Commercial considerations
Introduction
The diverse types of control and risk transfer observed in the international benchmarking reflects the absence of a predominant framework for delivering ferry services. This was also noted during our interviews with industry stakeholders who commented that there was not a “single model” for service delivery.
The key points of difference between the case studies nonetheless provide a useful illustration of the characteristics that could feature in a future model for Scotland’s ferry sector. These include:
- The presence of an independent regulator or commissioner
- The ability of the operator to raise finance for shipbuilding independently
- The extent to which procurement and management of ferry services should be decentralised
- The merits of an integrated approach in which roads and ferry services are managed together
- The presence of competition and the means by which it can be stimulated
- The full range of options for owning and maintaining key assets, including vessels, ports and shipyards
- The distribution of revenue demand and asset risk
These approaches, already proven to be feasible in other markets, will help to inform the future options analysis undertaken in this report.
Future Options
When undertaking our review of international comparators and subsidised services in Scotland our principal observation related to the range of different structures adopted and the different ways in which commercial contracts are employed to achieve different objectives.
When reviewing the future options of the ferry services, we have sought to therefore include:
- Commercial contractual considerations
- Options on increased regulation
- Options for structural reform
The text below includes an overview of our considerations which will be outlined and evaluated throughout the remainder of this report.
Commercial contractual considerations:
- Direct Award
- Long-Term Contract
- Management Contract
Options for Increased Regulation:
- Commissioner or Regulator
- Regulated Asset Base
Options for Structural Reform:
- Integration/ Assimilation
- Privatisation
- Decentralisation
The options identified are not exclusive of one another and could conceivably all feature in a future model for Scotland’s ferries sector. For the purposes of clarity though in this exercise though we have looked at each independently.
Commercial Contractual Considerations
The current CHFS Contract expires in 2024. Contracts of this nature typically take around 18 to 24 months to procure (excluding preparatory period).
Prior to any decision on the future contract, Ministers should consider their longer-term strategic objectives.
We have identified ways in which Ministers could amend the contractual relationship with the operator as part of the next CHFS procurement to strengthen the delivery of ferry services.
These commercial considerations are distinct from the regulatory and structural changes that are the primary focus of this report but could be considered in conjunction with any further change made to the structure of the Tripartite.
Commercial considerations relevant to the next CHFS procurement include:
- Changing how risk is allocated
- Changing the contract length
- Issuing a Direct Award for the operating contract.
Risk Allocation
Under the current CHFS contract farebox revenue and a majority of cost risk are transferred to CFL for the duration of the contract. Under a management contract, the transfer of risk to the operator is less extensive. TS would retain the revenue risk and potentially some cost risk where appropriate. A management contract of this nature could be preferable if it is judged that the operator has limited means of influencing farebox revenue or controlling certain types of spend (i.e. vessel maintenance). The operator is paid a fixed fee for delivering the services.
The amount payable would reflect the lower level of risk that the operator is exposed to in delivering the management contract versus the current arrangements. In addition, a performance payment can be included in the contract to incentivise certain behaviours.
As the holder of revenue risk, TS would be exposed to any rises or falls in demand. However, TS would also possess greater means by which it can influence farebox revenue due to its role in the policy making process. Analysis to understand how elastic demand is in response to policy changes may be required to understand TS’ ability to manage farebox revenue risk.
The table below presents types of contractual relationships observed in the sectors that have been reviewed as part of the international and domestic benchmarking exercise.
| Comparator | Contract type |
|---|---|
| TS Ferries | Farebox risk with operator |
| BC Ferries | Farebox risk with operator |
| Norway | Management contract and farebox risk contracts |
| TfNSW | Management contract |
| AT | Management contract |
| TS Roads | N/A no revenue from road passengers |
| TS Rail | Traditional franchise - Farebox risk with operator (pre-COVID) |
| UK Rail | Rail reform indicates a move to Management Contracts |
Risk Allocation and the Rail Sector
In the rail sector it is increasingly recognised that the operator has limited means of influencing farebox revenue relative to its risk exposure and as a consequence management contracts are now viewed as a more sustainable means of delivering rail services.
