Scrap HS2 to ease government debt crisis

Hyperinflation 206x167The recent announcement that the projected cost of Crossrail 2 has risen to £27 billion should be cause for deep concern within the Treasury. Added to High Speed 2 and High Speed 3, this means the total budget of just three planned or proposed rail schemes could be close to £100 billion – or perhaps even higher, given the overruns so typical of big government projects.

Economic conditions amplify the financial risks. The deficit remains stubbornly high, while robust medium-term growth cannot be guaranteed given the ongoing crisis in the euro zone and the fragile condition of the banking sector. This implies that a large proportion of future transport investment may be funded by government borrowing, adding a not insignificant amount to a national debt that has already reached £1.5 trillion.

There are clear echoes of Japan in the 1990s: a heavily-indebted government viewing transport investment as a way to stimulate growth after a deep recession.

To be fair, there is some merit in this argument. Improved transport links tend to raise productivity and boost growth by lowering the costs of trade. Greater specialisation and economies of scale are facilitated. Workers find it easier to access jobs that make good use of their skills and talents.

But transport spending also has major downsides. The additional tax burden needed to fund schemes directly, or repay debt incurred, suppresses economic activity. Incentives for work and entrepreneurship are diminished, while resources are misallocated due to the distorting effects of taxation. The overall cost to the economy is substantially higher than the direct tax bill.

The negative effects may be particularly severe if transport spending pushes levels of government borrowing into dangerous territory, such that market confidence is undermined. This risks a ‘debt spiral’, with a larger and larger share of tax revenues used to pay back investors in government bonds.

Heavily indebted governments should therefore exercise particular caution on transport investment. They must ensure that the economic benefits outweigh the full costs, taking proper account of the downside risks of budget overruns and the impact on public debt.

This didn’t happen in Japan. Vast sums were wasted on poor value schemes with low benefits – including the notorious ‘bridges to nowhere’. Government borrowing was pushed up, while taxpayers were also forced to pay ongoing maintenance and operating costs.

Unfortunately, a similar pattern is now emerging in the UK, as an ‘infrastructure craze’ grips our politicians. Rather than focusing on high-return, low-risk projects, the government is favouring low-return, high-risk schemes such as HS2. Once the negative effects on the wider economy of the additional taxation and borrowing are factored in, there is a significant chance that the costs of these projects will exceed their benefits.

The dangers are further exacerbated by rapidly changing technology. Developments such as advanced video-conferencing and driverless cars have the potential to completely transform transport markets by 2030. New technologies, for example in rail signalling or road pricing, also mean congestion and capacity problems can now be tackled at a tiny fraction of the cost of building brand new infrastructure.

Fortunately, there is still time for the UK to change course. One of the new government’s first priorities next year will be to instil confidence in its deficit reduction plan. Scrapping poor value transport projects would achieve this at minimal political cost.

City AM, December 2014

Why taxpayers should be angry about rail policy

Taxpayers have far more reason to be angry about rail policy than passengers. They pay about £6 billion a year to support the railways, even though most of them rarely use trains. And it makes little economic or environmental sense to subsidise long-distance commuting, which encourages inefficient travel patterns and energy intensive lifestyles.

The argument for subsidies on grounds of fairness is also weak, as rail commuters are on average far richer than the general population. Measures that froze rail fares or limited increases to the Consumer Price Index would benefit this affluent minority at the expense of taxpayers and the wider economy.

Moreover, stricter price controls would exacerbate overcrowding problems, putting pressure on the government to fund hugely expensive infrastructure projects to increase capacity.

Regulating fares is therefore not a sensible way to cut travel costs. Instead the government should reverse current policy and give train operators more flexibility to vary fares to address congestion problems, for example by introducing ‘super-peak’ pricing and offering large discounts to passengers who avoid travelling at the very busiest times.

 

A shorter version of this letter was published in the London Evening Standard on 8 December 2014.

