Profit restraints for directly awarded contract extensions are required by EU law – and lawyers believe these mechanisms could become permanent

Profit caps and other profit restraints are set to be imposed across the majority of train operating companies under the Department for Transport’s plans to restart the rail franchising process.

The measures will apply during the short term franchise extensions which the DfT is planning to negotiate with incumbent operators in order to reschedule its franchising timetable. Twelve of the 16 DfT franchises will be affected for periods ranging from 12 months to 50 months.

The move will be necessary to conform with EU law on the direct award of franchise extensions which are not provided for under operators’ current contracts. In these circumstances, EU law requires that operators’ returns do not exceed “a reasonable profit”.

In addition, the profit levels negotiated must take account of the relative risks borne by the operators and the Department for Transport. Potentially, this could enable operators making premium payments to the DfT to negotiate higher profit margins than those which receive subsidy. Profit restraints are expected to be removed when new long term franchises are let.

“The regulations don’t actually say what a reasonable profit level is, but one of the DfT’s priorities will be to prevent any legal challenges to ensure they can get the franchising programme back on track,” one industry lawyer told Passenger Transport. “We are working on the basis that this will mean introducing a mechanism to cap profits, or letting franchise extension contracts closer to a concession basis.”

An industry source familiar with the DfT’s plans confirmed that measures to limit profits are expected to be included in forthcoming franchise extensions. “There are clear and onerous EU requirements about not overcompensating owning groups during directly awarded contract extensions,” he said.

Although profits are expected to be constrained, the current 1% of revenue management fee in the ‘emergency’ extension to Virgin’s contract was not seen as a precedent. “That reflected the specific circumstances around the collapse of the West Coast competition and suspension of the franchising process, and there is also provision for that contract to be renegotiated so that Virgin can take revenue risk,” he said.

 

Caps may not be temporary

Profit restraints imposed during directly-awarded franchise extensions are currently envisaged as a temporary measure to comply with EU requirements on directly awarded contracts. However, law firms have warned operators that they should not be complacent in assuming that restraints will automatically be removed when new longer term contracts are let on the open market. “If temporary measures are subsequently viewed as a good idea in practice, there is a possibility that they can become permanent,” one senior industry lawyer told Passenger Transport.

 

Further analysis on rail franchising can be found inside the latest issue of Passenger Transport:

Will extensions set tone for addressing costs?
Is reprieve for ticket offices a sign of lack of desire to tackle costs?

Minimising impact on the reform agenda
Extensions must not slow efforts to reduce subsidy

Will extensions set tone for addressing costs?
Is reprieve for ticket offices a sign of lack of desire to tackle costs?

c2c’s new deal is confidential
DfT to remain tight-lipped during negotiations

‘Commercial stagnation’ fear
Short extensions may stifle essential innovation

 

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