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.


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