NETWORK RAIL’s chief financial officer is somewhat bleary-eyed on meeting Financial Director at the rail operator’s head office next to its £550m redevelopment of King’s Cross station in London.
“I’ve been up since 2 o’clock,” Patrick Butcher says somewhat apologetically, explaining that he has been on site overnight overseeing track improvement work.
Though a previous stint as finance director of the London Underground suggests a fascination with trains, Butcher’s time on the track is not the result of a burning passion for all things rail-related; instead it is the result of the rail network owner’s relentless focus on safety.
“It’s easy to become disconnected from safety and for safety to become a statistic and a change programme. It’s only when you go out and spend six hours in the rain in Wiltshire, watching people operate against tight production targets that you truly get a sense of the risks,” he explains.
Butcher says the network’s responsibility extends to the safety of passengers and members of the public, along with that of its staff. But it is an area in which the track operator has come in for some considerable flack after recently being subjected to a scathing report from MPs over deaths at railway level crossings.
Network Rail has closed almost 800 level crossings since 2010, and plans to shut 500 more by 2019, but Butcher goes further, asserting that the safest level crossing is “a level crossing that doesn’t exist”. On the wider point of safety, Butcher says there has been “a lot of dialogue about safety and finance being in conflict” and concedes “poor decisions” can lead to tension between safety and money.
However, he claims it doesn’t have to be that way: “Actually, they work together. A safe worksite is a worksite that is well planned, and consequently more efficient.”
It is a testament to the importance of safety that Butcher has made time to get out on site. During the past year, the operator published its strategic business plan for the next five years – Network Rail operates in five-year control periods for planning, financing and investment purposes – which then had to go through 200 meetings with the rail regulator before the plan was agreed.
Over the next control period – 2014 to 2019 – Network Rail will have to cut costs by 19.4% while spending more than £38bn on maintaining, renewing and improving the rail network. At the same time, train punctuality will need to be improved. Network Rail is to invest £12bn on infrastructure renewals and £12.8bn on enhancements such as electrification.
Yet this comes at a time when subsidies continue to fall. Government support reached a peak of £7bn in 2008/9 but has since fallen to less than £4bn, much of which is increasingly being used to pay off past investments. Since the collapse of FTSE 100 track operator Railtrack in 2002, Network Rail has been “grappling with an investment backlog”, explains Butcher. In many areas, the nation’s railways are still using the infrastructure bequeathed by the Victorians.
Much of the investment is aimed at network enhancements – such as extending platform lengths – but the rate of improvement is being stymied by the size of the operator’s debt position. The cost of servicing Network Rail’s debt, which currently stands at £30.4bn, has grown £1.5bn a year; it has a regulated asset base of £40bn, is one of the most capitalised industries in the UK, and has a larger debt portfolio than all the water utilities combined.
Indeed, net debt is forecast to be just shy of £50bn by 2019. Although the government-backed debt pile is below the regulatory limit, Butcher says there has to be a debate about how the operator is funded in the future.
“The reason our debt is growing is the railway growing. It is sustainable for our debt to grow as our regulated asset base grows. More or less, we get enough cash to fund our replacement capital,” Butcher says. “If you just carry on doing this then at some point – ten, 20 years down the track – we will be a very large bank with a small railway attached.”
As the debt continues to grow, Butcher says this has created “distorted incentives” for the business, which will need to look at fixing its interest costs.
“As we look at the next control period, the single biggest decision from a finance perspective is what to do about managing interest rates. We fixed them all and entered into a derivative programme to hedge out that risk,” he says.
In assessing the long-term financial sustainability of the UK’s railways, Butcher says it is important to consider whether Network Rail’s debt level can be re-financed and serviced effectively. But he thinks there is an opportunity to introduce risk capital – or private investment – into the railways.
According to Butcher, the UK should behave more like Hong Kong, where the network would develop large pieces of real estate and hold the assets. A global leader in the integration of rail investments and urban development, Hong Kong’s MTR Corporation operates the rail system and develops real estate around the station, which contributes to a significant portion of its revenues.
“In Hong Kong, the tenants would pay rent to the operator,” he says. “There’s lots of opportunity at that commercial intersection. Financing requires a funding model that provides a return on investment.”
In terms of the UK, Butcher says the redevelopment of Euston station is “interesting”. While King’s Cross is a “wonderful building” with some great retail, Euston offers the opportunity to do something different.
