced.375 There are currently nine major 
passenger operators on the East Coast main line plus a number of freight operators - yet average punctuality indicators have the highest score in that area.   
5.174 This is consistent with the view put to us by some industry experts that the 
impact of on-rail competition on performance may be route-specific.376 For 
example, capacity bottlenecks on the network affect different routes to varying 
degrees and, in turn, the impact that a greater number of operators has on 
punctuality. The successful operation of three franchised TOCs between Newcastle and Edinburgh - a section of the East Coast main line with less severe capacity constraints - was cited by one OAO as evidence of this. Network Rail also cited the example of London Midland and Virgin Trains competing on the West Coast main line without an adverse impact on punctuality. 
5.175 The extent to which the rolling stock and stopping patterns of competing operators differ may also determine the impact of competition on performance. Similar rolling stock operating services with similar calling patterns is less 
likely to create operational conflicts, although we note that a number of franchises successfully operate with a mix of rolling stock (including the Greater Western, East Midlands and East and West Coast main line franchises). In this regard, we note that greater on-rail competition would provide an incentive for operators to compete to serve key stations with the latest rolling stock. Moreover, in reviewing open access applications, ORR examines the rolling stock that OAOs plan to use to operate their proposed services and would not grant access where there would be any significant adverse impacts on performance.  

5.176 It was also put to us that the 'Schedule 8' indemnity that is included in track 
access agreements incentivises operators to plan their services in a way that will avoid disruption to services of other operators. Schedule 8 is also considered by ORR to incentivise Network Rail to coordinate the services of 
different operators as effectively as possible.377 Compensation payable covers 
fare revenue losses and costs (eg the cost of running replacement bus services). 
5.177 Moreover, greater on-rail competition would help to provide the correct signals 
and information for deciding on market trade-offs, eg between capacity maximisation and performance (ie punctuality/reliability), more effectively than a centralised process (see paragraph 4.33).  
5.178 It should also be noted that other operational factors, such as the requirement 
to provide unprofitable but socially valuable services (eg PSOs), which may include stops at less popular but nevertheless strategic stations, and to run suburban services alongside intercity services into key terminus stations in urban areas, will have some impact on performance regardless of whether there is greater on-rail competition.  
5.179 As considered in more detail in our assessment of the options for greater onrail competition in Chapter 6, we note that the impact assessment commissioned by ORR did not identify any significant operational barriers to greater on-rail competition.  

## Recovery From Disruption

5.180 It was put to us by some consultation respondents378 that it would be more 
difficult for the network to recover from service disruption with a greater 
number of competing operators having potentially conflicting commercial interests. It was also suggested that it would be necessary to designate operators of last resort.379 

5.181 However, the system is already designed to work with multiple operators (with 
most routes having more than one passenger or freight operator). Network Rail actively manages the response to disruption and current rules provide arrangements for ticket acceptance across operators once a certain disruption 
threshold is reached. Part H of the Network Code380 includes a requirement 
for operators to comply with the Railway Operational Code, which obliges operators to work together to recover from disruption, having regard to the needs of passengers and freight customers. Operators also have a range of obligations to provide passenger information during disruption, stations already show passengers all trains operating, and ORR is able to deal with inadequate responses to disruption through operators' licences.  
5.182 Moreover, the Rail Delivery Group plays an important part in promoting and 
developing operational best practices between passenger train companies, 
freight operators and Network Rail.381 This has the effect of enhancing the 
proper functioning of the system and, also, minimising disruption.    
5.183 Network Rail told us in its consultation response that increased competition 
from multiple operators may actually help performance and service recovery. This is because OAOs have a greater incentive to perform well, as they are seeking to attract new customers in new markets. 

## Conflicting Slot Requests And Timetabling

5.184 Within the current framework, the slot allocation process prioritises existing 
access rights allocated within the franchise agreements. Once any additional service applications (either from open access or franchised operators) have been successful and resulted in a track access agreement (subject to ORR approval and guidance), the access rights set out in the track access agreement are converted into the working timetable through the process outlined in Part D of the Network Code.  
(Part J), performance (Part L) and appeals (Part M). Access Dispute Resolution Rules are set out in the Annex. 

381 The Rail Delivery Group was set up in 2011 to provide leadership to Great Britain's rail industry, bringing together train operating companies, freight operators and Network Rail. 

5.185 The timetabling and timetable recasts are managed by Network Rail and 
based on demand traffic forecasts which are carried out following a transparent process that includes public consultations.382 In the case of conflicting 
requests with equal priority, Network Rail decides which train slot to include into the timetable plan according to the criteria set in Part D of the Network Code, eg to make journey times 'as short as reasonably possible' and 'enabling operators of trains to utilise their assets efficiently'. Network Rail can 
modify either or both train slots if timetable capacity exists.383 
5.186 Greater on-rail competition may lead operators to propose timetables that 
include a higher number of conflicting slot requests. In an enhanced competitive environment, the system operator has to design a nondiscriminatory and efficient slot allocation mechanism.  
5.187 As set out in the next section, ORR is currently undertaking work with a view 
to improving Network Rail's performance as a system operator, building on the commitments given in its PR13 determination. In particular, the project is looking at improving the availability of information about system operation activities, including through the publication of a system operation 'dashboard', and is also starting to consider how the regulation of system operation activities could be improved as part of the next periodic review. 
5.188 Moreover, in the context of greater on-rail competition, different allocation 
systems could be considered, eg the airport slot allocation system.384 
Although there may arguably be greater complexities in slot allocation in railways than in air transport (airport slots are for take-off and landing only, whereas rail slots must reserve track for the whole journey), Network Rail could take a more active role in managing the timetable, while reforms to access rights could increase flexibility, opening up more opportunities for new entry.  
(ii) 'grandfathering' - existing users retain slots subject to rules governing the frequency (at least 80% during the summer/winter scheduling period); (iii) slot switching - slots which are not sufficiently used by air carriers are reallocated, the so-called 'use it or lose it' rule; (iv) promotion of new entrants' access - if the 80% threshold is not reached, the slots go to a slot pool for allocation and 50% of the pool slots are allocated first to new entrants (defined as a carrier with only a limited presence at an airport). Finally, the airport package adopted on 1 December 2011 explicitly allows airlines to trade slots with each other at airports anywhere in the EU in a transparent way ('secondary trading'). 

5.189 An alternative slot allocation mechanism could be based on a 'cooperative 
approach', ie having the system operator facilitate agreement between 
parties.385  
5.190 Finally, there have been policy proposals looking at slot auctioning mechanisms, in particular combinatorial auctions, where participants make their bids contingent on getting a set or combination of the rights being auctioned rather 
than having to bid for rights individually.386 Network Rail told us that greater 
on-rail competition would necessitate having a bidding system for access rights in order to minimise the risk that capacity could be inefficiently left vacant. 
5.191 In summary, an efficient capacity and timetabling allocation process is necessary for greater on-rail competition to deliver its potential benefits. As set out above, the current framework is designed to work with multiple operators and the mechanism for allocating capacity could be further strengthened in an environment of greater on-rail competition, as described in Chapter 6. 

## Operational Issues And The Role Of A System Operator

5.192 We note that the operational issues discussed above could be addressed by 
enhancing the role of the system operator, and focusing on a clear definition, 
and effective implementation of, the functions carried out by Network Rail.387  
5.193 While a number of respondents,388 mainly regional bodies, suggested that a 
higher number of operators in the market would increase the fragmentation and operational issues in the rail system, other consultation respondents, 
including Network Rail,389 told us that these issues could be tackled by 
improving system operation and allowing an efficient, fair and transparent timetabling process.  
5.194 As ORR sets out in its review of system operation,390 the benefits of having an 
effective system operator comprise: 
 
achieving the most plannable capacity391 out of the system; 
 
enabling all users and funders to make the right trade-offs between the cost of the network, the level of utilisation and the performance; and 
 
allocating capacity to the 'right service' so as to keep an appropriate balance between the cost of providing capacity and its value (including its non-financial value) to users and to society. 
5.195 An effective system operator function would provide industry players and 
Network Rail with greater incentives to make efficient use of present resources. Moreover, developments in technology and regulation are also likely to have a role in achieving effective system operator capability in the future, facilitating the coordination of more services. Finally, as briefly described above, the work on developing a more flexible access rights policy is likely to assist in achieving efficient capacity allocation and performance optimisation as a consequence of a more flexible timetabling process. 

## Increased Complexity Of The System

Higher transaction and coordination costs for industry actors 

5.196 Complexity could also result in higher transaction and coordination costs due 
to an increased number of 'interfaces' and 'interactions' within the industry, eg between the train operators, between train operators and public bodies (ie 
Network Rail, DfT, ORR), and also between public bodies.392 
5.197 However, there are a number of factors which may mitigate possible concerns 
about an increase in transaction and coordination costs: 
 
First, as in other network industries (eg energy, telecoms and aviation), additional transaction costs resulting from an increased number of operators may be more than offset by efficiency and consumer welfare gains unlocked by greater competition (see Chapter 4).  
 
Second, an Oxera report (2010)393 found that rail sector transaction costs, 
while significant in absolute terms, may not be significant when compared 
through consultations and others. 

393 Ibid. 

with the greater efficiencies resulting from vertical separation and competition.394   

 
Third, within the current rail industry framework, additional transaction and coordination costs, resulting from an increased number of operators, do not seem to be significant in magnitude: (a) The Oxera (2010) report did not reach a view on the exact value of 
transaction costs itself, but cited a paper by Merket which found that overall transaction costs within UK TOCs in 2007 were no more than 5% of TOC operating costs.395  
(b) The report takes into consideration transaction costs due to the 
vertical disintegration of the industry (ie separation between upstream and downstream operations), which are not relevant for assessing the case for greater on-rail competition in Great Britain, where a framework of vertical separation is already in place. 
(c) Some transaction costs resulting from an increased number of operators may be reflected as 'diseconomies of density' and already well considered in the industry analytical framework. 
(d) Network Rail told us that it does not consider that the East and West 
Coast main lines are materially more expensive to run than a main line with fewer operators, such as Great Western. 
 
Fourth, an enhanced and effective system operation function, including an 
effective Network Code, would also reduce transaction costs associated with an increased number of interfaces and interactions by aligning the market players' incentives providing the right signals to decide upon tradeoffs. 
 
Lastly, we note that the level of transaction costs depends to a degree on the extent of public intervention in the market, ie the nature and scope of interactions between train companies and public bodies, and between public bodies. Greater competition in the market would be expected to result in a more decentralised approach to coordination, ie through market signals and decentralised use of disperse information rather than public 
information gathering and central planning. This would reduce the magnitude of 'publicly driven' transaction costs.  

## Retail Issues: Ticketing Complexity And Interavailability

5.198 Transport Focus told us that passengers struggle with the complexity of 
existing ticketing arrangements. A number of other consultation respondents have argued that increasing on-rail competition could exacerbate passengers' 
confusion about the fare structure that applies.396 However, many 
respondents also recognised the passenger benefits that new types of fare (eg advance tickets) have delivered. Transport Focus suggested that increased competition would need to be accompanied by measures to address the concerns that passengers have about ticketing complexity. 
5.199 We acknowledge that there is a degree of complexity in ticketing in the current 
system and that there may be scope for passenger confusion where there is a choice between operators in the current system (eg where franchises overlap). However, we note that much of this complexity results from the range of fares available and applies even on routes where there is a single operator. We consider that these issues are likely to reduce over time as new technology, including smart cards and mobile ticketing, is rolled out.   
5.200 Moreover, a number of examples of ticketing complexity cited were on 
commuter and regional routes, where most passengers buy a ticket for travel on the day. The options for greater on-rail competition that we recommend in Chapter 6 are focused on long-distance intercity routes where, as noted below, the majority of passengers book their tickets in advance. In this regard, we were not told of any concerns about ticketing complexity resulting from current open access services or from competition on high-speed routes in 
Europe. We also note the significant passenger benefits available from the sale of new tickets including carnet and advance tickets (which were introduced following strong passenger demand) and that greater flexibility in ticketing will allow operators to match passenger preferences more closely.   
5.201 We also note that operators would have commercial incentives to ensure that 
information regarding their services is made available. This model works well in other sectors, such as airlines, where there is often a greater choice of operators than would be the case in our recommended options, which would see a choice of two or three operators. Lastly, we note that ORR would also 
continue to have a consumer protection role in ensuring that ticket information is clearly presented to passengers.  

5.202 In summary, we are mindful of the importance of passenger clarity regarding 
their choice of operator. As this is fundamental to ensuring effective competition, we also consider this question in designing our options for greater onrail competition in Chapter 6.   
Interavailability of tickets  

5.203 As many passengers value the ability to change their travel plans, we have 
considered how competition may allow passengers to continue to 'turn up and go', ie boarding the first train service available.  
5.204 In order to overcome this problem, interavailable tickets have been developed. 
The passenger pays for a ticket which can be used on any of the various competing train operators' services, rather than dedicated tickets which are only valid on a single operator. Analysis by ORR indicates that passengers like this facility and the value and flexibility it offers. On many routes, passengers do not have the option of buying a dedicated ticket for travel on a competing operator. However, where passengers have a choice between a dedicated and interavailable fare, interavailable fares account, on average, for 37.5% of revenue, suggesting that many passengers value the option of 
cheaper dedicated tickets.397 Revenue from interavailable tickets is allocated 
among the train companies using a computerised system known as 
'ORCATS'. 398 
5.205 Although TOCs have an incentive to compete for passengers using dedicated 
fares, they cannot currently compete on price to attract passengers who value 
interavailable fares.399  
5.206 However, the following should be noted: 
 
Fewer passengers require interavailable tickets services on intercity routes where, generally speaking, on-rail competition has the greatest potential to develop. Analysis by ORR indicates that in 2013–2014, 
approximately 41% of passenger receipts came from interavailable journeys made on London and South East/ regional routes in comparison with 32% from interavailable journeys made on long-distance services.400  

 
In the case of OAOs, the percentage of passengers' journeys using dedicated and non-interavailable tickets is higher, eg over 60% of all 
Grand Central journeys in 2013–2014.401 ORR noted in the emerging 
findings of its retail market review that while passengers benefit from the flexibility provided by interavailable fares, passenger take-up of this type of fare is at least 10% lower for longer-distance, intercity travel and that there may therefore be merit in relaxing the obligations on TOCs to create 
and sell interavailable fares on all routes.402 This reflects the significant 
financial savings that passengers can achieve by purchasing dedicated tickets on long-distance routes. 
 
