Chapter 11
Transport subsidy
Learning Outcomes:
On reading this chapter, you will learn about:
᭿ The economic rationale behind the payment of subsidy to transport operators
᭿ Supply side and demand side subsidy measures
᭿ The drawbacks of paying a subsidy
᭿ The issues surrounding the cross subsidisation of transport services
᭿ The different ways and forms in which subsidy can be paid to the operators of transport
services.
INTRODUCTION
Subsidy plays a vital role in the operation of transport markets, possibly more so than in any other
industry. This is because transport markets are made up of a combination of market forces and the
actions of transport planning authorities, with subsidy playing the pivotal role in reconciling these
two ‘forces’ in the actual market place. An understanding of the uses of subsidy in transport
industries, and perhaps more importantly the issues that surround the payment of it, is therefore
vital to any analyst of transport markets.
Nevertheless, the payment of subsidy is closely related to aspects of regulation in transport
markets. With the general move away from transport provision through traditional forms of public
ownership towards far more private sector involvement, many argue that it is no longer a ‘subsidy’
but rather a payment for the performance of a contract for providing a service. In other words, like
university lecturers, doctors and nurses and policemen and women, they are simply providing a
service for the state. Irrespective of that argument, in return for the payment of the contract these
operators are ‘regulated’, i.e. required to provide a certain level of transport provision. Thus in
many areas the regulation and subsidisation of transport services are very closely linked. Furthermore,
with greater private sector participation more regulation is required as direct control
between the authority and the operator is lost with the loss of public ownership. Regulatory issues
have been examined in the previous chapter, and this chapter takes aspects of that topic forward
249
and deals specifically with the matters surrounding the actual transfer of funds between the state
and the operator.
At first sight, the payment of subsidy may appear to be a fairly straightforward process. For
example, if a transport authority wants a service provided that cannot be run at a profit, it would
appear to be a simple case of paying an operator to provide the service. The subsidy paid would be the
net difference between the cost of the service and the revenue gained from passengers. However, that
raises many issues and questions, such as how much subsidy should actually be paid to the operator to
run the service? What is the best way to pay that subsidy, i.e. simply hand over the cash, or is there a
better way? Should the operator that provides the service be publicly owned to increase ‘accountability’
or would that require more subsidy than a private operator? What is the likely impact of the
subsidy payment on what the authority is trying to achieve, i.e. what are the side effects of paying
subsidy on the standard of service provided and the efficiency of the operator providing it?
None of these questions are easily resolved. Taking the first point, how much subsidy should be
paid for a particular transport facility, this would be dependent upon a number of factors. Firstly,
how much it is decided that it is ‘fair’ to charge direct users of the facility and thus how much
should be paid by the state. That in turn will be dependent upon the costs of actually providing that
facility and the level of non-monetary benefits and costs associated with it. Finally, in the case
where a private operator is to be contracted, then is it right that they should earn a profit from its
operation, and if so, just how much profit should they earn? This raises the issue of what would be a
‘reasonable’ level of profit for the operator and to what extent should that be dependent upon
performance?
The issue is further complicated as the payment of subsidy is not a straightforward economic
issue, but also has a very strong political dimension, both in terms of the levels of subsidy paid
and how it is to be paid. Some governments or authorities for example may continue to operate
certain transport services irrespective of the costs involved and thus go way beyond any rationale
economic argument. For example, it could be argued that the provision of night sleeper rail
services from Fort William to London falls into such a category as its continued operation has little
to do with the economic realities of the costs and benefits of the service.
As can be seen from this brief introduction, there are far more issues surrounding the payment of
subsidy than actual subsidy itself. Nevertheless, without it the transport system of any country would
come to a grinding halt. It is the essential cog in the wheel that keeps the whole system moving and is
usually used to guide transport behaviour towards more land use efficient modes of transport or to
underpin, in whatever form, economic development of a particular region or locality.
In this chapter we explore these issues and hopefully provide some insights into the points
raised above. We begin by outlining the economic argument for the payment of subsidy to
transport operations and this should dispel any thoughts that subsidies are used simply because
transport services, particularly the train, are unprofitable because they are run inefficiently. We
then consider what are known as demand and supply side measures and the main drawbacks of
paying subsidy, before finally looking at the actual forms that subsidy payment can take and how
this contrasts with the idea of cross subsidisation. In reading this chapter, however, you should also
see that within the economics of transport it is very difficult to look at a single issue in isolation.
For example transport services are often subsidised because the service that is provided is seen to
be of a high ‘external’ value (e.g. provides a socially necessary service) but cannot be operated
profitably by private companies. The inevitable consequence therefore is that when subsidised
250
TRANSPORT SUBSIDY
there will only be a single operator, i.e. a monopoly, and this in turn raises the problems associated
with such market structures highlighted previously in Chapter 7, particularly the strong position of
the operator. Part of the system used to pay subsidy therefore is to ensure such drawbacks are
minimised.
THE RATIONALE FOR PUBLIC SUBSIDY
In most market-based economies, if a firm or industry cannot make a profit from selling its goods
or services then it simply goes out of business. This in a nutshell is what is known as the efficiency
of the market. Basically insufficient numbers valued the goods and services that were being
produced at the prevailing market prices, hence the continued employment of resources in the
production of those goods and services could no longer be supported. By going out of business, the
resources previously used are now ‘freed’ to be put to other purposes more in line with society’s
wants and needs. Why, therefore, should transport be any different? In order to address this issue,
we need to first introduce the basic idea of an externality using non transport examples before
applying this to the transport context. This is because the arguments that surround the payment of
subsidy for transport services are equally applicable to any other good or service, transport is no
different or no ‘special case’ with regard to this issue.
Externalities
We have come across externalities several times before in this text; however, it is one of the main
reasons for paying transport a subsidy. To quickly recap, externalities are often called ‘spill-overs’
and occur when the costs of producing a good or service fall not only on the producer of that good
or service but also on others that are not involved in the activity in any capacity. The full cost of an
activity therefore can be divided into two categories. Firstly, private costs, which are those that
fall on the producers or users of that product, and secondly public costs, which are those costs
that fall on others who are not involved in the activity and consequently do not benefit from it. The
full cost, i.e. private and public costs, is normally referred to as the social cost.
External costs and over production
The main implication of externalities is that they are not taken into account when individuals make
private production and consumption decisions, as only the private costs of that decision are
considered. In terms of an external cost, this leads to over-production of a given good or service,
as illustrated in Figure 11.1.
As only private decisions are taken into account in this market, the market would be in
equilibrium at point b with a market price of PPRI and quantity traded given by QPRI. When
externalities are brought into the analysis, however, in this case an external cost, the effect would be
that the supply curve should be further to the left,1
as now all costs are brought into the analysis.
Hence the market should be in equilibrium at point a, with a higher market price (PPUB) and lower
quantity traded (QPUB). This is a case of over-production, as not all of the costs associated with this
good or service are taken into account in the production/consumption decision.
251
TRANSPORT SUBSIDY
External benefits and under consumption
Externalities however not only work in relation to costs, but there may also be benefits that are not
registered in the market place. For example, if an individual chooses to undertake a programme of
physical fitness and also changes to a healthy diet, then a number of benefits will arise. Most of
these will accrue directly to the individual concerned, but others in society will also benefit from
the individual’s new healthy lifestyle. Firstly because of their actions they will probably be less of a
drain on health resources and consequently less of a drain on the tax resources used to pay for
those health services. Secondly, the individual’s employer will benefit in the form of less days off
sick and a more ‘wide awake’ employee. These ‘additional’ benefits are shown graphically in
Figure 11.2.
Figure 11.1 Over production due to an external cost
Figure 11.2 Under-consumption due to an external benefit
252
TRANSPORT SUBSIDY
As above, if only private decisions are taken into account in this market, the market (in this case
for exercise and healthy diets) would be in equilibrium at point a, with a market price at PPRI and
quantity traded given by QPRI. When externalities are introduced into the analysis, however,
because in this example these are benefits that are not taken into account by the individual, this
would have the effect of increasing demand at each and every price. This is because there is a higher
level of common utility (benefit) than is being registered in the market place by private individuals.
Once these are taken into account, the market demand curve should be further to the right. Hence
when all benefits, both private and public, are taken into account the market price should be higher
(PPUB) and the quantity traded higher (QPUB). This is therefore a case of under consumption, as not
all of the benefits associated with this good or service are taken into account in the production/
consumption decision.
