Delivery Considerations – a report for HS2

Delivery Considerations – a report for HS2

18 December 2009

Ernst & Young i

The UK firm Ernst & Young LLP is a limited liability partnership registered in England and Wales with registered number OC300001 and is a member firm of Ernst & Young Global Limited. A list of members’ names is available for inspection at 1 More London Place, London SE1 2AF, the firm’s principal place of business and registered office.

Ian Jordan High Speed Two 55 Victoria Street London SW1H 0EU

18 December 2009 IA/MG/AB/GF Direct Line: 0207 951 0742 e-mail: [email protected]

Dear Ian

Delivery Considerations – A report for HS2

I am pleased to provide you with this report setting out the delivery and financing considerations relating to the options for a potential High Speed Rail link from London to the West Midlands. This report provides a summary of the process undertaken in reviewing the options available to HS2 and our recommendations on the delivery and financing options to be adopted in the delivery of the rail link building on the conclusions of our phase I report dated 29 July 2009.

This report has been prepared in accordance with the terms and conditions of our existing contract with High Speed Two in respect of the Provision of Financial Advice under the ‘Buying Solutions Multi-Disciplinary Consultancy Framework Agreement Code: RM353’ (the ‘Contract’).

Our report may not have considered issues relevant to any third parties. Any use such third parties may choose to make of our report is entirely at their own risk and we shall have no responsibility whatsoever in relation to any such use.

Our work in connection with this assignment is of a different nature to that of an audit. Our paper to you is based on publicly available information and on discussions with you and your other advisers. We have not sought to verify the accuracy of the data or the information and explanations provided. Our work has been limited in scope and time and we stress that a more detailed review may reveal additional considerations that this review has not.

Should you have any questions please do not hesitate to contact me on 0207 951 1702.

Yours sincerely

Manish Gupta

Partner

mailto:[email protected]

High Speed Two – Delivery Report

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Contents

1. Executive Summary .............................................................................................. 1 1.1 Background .................................................................................................................................... 1 1.2 Analytical parameters ..................................................................................................................... 1 1.4 Strategic issues .............................................................................................................................. 2 1.5 Delivery considerations................................................................................................................... 4 1.6 Procurement ................................................................................................................................... 5 1.7 Governance..................................................................................................................................... 5 1.8 Financing ........................................................................................................................................ 6 1.9 Future proofing ............................................................................................................................... 7 1.10 Summary ........................................................................................................................................ 7

2. Introduction & Background .................................................................................. 10 2.1 Phase I .......................................................................................................................................... 10 2.2 Phase II ......................................................................................................................................... 10 2.3 Report Structure .......................................................................................................................... 10

3. Project Issues .................................................................................................... 12 3.1 Context ......................................................................................................................................... 12 3.2 Analytical parameters ................................................................................................................... 12 3.3 Findings from other High Speed Rail projects ................................................................................ 13 3.4 Strategic issues ............................................................................................................................ 14

4. Our Approach .................................................................................................... 20 4.1 Phase I .......................................................................................................................................... 20 4.2 Phase II ......................................................................................................................................... 21

5. Delivery ............................................................................................................ 23 5.1 Delivery Considerations ................................................................................................................ 23

6. Procurement ..................................................................................................... 31 6.1 Procurement considerations ......................................................................................................... 31

7. Governance ....................................................................................................... 43 7.1 Roles and responsibilities ............................................................................................................. 43

8. Financing .......................................................................................................... 50 8.1 Introduction .................................................................................................................................. 50 8.2 Requirement for significant Government support .......................................................................... 50 8.3 Leveraging the value of Government support ................................................................................ 51 8.4 Considerations from other projects ............................................................................................... 52

9. Future Proofing .................................................................................................. 53 9.1 Regulatory controlled structure .................................................................................................... 53

10. Summary .......................................................................................................... 56


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1. Executive Summary

1.1 Background

In January 2009, the Government created a new company, High Speed Two Limited (HS2), to comprise a non-executive Chairman, Sir David Rowlands, and a small number of full-time staff (mostly seconded from the Department for Transport (DfT) and Network Rail) led by a Chief Executive, Alison Munro. Lord Adonis, the Secretary of State for Transport, asked HS2 to consider and provide advice on options for an entirely new High Speed Rail (HSR) line between London and the West Midlands by the end of 2009.

In May 2009, HS2 commissioned Ernst & Young to provide support and advice on the delivery and funding considerations when developing a new HSR line. Our Phase I report of July 2009 summarised the lessons learnt from selected international HSR projects. The objective of this report was to discuss the Delivery options available for a new HSR line by considering the:

� Different operating and governance structures which may be used;

� Contractual and delivery models available;

� Financing issues that will need to be addressed; and

� Considerations on how to ‘future proof’ the project.

1.2 Analytical parameters

In undertaking a review of this nature, it is necessary to consider the parameters against which the project will be assessed. In considering the options for HS2, we have been mindful of the need to gain an appropriate balance between the following key areas:

� Affordability – the delivery option should be assessed and be able to be paid for in term of cash flows and resource costs

� Future Proofing – the delivery option should be sustainable and allow not only the delivery of an HSR line between London and the West Midlands, but also not preclude the potential development of a wider network

� Value for Money – with newly built assets, consideration should be given to the wider aspects of the asset and not just its cost of construction; it is therefore necessary to consider the design, whole life costs (i.e. operating and maintenance as well as construction), fitness for purpose and operational efficiency

Furthermore, the risk transfer needs to be assessed carefully since the nature of large scale and complex major rail projects means Government often ends up bearing major risks even though it has paid to transfer them.

1.3 Findings from other High Speed Rail projects

Globally, there has been a variety of HSR projects undertaken with varying degrees of success. In reviewing these projects, a common set of lessons emerge, including:

� The overall objective should be to deliver a functioning railway system not a construction project;


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� Full risk transfer is expensive and often illusory since the Government will in most cases end up bearing catastrophic risks or taking the role of operator of last resort;

� Developing a HSR network requires a strong, long term vision with sustained political support across all parties;

� Direct and indirect Government support is crucial to HSR projects;

� Traditional PPP approaches are not easily applicable to major railway projects — bespoke structures are needed;

� It is critical to have a strong project organisation set up to manage the design, development, procurement, delivery and funding of the project;

� Despite notable successes, infrastructure projects of this size and complexity will face a variety of challenges throughout their lifecycle, including:

� Varying degrees of political and stakeholder support;

� Difficulties in revenue and traffic forecasting due to network effects;

� Ability to complete the construction on time and on budget;

� Limited appetite of the private sector to retain commercial as well as full delivery and project risks; and

� Meeting the affordability challenge whilst demonstrating value for money.

1.4 Strategic issues

The following strategic issues should be considered when developing a delivery structure for the project.

1.4.1 Delivery structure focus

It is imperative that the project is developed whilst considering the long-term operational priorities and complexities associated with what will ultimately become a perpetual operational asset, rather than allowing short term funding or affordability considerations to drive the structure.

For the same reasons, financing priorities should not drive the delivery structure choice. Financing issues are important and the ability to finance the project in a sustainable manner is a crucial consideration in determining the most appropriate delivery structure. However, the financial structure should only be considered once the operational and construction characteristics are properly understood and developed. This approach is a key foundation of our analysis.

1.4.2 Profiling finances vs. risk transfer

The size and complexity of the project makes it very difficult to transfer significant risks to the private sector through, for example, a PPP arrangement. This is made more difficult by the fact that, having a single entity responsible for the availability and maintenance of the network is the most appropriate method of mitigating and managing interface risk during the operational period. Therefore, creating a number of smaller PPPs to deliver the different components of the HSR line, as has been the case in some of the HSR projects across Europe, is not practical because of the increased interface risk during the operational phase that this approach would create. Whilst profiling the cash flows to spread the Government’s


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contribution over time is an aspiration, the practical implications and potential consequences of this approach would make such an objective difficult to deliver in practice.

1.4.3 Government support

It is widely accepted that rail projects are typically not commercially viable without Government support. In some cases, rail revenues may be sufficient to cover the cost of operating the service, however, they are rarely sufficient to service the capital cost required to construct the asset. This factor remains true for HSR services and our Phase I report highlights that the majority of projects benchmarked benefitted from significant Government support. Therefore, it is likely that a large proportion of the capital cost and potentially the operating budget required for HS2 will need to be funded directly or indirectly by the Government.

1.4.4 Single InfraCo

As is the case for both high speed and conventional rail networks in many European countries, it is crucial that a single infrastructure company (InfraCo) is appointed to carry out the operation and maintenance of all elements of the completed HSR line infrastructure between London and Birmingham. This reduces interface risk during operations, which is crucial to optimising performance and delivering the passenger growth required.

It is important to note that the single InfraCo need not be the same across both the HS2 infrastructure and the conventional network. Rather, we believe it important to ensure that the responsibility for operations and maintenance of a specific route is not separated.

1.4.5 Timing considerations

There is a large amount of upfront work necessary in terms of planning, development, design and engineering before construction can be started. It will be imperative to understand fully these factors and the wider political priorities before construction begins. It is important to be clear as to how HS2 fits into the longer-term strategy for a rail network. Furthermore, the length of time and cost associated with proper planning and preparation should not be underestimated.

1.4.6 Strong client function

There is a need to establish a strong public sector client organisation. This should be independent, with sufficient skills and experience to deliver the project and with a budget sufficient to operate through to the completion of HS2. Recent major infrastructure projects such as the delivery of the Olympics and Crossrail have established the necessary skills and experience through the appointment of a delivery partner. If a network is preferred, and a long-term development cycle is expected, then better value for money will be achieved if this professionalism is developed in-house rather than sourced from a private sector delivery partner.

1.4.7 Commercial considerations

When considering the roles and responsibilities of the parties relevant to the various contracts it is important to consider the commercial and contractual implications the relationships between the respective parties can have on the project. Issues that should be


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considered when finalising the operating structure include the approach to demand risk and the performance regime to be adopted.

1.5 Delivery considerations 1.5.1 Bundling

International experience has shown that the level of unbundling of the sub-components of a new HSR line during the procurement and delivery phase can maximise market appeal. Whilst on the one hand a higher degree of unbundling may increase interface risks, on the other it reduces the size of the contracts and allows the private sector to better assess the risks associated with the specific components. It is important to recognise that the level of unbundling will have an impact on both the procurement method and the approach to financing. Within this section, we focus on the impact on procurement.

Recent projects that have ring fenced the delivery of specific assets include the GSM-R in France and HSR signalling and telecommunications in Portugal, with the operations being concessioned or managed directly by the public sector. Additional unbundling could also be possible by separating out the rolling stock, as is the case for HS1 and Crossrail.

Unbundling of the construction has advantages from both a financing and a procurement perspective. It has the advantage of avoiding the formation of large mixed consortia, facilitating increased market interest and, hence, competition whilst making the financing of the separate contracts more manageable.

The degree of unbundling of the project in its constituent elements will therefore determine:

� The number of contractors, or consortia, that have the capacity required to undertake the design and delivery of contract packages;

� The level of cost, construction, interface and integration risk that can be transferred to the private sector.

The review of international case studies and the analysis conducted suggests that the project could be procured and delivered by unbundling the asset in the following elements:

� Civils and Structures, potentially further split into civils and structures and in geographical segments;

� Rail Systems, as one contract, to avoid interface risks between different systems;

� Control systems as a single contract but ensuring compatibility between the railway systems and rolling stock;

� Stations, potentially split into the individual stations because of the wider technical and operational complexities at Euston compared to Fazeley Street;

� Rolling Stock and Depots, potentially split between the dedicated off-the-shelf HSR fleet and the bespoke fleet designed to run on both HS2 and the conventional rail network. Depot procurement could be separated from the rolling stock procurement.

The size of the project without unbundling the assets is likely to be too large to both attract significant market interest, limiting the level of competition, and access sufficient finance. However, whilst unbundling should facilitate market participation, the need to manage and mitigate the increased interface and integration risk will be crucial.


