Buy-back of the Regional Intrastate Rail Network
Audit summary
1.1 Introduction
1.1.1 The intrastate rail network
The non-metropolitan intrastate rail
network is a significant state asset, particularly for regional
communities that rely on it for passenger and freight services.
One of the aims in the government’s
Growing Victoria Together policy is to increase the
proportion of freight transported to ports by rail on this network
from around 10 to 30 per cent by 2010. To achieve
this, the network needs to be well maintained and efficiently
run.
In 1999 the state leased the network to
a private company for 45 years as part of the sale of the
V/Line Freight Corporation. The state was paid $70.4 million for
the ‘above-rail’ freight business and $89.7 million for the
rail network lease. The lease did not require the lessee to
maintain the network other than for the last five years of the
lease.
In August 2004 the lessee was taken over
when its business, including its plant and equipment and the
infrastructure lease over the intrastate rail network, was acquired
for $285 million. The state consented to this transfer of
control over the lease. The new lessee was owned jointly by two
major corporations operating in the Australian freight and
logistics sector.
There was a maintenance backlog on the
network when the first lessee took control from the state in 1999.
The lessees took a contractually compliant, minimum maintenance
approach on freight-only lines, and effectively allowed some lines
to fall out of service. This arose from the ineffective maintenance
obligations in the lease combined with lower than expected revenues
from freight services because of the drought, especially for grain.
The infrastructure deteriorated further, which added to the
maintenance backlog. The state responded in 2005–06 when it began
directly funding the lessee for maintenance work over and above
contractual requirements.
In 2006 the Essential Services
Commission confirmed that maintaining the intrastate freight
network at reasonable levels of service was unsustainable without
ongoing government financial support.
In August 2005 one of the joint owners
of the second lessee announced it intended to acquire the other
joint owner, which it did in May 2006. This triggered another
change in control over the network leaseholder, but the state’s
consent was not obtained triggering a termination event under the
lease. This allowed the state to consider the future of the network
and the lease.
The lease presented a number of
practical concerns. In addition to the inadequate maintenance
expenditure, having the network leased to and controlled by a third
party added to the complexity, time and cost when the state sought
to do major capital works such as the regional fast rail project.
The state was also the key revenue source for the lessee through
access fees paid by V/Line Passenger Corporation (V/Line).
The lessee also ran its own ‘above-rail’
business, running rail freight services on the network. Control of
the network by a private company that also ran an above-rail
business was perceived as a limiting factor in encouraging greater
use and competition on the network. The state also saw this as a
risk to its ability to run regional fast rail services at their
maximum intended speeds.
1.1.2 The
buy-back
In April 2007 the government announced
it had reached agreement to ‘buy back’ the intrastate regional rail
network from the lessee for $133.8 million. This confirmed an
earlier ‘in principle’ sale agreement announced in November 2006 at
the start of the caretaker period before the state
election.
The state determined that a buy-back
of the network would result in savings and other benefits
including:
- greater flexibility to develop and deliver
integrated transport plans to achieve government objectives for
regional rail
- aligning the interests of the below-rail
network with the government’s interests rather than a private
access provider’s commercial interests
- cost savings through competitive outsourcing of
maintenance and by removing the state’s obligation to make margin
payments to the lessee on infrastructure maintenance on the
network
- improving track maintenance and major project
delivery on the network without having to negotiate with a third
party leaseholder on matters such as track access and safety
issues
- facilitating progress on an open access regime
to create competition from other rail freight operators and for
greater freight efficiency
- allowing the government to make rail services in
and around the Port of Melbourne more efficient to improve direct
rail access to the port
- enabling the government to increase capacity on
certain rail lines through expanding and converting selected track
to standard gauge leading to greater efficiency for interstate rail
freight.
1.2 This audit
The objective of the audit was to
examine whether the state’s decision to buy back the regional
intrastate rail network was adequately informed and whether the
transaction was effectively managed.
This involved examining the advice given
to government on the buy-back, assessing whether the state paid a
fair and reasonable price based on sound valuation and other
relevant advice and analysis, its management of the transaction and
negotiations, and the state’s risks, benefits and future
obligations arising from the buy-back.
1.3 Conclusions
There is little doubt that the buy-back
unwound a lease which was ineffective in maintaining the asset. It
also mitigated financial and other impediments to the state’s
capacity to carry out major investments in upgrading the
network.