Both over production and under consumption are cases of market failure, as the presence of
externalities breaches one of the conditions of perfect competition. Thus the market does not find
the ‘right’ answer in terms of production and consumption decisions. Hence in the first case more
is produced than is optimal and in the second less is consumed than should be (note however that
over production equates to over consumption and vice-versa). Also note however that virtually all
goods and services to a greater or lesser extent have an externality associated with them. For
example, even a simple chocolate bar may provide a benefit to the person eating it but not to the
person sitting next to them who is on a diet! The presence of externalities on their own therefore
are not sufficient to justify the subsidisation of transport services; however, the issue is the extent
and far reaching consequences of such spill over effects.
The economic rationale for the subsidisation of transport services
Outlined below are the main economic criteria that support the idea of payment of a subsidy for
transport services. All however are related to the idea of market failure, where the market as such
is either providing too much (over production) or too little (under consumption). Correction of
such market failures is the strongest rationale for the payment of subsidy, and as highlighted in
Chapter 10 this is primarily on the basis that two ‘wrongs’ make one right. More precisely, where
a second breach of the conditions of perfect competition in the form of government intervention is
‘justified’ in order to compensate for the effects of a first breach in the form of the presence
of externalities. The following economic criteria should also move away from the idea that subsidy
is paid simply because transport firms are inefficient or ineffective. Such views are still a hangover
from the 1970s where industrial problems were widespread and many key industries and
employers effectively bailed out by government due to financial difficulties. This led to a general
perception that subsidy equated to inefficient operations. Supporting inefficient operations however
is not one of the criteria for the payment of subsidy, the four main ones being:
In support of land use efficient modes of transport
Some forms of transport are far more land use efficient than others. The private car for example
is said to take up some 30 metres of land space per vehicle. Whilst in many occasions this may not
be a major issue, there are certain areas and certain times where such inefficient use of land does
create major problems, commonly known as traffic congestion. Where such instances arise,
253
TRANSPORT SUBSIDY
authorities have basically two choices. Firstly, they could penalise users of the land inefficient
modes of transport through some form of tax. That however may have certain political drawbacks.
Alternatively, they could attempt to make the alternative land efficient modes of transport more
attractive to car users. This could either be in the form of directly reducing the fares charged,
hence directly subsidising the services, or through increasing the quality of the service provided.
This may be either through increased frequencies, hence again a direct subsidy on services, or
alternatively through the quality of the vehicles or the reliability of the infrastructure on which it
runs, hence subsidy would be used to encourage investment. Subsidies therefore can come in the
form of supporting the service or in providing financial support in investment in the service,
commonly known as capital grants.
To lessen the impact of environmentally unfriendly modes of transport
Not only are certain modes of transport less space efficient, but as illustrated in Chapter 9 some
have a far larger impact on the environment than others per passenger journey or tonne of freight
hauled. This is one of the major externalities associated with the use of the private car and road
haulage in the carriage of freight. As regards the solutions, these are almost identical to those
outlined above for land use purposes, hence in simple terms either tax the more environmentally
unfriendly forms of transport and/or subsidise the less environmentally harmful modes.
Both points one and two can be reinforced and explored further by the use of an example. Rail travel
is known to possess an external benefit, or to be more exact, both an external benefit and avoidance
of additional external costs. Those using rail services are not using private transport, therefore road
users directly benefit through reduced congestion, faster and less stressful journeys and a reduced
number of accidents on the roads. These are the direct external benefits of rail travel and all relate
to the land use issue. However, the train also reduces the overall impact of movement, and more
exactly private transport, on non road users for the simple reason that many who need to travel are
using the train and not the car. Thus the external costs of private motoring on non users, such
as noise, pollution, intrusion etc, are reduced because people are using the train to travel. The train,
as such, would therefore be a case of under-consumption, as it is valued only by those that directly
use the service, not by those that also benefit but whose benefits are not registered in the market
place.
To support economic development or regeneration of an area
As outlined in Chapter 2, transport can be viewed as the vital component in promoting and
sustaining economic growth. This relates to both enhancing the quality of the transport network
and also maintaining existing services at a desirable level. Whether a demand-led or supply-led
view is taken of the relationship between transport and economic development, economic
development is normally associated with improved or upgraded transport links and services. There
may be a political responsibility to take such projects forward; however, there are other reasons as
to why this provides an economic rationale for the subsidisation of transport services. These mainly
surround the idea of what are known as public goods, which we examined in Chapter 1. In this
example, no single individual or firm is ever going to finance the upgrade of transport services into
a particular area on economic development grounds. This is because (a) it probably could not
afford to do so entirely on its own and (b) once the services were upgraded it would not be the
254
TRANSPORT SUBSIDY
only firm to benefit from the improvements because of the free rider problem associated with
public goods. In this particular case, therefore, the payment of subsidy may be justified on economic
rationale grounds on the basis that such an upgrade of services and/or transport infrastructure will
boost the local economy. All individuals in the area will therefore benefit from this improved
wealth and the aggregated level of ‘benefit’ will be greater than the level of subsidy paid. This is a
topic which is developed further in Chapter 14 on Transport Appraisal.
To support socially necessary services
Grouped under this heading are a range of social considerations which can be commonly regarded
as issues concerning equity. Not everyone in the country either owns or has access to (as a driver
or as a passenger) private transport, i.e. the car. The 2004 National Travel Survey (DfT, 2004) for
example showed that 20 per cent of individuals that were 17 or over lived in a household with no
car. Car availability was found to be strongly related to income, with 47 per cent of those on the
lowest quintile living in a household with no car compared to a mere 8 per cent in the highest
quintile. Furthermore, 50 per cent of single-parent families did not have access to private transport.
Even these figures tend to underestimate the scale of the problem because an individual may
live in a household that does have a car, but it may be in constant use by other household members
and hence access may still be a major issue. This may be a particular issue in rural areas.
In today’s modern society, Barr (2004) views transport as a ‘participative requirement’, i.e. it
is required in order to fully participate within society. Education is a similar need, where a lack of
education will not kill you but it may make it difficult to ‘get on’ in the world. Contrast this with
an ‘absolute requirement’, which relates to food, shelter and health services. These are the basic
necessities required to sustain life, without access to which you simply could not survive. With a
participative requirement, however, the basic assumption is that some kind of minimum standard is
required. In other words, not everyone requires an Oxbridge education and a Ferrari but rather
requires access to some minimum level of provision. With regards to transport needs, public
transport fulfils this role. Many instances exist however where the very nature of these transport
operations means that they cannot be operated on a commercial basis. This would therefore be
termed a ‘socially necessary’ service and provides the rationale for the payment of subsidy, i.e. to
provide some minimum standard of living.
Some may question however whether the provision of a socially necessary service should be
listed under an economic rationale for the payment of subsidy, as essentially this may be viewed as
a purely political decision, and one based on maintaining the social fabric within society. Thus for
example it could be argued that within a civilised society all its members should have access to a
reasonable level of transport provision to enable them in turn to access their work, shops,
recreation and various other activities considered as essentials. That in essence would be the
political argument and furthermore that ultimately, it is politicians and not economists who decide
which transport services should be provided and which should not. The economic argument
however would surround the issue of equity (not to be confused with equality), and in particular
the equity of opportunity. Wealth-creation opportunities, such as employment, should be open to
all and thus those best qualified are those that benefit the most. Furthermore, if the best qualified
attain such positions, this will also have wider economic benefits. Transport depravation should not
debar such a process from taking place.
255
TRANSPORT SUBSIDY
As regards specific services that relate to ‘socially necessary’, this normally refers to the
provision of public transport in socially and economically deprived and/or rural areas. As seen in
Chapter 2, there is a very high level of correlation between the level of GDP and the level of
passenger transport. Whilst that relationship related to the whole of Great Britain, it also exists at a
regional, local and district level. Hence within economically deprived areas, the demand for
transport services tends to be far lower than in more prosperous ones. If left to the market,
therefore, very few transport services would be provided. The perceived danger is that the lack of
transport will only worsen the problems facing the area. Whilst extreme, this could almost be
termed the ‘ghetto’ syndrome. Transport services therefore need to be subsidised to assist in the
development of such areas and prevent a massive imbalance appearing between the ‘haves’ and the
‘have nots’ within society.
With regard to the rural transport problem, most services are provided on the basis of socially
necessary services where transport is supplied on the grounds of basic accessibility. It thus gives
those that do not have access to private transport a minimum level of transport provision. This is
even more acute in rural areas that are particularly remote. Thus for example the island communities
off the west coasts of Scotland and Norway simply could not be sustained at their present
population levels if ferry services were not subsidised. Faced with the full cost of transport to the
island, many important economic sectors, particularly tourism, would be severely affected and
the cost of living would also increase significantly as goods and services brought over from the
mainland paid the full transport cost. This would almost certainly lead to a massive depopulation
of the islands, especially of those on medium and lower incomes. This is a classic example of a
‘socially necessary service’, where without the service the local society would simply disintegrate.
