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

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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

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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.

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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

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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 million per 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.

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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.

Ferry competition

I mentioned earlier that it had been expected that the ferry operators would quickly recognise the inherent strengths of Eurotunnel, and particularly its permanence, and they would concede market share without much of a fight. The argument went that there would be no point in the ferries cutting prices to retain market share against Eurotunnel. Eurotunnel had high fixed costs but relatively low variable costs and it could therefore always match any price cuts the ferries made and still be covering its variable costs, even if it could not pay all the interest costs on its large debt. Even if Eurotunnel were made bankrupt because it could not pay its debts as result of a price war, the physical infrastructure would remain in place. Unlike ferries it could not be moved to serve another market. So if Eurotunnel went bankrupt, someone else would step in and operate it. And, without the burden of Eurotunnel’s debts, a new operator would be in a stronger position to compete with the ferries than Eurotunnel. Therefore the ferries had no interest in bankrupting Eurotunnel through a price war.

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The problem with this argument was that it tended to think of the ferries as a single operator, and a single mind, capable of unified action. In fact, there were two major operators – P&O and Stena Line plus a weaker, loss making, state subsidised operator Sea France; and also Hoverspeed which had a small niche in the market. The two major companies had effectively been operating a comfortable oligopoly for many years, tacitly dividing the market and matching each other’s prices. P&O and Stena had been making annual profits, of about £200million (after allowing for a normal return on capital) on a turnover of about £600 million in the period before the Channel Tunnel was opened. The average price charged for a car crossing was about £50 per vehicle in the year before the Tunnel opened and it had been £70 per car just a few years earlier.

While the Tunnel was being built, the ferry companies had invested heavily in new large efficient vessels in preparation for the opening of the Tunnel and had introduced various efficiency measures. They had also been actively “growing the market” by segmenting the market and offering different prices for different products; high prices for people going on their annual 2/3 week holiday with their car, who paid up to £300 return in the peak period; lower prices of around £100 for a short break trip; and very low prices of £10-20 or less for a day trip crossing to do some shopping.

One important feature of the economics of the ferries was that a lot of this shopping was done on board the ferries – particularly the sale of duty free alcohol and tobacco. The ferries were floating off licences and restaurants and they made a large proportion of their profits from on-board sales. In fact, about half their profits came from this source and the rest from ticket revenue. Hence it was in the ferry operators interest to fill their ships with shoppers, even if they were paying a low fare for a day trip because the profits made from on-board sales made ample contribution. The trick was to segment the market so you could charge different prices for different types of journey according to willingness to pay.

Although Eurotunnel potentially had the advantage of being able to offer a smooth fast journey across the Channel (when all was working well) it had some competitive disadvantages. For practical reasons it could not sell duty free on its Shuttle trains – only at its terminals. Therefore the advantage of the short journey time was offset by time spent shopping in Eurotunnel’s terminals if customers wanted duty free (and most people did). So, in practice, people were spending nearly as much time, terminal-to-terminal, crossing the Channel with Eurotunnel as with the ferries.

Furthermore, Eurotunnel’s TUGO ticketing system and toll booths did not easily allow price differentiation between different groups of passengers. Eurotunnel soon realised that this was a fatal flaw and set about introducing new ticketing and pre-booking systems, and a yield management system. But this took time.

Finally, there was the cost structure of the ferries. I have mentioned just how profitable the ferries were at the opening of the Tunnel. This implied that they had scope to cut their prices and still remain profitable. Although it had been argued that this would be counter-productive since Eurotunnel would always match any price cut by the ferries, none of the three ferry companies wanted to be the one which was squeezed out of the market following

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the inevitable loss of market share to Eurotunnel, so they fought each other, as much as Eurotunnel, by cutting prices to retain a viable share of the market.