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1.6 Procurement

Following on from the review of the bundling approach during construction, we have considered how these individual contracts could be procured. In considering the procurement options available for the project, we have identified three potentially different approaches:

� Civils and Structures, Railways Systems and Control Systems – these elements could be separately procured adopting a Design, Build and Transfer approach where HS2 would remain responsible for elements of the design in order to minimise interface risk whilst allowing the contractor scope to refine the design and introduce some innovation. The key characteristic of this approach is that HS2 maintains the responsibility of managing the interface and integration risk during construction before transferring the asset to an InfraCo, possibly through a sale process once the asset becomes operational. It is important to recognise that the size of these contracts will likely necessitate the identification of a number of smaller more manageable contracts;

� Rolling Stock and Depots – different approaches could be adopted to the procurement of the dedicated HSR fleet to that of the bespoke stock that will be required to run on the conventional rail network. Specifically, it is unlikely that it will be best value for money to finance the bespoke trains through a conventional rolling stock leasing model. Whilst a direct purchase could have negative implications from a Government affordability perspective it may be possible to address this issue by adopting an approach similar to that proposed for the recent Diesel Trains procurement, whereby Government was considering the creation of a new rolling stock company that it would subsequently sell once the initial procurement and construction risks had been mitigated; and

� Stations – a different approach could be adopted to the procurement of major stations and smaller stations: the delivery of the London terminus, an extension of Euston Station, includes complex interfaces with the operational railway and should involve a very strong organisation with single accountability for the delivery. Fazeley Street potentially offers more opportunities for private sector involvement. Significant benefits could also be achieved through redevelopment and regeneration around the stations.

1.7 Governance

Early consideration should be given to the roles and responsibilities that will apply to the parties to the project during the construction and the operational phases. Section 7.1 highlights the roles and responsibilities for the key parties to the project. It is important to note that these will require further consideration should the project progress.

The vision for HS2, whether as a single line from London to the West Midlands or as an HSR network, must be translated into a long-term governance and operational structure that fits the long-term strategy not only of the HSR line but also of the conventional rail network. The preferred solution must take an informed view of risk transfer and the appropriate roles and responsibilities. We have considered these options in more detail below based upon the role envisaged for each organisation, during both the construction and during the operational phase.


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1.8 Financing

Given its scale, HS2 represents a funding challenge for both the public and the private sector. Whilst commercial income from passenger services may cover the cost of operations and an element of infrastructure maintenance, it is extremely unlikely to cover the upfront costs of construction, even before any financing costs are considered. The project is, therefore, only viable if Government makes a sizeable contribution to the cost of construction.

It may be possible to profile this support over the operating period of the asset, but in the first instance, it is necessary for Government to acknowledge that railway projects are not self-funding. All European HSR projects currently under construction are underpinned by significant direct or indirect Government support.

The separation of construction from operations and the transfer to the private sector once operational has received a positive response in market consultations held as part of the evaluation process. How the transferred infrastructure would be regulated or controlled still needs to be refined, but options include adopting a regulatory mechanism similar to that applied to the conventional network. The alternative concession model allows a contractual mechanism to regulate and enforce the required outputs. The key differences to these approaches relate to the method of enforcement and the ability to respond to changes in the market.

1.8.1 Considerations from other projects

Our review of international HSR projects has indicated that Government support has been provided either directly through grants or indirectly through minimum revenue guarantees.

The market feedback included comments that, if its strategy is to sell it in the future, the Government must be active in the early stages with the objective of offering the asset to the broadest pool of capital with some appetite for revenue risk. Other considerations include:

� The UK has a good record of funding utilities, and a regulated approach is well understood, tested and proven;

� Alternatively, the continental concession model has been used to finance roads and is the approach that has been adopted for HS1;

� The value of cash paid for the concession or sale will be a function of the user charges, and Government would be able to increase the value of this by increasing the value of revenues the InfraCo receives, either through guarantees or grants;

� A regulated approach represents a flexible, yet long-term solution for attracting private capital as, once operational, it is relatively stable and well understood. Conversely, concessions are more rigid and relatively short term alternatives that can be complicated and not well suited to withstand major changes in strategy or industry wide shocks;

� Regulatory risk may be seen, by some, as excessive, however, considering the fact that the regulatory regime allows a response to significant shocks to the industry the allowed returns are relatively well protected.


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1.9 Future proofing

We have highlighted the need for Government to consider whether or not this project will require the development and delivery of a single HSR line or whether a longer-term strategic view is taken around the development of a network.

We recommend that Government considers this option so that, if appropriate, a structure can be developed that facilitates the delivery of future enhancements and ultimately an HSR network. Failure to consider this at an early stage may result in a structure that is not amenable to further line extensions in due course. Some of the primary considerations in this regard include:

� The potential to deliver significant future infrastructure programmes. It may be possible to create a financial structure that facilitates the delivery and financing of subsequent HSR line extensions which reduces the need for additional Government support;

� The concept of the creation of a Regulated Asset Base (RAB) is an established and well understood mechanism of enabling access to significant funding for the delivery of capacity enhancements, but will require the creation of a clearly defined payment and cost allocation mechanism that supports the workings of a regulated utility;

� It is important to consider and develop a sensible approach to managing the InfraCo during the operational phase. With a suitable and flexible operating structure, subsequent extensions to the network could benefit the Government by being able to capture economies of scale and other operational efficiencies. Creating an inflexible contract may, should subsequent extensions be delivered, lead to inefficiencies and increased network costs which ultimately destroy value to Government and/or reduce the commercial rationale of the open access arrangements;

� Seeking to create an operating structure that allows future expansion should not be considered to the detriment of the wider delivery considerations included in this report.

Across the UK, a utility-based regulatory structure is well established and understood and has facilitated significant investment in infrastructure assets. This mechanism may enable the delivery of an HSR network.

1.10 Summary

In summary, based upon the elements discussed in sections 5, 6 and 7 the emerging conclusions include:

� The infrastructure should be managed by a single InfraCo. This limits interface risk during the operations phase and transfers it to the private sector;

� The preference for a single InfraCo responsible for the operation and maintenance of the infrastructure whilst having a number of separate construction contracts drives the decision to separate construction from operations;

� Consideration should be given to the relationship between the Train Operating Company (TOC), HS2 and InfraCo, in particular, who takes revenue risk and the commercial implications for the structure;

� The payment mechanism to be adopted in light of the interface between the HSR and the conventional rail network and the differing operators will need to be clearly defined;


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Construct Co 1 Civils & Structures(Multiple contracts)

Single InfraCoMaintains whole asset

Construct Co 2Stations

(Multiple Contracts)

Construction Operations

TOC runs services

Construct Co 3Railway Systems(Single Contract)

Delivery Partner

HS2

HMG

Rolling Stock procurement

High Speed Rail Authority

� Unbundling is likely to offer better value for money since it is likely to generate a good level of competition without overly increasing interface risk;

� The level of unbundling should create multiple construction contracts, which then transfer to a single InfraCo for maintenance. There is a question as to where the asset acceptance and interface risk sits but, when considering that the Government will remain as funder of last resort and will be unlikely to transfer catastrophic and latent defect risk to the private sector, we have assumed that this will remain with Government;

� Rolling Stock and Depots should be procured as part of a single contract unless the value for money assessment undertaken during the procurement phase indicates otherwise; and

� Further work is required to finalise the preferred approach and structure of the delivery of the new stations. In particular, the approach to the expanded station at Euston is highly complex and faces significant risks and issues. The interface with Network Rail and the impact on the West Coast mainline will require a single point of responsibility during the delivery period.

Having undertaken the review of bundling, procurement, governance and financing, we have been able to develop an emerging delivery solution. We have sought to present this structure in the diagram below, which summarises the link between the construction and operations phase. The structure below presents interface and asset acceptance risk being retained by the public sector.

Figure 1: Example of construction contractual split and link to operations.

The procurement option depicted is that the Government undertakes the major features of the design whilst allowing the private sector contract to contribute to specific elements. Upon completion of the construction, the asset will transfer to a single InfraCo responsible for the


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maintenance and availability of the completed asset. The diagram highlights that there is the option for multiple construction contracts. These will need to be carefully managed and controlled. With Government retaining asset acceptance and interface risk, the need for support from a delivery partner is crucial to the management of risk and the successful delivery of the completed asset.


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2. Introduction & Background

In January 2009, the Government created a new company, HS2 Limited, to comprise a non-executive Chairman, Sir David Rowlands, and a small number of full-time staff (mostly seconded from the Department for Transport (DfT) and Network Rail) led by a Chief Executive, Alison Munro.

Lord Adonis, the Secretary of State for Transport, asked HS2 to consider and provide advice on options for an entirely new HSR line between London and the West Midlands by the end of 2009.

HS2 has commissioned Ernst & Young to provide support and advice on the delivery and funding of a new HSR line. Development of HS2 to date has focused on the overall London to Scotland HSR line feasibility and the development of whole life capital and operating cost estimates for a number of route and structural options for the London to Birmingham route.

Ernst & Young was appointed to assist in evaluating the funding and delivery options associated with the project. The evaluation was undertaken through two distinct phases:

2.1 Phase I

The objective of this phase was to enable HS2 to benefit from the experience of other international HSR projects. This entailed:

� Conducting research on international HSR projects and comparable UK infrastructure projects, including an analysis of the projects’ delivery structures and sources of funding adopted;

� Assessing how the lessons learned from these projects’ contractual delivery structures, risk allocation and sources of funding may be applicable to a new HSR line in the UK.

The Phase 1 report titled “International case studies on delivery and financing – a report for HS2” is included as Annex 1.

2.2 Phase II

The objective of this phase was to evaluate the financing and delivery considerations for a potential new HSR line. This entailed:

� Assessing the different operating and governance structures for a new HSR line;

� Evaluating the contractual and delivery options for a new HSR line; and

� Considering the financing issues that must be addressed in the delivery of a new HSR line.

2.3 Report Structure

The remainder of this report summarises our work for Phase II and is structured as follows:


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Figure 2: Our report structure

Section 3 indentifies the key issues associated with the delivery of a new HSR line and sets out the parameters against which the project will be assessed. Sections 4 to 6 detail our approach to addressing issues indentified in section 3 and summarises the key findings of our work. Sections 7 and 8 highlight the other important factors that need to be considered alongside the detailed assessment undertaken, whilst section 9 provides our overall recommendations for delivery and funding.

Analysis context Our approach

Our findings

Financing

Future proofing

Financial Analysis Recommendations

Section 3 Sections 4-6 Sections 7 & 8 Section 9

Analysis parameters Delivery, financing & procurement options

Further considerations Conclusions

Analysis context Our approach

Our findings

Financing

Future proofing

Financial Analysis Recommendations

Section 3 Sections 4-6 Sections 7 & 8 Section 9

Analysis parameters Delivery, financing & procurement options

Further considerations Conclusions


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3. Project Issues

3.1 Context

A number of studies looking into the feasibility of a new HSR network in Britain have been recently prepared or are underway. Network Rail has recently published its Strategic Business Case for its New Lines Programme, reviewing the main corridors across the country to assess a whole range of options to meet future demands for additional rail capacity from passengers and freight users. Greengauge21 has also recently published its proposal for an HSR network.

The work undertaken by HS2 and Ernst & Young is cognisant of these studies. HS2 believes that these network studies have been a useful contribution to the much more detailed work that it is carrying out on route and station options to the West Midlands, including Heathrow, and on corridor options beyond, going north to Scotland, together with a comprehensive business case covering all the costs and benefits associated with the project.

In this context, HS2 required support in considering and providing advice on the delivery and funding of a new HSR line, in order to develop a business case for the project suitable for public consultation.

3.2 Analytical parameters

In undertaking a review of this nature, it is necessary to consider the parameters against which the project will be assessed. In considering the options for HS2, we have been mindful of the need to gain an appropriate balance between the following key areas:

� Affordability – the delivery option should be assessed and be able to be paid for in term of cash flows and resource costs;

� Future Proofing – the delivery option should be sustainable and allow not only the delivery of an HSR line between London and the West Midlands, but also not preclude the potential development of a wider network;

� Value for Money – With newly built assets, consideration should be given to the wider aspects of the asset and not just its cost of construction. It is therefore necessary to consider the design, whole life costs (i.e. operating and maintenance as well as construction), fitness for purpose, and operational efficiency.

Furthermore, risk transfer needs to be assessed carefully since the nature of large scale and complex major rail projects means Government often ends up bearing major risks even though it has paid for them to be transferred.

