Financial considerations – a report for HS2

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Financial considerations a report for HS2

18 December 2009


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Ernst & Young i

The UK firm Ernst & Young LLP is a limited liability partnershipregistered in England and Wales with registered number OC300001and is a member firm of Ernst & Young Global Limited. A list ofmembers names is available for inspection at 1 More London Place,London SE1 2AF, the firms principal place of business andregistered 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

Financial considerations a report for HS2

I am pleased to provide you with this report setting out a summary of the financial outputs relating to

the options for a potential High Speed Rail link from London to the West Midlands. This report

provides a summary of the financial cost of the project from a capital and revenue perspective based

upon our recommendations on the delivery and financing options for the project addressed in our

separate report titled Delivery considerations a report for HS2 dated 18 December 2009.

This report has been prepared in accordance with the terms and conditions of our existing contractwith High Speed Two in respect of the Provision of Financial Advice under the Buying Solutions Multi-

Disciplinary Consultancy Framework Agreement Code: RM353 (the Contract).

The attached document is a result of the analysis that we have undertaken to develop an

understanding of the funding requirements necessary for a High Speed Rail link between London and

Birmingham. This analysis has been developed following a review of the cost and revenue forecasts

prepared and presented by HS2 and its Technical Advisers. We have not reviewed the adequacy or

appropriateness of the figures provided. As a result, should the cost and revenue forecasts differ from

those estimated by HS2, the findings of this analysis may be materially different.

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 report 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 analysis may reveal

additional considerations that this paper has not.

Should you have any questions please do not hesitate to contact me on 0207 951 1702.
mailto:[email protected]:[email protected]


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Contents

1. Introduction & Background .................................................................................... 11.1 Phase I ............................................................................................................................................ 11.2 Phase II ........................................................................................................................................... 11.3 Report Structure ............................................................................................................................ 2

2. Financial Analysis ................................................................................................. 32.1 Infrastructure Costs ....................................................................................................................... 32.2 Infrastructure Revenues ................................................................................................................. 72.3 Franchise Financials ....................................................................................................................... 72.4 InfraCo Financial Forecast .............................................................................................................. 92.5 Government Premium Summary ..................................................................................................... 9


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1. Introduction & BackgroundIn 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.

1.1 Phase IThe 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: lessons learned and recommendations

for HS2 is included as Annex 1.

1.2 Phase IIThe 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.

The findings of the Phase II analysis described above is included in a separate report entitled

High Speed Two Finance & Delivery Considerations Phase II Delivery Report dated 18

December 2009 (the Delivery report). This paper provides a summary of the financial

analysis undertaken in conjunction with the review of the delivery options.


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1.3 Report StructureSection 2 of this report summarises the financial analysis that we have performed and is

structure in the following sections:

2.1 Infrastructure Costs

2.2 Infrastructure Revenues

2.3 Franchise Financials

2.4 InfraCo Financial Forecast

2.5 Government Premium Summary.


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2. Financial Analysis2.1 Infrastructure Costs2.1.1 Infrastructure Capital Costs

The table below presents a summary of the capital costs for the High Speed Rail (HSR) link

from Euston to Birmingham.

Capital Item

(m real, base date September 2009)Risk Adjusted Capital Cost

Civils 3,615

Structures 5,154

Railway Systems 881

Control Systems 1,150

Stations 4,138

Depots 635

Mobilisation & Testing 938

Rolling Stock 2,835

Total 19,347

Table 1 : Capital Cost breakdown

This capital cost spend profile over the construction period is highlighted in Figure 1 below:

Figure 1: Capital Cost Spend Profile (including rolling stock)

The profile above includes the capital cost of the rolling stock at 2.8bn. As we have

highlighted within the Delivery report, we believe that the size of the rolling stock contract

and the bespoke nature of a large proportion of the trains may make financing through the

private sector using a conventional approach to train procurement challenging.

