INTRO: The process of reforming Russian Railways to meet the needs of a market-based economy is well advanced, with institutional separation complete, growing private investment in rolling stock and significant competition in the freight market

BYLINE: Anna G Belova

Vice-President, Russian Railways

Louis S Thompson

Principal, Thompson, Galenson & Associates

RUSSIA is a country of extremes. The territory is vast, the climate is cold, and the population density is low. Above all, Russia is transport-intensive.

Within Russia, the railway has always played a major role. Formerly known as the Ministry of Communications or MPS, it is now called Russian Railways (OAORZD). Socialist planners placed great emphasis on industrial production, leading to the production of enormous tonnages of basic commodities, especially coal, iron, steel and construction materials. Industrial dispersion policies coupled with a lack of emphasis on logistics costs further increased demand for transport. At the same time, the size of the country and the harsh climate limited highway construction and restricted the role that trucks and barges could play in Russia’s transport sector.

The bottom line was that the Russian economy depended on rail transport to a far greater degree than other economies: MPS was a conveyor belt that moved almost everything in the Soviet Union. Even today, Russian Railways loads more than 3·5 million tonnes every day, handling over 80% of surface tonne-km compared with just over 40% in the USA, Canada and China - the only other economies of similar, continental dimensions. In this context it is fair to say that MPS operated with an intensity and professionalism that fully matched any railway elsewhere.

Unfortunately, the transition from a planned to a market economy in the early 1990s had a catastrophic effect on the railway. Overall, the Russian economy and the railway faced a series of unprecedented shocks. For comparison, the US GDP fell in constant terms by less than 30% between 1929 and 1933, whereas Russia’s GDP fell by 45% between 1988 and 1998. As Fig 1 shows, from the all-time peak in 1988, freight traffic had fallen by 61% in 1998 and passenger traffic by 48% in 1999. Needless to say, railway earnings suffered greatly, and a considerable backlog in maintenance and rehabilitation of both track and rolling stock was unavoidable.

By 1999 the Russian economy had found its feet again, and it has since started to recover and grow rapidly, as has the railway. But it is a very different economy, based more on the Western model and far more open to the world economy. As a result, Russia needed a quite different kind of railway - one that responded to market forces without being told what to do by planners. Russia also needed a fresh government approach, with emphasis more on policy and market-based regulation than on command and control.

No precedent

Changing the railway is easy to talk about, but very difficult to bring about, because the railway reform cookbook had no recipes for Russia. The starting point was a monolithic railway/ government ministry that had no market economy equivalent, and among the socialist economies only China was at all comparable.

The accounting information, though accurate enough for government reporting purposes, was not compatible with International Accounting Standards (IAS) and was not adequate to support definition or evaluation of the real performance of any of the railway’s activities.

The vital role of the railway in the economy meant that the risk of disruption in the transition process had to be constantly kept in mind. The lack of effective competition, especially in freight transport, meant either that rail versus rail competition had to be introduced, or that tariff and entry regulation had to be more intrusive than in the Western economies, or both.

Finally, Russia is still the third largest rail freight carrier in the world in terms of tonne-km (Table I). Although the percentage of passenger-km to traffic units (passenger-km+tonne-km) at about 9% is lower than the 20% to 60% range found elsewhere in Western Europe, it is substantially higher than the 1% level in North America. The table also shows that passenger-km are the fourth highest in the world.

To underline the point, Russia carries far more rail freight than all the countries in Western Europe combined, and more passenger-km than Germany, France and Italy together. It has the second highest traffic density, measured in traffic units/km, and this means that it has to focus very carefully on freight and passenger traffic.

Another key element for Russian policymakers was the requirement to generate a stronger role for the private sector in the railway industry. This was needed to promote market focus and, frankly, because the investment needed to rebuild railway lines and rolling stock was beyond the capacity of government or railway earnings alone to finance.

In broad terms, the steps needed for the transition were clear. The enterprise and commercial activity functions had to be separated from regulatory and government functions, and the new roles and missions of both had to be clarified. The railway enterprise had to be reorganised by line of business to permit effective market-driven management; and the railway structure had to be analysed and developed with as much rail versus rail competition as feasible given government objectives and regulatory policies.