In undertaking the review of the delivery and financing options available for the project and in seeking to address the issues highlighted above, we have considered:

� The approach to bundling the components of the HSR line during the construction period;

� How these components could be procured;

� The operating structure once the project is completed and in revenue service;

� The roles and responsibilities of the organisation involved in the management of the HSR line during operation;


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� The issues associated with the financing of the project;

� The impact on finance of the various procurement and funding options; and

� The key recommendations for the project.

Figure 3: The competing considerations for Government

3.3 Findings from other High Speed Rail projects

Globally a large variety of HSR projects have been undertaken with varying degrees of success. There is a common set of lessons that can be drawn from the HSR projects reviewed during Phase 1. These lessons include:

� The overall objective should be to deliver a functioning railway system not a construction project;

� Full risk transfer is expensive and often illusory since the Government will in most cases end up bearing catastrophic risks or taking the role of operator of last resort;

� Developing a HSR network requires a strong, long term vision and a strong champion willing to invest into this vision and able to obtain cross party political support;

� Direct and indirect Government support is crucial to HSR projects;

� Traditional PPP approaches are not easily applicable to major railway projects — bespoke structures are needed;

� It is critical to have a strong project organisation set up to manage the design, development, procurement, delivery and funding of the project;

Future ProofingLong term vs short term solutions

Value for MoneyRisk transfer vs Cost

AffordabilityGovernment vs private sector funding


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� Despite notable successes, infrastructure projects of this size and complexity will face a variety of challenges throughout their lifecycle, including:

� Varying degrees of political and stakeholder support;

� Difficulties in revenue and traffic forecasting due to network effects;

� Ability to complete the construction on time and on budget;

� Limited appetite of private sector for commercial risks as well as full delivery and project risks; and

� Meeting the affordability challenge whilst demonstrating value for money.

The above lessons have been confirmed in market consultations held as part of the evaluation process.

3.4 Strategic issues

Within the backdrop of the analytical parameters set out above, we have undertaken our work on delivery and financing options with the following key strategic issues in mind for HS2.

3.4.1 Delivery structure focus

It is imperative that the project is developed whilst considering the long-term operational priorities and complexities associated with what will ultimately become a perpetual operational asset, rather than allowing short term funding or affordability considerations to drive the structure.

Large scale greenfield projects such as the construction of a new HSR line have a lengthy construction period followed by a long period of operation. The risks and issues, which need to be managed during the period of construction, are very different to those encountered during operations. The capital structure, its sustainability and its viability will be heavily influenced by HS2’s operating structure and the link to construction. How the implementation and operating phases are procured and linked will significantly influence the funding structure required. As an example, the HS1 model allows capital costs to be separated from operations, thus enabling an element of investment recovery over a long period while keeping infrastructure user charges competitive.

This is one method of making the investment attractive to the private sector whilst capturing some return for Government. An effective delivery structure would seek to manage both sets of risks, however, there is a balance to be obtained between whether managing construction or operational issues should be the primary focus.

Our recommendation is to ensure that the operating structure drives the end solution whilst ensuring that the construction period is properly planned, developed and executed. This approach has been strongly and consistently affirmed whilst engaging with the market. Our analysis is therefore based on the operations being the focus for the delivery structure. The argument in support of this approach is because the HSR line will be developed as a long-term asset and therefore the structure must enable long-term delivery and performance.

Furthermore, focusing primarily on issues such as affordability and financing has led to many projects failing or facing significant delays or subsequent implementation problems. The


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challenges that have faced HS1 and Crossrail in their initial stages, before the current delivery structures were finalised, are examples of this.

For the same reasons, financing priorities should not drive the delivery structure choice. Financing issues are important and the ability to finance the project in a sustainable manner is a crucial consideration in determining the most appropriate delivery structure. However, financial structure should only be considered once the operational and construction characteristics are properly understood and developed. This approach is a key foundation of our analysis.

3.4.2 Profiling finances vs. risk transfer

In developing a delivery strategy for this project, the Government’s affordability threshold has been considered as one element of the analysis. Ultimately, from an affordability perspective it would be preferable to develop a solution that spreads the cost to Government over the longer term and maximises the leverage of the Government contribution. However, profiling and affordability preferences should not take priority over other practical delivery considerations.

The size and complexity of the project, with a Civils and Structures budget in excess of £15bn, makes it very difficult to transfer significant risks to the private sector by, for example, a PPP arrangement. This is made more difficult as, once operational, we believe it most appropriate to have a single entity responsible for the availability and maintenance of the network. Therefore, creating a number of smaller PPPs to create more manageable sized contracts, as has been the case in some of the HSR projects across Europe, is not practical because of the increased interface risk during the operational phase that this approach would create. The European examples work because the separate PPPs are created for individual lines/routes rather than the splitting up of a single route into separate contracts. Whilst profiling is an aspiration, the practical implications and potential consequences of this approach would make such an objective difficult to deliver in practice.

It may, however, be possible to profile the spend associated with the delivery of the stations and rolling stock and these options are discussed later in this report.

3.4.3 Government support

It is widely accepted that rail projects are typically not commercially viable without Government support. In some cases, rail revenues may be sufficient to cover the cost of operating the service; however, they are rarely sufficient to service the capital cost, which was incurred to deliver the asset. This factor remains true for HSR services and our Phase I report highlighted that the majority of the projects benchmarked benefited from significant Government support. For example, the Spanish and French Governments have provided more than 80% of the total funding on several existing HSR lines with the balance covered by EU grants from:

� Trans-European Transport Network (TEN-T) funding

� Cohesion funds

� European Regional Development Funds (ERDF)


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Recent French HSR lines have also tapped into regional funding in return for the significant benefits that these lines bring to them. TGV Est, East Rhine-Rhone and Britanny-Loire HSR lines have all benefited from local funding covering between 25% and 35% of total funding requirements.

It therefore likely that a large proportion of the capital cost and potentially the operating budget required for HS2 will need to be funded directly or indirectly by the Government. This is a critical issue for the Government to consider and the quantum and timing is heavily influenced by a number of factors including the payment mechanism, approach to risk, and delivery structure adopted. Different approaches to each of these issues will influence Government support.

3.4.4 Single InfraCo

Once built, the HSR line will serve the UK over the long term and, as a perpetual asset, it is important to plan for its stewardship. Depending on the delivery model selected, the operation and maintenance of the different components of the asset might be assigned to different organisations. However, as in the case of the HSR and conventional rail networks in many European countries, where a single infrastructure manager is responsible for the operation and maintenance of the railway infrastructure, we recommend that a single infrastructure company (InfraCo) be selected to carry out the operation and maintenance of the completed HSR line infrastructure. This will reduce interface risk during operations, thereby optimising performance and delivering the passenger growth forecast.

It is important to note that the single InfraCo need not be the same across both the HS2 infrastructure and the conventional network. Rather, we believe it important to ensure that the responsibility for operations and maintenance of a specific route is not separated.

In order to be able to transfer all of the completed assets to a single InfraCo it will be necessary for Government to take a view as to the method of transfer and hence the approach to asset acceptance and latent defect risk. We discuss these issues later in this report. The single InfraCo may choose to sub-contract certain elements, but will remain ultimately responsible for the availability of the infrastructure.

3.4.5 Early decision making

There are a number of alternative solutions that could be adopted and that will need to be considered as part of the development of the project. However, many of these issues are best considered in advance by Government, including whether the structure developed is designed for a single line or a network approach and who owns the finished asset. Ownership could include Government, Network Rail or the private sector, either bundled or in an unbundled manner, and potentially more than one party at different times of the development cycle.

One option could be to create a specialised HSR Authority with the sole objective of developing and managing the HSR network in the UK. Similar structures are being used in the delivery of HSR in Portugal (RAVE) and in the development of the highway network in Austria (Asfinag). This solution would be more relevant should a network approach be adopted for the delivery of this project, however, we recognise that this is currently outside of the remit of HS2.


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Our recommendation is that these types of structural issues are considered by Government early in the process.

3.4.6 Timing considerations

There is a considerable amount of upfront work necessary in terms of planning, development, design and engineering before construction can be started. Crossrail, for example, required several years and significant upfront investment. It will be imperative to allow for this investment and understand the wider political priorities before construction begins. It is also important to be clear as to how HS2 fits into the longer-term strategy for a rail network. Furthermore, the length of time and cost associated with proper planning and preparation should not be underestimated.

Early commitment to provide development funding and the allowance of sufficient time to enable the proper planning and preparation at the outset is crucial to minimise risk and ensure the successful delivery of this project and the engagement and support of the private sector.

3.4.7 Strong client function

There is a need to establish a strong public sector client organisation. This should be independent, with sufficient skills and experience to deliver the project and with a budget sufficient to operate through to the completion of HS2. Recent major infrastructure projects such as the delivery of the Olympics and Crossrail have established the necessary skills and experience through the appointment of a delivery partner. If a network is preferred, and a long-term development cycle is expected, then better value for money will be achieved if this professionalism is developed in-house rather than sourced from a private sector delivery partner.

3.4.8 Commercial considerations

When considering the roles and responsibilities of the parties relevant to the various contracts it is important to consider the commercial and contractual implications the relationships between the respective parties can have on the project. Issues that should be considered when finalising the operating structure include the approach to demand risk and the performance regime to be adopted.

The project structures shown in Figure 4 and Figure 5 provide an example of how small changes in the project structure and contractual interfaces between HS2, the TOC and the InfraCo can have a large impact on the risk transfer and, consequently, on the market appeal of the HSR project.


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Figure 4: Option for Operational Structure for completed HSR line

Figure 4 shows one structure that could be developed for the operational phase of the project. In this structure, the link at the interface between the TOC and the InfraCo – also referred to as ‘wheel’ and ‘rail’ – is split and is coordinated through a HSR Authority. Demand risk for the operation of the scheme would sit with the Authority.

Conversely, the relationship between the TOC and the InfraCo could be more direct, as shown in the project structure in Figure 5. This structure is consistent with the approach adopted across the conventional railway.

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Figure 5: Conventional approach to the commercial relationships

The main difference between the two options relates to the commercial relationship between the infrastructure provider and the TOC, and has implications for where demand risk resides.

The rationale for choosing to move away from the approach adopted across the conventional network (in Figure 4) could be to insulate the InfraCo from demand risk. Evidence across other infrastructure projects is that the private sector and its funders in particular do not have an appetite for this risk on greenfield projects such as HS2. Passing demand risk onto the InfraCo may result in Government receiving best value from the project.

However, the structure in Figure 4 removes the direct relationship between the InfraCo and the TOCs that will utilise its asset. The Office of Rail Regulation (ORR) has stated in the past that a contractual relationship between these two parties is crucial to create an environment that stimulates working towards mutually beneficial goals.

Separately, but equally important, the performance regime to be adopted must also be considered, particularly in light of the likely interfaces with the conventional network and train services and the potential for delays arising from or being imposed on TOCs across the conventional network.

It will be important to address these issues as the project is taken forward and developed into a full major scheme business case compliant with Treasury and DfT guidance documents. Whichever structure is adopted, it will be important to ensure there is flexibility to change the commercial relationship in due course once patronage and demand levels have been better understood and established.

In the remainder of this report we highlight the approach we have adopted to address the above issues together with our key findings and recommendations for the project.


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4. Our Approach

Section 3 detailed the aims and objectives of the work undertaken by Ernst & Young. Our work was split into two phases, with Phase I comprising of benchmarking relevant overseas projects and Phase II developing the delivery and financing options.

Though the process we have followed reflects the principles of the HM Treasury Green Book approach to project development, the precise steps and processes of our analysis reflect the specific challenges and issues of this project. In overview, our process entailed evaluating shortlisted project options (including delivery structures and funding options) against a set of strategic evaluation criteria, which were developed and agreed with HS2.

The overall approach to Phase I and Phase II is summarised below:

Figure 6: Our approach

4.1 Phase I

Given that the objective of Phase I was to enable HS2 to benefit from experiences from international HSR and large-scale UK infrastructure projects, it was important to first identify an appropriate group of projects for HS2 to benchmark against.

Globally, there is a large variety of HSR projects that have been undertaken with varying degrees of success. Some countries, notably Japan, France, Germany and, to a lesser extent, Italy have had HSR for sufficiently long periods that the economic impacts of the HSR lines and services on land use and economies has been more thoroughly studied.