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2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026

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Construction Year


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Should a traditional approach to the procurement of rolling stock be used and a lease agreed,

the construction profile excluding the rolling stock capital cost would change, with substantial

ongoing annual lease payments required over 30 years instead. However, we have assumed

that for the central case, Rolling Stock is funded via Government Grant.

2.1.2 Infrastructure Operating CostsIn addition to the capital costs presented above, there will be a requirement to fund the

maintenance costs of the infrastructure once operational. We present below the annual

maintenance costs for the infrastructure.

Annual Cost (m real)

O&M Costs 45m

Station O&M 22m

Table 2 : Infrastructure Operating Costs

2.1.3 Infrastructure Renewals CostsOver the initial 30 year operating period it will also be necessary to renew elements of the

infrastructure. HS2 has estimated that the renewals requirement will be to:

Renew half of the control systems in operating year 14 and 15. This equates to 288m

per year for each of the two years (or one quarter of the initial capital cost of 1,150m

in each of two years);

Renew the remainder of the control systems in operating year 29 and 30. This equates

to a further 288m per year in each of these two years (a further quarter of the initial

capital cost of 1,150m in each of two additional years);

Fully replace the railway systems by the end of 30 years. This is estimated to take 4

years to complete starting in year 27. This equates to an annual renewal cost of 220m

(or one quarter of the initial capital cost of 881m in each of four years).

No renewals are forecast for civils, structures, stations and depots and the life of the rolling

stock is expected to exceed 30 years so a replacement will not be required within the initial

30 year operating period. In total over the first 30 year operating period, total renewals

spend is estimated to be just in excess of 2bn.

Figure 2 below provides a summary of the timing of the renewals spend over the first 30years of operations.


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Figure 2: Renewals profile over first 30 years of operations

In modelling this expenditure, in order to smooth the revenue impact of the cost, we have

spread the 2bn total over the 30 year period, similar to the approach adopted in standard

PPP contracts. This has lead to an annual revenue impact of approximately 68m.

2.1.4 Estimating Profit MarginsAnalysis undertaken by OXERA on behalf of the ORR during the CP4 determinations included

considering the margins made by companies undertaking a similar type of activity to Network

Rail (i.e., rail engineering). We have assumed that the InfraCo will seek a similar level ofreturn. The OXERA analysis was based upon a selection of companies undertaking rail

engineering activities, as well as United Utilities Operating Services, a company set up

specifically to take responsibility for the operation and maintenance of the entirety of Welsh

Waters assets. The results of the OXERA study are presented below.

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Table 4 : Estimated Franchise Profit excluding rolling stock lease charges & infrastructure access charges

NB: The High Speed operations start date is estimated to commence in January 2026 which would allow a 3 monthoperating period before the start of the first full operating year ending 31 March 2027. In order to present full yearmovements, this initial 3 month operating period has been excluded from the table.

The Net Revenue figures in Table 4 above is the revenue forecast to be received by the

franchise net of the revenue that the project will subtract from the conventional rail network.

The franchise figures above exclude rolling stock and track access charges at this stage and

highlight that, based upon the franchise cost and revenue estimates provided by HS2,

franchise operations will make an operating profit exceeding 180m in year 2027 increasing

to circa 422m by year 2033. Therefore, allowing for an operating profit in line with those

profits currently achieved across conventional rail franchises, the franchisee would be able to

pay a premium to Government of circa 152m in year 2027 increasing to 382m by year

2033. Under this scenario it would be possible for the franchisee to make Track Access

Charges in line with the minimum level of 150m per annum discussed in Section 2.2.