INTERVENTION IN THE MARKET
In order to pay subsidy to correct for the market failures outlined above, subsidies from transport
authorities can either be ‘injected’ into the supply side of the market or the demand side, known
conveniently as supply side and demand side measures.
Supply side measures
A supply side measure is where the subsidy is paid directly to the operator, not the consumer. This
then enables the operator to supply a level of service that it would otherwise not have been able to
in the absence of the subsidy. Services that are provided as a consequence of supply side measures
are open to all potential users and not specifically targeted at or restricted to certain groups within
society. The direct effect of a supply side measure is to increase the supply of that service to the
market. This is illustrated in Figure 11.3, which is an extension of Figure 11.2 outlined earlier. You
may also notice that this is basically one of the answers to Exercise 3.1 in Chapter 3.
In Figure 11.3, prior to the payment of a subsidy then as in Figure 11.2 the market is in
equilibrium at point a with a market price of PPRI and a quantity of QPRI. As illustrated, however,
due to an external benefit the ‘true’ market value, i.e. when all costs and benefits are taken into
account, would be at point b with a quantity traded of QPUB. In order to correct for this market
failure, one option for the transport authority is to increase the level of supply so that the market
256
TRANSPORT SUBSIDY
will be in equilibrium with a quantity QPUB. Using a supply side measure, this it does through
the payment of a subsidy to transport operators, hence producing a shift in the supply curve from
S = MC to S = MCSUB. The market would therefore be in equilibrium at point c, with a quantity
traded of QPUB. The difference in the prices between PPUB and PSUB is the effect of the subsidy, with
the state effectively paying the operators the value of the external benefit. Note also that the extent
to which subsidy impacts upon either reducing fares or increasing the level supplied will be
dependent upon the elasticity of demand. Where demand is inelastic, the effect will be to mainly
reduce the price with little impact upon the quantity traded. In markets with elastic demand on the
other hand, most of the impact will be on quantity with little effect on price. This has major
implications on transport markets, where as seen in Chapter 4 demand for most transport services
tends to be inelastic. This is one of the reasons why it is very difficult in general for authorities to
produce a modal shift from the car to public transport services using subsidies alone, as the biggest
impact is on the price and not on quantity demanded.
Note finally in this example, although an external benefit was identified as a demand side
problem (under consumption), the easiest ‘solution’ in most cases is a supply side measure (pay a
subsidy to operators).
Demand side measures
In theory these are far more straightforward, as a demand side measure is used to correct for a
demand side market failure and exists where specific groups or individuals are ‘targeted’ to receive
the subsidy. Unlike supply side measures, therefore, these are not open to all. In effect the
individual is given a ‘concession’ (a reduced fare) to use a transport service, either public or
private, but in reality most if not all concern some concession on the use of public transport. This
usually requires some proof of entitlement to the reduction and should not be confused with
commercial initiatives taken by operators such as the Young Persons Railcard. These are a form
of price discrimination and are offered purely for commercial purposes to fill spare capacity.
Concessionary fares are given to individuals that the state has decided should receive some
Figure 11.3 Subsidy to operators to correct for under-consumption
257
TRANSPORT SUBSIDY
form of discount on their travel needs. These are normally taken on social inclusion grounds and
are specified at the minimum level. Whilst in theory the ideas behind concessionary fares are
straightforward, the practice of actually bringing such schemes into operation are far from straightforward
and the situation in Britain is considered further in Case study 11.1 below.
Case study 11.1 Issues surrounding concessionary fare
reimbursement
Perhaps the most common form of demand side measure found in transport markets are
concessionary fare schemes. Within the UK, this type of subsidy has seen considerable reform
over recent years, which partly reflects the devolved nature of government in the UK. The
original Transport Act 1985 allowed for voluntary concessionary fare schemes to be operated
for the elderly and registered disabled, thereby leaving it entirely up to local authorities to
specify their own schemes for these two groups, including the option of not having one. Local
authorities would then allocate a budget that was available to run the scheme. This led to
considerable variations between different local authority areas regarding the level of actual fare
concessions given, with Scottish local authorities tending to be more generous than their
English and Welsh counterparts.Most schemes consisted of either the purchase or the free issue
of a pass that entitled the holder to some form of discount on bus travel,but not on train services
– as highlighted in the main text, any rail schemes that did exist were entirely on commercial
grounds. The actual concession was either set at a straight flat fare irrespective of distance
travelled or some form of percentage discount on the full fare.Hence in the Glasgow area,those
entitled to the scheme applied for a free bus pass and then paid a flat fare of 25p on all bus
services,whilst in West Berkshire a free bus pass entitled the holder to a 50 per cent discount.A
final example was in Darlington, where entitlement holders could pay an annual flat charge for
the pass, £80, which then entitled them to free travel in the Darlington area and half fare in the
outlying rural districts. These arrangements remained in place until the devolution of political
power to a Welsh Assembly and a Scottish Parliament, with transport being one of the devolved
powers. Wales was the first to introduce an area-wide free concessionary fare scheme in April
2002, covering essentially all of Wales. Scotland followed with first a free travel scheme within
local authority boundaries and then a nationwide free concessionary fare scheme that allowed
the crossing of local authority boundaries.England followed suit in 2006 with a free local travel
concession and then a national scheme in 2008. As can be seen from Figure 11.4, the move to
free travel concessions has led to a significant increase in the level of subsidy paid through these
initiatives.
Until the last few years shown, there had been a fairly constant pattern in concessionary
fare reimbursement. The general trend in the early part of the period shown was upwards, but a
squeeze on local authority finances in the early 1990s led to a decrease, although differences
are relatively small and the figure hovered around £600m in 2008 prices. The sharp increase in
the later years is entirely due to the introduction and expansion of free concessionary fare
schemes throughout Britain, firstly in Wales (in 2002), then Scotland (2003 and 2005)
and England (2006). In Wales the annual subsidy rose from £14m in 2001/2 to £38m by
2004/5, and in Scotland from £39m in 2001/2 to £92m by 2004/5. The final year shown is the
258
TRANSPORT SUBSIDY
impact of the free local travel English scheme,which led to a 42 per cent increase in the level of
concessionary fare reimbursement.
How these schemes are administered is a confusing and far from straightforward matter,but
in many ways tie in closely with the economics of bus operation. There are a number of ways
such schemes could be operated:
a) As an entirely demand side based scheme where the concession holder pays the full fare
to the operator.The traveller would then reclaim all fares at a later date from the authority.
The problems with such an arrangement however are considerable and would almost
certainly render such a system unworkable.
b) A voucher or token system could be used, where tokens are issued to entitlement holders,
who would then use these instead of paying the fare.Prior to 2006,this was an option in the
Cumbria concessionary fare scheme and a number of other English counties.Operators would
then reclaim the loss of fares from the authority on production of the vouchers received.
Such a system however would be open to exploitation, and thus would also require some
form of identification confirming that the user of the tokens was entitled to the concession.
c) The third option is a pass system, where the entitlement holder shows a pass on boarding
and the operator records the number of concessionary passengers. The operator is then
reimbursed for every recorded concessionary passenger carried.
As highlighted above, within Britain a pass system is used. However, how operators are then
compensated by the authority raises many issues. What complicates the process is that the
underlying principle is that the operator should be no better and no worse off as a result of the
scheme. In other words, company profits (or losses!) should be unaffected by the running of
the concessionary fare scheme. At first therefore the easy solution would appear to be simply
Figure 11.4 Concessionary fare reimbursement, 1984/85 to 2006/07, at 2008 prices
Source: Compiled from DfT Statistics
259
TRANSPORT SUBSIDY
to reimburse the operator for each concessionary fare passenger carried. For example, say a
50 per cent concession is introduced,and there is a hypothetical bus company that charges a flat
fare of £1, consequently those entitled to the concession only pay 50p. For each concessionary
fare carried,therefore,should the operator receive 50p as compensation for the loss in revenue?
The not so simple answer is no, due to the concept of ‘generated traffic’. The following examples
illustrate the idea of generated traffic and the process of operator reimbursement firstly
where a reduced fare is imposed and then where a completely free concession is introduced.
Figure 11.5 therefore shows the demand for bus services specifically from the sector of the
market entitled to the concession.