A variety of contractual delivery structures, risk allocation and funding models have been adopted in these projects. Whilst recognising that many of these structures and models are context specific and, as such, may not be directly transferrable or applicable to the UK, a review of the international experience would ensure that HS2 could, where possible, apply these lessons to the structuring and implementation of the project.

Phase I Phase II

Benchmarking Financing and Delivery

Prioritise Objectives

Agree Benchmarks

Undertake Review

High level funding options review

Phase I reporting Phase II reporting

1. Operations –understand how the asset will operate

2. Governance -assess roles,

responsibilities and risk transfer

Financial analysis

3. Contracting –evaluate potential ‘bundling’ options

5. Further considerations -

sustainability , market testing

4. Financing – assess potential financing

sources

Modelling Interface

Phase I Phase II

Benchmarking Financing and Delivery

Prioritise Objectives

Agree Benchmarks

Undertake Review

High level funding options review

Phase I reporting Phase II reporting

1. Operations –understand how the asset will operate

2. Governance -assess roles,

responsibilities and risk transfer

Financial analysis

3. Contracting –evaluate potential ‘bundling’ options

5. Further considerations -

sustainability , market testing

4. Financing – assess potential financing

sources

Modelling Interface


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With the benchmark group of projects agreed, the key observations were recorded, including:

� Project structures;

� Degree of unbundling of the project;

� Contracting strategy;

� Funding sources;

� Financing structures;

� Private participation;

� Time to delivery;

� Level of Government support;

� Social economic consequences; and

� Risk allocation.

The data collected was used to undertake a comparative analysis and to draw conclusions on key success factors for each project. The findings from this work are recorded separately in the Phase I report “International case studies: lessons learned and recommendations for HS2” in Annex 1.

4.2 Phase II

The process followed for Phase II was consistent with the HM Treasury Green Book approach to project development in that it has assessed available options (including contract bundling, procurement and financing options) taking into consideration parameters which were developed and agreed with HS2.

The process we followed for Phase II is summarised below:

Figure 7: Our process for evaluation

Operating considerations

Governance issues

Financing considerations Procurements models Industry consultation

Delivery strategy

Bundling options

Financial modelling

Operating considerations

Governance issues

Financing considerations Procurements models Industry consultation

Delivery strategy

Bundling options

Financial modelling


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Our approach to addressing the strategic issues highlighted in section 3.3 was to first work with HS2 to understand how the new HSR line would operate once complete. By focusing on the operational vision for the new line at the outset, we have aligned the delivery and procurement strategy towards developing an effective operating model rather than to suit a particular financing strategy.

Once the framework for the operating structure was established, it was necessary to consider the governance issues that would need to be addressed in order for the desired operating structure to work. In particular, our assessment of the governance issues focused on the respective roles and responsibilities of key stakeholders such as HS2, the Government, Network Rail and other infrastructure owners. As part of the review of roles and responsibilities, we also considered risk transfer and how that would influence the responsibilities of the respective stakeholders.

With the operating structure options established and the governance issues understood, we assessed the extent to which separate elements of the project could be grouped or ‘bundled’ together from a delivery and a financing perspective. For example, we assessed whether it was more effective to procure Rolling Stock and Depots separately or whether it was more practical to ‘bundle’ these two into a single procurement.

The next step was to assess which procurement model would best match the operating vision and desired level of bundling for the project. Various procurement options were assessed and the relative advantages and disadvantages of the different options were evaluated.

Finally, we considered the impact on the Government funding profile of the different procurement options considered and developed a financial model that was used to assess the potential cost of the project to the Government under the different scenarios.

In addition to the detailed work with HS2, throughout Phase II we consulted with industry participants to ensure our work also reflected the views of the market.

Within the next section of the report, we discuss the approach to evaluation and present the outcome of the analysis considering the construction and procurement options and the roles and responsibilities of the key stakeholders. This then allows discussion of the financial considerations and the options we have considered in order to evaluate the procurement and delivery of HS2.


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5. Delivery

5.1 Delivery Considerations

We set out below the key findings of our analysis following the approach detailed in Section 4. This analysis was based upon considering the preferred operating structure and ensuring that it is this solution that drives the outcome rather than financing or affordability preferences. As mentioned in section 3.4.4, the operational preference is for a single entity responsible for the availability and maintenance of the completed asset. The desire is to minimise operational interfaces post construction in order to create a structure that facilitates first class service delivery.

5.1.1 Bundling options

International experience has shown that the level of unbundling of the sub-components of a new HSR line during the procurement and delivery phase can maximise market appeal. Whilst on the one hand a higher degree of unbundling may increase interface risks, on the other it reduces the size of the contracts and allows the private sector to better assess the risks associated with the specific components. It is important to recognise that the level of unbundling will have an impact on both the procurement method and the approach to financing. Within this section, we focus on the impact on procurement.

Recent projects that have ring fenced the delivery of specific assets include the GSM-R in France and HSR signalling and telecommunications in Portugal, with the operations being concessioned or managed directly by the public sector. Additional unbundling could also be possible by separating out the rolling stock, as is the case for HS1 and Crossrail.

Unbundling of construction has advantages from both a financing and a procurement perspective. It has the advantage of avoiding the formation of large mixed consortia, which facilitates increased market interest and therefore competition, whilst making the financing of the separate contracts more manageable.

The degree of unbundling of the project in its constituent elements will therefore determine:

� The number of contractors, or consortia, that have the capacity required to undertake the design and delivery of contract packages;

� The level of cost, construction, interface and integration risk that can be transferred to the private sector; and

� The appetite and ability of the finance market.

The review of international case studies and the analysis conducted suggests that the project could be procured and delivered by unbundling the asset in the following elements:

� Civils and Structures, potentially further split into civils and structures and in geographical segments;

� Rail Systems, as one contract, to avoid interface risks between different systems;

� Control systems as a single contract but ensuring compatibility between the railway systems and rolling stock; and


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� Stations, potentially split into the individual stations because of the wider technical and operational complexities at Euston compared to Fazeley Street;

� Rolling Stock and Depots, potentially split between the dedicated off-the-shelf HSR fleet and the bespoke fleet designed to run on both HS2 and the conventional rail network. Depot procurement could also be separated from the rolling stock procurement.

The size of the project without unbundling the asset in its constituent elements is likely to be too large to both attract significant market interest and generate competition. However, whilst unbundling should facilitate market participation, the need to manage and mitigate the increased interface and integration risk will be crucial.

The degree of unbundling selected for the HSR project will therefore need to take into consideration market specific issues associated with market capacity and dynamics at the time of the construction, as well as the ability of HS2 to transfer key project risks to the private sector.

5.1.2 Available bundling options assessment

Figure 8 below highlights a range of unbundling options that could be adopted to help deliver the project. As part of our analysis, a wider set of options including different combinations of project elements was discussed in a workshop with HS2. These options are compared qualitatively in “Table 1: Bundling considerations” overleaf.

Figure 8: The bundling options

Rolling stock & Depots

£4.3bn

Stations

£3.6bn

Railway Systems

£1.0bn

Civils & Structures

£15.6bn

Single contract

£24.6bn

M&E

Rolling stock

Depots

Control Systems

Electrification

Tracks

Bridges & Viaducts

Tunnels

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Substructure

Earthworks & drainage

Station Access

Stations

Affordability & Value for Money vs Operational complexity


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Options Advantages/ disadvantages

Several small separate contracts

ü Increased competition driven by a larger pool of contractors able to bid

ü Smaller contracts play to the strength of specialist contractors

û Increased interface and integration risk between contracts means that these risks may not be adequately managed and can jeopardise the successful delivery of the project

û Complex, time consuming and may be expensive to procure

Partial unbundling

• Civils and structures

• Rail systems

• Control Systems

• Stations

• Rolling Stock and Depots

ü Allows the selection of the right size of contract for the specific market and stimulates competition with benefits in value for money

ü Allows flexibility in procurement

ü Easier to finance as it allows better risk allocation

ü Favoured by rail systems suppliers who do not have to enter in consortia with civil contractors

ü Several case studies support the split of rail system into one contract (i.e. French GSMR, Portuguese signalling PPP, Dutch HSL)

ü Stations could prove attractive to real estate and commercial developers

ü Rolling Stock and Depots, bundled together or otherwise, are often procured separately from the infrastructure

û Civils and Structures is too large for a single contract and would need to be further split to more manageable contract sizes. This can increase interface risk

û Interface and integration risk needs to be closely managed

û Some suppliers of rolling stock prefer to work with their own rail systems

One single contract

ü One organisation responsible for all interfaces

ü Lower integration and interface risk

û Decreased competition as accessible only to large consortia that may carry internal governance and misaligned incentives risks

û Limited competition would result in poor value for money

û Difficult to attract private financing given the size of the contract

Table 1: Bundling considerations

The analysis in Table 1 above indicates that a partial unbundling strategy should optimise the balance between maximising market appeal and generating competition and keeping interface and integration risk to an acceptable level.


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During construction, in addition to the functional split of projects elements illustrated above, HS2 will likely need to break down some of the elements into even smaller and more manageable bundles. Given the size of the expenditure involved, without further unbundling, contracts are likely to be too large to both finance and generate sufficient market competition.

Whilst this approach should facilitate market participation, the need to manage interface and integration risks will be crucial and should be the responsibility of HS2. We discuss later in this report the importance of HS2 as an informed client potentially alongside a delivery partner.

We consider below each project component in more detail.

5.1.3 Civils and Structures

Civils and Structures have a useful life of 100+ years and include all civil works and line side infrastructure such as tunnels, bridges and viaducts. Their risk adjusted capital cost is estimated at £15 -16bn.

Given the size of the capital cost, it will be almost impossible that a single contract could be let. It will therefore be necessary to further split up these contracts to more manageable sizes. This could be done by splitting the contract into geographical segments. This will have the added advantage of:

� increasing market appeal and competition;

� avoiding the participation of large consortia which often carry inherent governance issues; and

� Facilitating the achievement of a shorter construction programme.

The increased interface risk could be mitigated by transferring an element of design risk to the contractors, whilst retaining an element to ensure a consistent approach to technology and engineering solutions. Furthermore, since the interfaces between civil and structure works are relatively simple, especially compared with railway systems, the increased interface risk should be manageable.

In order to promote competition and achieve a tight construction programme, the Dutch Government opted to split the civil and foundations works into six geographical packages. Whilst this approach achieved its objective with the infrastructure being delivered on time by six different Design & Build (D&B) contractors, poor programme management, the lack of a strong delivery entity and delays in the delivery of the fleet of rolling stock resulted in a delay in the opening of the system to revenue service.

5.1.4 Railway Systems

Railway Systems include Mechanical and Electrical (M&E) systems such as heating, lighting and ventilation of tunnels. These components will attract the majority of the maintenance budget of the operational HSR but, at a cost of circa £0.5bn, their capital cost is considerably less than Civils and Structures.

Because of their characteristics and the preference for a single InfraCo to maintain the completed asset, it would be easiest to deliver the railway systems as a single contract. This


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approach is in line with best practice adopted in France, Holland and Portugal. The main reason for procuring and financing these assets as a single contract is in seeking to minimise interface risk during operations. Examples from HSR projects across Europe (including HS1), separating the delivery of Railway Systems into separate contracts can lead to different systems across different parts of the line, which in turn creates interface issues and higher maintenance costs, which may significantly impede operational performance.

5.1.5 Control Systems

Control Systems are a crucial element of the project and require specialist equipment and expertise that can be obtained from only a limited number of suppliers. Owing to the specialist nature of the asset, it is crucial that this asset is procured via a single contractor. With a capital value in the region of £0.5bn, a single contract is felt to be achievable.

The other crucial elements of procuring this asset is ensuring that the interfaces between the control systems, railway systems and rolling stock is properly managed to ensure no operational difficulties upon transfer.

A further consideration is that we believe that because of the unique technical nature of these systems it is likely that the body responsible for construction will need to remain responsible for their maintenance. This will require the InfraCo to work with the control systems InfraCo in potentially a sub contract or consortium basis. This is not wholly consistent with our objective of having a single InfraCo but is manageable through appropriate subcontracting arrangements.

