INTRO: Railways can and must carry freight commercially if they are still going to be useful in 2030, and that means rewarding private investment in modern equipment and sound infrastructure. It can be done, but many governments don’t know how to make it happen

BYLINE: Edward A Burkhardt

President, Rail World Inc

GETTING FREIGHT off congested highways and on to trains is a policy objective of many governments. This is especially true in Europe, where the creation of a single market of continental scale, coupled with the collapse of the Iron Curtain a decade ago, is generating exceptionally rapid growth in tonnage moving over distances where rail should be very competitive with trucks.

Most of the barriers that currently prevent railways from carrying freight as a normal commercial business, which must include investment in asset renewal, are artificial. Some arise from an uneven playing field between modes, but many are within the control of the rail industry and/or government departments.

The biggest development that started in the late-1980s, and has rolled forward through the 1990s, has been a growing realisation that fundamental change must come, and it embraces both restructuring and privatisation. The task in a new millennium is to make it happen - and to get it right.

Finance is the starting point

In state-owned railways, there has been a tendency to regard ’profitability’ as a surplus of revenues over operating costs - any operating ratio below 100% was hailed as good news. As soon as rail moves through privatisation into the commercial world of logistics inhabited by companies operating ships, planes and trucks, matching appropriate financing with railway businesses becomes an absolute requirement if our industry is to survive and grow. It is the ability to achieve a return on this capital at least equal to its cost over the long term that constitutes success.

More than ever, railway managers worldwide need capital to fund replacement and modernisation of locomotive and wagon fleets, infrastructure projects, terminals, workshop and station facilities - and the increasingly important information technology. Without this investment, gains in productivity and efficiency necessary to beat the competition cannot be achieved. Without the extra revenues and lower costs those gains generate, finance to make that investment cannot be rewarded.

Whilst investment to raise efficiency is a pressing issue, whatever form of ownership might apply, privatised railways must obtain financing without the benefit of sovereign credit. This makes their task much more difficult, and requires an exacting correspondence between a robust business plan and the capital markets.

The good news is that today there is more investment money available than there are managers who can put it to profitable use. Put another way, if there is a good project out there in a favourable environment backed by strong management, it will be financed. Here are a few insights into what are ’good projects’ in rail finance, and which are to be avoided.

Today’s rail financing can assume a near infinite variety of personalities depending on the type of transaction, the perceived risk profile, and debt versus equity considerations. Indeed, the deals themselves range all over the map from quasi-government financing to entrepreneurial projects dependent entirely on private initiative for success.

Rolling stock, if general in type so it can be used elsewhere if the intended service fails, can usually be procured using debt or lease financing. Fixed facilities such as track and signalling, terminals and workshops are viewed differently, and will require a substantial amount of equity to back up mortgage debt - if debt can be used at all.

Most rail assets tend to last a long time; obsolescence is slow. These characteristics suggest long-term financing and a relatively low risk profile. In other words, we are looking for patient money with moderate return expectations. This is not a business for venture capital, though from time to time it has been used, usually with disappointing results, for both the provider of the capital and the enterprise using the capital.

It is a rare case indeed where a rail enterprise can be floated in three years, thus providing an exit route for equity capital with an annual rate of return objective of 40%. But that is precisely what Wisconsin Central’s venture fund investor achieved between the time the company was founded in 1987 and its flotation in 1991. The problem there was the assumption that such results were normal, and subsequent transactions would do as well. The subsequent transactions did well, but not that well, and the investor was disappointed with returns that would have pleased most of the people reading this article.

Get the structure right

Intimately bound up with successful privatisation and financing is the structure of the rail industry. This is a very important issue in determining risk profile for investors.

North and South America, Japan and New Zealand have preferred vertically integrated railways with infrastructure in the hands of operators. The European model of separation of the infrastructure from operations has spread to a few Asian and African nations, but I predict it is near the end of its lifespan, primarily because the results have been uniformly bad. It may persist for a while in the European Union because the political commitment to this structure is very high.

With a vertically integrated rail operation, providers of debt and equity capital must look at the entire business from top to bottom. Specific assets, especially wagons and locomotives, can still be debt or lease financed, but the balance of the business is only as good as its earnings flow, and there is little security to be had from rails nailed to the ground in the desert somewhere.

The separated infrastructure model is deceptive, which is why it is so popular in some quarters. Someone figured out that the rail industry could be structured (and analysed) in separate pieces, but ignored the fact that the entire structure had to operate as a whole if the customer - freight or passenger - was to get good service. A high measure of government interference, regulation, and most importantly funding, further serves to muddy the waters.