Table 5 below highlights the impact on profitability and the value of the premium that could

be repaid to Government should Rolling Stock be procured up front and TACs are set at the

minimum 150m required to cover infrastructure costs.

m real year ending 31March

2027 2028 2029 2030 2031 2032 2033

Net Revenue 565 604 643 682 723 764 806

Franchise Op Costs (204) (204) (204) (204) (204) (204) (204)HST Maintenance (180) (180) (180) (180) (180) (180) (180)

Infrastructure TAC's (150) (150) (150) (150) (150) (150) (150)

RosCo Charges - - - - - - -

Profit 31 69 108 148 189 230 272

Government Subsidy/(Premium)

(2) (39) (76) (114) (152) (192) (232)

Retained Profit 28 30 32 34 36 38 40

Retained Profit (%) 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

Table 5 : Franchise forecasts assuming no rolling stock lease costs and minimum infrastructure access charges


The analysis above highlights that, assuming TACs are set at the minimum level required, it is

possible that the franchise operator could make a premium payment to Government in the

range 2m in year 2027 increasing to over 230m in year 2033.


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2.4 InfraCo Financial ForecastBy bringing together the estimated income from track access charges and subtracting theestimate infrastructure costs, it is possible to estimate the operating profit range that theInfraCo may be able to achieve and the possible premium payments to Government. Table 6below highlights the estimated profit and premium payment to Government assuming 150mper annum TACs.

m real / yearending 31 March

2027 2028 2029 2030 2031 2032 2033

HST TAC's 150 150 150 150 150 150 150

O&M Costs (45) (45) (45) (45) (45) (45) (45)

Station Op Costs (22) (22) (22) (22) (22) (22) (22)Renewals Spend (68) (68) (68) (68) (68) (68) (68)

Profit 15 15 15 15 15 15 15

Premium to Govt (8) (8) (8) (8) (8) (8) (8)

Retained Profit 8 8 8 8 8 8 8

Retained Profit (%) 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

Table 6 : InfraCo Profit estimate including infrastructure access charges at minimum TAC level


We have estimated the premium that Government could receive under a regulated capped

return model assuming a real (revenue) profit margin of 5% per annum being approximately

8m per annum. Track Access Charges of circa 150m are necessary to meet the forecast

operation, maintenance and renewals cost of the line once operational. NB: These costs

exclude any element of capital cost.

2.5 Government Premium SummaryIn summary, under the assumptions adopted for this analysis, the level of TACs will determine

how much premium the Government receives from the franchise operator and from the

InfraCo: the lower the track access charges, the higher the premium that the franchise

operator generates compared to the InfraCo and vice versa. The total premium to

Government is only marginally impacted by the level of TACs. The differences that arise are

the result of the increased premium that the InfraCo is allowed to receive as TACs increase as

profit is a function of revenue. There would be no difference to the premium to Government if

the profit margin was linked to costs but that would not create an incentive on the InfraCo to

increase capacity and usage of the HSR line. Table 7 below summarises the premium

payments to Government from the two sources.


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m real / yearending 31 March

2027 2028 2029 2030 2031 2032 2033

Premium fromfranchise

2 39 76 114 152 192 232

Premium fromInfraCo

8 8 8 8 8 8 8

Total Premium 10 47 84 122 160 200 240

Table 7 : Total premium to Government


Profile of Government Support

Figure 3 below provides a summary of the profile of Government spend and income assumingminimum TACs of 150m are set. The profile of the cash flows shows that HS2 will generate

a premium to Government from 2027.

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Figure 3: Government funding profile during construction and operations

2.5.1 NPV of Government SupportTable 8 below provides a summary of the net present value to Government discounted at

3.5% real.

Total NPV

3.50%

Income from Franchise 5,903 2,433

Income from InfraCo 231 102

Support to Franchise (8) (6)

Support to InfraCo - -

Support for Capital Cost (19,347) (16,679)

Net Government Position (13,222) (14,150)

Table 8 : NPV of Government Support over 40 years

NB: The support to the franchise forecast above is estimated to be required during the first 3 months of operationscommencing January 2026 whilst passenger revenues are still low and subject to future growth. Thereafter revenuegrowth is estimated to be sufficient to cover operating costs.

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Financial considerations – a report for HS2