Reforming and Revitalizing Ukrzaliznytsia

There are two distinct models for railway reform – European (vertical split) and American (horizontal split). The ‘pure’ European model suffers from conflict of interest and potential abuse of market power. The public-private partnership framework can be used to solve these problems but it raises other issues – in particular, the free-rider problem. Thus, we advise using the American model. It allows to attract investment into infrastructure. At the same time, regional railway monopolies compete with each other for long-distance transportation.

Ukrzaliznytsia has multiple immense needs if it is to support the recovery and growth of the Ukrainian economy, but high on any list of its needs must be money. The rolling stock park, locomotive fleet, and infrastructure have all been neglected for years and are generally in very poor condition. Reform experience in Europe and Russia suggest that attracting large amounts of private investment into rolling stock and locomotives is not difficult if the private sector is provided the proper incentives:

• In Russia, shippers and other private investors were invited to own their own rolling stock, and, once they received sufficient tariff discounts from Russian Railway (RZhD) for their use, private investment soared;
• In the European Union, most countries now require the infrastructure operator to permit the operation of private trains, powered by privately owned locomotives, over the monopoly track, and private train operating companies, with their own locomotives, have captured an increasing share of the freight haulage market. (RZhD has so far successfully resisted this reform step, though many of the largest shippers have purchased locomotives in hopes of future access.)

However, attracting private investment into the rail infrastructure is a problem that Europe has for the most part failed to solve. (We have solved it in the Americas, which I will get to below.) As Larysa Nekrasenko and I have argued along with co-authors [1], Ukraine has suffered along with most of the EU from inadequate government investment in rail infrastructure over many years, and as a result there are bottlenecks at crucial locations that threaten to seriously constrain growth of exports in particular and the economy in general.

Jefferson Sinclair has recently proposed a novel reform plan in these pages that is designed to address the problem of inadequate infrastructure funding [2]. Sinclair proposes that rail infrastructure be separated from train operations – as he notes, a European-style solution; that infrastructure remain a state-controlled monopoly; and that a strong rail regulator be created in order to insure fair access to the infrastructure for all train companies. The infrastructure funding problem would be solved in two principal ways:

• By declaring Ukrzhaliznytsia a “national champion”, and thus both increasing government investment into the system and removing the infrastructure enterprise’s tax-paying responsibilities; and
• By restructuring the infrastructure enterprise as a public-private partnership (P3), majority owned and controlled by the government but, importantly, attracting private investment by granting investors a voice in governance (the setting of access charges, for example).

Sinclair’s contribution to the reform debate is an interesting and welcome one. His plan has its flaws, but then so do all the other UZ reform plans. The question, to paraphrase Churchill, is whether his flawed plan is less flawed than all the others.

With respect, I must say that I am not convinced. First of all, I believe that anyone wishing for the improvement of UZ would welcome both increased government investment and a tax holiday. If declaring the firm to be a national, regional, or world “champion” would cause this to happen, let it be done tomorrow.

The problem with this solution is quite clear from the world railways experience: governments are unreliable suppliers of rail infrastructure investment. In every budget cycle of every parliament, the railway is competing for funds with the military, the health care system, pensioners, and everyone else. Other needs are always urgent, and the track will always last another year. Governments simply have not been able to commit to a continuous, reliable supply of rail infrastructure funding, despite attempts to craft innovative institutional arrangements.

The second component of the proposed reform is more intriguing. Most people wishing for the improvement of UZ would welcome private infrastructure investment as well. The question is how to accomplish this. Sinclair’s plan would have private investors – presumably among them the largest shippers of coal, grain, iron ore, steel, and other commodities – invest in a share of the infrastructure in return for “the ability to take part in decisions about infrastructure access and capital investments”.

If this means that a large coal shipper, for example, would join with UZ in investing to improve a section of the infrastructure for its own use, this definitely has potential – it has worked in the very different rail systems of China and the US, and it seemingly could work in Ukraine. But arranging and incentivizing investment in a relatively small section of “dedicated” infrastructure does not address the larger problem of the bottlenecks suffered by all shippers on the common infrastructure.