Beginning with the diagram on the left of Figure 11.5, this is the situation prior to the
introduction of the concession. The operator charges the full fare, PM, and at that fare the
quantity demanded for this sub group is QM. All revenue accrues directly to the operator. Once
the concession is introduced, however, the fare falls to PCF in this market sector, i.e. 50 per cent,
and sector demand increases to QCF. QCF – QM therefore represents the additional travellers who
did not travel before and this is known as the ‘generated traffic’. These individuals are now
paying the operator the concessionary fare, in this case 50p. These extra 50ps therefore are
fares the operator had not received before and are due to the increase in bus use, or generated
traffic, brought about by the introduction of the concession. This represents a net gain to the
operator’s revenue and needs to be taken into account in any fare reimbursement. The loss in
revenue on the other hand, i.e. those concessionary travellers who would have travelled at the
full fare, is shown by the area mapped out by PCF, PM, a, c. It should be clear now that the
amount of compensation due to the operator would be the loss in revenue minus the revenue
gain from the generated traffic,i.e.area PCF,PM,a,c minus area QM,c,b,QCF.There is however a
further complication.This would still not leave the operator no better or no worse off as there is
an additional cost connected with carrying more passengers. This will generally slow down
boarding times and hence more buses may be required to maintain route frequency. The operator
therefore also needs to be compensated the extra costs incurred as a result of carrying the
generated traffic and this is shown in Figure 11.6.
Figure 11.5 Generated traffic
260
TRANSPORT SUBSIDY
Figure 11.6 shows the marginal cost, and these are shown by adding the line labelled ‘MC’
which for simplification assumes constant non varying economies of scale. Thus the operator
also needs to be compensated by the area QM,f,e,QCF in order to cover these added costs in order
to be no better or no worse off as a consequence of the concessionary fare scheme.
In practice operator reimbursement has caused much confusion and resentment amongst
operators as to what the actual level of ‘generated’ traffic should be, as may be imagined this is
difficult to determine and even more so with the passing of time. Furthermore as most of these
reduced fare schemes were only valid at off peak times, the expectation was that concessionary
travellers would only use spare capacity and thus marginal costs would be minimal. This would
still be the case however where no such time restrictions applied.
Even under a free concessionary fare scheme, the issue is still not straightforward as to how
much the operator should be reimbursed. In Figure 11.6, demand for the concessionary group
would now increase to point d and whilst the level of generated traffic will be significant,
the level of generated (operator) revenue will be zero. DfT guidelines (DfT, 2008) on the
introduction of the English national scheme gives the following measures that should be taken
into account in the process of operator reimbursement:
᭿ The average number of pass holders
᭿ The average bus fare for the concession group, or where this is not available, the
average bus fare charged
᭿ The expected fare reimbursement revenue
Figure 11.6 Generated traffic with marginal costs added
261
TRANSPORT SUBSIDY
᭿ The expected number of concessionary fare trips
᭿ The expected additional costs.
In order to determine the actual amount of compensation due, the critical elements of those
listed above are the average bus fare, the expected number of concessionary fare trips and the
expected additional costs, and this is illustrated in Figure 11.7.
After Figure 11.6, Figure 11.7 should be a lot more straightforward, as under a free scheme
there is no revenue accruing to the operator from the concessionary passengers. Hence in order
for the operator to be left no better or worse off than if the scheme did not operate, they should
be reimbursed the loss in revenue and the additional cost of the generated traffic, which is
simply given by area 0, PM, a, QM plus area QM, f, e, QCF. Nevertheless, the whole process of
concessionary fare reimbursement is still a messy area, as how the level of generated traffic is
estimated is by the use of elasticities of demand. Hence if we have the level of demand at a zero
price, QCF, which is simply the total number of concessionary trips, we still need to estimate
the level of demand at the market price, QM. This would be done by applying an appropriate
elasticity of demand value which then gives the level of generated traffic from which the
additional costs could be calculated.
Another major issue with such schemes only briefly touched upon above is the question of
whether it is ‘right’ that the reimbursement does not include some form of normal profit for
the operator? By using the average fare in the compensation, this means that it will include
operator profit,but only on the lost revenue,thus leaving the operator ‘no better or worse off’ as
a result of the scheme.Many bus operators argue that the full fare should be compensated on all
passengers carried, as in effect they are providing a service to the government in putting such
Figure 11.7 Concessionary fare reimbursement, free concessions
262
TRANSPORT SUBSIDY
schemes into operation. For example, in the case of socially necessary services, services are
operated on behalf of the government where operators will bid on the tender that will include
a profit element, as in simple terms they will not do it for nothing. Why therefore should
concessionary fare schemes be any different? The problem with full fare reimbursement however
is that operators could increase profits by simply increasing the average fare, hence the
level of reimbursement would automatically increase. This would be a particular danger where
there is inelastic demand and a high number of concessionary passengers. The compromise
solution would be to agree some rate, and this indeed is the case in Scotland and Wales, where
all operators receive a flat rate of 73 per cent of the average full fare for each concessionary
passenger carried. Rye and Carreno (2008) argue however that this is over-generous and thus
provides an indirect form of subsidy to bus operators, and furthermore that such negotiations
should be far more localised to reflect local bus market conditions. Nevertheless, regardless of
the form of compensation arrangements in place, concessionary fare schemes are critical to the
economics of the local bus market – Rye and Scotney (2004) estimated that the revenue from
this market segment accounted for around 20 per cent of bus operators’ revenue, and that at a
time prior to the widespread introduction of free concessionary schemes.
All of the grey areas outlined in this case study are the main reason why such schemes tend
to be limited in scope and there is far more reliance on supply side measures.The actual costs of
administrating such schemes tend to be very high and thus should only be implemented where a
true ‘need’ exists. It also highlights the problems when involving the private sector in public
transport (i.e. a follow on from Chapter 10), as in the days of public ownership bus operators
could simply have been ordered to carry concessionary travellers and the whole reimbursement
process included in a single budget.Furthermore,given the criteria of ‘no better or no worse off’,
the success of such schemes in meeting the targeted group are very much dependent upon
market forces.If there are insufficient numbers of full paying passenger to support a bus service,
then it will be cut, even if it is carrying a high level of concessionary travellers as they in theory
do not contribute to operator revenue.In a deregulated transport market,this is always going to
be the case with demand side measures, as those targeted can only use the services that are
available, which in this case are in the main only those that can be sustained commercially. The
fallback position of course is that if cut, the service could then be subsidised by the local
authority by being deemed to be a socially necessary service. This clearly shows the areas of
cross over between demand-side and supply-side measures in the support of transport services.
That is, target specific groups through demand-side measures, and then ensure that a satisfactory
level of transport provision is available to such groups through supply-side measures.
Drawbacks of paying subsidy
As highlighted in the introduction, there are many more issues that surround the actual payment of
subsidy than subsidy itself. Most, if not all, agree it is a ‘good thing’; however, most if not all
recognise that there are many issues that need to be considered first before supporting transport
services in such a manner. There are thus several potential shortcomings from an economic
perspective when subsidy is paid. In this short section the four main drawbacks of paying subsidy
are outlined, although there are many more.
263
TRANSPORT SUBSIDY
It is always a second best solution
As we saw with regulation in the previous chapter, the payment of subsidy to a transport operator
to provide a service is what is known as a second best solution. The best solution is always
provision of the service by the market under the conditions of perfect competition. When subsidy
is introduced into the market, however, this will usually be accompanied by some form of regulation
in order to specify the conditions under which the subsidy is paid. With regulation comes the
associated added costs of the additional bureaucracy needed to measure and monitor performance.
The payment of a subsidy also interferes with the market signals generated by the forces of demand
and supply. In a free market situation (and again assuming perfect competition), the market will
ensure that the ‘right’ services are provided in the ‘right’ quantities. If consumers desire more of
one type of service over another, then demand for the former will rise and for the latter fall. This
will be signalled to producers through the price mechanism and they will ensure that more of the
former is provided. When subsidy is paid however this interferes with that process and it becomes
dependent upon accurate forecasting and planning in order to ensure that subsidy is used where it
is most needed. This procedure will never be as efficient as the market, although note that it should
be more effective.
Can lead to inefficient operations
In many ways, this is the most often cited case against paying a subsidy. The basic idea is that
because the organisation is not working to strict market principles (i.e. primarily survival of the
fittest), then costs are not as low as they should be. This is the x-inefficiency argument again. As a
result, public subsidy is used to support inefficient operations rather than providing the service for
which it was intended. Those more astute readers will realise that it is very difficult to isolate the
subsidy component in such an argument, as in most if not all cases such subsidises will be provided
in a monopoly type situation. In other words, if one operator cannot make a normal profit out of
such operations then it makes little sense subsidising two!! Hence it is very difficult to split
inefficient operations as a result of paying a subsidy or as a result of being the monopoly provider of
services, and as highlighted, the two are invariably linked.
