Development of the Channel Tunnel Business

1

The economics of the Channel Tunnel--Success or failure? Chris Castles

The Channel Tunnel offers an interesting case study from a number of perspectives:

• First there was the 15 year decision-taking process of studies, forecasts, feasibility analysis, debate about the basic configuration of the project and product (rail or road, tunnel or bridge), the false start and discussion about how it should be financed and then the competition for the concession,

• Then there is the story of the way the implementation of this unique, trans-national, infrastructure project was managed. This involved, not just managing all the engineering challenges, but also responding to the emerging safety regime and commercial requirements of the business and modifying the design accordingly, while dealing with a continuous financing crisis as the costs of the project ballooned;

• And then when the Tunnel opened the business failed to perform as forecast leading to the restructuring of its finances;

• and finally there is the ongoing story of how it is now operating as a business.

I will be talking mainly about the experience since the opening of the tunnel services. But I will give some background to the setting up of Eurotunnel as a context to subsequent events.

Eurotunnel is the operating company that was set up to finance and manage the development of the Channel Tunnel project and then to operate the business. It was created by a consortium of construction companies who, in 1986, had won the 50 year concession to construct and operate the Channel Tunnel. After winning the concession, they then distanced themselves from the business by creating Eurotunnel as an independent company separate from TML (Trans Manche Link) – the construction consortium which actually built the tunnel. TML passed the bills for the construction of the Tunnel to Eurotunnel which raised the finance and took ownership of the facilities.

This structure had some inherent problems in it, since TML had clear conflicts of interest. Its priority was to make money out of the construction activity. It was much less concerned whether or not Eurotunnel was going to be viable as a business, since the construction companies put little equity into Eurotunnel.

Eurotunnel was mainly financed by bank loans from a large consortium of over 100 European and Japanese banks ( US banks kept clear of the project at this time, although they were subsequently active in buying the distressed debt). Eurotunnel also raised substantial amounts of equity in four public offerings during the construction of the Tunnel, mainly from small shareholders in France and the UK. The marketing of the shares was pitched towards small shareholders with a strong emotional appeal based on linking Britain to the Continent, rather than on hard evidence of traffic and revenue potential.

Eurotunnel was therefore created late in the process, after many of the key decisions influencing its viability had been taken. The lending bank syndicate and the shareholders were too fragmented to control Eurotunnel effectively. And it took a long time before Eurotunnel developed as an effective organisation. Arguably it was never able to perform all the roles required of it during the construction period. These included:

• planning the future service offering and preparing the future operating business;

• specifying the physical requirements to meet the needs of the operating business and managing the construction of the required facilities and equipment;

• satisfying the aspirations of its financiers.

Eurotunnel was created too late to do the first job and it therefore had to largely accept the project design specified by the construction consortium, TML. The operating concept, developed at the early stage of planning, was based on a toll road arrangement with a simple ‘turn-up-and-go’(TUGO) Shuttle train service for road vehicles, without pre-booking and with a toll system and terminal area designed with this undifferentiated service in mind.

Eurotunnel was not able to revisit or to fundamentally modify this design and it simply had to try to control and manage the costs and the configuration of the project as best it could, during the 7 year construction programme. This proved to be very difficult, partly because the Independent Safety Authority, which was created by the governments, imposed significant constraints on the design and made up the rules as it went along; imposing more and more onerous and costly requirements on the project. This was an unusual arrangement since, for most projects, the safety design standards are known in advance. But it was inevitable in this case, because of the unique characteristics of the project. It was another risk that had to be accepted by the financiers.

The result was that costs soon ballooned, more finance was needed and the banks and shareholders were trapped into pouring in more and more money to get the project finished, in the hope of eventually recouping the money already spent. Eurotunnel found itself going from one crisis to another in the effort to get the project built. It had little time to focus on the future business of providing an attractive and competitive service able to operate commercially.

After the Tunnel was opened (in 1994) it was found that many aspects of the project design inherited from TML were not suitable for the operating business.( e.g. the toll system and the space constrained UK terminal).

In the end, the Channel Tunnel costs about £10 billion to build (compared with initial estimates 8 years earlier of about £5 billion). Of this £10 billion, £8 billion was raised in debt from banks and £2 billion in equity. The last fund-raising exercise took place in May 1994, just 2 months before the new services were to begin, when £800 million of new equity and £700 million of debt was raised to get the project finished and up and running. By then the banks and many shareholders were very nervous about the costs and delays to the project and the prospects of recouping their investment. Nevertheless, the Prospectus for the fund raising continued to express confidence in the future.