In negotiating the buy-back the state
also made other strategic gains of broader significance to
Victoria’s freight and logistics network. This primarily related to
freeing up rail access to the Port of Melbourne.
However, the audit cannot give any
assurance that the state paid the lowest reasonable purchase price
obtainable in the circumstances for the buy-back and it is clear
that the cost of the buy-back exceeded the cost publicly announced
in April 2007.
The announced cost was
$133.8 million. The full cost is likely to exceed
$200 million. Further, in addition to direct payment for the
buy-back, the lessee also secured other significant benefits from
the transaction including extended lease terms for the South Dynon
inter-modal terminal and over a small part of the Tottenham Yard,
and reduced rates for access charges for its above-rail
business.
Once the decision to seek a buy-back was
taken the terms were negotiated and agreed soon after. A
non-binding buy-back agreement was signed on 31 October 2006
immediately prior to the start of the caretaker government period
for the 2006 state election. The terms of that agreement including
the purchase price did not materially change in the final agreement
of May 2007.
When the state signed the non-binding
agreement, sufficient advice had not been obtained to support its
decision about how much to pay, for example there was not an
adequate business valuation. In addition, gaps and deficiencies in
the advice given to government on the buy-back included the lack of
a robust and agreed business case and a failure to advise
government on the limitations of some external advice.
These matters, however, do not
necessarily mean that the buy‑back failed to represent value for
money to the state. There were clear arguments to have the network
back under state control and opportunities to save and/or avoid
future costs and delays on routine maintenance and capital upgrades
of the network.
The question that remains is whether
such outcomes could have been achieved at a lower cost had the
state:
- offered less for the below-rail business based
on its market value not its book value
- negotiated an amended infrastructure lease with
incentives for the lessee to work cooperatively with government,
or
- terminated the lease and contested any legal
challenges mounted by the leaseholder.
V/Line managed the transition of the
network to state control well. However, there is potential conflict
between its roles as both access provider and rail passenger
services provider. Furthermore the 2006 government decision that a
separate entity be established to control the network has not been
acted on.
The government has commissioned a review
of the freight network since the buy-back and has started an
investment program for the regional rail network to improve
regional passenger and freight services.
1.4 Findings
1.4.1 Cost of the buy-back
In April 2007 the government announced
it had agreed to buy back the regional intrastate rail network
lease for $133.8 million. This was not the full known cost of
the buy-back. The state estimated the full cost to be
$164.4 million excluding estimated transaction and transition
costs of $9.7 million. The full cost of the buy-back is likely to
exceed $200 million based on more realistic assumptions about the
cost of reduced network access fees for the vendor agreed as part
of the transaction.
One hundred and fifty million dollars
was approved as the upper limit for the buy-back negotiations. This
‘remit’ was defined to exclude certain costs which were nonetheless
incurred. Under this restricted definition the purchase price of
the buy-back was within the approved remit.
However, the cost to the state is not
just what it paid directly, but also the lower rail access fees
agreed as part of the buy-back. The difference between access
revenue from the lessee and other users and the cost of running the
network is a cost to the state. The state agreed to access rates
for the lessee that would earn $15.3 million in an ‘average
grain year’. While these rates were higher than those sought by the
lessee, they were also well under break-even and would not cover
the efficient cost of running the below-rail network.
At the time of the buy-back the state
estimated this additional access fee ‘subsidy’ was
$27.6 million over 10 years in net present value terms,
assuming average grain years. This was not a realistic assumption
based on information available at the time about the continuing
drought. Experience since the buy-back shows that the actual
additional access fee subsidy will be at least $40 million
more than the state’s estimate in net present value terms.
1.4.2 Determining how much to pay
The value of the assets acquired
The state accepted the lessee’s position
that the ‘book value’ of the assets to be acquired by the state
should be the reference for determining the purchase price for the
buy-back. Audit was informed that this was based on undertakings
given by the joint owner of the lessee to the Australian
Competition and Consumer Commission (ACCC) about its proposed
acquisition of the other joint owner. The government was advised
that the book value of the assets was $120 million.