Whilst the general perception is that paying an operator a subsidy will lead to inefficiencies, is
there any evidence to support that general view? Most research on the topic has indeed found that
operators with higher levels of subsidy tend to be less efficient, although one problem in this
research area is that some transport operations by their very nature are technically inefficient to
provide, hence require subsidy. A classic example would be a rural railway, where frequencies will
be low but the necessary inputs, particularly the infrastructure, relatively high. There is thus a
problem of the direction of causation, where in many cases it is the inherent inefficient nature of
operations that requires higher subsidy in order to sustain the service, i.e. inefficient operations,
rather than higher subsidy sustaining inefficient management. Whilst most research has found an
inverse relationship between subsidy and productive efficiency, several other factors have been
found to impact upon that basic underlying relationship. For example, research on US public
transit operators (Pucher et al., 1983) suggested the source of the subsidy was an important
factor in this relationship: federal subsidies had a large adverse effect on productivity whilst state
subsidies had a small positive effect. This suggests that the nearer the transport authority is spatially
264
TRANSPORT SUBSIDY
located to the operator then the better targeted the subsidy can be on the use for which it was
intended. It is thus less likely to result in productive inefficiencies. Other US research (Karlaftis
and McCarthy, 1998) also found that the size of the firm was an important determinant. Larger
firms were more vulnerable to the effects of higher subsidy levels on efficiency than smaller firms,
with the source of the inefficiency being specifically x-inefficiency. Further studies (Sakano et al.,
1997) have also suggested that the source of the inefficiency is related to over-staffing, with those
firms with higher subsidy payments tending to employ unnecessary staff.
Understanding these basic underlying factors is important in ensuring that subsidy is used for
the purpose for which it was intended, rather than resulting in productive inefficiencies. This
whole area of research, however, whilst considerable, still has some way to go before this relationship
is fully understood, particularly in identifying the conditions under which paying a subsidy will
not have a detrimental effect on efficiency.
The winner’s curse syndrome
The idea of the winner’s curse is used in auction theory to explain why winning bids may be based
upon judgmental failures where the auction is ultimately won by the most optimistic valuation of
the auction’s item (Alexandersson and Hultén, 2006). Adnett (1998) further argues that winner’s
curse is more prevalent in tendering situations where the number of bidders is low and inexperienced
in the first round of tendering. In terms of the payment of transport subsidy, the idea of the
winner’s curse is highly relevant, particularly with the general movement towards competitive
tender. In these situations, the transport operator would bid for potential transport contracts based
upon market information, and this information would tend to be optimistic in its forecasts of the
potential market. The winner of the contract therefore would be that operator with the most
optimistic revenue figures, hence, all else being equal, requiring the lowest subsidy to operate the
service. The net result would be that when successful, the winning bidder would find out the
optimism of their forecast and encounter losses on the service (hence the idea of a winning curse).
For the transport authority, this would at first appear to be a beneficial situation, as basically they
have secured the service at a lower price than would have otherwise been the case. The problem
however is that such an argument completely overlooks the very the strong position of the
incumbent operator. In a worst case scenario the operator would go out of business due to the
losses being incurred, at best look for an early termination of the contract or finally they would
provide the required services to the very minimum of standards with a danger of defaulting on the
contract. Experience has shown that all of these scenarios are entirely unsatisfactory. In all
instances the authority would either be faced with or potentially be faced with refranchising the
service. The refranchising process would not only incur an added cost but would also undoubtedly
end with the authority paying a higher price for the contract. What usually happens therefore is
that the contract is re-negotiated with the existing operator being paid higher levels of subsidy, as
that is the lower cost option. There is strong evidence that this was the case with many of the
British passenger train operating companies (Cowie, 2009), which resulted in significant increases
in subsidy at the time of contract extensions. The real problem with the winner’s curse is that it is
not the ‘best’ or most efficient operator that wins the contract, but rather the one with the most
optimistic bid, but that it is the authority that ultimately has to address this problem. In simple
terms, even as a second best solution this is not market efficient in any sense of the word.
265
TRANSPORT SUBSIDY
Subsidise a service that doesn’t actually need a subsidy
This drawback in some ways is a bit unclear, as many proponents of public transport would be of
the view that all public transport services should be subsidised, even where a financial profit could
be made. Such a view would be based on the premise of market failure caused by externalities
(particularly public benefits) resulting in such services being undervalued by the market (see
Figure 11.2). Therefore, accepting a political view that only loss-making services should be
subsidised, the fourth and final drawback in paying a subsidy is that it may lead to the subsidisation
of a service that on strictly financial criteria grounds does not actually need a subsidy to operate
profitably. Hence rather than being used to provide an essential service, the subsidy is being used to
bolster the operator’s profit and increase the shareholder’s dividend at the end of the financial year.
The opportunity cost of these increased dividends therefore is the necessary service that is not
being provided, and hence such measures are highly regressive. Undoubtedly having a two-tier
system, where some services are subsidised and some are not, will affect operators’ behaviour in
transport markets. There is for example some circumstantial evidence of operators in Britain
withdrawing a marginal service in the knowledge that the local authority would have to re-instate
that service with the incentive of paying a subsidy. This in many ways is a consequence of a second
best solution, because under a highly competitive market such an occurrence simply would not
arise as the market would regulate itself.
As with point 2 above, there is far more to this argument than the simple provision of a single
service and whether or not it requires subsidy. One factor such an argument overlooks is the
systematic nature of public transport networks, and the extent to which one service ‘supports’ the
whole system (note, not to be confused with cross-subsidisation – see below). This is best
illustrated in the case of the Beeching closures on the British rail network of the 1960s. It has been
argued by Henshaw (1995) that closure of branch lines led to a reduction in patronage on the lines
to which they fed into, and thus those lines then became vulnerable and eventually closed. Public
transport networks should therefore be viewed as complete systems and the contribution to
overall revenues not based purely on whether each individual service covers its full costs or not. A
further complication arises as many transport services have shared costs, such as maintenance
and administrative overheads, hence how these are apportioned between the various services will
determine the extent to which services are profitable or not.
OTHER ISSUES SURROUNDING TRANSPORT SUBSIDY
We end the chapter with a look at some other issues surrounding the payment of transport subsidy.
The second, actual methods of payments, outlines the methods open to the authority for the
payment of transport subsidy; however, the first issue considered, cross-subsidisation, also relates to
how subsidy is paid. In simple terms should it be paid for a group of services which in total fail to
make an economic return or should they be subsidised individually?
Cross-subsidisation
Cross-subsidisation occurs where the profits of one route or service are used to pay for the losses
on another route or service. Why this idea is covered here under subsidy is that cross-subsidisation
266
TRANSPORT SUBSIDY
has often been used in the past as an alternative to a transport authority paying an operator a
subsidy, or has been used to at least reduce the level of subsidy to be paid. This is particularly true
of local authority owned and run bus companies, where the profits from high-density well-defined
bus routes were used to recover some of the losses from little used low-density routes, hence
reducing the overall reliance on subsidy.
In some ways, and to the general public at large, cross-subsidisation appears to be a ‘good’ thing.
This is because there seems to be some balance in such a system where profits from one part of
the operation are used to cover losses in another. As such, the system would appear to be selfcontained,
and where wholly cross-subsidised, the system entirely self-funded with no reliance on
public subsidy, i.e. tax payers’ money. Furthermore, in a regulated transport market where an
operator may be protected from competition through the regulatory system, then it may seem only
‘fair’ that in return for this regulatory protection the operator sacrifices a part of their profit to
provide some unprofitable routes for the authority.
The biggest argument against cross-subsidisation, however, particularly from an economist’s
point of view, is that it hides the true costs of providing a particular service. If profitable services
are used to support loss-making routes, then the true costs of providing these services is completely
hidden. In turn, if the true costs are not known then there is no way to judge if those routes
are worth supporting or if the money could be better spent on other transport services. Direct
accountability is therefore lost, which can lead to bad decision-making due to incomplete and
aggregated data.
A second argument against cross-subsidisation is that rather than the operator being ‘penalised’
by using potential profits to fund loss-making routes, it is the users of the profitable routes that are
being ‘penalised’ as they are paying for the users of the poorly used routes. This may well be a
regressive measure, particularly given that some of the high-density routes may serve less prosperous
areas, nevertheless the fares facing those individuals will be higher than they would otherwise
be. As a result, the market as such is not as efficient as it should be. More may well use profitable
services if fares were reduced to reflect their true market value, and hence it is also those potential
users that are also paying for unprofitable routes. In many ways, therefore, cross-subsidisation is
again in the realm of second best solutions, in which market signals are distorted by such measures.
