Category: Essential Economics for Business: Ch 09

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All change for the railways

The UK rail industry was privatised by the Conservative government in the mid-1990s. As Case Study 14.8 on the Economics 10th edition website states:

The management of rail infrastructure, such as track, signalling and stations, was to be separated from the responsibility for running trains. There would be 25 passenger train operating companies (TOCs), each having a franchise lasting between seven and fifteen years. These companies would have few assets, being forced to rent track and lease stations from the infrastructure owner (Railtrack), and to lease trains and rolling stock from three new rolling-stock companies. …In practice, the 25 franchises were operated by just 11 companies (with one, National Express, having nine of the franchises).

In 1996, at the start of the franchise era, the train operating companies were largely private-sector companies such as National Express, Stagecoach, Virgin Rail and Prism Rail. By 2020, most of the franchises were operated by a foreign state-owned business or a joint venture with a foreign state-owned firm.

As a result of poor performance (see above case study), Railtrack was effectively renationalised in 2002 as Network Rail – a not-for-profit company, wholly dependent upon the UK Treasury for any shortfall in its funds.

TOCs had mixed success. Some performed so poorly that their franchise contracts had to be temporarily taken over by a state-owned operator. For example, in June 2003 the Strategic Rail Authority withdrew the operating licence of the French company Connex South Eastern. The franchise was temporarily taken over by the publicly-owned South Eastern Trains from November 2003 until March 2006 before being returned to a private operator.

Perhaps the most troubled franchise has been the East Coast Main Line between London and Scotland. It was renationalised in 2009, reprivatised in 2015 and renationalised in 2018.

The effect of the coronavirus pandemic

The spread of the coronavirus and the accompanying lockdowns and social distancing saw a plummeting of rail travel. Passenger numbers fell to just 10% of pre-pandemic levels. In March 2020, the UK Government introduced Emergency Measures Agreements (EMAs), which temporarily replaced rail franchise agreements. TOCs were paid a 2% fee (based on pre-Covid costs) to run trains and losses were borne by the government.

When the EMAs ran out on the 20 September, they were replaced by Emergency Recovery Measures Agreements (ERMAs), set to last until no later than April 2022. Under these measures, the fees paid to TOCs were reduced to a maximum of 1.5%. These consist partly of a fixed fee (again based on pre-Covid costs) and partly on a performance payment, depending on punctuality, passenger satisfaction and financial performance. As with the EMAs, the new arrangements involve virtually no risk for the TOCs (except for the size of the performance-related fee). Costs and revenue will be passed to the Department for Transport, which will bear any losses.

TOCs were required to run a virtually full service to allow reduced passenger numbers to observe social distancing. Despite journeys still being only 30% of pre-pandemic levels, social distancing on trains meant that many trains were sold out.

The ERMAs also contain provisions for the replacement of franchises when they come to an end. The precise nature of these will be spelt out in a White Paper, which will respond to the recommendations of the Williams Review of the railways. This review was set up in 2018 in the aftermath of difficulties with various franchises and a chaotic nationwide timetable change. The review’s findings were originally scheduled to be published in Autumn 2019, but were then put back because of the general election and the disruptions caused by the pandemic. The government hopes that it will be published before the end of 2020.

It is expected that the review will recommend replacing the franchise system with something similar to the currents ERMAs. TOCs awarded a contract will be paid a performance-related fee and revenues will go to the government, which will bear the costs. While this is not quite renationalisation, it is not the previous franchise system where TOCs bore the risks. It is in effect a contract system where private companies are paid to deliver a public service.

The CrossCountry franchise

The first test of this new approach to contracting with TOCs came this month. Arriva’s franchise for running CrossCountry trains ran out and was replaced by a three-year contract to run the services, which span much of the length of Great Britain from Aberdeen to Penzance via Edinburgh, Glasgow, Newcastle, Sheffield, Birmingham, Bristol and Plymouth; from Bournemouth to Manchester via Reading, Oxford, Wolverhampton and Stoke; from Cardiff to Nottingham via Gloucester, Birmingham and Derby; and from Birmingham to Stanstead Airport via Leicester and Cambridge.

