OREANDA-NEWS. September 23, 2009. Rail reform has already been underway in Russia for more than ten years, but the debate about whether or not the industry actually needs reform has never ceased. Some believe that reform should be stopped during the economic crisis, while others believe that this is time to hand over the dominant role in passenger and freight transport to private business which, they maintain, is ready to solve all the problems and strategic challenges facing the industry.

In the current debate, we often hear a single argument: the railways should be opened up rapidly to broad “competition”, and the “market” will regulate itself. These ideas are usually voiced with regard to competition in the freight market, while private business is not interested in loss-making passenger services without guaranteed state compensation.

I don’t deny that competition is a strong incentive to efficiency, but it is more a theoretical promise of giving the maximum return in a perfect market. Russia’s railway freight transport market, however, is still far from perfect.

Specifics of Russia’s system
In Russia, the carrier’s responsibilities include not only transporting goods, but doing so publicly and providing equal access to the whole rail network, ensuring maintenance of the necessary infrastructure to meet the needs of special and military transport, and at rates set by the state. The latter aspect is particularly important, so I’ll focus on the specifics of Russia's tariff system a bit more.

Freight rates are averaged across the whole network, i.e. they are based on the average weighted cost spent on transporting one ton a distance of 10 kilometres. But the real cost of each transport can at times differ substantially from the estimated average over the whole network since it depends on many factors.

Another specific feature of Russia’s tariff system is the high level of internal cross-subsidies in transporting some goods at the expense of others. For example, the tariff for transporting petroleum products is much higher than that for coal over the same distance. As a result, Russian Railways makes a profit from shipping petroleum, while the Company doesn’t even cover all its costs when transporting coal. Overall though, the Company does break even.

The third feature of the rates is that the carrier lacks any right to regulate them flexibly, even within a specific corridor. As a result, it cannot adapt to prices on the commodity markets. When metal prices are increasing, for example, but the tariff remains unchanged, the metal sector receives additional profit, and the state more taxes. But when the prices start falling, metal manufacturers demand that the government reduces the rates to maintain the profit levels already achieved. As a result, Russian Railways today is used more to satisfy the needs of the economy as a whole - its own commercial interests are not the top priority.

In addition, we are not only the carrier, we also own the railway infrastructure, which allows us to improve our efficiency when carrying out government tasks at the macro-level. But this also creates significant additional burdens for business.

Reform Models
It is obvious that developing competition in freight transport is impossible at the moment. This means we there are three major options:

to separate infrastructure from transport and then develop competition in transport activities throughout the network (the so-called European competition model);

to divide the whole rail network into several “parallel” directions of traffic and then develop competition among vertically integrated companies in parallel steps (the so-called American model);

to spin off specific geographical segments from the single transport market, with their own rules and where market-based pricing for freight shipments will apply, and require Russian Railways to carry out the rest of the work.

There are a number of other ideas. The most popular is to spin off some “locomotive traction services” from the transport process and to develop competition within them. I have repeatedly posed in public the question of separating the business of locomotive traction services from the main activity of the carrier to the heads of the largest railway companies in Europe. They all give the same, definitive answer: this is a strange and harmful initiative which is capable of causing a serious deterioration in rail operations. Only Kazakhstan has such experience, and after several years of work, the country now understands that such a division is ineffective.

Neither the European nor the American reform models are suitable for Russia in their pure forms. But not taking into account the experience of other countries is also short-sighted, so let's analyze all three models.

In theory, the separation of infrastructure from transport seems the most logical and market-friendly step - a natural monopoly is separated from potentially competitive businesses. But such a separation will create a lot of conflicts that require adjustments to most technological processes, increase the risks of the system’s operation and create a lot of new transactions. Russia’s experts have calculated that for such a division, the costs of transport would increase by between 30 to 50% on the current level today. Similar calculations have been made in America, with similar results obtained.

The model of dividing the railways into several “parallel” companies in which infrastructure and transportation would be combined, is also theoretically feasible. But its disadvantages are obvious. Instead of just one single national monopoly, we would have several regional monopolies. An increase in tariff rates under these conditions is inevitable, and the losses to the economy resulting from the breakup of the single infrastructure would be very high.

