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BIS Shrapnel Report
05 March 2003
Review of an ARTC Proposal to Lease Rail Track in NSW - Preliminary Report
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BIS Shrapnel has been asked to provide advice to the Labor Council of New South Wales on a proposal to extend a 60 year lease of the main NSW regional freight lines to the Australian Rail Track Corporation (ARTC), and a related evaluation of the proposal conducted by the Office of the Coordinator General of Rail (OCGR) on behalf of the NSW Government. The focus is on the likely financial and economic consequences of the proposal for the NSW Government and the State of NSW, and the impact on different stakeholders, including rail workers. Our approach is to use the OCGR modelling and analysis, which provides a good assessment of the issues and quantification of the main impacts, as the main basis of our evaluation.
The following summarises BIS Shrapnel's main findings from a preliminary review of the ARTC Proposal and the NSW Government's evaluation.
The rail network is an essential part of NSW's infrastructure. It is currently run by Rail Infrastructure Corporation (RIC) at a significant financial cost to the NSW Government. RIC currently receives annual payments of Community Service Obligations (CSOs) from the NSW Government as a subsidy to cover shortfalls between revenues and costs (estimated at around $160m pa for the proposed lease section and $105m pa for the residual section).
ARTC Proposal
The ARTC Proposal is to take over management, operation and maintenance of the inter-state portion of the NSW rail network (excluding the metropolitan rail network and regional branchlines). It proposes to take a 60 year lease over the network at peppercorn rents, with the NSW Government providing a $61.9m financial contribution and an undertaking to complete some related capital projects. In return, ARTC would undertake an $872m capital investment project over the first five years, and relieve the NSW Government entirely of its CSO payment obligations relating to the leased network.
On the logic of the proposal, the ARTC would run the rail network as part of its existing network of interstate lines on a sound commercial basis. Its proposed investment program would improve network performance and revenues. However, the main improvement would come from running the leased rail network on a substantially lower cost basis than RIC currently achieves. In particular, the ARTC Proposal involves a significant reduction in labour costs relative to RIC and a move to outsourcing with contestable contracts.
OCGR review
The OCGR conducted a detailed review of the ARTC Proposal on behalf of the NSW Government. This included:
· contracting Maunsell to review the proposal's cost assumptions and projections;
· extensive modelling and evaluation of the financial consequences for the NSW Government and the development of a detailed business model of the proposal in order to test its financial viability (conducted by PricewaterhouseCoopers); and
· an assessment of its economic impact (conducted by Applied Economics).
The OCGR's review found that, on the basis of the ARTC assumptions, the proposal presents a good business case with a reasonable probability of achieving long term sustainability and a significant net financial benefit to the NSW Government, estimated at between $700m and $950m in net present value (NPV) terms. The main benefits and costs came from:
· the reduction in CSO payments, generating an estimated $1.5b NPV benefit to the NSW Government over the course of the 60 year lease;
· offset by transition costs (most importantly, substantial redundancy and salary maintenance costs RIC would face in downsizing operations), estimated to reduce the overall NPV benefit by around $780m; and
· costs of maintaining the residual network, estimated to reduce the overall NPV benefit by $120m.
It should be noted that the OCGR estimate of the net financial benefit to NSW Government is significantly lower than ARTC's estimate presented in the original proposal due to:
· the choice of a more appropriate discount rate (using NSW Government recommended standard rate of 7% real, compared with ARTC's rate of 6.3% nominal);
· a more detailed (and accurate) estimate of the reduction in the NSW Government's CSO payments; and
· the inclusion of a variety of NSW costs not included in the ARTC estimate (including the transition and residual network costs listed above).
Maunsell's independent estimate of costs casts doubt over ARTC Proposal's viability
However, the Maunsell review found several of ARTC's key cost projections to be seriously underestimated. In particular:
· Projected spending on inspections, minor works and major periodic maintenance (MPM) was found to be at least a third below the estimated minimum required for the assets (implying that these cost projections needed to be boosted by 50%).
· Capital cost projections were also well below the minimum estimated, especially for the Southern Sydney Freight Line. About $450m of ARTC's proposed $872m capital spending program was also found to be on items that would have been classified as major periodic maintenance (MPM) under RIC's projections, with a significant proportion of this work likely to have been conducted anyway as part of RIC's ongoing MPM program.
These findings cast serious doubt over the ARTC's ability to achieve its business plan, which depends heavily on key cost and staffing assumptions. While Maunsell's estimates suggest that ARTC's current costings are understated by around $800m in NPV terms, the OCGR's financial modelling shows that the viability of the proposal starts to become doubtful once costs increase by $300m in NPV terms (a 20% increase in costs compared to the 50% increase required to maintain assets at a minimum standard mentioned above).