The contract will last three years. The Department for Transport will gain the revenues and cover the costs and pay Arriva (owned by Deutsche Bahn) a management fee that is ‘performance related’ – as yet unspecified. This, like the EMAs and then the ERMAs, will remove the risks from Arriva.

Nationalisation in Wales

The Welsh government has announced that Transport for Wales will be taken over by a publicly owned company in February 2021. TfW operates many of the routes in Wales and the borders and most of the branch lines in Wales, including the valley commuter lines into Cardiff. It is currently owned by KeolisAmey (a joint company owned 70% by the French company, Keolis (part of SNCF), and 30% by the UK company, Amey), which took over the franchise in 2018 from Arriva. The Welsh government considered that KeolisAmey would collapse if it did not provide support. Ministers decided that nationalisation would give it greater control than simply subsidising KeolisAmey.

James Price, chief executive of the Welsh Government, stated that this allows it:

to reduce the profit we pay to the private sector massively over time, and make sure that when the revenue comes back, it comes back in to the taxpayer.

Under emergency measures, KeolisAmey has already been supported by the Welsh government to the tune of £105 million (£40 million in March and £65 million in June) to continue operating the franchise. Passenger numbers fell by 95% as the pandemic hit.

Is nationalisation a better way forward, or should private train operating companies continue with the government taking on the risks, or should the franchise system be amended with greater support from the government but with the TOCs still bearing risk? The articles below consider these issues.

Articles

Questions

  1. Explain how the franchising system worked (prior to March 2020).
  2. To what extent could each franchise be described as a ‘contestable monopoly’?
  3. What incentives were built into the franchising system to deliver improvements in service for passengers?
  4. What were the weaknesses of the franchising system?
  5. In the context of post-pandemic rail services, compare the relative merits of nationalisation with those of awarding contracts where the government receives the revenues and bears the costs and pays train operating companies a fee for operating the services where the size of the fee is performance related.
  6. What are the arguments for subsidising rail transport? What should determine the size of the subsidy?
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Assessing policies to tackle coronavirus: the use of cost–benefit analysis

It is commonplace to use cost–benefit analysis (CBA) in assessing public policies, such as whether to build a new hospital, road or rail line. Various attempts in the past few months have been made to use CBA in assessing policies to reduce the spread of the coronavirus. These have involved weighing up the costs and benefits of national or local lockdowns or other containment measures. But, as with other areas where CBA is used, there are serious problems of measuring costs and benefits and assessing risks. This is particularly problematic where human life is involved and where a value has to be attached to a life saved or lost.

Take the case of whether the government should have imposed a lockdown: an important question if there were to be a second wave and the government was considering introducing a second lockdown. The first step in a CBA is to identify the benefits and costs of the policy.

Identifying the benefits and costs of the lockdown

The benefits of the lockdown include lives saved and a reduction in suffering, not only for those who otherwise would have caught the virus but also for their family and friends. It also includes lives saved from other diseases whose treatment would have been put (even more) on hold if the pandemic had been allowed to rage and more people were hospitalised with the virus. In material terms, there is the benefit of saving in healthcare and medicines and the saving of labour resources. Then there are the environmental gains from less traffic and polluting activities.

On the cost side, there is the decline in output from businesses being shut and people being furloughed or not being able to find work. There is also a cost from schools being closed and children’s education being compromised. Then there is the personal cost to people of being confined to home, a cost that could be great for those in cramped living conditions or in abusive relationships. Over the longer term, there is a cost from people becoming deskilled and firms not investing – so-called scarring effects. Here there are the direct effects and the multiplier effects on the rest of the economy.

Estimating uncertain outcomes

It is difficult enough identifying all the costs and benefits, but many occur in the future and here there is the problem of estimating the probability of their occurrence and their likely magnitude. Just how many lives will be saved from the policy and just how much will the economy be affected? Epidemiological and economic models can help, but there is a huge degree of uncertainty over predictions made about the spread of the disease and the economic effects, especially over the longer term.

