S’pore’s rail industry reinvents itself with new financing scheme

The Land Transport Authority’s (LTA) announcement on Friday, in which it said it had concluded negotiations with SMRT Trains on its transition to the new rail financing framework (NRFF), is only the latest development in an ongoing process of finding the right business model for public transport operators in Singapore.

The move has brought most of the older MRT lines in line with that of the Downtown Line, which was the first to come under the NRFF in 2011. The LTA is now in discussions with SBS Transit, which operates the North-East Line and the Sengkang-Punggol LRT, on the transition of its operations to the NRFF.

Would the NRFF create the right environment for private-sector participation in the rail industry?

Given the high capital expenditure needed, the rail industry tends to be a natural monopoly. When the first MRT lines — the North-South and East-West lines (NSEWL) — commenced in 1987, the Government had invested heavily in the rail infrastructure and the first set of operating assets, and required the operator to accumulate funds from fare and non-fare revenues to fully replace operating assets when needed. This first rail financing framework had worked well enough, as long as operating assets were not in immediate need of replacement or major upgrading.

The potential financial strains on MRT operators under the first financing framework were recognised by a landmark 1996 transport White Paper, which saw the need for a sustainable policy on asset replacement. The White Paper proposed that the Government underwrite replacement costs above the historical value of the first set of operating assets.

In 1998, the operating assets of the NSEWL were transferred from the Government to SMRT at net book value, or historical value less accumulated depreciation. This worked out to about S$1.2 billion.

The NRFF was proposed in the 2008 Land Transport Master Plan, well before the major MRT breakdowns in December 2011.

The impact of the new framework reaches far beyond finances. By taking over the operating assets and leasing them to the operators, and shortening the licence period to 15 years, the LTA would be the sole provider of rail infrastructure and operating assets, while opening up the rail services segment to more competition.

Under the NRFF, the LTA would own, control and be financially responsible for the operating assets. This would make accountability and priorities between the LTA and the operators clearer.

A private operator would tend to under-invest, since it is unable to capture the positive externalities associated with a well-run rail system. For example, more reliable travel on the MRT would encourage more commuters to take the train and reduce congestion and pollution from private transport. But the operator would not enjoy any additional benefits since it would not be able to charge higher fares.

In comparison, the LTA could be expected to take timely action on expanding capacity, and replacing and upgrading the operating assets it now owns, such as trains and signalling systems. The operators would remain responsible for maintenance benchmarked to certain performance standards.

Such an asset-light structure should in theory enable operators to focus primarily on the service quality and maintenance of the trains.

The Government has also prudently earmarked licence charges to go into a Railway Sinking Fund that will cover future expenditures on operating assets. These charges are paid by the operators for the right to run the MRT and LRT lines. In the case of the Downtown Line, the accumulated payments were expected to total S$1.6 billion during its licence period from 2013 to 2032.

On the other hand, the NRFF has been prescriptive in moderating the revenue and profitability risks for the operators through adjustments to the licence charge.

According to the LTA, SMRT would be expected to achieve an operating margin of about 5 per cent across its fare and non-fare businesses. If actual revenues fell below certain percentages of revenue projected by the LTA (the “revenue collar”), the operator would pay less in the licence charge to LTA. If the actual operating margin (measured by earnings before interest and taxes) rose above 5 per cent or fell below 3.5 per cent (“profit cap and collar”), the LTA would correspondingly share the excess or shortfall with the operator.

While this is likely intended to mitigate profit pressures faced by a listed firm, it also raises some concerns.

The revenue and profit sharing scheme could potentially curtail the private sector’s incentive to innovate or improve efficiency, or possibly create shortfalls in the Railway Sinking Fund.

The United Kingdom government, for example, ended the “cap and collar” approach to risk-sharing for regional rail operators in 2010 because it created perverse incentives. These include overly optimistic revenue forecasts by the operators in their rail franchise bids, since they would be partially protected if actual revenues fell short. Operators also had less incentive to improve, since the revenue upsides were likewise limited as additional earnings had to be shared with the Government.

The changes in the rail financing framework underscore the challenges of structuring a viable business model for the industry. In many jurisdictions, fare revenues alone often cannot cover the operating costs of a rail line, much less the hefty expenses of replacing operating assets.

With the transition to the NRFF, the rail industry would be more akin to the government bus contracting model. Under such a scheme, infrastructure and operating assets such as buses are owned by the LTA, and bus operators bid for the right to operate bus services.

The 1996 transport White Paper pointed out that “the real issue is not who pays, but what system can best encourage fiscal prudence, individual financial discipline and efficient operations.”

In a public-private partnership, the risk-reward allocation needs to be finely balanced. Without the discipline of the market, the Government has to arbitrate on what constitutes a reasonable profit for the operator. Too little, and the operator becomes financially unsustainable; too much, and the Government, and ultimately the public, needlessly subsidises the operator’s shareholders. Almost 30 years after the launch of the first MRT line, the rail industry in Singapore is reinventing itself again.

ABOUT THE AUTHOR:

Jean Chia is a researcher with the Lee Kuan Yew School of Public Policy’s Case Studies Unit.