Open-Access vs. Contracted Operators: Business Models, Incentives, and Market Impact

Hello! Welcome to the final lesson of our first module on the structure and regulation of the UK rail industry.

In our last lesson, we analyzed the detailed structure of track access charges. We established a critical distinction: government-contracted operators are largely insulated from fixed infrastructure costs via the Fixed Track Access Charge (FTAC), while commercial open-access operators face a usage-based Infrastructure Cost Charge (ICC) that directly impacts their profitability.

This lesson builds directly on that foundation to address our final learning outcome for this module: Contrast the business models and incentives of open-access operators versus contracted operators, and analyze their respective impacts on competition and fares.

We will explore how this fundamental difference in charging, combined with exposure to revenue risk, creates two entirely distinct business philosophies. We'll examine the central economic debate around open access—whether it generates new demand or simply abstracts revenue from the taxpayer-supported incumbent—and how the regulator attempts to manage this tension.

1. Two Sides of the Same Track: Contrasting Business Models

The UK rail landscape features two primary types of passenger operators, each with a fundamentally different relationship with risk, revenue, and the government. A report by the open-access operator Lumo provides a concise summary of these differences.

Let's formalize these distinctions:

A. The Contracted Operator Model

• Who they are: These are the operators running most services, such as LNER, Avanti West Coast, and GWR. Following the Williams-Shapps reforms, they operate under National Rail Contracts (or similar arrangements), which are successors to the previous franchise system.
• Business Model: They are essentially service providers contracted by the Department for Transport (DfT). They compete for the market by bidding to win these contracts.
• Incentives & Risk Profile:
  • Revenue Risk: Minimal. The DfT collects the fare revenue and bears the risk of ridership fluctuations. The operator is paid a fixed management fee to run the specified services, often with a small performance-based bonus or penalty.
  • Cost Risk: Their primary commercial incentive is to control their direct operating costs (staff, maintenance, energy, etc.), as their profit margin is the difference between their management fee and these costs.
  • Flexibility: Very low. The service specification—routes, timetable frequency, and regulated fare levels—is tightly defined in their contract with the DfT.

B. The Open-Access Operator (OAO) Model

• Who they are: Commercial ventures like Lumo, Hull Trains, and Grand Central that operate without a government contract.
• Business Model: They are entrepreneurial, risk-taking entities. They identify what they believe is an underserved market and apply to the Office of Rail and Road (ORR) for the rights to run services. They compete in the market.
• Incentives & Risk Profile:
  • Revenue Risk: 100%. They bear the full commercial risk. All revenue from ticket sales is theirs to keep, creating a powerful incentive to attract passengers through competitive pricing, marketing, and service innovation.
  • Cost Risk: 100%. They cover all costs, including rolling stock leases, staff, and the full suite of track access charges (Variable Usage Charge and the per-mile Infrastructure Cost Charge).
  • Flexibility: High. Subject to ORR approval, they can define their own routes, service patterns, and pricing strategies to respond to market demand. All their fares are unregulated.

2. The Competitive Impact: Abstraction vs. Generation

The introduction of an OAO on a route dominated by a contracted operator creates a fascinating economic dynamic. The central debate revolves around two competing effects: revenue abstraction and demand generation.

A fantastic video by Wendover Productions explores this dynamic in the European context, drawing a powerful and relevant analogy to the rise of budget airlines.

As the video highlights, the key question is where an OAO's customers come from.

• Abstraction: This is the primary concern of the DfT. It refers to passengers who switch from the incumbent (contracted) service to the new OAO. Because the government bears the revenue risk for the incumbent, every £1 of abstracted revenue is £1 less for the Treasury, potentially increasing the net cost to the taxpayer. This leads to accusations that OAOs "cherry-pick" the most profitable routes, undermining the finances of the wider network.
• Generation: This is the primary argument made by OAOs. It refers to attracting new passengers to rail who would have otherwise:
  • Travelled by car or plane (modal shift).
  • Not travelled at all.
    This grows the total rail market, generating wider economic and environmental benefits. The video's example of Italo in Italy is a classic case study of this effect.

3. The UK Debate: A Practitioner's View

This theoretical tension is at the heart of every open-access application in the UK. Ian Yeowart, a key figure in establishing the UK's first open-access services, provides a compelling, first-hand argument for the generative power of this competition.

Yeowart's key arguments are that open-access competition:

• Grows the total market: He argues that the significant post-COVID recovery on the East Coast Main Line, compared to other routes, is direct evidence of the generative effect of OAOs like Lumo.
• Lowers fares for everyone: The presence of a low-cost competitor forces the incumbent to offer more competitive fares, benefiting all passengers on the route.
• Brings private investment: OAOs fund their own rolling stock, meaning new trains are brought onto the network without direct cost to the taxpayer.
• Improves connectivity: OAOs have historically provided new direct services to towns and cities that were poorly served by the franchised network (e.g., Sunderland, Hull, Bradford).

4. The Referee: The ORR and the "Not Primarily Abstractive" Test

Given the valid concerns about protecting public funds and the compelling arguments for the benefits of competition, how does the regulator decide? The Office of Rail and Road (ORR) arbitrates this conflict using a specific regulatory tool: the Not Primarily Abstractive (NPA) test.

The NPA test is the quantitative heart of the matter. Here's how it works:

1. The Calculation: For a proposed new service, the ORR models the expected passenger revenue. It estimates how much of this revenue will be generated (new money to rail) and how much will be abstracted from existing services. It then calculates the ratio: $$\text{NPA Ratio}=\frac{\text{Generated Revenue}}{\text{Abstracted Revenue}}$$
2. The Threshold: The ORR's guidance states it would not generally approve applications with a ratio below 0.3 to 1. This means for every £1 of revenue taken from the incumbent, the new service must generate at least 30p of new revenue for the railway system as a whole.
3. The Decision: As you saw in Table 3.1, the NPA ratio is a critical input, but not a simple pass/fail metric. The ORR weighs it against its other statutory duties, such as promoting competition, considering the absolute level of abstraction (a low ratio on a huge revenue flow might be rejected), and the benefits of new direct services. For example, Lumo's application (as East Coast Trains Ltd.) was approved with a very high NPA ratio of 0.81:1, signalling a strong generative effect.

Conclusion

This lesson concludes our exploration of the UK rail industry's structure and regulation. We have seen how the regulatory framework, particularly the design of track access charges, creates two distinct operator types with divergent incentives.

Key Takeaways:

• Contracted Operators are low-risk service providers for the government, competing for the market. Their main incentive is to control operating costs.
• Open-Access Operators are high-risk commercial ventures, competing in the market. Their incentive is to maximize revenue by growing ridership through competitive fares and service innovation.
• The core economic conflict is abstraction (siphoning revenue from taxpayer-supported incumbents) versus generation (creating new demand for rail).
• The Office of Rail and Road (ORR) mediates this conflict using the Not Primarily Abstractive (NPA) test, which seeks to ensure that new services provide a net benefit to the railway by generating sufficient new demand relative to the revenue they abstract.

Preview of the Next Module:

We have now established the institutional and competitive landscape. In our next module, The Cost Structure of Railway Operations, we will move from the "who" and "why" to the "how much". We will begin by decomposing the total costs of the railway, applying the concept of natural monopoly to the industry's cost characteristics, and exploring the profound implications of its high-fixed-cost, low-marginal-cost nature.