One estimate of the number of lives saved was made by Miles et al. in the NIESR paper linked below. A figure of 440 000 was calculated by subtracting the 60 000 actual excess deaths over the period of the lockdown from a figure of 500 000 lives lost which, according to predictions, would have been the consequence of no lockdown. However, the authors acknowledge that this is likely to be a considerable overestimate because:

It does not account for changes in behaviour that would have occurred without the government lockdown; it does not count future higher deaths from side effects of the lockdown (extra cancer deaths for example); and it does not allow for the fact that some of those ‘saved’ deaths may just have been postponed because when restrictions are eased, and in the absence of a vaccine or of widespread immunity, deaths may pick up again.

Some help in estimating likely outcomes from locking down or not locking down the economy can be gained by comparing countries which have taken different approaches. The final article below compares the approaches in the UK and Sweden. Sweden had much lighter control measures than the UK and did not impose a lockdown. Using comparisons of the two approaches, the authors estimate that some 20 000 lives were saved by the lockdown – considerably less than the 440 000 estimate.

Estimating the value of a human life

To assess whether the saving of 20 000 lives was ‘worth it’, a value would have to be put on a life saved. Although putting a monetary value on a human life may be repugnant to many people, such calculations are made whenever a project is assessed which either saves or costs lives. As we say in the 10th edition of Economics (page 381):

Some people argue ‘You can’t put a price on a human life: life is priceless.’ But just what are they saying here? Are they saying that life has an infinite value? If so, the project must be carried out whatever the costs, and even if other benefits are zero! Clearly, when evaluating lives saved from the project, a value less than infinity must be given.
 
Other people might argue that human life cannot be treated like other costs and benefits and put into mathematical calculations. But what are these people saying? That the question of lives saved should be excluded from the cost–benefit study? If so, the implication is that life has a zero value! Again this is clearly not the case.

In practice there are two approaches used to measuring the value of a human life.

The first uses the value of a statistical life (VSL). This is based on the amount extra the average person would need to be paid to work in a job where there is a known probability of losing their life. So if people on average needed to be paid an extra £10 000 to work in a job with a 1% chance of losing their life, they would be valuing a life at £1 000 000 (£10 000/0.01). To avoid the obvious problem of young people’s lives being valued the same as old people’s ones, even though a 20 year-old on average will live much longer than a 70 year-old, a more common measure is the value of a statistical life year (VSLY).

A problem with VSL or VSLY measures is that they only take into account the quantity of years of life lost or saved, not the quality.

A second measure rectifies this problem. This is the ‘quality of life adjusted year (QALY)’. This involves giving a value to a year of full health and then reducing it according to how much people’s quality of life is reduced by illness, injury or poverty. The problem with this measure is the moral one that a sick or disabled person’s life is being valued less than the life of a healthy person. But it is usual to make such adjustments when considering medical intervention with limited resources.

One adjustment often made to QALYs or VSLYs is to discount years, so that one year gained would be given the full value and each subsequent year would be discounted by a certain percentage from the previous year – say, 3%. This would give a lower weighting to years in the distant future than years in the near future and hence would reduce the gap in predicted gains from a policy between young and old people.

Conclusion

Given the uncertainties surrounding the measurement of the number of lives saved and the difficulties of assigning a value to them, it is not surprising that the conclusions of a cost–benefit analysis of a lockdown will be contentious. And we have yet to see what the long-term effects on the economy will be. But, at least a cost–benefit analysis of the lockdown can help to inform discussion and help to drive future policy decisions about tackling a second wave, whether internationally, nationally or locally.

Articles

Questions

  1. What are the arguments for and against putting a monetary value on a life saved?
  2. Are QALYs the best way of measuring lives saved from a policy such as a lockdown?
  3. If the outcomes of a lockdown are highly uncertain, does this strengthen or weaken the case for a lockdown? Explain.
  4. What specific problems are there in estimating the number of lives saved by a lockdown?
  5. How might the age distribution of people dying from Covid-19 affect the calculation of the cost of these deaths (or the benefits or avoiding them)?
  6. How might you estimate the costs to people who suffer long-term health effects from having had Covid-19?
  7. What are the arguments for and against using discounting in estimating future QALYs?
  8. The Department of Transport currently uses a figure of £1 958 303 (in 2018 prices) for the value of a life saved from a road safety project. Find out how this is figure derived and comment on it. See Box 12.5 in Economics 10th edition and Accident and casualty costs, Tables RAS60001 and RA60003, (Department of Transport, 2019).
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Should the post-Covid-19 recovery be a Green recovery?

