UPDATE 3-Britain scraps flawed rail deal in embarrassing U-turn

* Serious mistakes in franchise bidding process-govt

* Process must be run again; three more on hold

* Opposition accuses ministers of "shambolic incompetence"

* FirstGroup shares fall 19 pct; company says followed guidelines

(Adds Virgin Rail and analyst comment; three suspended; updates share price)

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) said 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 linking London and Scotland.

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

"The extent of this catastrophe is breathtaking," said industry commentator Christian Wolmar. "The whole rail industry is now apparently put on hold while a review of the process takes place."

Rail operator FirstGroup Plc , the shares of which were down by 19 percent at 1236 GMT, bid 5.5 billion pounds ($8.9 billion) to secure the 13-year franchise in August.

Virgin Trains, a venture between Richard Branson's Virgin Group and Stagecoach , has run the West Coast service since 1997 and offered 4.8 billion pounds to continue doing so.

The company, which said it spent 14 million pounds preparing the bid, mounted a legal challenge after FirstGroup was awarded the contract. Virgin claimed that the winning bid was a "ridiculous" sum that would have bankrupted the company.


UK needs to put outsourcing on new rails


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 that his department's 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.

"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.

The government said that evidence of mistakes related to the calculation of risks in the bids was uncovered during preparations for the Virgin legal challenge. Three employees in the transport department were suspended.

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.

Three active rail franchise competitions have been suspended pending an investigation. Nine more franchises were due to be awarded in the next three years, though the timetable is likely to slip.

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

The RMT rail union called for an end to the "sorry and expensive shambles" of privatisation, while Labour transport spokeswoman Maria Eagle said: "The West Coast rail franchise fiasco has yet again exposed the shambolic incompetence of this Tory-led government."

FirstGroup said that it learned of the reversal late on Tuesday and had no previous signal that the process was flawed.

"We submitted a strong bid, in good faith and in strict accordance with the DfT's terms," the company said.

Branson's Virgin Rail welcomed the decision. "We're ready to play a full part in assisting the review to help deliver a franchising system that better serves passengers, taxpayers and the interests of all bidders," it said. ($1 = 0.6196 British pounds)

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

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