One of the features of the economics of ferry operations is that there are significant economies of scale. Larger ships have much lower costs per unit of capacity provided than smaller ships. Furthermore, to maintain an attractive cross Channel service a ferry company needs to operate at least three ships to ensure a sufficient frequency of service. Otherwise waiting time gaps between services means that you lose customers to competitors, unless you offer price discounts (which is the way Sea France competed since it was operating only 2 vessels)

If you are operating three large ferries you need to attract a lot of customers to fill them. In fact, our calculations showed that the ferries were able to break even with an average load factor of only 30% at the low price levels which were prevailing then in 1995.Therefore any additional traffic above this level provided a contribution to profits.When we presented this analysis it was a shock to the Company who had not appreciated the scope the ferries had to cut prices, notwithstanding the fact that its Commercial department had spent a lot of time studying ferry competition.

So things did not go to plan in the competitive battle with the ferries in the first couple of years of Eurotunnel’s operations:

Eurotunnel did not enjoy as clear a competitive advantage in service quality as predicted, particularly given the technical problems it was experiencing;

the ferries did not tamely concede market share and withdraw ships from the route as expected;

prices fell sharply and Eurotunnel’s market share did not grow as forecast. (By 1995 it had captured only 30% of the DoCa car market and 36% of the freight lorry market).

Eurotunnel’s response

Eurotunnel appointed a new Commercial Director, Bill Dix, towards the end of 1995, who had a strong background in marketing. He quickly realised that the no booking, TUGO, system had to be changed so that he could segment the market and offer different prices to different types of customers. Also, given the vulnerability of the system to seizing up when demand built up quickly, he also needed to be able to influence when people arrived in order to control peak surges in demand. Demand management was crucial, but had not been allowed for in the design of the Tunnel and its services.

He also looked carefully at our analysis of ferry economics. One of his first actions was to take the competitive battle to the ferries, rather than simply responding to the ferries pricing initiatives. He cut the prices of duty free at Eurotunnel’s terminals by 30%, knowing that duty free sales were the basis of the ferries strong profitability. This had an immediate effect of stimulating demand and encouraging people to try Eurotunnel.

Great efforts were being made throughout this period to get to grips with the many technical problems affecting the services. A major retrofitting programme to replace defective components on the new rolling stock was being carried out, along with other technical

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measures. Gradually service quality improved. By 1996 Eurotunnel was delivering a reasonably reliable service.

Punctuality improved, from a situation in 1995 when about 1/3 of Shuttle trains were delayed by over 10 minutes and 10% of trains were cancelled; to a situation, in 1996, when less than 10% of Shuttles were being delayed by over 10 minutes and just over 5% cancelled – still not good enough. Now less than 5% of passenger Shuttles are delayed by over 10 minutes and about 2% are cancelled.

With the improvement in service reliability and capacity available, the Commercial Director was able to make his next move in the competitive battle with the ferries in 1996, code named Attack. He realised that it was essential for Eurotunnel to establish itself as the market leader so it could set the prices in the market. To do this it had to demonstrate its determination to take market share and force the ferries to withdraw capacity. While there was too much spare capacity in the market, there would always be the temptation to lapse into a price war.

So in the middle of 1996 Eurotunnel cut its published prices sharply. The standard brochure fare fell from a range of £70-£170 to £30 -£40 and the short stay 5 day fare from £40-£90 to £20-£30. In fact, the headline brochure prices were misleading since the majority of tickets were sold on various kinds of promotions. So to some extent the cut in brochure prices merely made transparent current practice. But cutting brochure prices gave a strong signal to the market and introduced a touch of reality into pricing.

It also sent a strong message to the ferry operators that Eurotunnel was not content to limp along with a modest share of the market. Eurotunnel let it be known that it was aiming to capture 2/3 of the market and to sustain a long competitive battle at low prices to achieve this. Since it had suspended interest payments on its loans and was negotiating with the banks to restructure its debt, the ferries knew that Eurotunnel was able to sustain the damage which low prices were doing.

The effect of this was to encourage P&O and Stena to resurrect a plan they had put together prior to the opening of the Channel Tunnel to merge their services into a single unified operation on the DoCa route. This would enable them to carry out a planned and agreed cut in capacity rather than carry on a damaging price war to try to force each other out. When this plan had been prepared before the opening of the Tunnel it was rejected by the Competition Authorities who feared (probably rightly) that Eurotunnel and a single merged dominant ferry operator would soon carve up the market between them while maintaining high prices.

