1. Investment, Reprocurement and Franchise Contract Length in the British Railway Industry Toulouse, 7-8 November 2003 Luisa Affuso NERA and London Business School David Newbery University of Cambridge Luisa.Affuso@nera.com

2. Background

3. 3 1994-1997 Railways Privatisation Decline in market share for rail transport Underinvestment Attempt to introduce competition in the industry British Rail was split into about 100 companies

4. 4 Infrastructure: Operations: Rolling Stock: Maintenance etc. One Company (Network Rail) regulated by ORR -Office of Rail Regulator- 25 Passenger Franchises of 7- 15 years (TOCs) regulated by SRA -Strategic Rail Authority- Three leasing Companies (ROSCOs) ~ 60 Companies The Privatised Industry Model Vertical Separation

5. 5 The industry structure Rail Regulator SRA Franchising Director Freight operators Passenger train operating co.s (TOCs) Open access operators e.g. Eurostar Network Rail owns the railway infrastructure Other service providers e.g. telecoms Infrastructure maintenance companies (IMCs) Track renewal companies (TRCs) Rolling stock companies ROSCOs Network Rail SuppliersNetwork Rail Customers

6. 6 Rail Demand Source: National Rail Trends- SRA 0 5 10 15 20 25 30 35 40 45 1986-19871987-19881988-19891989-19901990-19911991-19921992-19931993-19941994-19951995-19961996-19971997-19981998-19991999-20002000-20012001-20022002-2003 Billion- Passenger km/Tonne km Passengers Freight

7. 7 Investment in Rolling Stock and Infrastructure Source: National Rail Trends- SRA

8. Issue

9. 9 Issue: Decline in Rolling Stock Investment up to 1999-2000 Investment behaviour affected by: Extensive contractual structure (incomplete contracts of various duration) Specific Assets (e.g., diesel, electric) Track and train complementarities Hold-up problems at different levels Franchise contract length Uncertainty (demand, competition, re- procurement)

10. 10 Theory overview 1. Asset Specificity if investments are specific short-term contracts are not efficient (e.g., CATV), Williamson (1985) 2. Reprocurement rules vary, IF: (i) non perfect transferability of assets (ii) non perfect measurability of investment Favour incumbent otherwise: underinvestment, Laffont & Tirole (1993) 3. Uncertainty In the presence of uncertainty delaying investment has a positive value = Call option, Dixit & Pindyck (1994) Degree of irreversibility of assets and degree of competition are crucial in determining the sign of the effect of uncertainty on investment. Guiso and Parigi (1999), Abel and Eberly (1994).

11. 11 A model of investment behaviour I it Investment in rolling stock by company i at time t A Asset specificity variables C Contract characteristics (e.g., length, committed investment) U Uncertainty (demand, competition, re-procurement) F Firm i’s financial and organisational characteristics (profits, subsidy, horizontal/vertical consolidation)

12. 12 Hypotheses

13. Empirical Analysis

14. 14 The Data Panel Data: t=3, i=25 Specifically compiled from companies' accounts, annual reports of companies and regulatory offices, industry press.

15. 15 The Methodology Methodology: Random effects models Tobit estimation Tobit with pooled data

16. 16 The results

17. 17

18. 18 (1)Panel Tobit (2)To (5) Pooled Tobit

19. Conclusion

20. 20 Policy responses and Conclusion Evidence suggests 1. Short franchises may promote investment 2. Rolling stock investment responds to market signals SRA’s actions 1. Extend length of franchise contracts (15-20 years) 3 cases- Then change of directions: new policy is short franchises 2. SRA to procure rolling stock- Then questioned: opens consultation (June 2003) reporting date November 2003