The third model, which is to create local zones where carriers compete, can be implemented with minimal risk. There are two ways of proceeding here: creating competition among several local carriers on the same route, or creating competition “for the route” by holding a tender for the right to serve any part of the network on terms established by the state for a period of five to ten years.

Similar operational structures already exist in Russia, e.g. at Yakutia Railways and the Yamal Railway Company.

Such a model can be tested on “dead-end” routes up to 1,000 kilometers long, where there are fewer safety risks and the greatest potential to improve efficiency by reorganising operations in the local geographic segment. In terms of rail transport in general, this model is the least risky, both technologically and economically.

Market development in practice
All these models require systematic study and responsible solutions for these problematic issues. That is why I am not a supporter of the mindless development of competition between carriers just for its own sake. What is a private entrepreneur to do who wants to invest in the development of the rail business?

Let us recall a few economic axioms. First, the investor seeks to maximise profit on the invested capital with minimal risk. Secondly, substantial capital and profits can be generated in imperfect markets, in particular due to the imperfections of institutions and the lack of balance between market forces. And finally, some are natural monopolies because that is the most economical way of doing business.

All these axioms are confirmed in practice by the development of the rail transport services market in Russia. The best example is of course the development of the market for operators’ services.

But against the backdrop of the positive results in attracting private investment to the industry, we also encountered a number of new problems.

First of all, according to our estimates, the efficiency of the wagon fleet has declined by 10-15% as a result of the fragmentation - service operating companies delivering goods in certain types of cars before the crisis were almost 50% more expensive than similar Russian Railways’ cars. At the same time, competition in the operating business remains limited so far because the freight cars owned by Russian Railways operate according to regulated rates, while private cars are run on market principles. Restricting competition is yet another reason for the imbalance on the market. The operators, having virtually unlimited commercial flexibility, immediately selected the most technological and profitable shipments from the single transport process.

The result is that the remaining unprofitable and low-tech transportation has been “inherited” by Russian Railways. Is this fair competition?

As a result, the efficiency of the transport process has not increased overall due to the greater number of private cars now available - some have just skimmed off the cream, while others continue to carry out socially important public transport. For more than two years we have been trying to obtain a level playing field for business with regard to wagon operations. After lengthy discussions, we were able to create a subsidiary, Freight One, and are now trying to convince everyone of the need to set up a second freight company. This will ensure a level playing field for all market players, including Russian Railways.

An even more interesting situation arises with regard to private locomotives. Under existing regulations, Russian Railways can carry cargo not only in private cars, but in trains consisting of wagons and locomotives belonging to the shipper. For such shipments, a special, and in our opinion unfair rate was invented under which, in some cases, Russian Railways receives only 30% of the total cost of a standard shipment, although we bear more than 60% of its cost. The current situation, where a state-owned company loses money for maintaining infrastructure, but where private locomotives take the profits, is obviously unhealthy.

Opportunities for private owners
At the same time, I continue to believe that the expansion of private business on the rail system will be confronted with systemic economic and technological constraints.

Rail transport is a complex and very capital-intensive business. The payback period of most average projects in the cargo business at existing levels of rates exceeds fifteen years and the profitability of Russian Railways assets in 2008 amounted to just 0.4%. This means that the investor cannot count on an adequate level of dividends and that returns from the investment should not be reinvested in rail assets.

Economic and technological barriers to entry to the transportation market are very high: to reach the minimum amount of business means investing billions of roubles. To recoup these funds in seven or eight years, transport profitability has to be increased by 20-30%. Expenditures on the part of a private carrier would be higher than that of Russian Railways, since he loses economies of scale, and the cost of transportation of one ton would increase.

It is therefore necessary to raise rates. Most likely, additional charges will arise if the money is taken on credit. But the economy benefits little from such investments - services will become more expensive than its quality to the customer, risks to the system will increase and the use of infrastructure will deteriorate.

That is why all over the world, the overwhelming proportion of investment in the railway sector is made directly by the state or through special leasing companies.

We have a similar situation in Russia - the state-owned assets of Russian Railways give a 0.4% return on capital, but also provide support to industry and mobility and transport access to, from and within the country’s regions, as well as solving many other problems. If we want to replace government capital in the industry with private money – let’s prepare for the creation of conditions to guarantee its return, including an increase in rates.