Importantly, however, in this case the best solution (i.e. the market) is an option that is available
but simply not taken.
A final argument against cross-subsidising transport services is that there are other and better
measures and policy instruments available to ensure that necessary services are provided to those
that need them. Why should, for example, the users of profitable bus routes pay for the users of
non-profitable bus routes whilst car drivers make absolutely no contribution? Or put the other way
around, why should those dependent upon loss-making routes be reliant upon users of profitable
bus routes for their bus service? What happens if bus patronage falls and the number of lossmaking
routes increases, are the number of bus routes cut? If a transport service is deemed to be
a social necessity but is a loss maker, it should be the whole society that pays for the provision
of that service, not just those existing users on profitable routes. This relates to the argument
that transport should be provided on the basis of need rather than financial means. The ‘best’
mechanism for doing this is through the tax system, as this takes a far wider view than simply
concentrating on the users of the system.
Other instances arise which may be confused with cross-subsidisation, where a loss-making
267
TRANSPORT SUBSIDY
route is continued but it can be justified on purely economic grounds. This can occur where there
are short and long run factors or network effects present. In the first case, a route may be covering
its short run costs but is returning losses as it is not covering the capital costs. In such instances, it
makes economic sense to continue the service in the short run but when it comes to replacing the
capital stock to then withdraw it. This is because in the short run the route will be returning a
profit; however, the future return could never justify the investment required to continue operating
the service. The second instance may be where an individual route is making a loss; however, in
total it is adding to profits through network effects. This is because the service is making a positive
contribution to the network as passengers brought in are then using other services in the network,
hence if the route was cut these passengers would not use the service. Neither of these instances
however should be confused with cross-subsidisation.
Methods of payment of subsidy
Today transport subsidies increasingly come in the form of a contractual payment for a service and
may be applied to a specific route or a batch of routes or network. Where these are paid to a private
sector operator, this would normally be in the expectation that the operator could provide the service
at a lower cost than a publicly owned firm and that cost savings would more than offset the operator’s
profit from providing the service. Consequently, the total cost (i.e. subsidy) to be paid by the
transport authority would be reduced; however, practice has shown that this has not always been the
case. Moreover, such methods of subsidy payment are not the only ones open to transport authorities
and outlined below are the five main methods used to pay subsidy to transport operators, irrespective
of if the operator is publicly or privately owned. These virtually all concern supply side measures
used to provide a service where one would not exist under free market conditions.
Deficit subsidy
This is the simplest form of subsidy and as suggested by the name, this is where the authority pays
the difference between the revenue received from the service and the cost of providing that
service. In the past these have been in the form of open-ended subsidies, where the authority
covers the size of the deficit irrespective of how large that subsidy is. Increasingly, however,
authorities have moved to a form of an allocated or negotiated budget. In many respects these
forms of subsidy are consistent with the traditional view of the nationalised operator where the
operator is allocated a budget, usually on an annual basis, to provide public transport services.
Being publicly owned, the operator would be expected to provide the service in the public interest
rather than for profit and hence break even (after the payment of subsidy) at the end of the year.
This could be paid either through a straight allocation, as happened in the pre 1985 Transport Act
with local authority bus operators/departments, or alternatively through negotiation. Many, if not
most, of the Swiss independent railways operate along similar principles, where the standard of
services to be provided is agreed and an annual budgeted figure negotiated.
The modern day equivalent of the deficit subsidy is what is known as a management contract. In
simple terms, this is where a transport operator will run the service for a transport authority and
then invoice the authority for the cost of running that service. This will consist of the difference
between passenger revenue and operating costs in addition to a management fee. This will be
268
TRANSPORT SUBSIDY
subject to a negotiated budget beforehand and may be put out to tender. Such contracts may be
used where there is a high degree of uncertainty involved, both in terms of future demand and
future production requirements, and hence no operator willing to take on the business risk.
Net cost contract
Under such agreements, the operator in effect acts as a sub-contractor to government to provide
transport services within a given area. This also reduces cross-subsidisation and produces greater
visibility as to the actual cost of providing a given service/batch of services. Such contracts are
normally for a set period of time, after which point the contract is then re-tendered. This basically
is the idea of the contestable market outlined in Chapter 7 and it is over the last point highlighted,
the length of the contract, that much debate exists. This is because the length of the contract
ultimately determines the extent to which the market is actually contestable. In order to increase
contestability, contracts should be for relatively short periods, because a short contract length puts
added pressure on the incumbent to provide the best service. Under such a scenario, if they fail to
perform then they can be replaced in a relatively short period of time or alternatively strong
performance will increase the likelihood of success in any imminent re-bidding. However, there
are several problems with short contracts. Firstly, the cost of having to re-bid the contract on a
regular basis becomes a financial drain on the money available to actually spend on the service.
Secondly, constant changes of operator may become disruptive in the provision of the service and
hence not represent ‘best value’. Thirdly, the longer the contract then the more likelihood that the
operator will invest in new vehicle stock and a general organisational investment in the whole
operation which may lead to a better understanding of users’ needs and improvements in the
service provided. The length of the contract therefore is a question of finding the optimum time
period that maintains the contestability of the market but does not discourage investment in the
service being provided. Due to the heavier investment requirements in the rail industry, this has
tended to lead to longer contracts in the provision of rail services than for bus services. In Britain
standard rail franchise lengths are seven years, whilst as seen in Case study 10.2 in Sweden it is
five. For bus services, however, experience from around Europe shows that local transport authorities
offer bus contracts in most instances for two to three years.
Full cost contract
Under a full cost contract the operator’s bid for subsidy is based on the full cost of running the
service or network specified by the transport authority. This is what was referred to as an
operational contract in Case study 10.2. Under such a contract, the fares charged are specified
by the authority but collected by the operator who then returns the revenue to the authority. The
net subsidy paid under such a contract by the authority is therefore the cost of the operator’s
contract less the revenue received from passengers. All revenue risk therefore rests with
the authority and none with the operator. The operator thus knows exactly how much they will
receive whilst the authority’s revenue is dependent upon patronage levels. As with a net cost
contract outlined above, such contracts will normally be for a set period of time, with the same
issues over short versus long contracts. Several of the British passenger rail franchises operate
under full cost contracts, Merseyside for example, whilst again as seen in Case study 10.2 both
269
TRANSPORT SUBSIDY
Transport for London and the Helsinki Transport Authority operate a system of full cost contracts
for the provision of bus services.
Design, Build, Operate and Maintain (DBOM)
DBOM contracts usually surround a major infrastructure project, such as the construction of a
light-rail network such as the Nottingham Tram or a new (relief) motorway, such as the M6 Toll
around Birmingham. Under these contracts, tenders will be based upon the price required to
design, build, operate and maintain the infrastructure over a set period of time. Due to the high
level of investment required, in most cases these will tend to be long-term contracts. The actual
price bid in most cases is the difference between the revenue received from the operation of the
service over the contract period minus the cost of designing, building and maintaining the system
during that time. Therefore, once the lump sum is paid, the operator will be expected to make a
profit out of the operation of the service (i.e. cover its short run costs). The revenue risk in this
case therefore is with the operator of the service. Once the contract is completed the ownership of
the infrastructure will return to the transport authority and then the contract re-tendered based
upon either a franchised subsidy contract or a full cost contract. This is how the first phase of the
Manchester LRT system (Metrolink) highlighted in the previous chapter was financed, where
Serco won a DBOM contract for 15 years’ operation. Once that contract expired in 2007, the
facility was then re-tendered with Stagecoach winning it under a fixed term management contract
(see above). Many other variations of DBOM contracts exist, however, for example in some
specifications the revenue risk remains with the authority or others specify only operate and
maintain. The distinguishing feature of these types of contracts is that the assets used in the
provision of transport services are ultimately owned by the transport authority.
As we have seen, the payment of subsidy to a transport operator has seen considerable reform in
the recent past, with several different methods and models of delivery (see Figure 10.4) introduced
in the process of reform. Case study 11.2 considers the success in introducing these reforms
into the provision of transport services.
Case study 11.2 Success in the payment of subsidy
This case study examines the actual mechanisms used in the payment of subsidy to support
public transport services and the evidence of success or otherwise of these different approaches.