This is where the P3 solution fails to convince me. There is a “free rider” problem here. Why would I as a coal shipper invest in a large section of track that will be used by other shippers (including, presumably, my competitors who gain an advantage over me by not investing)? A shipper cannot be given a decision-making role in “infrastructure access” – that is for the new rail regulator – and its “voice” in capital investments can always be overruled by the government as the majority owner of the P3 infrastructure venture. It seems to me that a smart oligarch would almost certainly sit patiently and wait for others to invest their money in an infrastructure that someone else controls.

So how can private investment be attracted in large quantities into the UZ infrastructure? As mentioned above, several countries in the Americas have solved this problem, and I have argued in these pages that a similar solution could work in Ukraine [3].

Mexico, a country with a railway infrastructure roughly the size of that of UZ, offers the clearest example.

In the 1990’s, the government-owned monopoly Mexican railway was in much worse shape than UZ is today. Passenger service was slow and unreliable, and freight shippers had mostly given up on the system completely. With assistance from the World Bank, the Mexican government considered its reform options [4].

The government considered an “open access” reform model similar to those being implemented at the time in Europe (and to a part of Sinclair’s proposal here). However, along with another Latin American government facing a similar situation, Brazil, Mexico opted instead for a solution similar to the successfully reformed freight rail systems of the US and Canada (and historically of the UK): a small number of privately controlled, vertically integrated freight railway companies with some local monopoly power but competing with each other for traffic to and from common points.

The government divided most of the infrastructure system into three sections and put out for auction 50-year concessions for each, the first 30 years with exclusive access (with limited exceptions). The most important common point, the hub where all three connected, was Mexico City, whose entire metropolitan track network was set up as a joint venture that could be accessed by all the major concessionaires.

Bidding for the concessions was limited to joint ventures controlled by Mexican nationals, though all significant bidding groups included foreign investors. Overall the reforms were tremendously successful, beginning with bids for the concession rights averaging USD100,000 per track-km and continuing with hundreds of millions of dollars of investments by the private concessionaires over the ensuing two decades. A national rail system that had been both completely ineffectual and a bottomless drain for government subsidies was transformed into a prosperous, successful, and tax-paying contributor to Mexican economic growth. At the same time, freight tariffs remain among the lowest in the world — in the range of USD 0.03-0.04 per ton-mile. But unlike pre-reform, these rates cover costs and earn a profit, rather than reflecting heavy subsidies [4]. There is very little long distance passenger travel in Mexico.

Of course this organizational regime – now common to the US, Canada, Mexico, and Brazil – has its flaws as well. Under a European-style, “open access” system, if a shipper is dissatisfied with the service of its current rail carrier, it can begin running its own trains, or try to persuade another train-operating company to give it better service. Such options are not available in the Americas-style, vertically integrated regime, so that there are shippers who are “captive” to regional rail monopolists who rely on the regulator for protection against monopolistic abuses.

On the other hand, these systems in the Americas have been extraordinarily successful at attracting private investment, earning profits for their investors, and vastly improving service.

An interesting aspect of the Mexican reforms is that the two largest of the three concessions, Ferromex and TFM, included as investors US railway companies that planned to interline traffic with their “sister” Mexican railways upon winning the concessions. One could easily imagine Deutsche Bahn, the Polish rail company PKP, or – in a happier world – RZhD being willing to invest in a concession of a large section of the Ukrainian rail infrastructure as part of international consortia that planned future interline and transit traffic.

This “Americas style” system of rail reform is sometimes termed “horizontal separation” in contrast to the “vertical separation” model favored by the EU. This model has reportedly been considered – but so far rejected – in both Russia and China. In fact it was the historical model observed not only in the UK, as noted above, but also in the 19th century Russian empire. I have noted elsewhere a particularly apt observation from this period: the Russian transport press in the late 19th century reports intense rate competition between privately owned, vertically integrated railways seeking to ship grain from the Black Earth region to Baltic Sea ports for export and those seeking to ship the same grain to Black Sea ports for export [5].

In the world today, the financial sector is awash with private equity money looking for profitable investments – “dry powder”, it is termed in the trade press. Given the proper incentives – regulated control over a large section of the Ukrainian rail infrastructure, with access to potentially burgeoning export traffic in agricultural, mineral, and manufactured goods – I see no reason why this money should not flow into the UZ infrastructure and the Ukrainian treasury.

Notes