It seems that commuters are facing huge increases in train fares partly due to the unfair capital pricing model adopted by the rail industry
Steep price increases for rail passengers are once again in the news. Although many explanations for these price increases have been suggested, one thing that has not been explained to the unfortunate commuter is a very odd feature of the pricing model the Office for Rail Regulation (ORR) uses when it is setting rail fares.
A substantial part of rail fares is to cover the cost of capital expenditure on the network. The ORR sets a target rate of return, (of 6% per annum, pre tax): and investors in rail assets are given a series of annual payments that constitute, over the lifetime of the asset, a 6% real rate of return on the investment. The implication is that investors earn a nominal rate of return on their investment of 6% plus the rate of inflation.
These annual payments for capital, of course, ultimately come from rail fares, (or from the government subsidy to the rail industry). The ORR uses a version of current cost accounting in working out what these annual payments for capital should be.
The particular version of current cost accounting used by the ORR has the following feature: if the same amount of capital, (in real terms), is invested every year, and if inflation runs at the same rate every year, then once things have settled down to a steady state, customers will pay more each year than if capital had been procured under conventional loan finance – even though the same nominal rate of interest is being earned in each case.
And how much more the customer will pay increases rapidly as inflation rises. When inflation is 2.5% per annum, then customers will pay 18.7% more each year for capital investment under the ORR current cost charging model than under conventional loan finance: at 5% inflation, the differential rises to 26.2%: and if inflation were 7.5%, customers would pay 32.4% more.
If passengers were aware of this feature of the ORR’s pricing model, then it seems inconceivable that they would find this situation acceptable. A worked example showing how the effect comes about can be found here.
And it is not just rail fares that are affected. Current cost charging is used by the regulators of most UK utilities to work out the charges for capital investment: and although a slightly different version of the current cost charging model is used from that employed by the ORR, the effects are similarly damaging.
It is high time the public, and regulators, had an informed debate about this: and about how best to unwind the resulting overcharging for the capital element of utility prices.
Jim Cuthbert is an independent economic researcher at the Public Interest Research Network, University of Strathclyde