As will become apparent from the case, in many instances how subsidy is paid can be dependent
upon what is ‘in vogue’ rather than being based on any objective criteria. One problem when
examining the different methods that have been used to inject subsidy into transport markets, is
that there is a danger it can dissolve into an economic history on the payment of subsidies to
transport industries. In this case, some historical background and precedent is useful, as how
subsidy was paid in the past in some ways shapes how it is paid in the present. Nevertheless, this
case will particularly focus on the movement away from open ended lump sum subsidies to more
contract-based approaches.
Subsidies have been around for many years in one form or another, although there has
always been differences regarding the extent to which the state should intervene in transport
270
TRANSPORT SUBSIDY
markets with the support of public finance. Even back in the 19th century many railways
around continental Europe were constructed with heavy state backing due to their
perceived strategic importance,whilst in Britain all railways were constructed using only private
finance (although required state legislative approval). Even within Britain, however, the idea of
subsidising transport services was not a completely alien notion.In the 1930s the big 4 ‘private’
railways received substantial payments from government and the ‘national’ airline, Imperial
Airways,was allegedly supported by an annual subsidy of around £1m (a relatively large sum at
the time) to support air services that connected the Empire. The subsidisation of transport
services however never really became a major issue until the 1960s when the last of the major
state railways, Swiss Federal Railways, fell into deficit for the first time in 1969. With the rise
of the private car, the financial viability of bus services also became increasingly marginal and
ultimately required subsidy to support existing networks. The US experience for example shows
that subsidy for public transport from all levels of government (local, state and federal) rose
from $318m in 1970 to $9.27bn by 1990 (Karlaftis and McCarthy, 1998).
The first form of subsidy payment used was deficit subsidy, where subsidy bridged the gap
between passenger revenue and the cost of providing the transport service. This was given
legislative backing by the then European Community with the passing of directive 1191/69 in
1969 that introduced the idea of Public Service Obligations (PSO). This recognised that there
were certain transport services (mainly bus and rail) for which the then largely state-owned
operators were ‘forced’ to operate but which would never make a viable economic return.
The directive required the relevant authorities to re-compensate the operators for such public
service obligations in the form of a lump sum payment. When Britain joined the EC in 1973, the
PSO was introduced into the railways by the Railways Act 1974, which required that the then
state-owned British Rail provide services ‘broadly consistent with that provided at the moment’.
In subsequent years this was generally interpreted as a level of train kilometres consistent with
that run in 1974 (British Railways Board,1988).The PSO was paid on the basis of a lump sum
subsidy for the whole of the British network. In the 1980s, however, under the Organising for
Quality initiative, BR was re-organised more along market-focused principles and thus the PSO
was split between the three passenger sectors of Regional Railways, Network South East and
Intercity, and negotiated annually. By far the largest part of the PSO was taken by Regional
Railways, which consisted of all non Intercity routes outside of the south east. The Intercity
sector however was set a target of zero subsidy, a position it duly achieved in the years 1986/87
and 1987/88, whilst the Network South East sector (NSE – London commuter routes) hoped
to reach a target of zero subsidy by the early 1990s. A major change in the economic climate
however brought about a major re-think, in which it was realised that the Lawson Boom of the
late 1980s had been the prime driver behind the strong performance of NSE. Consequently it
was also realised that NSE would always require subsidy if it was to provide a valuable transport
service to the London commuter network.
The first country however to adopt full market principles in the payment of subsidy was not
Britain but New Zealand, with full deregulation of bus services in 1983 and railway reform
between 1986 and privatisation in 1993.The first large land-based passenger transport market
to be deregulated however was the British bus industry. The topic of transport industry reform
has been covered in the previous chapter, hence this case study only concentrates on the reforms
in the payment of subsidy to operators. The Transport Act 1985 put an end to open ended lump
271
TRANSPORT SUBSIDY
payment subsidies and all services were expected to make a profitable return, even where
provided by a local authority company. The one exception, as noted previously, was that local
authorities could specify a service where none was provided by the free market on the basis of a
social necessity.This would then be put out to competitive tender,hence creating competition for
the market rather than in the market.The impact these reforms had on subsidy payments can be
clearly seen in Figure 11.8, which outlines subsidy payments in constant 2008 prices from
1976/77 to 2004/05.
Figure 11.8 shows the total subsidy paid for services for all of Britain up until 1984/85, and
then due to availability of the data, splits this between London and outside of London after that
period. The rise in the level of subsidy paid throughout the mid 70s and early 80s is very clear,
primarily caused not only by falling passenger numbers, but also a suspicion of decreasing
efficiency in operations. With the change in the system of subsidy brought in by the 1985 Act,
subsidy levels fell considerably,so that by 1990/91 for supported services outside of London the
subsidy paid to operators had fallen to almost 40 per cent of its previous level. This should not
however be taken as an indication of simply moving from an open-ended-type payment to a
contractual payment, as other reformatory principles were also put into effect, principally the
requirement that fares could no longer be directly subsidised by local authorities.
The British experience is fairly consistent with that in other countries. Most of the research
cited below comes from the Thredbo series of conferences on ‘Competition and Ownership in
Land Passenger Transport’ led by Professor David Hensher of the University of Sydney and
held biannually since the first conference in Thredbo, Australia, in 1989. This has been a major
forum that draws on a wide range of international experience for the discussion of reforms in
the organisation and operation of public transport services, including, of course, the payment of
subsidy. For example, Hauge (1999) found considerable savings in the subsidies required to
maintain Norwegian ferry links, where the introduction of competitive tendering on a limited
number of routes had led to reductions in subsidy, improved efficiency and a better organised
Figure 11.8 Public financial support for services, 1976/77 to 2005/06, 2008 prices
Source: Compiled from DfT Statistics
272
TRANSPORT SUBSIDY
transport ferry operation. The author also found some evidence however of winner’s curse.
Johansen (1999), in an examination of the Norwegian bus industry, found that the movement
away from net cost contracts, i.e. lump sum subsidies, to contracts based on cost norms and
competitive tendering had had a major impact on the bus market in Norway. The main findings
were that costs had decreased by around 20 per cent, the reliance on subsidy had fallen from
37 to 24 per cent and finally that the reforms had sparked off major restructuring of the supply
side of the industry. This had seen the number of bus operators reduce from 220 to 83 and
the emergence of two dominant operators through mergers and acquisitions who held around
40 per cent of the total market. Van de Velde (2003) not only found that the introduction of
market reforms had led to considerable supply side consolidations across a number of countries
examined, but also strong evidence of the ‘internationalisation’ of public transport operations.
This was no more acute than in Denmark,where two foreign-owned companies held almost twothirds
of the bus market. This had led to an upward trend in contract prices; however, subsidy
levels had stabilised at around 10 per cent under pre-reform levels.Finally Preston (2001),in a
review of bus and light-rail systems across Europe, estimated that the dependence on subsidy
for fully competitive transport markets, at 37 per cent, was considerably lower than for either
limited competition markets or fully regulated markets,where the level for both was found to be
53 per cent. Competitive bus markets also had costs per vehicle kilometre some 23 per cent
lower than limited competitive markets and 51 per cent lower than regulated markets.
Whilst the evidence would undeniably support the view that the move away from open ended
lump sum payments towards more competitive and public sector contract agreements has
considerably reduced subsidy levels, there remains a question mark and debate over how far
such reforms can be taken. There is clearly a limit as to how little subsidy can be paid before the
low finance levels impact upon the quality of the service provided. Paying low subsidy levels to
sustain a poor quality service with little patronage could never be described as ‘value for
money’. Considered opinion is therefore moving back towards the idea of negotiated contracts,
where in the first instance, the transport authority will re-negotiate the contract with the
incumbent operator.This overcomes the problems of the transaction costs of having to re-tender
the contract as well as what can potentially be a disruptive period as one operator takes over
from another. The evidence suggests that where such initiatives have been put into place, then
potentially the added advantages are that it can lead to less conservative approaches to the
provision of public transport services and contract renewal can be directly linked to key performance
indicators and appropriate benchmarks. Hensher and Wallis (2005) clearly see a
greater role for negotiated contracts under a particular set of circumstances.Namely,where the
incumbent is recognised as an efficient supplier, where a greater focus needs to be placed on
innovation to grow patronage and finally where incentives need to be provided to encourage the
required investment to support such activities. Around the globe, such circumstances are hardly
uncommon. Rather than the authority/operator as a contractor/contractee relationship, this
encourages far more of a genuine partnership arrangement between the authority and the
operator. Much debate and inconsistencies however remain over this whole issue. The European
Union for example require that in certain transport sectors all public service contracts over a
given threshold be put out to competitive tender irrespective of the circumstances facing the
particular transport mode.