“For me it is about the short term versus the long term. In the short term, we could take the opportunity to take the funds from developers or we can stay invested in that and have long-term revenues. That’s a debate about what people want to do,” he says.
Lost in a sea of data
Nevertheless, debt is being put to use, investing in the most intensively used railway in Europe. Critical parts of the network are running at close to 100% capacity, while passenger demand has increased by 50% over the past ten years and another 400 million journeys will be made every year by 2020.
The operator is currently halfway through a programme to replace outdated equipment and renew structures, and Butcher says assets need to be maintained in a “sustainable way”.
“When people talk about decades of under-investment, they are talking about a failure to modernise and improve,” he explains.
Indeed, investing in new ways of inspecting the railway is already enabling the business to better work to targets, moving from a ‘find-and-fix’ approach to one where potential problems are spotted and dealt with before they happen. Last year, it completed the roll-out of 8,000 handheld devices with bespoke apps to log and record vital information, which have replaced millions of paper-based inspection records.
“Sometimes, the points are not where it says it is. A person gets a sheet of paper, it’s raining, and they have to find a defect to the nearest half-mile – and they fix the wrong thing. Now, we use 12,000 smartphones across the company, with an app that says where the defect is to within two metres.”
As Butcher explains, the business has to invest in order for it to become more productive. For instance, there is a cost attached for the business as it rationalises the number of signalling locations by putting in modern equipment.
“Overlaying that with traffic management systems allows us to go from 5,500 signallers to 1,000,” Butcher says.
The finance function is an integral part of calculating the business case for investments. That, explains Butcher, requires dialogue between engineers and the finance function. The business is also able to forecast the degradation of assets – clearly an inexact science despite its sophistication – which indicates when intervention is required.
“Unless you assemble data in a manageable way through organised, coherent systems, you just get lost in a sea of data,” Butcher says. “We know how many points we’ve got – we know the average length of time between points failing.”
While the business is able to forecast passenger growth, which drives its view of what needs to happen to meet anticipating capacity, and estimate the average length of time between points failing, there is still no accounting for the weather.
The past year saw an increase in the losses arising from weather-related incidents, compared to the previous year. Although storms were more frequent, the biggest costs came from sustained and excessive rainfall, which caused flooding on several parts of the network and was a contributing cause to the spoil heap collapse at Hatfield Colliery. This last incident alone resulted in a £15m loss – that figure being the excess under Network Rail’s insurance policy.
“We plan for the average of the past five years,” Butcher says. “Clearly, the past four years have not been average.”
Trimming the fat
Cutting costs is an ongoing task for Butcher. During the last control period, the business had to find savings of about £5.3bn with similar amounts expected in the next period. Rather than cut services – an unpalatable option – efficiencies have been ground out in the back-office functions.
“Every couple of years, head-office bureaucracy grows and you need to prune it,” says Butcher, who points to a management reduction programme which will reduce Network Rail’s number of managers by 15% by March.
Over the past nine to 12 months, back-office functions have been put under a single management structure that covers HR, payroll, budget, IT and procurement.
“The key value-add is about centralising things that are routine, repetitive and meaningful to scale,” Butcher says. “That will be an engine for further streamlining those services. We look at how we extract value by integrating those things, but also it provides a machine into which we can dump more processes, so you go from basic accounting to doing management accounting and from basic personal admin to something else.”
Butcher adds that IT can make a huge difference. For instance, 18 months ago the business automated its expenses which Butcher says used to be a “dog of a process”, while the business also invested heavily in an ERP system.
“It’s a much cheaper and better process that is automated and structured. Once you have got it automated, you get fantastic information. It grinds out another level of efficiency,” he says. However, he ends with a warning that the service should not be made efficient for the central functions alone.
“It’s very easy to design a really streamlined process for the shared service centre, which then requires all the managers to spend an extra hour a day filling in the form the way the shared service centre wants. It doesn’t mean the process is desperately effective for people in the business. Ultimately, the support functions are there to support the business,” he concludes. ?
IN BLACK AND WHITE
2009 – present Finance director, Network Rail
2004 – 2007 Finance director, English, Welsh & Scottish Railways
2000 – 2002 Finance director, London Underground
1994 – 2000 Finance director, King’s College Hospital