The implication is that while ARTC's revenue projections are reasonable, its cost projections are unachievable without leading to a serious degradation in the quality of the leased rail network over the longer term and, most probably, an associated deterioration in performance and safety standards.
This introduces a major element of risk to the proposal. If it were to go ahead as it currently stands, the likely emergence of serious financial problems would eventually put extreme pressure on ARTC management to:
· seek additional funding from the Commonwealth Government (and, either directly or indirectly, the NSW Government); and/or
· keep costs and manning levels below the levels identified as necessary to adequately operate and maintain the network.
The second outcome is highly undesirable, especially given that it would probably take 5-10 years before inadequate asset maintenance and renewal started to appear as a noticeable deterioration in network performance (including both standards and safety), with similar delays in official recognition, remedial action and the feedback to lower revenues. Deteriorating safety standards, for example, wouldn't necessarily result immediately in a major accident or disaster. Instead, they would tend to have a slow realisation rate, with the increased probability of major accidents only becoming apparent years later.
Recognition of risks forms the basis of NSW Government's response
The conclusion is that although the financial benefits of the ARTC Proposal to the NSW Government are tempting, the proposal itself is seriously flawed and opens up the NSW Government to substantial risks -- risks that would result in significant additional costs to the NSW Government. In short, in answering the question "Is this the right thing to do?" -- if you accept the ARTC financial assumptions, then "yes". But given the problems the OCGR review highlighted in the proposal and the risks this exposes the NSW Government to, the answer is "no".
The OCGR identified these problems early on, and made a response to the ARTC and the Commonwealth Government in late 2002. It is understood that their concerns included:
· that the proposal's forward expenditure proposals are not consistent with proper asset renewal and could be expected to lead to a deterioration in infrastructure condition and performance over time;
· that the NSW Government would remain exposed to substantial residual risk with limited recourse, e.g. if ARTC financial problems lead to a significant deterioration in track condition, the NSW Government would have little option but to take back control of the infrastructure in a potentially run-down condition; and
· other concerns regarding substantial transition costs the NSW Government would incur -- particularly the redundancy and salary maintenance costs for displaced RIC workers, and the increased cost to RIC of managing the residual network.
The OCGR is also believed to have expressed a more general concern that the ARTC lacked the capability and resources to adequately manage the proposed lease network, given that it would effectively double the size of the ARTC network, and more importantly, lead to a quantum leap in the complexity of ARTC's operations.
State of Play
As it stands, the ARTC Proposal doesn't work as a financial proposition to the NSW Government. The ARTC and Commonwealth Government are aware of this and the ball is now effectively in their court. The next step, if any, would be response from ARTC and the Commonwealth Government presenting a modified proposal with revised cost estimates and, probably, funding arrangements.
A revised proposal based on Maunsell's cost estimates would be appealing to the NSW Government
Although the NSW Government has essentially stated that the ARTC Proposal could not be recommended without addressing the fundamental concerns outlined above, it is important to note that if the ARTC and Commonwealth Government were to come back with a revised proposal consistent with Maunsell's cost estimates, this would be very attractive for the NSW Government, both on financial and economic impact grounds.
The OCGR evaluation clearly identifies the potential for a more sustainable, modified proposal to generate significant financial benefits to the NSW Government and net benefits to the broader economy. The ARTC's inadequate forward cost projections became apparent early on in the OCGR evaluation. Consequently, a "Key Sustainability Test" was developed based on Maunsell estimates of the minimum cost to maintain the leased rail network over the longer term, using "world's best practice" scope and unit rates. Although the ARTC business model, as presented, was not viable under these assumptions, the "Maunsell-based" cost scenario was also used as the basis for the OCGR's estimates of the net economic impact of the ARTC Proposal.
The upshot of this analysis was that a "Maunsell-based" cost scenario would generate:
· a significant net financial benefit to the NSW Government in the range of $700m to $950m; and
· a significant benefit to the broader economy, estimated at around $280m.
The main economic gains come from the reduction in maintenance and operation costs under the Maunsell cost basis relative to the most likely RIC costs (which are estimated to be about 40% higher than Maunsell's estimate of "world's best practice" in scope and unit rates). Once again, the main offset comes from transition costs and the increased cost of maintaining the residual network.
These estimated net benefits are not strictly an evaluation of the ARTC Proposal per se but are instead an estimate of "potential benefits" that would occur if a financially modified proposal were to go ahead based on Maunsell's cost estimates. In effect, they assume the ARTC:
· goes ahead with the proposal as it currently stands;
· experiences actual cost outcomes that match Maunsell's estimates (and in so doing, is able to achieve world's best practice); and
· manages to re-arrange funding so that it remains financially viable, and attractive or acceptable to the NSW Government (most likely through some form of increased Commonwealth Government funding).