Operators’ weakness with regards to influencing farebox revenue was acute during the pandemic when passenger numbers fell by more than 90%.
In order to ensure continuity of passenger ferry services during the pandemic, the SG introduced Emergency Measures Agreements (EMAs). These arrangements were designed to maintain the financial viability of the operators and transferred revenue and cost risk back to the procuring authority. These arrangements have since been extended and are expected to be maintained in part under the reforms proposed in the Williams-Shapps Plan (see Domestic Benchmarking section), albeit with the operators taking on more risk than under the original EMAs.
CHFS Network
A benefit that may be realised as a consequence of adjusting the risk profile of the CHFS contract is that TS could attract a wider pool of bidders. If the balance of risk is viewed more favourably by the market this could increase the competitiveness of the procurement exercise and result in lower priced bids.
Greater VfM may also be attainable under a management contract if bidders are no longer required to price risks over which they have limited control into their bid.
A potential downside of using a Management Contract is that without exposure to revenue risk or full cost risk, the operator may be less incentivised to drive performance. This could lead to a decline in service quality, which would negatively impact passenger experience and farebox revenue. Poor cost management could increase the cost of delivering the service.
An appropriate KPI regime would be required to mitigate these risks. To design an effective KPI regime, TS must possess both a strong understanding of the operator’s cost base and the technical capabilities to challenge the operator’s costs on an ongoing basis.
Risk Allocation – Key Observations
A management contract would change the risk profile of the CHFS contract, which may be more efficient and make it more attractive to operators. This may be desirable if TS wishes to stimulate competition in the market.
Drafting and monitoring a KPI regime successfully requires TS to have a strong understanding of the operator’s cost base and the technical wherewithal to challenge costs on an ongoing basis.
Contract Length
As illustrated in the table below, the eight year contract in place between CFL and TS is at the lower end of the range of contract lengths observed in our benchmarking exercise.
| Organisation | Contract Length |
|---|---|
| TS Ferries | 8 Years |
| BC Ferries | 60 Years |
| Norway | 6-10 Years |
| TfNSW | 9 Years |
| Auckland Transport | 6-12 Years |
| TS Roads | 8 Years |
| TS Rail | 7-15 Years |
| UK Rail | Typically eight years |
| HIAL | N/A - Framework Agreement |
| Scottish Water | N/A - Framework Agreement |
Shorter contract lengths require more frequent procurements that provide an opportunity for the procuring authority to test the market and ensure the operator represents VfM. The prospect of a competition in the near-term also encourages the operator to continue delivering against the contract. There are, however, a number of disadvantages associated with shorter contract lengths:
- Operators are not incentivised to invest in the service to the extent that the return on that investment is realised after the end of their contract term. This can lead to short-term thinking and a lack of focus on long term investment. This is problematic in the ferries sector where vessels have useful lives of 25+ years and strategic planning is required to have a similar horizon.
- There is a cost associated with bidding for a contract and the cost must be recovered over the lifetime of the contract. If the contract length is shorter, the operator may be more likely to pursue short-term profits in order to recoup these costs rather than focussing on what is financially sustainable in the long-term.
- Bidding for contracts is also resource intensive. For shorter contracts, the period of time during which the operator is dividing its attention between service delivery and bidding is proportionally greater. Conversely, for longer contracts the period of time that the operator can focus exclusively on service delivery is greater.
CHFS Network
The CHFS3 contract could be let with a longer contract length. This could support more joined up strategic thinking amongst the Tripartite.
The merits of longer contract lengths have been recognised in British Columbia, where BC Ferries holds a 60 year contract. To support investment in low carbon vessels, procuring authorities in Norway have also extended some contracts to 15 years. In the UK’s rail sector, the Williams-Shapps Plan noted that longer contracts may be desirable if major investment is required.
A risk presented by longer contract lengths is that in the absence of regular procurements, operators become complacent and service delivery declines. As with management contracts, an appropriate KPI regime would be required to incentivise / disincentivise certain behaviours. A commissioner or regulator could also be introduced to monitor compliance with the contract, similar to the Office of the Commissioner in British Columbia.
