Railroad Restructuring
by Sergei Guriev

The next stage of Russia’s railroad restructuring program,to be implemented between 2006 and 2010, basically follows the EU’s restructuring approach. That was the general view at a recent roundtable, "Railroad Restructuring in Russia: Regulation Versus Competition," held in Moscow and hosted by CEFIR.

The conference brought together high-level officials from the Russian government, including the Ministry of Railroads, the Ministry of Economic Development and Trade, the Federal Energy Commission, representatives of the private sector, including both shippers and operators, and Russian and foreign academics to talk about the challenges of restructuring Russia’s vast railroad system.

The roundtable began with the presentation of findings from the project "Railroad Restructuring in Transition Economies" supported by the Think Tank Partnership Program and sponsored by USAID. The partners in the project—CEFIR in Russia, the Stockholm Institute for Transition Economics (SITE), and the Institute for Social and Economic Reforms (INEKO) from Slovakia—discussed international experience in railroad restructuring.

Anna Tomova, professor at the Zilina University of Transportation (Slovakia), and Lubos Vagac (INEKO) described the design, expectations, and realities of railroad reform in Slovakia and other countries of Central and Eastern Europe. They emphasized the challenges and complexities of railroad restructuring in transition countries, as well as political resistance to change.

EU Experience

Guido Friebel of the School of Higher Education in Social Sciences—Institute of Industrial Economics, Toulouse, France, and SITE and Marc Ivaldi and Catherine Vibes of the University of Toulouse, have looked at EU railroad reforms over the last 20 years. They matched the World Bank’s railroad dataset with information about three main reforms in EU countries:

• Separating infrastructure from operations (vertical separation)

• Creating an independent regulatory institution

• Allowing competitors to enter the market (third party access).

Different countries have adopted these reforms to different extents and at different times. Sweden and the United Kingdom implemented reforms early and comprehensively, while other countries, for instance, Belgium and Italy, have lagged behind. In some countries, such as Germany, the access of third parties is not only possible by law, but has already occurred on a considerable scale, while elsewhere, like Belgium and Portugal, competitors cannot enter.

The variation over time and across countries permits estimating the impact of reforms on railroad factor productivity. Such estimation revealed the following:

• Reforms have indeed improved the efficiency of European railways; however, more reforms do not necessarily improve efficiency. What really matters is the initial set of reforms in a country. Starting with one set of reforms, learning about its effects, and then implementing the next set may often be the best approach.

• Many experts believe that complete separation of infrastructure from operations is necessary to improve railroad efficiency. According to Friebel and his colleagues’ analysis, however, this view cannot be supported empirically. Other things being equal, complete separation of railroad infrastructure from operations does not enhance railroad efficiency more than other more conservative reform models, including, for instance, separating accounts and changing the organizational structure of railroads to make operations and infrastructure management more independent from each other.

These results have also motivated theoretical research by Friebel and his colleague Aldo Gonzales on the costs and benefits of complete vertical separation. Their model identifies a trade-off that is important for Russia. While complete vertical separation may increase competition and raise efficiency, its success depends substantially on a country’s ability to subsidize the expected losses of railroad infrastructure through nondistortionary taxation. If a country’s tax system is weak and large deadweight losses are therefore associated with taxation, full separation of infrastructure from operations may reduce rather than increase consumer gains.

The CEFIR Proposal

In a report written with Russell Pittman of the Antitrust Division of the U.S. Department of Justice and Elizaveta Shevyakhova of CEFIR, we proposed an alternative scheme, arguing first that whether the vertical separation approach has succeeded in raising efficiency even in EU and CEE countries is not clear, and second that the initial conditions and goals of railroad restructuring in Russia are quite different from those of the EU.

Railroads play an extremely significant role in the Russian economy, more so than in the EU, where alternative means of transport, primarily road transport, are more readily available. In Russia the share of railroad traffic in freight transportation exceeds 80 percent (excluding pipelines) and is highly profitable. Railroads are especially important for long-haul traffic. They are the only economic mode of transportation for most shippers of bulk freight—such as coal, ore, timber, and construction materials—and these constitute the major share of railroad freight. The share of loss-making passenger traffic in overall revenues is only 11 percent. Even though in many respects (such as freight volumes and intensity of traffic) the Russian railroads perform similarly, or even better, than rail services in other countries, Russian railroads are still burdened by inefficient regulation, lack of competition, depreciated infrastructure and rolling stock, lack of investment, and huge social spending. Thus reform is unavoidable.

The government’s program for structural reform of the railroads is similar to the EU’s plan in that it is based on separating the infrastructure (rail system) from operations and keeping the infrastructure in state hands (see the box). However, the structure of Russian and European railroads is quite different, and therefore so are the problems. In Europe the railroads still make huge losses, and the main goal of reform is to reduce subsidies and increase market share at the expense of road traffic. Competition in the railroad sector is aimed primarily at reducing budget subsidies, creating equal conditions for companies from different EU countries, and developing an all-European railroad transportation market.