Operating as a whole to serve the customer is not the strength of the separated infrastructure railway. Indeed, the infrastructure owners, whether private as in the case of the UK’s Railtrack, or public as in all the rest of Europe today, proved to have completely different objectives from those of operators. They exhibit instead the characteristics of high-cost, inefficient and indifferent monopolies protected from market forces through a regulatory and financial structure underwritten by government.

These comments apply particularly to the situation prevailing in Britain, but to a degree the lack of common objectives between infrastructure owners and operators exists wherever this model has been adopted. Except where government funding is delivered directly to the infrastructure owner, the high costs passed on to the train operators have run counter to the declared policy of shifting freight off the roads.

This situation may be fine for the infrastructure owner, at least until the real market catches up with him. It is a disaster for operators who are not publicly supported. Not only must they finance their extravagant landlords, but also must dance to their tune as regards facilities, operational policies, productivity, the safety regime, and the attitude toward market growth and modal competition.

Competing with the subsidised highway is a problem for rail operators worldwide, and at best their lot is difficult. Throw in the difficulties of coping with infrastructure owners, as structured to date, and the task becomes well-nigh impossible.

Freight operators in the UK pay three times more per gross tonne-km than the all-in comparable cost of their American or Australian cousins. But that is just the start. They must suffer axleload limits so low that efficient wagons are ruled out; a restricted loading gauge and short passing loops that prevent the use of larger trains; and a safety regime that would curl your hair. Add to that attitudes straight from the days of pre-Thatcher British Rail, and a built-in priority for passengers, generally subsidised, when it comes to allocating line capacity.

Investors need to know and understand these things in assessing the business future of a train operator, or an infrastructure owner, which is operating under the separated infrastructure system versus that of a vertically integrated railway. My preference is obvious. And that is why EU policy to foster infrastructure separation as a means of securing open access on the railways of the member states has been a total failure.

Open access myth

The second of the twin devils is open access. Infrastructure separation and open access do not have to go together. In fact, Australia started down the path toward the European system and then pulled back, opting instead for open access but in most cases retaining vertical integration. It was only after reconsidering this issue that Australia obtained vigorous bidding in rail privatisations. But the milk had been spilt with respect to open access, and therein lies another pitfall to consider.

Railways in most nations today, and through all but the last of the 18 decades spanning rail’s history, have owned their infrastructure and only permit other operators to use it under negotiated agreements.

Not so today in Europe, where open access - a post-socialist structure - has been adopted. I could write an entire book on open access and the fallacies underpinning the concept. Indeed, I might do so some day. Here, I will cut to the quick. Open access is a government-mandated device to transfer money from the train operator to the rail freight customer in cases where the operator has been able to achieve above-average returns.

It has beggared the industry at a time when rail customers and others interested in the future of rail transport have bemoaned the paucity of private capital going into the business.

If you are a rail operator existing under an open access regime, you will not have competition for single wagon moves from a branch line location, or for most intermodal business, or for other traffics offering marginal results. However, if you have a coal or iron ore block train movement where you can undercut the truckers whilst still having quite respectable margins, you can be sure your customer will come to you and tell you that you can either reduce your prices to a hair over marginal cost or someone else will take over the business.

American shippers envy their European colleagues who have such a lever with which to beat up the railways. They too would like to have their hand in the railway’s pocket. Putting it bluntly, European shippers did a number on the state-owned railways, who were powerless to respond in influencing public opinion. The results, predictably, have been disastrous. Hundreds of millions of dollars have been transferred from the railways to their customers on traffic that was moving under the old rate structure and continues to move today.

That transfer of funds has raised the risk to rail operators, and stood in the way of major capital projects that should have occurred. Providers of financing need to analyse these structures carefully, and the specific situation prevailing.

In Europe, government generally funds directly all or part of the infrastructure authority’s requirements, while in Britain funding comes from private operators paying far above market rates, under a system designed to support the privatisation of Railtrack by flotation at a high price. Passenger franchise holders pass these bloated expenses through to government. Thus we have gone full circle, a scheme that would land one in prison if done by anyone other than government.

Making the EU model work

Despite these impediments to successful rail freight operation, I have recently been working in Eastern Europe on rail privatisation structures. I am advising governments there to adopt vertical integration with a fair and transparent open access regime. Much as I dislike open access, those nations want to join the EU, and the decision to adopt open access within the EU is, for practical purposes, irreversible.