The estimated benefits could not be expected to occur under the ARTC Proposal as it stands. The financial modifications required are significant, and while they might (arguably) be unimportant for the purposes of an economic evaluation, funding arrangements are critical to the viability of the proposal and its appeal to the NSW Government.
ARTC's unrealistically low cost projections mean that the NSW Government would be likely to encounter substantial costs further down the line if the proposal were to go ahead in its current form, i.e. taking the risk of being called upon, directly or indirectly, for additional funding to keep the ARTC Proposal commercially viable, and/or receiving a substantially degraded rail network once the lease expires (or is terminated). Indeed, the worst case scenario from the NSW Government's point of view would be being asked to take over a substantially degraded network again well before the lease expires. Even a modified proposal is liable to see some additional costs for the NSW Government.
The estimated net economic benefit under a "Maunsell-based" cost scenario is also still highly sensitive to changes in key cost assumptions.
· The net economic benefit is relatively small to start with (it is significantly smaller than the net financial benefit to the NSW Government as a large part of the latter comes from an effective transfer of CSO costs to the ARTC, which has a neutral impact on the economy).
· More importantly, the main source of economic benefit comes from cost reductions -- i.e. from ARTC achieving significantly lower costs than RIC currently does (i.e. achieving the Maunsell estimates).
A relatively small upward adjustment in projected costs would reduce these net benefits, and could see the overall benefit quickly swamped by the other costs involved (i.e. transition costs and costs of managing the residual network).
However, the main point is that, despite these sensitivities, if ARTC were to come back with a modified proposal consistent with Maunsell's cost estimates, the financials would work well for the NSW Government and the economic impact would still be a significant positive. They might remain concerned that Maunsell's cost estimates may not really be achievable, but they are likely to be willing to have a go at it.
There are a number of other important issues in considering the ARTC Proposal, including:
· the appropriate valuation of the ARTC's capital program, i.e. the $450m of ARTC's proposed $872m capital investment program that would be classified by RIC as MPM;
· the inclusion of a range of additional transition costs to the NSW Government, including likely redundancy and salary maintenance costs, and costs associated with the transfer of machinery to ARTC (including potential delays in securing replacement machinery);
· the potential (commercially unproven) for generating additional revenue streams through other services such as telecommunications;
· the positive impact of creating a "one-stop shop" for negotiating access to the national rail network; and
· the positive environmental spin-offs of encouraging a modal shift from road to rail.
And a key consideration is whether the proposal provides for the adequate maintenance of the rail network over the course of the 60 year lease. Maunsell's analysis shows that the ARTC Proposal, as it stands, falls well short on this count and consequently, the NSW Government faces substantial residual risk from the prospect of the ARTC Proposal not performing. It may be tempting to view the ARTC Proposal as an opportunity for the NSW Government to sell the asset at a "high" price (although the proposed lease arrangement is at a peppercorn rent, it is a good price given the CSO payments the NSW Government will be relieved of). But if the proposal doesn't work -- i.e. if it leads to major financial problems for the ARTC or to a long term deterioration in the rail network -- then the costs to the NSW Government could eventually outweigh the benefits.
However, while the OCGR review shows the ARTC Proposal does not provide for adequate maintenance, Maunsell's cost estimates suggest that, regardless of who ends up running the network, there is the potential for productivity improvements to significantly reduce costs of operation -- i.e. that there's room enough for an improvement that can be distributed among the various parties (i.e. State and Commonwealth Governments, rail users etc).
Would ARTC & Commonwealth Government come back with a revised Maunsell-based proposal? Additional costs may still be seen as worthwhile.
The problem from ARTC's point of view is that the necessary cost modifications would make the proposal financially unviable. A modified proposal would therefore require significant changes to its financing arrangements. Alternative financing arrangements that have negative spin-offs for the NSW Government or the economy more generally would reduce the appeal of a modified proposal to the NSW Government. However, an alternative financing arrangement that avoided this (e.g. involving significantly more Commonwealth Government funding) would probably be accepted by the NSW Government.
It should be noted that increased Commonwealth Government financing may not necessarily be forthcoming. As it stands, the Proposal would be a relatively poor investment compared to normal financial transactions the Government would look to fund, (i.e. with respect to meeting the Government's financial criterion for projects of a 7% rate of return -- the discount rate), and that the ARTC may be "paying too much" (even though its lease is at peppercorn rents and includes significant funding from the NSW Government).
A modified proposal based on Maunsell's cost estimates would generate an even worse NPV, probably resulting in negative free operating cashflow in most years, i.e. a modified proposal would probably require some form of ongoing funding arrangement for ARTC to meet annual operating shortfalls.
