What Next for Russian Railways Restructuring?

1. What Next for Russian Railways Restructuring? Russell Pittman New Economic School and Antitrust Division, U.S. Department of Justice Leontief Centre 27 September 2013 The views expressed are not purported to reflect the views of the U.S. Department of Justice.

2. How to handle “natural monopolies”: The restructuring debate

3. But competitive elements cohabit uneasily with monopoly networks… • How restructure the overall sector? • US telecommunications sector • First, 3rd party access • MCI competed with AT&T for long distance, while AT&T maintained local service monopoly • AT&T discriminated against MCI in order to favor its own long distance service • Then U.S. v. AT&T: Vertical separation • AT&T forced to give up local service in order to insure fair competition in long distance

4. The options • Vertical separation • Favorite of the World Bank, EU • 3rd party access • (Grudging) favorite of incumbents • “Horizontal separation”: competition among vertically integrated firms • Competition where networks intersect • The old status quo: Regulation of vertically integrated monopoly • Was it really so bad, compared to the costs of restructuring?

5. How to restructure a vertically integrated monopoly railway? • Economists’ (and EU) favorite: Vertical Separation • One track owner, many “train operating companies” (TOC’s) • UK, Sweden, Netherlands, Poland, Romania, parts of Australia • Removes incentives to discriminate in providing access to infrastructure • Railways’ (grudging) favorite: 3rd Party Access • Track owner is one of the many TOC’s • Germany, Austria, Italy, Chile, parts of Australia • Maintains economies of vertical integration: “where steel meets steel” • Can be imposed gradually (to a fault)

6. Other options? “Horizontal separation” preserves vertical economies, requires less regulatory oversight This is the model of North and South America USA, Canada, Mexico, Brazil Parallel competition where possible Chicago to Los Angeles? BNSF or UP Montreal to Vancouver? CN or CP “Geographic competition” otherwise Export grain from Chicago? Pacific NW competes with the Gulf Coast

7. Mexico, where “horizontal separation” relies on “geographic competition” only Imported steel to Mexico City? KCSM from Monterrey (or Laredo), Ferromex from Manzanillo (or El Paso), Ferrosur from Veracruz Exported auto parts from Mexico City? Same, in opposite directions.

8. How to decide? • Vertical separation removes incentives to discriminate but loses economies of scope (operations/infrastructure) and risks double marginalization • 3rd party access maintains economies of scope but creates incentives to discriminate • Horizontal separation removes incentives to discriminate but loses economies of scale (in this case, system size) and risks preserving local monopoly power

9. How to decide (II)? Facts and constraints • Small system or large? Passenger-based or freight-based? • Lessons from a small, passenger-based system (UK) may translate poorly for a large, freight-based system (RF) • What are you trying to accomplish? • Improve efficiency? Usually for rich countries • Attract private investment? Usually for poor and middle-income countries • In years past: Satisfy World Bank conditionality • Improve political and economic integration? • Reduce political power of giant firms?

10. What can economics contribute? • Economies of scope (i.e. vertical economies) • Presence not much in dispute, though estimates vary • Early econometric estimates of 20-40% likely too high • Most recent results: more important in a) densely operated and b) freight-dominant systems • Economies of scale: density • Probably exhausted for most densely operated systems • Economies of scale: system size • Certainly exhausted for largest systems • One takeaway from this combination: For largest systems, horizontal separation may dominate vertical separation (Savignat and Nash, 1999) • Access pricing issues • Especially, potential welfare advantages of discrimination

11. RZhD reform program 2001-2010, later extended to 2015 • OBJECTIVES • Improve sustainability, accessibility, safety and quality of the rail transport service to help create the country’s common economic space and ensure the national economy’s development • Establish a single harmonised national transport system • Lower rail transport costs • Meet the increasing demand for rail transport services • PRINCIPLES • Phased-in reforms and minimisation of irreversible action • Separation of government regulation and operations • Separation of the core and non-core operations • Migration from monopoly to competition • Function-based organisational structure • Government’s regulation of and control over the monopoly (infrastructure) • Partial infrastructure integration with freight transport during the first stages of the reform to be phased out to ensure rolling stock privatisation • (from a 2011 RZhD slide presentation)

12. How to achieve “migration from monopoly to competition”? • From the original reform plan: • Third Stage: 2006-2010 • Partial or complete privatization of subsidiary companies • “Develop competition in the freight traffic sphere” • “Estimate the opportunities of setting up several railway companies, competing and vertically integrated” • This last point has faded from the discussion • What competition has been created so far? • Rolling stock, repair facilities • “Daughter” operating companies • But INDEPENDENT train operating companies?

13. Current state of reforms • In RF there are plenty of independent “operators” (companies that arrange transportation for shippers and may own rolling stock) but not yet any “carriers” (companies that operate their own trains with their own locomotives on the RZhD infrastructure) • Barriers/complications to “carriers” • Continued cross-subsidy requirements for RZhD trains • “Common carrier” requirements – other countries do not impose these • Very high track access charges • Thus RF pioneered its own form of vertical separation: “infrastructure” includes locomotives • Kazakhstan, Ukraine have followed

14. What next? • “Target Model of the Cargo Railway Transportation Market till 2015” • “Continuing integration of rail transport infrastructure and transport activities until at least 2015” • “Pilot projects aimed at creating private carriers based on the principle ‘for route’ and ‘en route’ competition” – though RZhD resisting “en route” pilot • After 2015: Vertical separation? • Sale of majority shares of Freight One to ITC • Encouraging “further consolitation of rolling stock operators and, in the future, the formation of three or four companies operating across the whole rail network in Russia.” • Note the careful language! • “Operators”, not “carriers” • It appears that RZhD has not committed to exiting the locomotive business. Thus...