'Mobile' and 'smart ticketing' solutions could help to tackle the problem of allocating revenue from interavailable tickets as they would increase the incentives on operators to compete for passengers as their revenues would directly reflect passengers carried, allowing for a closer link between actual passengers and revenue than is currently possible under 
the ORCATS revenue allocation mechanism.403 A number of consultation 
respondents expressed their support for 'smart ticketing' solutions as an 
option to enhance competition in this sector.404  
 
In order to address the concerns that interavailability limits the ability of train operators to compete on price, passengers could be offered greater choice on interavailable tickets. For example, a discount could be given if they buy non-interavailable tickets and passengers could pay to 'upgrade' to non-interavailable tickets when they require more flexibility (a system that would be much easier to administer in an environment of 'smart ticketing'). 
5.207 In considering our options for reform in Chapter 6, we also note that, if 
industry agreement were achieved, interavailable tickets could be retained as an option for passengers even if greater on-rail competition were introduced.  

## Conclusions

5.208 In this chapter we have considered the potential technical, economic and 
policy obstacles to greater competition in the passenger rail market in Great Britain and considered possible ways to overcome these obstacles.  
5.209 The potential obstacles that we have considered fall into three main 
categories: 
 
access to infrastructure, network capacity and rolling stock; 
 
funding the network and loss-making services, and the financial sustainability of operators; 
 
an increase in the number of operators, which might lead to operational issues and to greater complexity of the system. 
5.210 We have carefully considered the evidence on each of these obstacles 
including through discussions with the DfT, ORR, Network Rail, franchised TOCs and OAOs, passenger groups and regional transport partnerships.   
5.211 We do not consider that any of the obstacles identified are insurmountable 
and summarise our conclusions in Table 5 below.   
5.212 We cross-refer to our analysis of these issues in discussing the design of 
options for greater on-rail competition in Chapter 6 and also cite the technical and legal feasibility analysis for each of the four specific options conducted in the impact assessment commissioned by ORR.

| Other regulatory or policy actions                                                  |                                                     |
|-------------------------------------------------------------------------------------|-----------------------------------------------------|
| Potential obstacle / risk from                                                      |                                                     |
| greater on-rail competition                                                         | Mitigating factors                                  |
| (Chapter 6 - Other recommendations to                                               |                                                     |
| support greater competition, paragraphs                                             |                                                     |
| 6.65–6.80)                                                                          |                                                     |
| Access to infrastructure, network capacity and rolling stocks                       |                                                     |
| Lack of level playing field (obstacle)                                              | Review of structure of access charges to create     |
| a more level playing field                                                          |                                                     |
| Paragraphs 5.7–5.14                                                                 |                                                     |
| Vertical separation and non-discriminatory                                          |                                                     |
| framework to access the network (ie Sale of                                         |                                                     |
| Access Rights Panel)                                                                |                                                     |
| Non-discriminatory obligations at retail level (ie                                  |                                                     |
| Ticketing Settlement Agreement)                                                     |                                                     |
| Network capacity scarcity (obstacle)                                                | Increased competition using existing capacity       |
| Paragraphs 5.15–5.58                                                                | Expected network enhancements increasing            |
| available capacity (eg ERMTS, HS2, stations                                         |                                                     |
| upgrades)                                                                           |                                                     |
| Review of access charges to better reflect value                                    |                                                     |
| of capacity (ie enhanced capacity charge or                                         |                                                     |
| charges reflecting scarcity)                                                        |                                                     |
| On-rail competition giving incentives to identify                                   |                                                     |
| additional capacity                                                                 |                                                     |
| Redesign of franchise contract scope, clearly                                       |                                                     |
| defining profitable services and PSOs                                               |                                                     |
| Rolling stock scarcity (obstacle)                                                   | Future additional availability of rolling stock (ie |
| as a consequence of IEP programme)                                                  |                                                     |
| Longer access rights, incentivising further                                         |                                                     |
| private investments                                                                 |                                                     |
| Paragraphs 5.59–5.68                                                                |                                                     |
| Further private investment in rolling stock,                                        |                                                     |
| especially when long-term access rights are                                         |                                                     |
| granted                                                                             |                                                     |
| Funding the network/ loss-making services and financial sustainability of operators |                                                     |
| Impact on funding of unprofitable                                                   |                                                     |
| services (risk)                                                                     |                                                     |
| Alternative to current cross-subsidies (eg PSO                                      |                                                     |
| levy)                                                                               |                                                     |
| Paragraphs 5.76–5.96                                                                |                                                     |
| Positive impact of on-rail competition on                                           |                                                     |
| productive efficiency implying the possibility of                                   |                                                     |
| reducing the overall scope of loss-making                                           |                                                     |
| services                                                                            |                                                     |
| Structure of charges (ie cost-reflective/                                           |                                                     |
| symmetric, OAOs making greater contribution in                                      |                                                     |
| return for greater access)                                                          | On-rail competition having a positive impact on     |
| demand growth (ie previously unmet demand,                                          |                                                     |
| transfer from other transport modes)                                                |                                                     |
| Redesign of franchise contract scope (profitable                                    |                                                     |
| services vs PSOs)                                                                   |                                                     |
| Limited empirical evidence of negative impact                                       |                                                     |
| of on-rail competition on recent franchise                                          |                                                     |
| awards                                                                              |                                                     |
| Reducing risk in franchise bids through greater                                     |                                                     |
| ex ante                                                                             | clarity of future level of on-rail                  |
| competition                                                                         |                                                     |
Assessment necessary for the reform options (Chapter 6 - Assessment framework, paragraphs 6.81–6.84) 
It is unlikely to be an obstacle to greater on-rail competition - no need for further assessment in Chapter 6 It is not a material obstacle to greater on-rail competition because of possibility of competing under capacity constraints. However reform options should be evaluated assessing their impact on: 
 utilisation of capacity and interconnectivity  cost efficiency at the upstream network level  
It is unlikely to be an obstacle to greater on-rail competition - No need for further assessment in Chapter 6 Impact on government funds Social inclusion and connectivity  

## Other Regulatory Or Policy Actions

Assessment necessary for the reform options  
Potential obstacle / risk from greater on-rail competition 
Mitigating factors 
(Chapter 6 - Other recommendations to support greater competition, paragraphs 6.65–6.80) 
(Chapter 6 - Assessment framework, paragraphs 6.81–6.84) Impact on government funds  
Impact on funding of network investments (risk) 
Balanced business case for new investments to be neutral to identity of train operators 
Longer access rights, incentivising further private investment 
Social inclusion and connectivity  
Paragraphs 5.97–5.109 
Greater private investment in network could be incentivised by increased on-rail competition 
Funding mechanisms aimed at recovering investment costs (ie access charge on new investments, rebate mechanisms) Structure of charges (ie cost-reflective/ symmetric, correctly remunerating the use of the network)  
Cost efficiency at passenger level  
Tight specification of franchised services (obstacle) 
On-rail competition would put competitive pressure on train companies, giving incentives to match the demand/consumer preferences  
Relax franchise service specification, especially in area where market could provide correct signals 
Paragraphs 5.130–5.141 
Impact on government funds  
Competition on quality and product 
differentiation limit 'race to the bottom' in fares 
Review of access charges in a cost-reflective 
way (building a price floor)  
Security of supply  
'Price war' and financial 
unsustainability for train operators (risk) Paragraphs 5.142–5.157 
Level playing field in UK prevents anticompetitive exclusive pricing strategy (eg predatory pricing) from incumbent TOCs 
Potential adverse effects of an increased number of operators Operational issues (risks):  
Network Rail as enhanced system operator 
Coordination issues and transaction costs Utilisation of capacity and interconnectivity  
In many cases, competition would not imply a higher complexity of operations in the network as a number of different operators are already active  
Alignment of industry incentives through market signals and decentralised coordination (eg Rail Delivery Group) Alternative slot allocation mechanisms 
 suboptimal use of capacity  interconnectivity  performance  recovery from disruption  conflicting slot requests 
There are regulatory tools in place aimed at coordinating operations and minimising operational issues  
Paragraphs 5.158–5.195 
ORR and Network rail would in any case keep a degree of control on operational issues, assessing possible trade-offs with competition enhancements Limited empirical evidence that on-rail competition has negative impact on performance 
| Other regulatory or policy actions                   |                                           |
|------------------------------------------------------|-------------------------------------------|
| Assessment necessary for the reform options          |                                           |
| Potential obstacle / risk from                       |                                           |
| greater on-rail competition                          | Mitigating factors                        |
| (Chapter 6 - Other recommendations to                |                                           |
| support greater competition, paragraphs              |                                           |
| 6.65–6.80)                                           |                                           |
| (Chapter 6 - Assessment framework,                   |                                           |
| paragraphs 6.81–6.84)                                |                                           |
| Higher transactions costs (obstacle)                 | Coordination issues and transaction costs |
| significant compared against efficiency gains        |                                           |
| Paragraphs 5.196–5.197                               |                                           |
| Alignment of industry incentives through market      |                                           |
| signals and decentralised coordination (eg Rail      |                                           |
| Delivery Group)                                      |                                           |
| Alternative slot allocation mechanisms               |                                           |
| Retail issues:                                       | Passenger experience                      |
| is more limited on intercity routes                  |                                           |
| Policy measures to raise consumers awareness         |                                           |
| and address possible higher retail complexities      |                                           |
|                                                     |                                           |
| Ticketing complexity (risk)                          |                                           |
|                                                     |                                           |
| Ticket interavailability (obstacle)                  |                                           |
| Paragraphs 5.198–5.207                               |                                           |
| Mobile/smart ticketing solutions and greater         |                                           |
| flexibility (ie possibility to spot upgrade/discount |                                           |
| on non-interavailable/interavailable season          |                                           |
| tickets)                                             |                                           |

## 6. Options For Reform Introduction

6.1 
In our discussion document, we set out the following four lead options: 
 
Option 1: existing market structure, but significantly increased open access operations. 
 
Option 2: two franchisees for each franchise. 
 
Option 3: more overlapping franchises. 
 
Option 4: licensing multiple operators, subject to conditions (including public service obligations). 
6.2 
In this chapter we first describe the options on which we consulted in detail. 
We then assess and compare each option in the light of consultation responses we have received and against an assessment framework, taking into account our goals (set out in Chapter 1), the benefits of competition (discussed in Chapters 3 and 4), and the obstacles and risks (discussed in Chapter 5).  
6.3 
In Chapter 7, we set out our conclusions and recommendations, including the steps and timings necessary for our recommended options to be implemented. 

## Approach To Assessing The Options

6.4 
In assessing the costs and benefits of the four options, we refer to the findings of the impact assessment undertaken on behalf of ORR by two consultancies, Arup and Oxera, with considerable technical, legal and economic expertise 
and knowledge of the railway sector.405 The impact assessment examined the 
legal and operational feasibility of each option. It also undertook both a quantitative and qualitative assessment of the options, considering the impact on passenger outcomes (such as fares and service quality), meeting social objectives (such as investment and accessibility), wider benefits (such as facilitating economic growth), impact on industry costs and efficiency and 
impact on rail industry funding and affordability.406 In doing so, we take 
account of the further consultation responses received following the 
publication of the impact assessment (which are published alongside this policy document).  

6.5 
In order to consider the incremental benefits407 of the options we compare 
them against a baseline counterfactual of a continuation of the current system under which franchises are awarded in the framework adopted following the recommendations of the Brown Review with some incremental improvements.408 This is consistent with the approach taken in the impact 
assessment, which used as its baseline a 'do minimum' scenario in which government policy on franchising broadly continues the existing arrangements.  
6.6 
The key assumptions made in the impact assessment are set out in Box 3.  

## Box 3: Key Assumptions In The Impact Assessment

The methodology used to model the impact of the options structured around three main mechanisms through which competition impacts can occur: 
 
Price benefits: entrants competing on price, but offering a similar product; 
 
Efficiency gains: from new entry of more efficient operators that encourage efficiency in incumbents; and/or 
 
Service benefits: entry on the basis of a differentiated product which better matches passenger preferences. 
The underlying assumptions include: 
 
Entrant fares - evidence on existing OAO fares 
 
Track access charges - as stated in ORR's CP5 
 
PSO levy - estimated from existing franchise premiums based on the proportion of total 
franchise revenue earned by each service group in the 'do minimum' scenario and calculated as an implied premium per passenger km 
 
Some operator costs (staff, rolling stock) - evidence on OAO costs 
 
Timetable scenarios  
These assumptions are applied to standard rail industry demand and revenue models to generate quantified estimates of: 
 
Fares and passenger revenue  
 
Journey times 
 
Operator costs 
 
Franchise premiums 
Non-quantified impacts include impacts on product offering and service quality, impact on the efficiency of Network Rail, positive or negative spillovers outside the intercity routes considered.  

