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Rail Transport Regulation Javier CamposUniversity of Las Palmas(Spain) Pedro CantosUniversity of Valencia(Spain)This paper has been prepared for the Economic Development Institute of the World Bank. The authors aregrateful to Ginés de Rus, Antonio Estache, Andrés Gómez-Lobo and Lou Thompson for valuable suggestionsand comments. They also acknowledge useful discussions with other colleagues at the University of LasPalmas and the University of Valencia.

1. – THE ECONOMIC CHARACTERISTICS OF RAIL TRANSPORT.41.1. – THE MULTI-PRODUCT NATURE OF THE ACTIVITY.1.2. – THE COST STRUCTURE OF RAILWAYS COMPANIES.1.3. – THE PARTICULAR ROLE OF RAIL INFRASTRUCTURE.1.4. – THE EXISTENCE OF ASSET INDIVISIBILITIES.1.5. – THE ORGANIZATION OF RAILWAYS TRANSPORT AS A PUBLIC SERVICE.1.6. – THE EXISTENCE OF EXTERNALITIES IN THE OVERALL TRANSPORT SYSTEM.4556772. – POLICY AND REGULATION IN THE RAIL INDUSTRY.82.1. – CONSEQUENCES OF THE TRADITIONAL POLICIES ON THE RAIL INDUSTRY.2.2. – RECENT RAIL DEREGULATION AND PRIVATIZATION EXPERIENCES.2.3. – VERTICAL SEPARATION AND PRIVATE PARTICIPATION IN THE RAIL INDUSTRY.2.3.1. – VERTICAL SEPARATION.2.3.2. – PRIVATE PARTICIPATION.2.4. – NEW REGULATORY SCENARIOS IN THE RAIL INDUSTRY.2.5. – DESIGN OF CONCESSION CONTRACTS FOR RAILWAYS.91013131416183. – PRICE REGULATION IN THE RAIL INDUSTRY.243.1. – RATE OF RETURN MECHANISMS.3.2. – PRICE CAP REGULATION MECHANISMS26274. – QUALITY REGULATION IN THE RAIL INDUSTRY.294.1. – DEFINITION OF QUALITY TARGETS IN THE RAIL INDUSTRY.4.1.1. – QUALITY OF SERVICE.4.1.2. – SAFETY AND EXTERNALITIES.4.1.3. – DYNAMIC QUALITY: INVESTMENTS4.2. – INSTRUMENTS FOR QUALITY CONTROL IN THE RAIL INDUSTRY.30333537395. – THE ROLE OF RAIL INFRASTRUCTURES.425.1. – ACCESS TO RAIL INFRASTRUCTURES.5.2. – THE PROBLEM OF RAIL INFRASTRUCTURE COSTS.5.3. – THE ACCESS PRICING PROBLEM.5.4. – COORDINATION AND INTERMODAL COMPETITION.424345486. – PERFORMANCE INDICATORS IN THE RAIL INDUSTRY.496.1. – THE USE OF PERFORMANCE INDICATORS IN THE RAIL INDUSTRY.6.2. – MAIN TYPES OF INDICATORS IN THE RAILWAYS INDUSTRY.6.3. – BEST PRACTICES IN THE RAIL INDUSTRY.4951537. – REGULATORY INSTITUTIONS FOR THE RAIL INDUSTRY.56

7.1. – SOME ISSUES IN THE DESIGN OF A REGULATORY AGENCY FOR THE RAIL INDUSTRY.7.1.1. – THE DEGREE OF INDEPENDENCE OF THE REGULATORY AGENCY.7.1.2. – THE RELATIONSHIP OF THE REGULATORY AGENCY WITH THE GOVERNMENT.7.1.3 – THE SCOPE AND JURISDICTION OF THE REGULATOR.7.1.4. – THE NUMBER OF REGULATORS AND ITS APPOINTMENT.7.2. – REGULATORY INSTITUTIONS IN PRACTICE: ARGENTINA AND THE UNITED KINGDOM.5656565757588. – CONCLUSIONS.619. – REFERENCES.63LIST OF BOXESBOX 1.1. – A SUMMARY OF THE ECONOMIC CHARACTERISTICS OF THE RAIL INDUSTRY.5BOX 2.1. – MARKET SHARES OF DIFFERENT TRANSPORT MODES (1970-1994).6BOX 2.2. – DEREGULATION AND PRIVATIZATION EXPERIENCES IN RAILWAYS.7-8BOX 2.3. – ALTERNATIVE ORGANIZATIONAL STRUCTURES IN RAILWAYS.12BOX 2.4. – DIFFERENT RAIL REGULATORY SCENARIOS AND THEIR OBJECTIVES.13BOX 2.5. – KEY VARIABLES IN DESIGNING RAIL CONCESSION CONTRACTS.15BOX 4.1. – QUALITY DIMENSIONS OF THE RAIL INDUSTRY.27BOX 4.2. – ROLE ASSIGNMENT IN RAILWAYS QUALITY OF SERVICE REGULATION.29BOX 4.3. – INSTRUMENTS FOR QUALITY CONTROL IN THE RAIL INDUSTRY.35BOX 6.1. – CONTEXTUAL INDICATORS IN THE RAIL INDUSTRY.45BOX 6.2. – MANAGEMENT INDICATORS IN THE RAIL INDUSTRY.46BOX 6.3. – BEST PRACTICES IN RAILWAYS MANAGEMENT INDICATORS.58

