Southeastern: Non-Breaking News

On 28 September the Department for Transport announced that they would be taking over the Southeastern franchise, following a breach of franchise agreement. We look at what this means for the franchise, and why it’s not quite the ‘breaking news’ that it seems.

In October, London and South Eastern Railway (LSER) will cease to be operate under the management of Govia and instead the franchise will be managed by the government under its Operator of Last Resort (OLR) arrangements. Passengers who use Southeastern services will not notice an immediate change (for better or worse) in their services. The OLR system exists precisely to ensure continuity of service, and to provide breathing room for the DfT to refranchise or plan differently in the wake of a service takeover. Nor is this the first time we’ve seen an OLR come into play – most notably and recently, with LNER.

The DfT have issued a full press release detailing the reasons for the franchise moving back into government hands. You can read that in full here. It’s broad points are:

• Government’s Operator of Last Resort to take over running of London & South Eastern Railway (LSER) services from 17 October.

• Decision follows an investigation which identifies over £25 million of taxpayer money was not declared by LSER, amounting to a significant breach of the franchise agreement, undermining trust.

• OLR will prioritise punctual and reliable services for passengers and delivery of crucial reforms set out in the Williams-Shapps Plan for Rail.

• Fares, tickets and services unchanged for passengers and no impact on frontline jobs.

Digging into the details

We are unlikely to see much detail about what specifically went wrong at Southeastern any time soon. A National Audit Office (NAO) enquiry was inevitable after a handback, but it is also worth noting that in this case the Serious Fraud Office (SFO) will be involved as well. This may sound… well… serious and that could turn out to be the case. But it is also standard practice when potential accounting issues are involved. As part of this process, the Senior Financial Officers for the period and firms (local and parent), the companies themselves and indeed their auditors will come under scrutiny. The recent case involving the collapse of Patisserie Valerie is a good guide to what is involved (and sometimes uncovered) by such an investigation.

With both those investigations pending, it’s important not to dive too far into hypotheticals about what happened. At the same time, however, it is important to highlight one of the biggest potential contributing factors to the failure: the complexity and incremental nature of the Southeastern franchise.

The Southeastern franchise has always included a level of complexity in its terms and conditions above and beyond that of most London-related franchises. This is in part due to the inclusion of HS1 within it. HS1 was never a natural fit for the franchise, due to the way it was built and funded, but it needed to sit somewhere and Southeastern was the least-worst fit. What that left the franchise with, however, was a somewhat byzantine set of extra terms, conditions and subsidies related to the operation of HS1 services. This included different Network Rail track access charges – and rebate levels for that access – related to the line.

This situation has been made even more complex by the resort to direct awards for the franchise over the course of almost a decade. Something that has limited the opportunity for old terms and conditions to be tidied up, while layering new complexities on top.

In this environment, this line from the DfT press release becomes rather telling:

An investigation conducted by the Department for Transport has identified evidence that since October 2014 LSER has not declared over £25 million of historic taxpayer funding which should have been returned.

It is perhaps not surprising that this line and figure have drawn the most attention among those looking for proof of deliberate corporate greed and failure, but also among those looking to see this as breaking news or a sudden decision (indeed the latter may well be the DfT’s intention). Stepping back and considering it in the context and complexity of the Southeastern franchise however, does put it in a different light.

Firstly, it’s worth noting that October 2014 marks the period from which the first major direct award of the LSER franchise happened. Indeed subsequent direct awards have mostly been copy-and-paste renewals of this deal. This means it is also the last time there will have been a substantial variation to the terms and conditions. It thus heavily suggests that this is the point at which a calculation error crept in, in access or rebate terms, that LSER failed to correct. This isn’t just a theoretical problem – it has happened before, elsewhere. Most notably, on the North London Line in the early 2010s when Network Rail was found to have been double-charging TfL for track access without anyone spotting it.

On that note the levels of cost indicated here would seem to nicely align with, say, an issue related to the calculation of access charges and rebates on HS1 (which are tenfold that of standard Network Rail rates). As would the apparent quick diagnosis once an issue was spotted and the payback (with an investigation as to why these went undiscovered for so long still to follow).