Recent projects that have ring fenced the delivery of specific assets include the GSM-R system for the HSR in France and HSR signalling and telecommunications in Portugal, which are being procured as one single PPP contract at network level.

5.1.6 Rolling Stock and Depots

Rolling Stock and Depots could be procured as separate contracts or bundled together as one contract. The combined capital cost of both of these elements is estimated at over £4.3bn. The significant size of this prospective procurement makes procuring these assets as one contract a significant challenge. The degree of unbundling will also depend by the market capacity at the time of the transaction. However, there is market precedent for large rolling stock procurement processes in the UK with the Intercity Express Programme (IEP) and Thameslink ongoing, and Crossrail in the pipeline.

The fleet will comprise both a dedicated off-the-shelf HSR fleet and a bespoke fleet designed to run on both HS2 and the conventional rail network. Given the large size of the fleets and the associated capital cost, two different procurements, and possibly delivery strategies, could be adopted for the two fleets.

The depot strategy is an important consideration to make the rolling stock procurement attractive to the market and achieve value for money. Options include:

� A bundled depot and rolling stock strategy (such as in IEP in the UK and in the New South Wales Rolling Stock PPP in Australia);

� An HS2 procured third party depot.


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Additional unbundling could also be possible by separating out the rolling stock, as is the case for HS1/Crossrail, again potentially reducing or deferring the level of public funding support needed.

It is important to note that some rail suppliers prefer the provision of a combined rolling stock and control system solution. Although this option may reduce integration risk, international case studies show that this risk can be managed without bundling.

5.1.7 Stations

Stations, with an estimated capital cost of over £3.6bn, are an obvious element that can be unbundled from the rest of the project because of their separate functional, technical and commercial nature. Several examples exist of railways where stations are split from the rest of the system and developed commercially by the private sector. Stations could be further split out into single stations because of the different degree of technical and operational complexities at Euston station compared to, for example, Fazeley Street.

Existing stations, especially major ones and termini, will carry a high degree of interface with Network Rail. In these cases it will be very important that a single entity is given overall responsibility for developing the station and managing the interface risk. This could be either Network Rail or a private sector company; the main issue will be ensuring that adequate communication and interfacing with Network Rail is enabled to minimize the disruption to the conventional network whilst maximizing the benefit of its experience.

Greenfield stations do not necessarily require Network Rail’s involvement. However, they could provide strategic and operational insight in their development either through HS2 or as an organisation.

Local authorities’ involvement, especially with regards to station access, should be assessed with opportunities at each location to be separately identified.

5.1.8 Property development

A consideration as part of the Station development aspects of the project, and particularly relevant at Euston, will be the potential to leverage value from property development and/ or regeneration of the surrounding area. This has been a highly successful element of the HS1/ St. Pancras redevelopment which has enabled significant regeneration improvements in the surrounding area. The key issues to consider are ensuring that appropriate stakeholder support and buy in is achieved early in the process, and that the right partnering arrangements are crucial in order to capture the benefits from the various aspects of the project including the railway enhancement, property development, capturing regeneration and value gain, and obtaining the appropriate approvals and consents.

There has been suggestion that the St. Pancras station development had too much interference on the operational railway. The potential for disruption at Euston may impact more widely on the conventional network and should be properly understood and planned in advance to avoid such potential risks materialising.

As an operating railway station, the ORR could have a duty to monitor the interface for the Euston station development, and that would include the need to ensure that each party is


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conscious of this issue and it can be properly managed. From a franchise disruption perspective, it may be sensible for Government to consider specifying the level of disruption (or, at least, a mechanism for dealing with it) in the franchises in advance, in order to minimise compensation costs for the Government.


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6. Procurement

6.1 Procurement considerations

Following on from the review of the bundling approach during construction where we have recommended a partial bundling strategy, we now consider how these bundled contracts could be procured. In considering the procurement options available for the project, we have separated the assets into three potentially different approaches. These include:

� Civils and Structures, Railways Systems & Control Systems

� we have already highlighted the need to procure these elements separately and the possibility that Civils and Structures will need to be further split from a contracting and financing perspective. However, for the purposes of procurement we believe that the same approach for each should be adopted to allow the interface and design issues for each to be considered properly. Therefore, whilst we may have a standard approach to procurement of the asset categories above, we anticipate these will be delivered through a number of separate contracts;

� Rolling Stock and Depots; and

� Stations.

In the following sections, we discuss the procurement options available for each of the above groupings.

Case studies of HSR and other models are useful to illustrate how different combinations of the above elements have been adopted across countries and projects, including:

� Traditional Design, Construction and Maintenance (DCM) type

� Traditional Design, Build, Finance, Maintain (DBFM) + Operation – DLR, UK

� Design, Build, Finance, Transfer (DBFT) – Project Evergreen, UK

� Availability based PPP – HSL Zuid, Holland

� Demand risk PPP – Channel Tunnel Rail Link, UK

6.1.1 Civils and Structures and Railway Systems

The generic models identified for delivering the HS2 railway infrastructure elements, either as stand-alone or in combination with an HSR network, are outlined below.

Partial Design Full Design Build Transfer Maintain

Option 1 ü ü

Option 2 ü ü ü

Option 3 ü ü ü

Option 4 ü ü ü Figure 9: Procurement options

Note: The models above are a shortlist of those discussed and agreed with HS2. Other models were considered and dismissed as not suitable to the project.


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Each of the models is relatively well understood in the market place and has been used in the past to deliver large-scale railway projects in the UK or abroad. A summary of the models for each contract package and suitability for HS2 and potential HSR network is provided below.


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Option 1 - Build & Transfer

Key characteristics

• This model would require HS2 to develop the design of the work and then to engage contractors to build the elements of it

• Payment for the construction is generally made on a fixed lump sum or milestone basis with appropriate incentive regimes to ensure delivery to time and budget built into the contract

• The contractor responsible for the construction is separate from the InfraCo

• An InfraCo is contracted to maintain the asset and paid through either track access charges or an availability based payment mechanism or a combination of both

• HS2 takes responsibility for the design and retains interface, latent defect and asset acceptance risk

• HS2 would require a delivery partner (or equivalent) to help it manage asset acceptance and interface risk

Advantages / disadvantages

ü Provides a simple model where operation and maintenance interfaces can be adequately managed by HS2

ü The transfer of construction, commissioning and interface risk in large rail projects is expensive and often illusory; this model recognises this and may represent better value for money than PPP

ü HS2 can control the detailed design and make changes prior to award of construction that is the competitively priced

ü Well understood model widely adopted nationally and internationally

ü Target cost contracting has been successfully used on CTRL in the UK

ü Opportunity for HS2 in managing the design to ensure that whole life cost is considered

ü Allows potential future sale of the project following construction and achievement of steady state operation

ü The Government/ HS2 bear construction, commissioning and interface risk and then sell the asset once these risks are nil, or much reduced, therefore obtaining better value for money

û HS2 needs to develop substantial technical, design and programme management capability (the latter could be outsourced)

û Design innovation: limited incentive for the designer to bring innovation, although, to a degree, design innovation is limited by EU interoperability standards

û Design risk remains with HS2, which limits bidder design innovation

û Allocation of technical risk is unclear: the design and contractor will blame each other for design errors or omissions

Suitability for HS2

• A Build & Transfer contract will enable the public sector to retain control over design and help manage interface risk and whole life cost minimisation

• However, it restricts the private sector’s ability to identify and capture elements of design innovation and potentially cost savings


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• Retaining full design risk may create increased interface and asset acceptance risks during operations

Option 2 – Partial Design, Build & Transfer

Key characteristics

• HS2 would remain responsible for elements of the design in order to minimise interface risk

• Allows the private sector to have some input to design in order to enable bidder innovation whilst protecting the final asset

• This model would require HS2 to engage a contractor to partially design and construct the project

• Payment is generally made on a fixed lump sum basis but incentives such as milestone payments or gain/ pain share associated to a target cost be built into the contract

• The D&B contractor is separate from the future operator and maintainer

• An InfraCo is contracted to maintain the asset and paid through either track access charges or an availability based payment mechanism or a combination of both

• HS2 takes responsibility for the elements of design and retains interface, latent defect and asset acceptance risk

• HS2 would require a delivery partner (or equivalent) to help it manage asset acceptance and interface risk

• HS2 maintains responsibility for managing the interfaces between D&B and Operating & Maintenance (O&M) contracts



ü The transfer of construction, commissioning and interface risk in large rail projects is expensive and often illusory; this model recognises this and may represent better value for money




ü Opportunity for HS2 in managing the design to ensure that whole life cost is considered


û Design innovation: limited incentive for the designer to bring innovation, although, to a degree, design innovation is limited by EU interoperability standards

û Whole life cost: incentive for designer to minimise future O&M costs will need to be carefully considered



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û Design risk remains with HS2


Suitability for HS2

• A Partial Design, Build & Transfer contract will enable the private sector to identify and capture elements of design innovation and potentially cost savings – more importantly, it allows an element of design risk to be transferred to the private sector and does not restrict operational choices

• However, these opportunities are mitigated by the need to comply with EU Interoperability standards

• Retaining an element of control over the overarching design allows interface risk to be better managed which can avoid interface or operational and maintenance issues post construction


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Option 3 – Full Design, Build & Transfer

Key characteristics

• This model would require HS2 to engage a contractor to fully design and construct the project or elements of it

• Payment is generally made on a fixed lump sum basis but incentives such as milestone payments or gain/ pain share associated to a target cost can be built into the contract

• The D&B contractor is separate from the future operator and maintainer

• An InfraCo is contracted to maintain the asset and paid through either track access charges or an availability based payment mechanism or a combination of the two

• HS2 takes responsibility to specify the services and allocate capacity

• HS2 maintains responsibility for managing the interfaces between D&B and O&M contracts



ü The transfer of construction, commissioning and interface risk in large rail projects is expensive and often illusory; this model recognises this and may represent better value for money




ü Does not require HS2 to develop substantial technical capability, although programme management still fundamental.

ü Opportunity for designer to bring innovation to the project


û Design innovation is limited by EU interoperability standards

û Whole life cost: incentive for designer to minimise future O&M costs will need to be carefully considered


û Increased interface risk with multiple different designers across different elements of the project


Suitability for HS2

• Whilst a Full Design, Build & Transfer contract will enable the identification and capture of design innovation and potentially cost savings, these opportunities are mitigated by the need to comply with EU interoperability standards, and relinquishing central control over the overarching design increases interface risk which can lead to interface or operational and maintenance issues post


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construction


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Option 4 – Full Design, Build & Maintain

Key characteristics

• Typically involves engaging a contracted entity to design, construct, maintain the project

• Construction costs could be funded via Government grant or through availability based PPP

• Maintenance and operation are usually for a fixed term after construction and paid for through availability payments funded through subsidy from Government to HS2 and track access charges from TOCs to HS2


ü Transfer construction risk and long term operational performance to a third party

ü Encourage whole life cost management and a high degree of integration

ü Provides strong incentives for completion of time through early capturing of revenue steams

ü In theory, the principal only pays when the service is delivered to the specified standard

ü Can be off balance sheet

û Size and complexity of the project means that the private sector is not necessarily the best party to hold construction and commercial risk

û The Government will ultimately have to explicitly underwrite major risks including interface, acceptance and a substantial part of commercial

û The size of the Civils and Structures contract means that this element will need to be funded through Government grant

û The lead time between end of construction of Civils and Structures and start of operation means that there is a long lead time in which the contracted entity does not receive any revenue

û PPPs have a poor record of delivering value for money for major rail projects

û The size of the contract would be too big for a single PPP which creates increased interface risk during operations as well as construction

Suitability for HS2

• Whilst a Full Design, Build & Maintain contract will enable the identification and capture of design innovation and potentially cost savings, these opportunities are mitigated by the need to comply with EU interoperability standards

• Furthermore, relinquishing central control over the overarching design increases interface risk which can lead to interface or operational and maintenance issues post construction

• Multiple PPP contracts across the operating network are not preferred and /or standard across European railway projects – it creates increased operational interface risk which may ultimately impact on long term operational performance

• Multiple InfraCos are not consistent with our preferred operating structure


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6.1.2 Rolling Stock and Depots

The relationship between rolling stock and the depots used to house and maintain it means that the Rolling Stock and Depots may be procured separately or combined into one single procurement. Our discussions with HS2 highlighted that, for new build HSR vehicles, it has become increasingly common to procure maintenance services and depot provision as part of the new build contract. The increasingly common approach to rolling stock procurement is to procure Rolling Stock and Depots together. However, for HS2, two different types of rolling stock are going to be procured and it is possible that these will be procured under separate contracts. Therefore, bundling depots within these contracts may not represent best value and may create complexities that are best managed separately. This should be reviewed with rolling stock providers at the time of procurement to ensure that the preferred approach reflects best practice at the time and best value for money for the project.