BOX 7.1. – INSTITUTIONAL STRUCTURE OF BRITISH RAIL SYSTEM.52BOX 7.2. – INSTITUTIONAL STRUCTURE OF ARGENTINA RAIL SYSTEM.53

1. – THE ECONOMIC CHARACTERISTICS OF RAIL TRANSPORT.The railway industry poses a number of specific problems for transport economists andregulators that are only partially shared with other transport modes. These elements are themulti-product nature of the activity, the particular cost structure of railroad companies, therole played by infrastructures and networks, the existence of indivisibilities in inputs andoutputs, the organization of the rail transport as a public service, and the existence ofexternalities in the transport system as a whole (Button, 1993). These characteristics notonly define a descriptive framework for this sector that will be continually referred tothroughout this paper, but also jointly determine the main factors that should be consideredwhen studying in detail the appropriate economic regulation for the rail industry.1.1. – The multi-product nature of the activity.Rail companies are, in most cases, multi-product firms that provide different types offreight and passenger transport services. In the case of freight, together with the usualtransport of bulk freight, rail operators also supply complete cargo wagons or trains, parceland postal services, as well as other services of intermodal transport. In the case ofpassenger transport, long-distance traffic usually coexists with local services (suburban andcommuter trains), regional services, and even with high-speed trains on certain corridors orroutes.1The implications of the multi-product nature of the activity can be examined atdifferent levels. At the accounting level, for example, it is often difficult to allocate totaloperating costs among services. For instance, many of the costs of running a long-distancetrain (including not only infrastructure costs but also variable costs) are shared by differenttypes of traffic and these joint costs coexist with other costs not affected by changes inoutput.2 Some cost elements may be attributable to a particular traffic (for example,passengers), but most of them (wagons, energy, staff,.) may not. Thus, costinterdependence requires simultaneous decisions on prices and services, which, in practice,makes any regulatory task much harder.At the cost level, another important aspect to be considered in the multi-productsetup of the rail industry is the sub-additivity of the cost function faced by a railroad.According to Baumol (1977), a cost function is sub-additive when the provision of servicesby a single firm is more efficient (in terms of a lower unit cost) than the same productioncarried out by two or more companies. This idea conveys two relevant implications for therail industry. First, is it more efficient for a single firm, rather than two separate firms, tosupply both infrastructure and transport services? Second, if the infrastructure and servicesare separated, is the supply of such services more efficient within the context of amonopoly, or should two or more firms participate. This analysis is connected with theadvantages and disadvantages of the separation of infrastructure from services and will bediscussed below in depth after first describing in more detail the cost structure of a typical1Commuter and suburban passenger traffic will be analyzed in other working-papers on this series.For instance, the common costs of signal maintenance along a line section usually do not increase if theproportions of traffic of the different services change.2-4-