## Addressing Potential Barriers To Competition

6.7 
In developing the four options, we have considered the potential financial, operational and implementation barriers to increasing competition outlined in Chapter 5. The options have been designed to achieve the maximum benefits of competition while mitigating the potential negative effects.  
6.8 
In developing the options, we also considered the proposals for on-rail 
competition prepared for ORR by Martin Cave and Janet Wright in 2010,409 
the proposals in the 2011 and 2013 ORR consultations and lessons from the experience of on-rail competition in Europe (described in Chapter 3). We have 
considered how our preferred options could be implemented, and in doing so have assessed their technical, economic and commercial feasibility.  

## Scope And Timing

6.9 
In assessing the options, we focus on those parts of the network in Great Britain where they are likely to deliver the greatest benefits. We consider these to be the three main intercity routes: the East Coast main line, the West Coast main line and the 'Great Western' route linking London with South West England and South Wales.  
6.10 We consider these routes to have the most potential for greater on-rail 
competition because they are the most financially viable, they have the fewest interconnections, and because passengers using long-distance services tend to be more willing to book in advance rather than primarily valuing a 'turn up 
and go' service.410 We consider there may also be greater potential for 
operators to compete on price and quality by introducing dedicated fares and 
differentiated service offerings on these routes.411  
6.11 We note, however, that some elements of our proposed options could be 
applied nationally, for example, to allow for open access growth elsewhere (with the Midland main line intercity route in particular being another candidate 
if it were isolated from the wider East Midlands franchise). This focus on the potential for on-rail competition on long-distance intercity routes is in line with 
the practice in other European countries.   
6.12 We consider that there may be potential for the options to be implemented on 
HS2 given the premium nature of the product, the potential for service differentiation and the fact that many HS2 services will continue onward to different 
final destinations using the classic network.412 We note that many of the 
examples of on-rail competition in other European countries are on dedicated high-speed lines.  
6.13 The opening of Phase 2 of HS2 in around 2033 might also create potential for 
on-rail competition. Services will operate in a 'Y' shape from the West Midlands up towards Manchester and the North West and up towards Leeds and the North East. We understand that it is possible that different operators 
might run the 'easterly' and 'westerly' parts of the route, creating the potential for on-rail competition between London and the West Midlands. 

6.14 We note that the government has not yet decided whether HS2 will be 
franchised or the number of operators that will run on HS2. In deciding whether to implement on-rail competition on HS2 in the future, we note that 
policymakers may take account of a range of other factors in addition to the 
potential benefits of on-rail competition (eg in relation to achieving lower fares) including the impact of on-rail competition on the HS2 business case (considered in Chapter 5) and capacity utilisation. HS2's eventual dedicated 
track access and charging structure will also be a relevant consideration.  
6.15 To protect existing and imminent franchisees against uncertainty and risk of 
significant, unforeseen revenue abstraction as a result of policy changes, we would not envisage any of these options coming into effect until after the end of the current rail franchise terms (or, where new franchise tenders are imminent, after the terms of those franchises about to be tendered), which would mean 2023 at the earliest.  
6.16 In addition, we note that there are a number of difficulties in introducing on-rail 
competition on commuter routes - for example (a) capacity constraints on 
routes to London and other major urban centres, and (b) the particular desire 
of commuters to take the first available train, which implies greater dependence on interavailable tickets and hence less price competition.  
6.17 We consider that implementing options to increase competition on regional 
routes would come with challenges as these routes are typically less profitable than the intercity routes which are the focus of this report. This may mean, for example, that OAOs would not by themselves choose to run services in these areas.  

## Option 1 - Existing Market Structure, But Significantly Increased Open Access Operations

6.18 In this option, the existing system would be adapted to allow a significantly 
increased role for open access alongside franchised TOCs. For example, there could be a 70:30 allocation of capacity between the franchised TOC and an OAO. In return for greater access to the network, OAOs would be required to pay an appropriate share of the costs of network infrastructure and to pay proportionately towards unprofitable but socially valuable services by way of a universal service levy or other appropriate funding mechanism, to avoid cream-skimming, as described in paragraph 5.79.  
6.19 This would allow the current franchising framework to continue broadly as it 
operates today, but support a significant increase in the role of open access. Under this option, we envisage that OAOs would make a similar contribution to network costs (following reforms to access charges) and the funding of loss-making services as incumbent franchised TOCs. Option 1 would also provide the government with flexibility to adjust the balance between franchised TOCs and OAOs in a more revenue-neutral way by, for instance, increasing or reducing the allocation to OAOs once the actual impacts on pilot franchises are observed.  
6.20 An alternative to establishing a new source of revenue for the funding of 
socially desirable but unprofitable services, through a PSO levy or other appropriate mechanism, would be for a reduction in government funds from greater on-rail competition being funded from general taxation. There may be some arguments in principle for this - for example it may be viewed as less 'distortionary' for funding of unprofitably but socially valuable services to be 
borne by the economy as whole, rather than the rail sector alone.413 In this 
regard, we note in paragraphs 5.81 to 5.83 that there is a trade-off between 
the benefits of on-rail competition in terms of consumer surplus and the impact on government funds. However, given that current government policy is to ensure that taxpayers do not fund a greater proportion of the operation of the network, we have proposed options that seek to address the reduction in government funds from on-rail competition.  
6.21 In view of current capacity constraints, an expanded role for open access 
could be achieved over time by using new capacity which is expected to 
become available in the longer term (see Chapter 5) and/or through reducing 
the proportion of services that are allocated to franchises specified by the DfT.  
6.22 In order for OAOs to retain full freedom to adapt their operations in a commercial manner, and on the basis that there will be no obligation for OAOs to apply to run train paths, in this option we envisage that all or the vast majority of unprofitable but socially valuable services in a franchise area would need to 
be undertaken by the franchised TOC.414 This would include the unprofitable 
but socially valuable aspects (ie essentially unprofitable destinations, unprofitable stops, and unprofitable stopping times) and the less profitable routes and connections which are valuable for social reasons but which may not be prioritised by a purely commercial operation.  
6.23 Nonetheless, it may be more efficient for an OAO to undertake some of these 
services, for example by adding an extra stop to one of its services when there are no franchised TOC operated services passing at a particular time, running an extra service late at night or early in the morning when balancing its rolling stock location in preparation for the next day, or taking into account calling times at stations for interconnecting regional services.  
6.24 Moreover, OAOs might be able to operate some of the unprofitable but 
socially valuable services currently provided by franchised TOCs and subsidised by the government in a commercially viable way. This could generate cost savings for the government and would, therefore, go some way to compensate for revenue abstraction from franchised TOCs. In this scenario, unprofitable but socially valuable services could be allocated to an OAO by an 
enhanced system operator.415  
6.25 Option 1 would be implemented in conjunction with changes to the structure 
of track access charges so that OAOs pay charges which are reflective of the 
fixed and variable costs of the infrastructure they use in return for greater access to the network. In this framework, OAOs and franchised TOCs would face broadly similar risks and broadly similar charges.  
6.26 A mechanism would also need to be established for allocating rights to the 
OAOs or operators within a franchise area in the likely event that more than one company wanted to operate those rights. As considered further in paragraphs 7.44 to 7.47, there are a number of possible allocation mechanisms which could be used, including an administrative process or an auction.  

## Designing A Pso Levy Or Other Appropriate Funding Mechanism

6.27 OAOs would contribute to the funding of unprofitable but socially valuable 
services, which would continue to be provided within franchises, through the payment of a PSO levy.  
6.28 In our discussion document we considered that a levy could be calculated on 
a per-passenger-mile, per-train, or per-carriage basis. Some further work on 
the design of a levy has since been undertaken by the ORR for the purpose of the impact assessment but, as noted in Chapter 7, further design work is required.  
6.29 In the absence of a developed model for a PSO levy at this stage, the impact 
assessment models an approach in which OAOs are charged based on the 
level of abstraction from franchises estimated using the MOIRA model,416 in 
conjunction with an estimated share of franchise premiums associated with the service from which abstraction occurs. The levy itself was modelled on a 
pound-per-passenger-mile basis.417 
6.30 In order to overcome short-term barriers to entry, the levy that OAOs pay 
could be phased in over time to allow OAOs a reasonable period within which 
to establish a viable commercial operation.418  
6.31 Arriva, the parent company of one current OAO, Grand Central, and one 
proposed service which has been granted access rights, Alliance Rail, stated in response to our consultation that: 
Article 12 of Directive 2012/34 allows operators of commercial services to support clearly defined PSOs by way of payment of a levy. Arriva is supportive of arrangements of commercial operators to be charged a levy in accordance with Article 12 in order to support PSOs and has discussed such mechanisms with DfT.419 

6.32 While we consider a PSO levy to be a leading candidate for funding 
unprofitable but socially valuable services under Option 1, we recognise that there may be alternative methods for OAOs to contribute to the funding of these services. For example, an auction of OAO paths, which could also be used for path allocation, could raise revenue to supplement higher access 
charges paid by OAOs.420  

## Option 2 - Two Franchisees For Each Franchise

6.33 This option would see suitable franchises tendered such that there would be 
two operators for each existing franchise area. Appropriate design of these franchises would ensure on-rail competition between franchised TOCs on all, or the majority of, flows by taking routes currently operated by only one 
operator and sharing them between two operators running similar services but with lower frequencies. This would incentivise competition between these operators.  

6.34 There are a number of ways this could be implemented, which were modelled 
in the impact assessment:421 
(a) two franchises of similar size in terms of revenue, number of services, and 
number of unprofitable but socially valuable routes; 
(b) asymmetric franchises, for example with a 60:40% split in terms of service 
frequencies and unprofitable but socially valuable routes;422 
(c) one 'anchor franchisee' responsible for the vast majority of unprofitable 
but socially valuable services and, most likely, some degree of profitable services, and one other franchisee responsible for the remainder of services, which would all be profitable.  
6.35 The chosen specification would need to strike the right balance between the 
benefits of competition from operators competing directly and the risk of operators engaging in tacit collusion to set fares.  
6.36 Under Option 2(a), with two equal franchises, there would be on-rail competition on the majority of flows operated. This may create stronger downward pressure on fares than Options 2(b) and 2(c) and therefore a larger impact on government funds. Higher track access charges and greater efficiency may mitigate this effect, and some socially desirable but less profitable service aspects in the areas where the franchises were run could be 'bundled' into franchises which were profitable overall. This point is considered further in our assessment of the options below.  
6.37 Another potential concern under Option 2(a) is that the franchised TOCs 
engage in tacit collusion. There are a number of factors that may facilitate tacit collusion, including there being two symmetric operators in the market, the existence of barriers to entry to the market, possible cross-ownership and other links between competitors and observability of fares and service offerings. This may enable operators to align their commercial strategies and 
to sustain a collusive outcome.   
6.38 The consideration regarding symmetry in franchise design and the stability of 
any collusive outcome can be outlined using an indicative example: 
(a) If there were two services operated by different companies leaving one 
after another on the same flow, eg London–York, both operators would have a good idea of the cost of running that service, and the demand from passengers at that time. Both operators would therefore know an ideal 'monopoly' price to set, from which they would both benefit as long as they both charged it.  
(b) If the second operator were to set a significantly lower price and was able 
to attract more passengers and, therefore, make a higher profit at the expense of the first operator, which lost customers, the first operator would realise that the second operator was deliberately undercutting it. Each operator would be unlikely to take such action in order to avoid a price war. 
(c) This can be contrasted with a situation with two operators running more 
dissimilar services, eg one directly to York and another to York but continuing on to another station on track which had not been electrified and so requiring the second operator to use diesel-powered rolling stock. If the second operator lowered its price, it would be harder for the first operator to be sure that this was a deliberate attempt to win its customers rather than a change in diesel prices or some other cost associated with diesel rolling stock which it did not face. The first operator may therefore respond to the change in prices, sparking a price war. 
6.39 The possibility of tacit collusion was highlighted in Cave and Wright (2010), 
although few consultation respondents raised the concern.423  
6.40 Option 2(b) would seek to address the problem of potential tacit collusion by 
implementing a degree of asymmetry between the operators. Other factors are also relevant, including the degree of product differentiation between the operators. As we note in paragraph 3.105, Spain is proposing to introduce duopoly competition on certain long-distance routes and is planning to ensure that the operators are asymmetric in order to mitigate the risk of collusion. 
6.41 We note that asymmetric operators would be less likely to collude because 
they would have different cost structures and may have different business 
models.   
6.42 We also note that the greater the degree of asymmetry, the more limited the 
extent of on-rail competition would be. This would limit the potential passenger benefits, although it would also reduce the impact on government funds.  
6.43 Option 2(c) would seek to maintain a degree of competition between 
asymmetric operators while providing unprofitable but socially valuable services in a coherent manner. 