However, this time the Competition Authorities agreed to the planned merger (with some conditions) since competition had already done the job of reducing prices on the DoCa routes (at the expense of Eurotunnel’s financiers). The merged service was not fully implemented until 1998 and it enabled a reduction in capacity from 16 to 13 vessels on Dover Straits.

It did not eliminate competition. Sea France still maintained its 2 vessel, low price/low quality service. And, as has been proved since, there was always the possibility of

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competitive entry by a new operator if prices drift too high. Thus in 1999 a new freight-only ferry service was started by Norfolk Line between Dover and Dunkirk. This has proved successful and capacity has been increased from 1 ship to 2 ships and the service now carries a limited number of passengers.

Furthermore, Sea France has recently invested in a new vessel and will be introducing another one soon. Sea France has been the Cindarella operator on Dover Calais, running old ships at low fares and receiving heavy subsidies from the French taxpayer. The recent gains in market share by Norfolk Line and Sea France have been partly at the expense of the other main ferry operator, P&O (which has had to reduce capacity), as well as Eurotunnel.

One other notable event should be mentioned before looking at some statistics on the development of the business. In November 1996, Eurotunnel suffered a major setback. A fire occurred on one of its Freight Shuttles. This both caused the closure of the Freight Shuttle services for over 6 months with a loss of revenue of over £50 million. And it also caused damage to confidence in Shuttle services more generally.

Fortunately Eurotunnel was able to recover the confidence of its users quickly after this fire but it cannot afford another fire. Instead it has suffered another setback in the form of disruption from illegal immigrants.

Eurotunnel’s business performance

It may be useful here to show you some statistics on how Eurotunnel’s market has developed since it first year of operation in 1995.

Market size and share

This shows the development in Eurotunnel’s Shuttle service car and lorry traffic (coaches excluded) and the next graph looks specifically at the growth of the car market and Eurotunnel’s share in it since 1995. Total Channel car market was 6.7 million vehicles in 1995 and it grew to a peak of 8.8 million in 1998. But after the withdrawal of Duty Free in 1999 it dropped sharply. This fall was partly due to reductions in the day trip shopping market, but more significantly it was due to the large increases in prices for cross channel services which were needed to compensate operators for the loss of revenue from duty free sales. The cross channel passenger market has continued to decline through 2001 and 2002 and is now below its 1995 level. This reverses a long term trend of strong growth which has been going on for many years. Much of this previous growth was due to incentive pricing from the operator’s encouraging trips to fill capacity and to generate duty free sales. It illustrates the highly discretionary and insecure nature of this leisure-based market

Perhaps more worrying for all of us as tax payers, is that the through rail market on Eurostar’s services has shown a similar trend decline in the last two years. It peaked in 2000 at just over 7 million passengers and has since declined to 6.6 m in 2002.This decline has not been influenced by duty free but is more to do with competition from low cost carriers, the maturity of the London/Paris/Brussels market and economic conditions The government

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based its decision, in 1998, to bail out the failed consortium who were constructing the Channel Tunnel rail link, on a forecast level of traffic of 10 to 12 million passengers by now. This was based on advice from consultants which led the government to claim that there was an ‘infinitesimal chance’ of the government’s guarantee of the funding being called. Lets see!

The cross channel passenger car and coach market is heavily concentrated on the Dover Calais routes.The effect of the opening of Eurotunnel and the price war which followed was to increase this level of concentration on the DoCa routes from under 60% to over 70%.

Eurotunnel initially gained a share of 30% of the DoCa market in its first year of operation and has since increased this to just over 50%. But it has not improved its market share over the last three years and is a long way from the 2/3 market share originally forecast.

This graph looks at the market for lorries crossing between Dover and Calais. This market has shown consistently strong growth at an average rate of 13% per annum since 1995. Eurotunnel has performed well in this market, gaining 36% market share in the first year of operation. It could have grown faster in this market if it had had enough Shuttle capacity.

It also became clear that the Freight Shuttle had much better long term profitability than the Passenger Shuttle – mainly because the Passenger Shuttles were extremely expensive to build and operate. The 9 Passenger Shuttles cost £80 million each; whereas the Freight Shuttles cost only £20 million each. The average revenue from a lorry is about £150 and from a car it is now £50. A lorry is roughly equivalent to 3 cars in space so they both generate roughly the same revenue per unit of capacity, but cars are much more expensive to transport.