Concerning the procurement of rolling stock, there are two different procurement models that can be considered:

� Rolling Stock Company (ROSCO) leasing model, the standard approach to procuring rolling stock in the current franchise market; and

� Direct purchase by HS2 or the Government, as considered by Government on recent projects such as the procurement of a fleet of Diesel Multiple Units (DMUs).

However, before considering the procurement approach to adopt we need to consider the level of unbundling for rolling stock, as discussed in section 5.1.1. Owing to the size of the capital cost of the project, we believe it will be necessary to unbundle the procurement of the rolling stock into standard and hybrid HSR vehicles.

Under the leasing model, the rolling stock would be procured and owned (and in most cases maintained) by a third party leasing company (ROSCO). The ROSCO would then lease its rolling stock to the HSR TOC for an agreed period of time in return for an annual lease or ‘rental’ charge, which would be set to enable the ROSCO to recover the capital cost of the trains and earn a profit. This is the model by which almost all the passenger rolling stock for conventional railways is currently procured in the UK. However, the capital cost and the bespoke nature of a large proportion of the fleet may make this option impossible.

The alternative approach is for either HS2 or the Government to directly procure and own the rolling stock. In this case, HS2 or the Government would own the rolling stock for their entire useful life and the ‘rental’ charge would need to be sufficient to cover the capital and operating cost of the trains.


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The relative advantage and disadvantages of these two procurement options are considered below:

Options Advantages / disadvantages

ROSCO leasing model

ü Procurement and asset specific risks are transferred to the private sector

ü Potential value for money gain through pricing benefit of capital allowances

ü Capital cost is spread over the life of the asset

ü Established and well understood approach to procuring rolling stock

ü Competitive market for initial procurement of international HSR rolling stock

û Bespoke nature of the rolling stock may be difficult, and expensive to lease, due to the pricing of stranding risk

û Conventional risks transferred to the private sector may not be accepted due to bespoke design

û It is unlikely that asset specific and residual value risk (i.e. unrecovered capital investment) will be accepted by the private sector

û Size of procurement may not be financeable

û Limited ability to influence the pricing of rolling stock rentals

Direct Purchase ü Most competitive form of borrowing

ü Greater control and flexibility over pricing and use of rolling stock

ü May speed up the procurement process as external finance would not be required

ü The size of the procurement, backed by Government may facilitate the creation of a new entrant in the market which ultimately leads to savings across other projects

û Large up front cost

û Asset specific and residual value risk (i.e. unrecovered capital investment) will be retained by Government or TOC

û Government or TOC affordability considerations given the size of the procurement

û Potential impact on the Government balance sheet

On the balance of advantages and disadvantages and considering the bespoke nature of the rolling stock and the capital cost estimate, it is unlikely that it will be best value for money to finance the hybrid trains through the conventional rolling stock leasing model. Whilst a direct purchase has implications from a Government affordability perspective it may be possible to address this issue by adopting an approach similar to that proposed for the recent DMU procurement, whereby Government creates a new rolling stock company that it subsequently sells once the initial risks have been managed.

It will be necessary to undertake significant further work to make a value for money justification for the preferred solution before a final decision can be made.


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6.1.3 Stations

Traditionally, railway stations have been procured as part of the Civils and Structures contract as they form part of the core railway infrastructure. For HS2, we have considered whether the procurement of stations should follow this traditional approach or whether there is scope and benefits to procuring the railway stations in London and/ or Birmingham separately from the core infrastructure contract.

The development issues, risks and operational issues at the Birmingham terminus are very different to those at the London terminus. Given this, different procurement options could be considered for these two stations.

The Birmingham terminus will be a completely new station separated from the existing conventional network and, therefore, there will be comparatively little interface risk and issues. This allows greater flexibility around design and how the infrastructure is developed. Given this degree of flexibility and the limited interface with the conventional network there are more options around how the Fazeley Street station may be procured. For example, the station could be procured as part of a private sector partnership, where the private sector would design, build, finance and operate the station, in return for an annual payment by HS2 or the franchisee. The precise payment mechanism and level of risk that can be transferred to the private sector will be driven by the station design and the commercial opportunities it represents (i.e. property development, retail space, etc). We understand that in the area adjacent to the station the may be opportunities for property development that may raise the interest of the private sector. A number of examples exist of private partners contributing to the development potential of major stations. For example, Grandi Stazioni, a spin off of the Italian railways, now partially privatised, has a successful track record of developing railways stations with private sector involvement in Italy and abroad.

The London terminus would not be a new station, but instead it would form part of an extension and significant redesign to the existing Euston station. Given that the London terminus will form part of the existing railway station, with operational interfaces with the West Coast mainline, the engineering solution will be far more complex than at Birmingham. This interface will be further complicated by the need to work closely with the existing station owner, Network Rail, and work within the confines of the existing operating services. This added complexity and the associated risks limit the scope of credible options and makes it less likely that a structure where the private sector takes on development or operation of the station can be successfully implemented.

It is important that a single party is given ultimate responsibility for the development and operation of the station during this time and significant further work is required to ascertain the identity of this party.

From our discussions with the HS2 team and our understanding of the commercial opportunities at the Birmingham terminus, we believe there may be scope for the private sector to play a role in the development of the station. In the case of Euston, there is a much weaker case for a private sector delivery solution due to the level of interface risk. At this stage we recommend that for both stations, HS2 remain flexible about the potential delivery solutions. The extent to which they may be viable for the private sector to deliver and operate


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will depend on the specific design and the commercial opportunities at the stations, which will be better known once the detailed work on station development has been carried out.

The London station issues are further complicated by the opportunity to consider regeneration and property development gain. In this respect, lessons can be learned from the recent redevelopment of St. Pancras, which has managed to deliver considerable regeneration improvements and development potential to the surrounding area.

Therefore, in considering the preferred approach to station development, we believe that HS2 should have due regard for the following:

� The potential private sector partners that could collaborate in the development of both sites;

� Whether a partnership or sub contract structure is appropriate (St. Pancras adopted a partnership structure);

� The interface with the operational network and the risks and issues that it can create and the consequent need for a single point of responsibility;

� Who should take on responsibility for the delivery of the Euston upgrade;

� The role of Network Rail and of the ORR;

� Whether the capital size will influence the preferred delivery structure; and

� If an expanded property development of the station generates value for money.

It should also be noted that the core costs included in the analysis do not include any aspect of property development. It is assumed that in developing the project in due course that including this aspect will in itself improve the financial case for the project, however, this has not yet been confirmed for this project.


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7. Governance

We have previously recommended that the long term operating structure should drive the preferred delivery solution rather than allowing procurement and/ or financing preferences to dictate the outcome. Early consideration should be given to the roles and responsibilities that will apply to the parties relevant to the project during both the construction and the operational phases. Section 7.1 below highlights the roles and responsibilities for the key parties to the project. It is important to note that these will require further consideration if the project is to progress.

The vision for HS2, whether as a single line from London to the West Midlands or as an HSR network, must be translated into a long-term governance and operational structure that fits the long-term strategy not only of the HSR line but also of the conventional rail network. The preferred solution must take an informed view of risk transfer and the appropriate roles and responsibilities. We have considered these options in more detail below based upon the role envisaged for each organisation, during both the construction and during the operational phase.

7.1 Roles and responsibilities 7.1.1 Government

Lessons learned from other HSR projects indicate that Government support is crucial to delivering HSR projects. As already highlighted, the initial cost to bring the project from concept to the delivery should not be underestimated and without Government support during this phase the project will likely fail to get significant support from the private sector.

Due to the nature of rail schemes and based on evidence from other projects both in the UK and overseas, the construction, regardless of the delivery model selected, is likely to require significant direct Government funding together with a number of implicit or explicit guarantees in order to be deliverable. Whilst it may be possible to profile this support over many years, it is important to recognise at the outset that Government funding will still be required.

It is also important for the Government to form a view as to whether it intends to make plans for a single additional HSR line or whether it should create a structure that facilitates the development of a HSR network in due course. This decision will likely impact on the exact structure to be adopted, the implications of which are discussed later in this report.

During the development of this report we have assumed that the Government will remain at arm’s length from the day-to-day decision-making. We have assumed that Government will require HS2 or an alternative sponsor body to take on responsibility for the following:

� Setting out the long-term strategy for the delivery of HS2;

� Specifying the requirements, budget and timetable for the HS2 project delivery body, and controlling any changes to these;

� Monitoring the performance of the delivery body for HS2 during construction;

� Balancing considerations such as value for money, affordability, whole life costs, and the impact on the classic rail network;


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� Acting as a single point of accountability for the delivery of the project; and

� Possibly, monitoring the performance of the HS2 operator and maintainer and/or managing the relationship with the long-term infrastructure owner during operations.

7.1.2 Project Delivery Organisations

HS2’s remit is currently to consider the case for new HSR services between London and Scotland, with a focus on the route between London and the West Midlands, where capacity is most constrained. In order to take any option forward, a Project Delivery Organisation will need to be appointed. For the purpose of this report we have assumed that HS2 will take on this responsibility either with the help of a delivery partner (as is the case for the Olympic Delivery Authority (ODA) in delivering the Olympics) or by recruiting sufficient relevant skills and experience to enable it to take on the role itself. The secondary option is only likely in the event that a network approach is preferred.

In terms of its remit, the role of HS2 (or equivalent Project Delivery Organisation) will vary depending on whether the project remains a single line connecting London to Birmingham and the North West or whether it will expand to become the enabler of a UK wide network. Since the development of a network is likely to be conducted sequentially, one line after another, for the purpose of this report we have assumed that the HS2 delivery organisation is set up with a single line remit.

Lessons learned from UK and international case studies clearly highlight the importance of a strong project organisation set up with the objective of managing the development, procurement, delivery and funding of the project. Particularly important will be the role of HS2 in:

� Inputting to the project’s specifications which could include both design and outputs;

� Reviewing progress and acting as “project manager”, a role that could be supported by engaging an independent entity;

� Making prompt decisions on project issues and, where appropriate, challenging and directing activities of contractors;

� Ensuring integration of different elements of the HSR;

� Managing interfaces with external parties;

� Managing the exposure to risk.

A number of successful examples support the importance of a strong Project Delivery Organisation:

� The HS1’s experience post restructuring;

� RAVE, the Portuguese HSR’s project organisation (which is still delivering the project);

� The ODA;

� Asfinag, Austria; and

� A number of other infrastructure projects such as the delivery of Heathrow Terminal 5 and the development of Crossrail.


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7.1.3 High Speed Rail Authority

Once the construction is finished, it will be important for the Government to create a body responsible for managing the relationship with the InfraCo and developing the longer-term strategy for the line. In the UK in the past, this role has been held by the Strategic Rail Authority and more recently a team within the DfT. Elsewhere, different types of Government agency have been given this responsibility, for example, Transport Scotland on behalf of Scottish Government. Whilst there are a number of alternative structures that could be implemented to undertake this role, for the purposes of this analysis we have assumed that the longer term responsibility for specifying the strategy for the network will be undertaken by a newly formed High Speed Rail Authority.

One argument for passing this responsibility to a High Speed Rail Authority is to ensure that the knowledge and expertise developed in the delivery of this project is not lost for future projects and that lessons learned are captured and built upon in subsequent projects.

Such a body, during operations, might have a remit of:

� Developing and specifying the strategy and long term aspirations for the network;

� Managing the contract and monitoring the performance of the project should this be handed over to a separate infrastructure manager; and

� Providing capacity allocation and railway traffic, should these activities not be in the remit of the infrastructure manager.