## Option 3 - More Overlapping Franchises

6.44 A franchise overlap occurs where two franchised TOCs provide some, but 
often not all, of the same services along a route or in their area of operation. Current examples are listed in Table 3 of Chapter 2.   
6.45 The SRA, the body responsible for franchising from 2001 to 2006, decided to 
reduce the number of franchise overlaps in the Great Britain passenger rail 
sector.424 As described in Chapter 3, the stated rationale for this was primarily 
to ensure there was only one operator at each London terminal, with the intention of improving coordination of traffic and so improving punctuality and 
other KPIs.425,426  
6.46 This option would reverse the SRA's policies by redesigning the franchise 
map to encourage more overlapping franchises. It would therefore create more flows on which there would be competition between franchised 
operators.427  
6.47 Competition between franchised TOCs may reduce the franchise premiums 
attached to bids, although we note in Chapter 3 that there is some evidence to suggest that franchised TOCs exposed to on-rail competition - notably London Midland and Chiltern Railways - have generated value in a more competitive environment. The fact that the government would retain control over where and when competition takes place would reduce uncertainty for bidders.  
6.48 Unprofitable but socially valuable services would be provided, as under the 
current system, by franchised TOCs. 
6.49 Less detailed specification of franchises would be particularly beneficial under 
this option as it would allow the benefits of competition to extend beyond price competition to service provision that better reflected passenger demand and innovations that franchised TOCs could deliver, including investment in new technology. Less detailed specification would also allow franchised TOCs to better respond to the competitive incentives to reduce costs. 

## Option 4 - Licensing Multiple Operators, Subject To Conditions (Including Public Service Obligations)

6.50 While the previous three options retain franchising, the fourth option is more 
radical, marking a significant departure from the current system in Great Britain.  
6.51 Under Option 4, certain franchise areas would move from using a system of 
franchises to one using 'licences'. In this option, operators are likely to be similar to OAOs, but subject to a licensing regime which would place some 
restrictions and obligations on their activities.  
6.52 These licences would seek to ensure that unprofitable but socially valuable 
services would still be provided, but would do so in a less prescriptive manner, by allowing market forces to decide which operators would be best placed to undertake them.   
6.53 We note that licensing or 'authorisation' regimes are used in a number of 
regulated UK industries such as energy, water, telecoms and postal services in order to require providers to undertake social activities which they may be unlikely to provide otherwise. This can cover both quality of service obligations and also requirements which ensure a minimum service for 
consumers.428  
6.54 There are a number of ways such licences could be implemented in the 
passenger rail sector. We have considered the following options: (a) **Administratively designed licences (Option 4(a))**: this approach would 
mandate that if an operator wanted to operate (profitable) services between destinations A and B, at time C, it would have to stop at intermediate stop X; would have to operate a service to nearby destination Y; 
and/or would have to run an additional service at time D. A planning body 
- potentially the DfT, ORR or the system operator function of Network Rail - would need to design the licences so that they produced an acceptable level of service and a coherently connected timetable in a financially viable framework. Depending on changes to access charges, it may be that some of the licences would need to have a subsidy attached. For example, licence conditions could require that any operator running a train between London and Manchester on the West Coast main line between 3pm and 4pm would have to stop at a less heavily used station such as Stoke-on-Trent, and/or would have to run at least one train between London and Birmingham at 11pm. There could be a number of other licence conditions, designed such that all the unprofitable but socially valuable services as well as all the profitable routes were being utilised, would be undertaken. It would not specify which, or how many, operators provided these services, unlike in a franchise system. 

(b) Licences with an associated 'number' of social obligations (Option 
4(b)): under this approach, alongside the licensed right to operate a service between A and B, there would be a condition that the operator must supply a certain number of unprofitable but socially valuable services, but without specifying where these were. There would need to be a 'list' of unprofitable but socially valuable routes drawn up by a central body from which operators could select. A trading system or platform could be implemented so that operators could trade these obligations 
between themselves, or could subcontract them to third parties.429,430 
An example of this approach would be a licence obligation which stated that any operator running a service between London and Manchester on the West Coast main line between 3pm and 4pm would need to run at least one unprofitable but socially valuable service each week, which it could choose from a list of such flows identified by the planning body. Again, unlike a franchise approach, the operators could use these licence obligations to put together a set of services designed by themselves rather than by a planning body.  

6.55 The funding arrangements under Option 4 would need to be carefully considered. If the profitable rights were greater or equal in value to the unprofitable 
responsibilities, no subsidy would be needed; the unprofitable parts could be funded through cross-subsidy.  

6.56 At a route level, in the areas where we are suggesting that more on-rail 
competition could deliver the greatest benefits, we consider it likely that unprofitable but socially valuable services could be funded through licence 
obligations. This is because these routes pay considerable premiums and so 
are profitable enough overall to fund the unprofitable but socially desirable services within them. 
6.57 If there were shortfalls in funding under Option 4, however, these could be 
made up in a variety of ways, including by universal service levies on licensed operators (similar to the levy proposed for OAOs in Option 1), by increasing 
the number of unprofitable services that licensees were required to provide under Option 4(b), or by raising revenue through the auction used to allocate access rights. 
6.58 These two sub-options bear some similarities to other options we have 
considered. Option 4(a) would be similar to a franchising system except that the specification would be much less detailed and the level at which licence obligations would be attached to access rights would be much more detailed. This option could be described as comprising 'bundles of mini franchises'. Option 4(b) bears considerable similarity to the OAO component of Option 1, as services would be provided by commercial operators with considerable freedom to innovate and to tailor their services to customer demand, but these commercial operators would undertake social obligations themselves. 
6.59 Under both sub-options, a mechanism would also be needed to allocate the 
scarce track access rights to operators. As mentioned under Option 1, this could be by way of an auction or an administrative process, as used in Sweden. As this option has no franchising component, and is also the most market-based option, we briefly consider the possibilities for using an auctionbased approach for the allocation of capacity, the timetabling of services or the selling of bundles of paths.  
The potential for train timetables to be drawn and operations to be allocated between companies by means of an auction process has garnered substantial attention from economists and auction theorists over the past 30 or so years. It was considered directly at the time of privatisation in Great Britain. We discuss this in more depth in the Appendix. Our overall conclusion is that it is unlikely that an overall timetable can be drawn, or train service operation allocated in real time through an auction process. However, taking a timetable which has been designed by a central body and auctioning bundles of paths within it is likely to be possible and may achieve many of the potential benefits of an auction approach to facilitating competition. 

 6.60 Secondary trading would enable operators to exchange paths between 
themselves in order to optimise the efficiency of their operations. Further work would be required to identify how secondary trading of paths could be 
designed to remain compliant with European legislation.431  
6.61 Suggestions regarding auctioning bundles of paths were made in the 
consultation response by Virgin/Stagecoach and Network Rail.  
6.62 As indicated in both responses, there would need to be rules in place to 
ensure that under Option 4 there was competition present on all or the majority of flows. This would effectively mean preventing operators gaining control of collections of rights which would allow them to exercise market power and so raise prices. If an auction mechanism were used, this would be likely to be best implemented through caps on the number of paths companies could win in particular areas.  
6.63 For the trading-based Option 4(b), a mechanism would also need to be 
designed to decide which operators were assigned responsibility for particular unprofitable but socially valuable routes, as these would differ in how costly they were to provide or finance.  
6.64 We consider that with multiple operators on each route, greater operational 
complexity may require a strengthened role for the system operator. This is also noted in the impact assessment's analysis of Option 4. An improved system operator function is a general recommendation we make below - but may be particularly important for this option.  

## Other Recommendations To Support Greater Competition

6.65 In our discussion document, we set out a number of more general ideas that 
could usefully be adopted alongside any of the options for greater on-rail competition coming into effect after 2023: 
 
reducing the level of detailed specification of franchise contracts (paragraphs 6.67 to 6.70);  
 
reforming the structure of access charges (paragraphs 6.71 to 6.78);  
 
improving incentives to facilitate better responsiveness of Network Rail in its 'system operator' function (paragraph 6.79); and 
 
encouraging the use of smart ticketing so that real passenger journeys are tracked within the system (paragraph 6.80). 
6.66 In our evaluation of the options we assume that these changes (which are all 
under active consideration by DfT and ORR) would also be implemented. 

## Detailed Specification Of Operators' Obligations

6.67 We are conscious of the need for a degree of franchise specification, for 
example on commuter routes and on services which mainly deliver social objectives. We also note that a degree of specification is needed to ensure that certain services (eg appropriate first and last trains) are provided on 
commercial intercity routes. 
6.68 However, we consider that the degree of specification in some of the current 
franchise agreements may significantly restrict the ability of franchised TOCs to manage their businesses commercially. We were told by certain operators that they are taking the role of 'service delivery contractors' rather than commercial operators. This detailed specification of services is likely to limit the ability of franchised TOCs to tailor their services to passenger demand (eg by adjusting service frequencies and introducing innovations), particularly as 
market dynamics evolve during the course of a franchise.432 It may also 
restrict the ability of a franchised TOC to reduce costs. In turn, this may lower 
franchise specifications can limit the ability of operators to adapt to passengers' changing demands. This point was also noted in the impact assessment which stated that prescriptive franchise specifications can limit the scope for operators to innovate to maximise revenue or reduce costs.   
customers' satisfaction. We were also told by some franchised TOCs that service specification blunts their incentives to run additional trains.  

6.69 As set out in Chapter 2, the Rail Group is in the process of undertaking 
reforms to the system (most notably in the recent East Anglia Invitation to 
Tender).433 This changing approach is welcome. In this regard, we note that 
where franchise specification is less detailed, we have seen evidence of 
operator-led innovation, service improvement and growth.434 
6.70 In order to realise fully the benefits of on-rail competition it is particularly 
important to ensure that franchises are not over-specified.435 For example, in 
Option 1, the franchisee would need sufficient flexibility to respond to open access competition, while in Options 2 and 3, the specification should be sufficiently flexible to allow the franchised TOCs to compete on factors other than price. This is a point that has been made to us by franchised TOCs which face competition from existing or potential OAOs.  

## Reforming The Structure Of Access Charges

6.71 We consider that a number of benefits to passengers and taxpayers could be 
delivered by reforming the structure of access charges.  
6.72 As described in Chapter 2, ORR is currently conducting a review of the 
structure of access charges paid to Network Rail. ORR has identified four gaps in the current charging regime: (a) a limited ability to drive down costs; 
(b) a lack of specific and strong incentives to provide and allocate capacity most efficiently; (c) a potential inability to support effective competition 
between different types of passenger train operator; and (d) complexity.  
6.73 Reforming the access charging structure would create a more level playing 
field in terms of the risks and charges faced by franchised TOCs and OAOs (eg by requiring OAOs to pay charges that are reflective of the fixed and variable costs of the infrastructure that they use and reviewing the indemnity that franchised TOCs enjoy against changes in track access charges during their franchises). 
6.74 Implementing cost-reflective access charges would also facilitate the 
implementation of reforms to increase competition. Under the current framework, if competition is introduced while the government continues to subsidise infrastructure through the network grant and fares fall, reducing franchise premiums, government may be left to provide funding for this shortfall through a higher network grant. If operators paid cost-reflective access charges this problem would be mitigated as a new, larger revenue stream would be created. 
6.75 We note that changes in this regard are already taking place. In the summer 
2015 Budget the government announced that it will change the way in which it channels public money through the industry, directing it through the franchised TOCs, rather than straight to Network Rail in the form of a network grant. This has the stated aim of encouraging Network Rail to focus firmly on the needs of train operators and, through them, passengers - encouraging customers of the railway to demand efficiency and improvements that matter 
to them and making the best use of scarce capacity on the rail network.436  
6.76 Introducing access charges which were reflective not just of the resource 
costs of infrastructure used by operators, but of the opportunity cost, or value, would also allow scarcity to be reflected in the allocation of train paths, 
increasing the efficiency of the track allocation process.437  
6.77 This ability of reformed access charges to mitigate the impact on funding the 
network and unprofitable but socially desirable services is demonstrated in the 
MVA report for the 2011 ORR consultation.438 MVA modelled a number of 
different access charges when applied in conjunction with a significant expansion of open access operations on the East Coast main line. One such 
scenario is shown in Figure 16 below:439 
where OAOs paid 90% of their profits as bids in auctions for slots; and (v) an 'FO Opportunity Cost' option where OAOs pay the difference between the revenue the franchised TOC receives if it faced competition and if it did not.  
 

6.78 In the MVA report, FTAC charging options 2, 3 and 4 involve access charges 
where operators do not only pay the accounting costs of using the network, but also pay towards the opportunity cost of the access rights that they are using. This would mean they would pay more for more valuable access rights such as those at peak times on high-demand routes. As can be seen from the chart above, this has the potential to lower the cost to government of 
increasing competition and losing revenue from premium payments.440 

## Network Rail'S Incentives As System Operator

6.79 We consider that the incentives placed on Network Rail in its role of 'system 
operator' should be sharpened in order to ensure that current infrastructure provides the highest feasible number of train paths for a given level of 
performance and cost.441 As set out in Chapter 5, evidence shows that new 
entrants have greater incentives to put pressure on Network Rail to accommodate new entry and therefore to optimise the use of the network. ORR is currently reviewing Network Rail's role as a system operator. We see 
the strengthening of the system operator role as important to our options for 
reform as enhanced coordination of the network would be important for 
managing the greater number of operators on the network. This is discussed further in Chapter 7.  

## Smart Ticketing

6.80 We consider that the implementation of smart ticketing systems, which 
monitor the actual trains that passengers take, would be beneficial as it would 
allow revenue to be more accurately apportioned to operators.442 The current 
ORCATS model, described in paragraph 5.204, allocates revenue from passengers travelling on interavailable tickets based on estimates of passenger demand and therefore blunts incentives for operators to attract 
more passengers.443 

## Assessment Of The Options

6.81 Our discussion document considered the advantages and disadvantages of 
four options for greater on-rail competition at a high level. We have built upon the factors discussed and the comments we have received during our 
consultation to produce the assessment framework outlined in Box 5 below.  
6.82 The options assessment framework takes into account the risks and obstacles 
to greater on-rail competition described in Chapter 5, as well as the benefits identified in Chapters 3 and 4. We cross-refer to these chapters in our assessment where appropriate. 