The original fleet of 8 Freight Shuttles were soon shown to be insufficient, particularly since they proved to be technically deficient. So Eurotunnel soon ordered 2 more Shuttles in early 1996 and have subsequently double the original fleet size of Freight Shuttles, while the Passenger Shuttle fleet size has remained constant.

The fire on a Freight Shuttle in November 1996 was a serious set back, but despite fears about the impact on customer confidence, the lorries quickly returned on the reopening of the service in June 1997 and Eurotunnel’s market share grew steadily until it was again facing capacity constraints. In 1999 it decided to accelerate its investment programme in 3 new Freight Shuttles. This enabled it to increase its market share to 47% in 2000 and it expected to achieve 57% market share in 2002.But recently it has failed to achieve any increase in market share despite the increase in capacity due to increasing competition from the ferries and the disruption to operations caused by asylum seekers.

Sources of Revenue

This figure shows the development of Eurotunnel’s revenue since 1995. It also shows the free cash flow available to service its loans, after covering operating costs and investment costs.

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Eurotunnel generated revenue of £287 million in 1995 – a long way short of the forecast of £440 million. With operating costs of nearly £300 million per year, it was not able to generate any cash to service the debt in this year.

Revenues improved quickly to £470 million in 1996 but the gap between the forecast revenue and actual grew. Revenues were expected to be £720 million in 1997 and to reach over £1 billion by now. In fact they peaked in 1999 at £645 million, generating £233 million surplus cash flow after operating costs and capital expenditure, well below what would have been needed to service its original debt, before restructuring. Since then revenue has fallen but Eurotunnel has made a modest increase in free cash flow through tight cost control.

However, when one considered that the Tunnel cost £10 billion to build, it would not be unreasonable to expect a long term average surplus over operating costs of about £1 billion per year for such a costly and risky project. Clearly, after 7 years, Eurotunnel is nowhere near achieving this and is never likely to.

If you look at the composition of Eurotunnel’s revenue you will see that it is underpinned by a steady £220 million annual revenue from the national railways which has contributed between 35-45% of Eurotunnel’s revenue. This is a guaranteed MUC. Railway revenue will only go above this if the traffic carried by the railways increases above a certain level. Unfortunately, growth in both Eurostar passenger traffic and railfreight through the Tunnel has been well below forecast. Eurostar carried less than 7 million passengers last year compared with 12 million originally forecast and freight traffic was 3 million tonnes compared with 8 million tonnes forecast.

So there is little prospect of revenue from national railways increasing. In fact, the guaranteed MUC is due to end in 2006 and Eurotunnel may then be faced with a reduction in revenue from the source.

Revenue from Eurotunnel’s own Shuttle services has now grown to £335 million, over half of which comes from the Freight Shuttle.

Revenue from Duty Free was very significant. It peaked at £166 million in 1998 (27% of total revenue) generating profits, after cost of sales, of about £100 million. With the withdrawal of duty free in 1999 Eurotunnel (and the ferries) lost this significant source of profits. In response, both have had to push up their prices significantly to try to recoup the revenue lost. Thus Eurotunnel’s average revenue yield from cars and coaches increased by 87% since 1998. It is not therefore surprising that Eurotunnel lost about 30% of its car traffic.

The net result has been a significant overall loss of net revenue from the passenger market since the abolition of duty free. Passenger Shuttle ticket revenue has increased by about £34 million but this was not enough to compensate for the loss of £100 million profits from Duty Free.

In the long term, the withdrawal of Duty Free is expected to benefit Eurotunnel by improving its competitive position against the ferries. The ferries have needed to increase their ticket yields at least as much as Eurotunnel since duty free profits had been even more

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important to them. However, Eurotunnel will not be able to increase its passenger Shuttle capacity because the Shuttles are just too expensive. Thus, in the longer term, it needs higher yielding traffic to use the limited capacity available cost effectively and the withdrawal of duty free has had the desired effect of pushing up yields. Providing growth in the market resumes Eurotunnel’s business economics should be stronger in a high ticket yield no duty free environment.