We recommend that Government form a view as to the best method of managing these elements early in the process. Whilst Government may prefer another approach to managing the operational asset, it is important to recognise that the responsibilities highlighted above will need to be addressed by somebody. Another aspect that we recommend is considered early in the process by Government is the approach to regulate or control the InfraCo and operations elements of the service and how this regulatory body interacts with the High Speed Rail Authority. The Office of Rail Regulation, or equivalent body set up to take on this role, is well placed to be involved in an HSR network. This is discussed later in this section.

7.1.4 Delivery Partner

A Delivery Partner is a way of procuring external support to fulfil the day to day role of managing and delivering a complex programme, which necessitates a broad range of project and programme planning and delivery expertise. Evidence suggests use of a Delivery Partner can be an efficient model for an organisation to obtain the skills and capacity required to manage risk and expedite a programme efficiently, whilst also delivering innovative solutions and value for money.

HS2 should have a clear rationale for adopting a Delivery Partner model to support its delivery of a programme. This rationale should provide clarity over the required nature of the model to be procured. In this vein, prior to procurement, the following issues should be considered:

� Roles, responsibilities and scope of services – what responsibilities must the client retain and which responsibilities/ services will be more effectively provided by the delivery partner?


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� Is building client capability a requirement – if so, how will the client utilise this increase in capability through the programme lifecycle and beyond?

� What will be the delivery partner relationship with other programme stakeholders including funding or sponsoring organisations?

� What form of contract best meets the model required?

� What procurement route is most appropriate?

� How will the client’s affordability and value for money criteria be embraced within the process?

� What are the key financial and commercial features of the contract (e.g. payment provisions, risk allocation, incentive framework, financial security)?

� Is the client organisation resourced to procure and manage the contract going forward, or is external technical, financial, commercial and legal support required? and

� How will the client be ready to engage and manage a delivery partner from a people, organisation, process and systems perspective?

Although the above is not an exhaustive list of all issues, it highlights the necessary considerations to link the client’s needs with defining its requirements for a delivery partner and how the client may effectively manage the procurement and operational phases of the delivery partner contract.

7.1.5 Construction companies

We discuss in this report the preferred approach to construction of the asset and highlight the importance that the role of the construction market will play in the delivery of this project. We have also discussed the rationale for having multiple construction parties and contracts. Furthermore, we have highlighted the importance of having a single InfraCo that takes on responsibility for the availability and maintenance of the completed asset. It is, therefore, important to consider the roles and responsibilities of the construction companies, their relationship with Government and HS2 and the method of transferring the completed asset to the InfraCo while managing the risk for the Government.

In delivering the asset to an InfraCo, we recommend the following roles for the construction companies:

� Partial design of the infrastructure;

� Close working with the HS2 design team to ensure compatibility with the overarching network design. This process will be required to address interface issues and to minimise whole life costing;

� Construction to time and budget. Whilst Government may retain catastrophic risk, we anticipate that the private sector would retain standard time and budget delivery risks and would be expected to contract for elements on a fixed or target price basis. This approach will incentivise delivery and allow the public sector to capture the benefits associated with working with the private sector whilst negotiating an element of price certainty;

� Working closely with Network Rail, where appropriate, to manage the interface with the existing infrastructure; and


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� Preparing the asset for transfer to the InfraCo. The exact process for transfer and acceptance will require negotiation and support of the private sector, but considering that Government will be unable to transfer latent defect risk and full asset acceptance risk to the private sector, we believe it appropriate that Government take on this responsibility. This will involve taking the asset back from the construction company and then transferring it on to the private sector for maintenance.

7.1.6 Network Rail

As owner and operator of the traditional rail network, Network Rail’s role in the HS2 project and, potentially, in the wider HSR network must be clearly defined, both in the long and short term. During operation, Network Rail’s role and involvement in HS2 could vary from:

� Interface – there will be interfaces along parts of the route and at stations where risks will need to be managed. These interfaces should not be underestimated, for example, at Euston station, the link to the West Coast Main Line and the signalling interfaces when rejoining the West Coast Main Line around Birmingham;

� Maintainer – as in the case of HS1, Network Rail could carry out the maintenance of some or all of the elements of the HS2 project;

� Owner and steward of the HSR line or of specific elements of it – although Network Rail may not have a large involvement in the procurement and delivery of the project, it could potentially be one of the long-term owners of the asset.

In considering Network Rail’s function, as is the case with the InfraCo, its capacity to take on a major role in the delivery or management of the HSR line should be carefully considered in light of the negative experience of Railtrack in the development of the West Coast Route Modernisation. It will be important to ensure that, whilst it has technical and engineering excellence, this should not be diverted to the HSR line to the detriment of the conventional network.

During the procurement and delivery phase, Network Rail will have an important role in sharing its experience with HS2 through secondments. Its role could be expanded to include:

� The design and development of specific elements of the project, such as the London stations;

� Entering into asset protection agreements with the InfraCo contractors; and

� Under the InfraCo structure, Network Rail could play a role in design or construction approvals or in supporting HS2 as part of a larger delivery partner.

7.1.7 Infrastructure Company

We have already highlighted within this report the rationale for having a single InfraCo during the operational phase. We see the role of the InfraCo as being:

� to maintain and operate the asset;

� to manage operational and interface risk; and

� potentially to allocate capacity, although this responsibility could pass to HS2.

We envisage that the InfraCo will take on a number of responsibilities similar to those undertaken by Network Rail for the conventional network. However, we believe that these responsibilities should only include those that focus its efforts on ensuring that the


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infrastructure is available for operations. Its remit should not be clouded with responsibilities that dilute this primary requirement – for example, should an extension to the HSR network be agreed, it would be important to ensure that the operations and availability of the existing line is not adversely affected in the delivery of the extended network.

7.1.8 The TOC

In our review, we have assumed that a train operating company (TOC), which pays track access charges to the InfraCo will carry out the operation of passenger services.

During the operations phase, the HSR line will be subject to EU open access requirements. Effectively, any operator, subject to meeting certain core criteria and capacity availability, will be able to provide passenger services on the completed infrastructure in return for pre-agreed infrastructure user charges. However, upon completion it will be necessary to ensure that a core timetable of services is provided. It will therefore be necessary for Government or HS2 to procure a train operator that will provide initial services on the new infrastructure.

Open access operators have recently entered the HSR market: Nuovi Treni Veloci (NTV) has recently procured the rolling stock required to compete with Trenitalia on the Rome to Milan route. We recommend that one consideration in creating these core services is how best can open access competition be encouraged to facilitate cost and performance improvements through market competition.

7.1.9 Regulatory Body

How the new infrastructure will be regulated will be crucial to delivery and obtaining both financing and private sector participation. The regulatory regime will also heavily influence the procurement and financial structuring options available. The options available could include either RAB based independent regulation, or a concession based structure (e.g. Portuguese or Dutch HSR lines).

The objectives and functions of the regulatory body will be different in the construction phase, compared with the operational phase. During operation, the Office or Rail Regulation’s (ORR’s) role will vary depending on whether the delivery model selected takes the form of a concession contract or a more conventional regulated structure. In the former, the regulation will predominantly be enforced through the contractual mechanism in place. However, the ORR could still get involved in issues related to operations and open access, a role more aligned to that undertaken by the PPP Arbiter for London Underground. In the latter, the ORR could have a role as economic regulatory body and be responsible for providing regular benchmarking and price setting, together with providing a value for money challenge – as is the case with the conventional railway.

During construction, the ORR will have a duty to monitor the interfaces with Network Rail, especially at large stations such as Euston, and to ensure that the parties involved are conscious of the complexity of these interfaces and that they manage them properly.

It is also possible to construct the asset using a contractual approach with minimal regulatory involvement and then transfer the completed asset, to be operated under a more traditional regulatory regime. We consider this approach to be the most sensible for the following reasons:


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� The market is likely to be uncomfortable taking regulatory risk during construction and is likely to prefer the certainty offered in a concession contract;

� A balancing rather than an overriding duty on ORR regarding the construction of HS2 might enable it to deal with some conflicts between an HSR Authority and Network Rail;

� The benefit of a regulatory regime is the flexibility, protections and responsiveness it offers core stakeholders;

� Under a regulatory regime, material changes in circumstances can be addressed which are not often foreseen in contracts – this provides the private sector with an element of protection whilst preventing the long term abstraction of super profits;

� There remains a well understood and accepted process for addressing such issues which has been developed and adopted across a number of other regulated industries;

� A regulatory body provides Government with independent scrutiny and value for money challenge to private sector proposals;

� Having a common and well understood regulatory regime creates confidence in the private sector, which would still allow differences to functions so a regime tailored for the HSR line is possible, as is the case in HS1;

� A regulatory regime allows the necessary flexibility should it eventually evolve into an HSR network;

� A regulatory regime allows the management of the capacity allocation and access charging regimes to be managed together with the protection of the owners interests in the infrastructure – these areas are critical; and

� A regulatory regime enables cost efficiencies to be captured more readily.

The implications for the current network will also need to be fully understood and will require the involvement of the ORR. Any new HSR line between London and the Midlands will directly affect the traffic pattern on the existing West Coast Main Line, but could also potentially release spare capacity, which could compete with HS2 in an open access scenario. The ORR is likely to have a significant input to this process and the exercise must consider the strategic and economic implications of this. The secondary issue of franchise disruption will also need to be considered and could be avoided by aligning the renewal to HS2 delivery schedule.

Interfaces become much more important if the HSR network develops beyond Birmingham. In addition, HSR trains will initially use Network Rail infrastructure to continue beyond Birmingham and the payment and performance regime adopted will need to be consistent with that. A further interface consideration will need to be the comparability of the regulatory approach to HS2 compared to HS1. It may be sensible to create comparable regimes in order to create a more attractive option to operators of HS1 services. This, however, should not preclude the preferred approach for HS2 stimulating changes to the HS1 regulatory approach in due course.


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8. Financing

8.1 Introduction

Within this report, we have so far discussed the:

� Strategic criteria to consider in developing a solution to this project;

� Level of unbundling necessary to generate sufficient market interest

� Procurement approach to the respective elements of the project:

� Railway Infrastructure

� Rolling Stock and Depots

� Stations & Property Development

� Roles & responsibilities of the key stakeholders in the project

� Commercial implications of the contractual relationships.

Within this section of the report, we move on to considering the financing issues that must be addressed in the delivery of this project.

8.2 Requirement for significant Government support

Given its scale, HS2 represents a funding challenge for both the public and the private sector. Whilst commercial income from passenger services may cover the cost of operations and an element of infrastructure maintenance, it is extremely unlikely to cover the up-front costs of construction, even before any financing costs are considered.

The project, is therefore, only viable if Government makes a sizeable contribution to the cost of construction. It may be possible to profile this support over the operating period of the asset, but in the first instance it is necessary for Government to acknowledge that railway projects are not self-funding. All European HSR projects currently under construction are underpinned by significant Government support.

PPPs have often been used to spread the cost of infrastructure projects over their economic life but do not have a good record of achieving value for money in the funding of major rail and significant infrastructure projects. As we have already highlighted, we believe there to be a strong commercial, practical and value for money case for Government to fund the full costs of construction up front and then transfer the asset to an InfraCo which would take responsibility for the maintenance and renewal of the asset and ensuring it is available for the provision of passenger services. This approach to delivery necessitates the funding of construction via Government capital grant.

Risk transfer, one of the main arguments for selecting the PPP route, is often illusory in large-scale rail projects. This is because Government is explicitly or implicitly the ultimate underwriter of the major risks including construction, commissioning and commercial risk. Attempting to transfer these risks to the private sector will be expensive from a financing perspective and not value for money since the Government may be ending up paying for them twice. Furthermore, we anticipate that HS2 will be constructed by the private sector under a contract similar to the construction contract element of a PPP – therefore, to a large degree,


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the private sector efficiencies and risk transfer goals should still be achievable. What would be different is the ability to transfer financing responsibility and risk to the private sector.

Whole-life cost optimisation, another argument often used to justify the same entity carrying out design, construction and maintenance, can also be achieved through specifying a design that is based upon a whole life cost optimisation approach.

8.3 Leveraging the value of Government support

Accepting that a PPP does not represent a value for money solution in the case of this project and that Government will retain the majority of the risk, the only benefit of a PPP would be to enable the spreading of cost over time. As we have already highlighted, the operational priorities should be the primary influence on the solution adopted and the objective of spreading cost over time should remain of secondary importance. What is of importance, whatever the structure to be adopted, is to maximise the benefit that Government support can provide.