The open access regime I have proposed is to split maintenance, train control, and capital costs of the infrastructure provider between operators on a proportional gross tonne-km basis. Infrastructure expenses for specific traffics, such as the incremental cost of providing track for high speed passenger service, would be split among operators actually utilising such facilities.

This is simple, direct and transparent. What it is not is Ramsey pricing, or some other device to pump up the revenues of the infrastructure provider (who is a monopoly) at the expense of the operators (who are not). I think this structure is in full compliance with EC Directive 91/440, while providing a more customer-friendly environment for rail operators.

Those operators, after all, are the people serving rail customers. They must operate in a healthy environment, and must be able to finance their rolling stock, terminals, information systems and workshops. Current European structures that centre around the infrastructure provider and ignore the operators have resulted in just the opposite.

At the end of the day, organisational structures must serve the customer while providing a business environment that will attract the capital required. This has to occur, like it or not, on a vertically integrated basis. In operating on the European model, these attributes must be equitably divided between all entities in the customer service chain. In this regard, the infrastructure authorities must be handmaidens to the operators, who hold the heavy responsibility of delivering the final product to an increasingly discerning customer and to meet cut-throat competition from the highway. This is the exact reverse of today’s organisation, which puts infrastructure owners at the top of the railway pyramid.

My new organisation, Rail World, stands squarely in the no-man’s land between rail operations, governmental policy makers, and capital providers. We are seeking to match up effective structures, worthy projects and funding sources. As I said at the outset, there is no shortage of investment funds. But there is a huge disconnect between management structures and the transport market that must be successfully bridged before the rail freight industry will get access to capital markets without sovereign guarantees.

The inherent efficiency of the steel wheel on the steel rail is as true as ever. Our problems are man-made - political, cultural, organisational, structural and managerial - so we must create the answers. If we can overcome these obstacles, the best days for our industry truly lie ahead. n

Ed Burkhardt is President of Rail World Inc, a rail management, investment and consulting company formed on July 31 1999. After 20 years with Chicago & North Western, Burkhardt led the 1987 purchase from Soo Line of routes that formed Wisconsin Central. Subsequent acquisitions extended Wisconsin’s unique railway empire into Canada, New Zealand, Britain and Australia through subsidiaries and affiliates, in all of which Burkhardt played a leading role. He left Wisconsin Central Transportation Corporation on August 31 1999

CAPTION: Infrastructure investment is key to providing a high quality operation, but infrastructure decisions must be taken as part of an overall package focused on customer service, which favours a vertically integrated structure

CAPTION: German open access operator HGK and its Dutch counterpart Shortlines have started making inroads into lucrative freight flows between Germany and Rotterdam, restricting the national railways’ ability to price up

CAPTION: In November 1999 Rail World Inc formed a Polish subsidiary to bid for control of Polish State Railways’ freight operations, due to be privatised over the next year or two

CAPTION: Innovative service concepts are needed to win high-value time-sensitive merchandise traffic back from road transport. This is the EWS overnight refrigerated swap-body train launched last year to move food between Glasgow and supermarkets near Inverness

Transforming freight into long term profits

Railways the world over can and must carry freight commercially if they are still going to be effective players in 2030. That means rewarding private capital at acceptable risk to pay for locomotives, rolling stock, good quality track and not least, information technology to underpin the delivery of high service reliability. We have proof that it can be done, and not just in North America. The problem is that too many governments wanting to restructure their loss-making railways have been seduced by the twin devils of open access and separating infrastructure from train operations

Transformer le fret en bénéfices à long terme

Les chemins de fer du monde entier peuvent et doivent transporter du fret sur des bases commerciales s’ils veulent encore être des acteurs effectifs en 2030. Cela signifie une rémunération des capitaux privés à un niveau de risque acceptable afin de financer les locomotives, le matériel roulant, une voie de qualité, et, détail qui n’est pas des moindres, financer également les équipements informatiques afin de maintenir un bon niveau de fiabilité pour les livraisons. Nous détenons la preuve que cela peut être fait, et pas seulement en Amérique du Nord. Le problème est que, de trop nombreux gouvernements soucieux de restructurer leurs chemins de fer déficitaires, ont été séduits par un démon à deux têtes: le libre accès et la séparation de l’infrastructure et de l’exploitation

Güterverkehr langfristig profitabel machen

Bahnen in der ganzen Welt k