Throughout the process, a group of traffic and revenue consultants had produced regular forecasts annually which were independently reviewed by another set of consultants. These forecasts were produced by the same consultants who did the original feasibility study. They never found reason to significantly alter their view that cross channel demand would continue to grow strongly over the long term, Eurotunnel would capture about 2/3 of the market on the Dover Straits, leaving the ferries with the rest and, despite the implied competitive battle for market share, prices would remain broadly at the same level as before the opening of the Tunnel. .

A second set of consultants, employed by the banks, carried out a regular independent annual review of these forecasts. But they never deviated by more than 5% from the traffic and revenue consultants’ numbers over the 8 years that they carried out their reviews. Their reviews tended to concentrate on the wrong issues i.e. the prospects for economic growth and the size of total the market, rather than Eurotunnel’s likely share of this market and the effect of competition from the ferries on prices.

There is a strong resonance here of the messages from Roger Alport’s and Jeremy Berkoff’s paper given at the ICEA meeting a few months ago, about forecasting for major infrastructure projects. The traffic and revenue forecasts for Eurotunnel have proved disastrously optimistic, as have the forecasts for the Eurostar rail traffic between London, Paris and Brussels, ( which I also reviewed as part of other work). I could comment on the reasons for these failures and the weaknesses in the methods used, but this would need to be the subject of a separate paper..

Eurotunnel’s business

Eurotunnel provides two basic forms of cross-Channel transport service plus some retail and ancillary services.

It operates its own train services called Le Shuttle, which shuttle road freight and passenger vehicles between Folkestone and Calais in specialised purpose built trains. The Freight Shuttle trains carrying lorries are separate and differently designed from the Passenger Shuttle trains which carry the cars and coaches. These freight and passenger vehicle Shuttle services compete directly with the well established cross Channel sea ferry services.

Eurotunnel’s other cross-channel service is simply to provide tunnel capacity for national passenger and freight railway trains which pass between Britain and France, thus linking the rail networks on each side of the Channel. Eurotunnel does not operate these services itself. It is paid on the basis of the volume of traffic carried plus a contribution to its operating costs. But, importantly, these charges are subject to a Minimum Usage Charge (MUC) which put a floor under the payments from the railways to Eurotunnel. Significantly the volume of rail traffic has been so low that charges have never exceeded the minimum.

The provision for the MUC runs out in 2006, so Eurotunnel will then receive only the revenue determined by the levels of rail traffic. This will have two effects. Firstly, it is likely to reduce its revenue from the railways significantly, given current prospects for rail traffic which is running at half the forecast levels. Secondly it will create a significant marginal cost impact on the railways who will then face a charge for every additional passenger carried. This may influence pricing strategy by giving a disincentive to carry low yield passengers on Eurostar.

Eurotunnel’s ancillary businesses are retail services at Eurotunnel’s terminals at Folkestone and Calais, the telecoms and electricity connector and some interests in the shopping centres in Calais.

Opening of the services

The services were due to open for full commercial services in July 1994 with the aim of catching the summer peak. In fact, the services were delayed 4/5 months and very soon they began to experience a range of technical and operational problems.

Therefore instead of Eurotunnel creating a strong positive impact on the market by the launch of fully operational, reliable services, superior to its competitors the ferries, the launch was an embarrassing failure with a delayed and gradual opening of erratic services which were subject to breakdowns, delays and queuing.

The Shuttle services were expected to have a number of clear competitive advantages over the competing ferry services:

• faster crossing times (expected terminal to terminal times about 1 hour v 2 ½ hours by ferry);

• high frequency services – 3/hour (rising to 4/hr later);

• provision of a smooth, convenient, hassle-free journey with no booking, just turn up and go (similar to a road toll way system);

• greater reliability and freedom from bad weather disruptions.

These advantages were expected to enable Eurotunnel to capture rapidly 2/3 of the Dover Straits market and to act as price leader in the market, and also maintain a price premium over the competing ferry services.

In the event, actual gate to gate crossing times were 1½ - 2 hours rather than the 1 hour and the introduction of the three departures/hour service was delayed by six months. But worse; a series of technical problems undermined the competitive advantage of the services. These arose because Eurotunnel was reliant on a unique integrated system which was only as strong as its weakest link at any time. And the many weak links included:

• problems in the Tunnel environment due to dust, salinity, humidity, water seepage and high temperatures, which caused failures to the signalling system and electrical supplies;

• numerous problems with the rolling stock, which had been purpose-built, largely untested and stuffed with unique features, all prone to teething problems and failures.