While in Europe fierce competition between roads and railroads eliminated the monopoly of the railroads, Russia has hardly any intermodal competition. The government’s program envisages competition only in operating the system and in related industries, while preserving the tracks and locomotives in a single, 100 percent state-owned company. As a result, the reform will not eliminate the railroad monopoly. Regulating this monopoly to avoid overcharging for infrastructure services will be a complex task, both technically and politically. The state-owned company could seriously impair private investment in railroads.

The current plan for railroad reform is unlikely to increase efficiency, induce investment, and create competition. The costs of mistakes in railroad reforms in Russia could be high, given that railroads are much more important in Russia than in the EU. Our report suggests an alternative model of railroad restructuring based on competition between vertically integrated, competing railroad companies. This model has been successful in Argentina, Brazil, Canada, Mexico, and the United States, countries that are similar to Russia in terms of their size, density of railroad network, and structure of traffic.

Long-term concessions for vertically integrated railroads may help achieve three goals simultaneously: promote competition, increase investment, and keep state ownership of infrastructure. Competition between concessions will be possible given enough parallel tracks, that is, tracks of approximately equal length going in the same direction. [Editor’s note: Concessions are an arrangement whereby a private party, the concessionaire, leases assets from a public authority for an extended period and is responsible for financing specified new fixed investments during the period and for providing specified services associated with the assets. In return the concessionaire receives specified revenues from the operation of the assets, which revert to the public sector at the expiration of the contract.]

The geographic structure of railroads in the eastern part of Russia, that is, the lack of parallel tracks, precludes the introduction of such a scheme; however, the western part of the railroad network is dense enough to permit competition. Dividing the railroads in the European part of Russia into two vertically integrated companies will provide a choice between major shippers and will also introduce competition for most freight traffic. Certainly the network could be divided in other ways: the size and density of European Russia’s railroad system could permit up to six vertically integrated companies. Choosing the optimal design of concessions requires further analysis using detailed interregional traffic flow and activity cost data that are not yet publicly available.

To make the plan work, concession contracts and operational rules need to incorporate several provisions. In particular, concessionaires must be obligated to post tariffs, allow shippers to use their own cars, and create a joint dispatching service. Scrutinizing the ownership structure of concessions is important to reduce the risk of collusion between concessionaires.

Critics and Supporters

At the workshop, Anna Belova, deputy minister of railways, presented the official position on progress in implementing the structural reform program. Belova focused on the current stage of the reform, emphasizing success in drafting and passing the legislation necessary for subsequent stages, increasing transparency, and implementing the separation of activities within the current system. Belova paid special attention to the emerging private freight operators. Even though these still represent a small part of the sector, their market share and investment in rolling stock are growing.

Belova criticized the CEFIR proposal on several grounds, namely:

• Having two companies is not enough to assure competition given Russia’s weak antitrust regulation system.

• Dividing the grid as proposed may not provide the basis for parallel competition given that many parts of the infrastructure are depreciated and substantial investment may be required to reroute existing traffic flows to the competing company.

• Auctioning off concessions may be too costly for private owners and may take away cash and working capital needed for further investment.

• Creating and maintaining two infrastructure companies may be wasteful from the point of view of social efficiency.

• Determining the true costs of different activities, and therefore putting together a workable solution for competition between vertically integrated companies, is too hard during the current stage, before railroads’ internal governance has been restructured.

Other workshop participants were more supportive of CEFIR’s proposal. Senior officials from the Ministry of Economic Development and Trade and the Federal Energy Commission (the agency responsible for regulating natural monopoly tariffs) suggested that while further work was required, the proposal to create competition may be the only viable solution. The existing plan preserves a monopoly in infrastructure, including tracks and locomotives, hence competition may emerge only in freight wagon operations, which account for only 15 percent of total costs. In addition, whether the government’s plan will provide incentives for infrastructure investments is not clear, a problem encountered in the U.K. rail reform. The participants agreed that the current plan requires effective regulation to assure nondiscriminatory access; restrain abuses of monopoly power; and provide incentives for investment by the infrastructure monopoly, which is hard to achieve even in EU countries.

Sergei Guriev is a senior economist at CEFIR, Moscow. Russell Pittman is director of the Antitrust Division, U.S. Department of Justice, and Ålizaveta Shevyakhova is a researcher at CEFIR. The views expressed in the CEFIR report are those of the authors alone and not of the US Department of Justice or the U.S. government. The report cited is part of the Railroad Restructuring in Transition Economies project supported by the Think Tank Partnership Program and sponsored by the U.S. Agency for International Development. CEFIR, SITE, and INECO (Slovakia) are partners in the project. For more information about the workshop and the project go to http://www.ttpp.info, http://www.cefir.org and www.cefir.ru.