railway company.1.2. – The cost structure of railways companies.Railways costs are often classified into four broad cost categories: (i) train working costs,which include the costs of the provision of transport services (fuel, crew, maintenance anddepreciation of rolling stock); (ii) track and signaling costs (including the operation,maintenance and depreciation costs of the infrastructure); (iii) terminal and station costs;and finally (iv), administration costs (Waters, 1985). The first two cost categories, typically,are prevalent in most companies and change according to several factors.3Among train working costs, the cost of rolling stock items depend on both theiramount and the distance they run. Fuel costs depend on car-kilometers run for each type ofvehicle, while train crew costs vary according to train-kilometers run. Track and signalingcosts usually rely on the length of the route (since they all usually rely on a single,standard-quality track). The amount of track and signaling required, however, changes withthe number of trains for which paths are required, although this relationship is not constant.Terminal and station costs depend on the traffic volume, but they vary considerably withthe type of traffic.4 Finally, administration costs fluctuate depending on the overall size ofthe firm, although the precise nature of this dependence is difficult to determine in general.Therefore, as mentioned above, allocating the different costs of a typical railoperator to the multiple outputs or inputs it produces is a complex task. It often involves adegree of arbitrariness that requires, from a regulatory point of view, a clear distinctionbetween costs that are avoidable and those that are not. The avoidable costs are uniquelyassociated with a particular output: were this output not produced, no cost would beincurred. This guiding principle relates to the cost recovery for particular outputs.Avoidable costs may therefore be considered as a floor to regulated prices (if any), sincecharging less than the avoidable cost would be equivalent to operating at an economic loss.1.3. – The particular role of rail infrastructure.Since the birth of the rail industry in the last century, mainstream economists have alwaysconsidered that the larger the size of a railway company, the greater was its efficiency. Theexistence of substantial fixed costs (particularly, those associated with infrastructures)traditionally led economists to assume the presence of important economies of scale in thisindustry, and thus the provision of rail transport services was typically regarded as atextbook example of a natural monopoly.However, this notion has been heavily challenged in recent decades and a number ofnew ideas have been brought to the economic analysis of this industry. The upheaval anddevelopment of the theory of contestable markets (Baumol, Panzar and Willig, 1982)3Nash (1982) finds that train working costs in European firms (with the notable exception of high speedpassenger traffic) accounted for 44%-45%, whereas track and signaling was just 23%-26% of total costs.4For instance, bulk freight handling requires more terminal expenses than parcel services. Similarly, longdistance passengers require more services (ticketage, reservations, luggage,.) than short distance users.-5-

contributed to clarifying the proper definition of the natural monopoly concept, in terms ofthe cost function being sub-additive. This concept implies that whereas duplicating railinfrastructure is generally inefficient (therefore categorizing the rail network as subject tonatural monopoly conditions), the cost relating to the operation of rail transport servicesand rolling stock once the network has been deployed can be efficiently provided by morethan one company, which can be viewed as actual or potential competitors.Therefore, from the regulatory point of view, it has been concluded thatinfrastructure and services can be dealt with in different ways: the former, as a naturalmonopoly,5 but also as a potential provider of adequate access to any willing-to-serveoperator; the latter, however, can be treated, in principle, as any other competitiveeconomic activity that could be provided by multiple competing operators or by a singlefirm under some sort of concession or license arrangement.1.4. – The existence of asset indivisibilities.Even though this potential vertical separation can alleviate some of the natural monopolyproblems, the rail industry remains a very capital-intensive sector with several otherindivisibilities within its productive process. Specifically, the capital units (rolling stock,track and stations) can be expanded only in discrete or indivisible increments, whereasdemand may fluctuate in much smaller units. Consequently, increases (decreases) in supplycould clearly exceed the increases (decreases) on the demand side, thus resulting in excesscapacity. These problems appear in connection to both rolling stock and rail infrastructure.Given that the unit of supply is usually a train or wagon of a given capacity, increases incapacity can only be achieved by the supply of additional units.This lumpiness of rail transport facilities has several important implications forinvestment and pricing. For example, the transportation costs of an additional unit of traffic(freight or passengers) may be insignificant when there is idle capacity, but may besubstantial when the capital is at the limit of its full use.Firms can also be forced to employ fixed assets with differing economic lives,whose reliability spans over a large time horizon and affects heterogeneously the cost itemsdescribed above, modifying investment decisions, and requiring a complete accounting andmanagement information system. Therefore, dynamic price and output considerationsbecome crucial in order to recover the real costs associated with each period of activity.Similarly, a final implication of the presence of indivisibilities in the capital assetsused in the rail industry is that innovation and infrastructure improvement projects areusually deferred and only carried out in small discrete amounts. Railway firms seldomchange the entire definition of their existing network even though in most countries it mightcorrespond to an inherited burden from past decades when the structure of traffic was quitelikely different from what it is today. Instead, they opt for partial renovations that oftenintroduce technical asymmetries between tracks within a country or region, accentuatingtheir indivisibilities and inflexibilities (Boyer, 1997).5At least, when the infrastructure has not been built yet, although not necessarily after that moment.-6-

1.5. – The organization of railways transport as a public service.Although not derived from any of its technical characteristics, but rather from historical andorganizational reasons, the conception of rail transportation as a public or social service,irrespective of its profitability, is another of the defining elements that