## Box 5: Options Assessment Framework

1. Passenger and efficiency benefits  
(a) Lower prices and fares (b) Improved overall passenger experience, including service quality, choice and  
complexity 
(c) Greater cost efficiency at the passenger services level (d) Dynamic or innovation benefits 
2. Funding and risk 
(a) Taxpayer funding - impact on government funds (b) Impact on risk for government and operators (c) Impact on investment incentives 
3. Network considerations, including operational issues 
(a) Impact on coordination and the level of transaction costs (b) Utilisation of capacity and interconnectivity (c) Impact on efficiency at the upstream network management level (d) Impact on safety  
4. Wider social benefits  
(a) Externalities generated: regional economic growth and environmental benefits (b) Impact on social inclusion and connectivity 
5. Ease of implementation, including legal and operational feasibility 
Scale of policy and regulatory changes required 6.83 In the following paragraphs, we use the five elements of the framework to 
assess each of the four options against the base case scenario of the 
reformed franchising system continuing with incremental improvements.444  
6.84 In assessing the options, we refer to the impact assessment which considered 
many of the elements in our assessment framework.  

## Passenger And Efficiency Benefits

6.85 In Chapter 3, we found that greater on-rail competition may be expected to 
bring passenger benefits in terms of lower prices or fares, improved quality of service and greater innovation. In Chapter 4, we also found evidence to suggest that greater on-rail competition may be expected to lead to cost efficiencies at the passenger service and upstream network levels.  
6.86 The importance of examining these potential benefits was highlighted to us in 
consultation responses, for example from passenger and consumer groups.445 
An additional factor relevant to the passenger experience highlighted in consultation responses was the level of complexity faced by consumers in 
purchasing tickets or planning their journey.446 We therefore also consider this 
in our assessment. 

## Lower Prices And Fares

6.87 The impact of each option on fares may relate to factors such as: 
 
The degree of on-rail competition introduced, as the greater the number of flows on which there is an overlap, the more flows there are on which price competition would occur. 
 
The extent to which operators compete, including: 
- the respective business models of the operators, including the extent of 
product/service differentiation; 
- the degree of freedom from specification of services (with greater 
freedom allowing more scope to lower fares, change business models and generate cost efficiencies); and 
- the charges and levies paid by operators. 
 
Whether firms could collude tacitly or otherwise to limit competition.  
6.88 Options 1, 2 and 4 would each create direct competition between operators 
on many flows, while Option 3 would be likely to result in competition on a more limited number of overlaps.  
6.89 In the baseline scenario, the degree of price competition between operators is 
relatively limited as many operators face no (or limited) on-rail competition on the flows they operate and are constrained in their ability to respond to competition where it exists by franchise specification and ticketing rules. 
6.90 Option 4 would lead to the lowest degree of specification, as services on the 
long-distance routes would be entirely or mostly comprised of OAO-type 
operators.447 We consider that this is likely to result in the highest degree of 
price competition. In Option 1, an OAO that was free from franchise specification would compete with the franchised TOC on a significantly expanded scale relative to the base case. In contrast, Options 2 and 3 would retain competition between franchised TOCs subject to franchise specification.  

6.91 We note in paragraph 6.37 that Option 2 may create a risk of tacit collusion 
between operators. The likelihood of this concern arising depends on the degree of symmetry of the operators in terms of their size, cost base and business models. A more asymmetric split between operators is likely to reduce the risk of coordination between operators - although it would also reduce the degree of competition. We also note that the government would retain the ability to specify the types of services run by both operators (eg in terms of their rolling stock, calling patterns and strategy) and that operators might therefore be differentiated. In summary, while there is a risk of coordination between operators in Option 2, there is scope for this risk to be addressed. 
6.92 We do not consider that tacit collusion would be a considerable concern under 
Option 1 as the franchised TOC and OAO would be differentiated in terms of their scale and business model. In Option 3, franchised TOCs would only overlap with other operators for part of their routes, reducing the risk of collusion. In Option 4, there would be multiple operators which may have different business models (eg to target premium or low-cost segments of the market), therefore reducing the risk of coordination.   
6.93 The modelling in the impact assessment suggested that average price 
impacts from competition would primarily depend on the proportion of flows on 
which competition was introduced in the indicative scenarios they modelled.448 
The modelling suggests that Option 1 would have a greater impact on fares 
than Options 2 and 3: 
 
The average impacts of the scenarios modelled for Option 1 on the East Coast and West Coast main lines range from 2.5% to 5.2% while for 
Option 2 the respective reductions range between 1.9% and 3.6%.449 
 
The modelling of the Great Western main line finds overall fare reductions under Option 1 of between 1.4% and 2.9%, compared with reduction of between 0.6% and 1.3% under Option 3.  
6.94 Taking these considerations into account, we therefore expect fares to fall the 
most under Option 4,450 followed by Option 1, Option 2 and then Option 3 
(with fares falling relative to the base case under all four options).  

## Improved Overall Passenger Experience

6.95 We consider that the factors set out in paragraph 6.87 which we considered 
important for driving price competition are most significant in determining the passenger experience, since operators facing strong competitive pressure and with minimal specification are more likely to compete strongly on quality. 
6.96 As discussed in Chapter 5, we note that passengers may face a greater 
degree of complexity if their choice of operator increases, potentially leading to confusion (eg making it more difficult for passengers to buy the best available ticket for their journey). This is likely to increase with the number of operators on a route, and also with how frequently operators' services change. However, this must be balanced with the passenger benefits of new fare types, including lower fares and products which better match demand. 
We concluded in Chapter 5 that these issues are less likely to arise on longdistance routes, where most passengers plan their journeys in advance. 
There are also mechanisms for dealing with difficulties from complexity.451 
6.97 We consider that Option 4 has the potential to give passengers the best 
experience, as having multiple operators with the scope to set their own business models would create the strongest incentives for operators to differentiate their services and compete on quality. Option 1 would deliver these benefits to a degree as the OAO would be free from specification (and the franchised TOC could respond by introducing service quality improvements if its franchise specification allowed it to do so). Options 2 and 3 may create an improved passenger experience relative to the base case, although this would depend on the freedom for the franchised TOCs are free to introduce service quality improvements. The impact is likely to be more limited in Option 3 than in Option 2 given the more limited degree of on-rail 
competition. We consider that all four options would lead to an improvement compared with the base case. 

## Greater Cost Efficiency At The Passenger Services Level

6.98 We consider that there is the potential for efficiencies to be achieved at the 
train operating level, which - in an environment of enhanced competition in 
the market - may be passed on to consumers through service quality improvements or lower fares. 
6.99 As discussed in Chapter 4, efficiency gains are likely to be achieved by 
increasing open access competition. We also consider that there would be potential for improved efficiency from greater on-rail competition between franchised TOCs, although these effects may be lower (in particular given service specification and staff TUPE arrangements). In addition, any economies of density may be lost when services within a route are run by multiple operators, rather than one operator.  
6.100 The impact assessment used similar assumptions and included potential 
adverse impacts on efficiencies due a reduction in economies of density in its analysis. As noted in Chapter 4, under Option 1, where OAOs expand, total 
industry costs fell under most of the scenarios.452 The results for Options 2 
and 3, in which greater on-rail competition between franchised TOCs is 
introduced, were more mixed.453 Efficiencies were not quantitatively modelled 
for Option 4, although the qualitative assessment suggested that Option 4 would create the strongest incentives for operators to reduce costs.  
6.101 In summary, we consider that the extent of efficiency benefits would primarily 
be driven by the degree of open access operations relative to franchised services and degree of on-rail competition between operators. We consider that overall Option 4, followed by Option 1, then Option 2 and finally Option 3 would be most successful in this regard. We also consider that all four options would lead to an improvement in comparison with the base case. 
453 For Option 2, total industry costs were higher in the low scenarios for the East Coast and West Coast main lines, higher in the central scenario for the East Coast main line and did not change on the West Coast main line under the central case scenario. Costs fell under the high scenarios for the East Coast and West Coast main lines. For Option 3, which was modelled only on the Great Western main line, total industry costs rose in the low scenario, fell marginally in the central scenario, and fell slightly in the high scenario. 

## Dynamic Or Innovation Benefits

6.102 We would expect the scope for dynamic competition and innovation to 
increase with the degree of on-rail competition between operators and with the level of freedom from detailed franchise specification.  
6.103 The impact assessment considered that increased competition would be likely 
to lead to innovation benefits,454 and highlighted that OAOs have introduced 
innovations in Great Britain and Europe to date.455 It also considered that 
Option 4 has the most scope to attract new operators to the Great Britain rail 
market and so may increase the likelihood of increased innovation.456  
6.104 With the greatest freedom to introduce innovation, we would expect Option 4 
to achieve the most significant benefits in terms of dynamic competition, 
followed by Option 1, then Option 2, then Option 3. We consider that all four options would lead to an improvement in comparison with the base case. 

## Overall

6.105 Our assessment above suggests that Option 4, followed by Option 1 then 
Option 2 and finally Option 3, would be most successful in delivering passenger benefits. We consider that each of these options would deliver benefits relative to the base case on long-distance intercity routes.  

## Funding And Risk

6.106 As discussed in Chapter 5, greater on-rail competition may be expected to 
reduce government funds from franchise premiums. In relation to risk, we also note that, in the base case, franchised TOCs face uncertainty at the time of franchise bidding as to the extent of on-rail competition that they will face during their franchise. More generally, changing economic circumstances and shocks to the system may lead to the failure of a franchise (as happened twice on the East Coast main line).   

## Taxpayer Funding - Impact On Government Funds

6.107 Option 1 seeks to address this through OAOs making a greater contribution to 
the cost of the network through higher access charges and by way of a PSO levy. The implementation of these mechanisms is considered further in 
Chapter 7.  
6.108 As noted in paragraph 6.29, in the absence of a developed model for a PSO 
levy, the impact assessment models an approach in which OAOs are charged based on the level of abstraction from franchises in conjunction with an estimated share of franchise premiums associated with the service from which abstraction occurs. The levy itself was modelled on a pound-per-passengermile basis. This modelled PSO levy almost entirely offsets the impact on government funds in most scenarios measured, for example leading to a 3% fall in government income under the central scenario on the East Coast main line, and an equivalent 4% reduction on the West Coast main line. The impact was, however, greater on the Great Western main line, where a 15% 
reduction occurred under the central scenario.457  
6.109 The DfT told us in its supplementary consultation response that the impact 
assessment does not propose any deliverable operational model for a PSO levy. In its view, further work should be undertaken regarding the design of deliverability of the PSO levy before a significant programme of reform to introduce greater on-rail competition is introduced. We discuss further work that should be undertaken in relation to the design of the levy in Chapter 7.  
6.110 As noted above, we are aware of the limitations of the quantitative modelling 
in the impact assessment, but note that it provides a broad indication of the likely direction of the impact of the options. In relation to government funds, we also note that there are factors not modelled which might have resulted in a lower impact on government funds than estimated: 
 
OAOs are sufficiently profitable such that they may be able to pay a 
higher PSO levy and remain profitable.458 
 
If higher, cost-reflective, access charges are introduced, OAOs would pay higher access charges than are modelled by the impact assessment.  
6.111 Option 2 is also likely to reduce government funds to a degree by lowering 
franchise premiums (with the impact depending on the extent of on-rail competition created in the design of the franchise split). However, as noted above, higher and more cost-reflective access charges would help to mitigate this effect. The government would also retain control of the flows on which onrail competition would take place and, through franchise specification, the scope for the franchised TOCs to compete. As noted in Chapter 5, any impact on government revenue would need to be balanced by policymakers against improvements in consumer surplus.   
6.112 The impact assessment estimated that the impact on funding under Option 2 
on the East Coast and West Coast main lines was slightly higher than under Option 1, with a 7% and 3–4% reduction, respectively, under central 
assumptions.459 The Great Western main line was not modelled for this 
option. 
6.113 Option 3 would have a more limited impact on government funds as the 
degree of franchise overlap would be more limited. The impact assessment found a relatively small impact on government funds, with a reduction of 2% of 
premium on the Great Western main line.460  
6.114 Option 4 would end franchising on the long-distance routes on which it was 
implemented, but the 'licence' system would be designed to ensure that all PSO services within the main line routes are provided by the OAO-type operators. Revenue raised from the auction mechanism (if this were the approach used), could be used to fund unprofitable but socially valuable services in other loss-making areas which are currently subsidised through franchise 
premiums on other parts of the network. The impact assessment did not model Option 4 quantitatively, but it noted that auction revenue raised from this process would be lower than that raised under franchising, as monopoly rents could not be raised to the same extent, and that licence auctions may therefore raise less revenue than franchising.   
6.115 Overall, we consider that Option 1 has the potential to address the impact on 
government funds from greater on-rail competition, although noting that further work is needed on the PSO levy (we also note, however, that no such mechanism to address the impact of on-rail competition is available to policymakers today). Option 2 would be expected to have some impact on 
government funds, with Option 3 having a lesser impact. Further work would 
be required to examine the impact of Option 4 on government funds, although we note that significant funds could be raised from the auction of paths and that the system would subsequently function without ongoing central government involvement.  

## Impact On Risk For Government And Operators

6.116 Government and operators face risks both under the options and the base 
case. Under the base case, there is a risk of there being an insufficient number of bidders for franchises. As discussed in paragraphs 2.113 to 2.115, 
this risk was noted by the NAO in 2015 and Public Accounts Committee in 2016.  