This value could be maximised by seeking investment from the private sector once the construction is complete and the project is operational. This has the benefit of reducing the perceived risk of the project, as construction risks have been separately managed and the demand for the operational services is better understood.

Removing or better understanding these two risks will enable a higher valuation for the private sector that could be captured by Government. Therefore, the emerging structure for the delivery of HS2 whilst maximising the value of the Government support is to construct the asset and then separately transfer availability and maintenance responsibilities to the private sector contractor either through a concession (“Concession Model”) or in an asset sale (“Build for Sale”). The concession model is the approach being adopted for HS1. The sale model would be more closely aligned to the approach to the privatisation of a number of utilities in the UK in recent years including the power and water industries.

Under either scenario, it is envisaged that Government will fund the initial capital cost and then recover an element of the cost through the price the private sector is willing to pay for the prospect of maintaining, and making available, the infrastructure.

The value of the payment to Government will be dependent upon the operating premium the InfraCo is able to forecast. This value will be heavily influenced by the approach to demand risk and the contractual and regulatory mechanisms adopted during the operating phase. Having a more certain view of passenger demand and the subsequent impact on track access charge income or the value of availability payments under the contract will result in a lower risk premium being applied by the private sector in its valuation of the infrastructure. This in turn will lead to a maximisation of the return to Government.

Other factors that will likely impact on private sector appetite and valuation include:

� The impact of traffic risk;

� Integration and interoperability;

� Contractors taking risk with a project of this size;

� New technology;


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� Construction and planning (particularly in respect of Euston); and

� Political sustainability and support.

The separation of construction from operations and the transfer to the private sector once operational has received a positive response in market consultations held as part of the evaluation process. How the transferred infrastructure would be regulated or controlled still needs to be refined, but options include adopting a regulatory mechanism similar to that applied to the conventional network. The alternative concession model allows a contractual mechanism to regulate and enforce the required outputs. The key differences to these approaches relate to the method of enforcement and the ability to respond to changes to the market.

8.4 Considerations from other projects

Our review of international HSR projects has indicated that Government support has been provided either directly through grants or indirectly through minimum revenue guarantees.

The market feedback included comments that, if it is to sell it in the future, the Government must be active in the early stages with the objective of offering the asset to the broadest pool of capital with some appetite for revenue risk. Other considerations include:

� The UK has a good record of funding utilities, and a regulated approach is well understood, tested and proven;

� Alternatively, the continental concession model has been used to finance roads and is the approach that has been adopted for HS1;

� The value of cash paid for the concession or sale will be a function of the user charges, and Government would be able to increase the value of this by increasing the value of revenues the InfraCo receives, either through guarantees or grants;

� A regulated approach represents a flexible, yet long-term solution for attracting private capital as, once operational, is relatively stable and well understood. Conversely, concessions are more rigid, relatively short term alternatives that can be very complicated and not well suited to withstand major changes in strategy or industry wide shocks;

� Regulatory risk may be seen, by some, as excessive, however, considering the fact that the regulatory regime allows a response to significant shocks to the industry, the allowed returns are relatively well protected.


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9. Future Proofing

We have highlighted the need for Government to consider whether or not this project will require the development and delivery of a single HSR line or whether a longer-term strategic view is taken around the development of a network.

We recommend that Government consider this option so that, if appropriate, a structure can be developed that facilitates the delivery of future enhancements and ultimately an HSR network. Failure to consider this at an early stage may result in a structure that is not amenable to further line extensions in due course. Some of the primary considerations in this regard include:

� The potential to deliver significant future infrastructure programmes. It may be possible to create a financial structure that facilitates the delivery and financing of subsequent HSR line extensions which reduces the need for additional Government support;

� The concept of the creation of a Regulated Asset Base (RAB) is an established and well understood mechanism of enabling access to significant funding for the delivery of capacity enhancements and is discussed in more detail later in this section, but will require the creation of a well understood and clearly defined payment and cost allocation mechanism that supports the workings of a regulated utility;

� It is important to consider and develop a sensible approach to managing the InfraCo during the operational phase. With a suitable and flexible operating structure, subsequent extensions to the network could benefit the Government by being able to capture economies of scale and other operational efficiencies. Creating an inflexible contract may, should subsequent extensions be delivered, lead to inefficiencies and increased network costs which ultimately destroy value to Government and/ or reduce the commercial rationale of the open access arrangements;

� In seeking to create an operating structure that allows future flexibility and enables future growth, it will be important to ensure that the delivery considerations discussed in the report to this point are not affected.

Across the UK, a utility-based regulatory structure is well established and understood and has facilitated significant investment in infrastructure assets. This mechanism may enable the delivery of an HSR network. This option is discussed in more detail below.

9.1 Regulatory controlled structure

A regulatory controlled structure is a well-understood and well-established approach to the delivery and maintenance of major infrastructure in the UK. The added advantages that a regulatory approach, with the creation of a RAB include:

� Acceptance by the market;

� A dynamic, flexible mechanism that can be adapted to respond to major shocks and unforeseen circumstances;

� It sets forward looking expectations for behaviour and can avoid damage from anti-competitive behaviour by anticipating and preventing it;


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� It can provide certainty for market participants, by setting out clear rules in advance (this requires good regulatory and institutional design that prevents Government or regulator from changing the rules unpredictably);

� It promotes transparency;

� It eases dispute resolution, as the competition framework is already established;

� Regulators and affected parties know in advance the types of information required for regulatory proceedings, and can collect it accordingly; and

� Competition laws specify in advance which forms of conduct are prohibited.

The adoption of a regulatory approach to controlling the operating entity could be used under a long term concession, as has been adopted on HS1, or under the creation of a private sector ownership structure, such as a not for profit entity responsible for maintaining the infrastructure similar to Network Rail for the conventional railway. Both approaches could deliver the operational aspirations of Government and could raise revenue to offset the cost of construction, however, the wider governance considerations discussed in section 7.1 will still need to be addressed.

In addition to consideration of the form of regulation to adopt for the HSR infrastructure, it is important to consider the prospect of creating a RAB to enable future network expansion. The single biggest benefit is that, with a complimentary and well-defined payment mechanism, a regulatory structure enables significant additional finance to be raised. This finance could facilitate the delivery of additional lines post completion of HS2.

The principle that underpins this structure is that financing becomes a primary element of the payment mechanism. Under this structure, debt raised efficiently for the construction of infrastructure assets is added to the value of the RAB. The InfraCo is allowed to receive a return on the RAB, sufficient to enable the InfraCo to service the debt and retain a profit. The amount of finance is limited to a proportion of RAB, therefore, ensuring that the value of assets always exceed the value of debt. Creating a RAB structure could be used to deliver additional network enhancements. The principles that HS2 will need to be mindful of when considering the creation of a RAB include:

� The sourcing of equity to be injected into the RAB;

� In order to create a RAB, it is necessary to have an element of equity. The value of the equity will directly influence the level of debt that can be raised to fund future projects. A standard limit of gearing for a regulated utility is circa 80%. Therefore, the level of debt that can be raised will be directly proportional to the amount of equity included in the initial RAB;

� If the Government is to fund the construction, it will have the option of transferring this asset into a RAB and thereby creating the equity within the RAB that is used to raise additional finance in due course;

� An alternative method of raising equity would be through an IPO or equivalent, similar to the approach to create the privatised Railtrack. Under this model, equity is raised from the public and/ or private companies purchasing shares in the asset. The value of the share sale is what is used to calculate the value of the RAB;


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� However, when creating a RAB, in order for the regulatory principles to work, the Government must be aware that the RAB creates a commitment to provide future income to service the RAB. This does not mean the requirement for a Government guarantee, although one is provided to Network Rail, rather it requires that track access charges will be sufficient to service the RAB. This may require Government to act as funder of last resort in the event that track access charges are not sufficient to cover the RAB costs.

� Governance arrangements;

� The structure and governance arrangements of the regulated utility should be developed and agreed in advance, particularly in light of the requirement to fund the construction of the asset at the outset;

� A not for profit distribution model, similar to Network Rail, could be created such that profits are reinvested in the network. An alternative could be a Company Limited by Shares (CLS), which would allow the distribution of dividends to shareholders who have injected the equity. There are many other alternative options that will need careful consideration as part of the future development of any scheme;

� The quantum of the RAB will dictate how much additional debt can be raised;

� It will be necessary that the size of the RAB created is commercially viable, therefore, it should have due consideration for the potential value of track access charges that the asset may generate. This, however, may limit the size of the RAB to a level which is insufficient to raise sufficient finance for the delivery of subsequent network expansions. It may therefore be an option for Government to provide direct grant, as is the case with Network Rail, which allows a larger RAB to be created and allows more finance to be raised for the delivery of greater network expansion.

HS2 will need to consider carefully the implications and practicalities of creating a RAB in more detail before a preferred structure is finalised. It may not be practical to consider creating a capital intensive structure through a RAB as utilities with extensive enhancement and renewals spend can be less robust than steady state entities. Examples from the water and electricity distribution sector should be carefully considered and factored into any decision on the best approach to HS2.


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10. Summary

Based upon the analysis included in section 7.1, it is possible to present the various roles and the relationships between each party during construction in a single diagram. This is presented in Figure 10 below.

Figure 10: Construction Interfaces

In summary, based upon the elements discussed in sections 5, 6 and 7 the emerging conclusions include:

� A single InfraCo should be set up to carry out the operation and maintenance of all elements of the completed HSR line infrastructure. This should reduce interface risk during operations thereby optimising performance and delivering the passenger growth forecast. The infrastructure should be managed by a single InfraCo as it limits interface risk during the operations phase and transfers it to the private sector. The interface with the Control Systems contract will be a crucial element of this contract;

� Separate contracts should be created for the delivery of the Civils and Structures, Railway and Control Systems, Rolling Stock, Depots and Stations. Further geographical and functional split is likely to maximise market appeal and ability to finance;

� Construction should be separated from operations to ensure that the constituent elements of the HSR line once delivered are transferred into a single InfraCo;

� The interface between the Maintenance of the Railways Systems and Control Systems should be carefully managed;

� Consideration should be given to relationship between TOC, HS2 and InfraCo – who takes revenue risk and the commercial implications for the structure;

� The payment mechanism to be adopted in light of the interface between the HSR and conventional network and operators needs to be clearly defined;

� Partial unbundling is likely to offer better value for money since it is likely to generate a good level of competition without overly increasing interface risk;


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� The level of unbundling should create multiple construction contracts, which then transfer to a single InfraCo for maintenance. There is a question as to where the asset acceptance and interface risk sits but, when considering that the Government will remain as funder of last resort and will be unlikely to transfer catastrophic and latent defect risk to the private sector, we have assumed that this will remain with Government;

� Rolling Stock and Depots should be procured as part of a single contract unless the value for money assessment undertaken during the procurement phase indicates otherwise; and

� Further work is required to finalise the preferred approach and structure of the delivery of the new stations. In particular, the approach to the expanded station at Euston is highly complex and faces significant risks and issues. The interface with Network Rail and the impact on the West Coast mainline will require a single point of responsibility during the delivery period.

Having undertaken the review of bundling, procurement and governance we have been able to develop an emerging delivery solution. We have sought to present this structure in the diagram below, which summarises the link between the construction and operations phase. In the diagram the structure presents interface and asset acceptance risk being retained by the public sector.

Figure 11: Example of construction contractual split and link to operations.

The procurement option depicted is for the major features of the design to be undertaken by Government but to allow the private sector contract to input to specific elements. Upon completion of the construction, the asset would transfer to a single InfraCo responsible for the maintenance and availability of the completed asset. The diagram highlights that there is the option for multiple construction contracts. These will need to be carefully managed and controlled. With Government retaining asset acceptance and interface risk, the need for support from a delivery partner is crucial to the management of risk and the successful delivery of the completed asset.

Construct Co 1 Civils & Structures(Multiple contracts)

Single InfraCoMaintains whole asset

Construct Co 2Stations

(Multiple Contracts)

Construction Operations

TOC runs services

Construct Co 3Railway Systems(Single Contract)

Delivery Partner

HS2

HMG

Rolling Stock procurement


Delivery Considerations – a report for HS2

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