Crossrail: On time and on budget, or delayed and descoped?

construction cranesMinisters and rail industry bosses frequently claim that Crossrail is being delivered ‘on time and on budget’, but is that really the case? A 2014 National Audit Office report suggests that, at best, these spokespeople may have been misinformed by their advisers.

The NAO analysis reveals that in 2009 ‘the anticipated cost of the programme had escalated to £17.8 billion’, taking the likely budget to about £19 billion once the rolling stock is included.

The report states that to reduce costs to an acceptable level, ‘the schedule for opening the railway has been extended’, with sponsors agreeing ‘to extend the timetable for full opening from May 2018 to December 2019’ (p. 22). Further economies were achieved by ‘simplifying integration works, re-sequencing work and reducing scope, saving £800 million’ (ibid.). In other words, the project seems to have been delayed and descoped and apparently will not be built to the specifications originally envisaged.

If an infrastructure project is already underway but heading over-budget, there are of course two main options to address this: increasing the budget by obtaining more money from funders, or building less infrastructure for the same money. In the case of Crossrail, the NAO analysis implies that if it had been built on time and to the original specification, the cost may have been approximately £20 billion (and it may have been far higher if the prolonged slump had not put downward pressure on construction rates).

It remains to be seen whether the scheme will actually meet the revised schedule and budget, since much of the construction work is yet to be completed. Whatever the outcome in five years’ time, claims that Crossrail is ‘on time and on budget’ risk misleading the public.

Is privatisation to blame for high rail fares?

IEA Blog, December 2014

Rail fares per passenger-kilometre are on average around 30 per cent higher in Britain than in comparable Western European countries. In addition, annual regulated fare increases exceeded the Retail Prices Index, an official measure of inflation, by 1 percentage point per year from 2004 to 2013. This is widely held to be a consequence of privatisation: the necessity for private rail firms to make a profit and pay dividends to shareholders meaning that fares must be substantially higher than otherwise would be the case. It is therefore argued that the rail industry should be reformed to help tackle the cost-of-living crisis and secure a ‘better deal’ for passengers.

In May 2014 more than 30 Labour parliamentary candidates called for train operations to be taken over by the government as current franchise agreements ended – a form of gradual renationalisation. Official Labour Party policy does not go quite so far, but would allow publicly owned train operators to compete with private firms. This approach could lead to creeping renationalisation given political influence over the franchising process. There are also calls to introduce a freeze on rail fares or at very least a ‘tougher cap’ on increases.

Proposals to address the cost-of-living crisis by increasing state involvement in rail are based on a series of misconceptions. Indeed, the heavy focus on fares suggests fundamental ignorance of the economic importance of rail to the UK economy. While the average household spends approximately £64 per week on transport, only about £3.30 is spent on train and tube fares. The impact of any fare reductions on the cost of living would thus be trivial. By contrast, policies that reduced motoring costs (c. £56 per week per household), such as cuts to fuel duty and car tax, would offer substantial relief to household budgets.

Another problem for the re-nationalisers is the relatively modest profit margins of the train operating companies, estimated at around 3 per cent of turnover. This implies that the ‘savings’ from no longer paying out dividends to shareholders would simply not be large enough to fund a significant reduction in fares. This conclusion also holds when other privately owned elements of the rail industry are considered.

Additional state intervention in the rail market would also be poorly targeted if poverty alleviation were the aim. On average rail travellers are far better off than the general population. Almost 60 per cent of spending on rail fares is undertaken by the richest 20 per cent of households, who also spend a higher proportion of their incomes on rail fares than poorer groups.

The skewed distribution of rail ridership towards high-income groups severely limits the potential for enhanced price controls to reduce the living costs of those on modest incomes. Indeed, for the population as a whole, more stringent fare regulation is fundamentally flawed as a cost-reducing measure, since what is saved in fares must be paid in additional taxes. Worse still, price controls reduce the efficiency of the rail network by artificially stimulating demand and increasing industry costs. Lack of price flexibility also makes it much harder to make better use of existing capacity. The resulting overcrowding creates political pressure for state spending on uneconomic new rail infrastructure, at additional expense to taxpayers.