Contract Length – Key Observations
The procuring authority can be responsible for monitoring performance against KPIs and / or compliance with the contract. Alternatively, this responsibility can be passed to a commissioner or regulator, as happens in British Columbia.
The length of the CHFS contract is noted as being at the lower end of the observed range. Its brevity relative to other contracts may become more pronounced as there is a noted trend towards longer contract lengths in the ferries and other sectors. Longer contract lengths are often deemed necessary to support capital investment.
A longer CHFS contract could allow the operator to act more strategically and reduce the likelihood of short-term decision making. It may also allow the operator to align itself with TS and CMAL’s asset renewal strategy, as the operator would be more likely to benefit from the realisation of that strategy. This could support vessel renewal and in the long-term reduce the average age of the fleet.
Direct Award of the Operating contract
A ‘Direct Award’ refers to a situation whereby the procuring authority negotiates a contract directly with a single operator (to date all Direct Awards in the UK have been made to the incumbent operator, although this does not have to be the case). No competition takes place. In making a Direct Award, there is an emphasis on the achievement of VfM and use of good commercial judgement.
Direct Awards are normally permitted when a competition is:
- not possible for a technical reason (e.g. there is only a single supplier capable of delivering the contract)
- is likely to cause significant disruption
- is unlikely to deliver good value
Direct Awards are also permissible in an emergency situation while a longer-term solution is sought. However, it must be demonstrated that the Direct Award represents VfM. It is under this circumstance that a number of Direct Awards have been issued during the pandemic.
CHFS Network
TS could in the future make a Direct Award to CFL for the CHFS contract rather than running a competitive procurement. In doing so, TS would need to satisfy the legal considerations set out in the following section.
Assuming a Direct Award were made to the incumbent, it would release CFL from the resource intensive process of bidding for the CHFS3 contract. TS would also be released from having to run a competitive procurement. However, due to the stringent requirements of making a Direct Award TS may have to invest a similar level of resource in proving that these requirements are satisfied.
The negotiation process under a Direct Award does not benefit from the competitive tension present in a normal procurement. Without this pressure, the operator is less likely to offer competitive terms, which could increase the overall cost of the service for TS.
The threat of the Direct Award being removed and put out to tender is also an important incentive for the operator to deliver against the contract. If there is no viable competitor, this incentive may be absent and lead to higher costs. These factors would need to be considered as part of any evaluation of whether or not a Direct Award would offer VfM.
Direct Award – Key Observations
TS could in future make a Direct Award to CFL for the CHFS contract rather than running a competitive procurement. In doing so, TS would need to satisfy the legal considerations from both a procurement and a UK Subsidy Control perspective. In order for Direct Award of CHFS routes to proceed, the SG’s Subsidy Control Unit would need to set out how adherence to the principles set out under the Subsidy Control Bill – expected to be passed into law in summer 2022 - are being met under the Direct Award.
Conclusions
TS could consider making a number of reforms to enhance the delivery of services on the CHFS network. We included within this section an overview of commercial changes Ministers could consider for the CHFS3 which could be implemented when the contract terminates in September 2024, whether that be a Direct Award to the existing operator, implementing a management contract or extending the length of the contract. Each of these proposed changes could deliver on a range of objectives:
- A Direct Award in the short-term could enable Ministers to focus on future strategy, rather than resource being used to run a competitive procurement process.
- A management contract could remove the element of revenue risk from the contract and potentially increase competition.
- Extending the contract length beyond eight years could encourage longer term strategic thinking from the operator, giving them stability over a longer period and enabling them to focus on the future.
Prior to any changes on the CHFS network, Ministers should consider what it would like to achieve from any change, i.e. what are their longer-term aspirations for the sector and how they would like to achieve these objectives through either commercial change, structural change or a combination of both. Developing a long-term strategy with future goals will help aid decision making in both the short and medium-term.
In the following sections of this report we have included options and performed a preliminary assessment around enhanced regulation and structural change to the CHFS network. Each of the future options considered should be assessed along with the commercial considerations available to Ministers.
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