Pre-Covid 19, the climate change movement had gathered momentum with climate activist Greta Thunberg regularly in the news and people around the world striking in protest of inadequate government action on the climate crisis. However, now in a world overtaken by the pandemic, climate change is no longer at the centre and appears a more distant threat. The majority of the large climate change events due to take place this year have been delayed and policy announcements are aimed at supporting the current economic hardships. This is not surprising nor debatable, but there is a risk that, as Covid-19 dominates the news, policy and debates for a long time to come, this will overshadow any environmental initiatives that were due to be implemented.

Governments around the globe are navigating their economies through the pandemic and starting to think about the future road to recovery. However, there is an argument that it doesn’t have to be a case of ‘either or’, as there is the potential for policies to address the Covid-19 crisis and climate change at the same time. How policy makers respond now could shape the fight against climate change for the future. One of the lessons from the pandemic is that quick responses to high impact risks are vital to reduce costs. With that in mind, and given the costs of climate change, it is arguable that now is the best time to address its challenges.

Climate change and Covid

It is estimated that there was a total global loss of $3tn caused by natural disasters over the past decade. By 2050, cumulative damages from climate change are predicted to reach $8 trillion, impoverishing the world as a whole by 3% of GDP and the poorest regions by more. Climate activists argue that despite the economic consequences of climate change, the action taken by governments has been insufficient. In 2015, the then Bank of England governor, Mark Carney warned: ‘Once climate change becomes a defining issue for financial stability, it may already be too late.’

However, since the pandemic struck all over the world, there have been positive consequences for the environment. Pollution levels started dropping fast as airlines grounded fleets, car travel came to a stop and industries shut down. With 2.6bn people living under restrictions under their country’s lockdown, there has also been an impact on the environment, not just the spread of the virus. Given that the lockdowns across the world have come at huge social and human costs, is now not the time to ensure that these improvements for the environment are not just temporary but ignite long-term changes?

Given the clear impacts and risks of Covid on peoples’ health, our ability to change our behaviour quickly has been striking. The importance of behaviour change has been brought to the centre and, arguably, it shows that we are capable of change when lives are at risk and are deemed more important than business-as-usual GDP growth. The application to climate change, however, is not as straightforward, as the costs to human lives are often viewed as a future problem.

Global cooperation

Dr Laure de Preux, Assistant Professor of Economics at Imperial College Business School, highlights the important role that cooperation across borders plays in the face of a global crisis like Coronavirus, and how that can be applied to the fight against climate change.

The big challenges the world is facing, including the climate change crisis, can only be dealt with efficiently through international cooperation. We cannot only act individually; the benefits of our actions are multiplied if integrated into a global strategy. In the case of COVID-19, social distancing measures can only be truly effective if they are adopted at a large scale.

World leaders are aware that their economies now face one of the most severe recessions in history as a consequence of the coronavirus restrictions. Governments are going to have to dedicate huge budgets to enable the economic activity to resume again. This presents a unique challenge, but also a massive opportunity for global cooperation. The question to be asked, therefore, is that if these stimulus packages are a one-off chance to transform the economy, how should the government spend it and what should be their focus? Should the recovery policies focus on creating a greener economy?

The European Union unveiled what it is calling the biggest ‘green’ stimulus package in history. Ursula von der Leyen, the European Commission president, told European Parliament members that this issue is about all nations and it is bigger than any one of them. The deputy Prime Minister of Spain, Teresa Ribera, states that there is a greater risk by not acting in this way. She argues that if the recovery is not green, then it will be nothing but a short-cut to solve the current problems rather than a true economic recovery.

It is not just in Europe where the recovery has an environment focus. Joe Biden is believed to be planning a similarly huge green stimulus package for the US. The model echoes the vast investment projects of the New Deal that helped lift America out of the Great Depression in the 1930s.

