As if the government didn't have enough to worry about, the rail industry is going to tip very quickly into crisis. The steep rise in unemployment announced today, together with other effects of the deepening recession, will mean that for the first time since privatisation the railways are facing decreasing passenger numbers. The franchise system created by the Tories and left intact by Labour is simply not geared up to deal with this situation.

That is a fundamental lack of foresight. Economic growth could not have been expected to continue forever, but the franchise agreements have been drawn up on that basis. Railways are always vulnerable during recessions because they have high fixed costs and passenger numbers can decline very quickly once a recession bites. Moreover, the operators have scored an own goal by pushing up fares by the more than 6% at a time when inflation is half that and wages are not rising. They have also cut back on services such as meals, and have reduced carriage lengths, laid off staff, and pushed up car parking charges, sometimes by more than 100%. It is almost as if they have a death wish and want to encourage people back into their cars – which, of course, have become cheaper to drive, thanks to lower oil prices.

Not surprisingly, with rising fares and worsening services, the train operators are facing a fall in passenger numbers for the first time since the last recession 20 years ago.

The Department for Transport thought it was jolly clever in pushing the train operators to sign up to deals during the last three years based on income growth of between 8% and 10%. The sums involved are massive. For instance, South West Trains receives £28m in subsidy this year but will have to fork out £36m in premium payments next year, a pretty massive shift on a turnover of £600m. Other train operators such as Great Western, First Capital Connect and National Express East Anglia are in a similar position.

Now the DfT does not look so clever. The operators always knew that train services have to keep running, which means that the risk of the franchise contracts can never really be passed to them. Just like the banks, the railways cannot go bust. Therefore the problem is not with the operators but with ministers, who have to decide how to deal with this crisis.

We have, of course, been here before. In the early days of franchising in the late 1990s, many companies signed deals on the basis of making drastic cuts to costs but found that British Rail had been more efficient than they realised. Despite passenger growth, the companies were facing years of losses. Several such as Prism and MTL had to be taken over by other companies, with a sympathetic government allowing them extra subsidy.

This time the DfT has consistently insisted the contracts are not open to renegotiation, although the train operators are clearly expecting to cut a deal. This leaves few options for ministers. If they refuse to budge, they may find that so many operators try to throw in the towel that it becomes a renationalisation of the railways by the back door. Alternatively, if they bow to pressure, they will be tacitly accepting that the contracts are worth as much as a football manager's deal. If unemployment continues to rise at the current rate, there is no doubt that by the end of the year, ministers have to make a decision over whether to cave in or stand firm.

See also:

Christian Wolmar: It's a tough ask for the rail companies to sell more tickets while hiking fares

Independent: 21 January 2009

The meeting yesterday between the train operators and transport ministers was the first in what is likely to be an elaborate game of cat and mouse played against the backdrop of the recession.

Railways always do badly in economic downturns because they have fixed assets and costs while passenger numbers normally fall sharply as people cut work and leisure travel. And this is the first time the rail companies are faced with the possibility of fewer passengers since they took over from British Rail in the mid-1990s. During the last recession in the late 1980s, the then Tory government responded by cutting back on investment to British Rail while allowing the deficit to soar.

That option is no longer open to the Government. The private franchise companies have signed contracts of, mostly, seven years, and the investment funding paid to Network Rail, the infrastructure company, is fixed by a regulator. Private companies bear much of the risk of any loss of revenue.

It is bad news for them that they have signed increasingly bullish franchise contracts based on the assumption that revenue would grow at 3 to 5 per cent above inflation. To achieve this, they have to attract increasing numbers of passengers, and have to put up fares in real terms, as witnessed by the recent rises averaging over 6 per cent.

Keith Ludeman, the head of Go Ahead which has the majority stake in two of the big three south-of-the-Thames commuter services, has said the contracts are renegotiable. Ministers have stressed that the deals are immutable.

Ministers will be able to stick to that line if just a single company gets into trouble, but they would be in a very difficult position if several operators threatened to throw in the towel. That would risk the fragile edifice of rail franchising, and the industry has already been part-renationalised when Railtrack went bust in 2002 and was replaced by the not-for-profit Network Rail.