Passenger service support

It was equally important to separate the socially-driven passenger services, especially suburban services, from the market-competitive freight traffic and to negotiate an agreement for direct government support in the form of a Public Service Obligation for the social services. Revised tariffs for the freight business that would reflect the new competitive realities and operating structure had to be devised, and a new organisational structure that would generate more private sector investment was essential. Most important, the process had to be implemented in phases that would balance the need for results against the risks of disruption.

None of the available models fitted completely. The existing monolithic approach was not workable in the emerging competitive, market economy, especially if the role of the private sector were to be increased. The European Union model with separation of infrastructure from the operators offered advantages in clarifying lines of business and promoting freight competition, but it did not match the Russian emphasis on freight rather than passenger traffic. It also offered no guidance on promoting the role of private investors, nor did it reflect the fact that rail freight has more market power in Russia than elsewhere and would need regulation.

The North American model, which integrates the dominant freight operator with the infrastructure, did match the Russian freight emphasis. It also offered extensive experience of private investment and regulation, but it made the development of competition difficult because it would entail break-up of the system into a set of competing, integral companies. This may eventually be possible in European Russia, but it was not feasible in Eastern Russia.

In other words, Russia needed to adapt the different models to suit its own conditions. In broad terms, the approach chosen includes elements of both European and North American experience. The panel (left) summarises the different processes in the transition, which is taking place in three phases:

Phase I (2001-02) was a preparation period to identify and construct the basic legal framework for the reforms. Based on this framework, six new laws and 14 governmental decrees were adopted by the State Parliament and government, an asset register was completed, the institutional separation was started, and the necessary tariff changes put in place along with the appropriate regulatory system.

Phase II (2003-05) covers implementation of the institutional separation and completes the legal set-up for reform. It includes creation of the open joint stock companies (with access to the capital markets) and spinning off the initial set of ancillary activities. In addition, the expectation was that an initial round of private investment would be triggered in freight wagons, and possibly in competing freight operators; also, the arrangements for PSO support for socially-driven passenger services were to be developed.

Phase III (2006-10) would see the passenger services fully separated and supported by PSO arrangements; private operators are expected to offer effective competition for the main freight operator under an evolving tariff structure that will foster new entrants, while the possibility of creating new, integrated freight companies will be evaluated. Significant private investment in the freight wagon and locomotive fleet would be encouraged, as would access to the private capital markets by OAORZD.

Progress to date

By any reasonable standard, progress so far has been considerable, with most of Phase II completed on schedule. Most of the legal framework is in place and the institutional separation of enterprise from government is complete. OAORZD is now established and actually has a higher bond rating than the government as a whole.

Private investment in rolling stock has grown rapidly, exceeding US$600m so far, with approximately 200000 freight wagons now privately owned - and the number is growing. The accounting system has been upgraded to IAS compatibility, and the lines of business will be put in place during 2005.

The initial version of the new tariff system has been published, and this incorporates a novel approach to infrastructure access charges in which competing operators receive a discount from the OAORZD tariff if they provide their own wagons and/or locomotives. Fig 2 shows that freight competition is significant, and growing.

On the less positive side of the ledger, it is proving difficult to separate fully the passenger companies and get the PSO agreements in place, even though the tariff and support combination per passenger-km in Russia is far below European and North American experience. The resistance is partly due to the large support costs, about US$1·4bn a year for long-haul trains and US$0·8bn for suburban services - approximately 50% of OAORZD’s freight profit is being absorbed by passenger losses.

Another factor is that local governments have little experience in either contracting for services or operating their own. Perhaps more importantly, because IAS-based, line-of-business information is only now emerging, many critical investment and market decisions are necessarily being made on approximate information, although this will improve in years to come.

Reformers inevitably worry more about the future than congratulating themselves on progress so far, and Russia is no different. An ECMT study published in 2004, Regulatory Reform of Railways in Russia, discussed the challenge in finding the right balance among competition objectives, railway structure and regulatory approach. This balance is still evolving, with two sets of issues needing priority attention: