Russell PittmanNew Economic School and Antitrust Division,

U.S. Department of Justice Российская экономическаяшкола

30 September 2013

The views expressed are not purported to reflect the views of the U.S. Department of Justice.

What Next for Russian Railways Restructuring?

How to handle “natural monopolies” (II): The restructuring debate

SECTOR Electricity Natural gas Telecoms Railways

NETWORK: MONOPOLY?

Long distance transmission lines, local distribution lines

Long distance pipelines

Local “loop” – fixed wire service to households and businesses

Track and signalling

COMPETITIVE? Generation: natural gas, coal, hydro, nuclear

Exploration and production

Long distance, mobile, internet

Trains

But competitive elements cohabit uneasily with monopoly networks…How restructure the overall sector?US telecommunications sectorFirst, 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 separationAT&T forced to give up local service in order

to insure fair competition in long distance

The optionsVertical separation

Favorite of the World Bank, EU3rd party access

(Grudging) favorite of incumbents“Horizontal separation”: competition

among vertically integrated firmsCompetition where networks intersect

The old status quo: Regulation of vertically integrated monopolyWas it really so bad, compared to the costs

of restructuring?

How to restructure a vertically integrated monopoly railway?Economists’ (and EU) favorite: Vertical

SeparationOne track owner, many “train operating

companies” (TOC’s)UK, Sweden, Netherlands, Poland, Romania, parts

of AustraliaRemoves incentives to discriminate in providing

access to infrastructureRailways’ (grudging) favorite: 3rd Party

AccessTrack owner is one of the many TOC’sGermany, Austria, Italy, Chile, parts of AustraliaMaintains economies of vertical integration:

“where steel meets steel”Can be imposed gradually (to a fault)

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

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.

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

How to decide (II)? Facts and constraintsSmall 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 countriesAttract private investment? Usually for poor

and middle-income countriesIn years past: Satisfy World Bank conditionality

Improve political and economic integration?Reduce political power of giant firms?

What can economics contribute?Economies of scope (i.e. vertical economies)

Presence not much in dispute, though estimates varyEarly econometric estimates of 20-40% likely too highMost recent results: more important in a) densely

operated and b) freight-dominant systemsEconomies of scale: density

Probably exhausted for most densely operated systems

Economies of scale: system sizeCertainly exhausted for largest systems

One takeaway from this combination: For largest systems, horizontal separation may dominate vertical separation (Savignat and Nash, 1999)

Access pricing issuesEspecially, potential welfare advantages of

discrimination

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)

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 companiesBut INDEPENDENT train operating companies?

Current state of reformsIn 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 theseVery high track access charges

Thus RF pioneered its own form of vertical separation: “infrastructure” includes locomotivesKazakhstan, Ukraine have followed

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 ITCEncouraging “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...

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

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.

Large railway networks

Country KM TrackFreight

ton-KM(M)

Passenger-

KM(M)

(Freight + Passenger)/

Track

KM Track/ Land Km2

(US lower 48)

Population (2010)/ Land

Km2 (US lower 48)

China 60,8092,511,80

4772,834 54,015,656 0.0063 139

India 63,327 521,371 769,956 20,391,413 0.01926 357

Russian Federation

84,1582,400,00

0175,800 30,606,716

0.0049(European

Russia .0138)18

USA 227,0582,788,23

09,935 12,323,569 0.0296 40

Sources: US Census, CIA World Factbook, World Bank

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.

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.

2121

Analysis of the Feasibility to Divide the Single Business Entity (Russian Railways JSC) into Several Vertically Integrated Companies (VICs) Competing among Themselves

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.

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.

Work distribution among VICs:

Southern VIC

Northern 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.

Each VIC services customers located in its region of activity and performs the domestic and international freight transportation with the use of its infrastructure.

Northern VIC

Northern VIC

Eastern VIC

Eastern VIC

An alternative plan, combining parallel competition with geographic competition