The undertakings given to the ACCC
included a commitment to selling key assets to address concerns
about a loss of competition resulting from the proposed
acquisition. One of those assets was the lessee. The commitment
required the joint owner of the lessee to protect the value of
assets to be sold by maintaining their trading and financial
position and not making any material adverse changes to the nature
or key features of the business. The lessee’s lease over the
intrastate rail network was a key asset.
Audit was advised that given these
commitments the state considered it had to ‘act reasonably’ when
negotiating the price for the buy-back with the lessee. Audit
considers that the ACCC undertakings were aimed at preventing
substantive changes to the business that could have undermined
competition in the freight forwarding sector, and need not have
limited the state in seeking to negotiate a purchase price less
than book value. Of course, even without the ACCC undertakings the
vendor was motivated by commercial considerations to achieve a sale
price at least equal to book value.
The state did not try to secure a
purchase price which was substantially below the book value of the
assets despite advice from two expert external advisers that the
market value of the relevant assets was likely to be significantly
less than book value.
The book value of assets acquired by the
state was $75 million for the infrastructure lease and $58.8
million for the physical assets. The state had legal advice saying
it had no legal obligation to pay back the value of the remaining
37 years on the infrastructure lease but did not pursue termination
of the lease to avoid legal dispute and the likelihood of severe
disruption to passenger and freight services.
The state commissioned a due diligence
review of the lessee’s financial records on the book value of
assets to be acquired but it was qualified because of difficulties
in obtaining the required information from the lessee.
The value of the business as a going concern
Two preliminary ‘desk top’ market
valuations of the lessee’s below-rail business using unverified
data but based on conventional discounted cash flow analysis, were
considerably less than the book value of the assets. One valuation
was from $57.6 million to $65.3 million. The second valuation
was between $70 million and $96 million.
Advice to government in September 2006
included these valuations but did not set out their limitations.
One of the valuations was also used by the then Department of
Infrastructure (DOI) in the development of assumptions for its
business case about the range of potential purchase prices for a
buy-back.
The acquisition’s ‘special value’ to the state
The price for the buy-back was justified
on the basis of potential cost savings to the state from owning the
below-rail business. The savings were based on advice from DOI and
external consultants on the ‘value to the state’ of acquiring the
below-rail business. The government was advised that the state
could realise savings of
$204–250 million in net present value if it bought back the
network. The robustness of some assumptions underlying these
estimated savings, including whether there was evidence to
substantiate the assumption that once the state ran the network it
could achieve ongoing savings on maintenance, is questionable.
Conclusion
The full cost of the buy-back will
likely exceed the special value or future savings to the state in
regaining control of the intrastate network depending on the
assumptions adopted about costs and savings. The state will pay
over $200 million for assets of $58.8 million and for control
of the network from which future ‘savings’ can be derived, but only
by incurring significant expenditure.
There is a lack of data to demonstrate
whether the new operator, V/Line, is doing maintenance more
efficiently than the lessee.
1.4.3 Advice to the government on the buy-back
Nature of advice
Between late 2005 and late 2006 the
government was advised on options and strategies for negotiations
with the lessee. Options included negotiating a revised
infrastructure lease, terminating the lease, or buying back control
of the network.
The government was not provided with
consolidated advice which robustly analysed and assessed all the
options available to the state despite repeated requests, and
assurances that such advice would be supplied. While a business
case was developed by DOI, the three departments involved in
advising the government did not agree on and nor did they present
the results of a comprehensive business case for the buy-back to
government.
The business case prepared by DOI to
analyse buy-back options was based on data sources from the
Essential Services Commission (ESC) 2006 regulatory process to
establish a rail access arrangement for the regional intrastate
network. Those data sources included information prepared by the
lessee and the ESC and its advisers. The departments advised that
they accepted the veracity and reliability of the ESC data and that
the state had no other option or alternative sources of data
available.
Audit does not question the veracity of
the ESC data set, or suggest that there was a more credible
pre-existing set of data available at the time of the
deliberations. However, the ESC data was prepared for a different
purpose and did not directly examine the likely cost of network
operation under government ownership. Therefore it is questionable
whether the ESC data set should have been solely relied on. In
addition, the departments had explicit external advice noting
limitations in the available data set and recommending that a more
detailed valuation process, based on more comprehensive information
sourced directly from the lessee, be undertaken in order to support
a decision on a buy-back.