15. RZhD’s secret weapon: The Institute of Natural Monopolies Study • 1. Detailed engineering/accounting cost analysis of a) vertical separation and b) creation of 3 competing vertically integrated firms • Conclusions: • A. Vertical separation would increase railways transports costs by RUB 223 billion – about 1/3 – with small and uncertain benefits • “Occurrence of the positive consequences has probabilistic nature. Occurrence of the negative consequences is inevitable.” • B. In fact, given these costs as well as additional complexities of operation, vertical separation is “not feasible”. • C. Regarding vertically integrated firms, parallel competition is “impossible ... as there is only one shortest distance between two stations.” • D. For vertically integrated firms, geographic competition is feasible, but would increase costs by RUB 105 billion – over 15 percent – with small benefits

16. RZhD’s secret weapon: The Institute of Natural Monopolies Study (II) • 2. Extensive review of the international economics literature on vertical separation in railways – 25 “foreign studies” • (Full disclosure: I was the author of 2 of the foreign studies and the co-author of a 3rd.) • Conclusions: • A. “There is no practical evidence that vertical separation increases the internal competition and the rail’s modal share in freight or passenger transport or enhances the productivity and efficiency of the rail transport.” • B. “The authors of the majority of studies assert that the efficiency of each structural model depends on conditions ... in each country.” • C. A large number of the studies focus on Western Europe. Russian railways are very different from Western European railways. • D. “For rail networks with high traffic density and a large share of freight trains [like the RF] the preferable solution is not to perform vertical separation.” • Footnote: The  authors do not seem to have noticed that the study they rely on for this point uses an unusual measure of traffic density, under which density in the RF is below average: 48 train-km per route-km per day, in contrast to the sample average of 61.

18. Large railway networks Sources: US Census, CIA World Factbook, World Bank

19. Responses to the  Study • 1. Literature review is accurate. • Vertical separation has not been shown to be important for competition or efficiency. • In any case, it is difficult to apply the experience of UK or Sweden to Russia. • 2. But RZhD’s conclusion – “competition does not have a direct impact on improving the efficiency of railways and should not be an end in itself” – does not follow. • 3. The report underestimates the benefits of competition. • Companies with different costs can compete quite fiercely. • Parallel railways in the US and Canada • TSR with the all-water route from East Asia to Europe • The benefits of competition are not limited to shaving a few rubles off costs – competitors improve quality and come up with new products and services to capture business. • US airline deregulation • US rail deregulation • Also, competition may reduce, not increase, the requirements for regulation. • The report is correct: Vertical separation creates increased complexity and requirements of regulation. • But competition among vertically integrated railways greatly reduces the need for regulation. • This is certainly the US experience.

20. So: Competition among vertically integrated railways in the RF? Why not? • 3 is a good number (as in Mexico). • One possibility is  plan: “Geographic competition among 3 vertically integrated railways”, all moving in different directions from the Kuzbass • An alternative possibility: parallel competition based on the TSR and the BAM through the Kuzbass to Moscow, with geographic competition from a 3rd railway between Moscow and the Baltic Sea • Facts and figures: • RF Railway Strategy 2030 calls for doubling capacity and tripling traffic on the BAM, including plan for “strategically important” extension to Magadan. Why not direct, parallel competition between TSR and BAM? • Traffic density on the Russian railways much greater than US (in fact 2nd in the world to China). So economies of density likely exhausted. • 86,000/3 = 29,000 km average track length. Not as big as BNSF or UP in US, but in the same range as NS, CSX, and CN, and larger than CP. (Average length of 7 US Class I railways is 33,000 km.) So economies of system size likely exhausted, or nearly so.

21. Analysis of the Feasibility to Divide the Single Business Entity (Russian Railways JSC) into Several Vertically Integrated Companies (VICs) Competing among Themselves Work distribution among VICs: Northern VIC Northern VIC Focused on the Kuzbass — Northwest flow, participates in forming and advancing the North — South flow in its service range. Competes with the Southern VIC when relocating the Centre — Volga Region — Ural Mountains flow, and probably competes for part of the Kuzbass — Centre flow. Northern VIC Focused on the Kuzbass — Azov-Black Sea Traffic Centre and North — South flows, maintains the Centre — West flow, competes with the Northern VIC when relocating the Centre — Volga Region flows, and also probably for part of the Kuzbass — Centre flow. Southern VIC Eastern VIC Focused on the work with the Kuzbass — Far East Traffic Centre cargo flow, forms and sends the Kuzbass — Northwest and Kuzbass — Azov-Black Sea Traffic Centre flows to the Northern and Southern VICs. Eastern VIC Each VIC services customers located in its region of activity and performs the domestic and international freight transportation with the use of its infrastructure. 21

22. An alternative plan, combining parallel competition with geographic competition