At the risk of busting the Holmesian image that we are rapidly building up of ourselves though, it is perhaps worth noting that none of this is breaking news. At least not here in LR Towers. Nor was it likely news in the esteemed Palace of Rail, or the vast halls of Modern Railways.

Everyone has been watching LSER for precisely this issue, and this news for some time because LSER and the DfT had already disclosed that it existed. The DfT discovered the issue in 2020, presumably as a consequence of reviewing all terms and conditions in detail during the process of dealing with COVID arrangements and rebates, and as part of the modernisation and standardisation they need in place for their ‘Great British Railway’ (GBR) plan.

To quote LSER’s own 2019 accounts:

On 31 March 2020, the Secretary of State for Transport notified one of the Group’s subsidiary companies, London and Southeastern Railway Limited (LSER) that it was required to recalculate the Profit Share payable over the period from 12 October 2014 to 29 June 2019 pursuant to the Franchise Agreement dated 10 September 2014. LSER has subsequently provided the Secretary of State for Transport with an explanation for the historical calculation of profit share and has recognised a best estimate of the assessed outcome within these financial statements. Any additional amounts payable are disputed due to LSER’s statement of position being supported by express terms or agreement, correspondence between LSER and the Secretary of State for Transport, treatment in practice and the development and terms of the Franchise Agreement. Should the Secretary of State for Transport’s notification prove successful then the outflow of resources could be in the region of £8.0m.

For this reason, we had (within LR Towers) been awaiting the release of this year’s LSER accounts with a certain amount of excitement and anticipation. We doubt we were alone. Sadly, but understandably, the publishing of these has now been delayed. That the assessed figure seems to have grown to £25m since March 2020 though does suggest they would have made for interesting reading, and that the eventual National Audit Office report will, too.

Not everything is breaking news

In the meantime, however, this does serve as a healthy reminder that just because a press release breathlessly announces that something has been discovered and indeed that Something Is Being Done™, doesn’t necessarily mean that this happened at the pace or in the timescales the tone implies. It is easy to be shocked at the discovery that gambling is happening in this establishment if you’ve been aware that gambling has been happening in this establishment for some time.

This is not to imply that the DfT, or current Secretary of State for Transport have been (within the context of the metaphor) engaged in any of the gambling. Simply that the response to it had long been decided and planned for. The current Southeastern award expires in October. It takes far longer than three weeks (two months if you’re being brisk) to prepare for a transfer to an Operator of Last Resort and, as the above quote from LSER’s accounts shows, the likelihood of the franchise transitioning onto an OLR setup has been practically a certainty since March 2020. Planning for this transition started a long time ago.

Before looking at what comes next, therefore, it is worth once again stressing what this announcement actually is: confirmation of an action long-planned but now imminent. Is it the correct action? Yes. But it is also not the sudden knocking down of office doors and decisive, swift action by the DfT and Secretary of State for Transport that their breathless announcement of it is keen to suggest. Indeed given the department have had since March 2020 to announce it, and with three weeks left before contract handover, one is tempted to ask what circumstances perhaps prompted the desire by both Department and Minister to be seen as acting swift and decisively about something right now. Perhaps this is a question for those queueing for petrol to ponder.

What comes next

Looking forward to what comes next for Southeastern services, there is one thing that is very important to stress: nobody knows. This includes the DfT.

This is not to suggest any failure of planning or imagination on anyone’s part. It is simply recognising that this is the worst possible circumstance in which to be trying to plot the future of a failed franchise.

Broadly, the options on the table remain what they have always been with the franchise, throughout its various direct awards (and even before): Devolve all, or just the suburban metro services, to TfL, or push it out again under a new franchise arrangement. Yet the variables, benefits and costs involved in both of those activities are murkier than they have been for almost a decade.

Just two years ago, one might have assumed that the politics of potentially devolving additional services to TfL were looking bright. Shapps (as Transport Secretary) and Khan (as London Mayor) lack the very real personal rivalry and animosity that had existed in the Grayling/Khan relationship and which scuppered various genuine (and not so genuine) conversations about devolution before.

