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UPDATE 2-Britain scraps flawed rail deal in embarrassing U-turn

* Serious mistakes in rail franchise bid process-govt

* Process must be run again; three more on hold

* Opposition accuses ministers of "shambolic incompetence"

* FirstGroup shares fall 18 pct; company says followed guidelines

(Recasts, adds analyst and union reaction, background)

By Stephen Mangan and Peter Griffiths

LONDON, Oct 3 (Reuters) - Britain has torn up a deal awarding one of its biggest rail franchises to a private operator, in a humiliating U-turn that raises doubts about the government's handling of the privatised railways.

Ministers froze three more rail franchise competitions on Wednesday after the Department for Transport (DfT) announced that "completely unacceptable" flaws had been uncovered in its handling of bids to run the West Coast Main Line, a jewel in the crown of the rail network that links London and Scotland.

The debacle is damaging for the ruling Conservative Party, which began a difficult programme of rail privatisations in the 1990s that has been dogged by fatal accidents, financial crises and political infighting.

Rail operator FirstGroup Plc , the shares of which tumbled 18 percent by 0946 GMT, bid 6 billion pounds ($9.7 billion) to secure the 13-year franchise in August. Virgin Trains, a venture between Richard Branson's Virgin Group and Stagecoach , mounted a legal challenge, claiming that the winning bid was unrealistic.

The Conservative-led coalition, trailing in the polls and accused by the Labour opposition of "shambolic incompetence", is already under pressure over the stagnant economy, public spending cuts and an unpopular budget this year.

Transport Secretary Patrick McLoughlin said the mistakes would cost the taxpayer at least 40 million pounds, a relatively small but politically awkward sum at a time of recession and squeezed household budgets.

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"I have had to cancel the competition for the running of the West Coast franchise because of deeply regrettable and completely unacceptable mistakes made by my department in the way it managed the process," McLoughlin said in a statement.

Staff in his department may be suspended after officials made serious mistakes in how they calculated the bids. McLoughlin's position looks safe, however, having replaced Justine Greening as transport minister only last month in a government reshuffle.

The DfT will no longer award a contract to run the West Coast service when the current contract expires on Dec. 9. Trains will continue to run with the same drivers, staff and timetables while the problems are resolved, the government said.

Most of the rail network was in public hands between 1948 and the mid-1990s, though Britain's passenger rail services are now operated by 16 private train operating companies that have signed legal contracts with the government.

The three active franchise competitions have been suspended while the handling of the awards is investigated. These franchises are to run the c2c service between London and Essex in southeast England, the Thameslink route from the capital to Brighton on the south coast and Great Western services from London to central England.

Another nine franchises were due to be awarded over the next three years. The timetable for all of these is expected to slip backwards.

"The direct impact clearly falls on FirstGroup, where the shares had priced in the franchise win," said Jefferies analyst Joe Spooner. The delay in the franchising would also be a negative for UK transport groups Go-Ahead and National Express , who are shortlisted in the contests, he added.

'SHAMBOLIC INCOMPETENCE'

Labour transport spokeswoman Maria Eagle said: "The West Coast rail franchise fiasco has yet again exposed the shambolic incompetence of this Tory-led government."

The RMT rail union, meanwhile, described rail privatisation as a "sorry and expensive shambles", insisting that the process should be halted. "Instead of re-running this expensive circus, the West Coast route should be renationalised on a permanent basis," said RMT chief Bob Crow.

FirstGroup said in a statement that it was disappointed with the government move and that it had only been told of the issue late on Tuesday night.

"Until this point we had absolutely no indication that there were any issues with the franchise letting process and had received assurances from the DfT that their processes were robust," it said. "We submitted a strong bid, in good faith and in strict accordance with the DfT's terms."

In its trading update on Tuesday, FirstGroup had said that it was getting ready to run the West Coast line and was planning for a successful start on Dec 9.

Branson welcomed the government announcement.

"They have basically acknowledged that what we had been saying is correct," he said in a blog post.

"From the moment we found out that FirstGroup had been made the preferred bidder with a completely unrealistic bid, we questioned the way the offers had been assessed and asked government to review and explain how it came to its decision." ($1 = 0.6196 British pounds)

(Additional reporting by Rosalba O'Brien and Rhys Jones; Editing by David Goodman)

((London newsroom)(+44 207 542 7947))

Keywords: WESTCOASTRAIL FIRSTGROUP/