Ten years after privatisation, rail travel is booming but the network franchise system put in place by the last Tory government is being criticised by some train operators as unsustainable.

Train operators pay the government a set fee for the right to run services on the rail network. The franchises, which usually run for 10 years, are coming up for renewal and companies are being forced to increase their payments to unprecedented levels.

This weekend a report by MPs will scrutinise the system. The government has poured billions into restoring the railways but it is now accused of taking too much money out of it.

The structure has put intolerable pressure on arguably the most popular train service in Britain: the London to Edinburgh operation run by GNER.

Anthony Smith, head of the rail watchdog Passenger Focus, says: "GNER was a company making money and investing in the railway. Now it is on the rocks and the UK's premier railway is hanging by a thread. The problem has to be laid at the door of the government. It accepted this whopping bid and now we are seeing some of the consequences."

GNER has hit the buffers one year into a pledge to pay the government £1.3bn for the right to run trains on the east coast main line until 2015. It is underperforming revenue forecasts that underpin those lofty terms, having posted turnover growth of only 3.3% last year when it needed to reach 10%. Having admitted that the contract is all but impossible to fulfil, it is attempting to alter the franchise terms despite the Department for Transport's insistence that it will not renegotiate.

Unease

Industry unease has grown following two more huge bids: Stagecoach recently renewed the South Western service with a £1.2bn bid and FirstGroup, the UK's largest train operator, won the Great Western route with a £1bn offer. Three more lucrative franchises are up for grabs over the next year: the Penzance to Aberdeen Cross-Country route; east Midlands, and west Midlands.

The alarm over franchise bids comes at a time when customer satisfaction with railways is at a record high. However, the high approval rating masks growing concern over congestion on commuter routes amid projected passenger growth of 30% across Britain in the next decade.

Industry experts openly question whether the franchise system is flexible enough to accommodate that demand. According to Passenger Focus, only 41% of train users believe they get value for money from fares, with commuters on crowded routes in London and the south-east the least satisfied.

Mr Smith says the franchise system has become "really worrying" because the payments boom is coinciding with stripped-down services such as the sidelining of buffet trains on the Great Western franchise and the removal of seats on the South West Trains routes.

"In the long term, it will produce a very different type of railway - a railway that is very crowded for a large part of the day," he says. "You wonder if that will tempt people out of their cars."

Stephen Joseph, director of the environmental body Transport 2000, adds: "We want a growing railway and not a franchise system that prices off demand." A road-pricing bill, allowing local authorities to install pay-as-you-drive schemes, is expected to appear in the Queen's speech on November 15. Experts warn that a perception of steep fares will dissuade people from dumping their car for the train and high franchise payments could lift ticket prices further.

An efficient and growing railway network is central to the government's goal of reducing road congestion and a high-speed north-south rail link is one of the most ambitious proposals to raise rail capacity. But rail infrastructure is costly to maintain and build. Excluding the north-south link, the company that runs Britain's railways, Network Rail, is seeking £21bn just to keep the network ticking over from 2009 to 2014. It wants a further £8bn to increase capacity, with nearly half earmarked for overhauling the Bedford-to-Brighton Thameslink.

With that level of investment being called for, it seems no surprise that the government was dazzled by the riches promised by GNER. Christian Wolmar, a veteran railways expert, says the Treasury windfall from train operators masks the huge indirect subsidy they receive from Network Rail, via the government. Network Rail gets about £2.5bn a year in government grants, allowing it to levy much lower track access charges on the train operators - equivalent to an extra £100m a year for GNER. He believes the DfT is under pressure from the Treasury to redress the fiscal imbalance created by the enormous investment in Network Rail.

The four largest franchises pay about £500m a year so the operators' profits are flattered by state benevolence, says Mr Wolmar, adding that train operators are not accountable for the risk they take on board anyway. "Why are we quasi-transferring some risk to the private sector to run these trains when, at the point where it all goes wrong in the case of GNER, they are highly likely to be bailed out or be asked to hand the keys back? And why are we making these companies bet on how well the railway will do over the next 10 years, when that is largely based on the health of the economy and not their own efforts?"

Windfall

Network Rail says the government must use the franchise windfall to improve the railways and increase capacity to meet growing demand. Otherwise, the likes of StageCoach and FirstGroup will fail to cope with the extra passengers they need to pay for the franchise, argue the executives who run the rail network.

Iain Coucher, deputy chief executive of Network Rail, says projects such as the £3.5bn Thameslink overhaul need the government green light if the UK is to cope with projected demand. "For the train-operating companies to meet these premium payments, it is dependent on getting more people into trains," he says. "Therefore, the Thameslink programme is one of the things we have to do if the industry is to meet those premium payments."

Many of those demanding extra cash are also urging the government and DfT to devolve and step away from the franchising process. Ken Livingstone, ever eager to expand his transport powers as London mayor, has won control of the former Silverlink rail franchise in north London and is considering tendering the service as a quality incentive contract, similar to the arrangement for bus operators in the capital. Under this contract, operators would be paid a fixed rate, plus a bonus for hitting targets such as punctuality and cleanliness. Revenues go to the local authority and the profits are lower but at least there is no risk of being swamped by lofty franchise payments.

The devolution argument has many fans, including the mayor's transport adviser, Bob Kiley. The government should move to a decentralised model that is now well established in Europe, says Transport 2000's Mr Joseph: "Everywhere else in Europe there has been real reform. There has been a decentralisation so local train services are franchised by local train authorities."

Franchises make cash for operators and the government but there is concern that tough specifications on issues such as train lengths and timetables do not leave enough latitude to accommodate the looming 30% leap in demand.

Bob Mackenzie, GNER executive chairman, says financial demands are now the main factor in bidding. "Price seems to be the primary focus," he says. "We accept that tenderers have to take risks in a commercial bid of this scale but there could be more risk-sharing. [Franchises] will work if approached in the spirit of real partnership, with shared successes and shared problems."

Backstory

The much-criticised privatisation of the railways under John Major's Tory government was complicated and rushed. The privatisation of BT and British Gas created monopolies, so in an effort to create competition, railways and trains were separated. Railtrack, which owned the track and signals and is now Network Rail, was carved out of British Rail in 1994. Keen to complete the sell-off before a general election, the Tories raised £1.9bn by floating Railtrack in 1996 and awarded the last of the train operator franchises to private firms a month before the May 1997 election that ushered in Tony Blair. Two rail crashes - at Paddington in 1999 and Hatfield in 2000 - led to a series of damning reports on railway safety by Lord Cullen, which warned that privatisation had left the industry too fragmented.