But then COVID hit and, whether it was Shapps’ personal intention or not, it became quickly clear that TfL, and Khan in particular, were to be singled out for particularly harsh and public treatment over the cost of providing transport through the crisis. The political legacy of this has been a drastic weakening of TfL’s political independence and an even more drastic worsening of its financial position. Earlier conversations related to the devolution of Southeastern had, according to sources, in part come to nothing because TfL saw the predicted cost of bringing services up to scratch as prohibitive. This was due to years of direct award-related under-investment. TfL indicated that it would require a level of subsidy or significant investment guarantees from the DfT which the DfT did not wish to make part of the deal. TfL’s financial position is even worse now, thanks to COVID and the delayed opening of Crossrail, so they’re hardly likely to be open to the idea again.

When you’re the bank’s problem…

Nor, one suspects, could the DfT simply demand TfL take Southeastern over as part of the continuing negotiations for COVID financial support for TfL. The truth is that TfL’s levels of debt, in part the result of the government’s desire to prove a political point outside of the capital, now mean that landing it with a devolved Southeastern and limited support would likely tip it over the financial edge. TfL (and by extension the Mayor) defaulting on their loans might be something that would trigger a few high-fives in certain parts of the DfT and government, but one body who would be substantially less amused would be the Treasury.

TfL is, to all intents and purposes, a local authority. An unusual one certainly, but a very large one too. Certainly one that belongs in the category of ‘too big too fail’. Indeed oddly, by placing so much short term financial pressure on TfL the government have given them a certain amount of financial soft power. Any financial failure of TfL would send enormous ripples through the UK borrowing market for other public bodies. At that point, TfL’s failure stops being a DfT or local government problem. It becomes a Treasury problem. And nobody wants to annoy the Treasury.

Going back out

If the political and practical variables around devolving Southeastern are complex, then the alternative appears no better. The UK rail franchise market was hardly buoyant in 2014, when the first major direct award of the franchise was made. Since then both Brexit and COVID have happened, making the idea of taking on a failed commuter (and thus low-profit) franchise even less palatable to potential bidders.

Key to that problem is the thing that bidders hate most: uncertainty. The traditional model of rail franchising has, since its beginning in the UK, been about persuading bidders that if they shoulder the uncertainty and complexity of running a railway service they can turn a profit. It is about the taxpayer outsourcing the risk in return for also outsourcing any financial profits, with the expectation that the service is the same, or ideally better, than a government-run service could provide.

Whatever one’s thoughts on the underlying model, it is not hard to see that the critical factor in the entire equation is the uncertainty. And we live in uncertain times. Not just over the question of whether the immediate future will include further temporary restrictions on travel, but also on what the future of London commuting will be. That passenger numbers will (and are) bouncing back is absolutely certain. That they will resume a similar demand curve as before is possible and perhaps likely. But its not hard to see what a largely South London-based franchise, which is heavily reliant on both supporting (and profiting) from commuters might look like a bad bet for a bidder right now.

There is, of course, an alternative. The TfL Overground model. The risk is retained, the service is specified and the bidders compete to deliver the service at a lower cost, but with a far better idea of what profits can be expected. This is the obvious model for at least the suburban sections of Southeastern, whether in the hands of TfL or not. Indeed even the DfT now accepts that such a model (combined with longer franchises to avoid the inherent under-investment found in shorter ones or direct awards) is its future. But it is not the DfT’s now. It is only beginning the journey laid out in its GBR plan and is poorly prepared for making Southeastern a landmark new franchise under a new improved model.

The beginning, not the end

The story about how Southeastern ended up in the failed state it did is only beginning. Only time, the NAO and SFO will reveal the secrets there. We look forward to writing about it when they do. It will likely not be a fun story for LSER or its parents when it comes to accounting practices and railway management. But it will also likely include some harsh truths for the DfT about the significant damage that continual direct awards have done to the railway.

There is a good chance, however, that even the slow wheels of the NAO and SFO may turn faster than those related to what happens with the Southeastern franchise next. It’s not that the diverging paths the franchise could take aren’t clear, its that the swirling waters of government policy, politics, COVID and more mean that it will be some time before even a least-worst option becomes clear.

In the meantime, the Southeastern’s long-suffering passengers, and in many cases its long-suffering employees, will have to hope things don’t get worse. Unfortunately they’ll also need to accept that there is limited scope within the Operator of Last Resort setup for things to get any better.

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Cover photo by Chiltern006