However, this does depend in a resumption of growth in the market and given the type of market which Eurotunnel serves this cannot be assured.

Composition of the Cross Channel Passenger Market

The cross Channel passenger market is primarily a leisure market and the key feature is that it is therefore highly discretionary. It depends on people’s whims and tastes; whether they favour motoring holidays in France against charter holidays on the beaches, short breaks across the Channel or the attractive offers now provided by the low cost airlines. In this respect it differs from the freight market which is driven by the fundamental constants in the economy i.e. trade.

The leisure passenger market is rather fickle and requires constant marketing and promotion efforts to encourage people to choose to take trips across the Channel. It is also price sensitive because there are plenty of close substitutes i.e. other things people can do with their leisure time.

It is interesting to look further at the composition of this market and how it has changed.

This figure shows the breakdown of Eurotunnel’s car market by segment in 1998 and 2000 i.e. in the last full year of duty free and after the abolition of duty free. Segments are defined in terms of ticket type – day trips, short break (under 5 days), long stay and MIT sold to tour companies.

Day trips are by far the largest segment, 46% in 1998 and, perhaps surprisingly, this proportion has not changed since the loss of duty free (in fact increased slightly). This is because it has been the price rises rather than the loss of the opportunity to buy duty free which has mainly affected the market and led to the drop of nearly 600,000 car trips. And the short stay and long stay market has fallen more than day trips so their shares have reduced.

The difference in composition of revenue from each of the segments reflects the differences in ticket prices. Day trip tickets are much cheaper than long stay so only 19% of revenue is generated by the 46% of cars which are day trips. But 40% of ticket revenue in 1998 came from 19% of cars on long stay journeys.

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Success or failure

So should the Channel Tunnel project be regarded as a success or a failure? From a civil engineering point of view it was undoubtedly a success. The very challenging undersea tunnel works were carried out broadly within budget. Most of the technical problems which subsequently arose were associated with the mechanical equipment. A significant reason for these problems was the need for continuous adaptation to an emerging safety regime.

From a bankers and shareholders point of view, the project has been pretty disastrous. Much of the original debt has either been written off, restructured or sold off cheaply in the hope that some will be recovered in the future. The shareholders have effectively been wiped out, although, the shares continue to trade. From a cynical, national perspective, one could view the project as a success for Britain in that the majority of the debt and equity was raised from foreigners. So we got the Tunnel cheap and they can’t take it away! It was clearly a learning experience in private finance and the two governments were quite right to leave the problem with the banks. The Japanese banks seemed to have believed that there was an implicit government guarantee to the debt, since the governments had been so active in pushing the banks to back the project.

It is a great pity that the Labour government did not learn this lesson when the backers of the Channel Tunnel rail link came back to admit their ( predictable) failure to generate the expected revenue to complete that project. Instead, we as tax payers will be paying for that unnecessary project at a time when rail investment is urgently needed elsewhere on the network.

From a customer perspective, the project could be viewed as a success since it effectively broke the oligopoly that had been operating for decades on the Channel Straits route with the connivance of the two dominant ferry companies and Dover Harbour Board ( who contrived to keep port capacity tight, leaving no room for new entrants). As we have seen, this resulted in excessive profits and very high prices, with an additional subsidy provided by the tax payer in the form of duty free. The customers also got a new choice of service from the Shuttles as well as lower prices.

From a broader economists perspective, I would not rate the project as a success. Huge resources have been wasted providing this expensive piece of infrastructure which provides only a marginal quality of service advantage over the alternative means of transport by ferry. The ferries could have continued to the job much more cost effectively. All that was needed was some proactive competition policy action to break the cartel which was operating and to bring the prices down to their economic level. Furthermore, the building of the Tunnel has stimulated further waste by prompting the effective government financing of the Channel Tunnel rail link. When we look the composition of the passenger traffic which has been stimulated by all this expenditure, we find that it is 90% leisure trips, mainly consisting of short breaks and shopping day trips for which there are close substitutes. It is questionable whether this provides a significant contribution to either the economy or to welfare.

Chris CastlesJune 2003

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