This case has provided a review of the development and changing trends in the payment of
273
TRANSPORT SUBSIDY
subsidy and would appear to outline a clear evolutionary process in the structure of subsidy
payments.Starting from a simple open-ended lump sum payment,regulatory reform has tended
to move the operator towards a more market-driven focus and subsidy usually paid on a
negotiated or cost norm basis with clear ‘targets’ set. The next stage would be to introduce
competition for the market through competitive tender, where the market for the payment of
subsidy is ‘opened up’ to other operators. Research suggests however that whilst both these
regulatory reforms can produce considerable reductions in subsidy, these appear to be one-off
effects and are not continued into the medium to longer terms; in fact if anything, such trends
are reversed in subsequent rounds. Under such circumstances, therefore, negotiated contracts
may produce better results, where the authority negotiates with the incumbent, rather than
continue with a system of competitive bidding.
CHAPTER SUMMARY AND REFLECTION
This chapter has directly followed on from the previous chapter on regulation and ownership in
transport markets, and examined the issue of where the state directly funds transport operations or
investments in a specific location. It has considered the main issues surrounding this topic in the
form of the reasons for doing it and the associated drawbacks in doing so. Whilst this has generally
been from a ‘pro’ perspective, i.e. under certain conditions transport services should be subsidised,
alternative views do exist. For example Karlaftis and McCarthy (1998: 359) state that while
capital subsidies to transport industries can be justified on the grounds of achieving returns to
scale, ‘. . . there are no economic grounds for providing operating subsidies’. To a certain extent
such a view may reflect a far narrower definition of what constitutes ‘economic grounds’, as
‘revitalizing cities’ for example is considered as a social objective, but it is nevertheless a statement
that few would agree with. What we have seen in the course of this chapter is that the rationale for
the payment of subsidy mainly surrounds issues of market failure, thus in a mixed market economy
one of the roles of the state is to correct for such market failures. It cannot however correct for all
market failures, as the resources at its disposal are limited. It therefore has to ensure that when
such action is taken, the financial resources are used in the appropriate manner, i.e. to correct the
market failure, and are not wasted in the process due to inefficiencies. It is thus this second point
around which most of the issues surrounding subsidy revolve.
CHAPTER EXERCISES
Exercise 11.1 Options in the payment of subsidy
A transport authority seeks to produce a modal shift from the car to public transport services in
order to encourage local economic development and reduce traffic congestion. Outline in a variety of
diagrams the main options that are open to the authority to achieve this aim and come to a conclusion
as to which you believe to be the ‘best’ approach or combinations of approaches that should be used.
274
TRANSPORT SUBSIDY
Where subsidy features in your solutions, you should outline the main drawbacks that stand in the way
of a successful outcome and what measures you propose to take to minimise the impact of these
drawbacks.
Exercise 11.2 Which type of contract to use
As the recently appointed leader of your local transport authority, you are given a blank sheet of paper
with which to re-organise urban based public transport services in your local area. Assume that the
national legislation allows for any of the models of delivery outlined in Chapter 10 to be used, but
nationalisation is out of the question.
Using Figure 10.4,which related to ownership forms in the provision of transport services,consider
for each of the following scenarios which ‘model’ of ownership would be most suitable for the
particular situation:
A pro public transport council that has a strong policy stance on encouraging more people to usei
public transport.
A council that is facing possible budget cuts in the medium to longer term and seeks to reduceii
its budget for public transport services.
A council that is expecting strong economic growth in the medium and long runs and isiii
concerned that the current public transport provision, which is mainly bus based, will limit this
economic growth.
Where public transport services have been run directly by the local authority department,iv
however, the last ten years have seen a significant decline in patronage and low investment
levels.
Public transport services are currently run by private sector companies; however, the overallv
perception is of poor quality services that have seen significant passenger declines in the last ten
years.
A publicly owned and run urban rail metro that is badly in need of refurbishment; however,vi
budget constraints means that the local authority do not have the funds available to undertake
the investment required.
Then consider under what type of the following contracts should be used in delivery of these services:
a) Complete deregulation with contracts only for socially necessary services
b) Tender all services on a full cost basis
c) Tender all services on a relative cost basis.
Exercise 11.3 Blue bus company’s bid for a local authority contract
This exercise concerns the costing of a bid for a local authority specified bus service contract.The case
surrounds a local operator, The Blue Bus Company, that is a very traditional local operator with a
reputation acquired over a number of years for providing an excellent service. Blue Bus has won
several Local Authority contracts in the past. It has however recently experienced a small dip in its
share of the local market.
275
TRANSPORT SUBSIDY
The Contract
The contract is for a new route of 6 kilometres in length that will operate from 7am in the morning
(first service) until 7pm in the evening (last service) from Monday through to Saturday. Total annual
revenue is expected to be in the order of £85,000 and you should assume a 50 week operating period.
New buses will have to be purchased if the company is successful in its bid for this contract. These
will cost £110,000 each and will be written down to their scrap value of £10,000 using the straight
line method over a period of ten years. The company expects that the buses operated on this route will
broadly match the company’s current average annual mileage per bus.
The specific costing figures for Blue Bus are:
The variable costs per kilometre run include all the costs associated with the running of the buses,
including staff costs, fuel and maintenance and so on. Fixed costs include depreciation, interest
payments and fixed depot costs. For the purposes of this exercise, assume that the only fixed costs
associated with the new contract will be the depreciation of the vehicles used.
Competition
The company is likely to face competition for this tender from two other bus companies, with some
brief details given of these below:
The Go By Red Bus Company
Go by Red is a bit of a pushy company known for its aggressive marketing campaigns and cut-throat
competition in the market place. A well-known local operator, the company was acquired by a major
UK and international bus company with a similar reputation of aggressive and rough market tactics.
Since the take-over, the company has not bid on any Local Authority contracts.
Black and Gold Platinum Bus Services
Part of a major UK bus group, Black and Gold are looking to expand operations and have
not previously run bus services in this area, either commercially or under contract to the local
authority.
You should price this contract in the first instance based upon the Blue Bus Company’s current
costs and profit mark-ups.Having done so,you should then consider the competition and whether there
are any ‘adjustments’ that you feel should be made to the contract price before putting in the final
tender. Note in making these decisions your figures should still make economic sense, i.e. running the
company into the ground to win this contract is not an option!
Exercise 11.4 Concessionary fare reimbursement
Consider the following exercise below which concerns compensation for the implementation of a
concessionary fare scheme.
The transport authority wishes to implement a concessionary fare scheme on the basis that the
Fixed costs: £350,000
Variable costs, per kilometre run: £0.95
Annual vehicle Km: 1,200,000
Number of buses operated: 27
Profit Mark Up: 12%
276
TRANSPORT SUBSIDY
operator should be ‘no worse or no better off’ as a result of the scheme. The current demand for bus
services from those that would benefit from the scheme is estimated to be in the order 3,500 passengers
daily and the flat fare charged by the operator is £1.20.The authority is considering the following
options.
Scheme 1: The concessionary fare to be implemented would be a flat 25p charge. This would be
expected to increase demand of those entitled to the concession by 10 per cent and the authority
agrees to pay 20p to the operator to cover the cost of each additional passenger carried.
Scheme 2:An entirely free concessionary fare scheme which would be expected to increase demand
of the entitled group by 25 per cent with again the authority agreeing to pay 20p to the operator for
each additional passenger carried
a) Calculate for both schemes the expected level of compensation that will be due to the operator
on an annual basis, where the schemes are assumed to operate for 360 days a year.
b) Having looked at the figures, which of the two schemes do you think the authority should
introduce?
c) An alternative form of reimbursement is proposed, where the operator receives a straight
compensation of 75 per cent of the full fare for each concessionary passenger carried. Rework
the levels of reimbursement under this proposed form for both the flat 25p and free
concessions.
d) Using these figures and comparing them to the values given in Figure 11.4 and Case study 11.1
regarding increases in compensation levels in Wales and Scotland (which is on a straight 73
per cent of full fare compensation), what possible reasons can be given for the considerable
increases in the levels of reimbursement being paid with the move to a completely free scheme?
Exercise 11.5 Questions for discussion
Discuss the following simple statements, which should help to build on and develop some of the issues
discussed in this chapter:
᭿ ‘Low subsidy is “good”, high subsidy is “bad”.’
᭿ ‘Transport should only be subsidised on the basis of what can be afforded by the relevant
authorities.’
᭿ ‘ “Public” Transport is a “public” good, therefore should be subsidised.’
᭿ ‘Road networks, because they are provided and maintained by the state, are therefore provided
free of charge.’
277
TRANSPORT SUBSIDY