6.117 The possibility of franchise failure, at which point the government may be 
required to step in as 'operator of last resort', is another risk under the current 
system.461  
6.118 By creating uncertainty for bidders, open access applications in the current 
framework may risk both the intensity of competition for a franchise and, if OAOs enter, the financial viability of a franchise. TOC owner groups also face the risk of losing key franchises which may mean that they are out of the market for a number of years, making it difficult for owner groups to balance risk across their portfolios. 
6.119 We note that the options that we propose offer policymakers additional tools 
for strengthening the current system and addressing risks. In particular, Option 1 seeks to address the risk from open access applications by coordinating the timing of applications with franchise bidding rounds and seeking to address funding issues. Both Option 1 and Option 2 also create smaller franchises, potentially lowering barriers to entry and helping owner 
groups to balance risk across their portfolios.462   
6.120 As we have noted, a potential concern with Option 1, using a PSO levy 
approach, is that OAOs may struggle to be financially viable if paying such a 
levy.463 However, OAOs responding to our consultation told us that they would 
be willing to pay such a levy in return for greater access to the network and, 
as noted in paragraph 6.30, the levy could be introduced over time. The 
modelling work in the impact assessment is consistent with this, with OAOs forecast to be profitable in the scenarios modelled, even after PSO levy 
payments.464 The impact assessment does, however, note that operators' 
profitability would be dependent on the relative treatment of OAOs and 
franchised TOCs in terms of charging and funding.465 
6.121 Under Options 2 and 3, the risks facing operators and government would be 
similar to those under the base case. However, as noted above, Option 2 may reduce the risk to operators of failing to win franchise competitions, as by 
splitting current franchises, competitions may take place more frequently. Security of supply considerations may be reduced as if one franchise were to fail, the other franchised TOC on the route, rather than the government, may be able to operate the failing franchised TOC's services. As discussed further in paragraph 6.171, the application of UK merger control to the award of franchises would also create a risk in Option 3 as bidders with overlapping services would face detailed competition scrutiny.   

6.122 Under Option 4, a dynamic commercial market with multiple intercity 
operators would result and firms may enter and exit the market over time. This may involve some new risks for operators within the market, but this risk may not be substantially more severe than operators face under the base case, from franchise failure, OAO applications or from failure to win franchise competitions. Option 4 may reduce the security of supply risk, as there would be a greater number of intercity operators within a franchise area.  

## Impact On Investment Incentives

6.123 We consider the impact of greater on-rail competition on investment business 
cases and the potential for greater private investment to be incentivised in the network in a more commercial environment in paragraphs 5.97 to 5.109.  
6.124 By increasing the scale of open access operations, Option 1 could incentivise 
greater private investment in the network. As considered in Chapter 3, on-rail competition may increase demand for rail travel, unlocking considerable social benefits and incentivising further investment.   
6.125 We consider that Option 2 would be very similar to the base case in terms of 
investment incentives as franchising would be retained. There may be some impact on government funds, but increased passenger use of infrastructure would be likely to yield passenger and wider social benefits. Option 3 would be very similar in this regard, but with less pronounced effects. We do not consider that the incentives for operator investments would change considerably from the base case. 
6.126 We consider that under Option 4, the creation of a more dynamic, marketbased system may provide strong incentives for operators to invest, particularly if long-term access rights are granted to operators. This may represent a significant opportunity for harnessing private sector investment in the network in the longer term.  

## Overall

6.127 Overall, we consider that while Options 1 and 2 would be associated with 
some impact on funding and risk, they have potential to address some of the risks in the current system. We consider that Option 3 would lead to limited change from the base case. The risks in Option 4 are more difficult to model 
at this stage, although we note that this option has the potential to drive longer-term reductions in risk for government by creating a self-sustaining commercial model of operation. 

## Network Considerations, Including Operational Issues

6.128 As set out in Chapter 5, there are a number of potential adverse effects which 
could result from an increase in a number of operators on the network, including coordination and operational issues. In this section we consider the operational impact of the four options. We also consider the degree to which the options would incentivise efficiency at the upstream infrastructure provision level, the degree to which track capacity would be most efficiently used and whether there would be any impacts on safety.  

## Impact On Coordination And The Level Of Transaction Costs

6.129 In Chapter 5, we concluded that there may be some operational issues in 
introducing greater on-rail competition, although no barriers were found to be 
insurmountable.   
6.130 By introducing an OAO competing with the intercity franchised TOC, Option 1 
may create some additional operational risk. However, as discussed above, we found that this risk would be manageable and would not be significantly greater than in the current system in which multiple franchised TOCs, OAOs and freight services operate on the network.  
6.131 In Options 2 and 3, the government would, through franchise specification, 
retain operational control over the competing franchised TOCs. As such, there would only be minor implications for operational control and performance.   
6.132 In Option 4, a strong system operator function would be required in order to 
manage the timetables of multiple intercity train operators. Changes to timetables and licences would have to be coordinated over time and with major projects. However, while the operational risk is higher than in the other options, we do not consider the issues to be insurmountable.  
6.133 In relation to transaction costs, we consider that challenges in coordination 
issues in the rail network, and the transactions costs involved in internalising 
these, would increase with an increase in the number of operators on the network, and the dynamism of the market. We therefore consider that transaction costs would be highest under Option 4,466 followed by Option 1, followed by Option 2 then Option 3, then the base case. However, as set out in Chapter 6, given the low magnitude of transaction costs currently in the industry, we do not consider that the magnitude of these differences would be very significant.   

## Utilisation Of Capacity And Interconnectivity

6.134 We discuss the impact of on-rail competition on capacity utilisation and 
interconnectivity in Chapter 6.   
6.135 The impact assessment considered that Option 1 and Option 4 may more 
efficiently match services to demand, and that OAOs have in the past successfully put pressure on Network Rail to find capacity, while Option 2 and 
Option 3 would be similarly effective to the base case in this regard.467   
6.136 We consider that Option 4, if designed appropriately, would yield the best use 
of capacity and provision of interconnectivity, as it would be based on market signals and would give the flexibility for services to change in response to demand.  
6.137 Option 1 would achieve benefits in this respect as it has the next greatest 
degree of open access services, which creates incentives to utilise capacity efficiently in response to market signals and to ensure connectivity. Option 2 and Option 3 are unlikely to lead to significant changes in this area.  

## Impact On Efficiency At Upstream Network Management Level

6.138 The impact assessment considered this in its general considerations but did 
not model it explicitly.468 Its qualitative assessment suggested that competition 
downstream may be likely to have an impact on efficiency upstream.469 It also 
suggested that Option 4 provides strong incentives for operators to engage with Network Rail to ensure that it delivers performance and enhancements in a cost effective way. 
6.139 The potential for the options to generate efficiencies upstream depends on the 
intensity of on-rail competition and the degree of commercial freedom and incentives afforded to operators. We therefore consider that Option 4, 
followed by Option 1, would result in the strongest incentives to achieve upstream efficiencies. Options 2 and 3 may have a limited impact in this regard.   

## Impact On Safety

6.140 Safety was cited by many consultation respondents as an important criterion 
against which the options should be assessed.470  
6.141 Rail safety is a primary policy objective both at European and national level. 
An effective European regulatory framework for safety is in place as well as 
detailed national legislation and a safety management system.471 Moreover a 
European Railway Agency, an independent national safety authority (in the UK, ORR) and an independent accident investigation body (the Rail Accident 
Investigation Branch (RAIB)472 in the UK) have been established in all 
member states.  
6.142 Europe's railways are among the safest in the world and Great Britain now 
has one of the safest railways in Europe.473 Consistent with the existing 
legislation and policy, safety is the primary consideration in the Great Britain rail sector.  
6.143 We have not received any evidence that any of the four options under 
consideration would reduce safety on the railway. The options that we are considering would be implemented within the relevant national and European 
Standards Board (RSSB) to develop the Railways and Other Guided Transport Systems (Safety) Regulations 
2006 (as amended in 2011 and 2013), which implements the European Railway Safety Directive and provides the regulatory regime for rail safety. In addition there are a number of further national measures, as the Railway Safety (Miscellaneous Provisions) Regulations 1997, which cover a wide range of safety issues, such as prevention of unauthorised access to the railway infrastructure or providing adequate braking systems; the Railway Safety Regulations 1999 which required the installation of a form of train protection on the railways; and the Train Driving Licences and Certificates Regulations 2010, which brings the requirement to hold a licence and certificate to drive a train into force by 2018.  
safety legislation. In considering implementation, policymakers in Great Britain will be required by the relevant legislation to ensure that no steps are taken which would compromise safety.  

## Overall

6.144 Taking the above factors into consideration, we consider that Options 1 and 4 
would lead to better outcomes at the network level than Options 2, 3 and the base case.  
6.145 While Options 1 and 4 may lead to small increases in transaction costs, we 
consider they may also increase connectivity and capacity utilisation, and reduce infrastructure costs the most. Options 2 and 3 would see savings in infrastructure costs compared with the base case, but may also see higher transaction costs. Options 2, 3 and the base case would be the same in terms of capacity use and interconnectivity as they would all be based on centrally designed franchises.  

## Wider Social Benefits

6.146 As discussed in Chapters 3 and 5, there are a number of wider social considerations associated with the use of the rail network. In some cases this means that services are socially desirable even when they may not be profitable. In 
this section we assess the ability of the options to generate wider social and economic benefits.  

## Externalities Generated: Regional Economic Growth And Environmental Benefits

6.147 As discussed in Chapter 3, rail travel may generate wider economic benefits, 
for example by facilitating regional growth and reducing congestion on road networks. Rail may also help environmental sustainability when rail is less polluting than alternative forms of travel. 
6.148 We consider that Options 1 and 4 would be most effective at generating the 
external benefits provided by the rail network. This is because they have the potential to grow demand by lowering fares and improving service quality. These options could also capture unmet demand at poorly served destinations by making better use of market signals. These options may also take passengers from more polluting forms of travel such as air and road where a degree of intermodal competition exists, and may also reduce congestion on these other transport routes which is in turn likely to have economic benefits. This is consistent with the findings of the 2011 MVA Report for ORR (discussed in Chapter 3), which modelled significant benefits from open access operations on the East and West Coast main lines. 
6.149 Options 2 and 3 would be likely to generate some wider economic benefits 
compared with the base case, as price competition increases passenger volumes. This would, however, be lower than under Options 1 and 4.  
6.150 The impact assessment modelled the environmental and wider economic 
benefits of the options. It suggested that Option 1 would have a greater 
impact than Option 2 and Option 3, and that all options produce positive results relative to the base case: 
 
Option 1 was found to produce benefits valued at between £144 million and £221 million on the East Coast and between £324 million and £671 million on the West Coast main line, in comparison with Option 2 which produced £131 million and £266 million and £59 million and £119 million, respectively, depending on how Option 2 is implemented. 
 
Option 1 was found to produce £50–£97 million on the Great Western main line, in comparison with £21–£41 million on the same line for 
Option 3.  

## Impact On Social Inclusion And Connectivity

6.151 We consider that all the options would be the same in this respect, as 
franchise design under Options 1, 2 and 3, and licence design under Option 4 lead to the same pattern of service provision for less profitable but socially desirable services. Options 2 and 3 may, however, provide the simplest means to achieve these objectives. Some respondents emphasised the benefits of franchise-based options in safeguarding regional services, and 
considered that Option 1 might be less successful in this respect.474 

## Overall

6.152 We therefore consider that in terms of wider social benefits, the appropriate 
ranking would be Option 4 followed by Option 1, then Option 2, Option 3 and the base case due to the revitalised role the rail network could play for the UK.   

## Ease Of Implementation, Including Legal And Technical Feasibility Scale Of Policy And Regulatory Changes Required

6.153 There is a degree of variation in the policy and regulatory challenge in 
implementing any of the options. It was put to us during our consultation that 
we should consider the costs related to implementation of the options and whether these outweighed the net benefits generated by the options in comparison with the base case scenario.475 

6.154 The impact assessment found that Options 2 and 3 could be implemented 
under the current framework. It found that Option 1 was legally and operationally feasible, although further examination of the PSO levy would be required. In relation to Option 4, the assessment found that while there would be significant challenges in implementation, these were not considered to be insurmountable. 
6.155 Option 1 would require a change to the structure of track access charges and 
the introduction of a PSO levy. The former is already under way but, as noted above, the PSO levy would require careful design and possibly primary legislation. A system for allocating paths to an OAO would also have to be designed. However, we have not received any evidence to suggest that these challenges are insurmountable.   
6.156 Options 2 and 3 could be delivered within the current legal framework, 
although a change of franchise policy and, potentially, franchise design, would be required. Option 3 could be implemented gradually as new franchises 
came up for renewal.  
6.157 We note that there is the potential for outcomes similar to those envisaged in 
Option 3 to begin to arise under current policy conditions in some areas, as the DfT may seek to reduce the size of some current franchises in order to reduce the level of financial risk in the system. 
6.158 Option 4 would require an overhaul of the current system in areas where it 
was implemented, including the design of licences and a mechanism for 
auctioning train paths.476   
6.159 The base case does not include significant implementation challenges, as the 
current franchise framework is already in place.  
6.160 Overall, we consider that Options 2 and 3 would be the most straightforward 
to implement as they could be introduced under the current legal framework. Option 1 would require some further steps to implementation, with Option 4 requiring an overhaul of the current system. 
6.161 We consider the steps required to implement our preferred options in 
Chapter 7.  

