The great railway robbery

What's been going on?

Last week the government settled on who gets to run the trains between London and big cities such as Manchester, Birmingham and Glasgow. Virgin Rail a joint venture between Richard Branson's Virgin Group and Stagecoach has run the trains on the West Coast mainline for the last 15 years.

However, from December this year until 2026, FirstGroup, a rival train operator, will take over the service having outbid Virgin Rail. The contest has raised questions over how train franchises are awarded. The concerns stem from the fact that, in order to win the bid, FirstGroup has promised to pay the government nearly £10bn over the life of the franchise.

Virgin has branded the government's decision as "insanity", claiming that FirstGroup's numbers don't stack up and that it risks going bust and leaving the service in turmoil. It looks likely that MPs will now investigate this bid and whether the bidding process for train franchises will need to change.

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Why do we have rail franchises?

Franchises began when John Major's Tory government privatised the railway network in 1993. Like industries, such as electricity and water, Major thought that the railways would be run better in private hands. His government believed that private sector money and innovation would give the British public a better railway. So British Rail was broken up into lots of different parts and 25 different rail franchises were let to private companies.

How do rail franchises work?

The government invites companies to tender a bid. It then examines whether these firms can run a railway. It looks at proposals for things such as the frequency of train services and the number of trains and carriages. Once satisfied, a few companies are asked to submit formal, priced bids.

For busy and profitable commuter and inter-city lines, bidders compete on how much money they will pay back to the government over the life of the franchise. These payments are known as premiums.

For inherently loss-making lines, such as those in Wales and Scotland, bidders compete on how much subsidy they will need from the government in order to make a reasonable profit.

In most cases, the winner tends to be the one that offers to pay the biggest premiums or take the lowest subsidies. In return, they get to run train services on the route with little or no competition. If the franchise performs better than expected, the operator shares its excess profits above a pre-determined level with the government. If performance is worse than expected, and revenues or GDP are below a certain level, the government covers a large proportion of the losses (say 80%).

What's wrong with franchises?

Quite a lot. The franchise system does not encourage large investments by train companies. The tracks and trains are rented from other firms who put up the cash to buy them. The taxpayer ultimately underwrites the returns on these assets.

The main problem levelled at the current system is that it encourages firms to bid in a way that exposes both the firm and the taxpayer to big financial risks.

Take FirstGroup's bid for the West Coast franchise. Its promised payments of a total of £10bn to the government are heavily loaded into the last few years of the franchise. This gives it a chance of making good money in the early years and walking away later on if the premium payments get too steep. It would have to pay £265m to walk away, but it might be a price worth paying. The government then doesn't get the money it was expecting and is left with the line's running costs. This is what happened with the East Coast franchise when National Express made promises it could not keep.

It seems that a cash-strapped government will always take the promise of lots of cash before working out whether it will see much of it. As a customer, it's sometimes difficult to see what difference a change of operator brings. Often it's the same trains just painted differently, with the same timetable and staff so nothing really changes.

So will fares keep going up?

Railways give governments headaches. They are a vital public service that cost a fortune. Total public spending on the railways was £7.6bn in 2010/2011 but just £431m before privatisation. Very few railway systems make money. It's often a question of how much subsidy a government wants to put into it. The British government wants to commit less and less taxpayers' money. As long as the current franchising system encourages operators to promise lots of money to the government, things are unlikely to change. With less government cash, it looks like rail firms will have to tap customers and raise fares to make their franchises pay.

Is there a better alternative to franchises?

Calls for the re-nationalisation of the railways will probably fall on deaf ears. But the British system costs too much, while passengers pay some of Europe's highest fares. One solution advocated by Stagecoach boss Brian Souter is to make the railways less complicated for example, by allowing operators to manage the tracks and infrastructure currently controlled by Network Rail.

Millions are wasted each year when Network Rail pays compensation to companies for delays caused by track maintenance. If the same firm performed these tasks then costs would fall and fare increases would be kept reasonable. Operators would also be given an incentive to buy trains with their own money.

Giving them permanent franchises would create an incentive for long-term investment and could lead to a better railway than the segregated system currently gives us.