Financial considerations – a report for HS2

18 December 2009
Ian Jordan 18 December 2009
High Speed Two IA/MG/AB/GF
55 Victoria Street
London Direct Line: 0207 951 0742
SW1H 0EU e-mail: mgupta@uk.ey.com

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 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’).

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.

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
Ernst and
& Young ÷ i
registered office.
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Yours sincerely

Manish Gupta

Partner

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Contents

1. Introduction & Background.................................................................................... 1

1.1 Phase I ............................................................................................................................................1
1.2 Phase II ...........................................................................................................................................1
1.3 Report Structure ............................................................................................................................2

2. Financial Analysis................................................................................................. 3
2.1 Infrastructure Costs .......................................................................................................................3
2.2 Infrastructure Revenues .................................................................................................................7
2.3 Franchise Financials .......................................................................................................................7
2.4 InfraCo Financial Forecast ..............................................................................................................9
2.5 Government Premium Summary .....................................................................................................9

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1. 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.

1.1 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: lessons learned and recommendations
for HS2” is included as Annex 1.

1.2 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.

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 Structure

Section 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 Analysis
2.1 Infrastructure Costs
2.1.1 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 Risk Adjusted Capital Cost

(£m real, base date September 2009)

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:

4,500

4,000

3,500

3,000

2,500
£m

2,000

1,500

1,000

500

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

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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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 Costs

In 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 Costs

Over 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 30
years of operations.

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600.0

500.0

400.0

300.0
£m

200.0

100.0

-
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Operations year

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 Margins

Analysis 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 of
return. 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
Water’s assets. The results of the OXERA study are presented below.

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Margin on turnover Margin on costs

2003 2004 2005 2006 2003 2004 2005 2006
United Utilities 0.14 9.74 9.12 5.54 0.14 10.79 10.03 5.87
Alstom Transport (0.47) 1.32 4.27 6.32 (0.47) 1.33 4.47 6.74
Atkins Rail 4.74 1.47 4.98 1.50
Babcock Rail 5.03 4.05 5.30 4.22
Balfour Beatty 5.48 4.18 5.80 4.36
(rail)
Grant Rail 1.19 4.03 1.20 4.20
Jarvis Rail (6.97) 10.85 (6.52) 12.18

Source: OXERA risk analysis for ORR – October 2006

Table 6: OXERA O&M margin findings

OXERA went on to summarise the analysis above and suggested a margin on costs of around
4.25-4.5%, and a margin on turnover of around 4%.

These results are also broadly corroborated by the comments made by representatives of
these companies in a parliamentary inquiry into the costs of the rail network:

Mr David Clarke, Strategy Director at Jarvis Rail, estimated [that the profit margin] was in the
‘range’ of 4% for maintenance and 6% for renewals. (House of Commons Select Committee on
Transport (2004), ‘Transport: Seventh Report’, section 3, para 91.)

Mr Andrew Rose, Chief Operating Officer of Balfour Beatty Rail thought profits on
maintenance for the private sector under Network Rail's ‘new maintenance contract’ (since set
aside when the company took direct control of maintenance) would be ‘4.7% of sales value’.
((House of Commons Select Committee on Transport (2004), ‘Transport: Seventh Report’,
section 3, footnote 124.)

As a result of the OXERA analysis it seems prudent to assume a profit margin of 5% for the
InfraCo when undertaking our analysis.

2.1.5 Cost Summary

The total of the costs associated with operating and maintaining the infrastructure once
operational is summarised in Table 3 below.

Annual Cost (£m real)

O&M Costs £45m
Station O&M £22m
Renewals Costs £68m
Profit Margin (5%) £5m
Total £140m

Table 3: InfraCo Operational Cost Summary

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2.2 Infrastructure Revenues

It is envisaged that the InfraCo will receive revenue sufficient to cover its operating costs. We
have highlighted within our report on the Delivery considerations that the operational
structure will need to be developed and agreed with particular consideration given to the
payment mechanism and to where demand risk resides. Furthermore, the income level for the
InfraCo will need to be a function of the passenger revenues generated, the level of
maintenance and renewals costs to cover and the potential for ongoing Government support.

As such, based upon InfraCo operating costs (including a profit margin of 5%) of circa £140m
per annum (as summarised in Table 3), revenues will need to cover at least that level. We
have assumed for the purposes of this analysis that revenues will be received from train
operating companies in the form of infrastructure track access charges and that these will
need to at least meet the £140m of infrastructure operating costs referred to above. For the
purposes of this analysis we have assumed a minimum income from track access charges of
£150m per annum. Infrastructure track access charges will be generated from passenger
revenues. The exact nature of the mechanism for setting and calculating track access charges
has not yet been developed and will depend, in part, on the approach to regulation, risk
transfer and the payment mechanism developed.

By estimating the InfraCo operating costs it is possible to estimate the minimum level of track
access charges necessary to make the entity financially robust. In addition, it is also possible
to estimate the maximum level that track access charges could be set at whilst still allowing
passenger services to remain commercially viable. In calculating the maximum it is first
necessary to understand the financial status of the passenger franchise.

2.3 Franchise Financials

We set out in Table 4 below Operating Profit estimate for the train operations based upon the
revenue and cost estimates provided by HS2.

£m real / year ending 31 2027 2028 2029 2030 2031 2032 2033
March

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 - - - - - - -
RosCo Charges - - - - - - -

Profit 181 219 258 298 339 380 422

Government Subsidy/
(152) (189) (226) (264) (302) (342) (382)
(Premium)

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%

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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 month
operating period before the start of the first full operating year ending 31 March 2027. In order to present full year
movements, 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 TAC’s are set at the
minimum £150m required to cover infrastructure costs.

£m real / year ending 31 2027 2028 2029 2030 2031 2032 2033
March

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

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

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

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 Forecast

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

£m real / year
2027 2028 2029 2030 2031 2032 2033
ending 31 March

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

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 Summary

In 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 / year
2027 2028 2029 2030 2031 2032 2033
ending 31 March

Premium from
2 39 76 114 152 192 232
franchise

Premium from
8 8 8 8 8 8 8
InfraCo

Total Premium 10 47 84 122 160 200 240

Table 7 : Total premium to Government

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

Profile of Government Support

500

-500

-1000

-1500

-2000
£m

-2500

-3000

-3500

-4000

-4500

Figure 3 below provides a summary of the profile of Government spend and income assuming
minimum 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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500

-500

-1000

-1500

-2000
£m

-2500

-3000

-3500

-4000

-4500

Figure 3: Government funding profile during construction and operations

2.5.1 NPV of Government Support

Table 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 operations
commencing January 2026 whilst passenger revenues are still low and subject to future growth. Thereafter revenue
growth is estimated to be sufficient to cover operating costs.

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