## Overall Assessment Impact Assessment Modelling

6.162 The impact assessment produced quantitative estimates of the overall impact 
of the options measured in terms of NPV of the costs and benefits for Options 1 to 3.  
6.163 The quantitative assessment aimed to consider the likely direction and broad 
magnitude of the impacts under a range of scenarios intended to be indicative of the type of service pattern and other impacts that could result under each of the options.  
6.164 The impact assessment found that all three options modelled led to positive 
net benefits relative to the base case in central assumption scenarios.477 
Measured in terms of NPV of costs and benefits over a 20-year appraisal 
period,478 the findings (in 2010 prices) were as follows:  
 
Option 1 would generate £489 million of benefits under the central case assumptions on the East Coast main line, £915 million on the West Coast main line and £262 million on the Great Western main line. 
 
Option 2 was modelled as producing £95–£236 million of benefits on the East Coast main line and £151–£166 million on the West Coast main 
line.479 
 
Option 3 under the central case assumptions was modelled as producing 
an NPV on the Great Western main line of £56 million.480  
6.165 Option 4 was deemed too difficult to model quantitatively in the time available 
due to the uncertain nature of the service patterns and exact regulatory framework which it would entail. 
6.166 As set out in Box 3, a number of potential impacts of the proposed options, 
which we considered in our assessment framework, were not quantified in the 
impact assessment.481 Non-quantified impacts include impacts on product 
offering and service quality, impact on the efficiency of Network Rail and positive and negative spillovers outside the intercity routes considered. Some of these may have made the net benefits of the options greater, while others may have had a negative impact on the net benefits.  
6.167 The DfT raised this as a particular concern, noting that no fewer than ten 
distinct relevant issues were explicitly excluded from the quantification of impacts. A number of other consultation respondents raised methodological 
concerns about the impact assessment.482 We have taken these concerns 
into account in the weight that we have placed on the modelling in the impact 
assessment in our overall analysis which, as noted in paragraph 6.163, aimed 
to consider the likely direction and broad magnitude of the impacts.  

## Conclusions - Our Preferred Options

6.168 For ease of understanding we summarise our assessment of the options in 
Box 6 below. We note that this representation is indicative and intended as an aid to understanding rather than a definitive marking.  

 
1 - Greater Open Access 
2 - Split franchises 
3 - Overlapping franchises 
4 - Licence system 
0 - Base case 
Passenger and 
efficiency benefits 
 
 
 
 
- 
Funding and risk 
× 
× 
- 
× 
- 
 
- 
- 
 
- 
Considerations within the network, including operational issues Wider social/ economic benefits 
 
 
 
 
- 
Implementation ease 
×× 
× 
× 
××× 
- 
 

6.169 Overall, we found that Option 1 would be likely to generate significant 
passenger, efficiency and wider economic benefits as a result of competition between two large-scale train operators on key routes, one of which would be an OAO that was not subject to franchise specification. Option 1 also has the advantage of addressing the funding challenge from open access, which is also a feature of the current system. We did not find any legal or operational barriers to implementing Option 1, although the design of a levy to mitigate the impact of greater competition on government funds would require further design work and possibly primary legislation. Option 1 received support from 
a number of stakeholders.483  
6.170 We also found that Option 2 could provide benefits by introducing on-rail 
competition on key routes. Although the scope of the benefits - particularly those arising from dynamic competition - may be reduced by both operators remaining as franchised TOCs subject to franchise specification, Option 2 could generate large-scale on-rail competition and is implementable under the current legal framework. Given the diversity of the network in Great Britain, Option 2 may also have the potential to deliver benefits on parts of the network where Option 1 is less suitable. 
6.171 We consider that Option 3 would produce lower passenger and efficiency 
benefits than Options 1 and 2 given the limited degree of on-rail competition 
that it would generate.484 The application of UK merger control to the award of 
franchises would create a risk as bidders with overlapping services would face detailed competition scrutiny, possibly reducing their appetite for bidding and, consequently, the intensity of competition for the franchise award.   

6.172 Option 4 has the potential to generate the strongest on-rail competition, with 
three or more fully commercial operators competing on key flows, subject to licence conditions. This option would require an overhaul of the current system in areas where it was implemented, including the design of licences and a mechanism for auctioning train paths. Although these barriers do not appear to be insurmountable, further work would be required to fully develop the framework.  
6.173 In Chapter 7, we set out our final recommendations and consideration of the 
steps required to implement our preferred options. 

## 7. Recommendations And Next Steps Introduction

7.1 
In this chapter we set out our recommendations for achieving greater on-rail competition and the key steps for implementing our preferred options to introduce greater on-rail competition.  
7.2 
As described in Chapter 2, the rail industry is complex and changes to the structure of the industry are ongoing. We are conscious of the importance of ensuring that the key stages in implementing our recommendations are coordinated with developments in the sector, such as the recommendations following the Shaw report into the future of Network Rail, ORR's structure of charges review and the development of HS2.  
7.3 
The publication of this policy document does not mark the end of the CMA's engagement in this area. The recommendations we have set out are for the long term and the CMA will continue to engage with policymakers, regulators and other stakeholders to advocate the report's recommendations and to consider further development of the options, as appropriate.  
7.4 
We also encourage industry participants and stakeholders to continue to consider the benefits that greater on-rail competition may bring, and to consider further ways in which opportunities to expand on-rail competition for the benefit of passengers and wider UK productivity may be pursued. 
7.5 
In setting out next steps, we focus first on general recommendations to lay the foundations for a dynamic, competitive industry, and then on the key steps for implementation of our options to introduce greater competition. In order to give future policymakers flexibility in a rapidly evolving sector, we do not attempt to set out the precise mechanisms by which the options would be implemented or the exact form which the options would take. We recommend that these questions are addressed through further discussions with government, the regulator, the industry and passenger groups.   

## General Recommendations: Laying Foundations For A Dynamic, Competitive Industry

7.6 
In this section, we consider the steps required to implement the four general recommendations set out in Chapter 6 that we consider to be key to enabling full realisation of the benefits of greater on-rail competition. These were: 
 
further reducing the level of specification of franchise contracts wherever possible;  
 
reforming the structure of access charges so that charges are more costreflective;  
 
improving incentives for Network Rail in its 'system operator' function to manage traffic and capacity more efficiently and to become more responsive to customer demands; and 
 
encouraging the use of smart ticketing so that real passenger journeys are tracked within the system and potential distortions by the ORCATS system are removed.   

## Further Reducing The Level Of Detailed Specification Of Franchise Contracts

7.7 
We recommend that, as noted in paragraphs 6.67 to 6.70, the government's 
current direction of travel towards less tightly specified franchises continues and that further consideration is given to the appropriate level of specification on franchises where there is a degree of on-rail competition.  

## Reforming The Structure Of Access Charges

7.8 
As set out in paragraphs 6.71 to 6.78, we consider that a number of benefits 
to passengers and taxpayers could be delivered by reforming the structure of access charges. These issues are being considered as part of ORR's structure of charges review.  
7.9 
We also note that the government is changing the way in which it channels public money through the industry, directing it through the TOCs instead of the network grant, with the stated aim of encouraging Network Rail to focus 
firmly on the needs of train operators and, through them, passengers.485 
7.10 We support these steps and consider that they are important in laying 
foundations for a more competitive, dynamic sector. 

## Improving The 'System Operator' Function

7.11 As set out in paragraph 6.79, we consider that an enhanced system operator 
would provide benefits for the rail network, by efficiently managing network capacity and assisting decisions regarding path allocation and investment decisions on the network.  
7.12 Improving the system operation activities would be particularly beneficial if 
greater on-rail competition were introduced, as an enhanced system operator 
would facilitate the allocation of train paths between competing operators and minimise the potential adverse operational effects of an increased number of operators. 

7.13 Again, we note that positive steps are already under way:  
 
ORR is currently conducting a review of system operation activities; and  
 
Network Rail has consulted on an initial system operation dashboard in order to improve the information available about how the system is operated. ORR's findings will feed into its PR18 work, which is now under way. 

## Encouraging The Use Of Smart Ticketing

7.14 As set out in paragraph 6.80, we consider that smart ticketing has the 
potential to strengthen the incentives of operators to compete by allowing revenue from interavailable ticket sales to be apportioned to operators based on the actual journeys taken. This would, in turn, encourage operators to compete to attract these customers, and would provide incentives to raise 
quality and to meet customer demands.486  
7.15 Again, we note that some developments in this area are already under way. 
As of June 2015, 14 operators already offered smart cards to passengers.487 
Moreover, the provisional findings of the ORR's retail market review included short-term recommendations to continue promoting and developing innovative 
ticketing solutions such as smart card and mobile ticketing.  

## Recommended Options For Reform

7.16 We set out our preferred options for reform in paragraphs 6.168 to 6.172. In 
this section we consider the steps required to implement these options.   
7.17 We note that Option 1 and Option 4 share some similarities, with their benefits 
primarily coming from OAO-type operators, and some similar implementation steps such as establishing mechanisms for allocating paths to operators.  
7.18 We also consider that the options we have set out are not exhaustive, and 
that industry, policymakers and regulators are likely to develop further 
proposals for implementing increased competition between operators on the network, taking the spirit of these options forward and adapting to changes in the management of the network in the future. 

7.19 Taking these considerations into account, we recommend that the foundations 
for introducing greater on-rail competition are introduced through our general recommendations. 
7.20 We consider that the first opportunity for implementation of significantly 
greater on-rail competition would come on the East Coast main line franchise 
in 2023.488 However, there will be future opportunities to expand on-rail 
competition on these routes, with the subsequent West Coast main line franchise expected to be awarded in 2025 and the subsequent Great Western main line franchise expected to be awarded in 2026.  
7.21 We note that the reformed structure of track access charges will come into 
effect in 2019. Moreover, given the links to the charging regime, the PSO levy would ideally be in place by the time that the new structure of track access charges is implemented in March 2019. It may therefore be possible to address some of the funding issues in open access applications from 2019 onwards. However, we note that capacity constraints might limit the scale of open access prior to 2023 (at which point capacity could be allocated to OAOs as part of the next East Coast franchise).  

## Recommended Option: Option 1, A Significantly Greater Role For Open Access On Intercity Routes

7.22 We consider that Option 1 is the lead option for introducing greater on-rail 
competition on key intercity routes for the benefit of passengers and wider society. This option could be piloted in one franchise area before being extended to other areas.  
7.23 The first intercity franchise for which an Invitation to Tender will be issued 
following the implementation of the new structure of track access charges - and which would allow time for the other necessary implementation steps - is the next East Coast main line franchise, which will commence in 2023.   
reducing the size of certain franchises. We note, however, that implementing Option 1 would not be feasible in the 2018 award of the Great Western franchise as the steps required, including the new structure of charges, will not be in place until 2019. 

7.24 It would also form the first step in any future transition into the licensing model 
proposed under Option 4.  
7.25 In order to implement Option 1, a number of changes are required which we 
consider in turn below: 
 
Reform of the structure of track access charges to create a level playing field between OAOs and franchised TOCs. 
 
Designing a PSO levy (or other appropriate funding mechanism) and implementing the required legislation. 
 
Providing capacity for OAOs on the relevant routes. 
 
Establishing a system for allocating paths to OAOs. 
 
Legislation to allow path trading (desirable but not strictly necessary).  

## Reform Of The Structure Of Track Access Charges

7.26 The first stage of this process is already under way. ORR's review of the 
structure of track access charges has identified a potential inability to support effective competition between different types of passenger train operator as a gap in the current system. ORR is therefore consulting on proposals for OAOs to make a greater contribution to network costs, particularly where capacity is scarce and most valuable. ORR's consultation notes that such changes might allow for a better allocation of capacity between OAOs and franchised TOCs, which may lead funders to be relatively neutral between them in terms of the 
revenue impacts on the taxpayer.489 
7.27 As part of the review, ORR is considering whether OAOs should pay costreflective charges, thus covering some of the fixed costs of the infrastructure they use. In order not to impose an excessive burden on OAOs and to take into account the existing market differences and long-term business decision taken by OAOs which are already in the market. ORR is also considering possible adjustments and transitional arrangements. 
7.28 Moreover, it its review of charges consultation document, ORR notes that the 
government is considering allowing some exposure of franchised operators to changes in track access charges within franchise periods.  
7.29 We envisage a PSO levy being introduced to allow OAOs to contribute to the 
costs of unprofitable but socially desirable services, both on the routes on which they operate and in other areas. While we consider a PSO levy as the lead option for addressing the funding issue, we recognise that other appropriate funding mechanisms could be used as well, for example an 
auction of paths or slots for open access.490  
7.30 Primary legislation is likely to be required to implement a PSO levy to mitigate 
the impact of greater on-rail competition on government funds, as the levy would be government imposed and distinct from the track access charges set by ORR. 
7.31 EU legislation provides for member states to employ a levy to compensate for 
PSOs, but its imposition is discretionary, and the government has not 
transposed the relevant legislation into UK law to date.491 Transposing the 
relevant EU legislation may be an alternative to making primary legislation in the UK. However, further work is needed to establish whether the levy under EU legislation would raise sufficient funds to compensate for the loss of government funding as it only permits the recovery of the cost of operating PSOs. The levy would need to be designed carefully to ensure that its fits with EU legislation regardless of whether it is imposed by primary legislation or the transposition of EU legislation. 
7.32 It is important that the design and implementation of the levy is coordinated 
with ORR's proposals for the structure of track access charges.492  Therefore, 
while primary legislation would fall to the DfT, we envisage that ORR and the 
DfT would work together closely in the design of the levy.  
7.33 There are a number of aspects of a levy to consider, in particular: 
 
how the levy would be charged, for example on a per-passenger mile, per-train, or per-carriage basis; 
member state to impose a levy on rail operators providing passenger services to contribute to the financing of PSOs laid down in PSCs that have been awarded according to European law. 

 
whether and how the levy would change over time, for example whether it would increase over time as OAOs establish their services; 
 
the interaction of the levy with Article 12 of the Recast Directive,493 
including how to ensure the levy would be designed precisely enough to ensure it would not overcompensate for the cost of PSOs (which would not be compatible with Article 12 of the Recast Directive); and 
 
other more detailed considerations regarding the practical arrangements for charging the levy. 
7.34 In terms of timing, the design and introduction of legislation for a PSO levy or 
other appropriate funding mechanism would need to be undertaken in advance of the implementation of Option 1 on an intercity franchised route in order to give bidders a clear understanding of the new framework. Any levy would need to be in place as soon as possible so as to inform open access entry decisions. 
7.35 Given the links to the charging regime, ideally the levy should be in place by 
the time the new structure of charges is implemented in March 2019. In order for a PSO levy or other appropriate funding mechanism to be ready in time for 2019, development and drafting of legislation would need to begin a number of years in advance, potentially as part of a future Markets or Transport Bill.  
7.36 We recognise that designing a PSO levy or other appropriate funding 
mechanism that meets the objectives of funding unprofitable but socially desirable services while not deterring entry by OAOs requires further work. However, we consider that this is both technically and legally feasible, as discussed in Chapter 6.  
7.37 While OAOs responding to our consultation stated that they would be willing 
to pay a levy in return for greater access to the network, care would be 
needed to ensure that the levy did not act as an unjustifiable barrier to entry. It may also be appropriate to consider whether any levy should apply to current OAOs with small-scale operations focused on previously unserved destinations.  
7.38 The DfT and ORR are best placed to take forward the design of the PSO levy, 
with the CMA providing input, as appropriate. We recognise that there are considerable complexities and challenges in relation to this issue, which will require further work to fully consider.   

