Stagecoach : Rail franchise update

02 May 2019

Stagecoach Group plc

Rail franchise update

Stagecoach Group plc ('the Company') is today providing further information on the approach taken on pension risks in its three most recent bids for UK rail franchises. Those bids were disqualified by the Department for Transport. This information is being provided in light of the significant media comment on the disqualifications and, in particular, on the issue of pensions.

We announced on 10 April 2019 that we had been informed by the Department for Transport that we had been disqualified from a total of three rail franchise bids. We were shortlisted in the following franchise competitions:

• East Midlands, where we were bidding independently

• South Eastern, where we were bidding with support from our intended partner, Alstom

• West Coast Partnership, where we were part of a joint bid with Virgin Group and SNCF

A senior Department for Transport official verbally advised that we had been excluded from all three competitions for submitting non-compliant bids, principally in respect of pensions risk. In our bids, we refused to accept the potential pension risks that the Department for Transport requires operators to bear in relation to the three new franchises. The full extent of these risks is unknown, but we estimate them to be well in excess of £1 billion for the three franchises. Further information on those pensions risks is provided below.

Background to the pensions risk

The Railways Pension Scheme ('RPS') is a defined benefit scheme split into a number of sections, including sections covering the franchised train operating companies.

Each section operates on a 'shared cost' basis with the employer responsible for 60% of the total contributions payable to the scheme and the employees responsible for 40%. Throughout the period of the privatised UK railway since the mid-1990s, a franchised train operator's obligation to RPS has been limited to paying the employer contributions due for the period of its franchise. No train operator has been held responsible for any scheme deficit remaining at the end of its franchise and nor has it had any entitlement to benefit from any scheme surplus at the end of the franchise. Since privatisation, the Department for Transport has had and continues to have a veto over train operating companies' decisions on RPS funding, benefit and contractual arrangements.

The sections of RPS relating to franchised train operators have been funded on a long-term basis. That funding approach was determined by the RPS Trustee Board, taking comfort from its understanding that the Department for Transport effectively stands behind any RPS liabilities as each franchise ends. More recently, the Pensions Regulator has questioned that extent to which RPS does in fact benefit from that underpinning support from the Department for Transport. We understand that the Pensions Regulator considers there to be a deficit of up to £7.5 billion across the franchised train operators and is seeking significant additional contributions to the scheme which are as yet unquantified.

As a result, in the absence of any contractual protection, an operator of any new rail franchises could have an exposure to substantial additional pension contributions. As yet, there has been no final determination by the Trustees or the Pensions Regulator of the extent of the liability that would be borne by franchisees. While ultimately the Department for Transport provided limited protection against the risk in the specification for the three current franchise competitions, our assessment was it still left the successful operators with substantial risk which could not be assessed. The Department for Transport's protection was limited to:

· the 2019 scheme valuation only (so the train operator took the full risk of contribution increases arising from the 2022 and all subsequent valuations);

· deficit contributions only (so the operator took the full risk of contributions in respect of contribution increases relating to ongoing employee service costs) and;

· employer contributions only (so the operator took the risk that employees were unwilling to accept increased employee contributions leading to either industrial action or a need for the operator to fund the increases).

In previous UK rail franchises, we accepted that each of our train operating companies bore the risk of increases in the pension contributions payable to RPS during the period of the applicable franchise. However, that was prior to the requests from the Pensions Regulator for substantial and not yet fully quantified increases in contributions to RPS. Therefore, in our more recent franchise bids, we took specialist actuarial advice. Following careful consideration of the protection offered by the Department for Transport, plus a review of potential downside scenarios, the outcomes showed that the potential additional cost and risk were substantial. We therefore, as a responsible business, included increases in pension costs in our bid forecastsand sought additional contractual protection beyond that offered. The additional contractual protection sought was to ensure that in the event a bid was successful, the relevant train operating company's exposure to increases in pension contributions to RPS would be limited to a manageable level which it would be reasonable for a train operator to bear should those circumstances arise.

Notwithstanding the significant increases in pension costs included in our forecastsfor the three bids and the contractual protection offered by the Department for Transport, the pension risks remained substantial. For illustration, we show below one downside outcome we considered as part of the bidding processes. The scenario shown reflects a 20% fall in the value of pension scheme assets post 2019 and a reduction in the discount rate applied to liabilities from 5.7% to 2.7% (reflecting the views of the Pensions Regulator on private pension schemes more widely).

	East Midlands £m	South Eastern £m	West Coast Partnership £m
Additional cost in bid	81	167	102
Further downside risk	319	358	589

The above figures represent undiscounted contributions over the expected lives of each franchise.

The above illustrations of downside risks are in addition to risks covered by the contractual protection offered by the Department for Transport which in any event extended only to the 2019 valuation. Notwithstanding the disqualifications, we continue to believe we were right not to accept the pensions position sought by the Department for Transport and that to have done so would have been to take on unknowable risk and been contrary to the success of the Company and also contrary to the interests of employees, customers and the franchise.

Our West Coast Partnership bidding partners, Virgin and SNCF and Alstom (our proposed partner for South Eastern), supported those bidding positions. We also note media reports that at least one other bidder took a similar position and was disqualified from the East Midlands competition.

While a parent company's liability to any particular UK rail franchise should be limited to its risk capital (principally, performance bond and loan commitments), an exhaustion of that parent company risk capital, in our view, is not desirable for customers, employees or the relevant franchise. We experienced this first hand through our involvement in the Virgin Trains East Coast franchise. The Department for Transport was clear that it expected the parties to that franchise agreement to adhere to all of their obligations under that agreement, regardless of any changes in circumstances. We would therefore expect the Department for Transport to apply the same approach on any other new franchise, and this was reflected in our approach during the bidding processes.

For further information, please contact:

Analysts

Ross Paterson, Finance Director ​​​​01738 442111 Bruce Dingwall, Group Financial Controller ​​​01738 442111

Media

Steven Stewart, Director of Corporate Communications

​01738 442111 or 07764 774680

Notes to Editors

Stagecoach Group

• Stagecoach Group is one of the UK's largest and leading public transport groups. The Group employs around 26,000 people.

• Stagecoach is one of the UK's biggest bus and coach operators with over 8,000 buses and coaches on a network stretching from south-west England to the Highlands and Islands of Scotland. Low-cost coach service, megabus.com, operates a network of inter-city services across the UK.

• Stagecoach is a major UK rail operator, running the East Midlands Trains network and holding a 49% shareholding in Virgin Rail Group, which operates the West Coast rail franchise.

• Stagecoach operates the Supertram light rail network in Sheffield.