There are sound economic reasons why politicians see green technology as a prudent investment. Renewable energy is now often cheaper than fossil fuels in large parts of the world and the technologies are proven and can be built at scale today. The argument for renewables providing a pathway for clean future growth is based on the logic of much of manufacturing – the more you produce, the cheaper it gets. However, China does not appear to have similar plans for their recovery. China produces almost a third of the world’s emissions, as much as the USA and the EU combined. At the annual National People’s Congress, there was no indication that the big expansion of coal-fired electricity generation would be reversed, even though it is also expanding the production of renewable energy. China expanded its coal-fired power stations as a key part of its stimulus package after the 2008 financial crisis.

Policy decisions

The UK government receives ongoing pressure from energy companies. The boss of energy giant SSE, Alistair Phillips-Davies has warned that a failure to deal with climate change could eventually have a greater economic impact than coronavirus. SSE wants the UK government to encourage private investment in renewables by giving the green light to big new projects, such as hydrogen and carbon capture plants and boosting electric vehicles. Despite the impacts of climate change not being immediately felt in comparison to Covid-19, Phillips-Davies argues that a failure to deal with climate change could lead to great long-term impacts:

While it is still too early to predict with confidence the full human, social and economic impact of coronavirus, we can say with certainty that significant investment will be needed to rebuild the UK economy in its wake.

It is clear that any pandemic-induced financial decisions made over the next 12 months will shape the global economy for the next decade. The full impact of the virus on climate change will be determined by the world’s stimulus measures adopted post-pandemic. Following the 2008 financial crisis, the energy-intensive stimulus measures that followed, particularly in China, boosted emissions. Therefore, if we are to meet the reduction in emissions target our response needs to be green, helping to shape a sustainable future. Dr Alex Koberle, of the Grantham Institute at Imperial College London, argues that Governments should take time to reflect, learn from past mistakes and redirect development towards a sustainable future.

Shouldn’t growth be given priority?

With 1.6 billion people working in the informal economy worldwide reckoned to be in immediate danger of losing their livelihoods (according to the International Labour Organization), is now the right time to be focusing on the climate? Industries such as airlines and car manufacturing are strategic industries, employing millions of people. Headlines of longer-term environmental targets will be given less importance than headlines of job losses. Recovery relies on the government finding ways to employ lots and lots of people. There is a close relationship between real GDP, employment and energy consumption. Therefore, any policies aimed at reducing greenhouse gas emissions, unless carefully directed, could reduce economic growth and employment for both less and more developed economies. Such policies would increase the cost of conventional energy sharply.

Critics of a green energy policy for recovery argue that investing in renewable energy ignores the adverse effects of reduced investment and higher energy costs in other sectors. By governments prioritising policy to focus on the environment, they could harm the ability of most people to improve their own circumstances, especially given the terrible economic shock caused by the lockdowns.

Conclusion

With the majority of news in recent months providing little joy, there has been at least the positive impact on the environment. However, advocates say it not a cause for celebration and warn that any benefits are likely to be short lived. There have been some positive behavioural impacts but the true test will be what happens in the recovery phase. If the focus is returned to business as usual what happens to the targets actioned prior to Covid-19?

The immediate priority of all governments right now is to control the pandemic and to save lives. As their policy interventions have an impact and economies start to emerge from this crisis, then there is an important debate to be had about how new investments can help create a cleaner, greener recovery. We have learnt from the current pandemic that changes can be made when consequences are imminent, however, climate change is a threat that doesn’t go away, and is arguably just as urgent. Solutions to both crises can be integrated into a coherent response to propel the global economy towards sustainable growth and increased resilience.

Articles

Letter

Questions

  1. Are government attempts to reduce the impact of climate change beneficial or harmful to UK firms?
  2. What policy instruments can the government use to increase economic activity?
  3. How does an increase in investment affect aggregate demand?
  4. What are the costs and benefits of economic growth?
  5. Why can climate change be described as a market failure?
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Private schools warned regarding price fixing

Like most other sectors of the economy, private schools have been significantly affected by the coronavirus pandemic. As with all schools, they have been restricted to providing their pupils with online instruction. In addition, some parents are likely to have seen their ability to pay the high fees private schools charge restricted. As a result of both of these factors, private schools have been forced to look into providing discounts or refunds on their fees. However, the UK competition authority have received evidence that these schools may have been communicating with each other over how they will set these fee reductions. The authority is concerned that this will allow the schools to restrict the discounts and keep their fees higher.