Indeed, that is why the proposal, if it can be fixed (i.e. in terms of funding and improving forward cost provisions) would be so attractive to the NSW Government. Provided that it maintains the network and carries no additional (or hidden) costs to the NSW Government, a revised proposal effectively transfers a poor investment/funding arrangement off the NSW Government's books.
The Commonwealth Government may still decide to fund a modified proposal. But, once they recognize the realistic costs involved in running the network, they would have to view the proposal as generating significant non-financial benefits to offset the high cost, i.e. they would have to have a good reason for committing to that level of exposure.
This really just highlights the "public good" nature of the rail network. The NSW regional freight lines are difficult to run on a purely "commercial" basis and not helped by climatic and geotechnical problems, competition from a heavily subsidised road network, and the regulation of rail access prices. The rail network is a classic item of public infrastructure which provides a benefit to NSW but can't get users to pay.
The crux of the issue is potential for further productivity gains, reducing the costs of operation
But these issues are not really the main game when it comes to assessing the proposal. Instead, the key is the belief that there is the potential for major efficiency gains to be made on RIC's current performance, i.e. for substantial cost reductions.
The ARTC Proposal goes too far, with cost projections set at levels too low to ensure the adequate long term maintenance of the network. But Maunsell's estimates suggest that costs can still be brought down significantly from RIC's current level, with positive spin-offs for the NSW Government and the economy. Whereas ARTC's costings are roughly 50% below what Maunsell considers to be the minimum cost to maintain the leased rail network over the longer term, RIC's current cost basis is around 40% above this level.
The key is whether Maunsell's estimates are realistic. While this is beyond the scope of this review, it is worth noting that:
· Maunsell's estimates are the result of a desktop technical analysis, not a full shadow modelling exercise;
· They are based on "world's best practice" scope and unit rates (in effect, observable Australian best practice adjusted for specific NSW conditions) -- that would take time to implement and may not be readily achievable; and
· They also imply substantial changes in manning practices with a major impact on employment conditions and enterprise agreements.
Consequences for rail workers
There may be a concern that (high?) costs associated with current manning practices could still be reduced by an alternative arrangement with the ARTC letting contracts for specified work and breaking up the current system.
· The concern for workers and RIC is that it would also lead to deterioration of the network, lack of training and accreditation, shifts in responsibility for line quality and reduction of safety standards.
· For workers, the likelihood is a shift from essentially tenured employment to subcontract work, competing with less skilled workers.
· Several experiments with contracting out responsibility for sections of line in NSW have found difficulty in achieving the desired cost reductions.
· And many participants cite with horror the events following privatisation of British Rail in the UK.
Both the ARTC Proposal and Maunsell's cost estimates propose operating and maintaining the proposed lease network and conducting a major capital investment program with significantly fewer staff than RIC and SRA currently employ just to operate and maintain the same lines. Although specific figures are not available for direct comparison, RIC currently employs about 2150 employees on the proposed lease network. The ARTC Proposal would underwrite employment for around 880 RIC staff and 200 SRA staff over through the initial three year transition period. However, it provides no other staffing details, e.g. for staffing requirements beyond year 3, or for the proportion of work not conducted by RIC or SRA -- ARTC anticipates only 20-30% of the $639m infrastructure investment program being conducted by RIC.
However, the likely consequences for rail workers are reasonably clear. These will include:
· changes to manning and employment conditions;
· a substantial decline in employment;
· significant changes to employment arrangements, with a likely shift from day labour to a contract or sub-contract basis; and
· (arguably) potential impacts on safety standards and the performance of network.
From the point of view of operating the network, there is also a concern that shifting to a competitive contract model for maintenance etc, and an overzealous approach to reducing costs could also lead to the loss of a "culture of responsibility" -- whereby individual workers take responsibility for specific sections of track -- and the risk of falling standards.
While it is difficult to know how it will turn out, and much will depend on the final form of an alternative agreement, there are clearly substantial risks involved in taking an overly-aggressive approach to reducing costs.
Context of future growth in rail freight
Improving the productivity of the rail network would also be of benefit from a broader infrastructure perspective. BIS Shrapnel expects that, longer term, the logical solution for containerized inter-capital city transport is a continuation of the switch from road to rail. The main drivers of this switch will continue to be rising safety concerns as the volume of trucks increases, improving rail services generating significant cost advantages, and changes in other parts of the distribution system (especially container shipping). Although road is currently heavily subsidized, the policy problem will increasingly become how to continue and accelerate the shift from road to rail freight. This positive long term outlook is predicated on significant capital investment to upgrade the national rail system. Rail freight will be a major beneficiary of this process.
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