In addition, the system was vulnerable to peak demand overload. So at popular times (a sunny bank holiday) the service became a ‘turn-up-and-go away’ service as queues formed at the toll booths and extended down the motorway. The Shuttle service was designed like a road toll way system with no booking and simple standard fares which you paid as you arrived; so that it was easy to understand and use. The disadvantage was that Eurotunnel had no means of managing demand to prevent peak overloads (or to encourage off peak use). As a consequence, it was not able to maximise its revenue by matching its prices to what people were willing to pay for different types of journey.

This problem was symptomatic of one of the key problems for Eurotunnel at the time – it did not understand its market. It had spent seven years concentrating on building the Tunnel and mastering the technical aspects of operating the services. But it had not properly understood its customers or its competitors. It had a Commercial Department which had carried out a lot of analytical work with consultants on forecasting and examining the costs of its ferry competitors. But they failed to draw the relevant conclusions. I will discuss these issues further but to summarise the issues briefly:

• Eurotunnel did not appreciate fully the implications of the fact that it would be serving primarily a leisure passenger market

-in this market people’s willingness to travel is highly discretionary and needs to be constantly stimulated by promotion and pricing. (And it can easily be inadvertently suppressed by uncompetitive pricing)

• Secondly, Eurotunnel did not properly understand the economics of its competitors the ferries and their potential to cut their prices by large amounts and still remain profitable;

• and it did not realise at that time that freight lorries would prove to be its most profitable market, requiring a switch of emphasis from the Passenger Shuttle over time.

During 1995, in the first year of Eurotunnel’s operations it was offering an unreliable service and struggling to build up traffic at anything like the rate forecast ( ie practically immediately, the “bingo effect”).

Furthermore, the ferries were not behaving as planned. It was expected that the ferries would recognise that, since the Tunnel was not going to go away, there would be no point cutting prices to compete with it. They would therefore simply concede the market and price levels would be broadly maintained. This did not happen. Eurotunnel found itself in a price war with the ferries and prices soon fell by an average of about 30-40%.

It was soon apparent that Eurotunnel was not going to achieve anything like the level of traffic and revenue which it had forecast just a short time ago in its 1994 Prospectus when it raised the last £1½ billion of financing.

At the end of 1995, 18 months after its planned opening, Eurotunnel was still not earning enough revenue to be able to generate any free cash flow above its costs to pay any of the £700 millionper year interest rate bill. As a consequence of this crisis the banks called in my team at Coopers & Lybrand in to answer the following questions:

• what had gone wrong with the business and why;
• what was the likely medium term prospect for the Company’s financial performance.

It was soon apparent that there was little prospect of Eurotunnel servicing its debt burden, let alone paying any return to its shareholders. Therefore a restructuring of its finances was needed. We were retained as business advisers to comment on the long term forecasts for Eurotunnel for the next 50 years to give a realistic profile of its financial performance and ability to service its debt as an input to the negotiations over restructuring its debt.

We were subsequently retained on a continuous basis as business advisers to the banks to monitor the progress of the Company. This involved carrying out a regular annual cycle of reviews of Eurotunnel’s business covering its recent performance, its 3 year Business Plan, its 10 year capex programme and its next year’s budget.

So what went wrong?

The immediate causes for Eurotunnel failing to meet its 1994 Prospectus forecasts were fairly straightforward:

• it lost 6 months revenues due to delay in opening;
• its services were disrupted by technical problems;
• this had an impact on the market and damaged customer’s confidence;
• it encouraged the ferries to compete vigorously and prices fell well below expectations.

Some at least of these problems should have been anticipated in the forecasts. Delays and teething problems were almost inevitable for such a unique project using untried technology. It was also very optimistic to expect to capture 2/3 of the market from the ferries within the first year of opening without a competitive fight with a consequential impact on price levels. Furthermore, there was a fundamental misreading of the economics of the ferries so that Eurotunnel did not appreciate their capacity to cut prices while still operating profitably. It is worth exploring this issue of ferry competition in more detail since it is one of the primary underlying and long term weakness in the business. The technical problems of the Shuttle services have largely been solved, but Eurotunnel must live with its competitors over the long term.