In other markets (see here and here) the competition authorities have been prepared to relax certain elements of competition law in light of the coronavirus situation. However, price fixing is the severest breach of competition law and the Competition and Markets Authority (CMA) has been clear that this continues to be the case in the current climate. A CMA spokesperson said:

Where cooperation amongst businesses or other organisations is necessary to protect consumers in the coronavirus outbreak, the CMA will not take enforcement action. But we will not tolerate organisations agreeing prices or exchanging commercially sensitive information on future pricing or business strategies with their competitors, where this is not necessary to meet the needs of the current situation.

Therefore, the CMA has written to the Independent Schools Council and other bodies representing the private school sector. This letter made clear that communicating over the fee reductions would be very likely to breach competition law and could result in fines being imposed.

This warning is important since the sector has a history of illegal communication between schools. In 2006 the Office of Fair Trading (OFT) (one of the predecessors to the CMA) imposed fines when it discovered that 50 of them, including Eton and Harrow, had for a number of years shared information on the fees they intended to charge. The OFT discovered that this had taken place following evidence obtained by a student who hacked into their school’s computer system. Here the student found information on the intended fees of competitor schools and leaked this information to the press. It is clear that the CMA will keep a close eye on private schools as they react to the ongoing pandemic.

Articles

Questions

  1. What are the key features of the private school sector? Is this a market where you would expect competition to be intense?
  2. Why is price fixing the severest breach of competition law?
  3. Assuming communication between the private schools is eradicated, how would you expect the sector to be affected by the coronavirus pandemic?
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Amazon’s investment in Deliveroo provisionally cleared

Late last year I wrote a blog post describing how the UK Competition & Markets Authority (CMA) was looking into Amazon’s investment in online food delivery company Deliveroo. Through this investment Amazon would become a minority shareholder in Deliveroo and be able to participate in the management of the company.

At this time the CMA had completed its initial investigation and decided that it had concerns about the impact the investment would have on competition. Since Amazon and Deliveroo did not then offer any proposal to address these concerns, the CMA referred the case for a full-blown investigation. They were not expected to make a decision until June. However, earlier this month the CMA announced that they would provisionally clear the investment.

This decision is a result of the impact coronavirus pandemic has had on the UK economy. The lockdown in the UK has seen many of the restaurants Deliveroo previously delivered from temporarily shutting down. In response, Deliveroo has significantly expanded the online grocery store delivery part of its business. Despite this, it appears that overall the pandemic has significantly reduced their revenues. This will clearly have a significant impact on gig economy workers who, more generally, are particularly affected by the current circumstances (see the earlier post on this site).

As a result of the pandemic, Deliveroo informed the CMA that they would go out of business without the investment from Amazon. This is very much in line with wider evidence of the impact the pandemic is already having on businesses. The CMA accepted that without additional funding Deliveroo would exit the market and that under the current circumstances it would be very difficult for them to secure an alternative source of funding. Furthermore, they regarded Deliveroo exiting the market as the worst outcome for competition, with Stuart McIntosh, Chair of the inquiry group, stating that:

This could mean that some customers are cut off from online food delivery altogether, with others facing higher prices or a reduction in service quality. Faced with that stark outcome, we feel the best course of action is to provisionally clear Amazon’s investment in Deliveroo.

The unprecedented circumstances created by the coronavirus pandemic provide a clear justification for the approach the CMA has taken. However, in the long-run there may be adverse consequences for competition. For example, the reduction in competition in online grocery store delivery that the CMA originally feared may materialise. In addition, it will be interesting to see whether the effect the pandemic has on Deliveroo’s business makes it more likely that Amazon will look to fully acquire them.

Articles

Questions

  1. Distinguishing between the short and long run, how do you think the market would change if Deliveroo were to exit?
  2. Why do you think it would be difficult for Deliveroo to find alternative sources of funding at the current time?
  3. What trade-offs would the CMA have had to consider when deciding to clear Amazon’s investment?