## Providing Capacity For Oaos On The Network

7.39 In order to facilitate a significantly expanded role for open access, Option 1 
requires paths to be available on the relevant routes for OAOs. As set out in Chapter 5, we understand that while electrification programmes and other short-term enhancements will deliver some additional capacity, this is unlikely to be sufficient alone to facilitate full-scale open access operations in addition to current franchised services. In the longer term, ERTMS may deliver 
additional capacity, although the magnitude of this is still not clear.494  
7.40 Towards the end of current intercity franchises we envisage franchise design 
being undertaken with the intention of leaving significant commercial flows available to OAOs. We anticipate that for the East Coast main line franchise beginning in 2023, this would mean the DfT taking this into account in advance of the intended issue of the franchise expression of interest 
documents for the East Coast in August 2021.495 This is likely to mean 
preparations beginning by early 2020  at the latest. 
7.41 It terms of implementation, this would require the DfT to design a smaller 
franchise on the East Coast main line. This is likely to involve: 
 
First, the identification of elements of service provision which are unprofitable (or less commercial) but which are socially valuable.  
 
Second, franchise designers at the DfT would need to design a franchise such that all, or as many as possible, of these aspects were included within the franchise. A number of the more profitable service aspects would also be bundled into the franchise in order to ensure competition with the OAO on commercial flows. 
 
Third, consideration would need to be given to the services which OAOs would be likely to provide based upon this proposed franchise pattern. 
7.42 It would also be necessary to ensure that the OAO's access rights were 
coordinated with the timing of the franchise bidding process in order to provide certainty for bidders regarding the future level of on-rail 
competition.496 Consideration should also be given to whether the OAO's 
access rights would expire at the end of the franchise (with another competition for open access rights potentially taking place at this point).   
7.43 We also note that it is important to retain flexibility to make changes to access 
rights during the course of the franchise in order to respond to changing market dynamics and changes in competitive dynamics. In order to give Network Rail the possibility of changing timetables over time, access rights could become more flexible during the course of the contract. 

## Establishing A System For Allocating Paths To Oaos

7.44 It would be necessary to establish a mechanism for allocating the paths 
reserved for open access. A system for allocating paths would be likely to be best carried out by ORR or a more developed system operator function undertaken by Network Rail. The design of this system could be undertaken by ORR or the DfT.  
7.45 There are a number of possibilities as to how paths could be allocated. For 
example, there could be an economic assessment of OAOs' proposals (for example, by ORR), within which the PSO levy that an OAO would be willing to pay could be one assessment criteria. Alternatively, a bidding or auction process could be used (discussed further in the context of Option 4 in paragraphs 6.59 to 6.61). This could create a source of revenue for funding 
unprofitable but socially desirable services elsewhere on the network. 
7.46 As with the design and implementation of the PSO levy or other appropriate 
funding mechanism, it would be important for this system to be in place before the Invitation to Tender is issued for the franchise on which it would be implemented. For new OAO applications taking advantage of new capacity prior to the first significant intercity franchise award in 2023, this would mean being in place by 2020. 
7.47 These approaches would involve substantial policy design and consultative 
work with industry. The scale of this task is likely to be determined by the number of paths which would be transferred to OAOs and the number of operators which expressed interest.  

## Legislation To Allow Path Trading

7.48 Although not a prerequisite for implementing Option 1, the ability of operators 
to trade paths could enhance the scope of on-rail competition by allowing operators to trade paths as competition between them develops. In practice there is likely to be a need for a system of supervision of path trading to ensure that operators are not able to achieve control of groups of routes which give them market power and raise prices. 
7.49 We note that trading of infrastructure is prohibited by Article 38 of Directive 
2012/34/EU, which specifically prohibits the trading of infrastructure between applicants for that capacity. Further legal analysis of whether this would prevent a system of trading paths or slots such as we envisage here would need to be undertaken. If so, exemptions to this Directive may need to be 
sought.  
7.50 Network Rail's system operator function is likely to be the best placed 
organisation to run a supervised system for path trading. Design of this system could be undertaken by ORR or the DfT. However, this proposal would be likely to need primary legislation and so design may need to be undertaken by the DfT.  
7.51 This proposal is likely to be most significant for full-scale implementation of 
Option 1, which we consider would take place at the earliest at 2023. In order for franchised operators to fully understand the context in which they were bidding, this feature, if it were to be implemented as part of Option 1, would ideally be in place by 2020. 
7.52 We consider that this aspect of implementation would, if pursued as part of 
Option 1, involve substantial policy design and consultative work with industry. The scale of this task is likely to be determined by the number of paths which would be transferred to OAOs and the number of operators which expressed 
interest.497  
7.53 As noted in paragraph 7.43, flexible access rights would, in any event, allow 
adjustments to the timetables of the franchised TOC and OAO to be made over time.  

## A Vision For The Longer Term: Option 4, A Licensing System For Operators On Main Intercity Routes

7.54 Option 1 could be extended towards the model of competition in Option 4 in 
the future. For example, instead of a TOC operating 70% of train paths for intercity services and an OAO the remaining 30%, three OAOs of a similar size could be licensed to operate all the paths.   
7.55 This is an ambitious proposal and would require an overhaul of the current 
system.  
 
The design of an auction or other process for allocating paths, including the design of licences themselves and a decision between administratively designed licences or a trading-based system of allocation, or a similar variant. 
 
The adaptation of national legislation regarding the licence system and fine-tuning with the EU framework. 

## Design Of An Auction For Allocating Paths

7.56 The implementation of this option will depend on the process used to allocate 
paths to operators. We envisage that this would be likely to be based primarily around auctions for a form of licence. Effective auction design would therefore be central to successful implementation. 
7.57 In Chapter 6, we set out two sub-options within Option 4 regarding the form 
that licences might take:  
 
The first is for 'administratively designed licences', where a planning body would design licences so that they produced an acceptable level of service and a coherently connected timetable in a financially viable way.  
 
A second approach would be to have a licences with an associated number of social obligations where operators would have to provide a certain 'number' of unprofitable but socially valuable services which was tied, for example proportionally, to the profitable services they would run. These services could be chosen from a 'list' drawn up by a central planning body, and ideally a trading system or platform would allow these obligations to be traded between operators.  
7.58 In Chapter 6, we considered that a system of auctioning bundles of paths or 
'mini franchises' may be the most practical and effective way forward. This mechanism would be intended to be used for both allocating capacity and ensuring provision of unprofitable but socially desirable services, either through bundling with paths, or through raising revenue to help pay for their provision, or through a combination of the two. 
7.59 Given that we recommend that Option 4 is only implemented after the 
introduction of Option 1, the policy work regarding design of an auction and associated choices would be likely to take place in the early 2020s. The design could be informed by the experience of allocating paths to OAOs under Option 1. 
7.60 Designing an auction to allocate all paths on a route would present a number 
of challenges. However, we consider that an iterative process increasing in 
ambition and moving in this direction over time, as we recommend in this chapter, would provide a feasible method for industry, policymakers and regulators to undertake this task. 

## Adaptation Of National Legislation Regarding The Licence System, And Compatibility With The Eu Framework.

7.61 The licensing system for multiple operators we propose under Option 4 is an 
ambitious, fully competitive solution, which would be much more advanced than other systems currently operating in Europe.  
7.62 In order to implement such a system a number of amendments to domestic 
legislation, in the form of the Railways Act 1993, are likely to be necessary. This may include the licensing of operators and with the role of a system 
operator as possibly distinct from the current network operator role.498  
7.63 Although the principles underlying this option, and our other recommendations, are broadly in line with current EU legislation and the expected direction of travel, engagement with EU institutions would be necessary in order to establish the compatibility of the licensing system with EU law. In particular, it would be necessary to ensure compliance of Option 4 with the 
Recast Directive499 and any forthcoming EU legislation.  
7.64 The DfT would be well placed to pursue such steps if it were minded to do so, 
given the requirement for primary legislation and policy engagement with EU institutions. In practice, this would be likely to be undertaken in consultation and conjunction with ORR and the industry.  
7.65 The work to design the legislative process and interaction with EU institutions 
would need to begin some years in advance of implementation, for example in the early 2020s. 

## Our Parallel Recommendation: Introducing Option 2 Where It Has The Potential To Deliver Benefits On The Network

7.66 In parallel to our main recommendations, we also recommend considering the 
introduction of Option 2 on areas of the network where it has potential to deliver greater benefits. This would allow policymakers a choice of tools to achieve greater on-rail competition in the future. Option 2 would be implemented under the existing regulatory framework.  
7.67 The franchises on which the option was implemented would need to be 
redesigned in order to ensure that there is appropriate competition between the two franchised TOCs on the selected routes, while retaining operational integrity.  
7.68 Key steps for using Option 2 where it has the potential deliver benefits are as 
follows: 
 
Identifying the routes where it would deliver the greatest potential benefits.  
 
Redesigning franchises to increase competition between franchised TOCs. 
 
Reforming the structure of access charges so that charges are more costreflective. 
Identifying the routes where these options would deliver the greatest potential benefits  

7.69 This process would be undertaken by franchising and other regulatory bodies 
in conjunction with the industry and other stakeholders. The exercise would need to be completed in advance of the issuance of the expression of interest documents for the franchise(s) on which it were implemented (2021 in the case of the East Coast main line). 

## Redesigning Franchises To Facilitate Greater On-Rail Competition

7.70 Services on the relevant routes would need to be divided between two 
franchises to ensure the provision of desired services and to achieve the desired degree of competition between the operators. This would require the franchise-letting body, the DfT, to redesign franchises in advance of tendering them.  
7.71 This exercise would be similar to that required in redrawing franchise maps to 
allow Option 1 to be implemented. However, the process may be simpler as the dynamic of competition between a franchised TOC and an OAO would not need to be considered to the same extent and it would not be necessary to identify each PSO service.  
7.72 Consideration would also need to be given to accommodating current OAOs 
and in dealing with future open access applications.  
 Reforming the structure of access charges so that charges are more cost-reflective  

7.73 Option 2 could have a significant impact on government funds if extensive 
competition were introduced and no other changes to the industry framework were made. However, this impact could be mitigated by reducing the extent of on-rail competition (eg splitting the franchise 85:15). Moreover, reforming the structure of access charges to make them more cost-reflective, and therefore higher on key intercity routes where capacity is limited, could create an additional source of revenue for the government.  

## Conclusions On Our Recommendations And Next Steps

7.74 Overall, we conclude that implementation of our options may be expected to 
bring benefits to passengers and the wider economy. We conclude that these options are feasible and we have identified a number of steps by which a process towards establishing greater on-rail competition can be undertaken.  
7.75 Our general recommendations seek to lay the foundations for greater on-rail 
competition. We note that many of these initial steps, for example access charges reform, smart ticketing and reducing franchise specification, are already underway. 
7.76 We further recommend that Option 1 - a greater role for OAOs - is 
implemented in the medium term and that this could in turn lead to movement towards a system along the lines of Option 4, based upon multiple competing, licensed operators. Meanwhile we recommend that Option 2 be considered in parallel as a potential means to introduce competition between franchised TOCs on parts of the network where this may be most beneficial and as an 
alternative tool for policymakers.  

## Next Steps

7.77 The publication of this policy document does not mark the end of our engagement in this area. The recommendations we have set out are for the long term and we will continue to engage with policymakers and regulators as appropriate to discuss how the benefits of on-rail competition can be harnessed on the network in the future.   
7.78 We also encourage industry participants and stakeholders to continue to 
consider the benefits that greater on-rail competition could deliver, and to consider further ways in which opportunities to expand on-rail competition for the benefit of passengers and wider UK productivity may be pursued.