Russia’s transport industry also has a lot more simple technological, organizational and institutional spheres of activity requiring the development of private business and investment initiatives - and there are a lot of these in rail transport.

Above all, this is industrial rail transport and rail transportation not for general use, which is a very large-scale segment, with more than 80,000 kilometres of track, thousands of locomotives, tens of thousands of cars and loading and unloading facilities... All this requires effective technological solutions and investments. This business is in most cases not regulated by the state, technical standards are less strict, and the risks from safety violations less.

Private entrepreneurs are also able to develop the repair business and provide services in rolling stock, construction and the repair of infrastructure, as well as many other areas.

A second ambitious area for the possible development of private business and transport activities is logistics, which is in its infancy in Russia compared to the standards in developed countries.

Ten Steps
So what kind of rail transport reform is required to meet the needs of the economy in crisis?

Our answer: pragmatic reform, with no risk, which is also consistent, economically sound and able to make the entire rail system effective and efficient, rather than creating mechanisms for the redistribution of assets and perpetuating the already low profits in favour of a private investor.

In fact, this is the kind of reform conceived more than ten years ago.

Today, when just over a year remains to the completion of the official reform programme, we know what to do in order to implement its stated principles in practice.

First. Create fully-fledged competition between freight car operators, which requires that by the end of the year all cars should be transferred from Russian Railways to the Freight Two, the second freight company. Let this segment continue to develop according to the market, with all its advantages and disadvantages.

Second. Complete the process of separating the passenger business from the infrastructure and freight transport, creating for these areas a subsidiary Federal Passenger Company and continuing to set up suburban passenger companies. The state has to clarify the rules for government orders at both federal and regional levels – for the transport of passengers entitled to reduced fares and transport according to regulated, socially-oriented fares. Developing such a mechanism would guarantee the creation of conditions for the development of private carriers in a competitive environment for such state orders. Developing competition in this field based on franchises can be much easier and faster than in the cargo business.

Third. Complete the spinoff from Russian Railways of non-core activities and develop among them a competitive market to attract private investment and skilled partners.
 
Fourth. Organize the relationship between the government and Russian Railways as the infrastructure owner. A form of agreement is needed which defines the requirements of railway infrastructure intended for joint or common use, of its technical condition and its national coverage and the country’s development priorities. There is also the question of whether the country and the regions need little-used and unprofitable stations? It is also important that any such agreement provides for the sources of the funds needed to maintain and develop the infrastructure, and if the funds received by Russian Railways from its activities governed by regulated rates will be sufficient.

Fifth. Start actively changing the system of freight rates. The current system hinders the development of relations between Russian Railways and its clients. When changing the system, it is vital to give Russian Railways the right to adjust the rates flexibly within a specific corridor, for example + / - 5% of the level established by the state according to transparent and understandable commercial criteria.

Sixth. Create the right incentives to improve the efficiency of Russian Railways and scrap methods of regulating its activity based on cost. The government must determine a long-term tariff policy and reiterate its willingness to reimburse the Company for lost income if the rates are lower, thus providing an effective incentive to increase profits. A state programme could provide strong support by releasing rail employees and experts during the reform process.

Seventh. Adopt a system of measures to develop the rail industry in Russia and bring in foreign technologies in some areas.

Eighth. Improve conditions for private businesses in those areas where there is no systemic risk from the reforms, but which can provide maximum impact, as discussed above.

Ninth. Build new railway lines on the principles of public-private partnerships and start creating a network of high-speed dedicated lines. Solving these problems is a powerful anti-crisis measure, as evidenced by the experience of many countries.

Tenth. Consider an IPO of 20-25% of Russian Railways while maintaining absolute government control. The state would then receive funds for investment in new rail projects, while the preparations for an IPO would lead to greater transparency and the long-term sustainability of the Company’s business development. It would also attract private shareholders and investors. In addition, establishing a market price for Russian Railways shares on the stock exchange would create a very effective tool for public control and pressure on the management effectiveness.

We believe that this approach to of reform is much more efficient for the government than the endless division and fragmentation of the industry and the expectation that pseudo-competition at the local levels of a unified system will be able to increase productivity and socio-economic efficiency in general.