Incentive misalignment and cost implications of vertical separation in railways

1. Railway Days. Bucharest. October . October 8. Incentive misalignment and cost implications of vertical separation in railways Didier van de Velde (inno-V, Amsterdam) Prof. Chris Nash & Andrew Smith (ITS, University of Leeds) Prof. Fumitoshi Mizutani (Kobe University) & Shuji Uranishi (Fukuyama Heisei University)

2. EVES-Rail Team EVES-Rail Study

3. Background • EU Policy of introducing competition within mode for freight and passenger • Requires non discriminatory access to infrastructure for competitors • Current legislation requires separate accounts and separation of ‘key powers’, but holding company model permitted • Big issue in current EC proposals: should complete vertical separation be required? EVES-Rail Study

4. RESEARCH GOALS:- Quantitative- Qualitative

5. Research Goals:Quantitative • Effects of vertical separation on the rail sector’s economic performance in the EU context • How do costs vary between vertically integrated, holding company and vertically separated companies controlling for other factors (including competition) EVES-Rail Study

6. Research Goals:Qualitative • If vertical structure does influence performance, why is that? • Degree of competition? • Transaction costs? • Misalignment of incentives? • Can we identify and describe potential misalignments at various points in the value chain of the rail sector? • And if misalignments occur, how to overcome them? EVES-Rail Study

7. QUANTITATIVE RESEARCH • Cost Modelling EVES-Rail Study

8. Conflicting evidence on the impact of rail reforms on cost • US studies (e.g. Bitzan, 2003) – vertical separation raises costs • 4 European studies. E.g. Growitsch and Wetzel (2009): vertical separation raises costs • Friebel et. al. (2010). Reforms improve efficiency but only where they are sequential and not in a package • Cantos et. al. (2010). Vertical separation with horizontal separation and new entry in freight improves efficiency. Cantos et. al. (2011). Vertical separation effect not statistically significant; passenger tendering found to improve efficiency • Merkert, Smith and Nash (2011). Transaction costs around 2-3% of total costs • Mizutani and Uranishi (2012). Impact of vertical separation depends on traffic density EVES-Rail Study

9. Weaknesses of previous studies • US studies • Technology differences • Based on VI firms only • European studies • Inputs physical only (employees; rolling stocks; network length) • Or, includes all costs (not stripping out access charges) • One European study relies on “virtual” VI firms • Density + load factors • In Cantos et. al. (2010) and Mizutani and Uranishi (2012) • Not in others • Data • Britain not included in most studies. • Most up-to-date data is to 2008. • General reliance on published UIC data EVES-Rail Study

10. Contribution of EVES-Rail Cost Modelling • Data • Adding the British data to the sample. • Updating in time from 2007 to 2010. • Uses UIC data but verified, improved and extended by CER members via questionnaire • Develop structural dummies to better answer the research questions • In particular: holding versus vertical separation • Improve modelling of market opening dummies • Actual rather than potential freight entry • Passenger competition index that reflects degree of entry • Improve accuracy of timing of structural and market opening reforms EVES-Rail Study

11. Cost regression:Model • 26 OECD countries – 1994-2010 • Total rail industry cost = f (control variables, test variables) EVES-Rail Study

12. Cost regression:Summary of key findings • At higher traffic densities, vertical separation increases costs • At mean traffic densities, vertical separation does not significantly change costs • Whereas a holding company model reduces them, compared with complete vertical integration (weakly significant) • A higher share of freight in total revenues increases the costs of vertical separation • Freight traffic may cause more coordination problems in a separated environment than passenger traffic EVES-Rail Study

13. QUALITATIVE RESEARCH:- Incentive misalignment analysis- Realignment mechanisms

14. Incentive misalignment:Concept – actors – economic effects • VS leads to the existence of a fully separated IM alongside RUs • Each subject to a set of incentives given by the market and/or by the regulatory context • Each actor makes choices that optimise its economic position • These choices may well be optimal for each individual actor… but not necessarily for the rail sector as a whole • Misalignment of incentives is when economic losses occur due to choices that are sub-optimal compared to what would occur in a more cooperative set-up (better aligned) EVES-Rail Study

15. Incentive misalignment:Findings: size • Literature review: • Induced costs from misalignment (up to +20%) • Vertical separation also leads to additional transaction costs, but these are limited (+1%) • Misalignment issues increase in importance • In non steady-state railways (demand increase, investments, reconfigurations) • In systems with higher train densities EVES-Rail Study

16. Incentive misalignment:Findings: realignment options • How to solve misalignment issues? • Track access charges and performance regimes are important but cannot solve all misalignment issues • Regulators cannot either solve all misalignment issues (compared to holding or vertical integration steering) • Various hybrid arrangements have started to appear • Joint ventures, sharing of surplus/loss from joint actions • Non-financial cooperation, joint facilities • Remark: Easier to reach where a single operator carries a large part of the traffic • Can re-alignment mechanisms solve all problems? • How do re-alignment mechanisms perform compared to alternative arrangements? EVES-Rail Study

17. Overview of findings on the effects of vertical separation • System cost effects • Depend on train density and share of freight • Negative aggregate effect for the EU if all switch to VS (costs increase) • Alignment of incentives • Effects are important and require much more attention • New trend towards re-alignment (e.g. GB, NL) EVES-Rail Study