Something is changing. Not only is America waking up to the need for government (as Bob Borosage reports in this issue) Britain’s New Labour government is too. When Tony Blair launched the ‘Third Way’ after he was elected in 1997, it generated serious discussion across Europe where the need to modernise social democracy connected to relatively successful state-run sectors of the economy. In the UK, the notion was seen as mainly spin. Not without justification. Blair’s first administration did not pursue an alternative to ineffective state control and unbalanced market rule. Instead, it cut back government expenditure and appeared to be a variety of Thatcherism with a human face.

Now, through force of circumstance rather than design, something which could genuinely be described as ‘Third Way’ has arrived on the back of catastrophic market failure.

British railways were privatised in the mid-1990s by the Conservative government of John Major. Over the weekend of October 6-7, Railtrack, the company which owns the infrastructure, though it does not run the actual trains, went bankrupt as the Transport Secretary, Stephen Byers, decided that he could no longer continue to subsidise it. Instead, he declared that a not-for-profit company should be established to do the job – and a new way to run the railroads may be the result.

He announced that he was forcing the company into administration to be run, temporarily, by Ernst & Young. After a period of administration, the aim would be to transform Railtrack into a private company limited by guarantee, with no shareholders and a membership drawn from all parts of the rail industry - ranging from train operators and rolling stock firms to trade unions and passenger groups. It looked like an audacious and ground-breaking move, even if the government had been forced into it by the precarious nature of the company’s finances.

The costs of panic

Railtrack was floated on the Stock Exchange in a £2.5bn sale in 1996 and for several years made healthy profits, but it started haemorrhaging money as a result of the Hatfield train crash in October 2000. Hatfield exposed both the engineering and financial flaws of privatisation. The accident, which killed four people, was caused by a broken rail which derailed part of an electric train travelling at 115 miles per hour. The subsequent investigation revealed that cracks in the rail had first been spotted nearly two years previously and that a series of mistakes by Railtrack and its contractors, Balfour Beatty, resulted in such a lengthy delay to effect the repair that the rail finally broke a couple of weeks before its replacement was scheduled.

Railtrack, which had lost much of its engineering expertise following the privatisation, panicked. It embarked on a massive rerailing programme, much of it unnecessary, in order to ensure that no similar accidents occurred. In the meantime, it imposed hundreds of speed restrictions around the country which turned the railway timetable into a work of fiction and stopped the previously healthy growth in passenger usage. Under the complex performance regime the company had to pay out over £400m in compensation to operators and another £200m on the rerailing programme. As a result, this previously profitable company which at one time was creaming off £1m per day, plunged £534m into the red during the 2000/1 financial year.

If Hatfield had merely been an aberration, Railtrack might have survived. But there was another cancer eating away at the heart of the company which was to prove a mortal blow – its complete inability to control costs. Every project it undertook went way over budget. This was partly because the way it had been privatised meant it had no in-house engineering capacity nor, indeed, did it undertake any of its own research and development.

The project that was to prove fatal to Railtrack was the modernisation of the West Coast Main Line, Britain’s most heavily used long-distance rail route which links London with Birmingham, Manchester, Liverpool and Glasgow. Initially costed at around £2.4bn, when Railtrack was privatised, the cost seemed to go up in £500m chunks any time the project featured in a press release, and reached a staggering £7bn – possibly £8bn – by the time Railtrack was forced into administration. The West Coast project was only the most expensive of a series of similar schemes. Railtrack seemed to have lost all ability to keep a tight rein on costs.

The company realised that, with debts already at £3.3bn and rising rapidly, and its share price below the flotation price, drastic action was required. It commissioned a report from Credit Suisse First Boston which suggested three possible outcomes: restructuring, renationalisation, or receivership (effectively the same as administration). Railtrack’s chairman John Robinson went cap in hand to the government with the report, but strongly recommended restructuring. The only problem was that this would have entailed ministers caving into Railtrack’s demand for a £4bn bail out, which was in addition to the massive £15bn (most of it public money) it had been granted over five years by the regulator and an earlier £1.5bn bail out. Byers promised to go away and think about it over the summer.

A hybrid solution

Renationalisation, however, was also problematic. It not only went against the grain of New Labour’s one little Big Idea at the 2001 election – greater involvement of the private sector in the public sector - but it would have put the railway’s finances back on the government’s balance sheet as part of the Public Sector Borrowing Requirement, something the Chancellor, Gordon Brown, was desperate to avoid. Moreover, Byers learnt that under European rules, shareholders bought out by the government might have been entitled to the average price of the past three years, something like £8, rather than the £3 around which they had hovered since the summer.

Therefore, receivership with the subsequent transformation of the company into a kind of non-profit making trust looked a canny option. It gave the government a measure of control of the company, albeit at arms length, without having to pay out the shareholders. It looked radical and groundbreaking, pleasing to Labour’s heartlands – a deft solvent to the running sore of the railways.

So the thinking went. But the reality was different. Guess what? The shareholders noticed that they were going to lose all their money and were not best pleased. Nor was the City, which warned that any future funding for the railways – or indeed any other joint private/public schemes – could be jeopardised because the government had broken their trust.

Interestingly, commentators both from Left and Right criticised Byers’ refusal to bail-out the shareholders. The Left wanted to see a clear renationalisation to give the state control, while right-wing City commentators argued that the shareholders had been cheated. Railtrack even had the gall to demand £3.60, close to the flotation price of £3.90, for its shareholders because … well, because they deserved it.

Their complaints are, so far, to no avail. A strange hybrid of a private company without shareholders is being created - in order that the railways stay off the government’s balance sheet and can raise money that will not count as part of the Public Sector Borrowing Requirement but nevertheless work to aims set by ministers.

Stumbling towards Jerusalem?

The lessons of Railtrack’s demise will be felt across Europe. In an effort to promote competition between different operators, the European Commission has been fostering both rail privatisation and the split between infrastructure provision and service operators. Britain took the model to extremes as it was the only country to privatise its infrastructure, but several European countries have been considering similar models. Now that Railtrack’s collapse has shown the limits of both privatisation and fragmentation, a period of reflection on the future of the railways is called for.

Railtrack’s failure also raises questions about the limits of privatisation. Monopolies, heavily dependent on subsidy and requiring massive investment programmes will now presumably be off-limits. Moreover, the cost of capital provided by private investors for public services is likely to rise, given that this episode has shown that the government will not always be a guarantor of last resort. The risk transfer which is at the heart of privatisation has been shown to be real, despite the intemperate whinges of the Railtrack shareholders who should have heeded the advertisements which stress that shares can go up or down.

Meanwhile, within the policy units and think tanks of New Labour, there is considerable excitement at what is happening to the railways. Indeed, it was the most New Labour-friendly think tank, the Institute of Pubic Policy Research, which came up with the non-profit making trust idea for Railtrack. And already this Third Way model had been presaged by the transformation of Welsh Water into a mutual company owned by its customers, an arrangement which will lead to higher investment as well as reduced water rate charges.

Railtrack’s case is, admittedly, more complex; but it opens the way for a more informed and practical debate on Third Way models for the future. It is just a pity that it took an immense and costly failure - the crude imposition of an unrealistic capitalist model on a crucial industry - to spur New Labour into some serious thinking about genuinely radical alternative methods of providing public services.