Advice to government at various stages
by DOI and the Department of Treasury and Finance indicated that
the financial outcome of a buy-back was uncertain. These
departments used different assumptions when estimating the net
present value of a buy-back to the state and consequently their
estimates varied widely and ranged from positive to negative
returns to the state.
Using the work of experts
Advice from external consultants and
advisers was central to the government’s final decision to buy-back
the network and the price it was prepared to pay. DOI wrote a
business case in 2006 which was the main source of information and
assumptions for the consultants and advisers. Audit identified
issues both with the robustness of this business case and the
advice from external consultants that the government relied on when
approving the buy-back and deciding on the price.
The departments had clear advice from
external consultants that the state should obtain a formal and
unrestricted business valuation of the network and below-rail
business before committing to a purchase price. There is no
evidence that this advice was passed on to the government.
The consultants clearly explained the
qualifications and caveats on their analysis and opinions to the
departments. However, in some instances government decisions were
at least in part based on this external advice without being
advised of these limitations.
Timing of advice and announcements
The terms of the buy-back including
price were negotiated and agreed within a very short timeframe
after the government decided on 21 September 2006 to pursue a
buy-back. The buy-back was agreed ‘in principle’ on 31 October 2006
and it was announced at the start of the caretaker government
period for the 2006 state election. Sufficient advice, most notably
an adequate business valuation, was not obtained or provided before
committing to the buy-back.
The public announcement of the
non-binding agreement and the purchase price placed the future
government in a weakened negotiating position during preparation of
the final binding agreements. Publicly announcing the ‘in
principle’ agreement effectively committed the state to the
buy-back and limited its capacity to withdraw or renegotiate key
aspects of the agreement.
Valuation procedures undertaken after
the signing of the non-binding agreement focused only on the value
to the state of the transaction, and did not demonstrate bringing
into consideration the value of the business itself.
Limited action was taken in response to
adverse due diligence findings received after the signing of the
non-binding agreement and documentation indicates those findings
were not passed on to government decision makers when the
departments sought approval of the buy-back agreements. This was
countered by the outcomes of a completion accounts process included
in the agreement which resulted in net adjustments in favour of the
state, reducing the base purchase price by $890 000 to $132.9
million.
1.4.4 The negotiation process
The departments administered the
negotiations adequately. The state obtained appropriate expert
external advice and engaged a commercial adviser to lead
negotiations with the lessee.
DOI documented the process
adequately.
1.4.5 Transition of the network to state control and
management
At the time of the buy-back V/Line was
best placed to take immediate responsibility for running the
below-rail network. V/Line became the access provider for the
intrastate regional rail network on 4 May 2007.
V/Line managed the transfer of the
network back to state control effectively and within the approved
budget of $5.2 million. A further $1.3 million was allocated
for V/Line’s accreditation to operate the network under the state’s
rail safety legislation. V/Line developed and implemented a
thorough plan for the transition and there was minimal disruption
to the day to day running of the network or to V/Line
operations.
V/Line was endorsed as the agency
responsible for the below-rail business on an interim basis, due to
concerns about having a rail services operator also providing
access to the network to third parties. The view was that V/Line’s
operation of the below-rail business on a long term basis had the
potential to take its focus away from its core business, the
delivery of passenger rail services. Also, as for the former
lessee, V/Line could not be seen as an impartial and independent
party in providing network access.
In December 2006 the government directed
that a new body be established under the State Owned
Enterprises Act 1992 (SOE) to enable transfer of the below the
rail network from V/Line to the new body at a date promptly
following its safety accreditation.
In September 2007 the Treasurer approved
the postponement of the establishment of the new state body and the
declaration of V/Line as a state body under the SOE.
The new body has yet to be established.
In October 2008, V/Line was declared a state body under the SOE to
provide a shared governance role for the Treasurer and the Minister
for Public Transport.
V/Line management advised they consider
it is the appropriate entity to run the below-rail business and do
not believe that rail operators on the network are concerned about
V/Line’s dual role as access provider and access taker.
1.5 Recommendations
- That the 2006 decision to establish a state body
under the State Owned Enterprises Act 1992, independent of
VicTrack and V/Line, to operate the below‑rail business for the
intrastate rail network be revisited and actioned or set aside
(Recommendation 6.1).
- That the actual cost savings achieved compared
to the business case be determined and a full accounting of the
transaction, based on actual costs, be disclosed
(Recommendation 6.2).