Even if they were successful then, the proposals for additional state intervention to moderate rail fares would be ineffective at addressing cost-of-living issues, and in the case of further price controls entirely counterproductive. However, the proposed interventions would almost certainly fail to achieve even their stated objectives because they reflect a flawed analysis of the problems facing the sector.

There are several reasons for the high costs of the rail industry, but ‘privatisation’ per se is not one of them. Firstly, the effects of the history and geography of Britain’s railways should not be neglected. For example, the high share of rail travel involving trips to and from London – a vast and expensive global city – raises costs compared to other countries, even if other factors are held constant.

Secondly, it is misleading to refer to the reforms of the 1990s as ‘privatisation’ without understanding the extent to which the state continued to regulate, fund and direct the industry. Nominal ownership was indeed transferred to the private sector, but key decisions remained with the government. Opportunities for entrepreneurship, innovation and cost-cutting were heavily restricted by regulation. Unsurprisingly, major productivity gains were not forthcoming.

To make matters worse, policymakers imposed a complex, artificial structure on the industry. Contrary to evolved practices, the sector was fragmented, with separate firms managing the infrastructure, owning the rolling stock and operating the trains. These arrangements required armies of highly paid lawyers, consultants and bureaucrats, and also created numerous other inefficiencies.

Under a genuine privatisation model, there would have been strong incentives to reduce these additional costs, for example by moving back to a structure of vertical integration. However, traditional railway industry structures and full private ownership are effectively banned under European Union law. The proposals for part-renationalisation will not address the fundamental flaws in the structure of the rail industry that push up costs. EU ‘open access’ rules limit the options for more radical reform.

Renationalisation policies also risk further undermining the limited opportunities for entrepreneurship and innovation on the railways. The shortcomings of state-owned enterprises are well documented, and include poor cost control, lack of entrepreneurship, susceptibility to political interference and endemic misallocation of resources. In the longer term, these inefficiencies would tend to lower productivity on the railways, resulting in some combination of higher fares, higher subsidies or reduced quality of service. A range of new problems would be added to an already suboptimal industry structure.

Finally, the high cost of Britain’s railways to a large extent reflects wasteful investment in uneconomic new infrastructure. Since the mid-1990s it has been government policy to encourage modal shift from private road transport to public transport. This contrasts with the previous post-war emphasis on the managed decline of rail.

In this context, subsidies and other interventions have artificially inflated passenger numbers, creating a rationale for new capacity. Moreover, government funding helped create a powerful rail lobby with a strong financial interest in extracting additional resources from taxpayers.

Several large rail projects have been undertaken during the ‘privatisation’ era, including High Speed 1 (HS1), the West Coast Main Line upgrade, Thameslink and Crossrail. The cost of these five schemes alone is approximately £50 billion in 2014 prices. While taxpayers have paid the lion’s share of the bill, there has also been a significant impact on fares in some areas. For example, passengers in Kent have seen steep increases following the commencement of HS1 commuter services.

More generally, wasteful spending has contributed to concerns about the taxpayer funding such a high proportion of industry spending, strengthening the case for regulated fares to be raised above the official rate of inflation. Importantly, rail infrastructure projects have typically been heavily loss-making in commercial terms and poor value compared with road schemes. They would not have been undertaken by a genuinely private rail industry that was not reliant on state subsidy. Wasteful investment, and its impact on fares, is the direct result of government policy and should not be blamed on privatisation.

Clearly there are strong grounds for criticising the privatisation model imposed on the rail industry. The productivity gains associated with private enterprise were largely suffocated by heavy-handed regulation; a complex and fragmented structure pushed up costs; and huge sums have been wasted on uneconomic projects. In this context, it is unsurprising that fares have not fallen. However, it is also the case that these problems are symptoms of government intervention rather than the result of privatisation per se. Indeed they would not have occurred had the railways been privatised on a fully commercial basis under a ‘light-touch’ regulatory framework which allowed the organisation of the industry to evolve according to market conditions.

 

A longer version of this article was published in Smoking out red herrings: The cost of living debate.