Market reforms revitalise European rail freight

Jeremy Drew is an independent consultant advising on the reform and privatisation of railway operations around the world.

Much has been written in recent years about the benefits, or otherwise, of the separation of infrastructure from operations, and of introducing competition between open-access operators. However, there has been little hard analysis to justify the arguments — partly because few countries had introduced these changes until relatively recently.

In order to try and understand the benefits for customers of introducing more competition, with and without infrastructure separation, I have tried to compare the impact of reforms on rail freight in the three European countries which have the most open markets: Germany, Sweden and the UK. Each of these countries has liberalised in a different way: the rail industry in Germany has not been fully separated, whilst the UK is the only one of the three to have completely privatised its rail sector. Customer benefits are assessed in terms of the development of competition and traffic growth.

International context

The granting of access for other operators to use parts of a national rail network is quite common internationally, although usually limited to specific locations. However, full separation between infrastructure management and train operations has been limited to a few mixed (freight and passenger) railways in Europe, long-distance freight in Australia and a few developing and transition countries. In North America, both the vertical separation and open-access models have been rejected on the grounds that, for most markets, there is adequate competition from other modes, notably road. There is also 'source competition’ between different suppliers — such as coal for a power station. Similarly, vertical separation and open access were rejected for the passenger-dominated railways in Japan.

Until recently, most European national railways were vertically-integrated monopolies. EU Directive 91/440 began the process of introducing competition across Europe, partly to create an open 'single market’ in railway services with no discrimination between companies from different member states, and partly to encourage modal shift and boost rail’s share of international freight movement.

Although only a few countries took practical steps to liberalise in the early days, rail freight has already exper-ienced a significant turnaround in traffic levels following a long period of decline (Table 1). After falling by 27% between 1970 and 1993, traffic then began to increase for the EU as a whole. As a result, rail freight in 2006 was 36% above the level recorded in 1993 in terms of tonne-km. However, it is unclear how much of this can be directly attributed to competition, since traffic in the less liberalised countries has increased by 20% over the same period.

Of the three sample countries, the largest increase since 1993 has occurred in the UK, where total tonne-km grew by 67% between 1993 and 2006, although freight volumes are still below the 1970 level. The upward trend really took off in 1997 following privatisation. However, rail’s share of total traffic is still below the EU average, probably because of the UK’s geographical characteristics rather than any specific failure of the rail sector.

Rail freight in Germany has grown by 62% since 1993, although growth in Sweden has only been 18%. Although other factors are likely to have affected traffic growth, the fact that the increase in two of the three countries has been substantially above the average suggests that competition has indeed contributed to growth.

The German model

The most notable feature of German railway reform to date has been the retention of a vertically-integrated organisation under a holding company structure. The need for trans- parency to encourage on-rail competition was not considered as important as achieving an improvement in DB’s financial and operational performance.

Open access was introduced in 1994, but competition was initially limited because of various obstacles, leading to allegations that barriers had been erected by DB to keep out the competition. These included difficulty in obtaining access to the network at the times required and problems obtaining information about the availability of paths. Some of these complaints were indeed substantiated by the regulatory authorities.

Over the years DB’s freight business has acquired all or part of rail freight operations in several other European countries as well as buying a major international logistics company. It remains dominant in its home market, although the level of competition has ramped up steadily. Open-access operators carried 17% of total rail freight traffic in 2007, compared to just 2% in 2000.

The development of competition has been assisted by Germany’s position at the centre of Europe. Germany has land borders with nine states, so there is a considerable volume of international business, including transit traffic, which is particularly well-suited to being carried by other operators. National railways from Switzerland, Italy and Poland run into Germany as do some private operators based in other EU member states. Thus geography can be seen as a clear reason to expect more competition in Germany than in more peripheral countries such as the UK or Sweden.

One result of increased competition is that DB has been achieving relatively low profits in the freight sector. This raises the question — also asked in countries as diverse as Sweden and North America — whether competition may be restricting DB’s ability to earn adequate funds for re-investment.

The German model is held up by some as combining the advantages of open access with the integration of track and operations to optimise co-operation. The decline of rail freight has certainly been reversed, achieving one of the government’s original goals, and the restructuring has not as yet involved any significant expenditure. Overall, it appears that the reforms have been successful, although given the obstacles faced by new entrants they might have produced greater competition and benefits to customers if open access had been accompanied by vertical separation.

It will be interesting to see whether the current restructuring of DB to permit a partial flotation of the operating business (DB Mobility Logistics) results in greater competition between operators and/or calls for a more transparent separation of infrastructure management. The competition authorities have already warned that any proceeds of the flotation must not be used to support DB’s operating business, but some is to be allocated for infrastructure investment.

Socio-economic priority

Back in 1988 Sweden led the way towards separation, when it became the first country in the world to establish a separate state-owned rail infrastructure authority. The idea was to provide a 'level playing field’ between road and rail, with the government directly financing the provision and maintenance of rail infrastructure in the same way as roads. At the same time, separation was expected to reduce the overall 'burden’ of the railways on the state budget.

Even with separation, train operations initially remained in the hands of a single state-owned company. SJ was gradually exposed to competition in different market sectors and then split up into six companies. Competition for freight began with a handful of 'short line’ operators taking over selected local feeder services in the early 1990s. Full open access to the main line network was introduced in 1996, two years later than in Germany and the UK, and by 2006 there were six freight operators.

Some of the services offered by new entrants are complementary rather than competitive with the state-owned operator Green Cargo. They continue to operate on a small scale, effectively acting as subcontractors to Green Cargo on more peripheral parts of the network.

By 2007 other operators had a 35% share of the rail freight market. Competition — or the threat of competition — has reduced rates and improved the quality of service. But as seen in Germany, the financial performance of Green Cargo has been relatively poor, with an operating margin of less than 5% recorded in both 2006 and 2007.

Whilst competition within the rail freight market has been strong, the overall growth in rail freight traffic has been much weaker than elsewhere, which can be attributed to strong modal competition from the 60 tonne lorries permitted on Swedish roads. To support rail freight in the face of such competition the government decided in the early 1990s to reduce track access charges to a nominal level close to zero.

Separation of the infrastructure has also proved expensive for the government. According one Swedish academic, investment levels increased five-fold in the early 1990s, with Banverket receiving a greater proportion of the total rail and road budget based on socio-economic analysis. However, some poor investment decisions were made, due in part to political intervention but also to the disconnection between the end customers and the infrastructure owner.

Overall, the reforms appear to have benefited freight customers but at the cost of an increased burden on the taxpayer.

Fragmentation and consolidation

The desire to facilitate competition, particularly in the freight sector, was a key factor influencing the decision to separate infrastructure management when British Rail was privatised in the 1990s. The UK government considered a number of options, including floating the railway as a single entity, breaking it up into separate regional operators, or into vertically-integrated companies based on the existing market sector business units.

The pre-privatisation debate on structure largely revolved around the passenger railway, which represented about 80% of rail revenues in 1993-94 and absorbed almost all the operating subsidies.

The passenger businesses would have preferred a sector model, as they would retain control of the infrastructure, but the freight units feared dominance. The government decided in favour of full vertical separation, triggering a complex restructuring which saw the creation of nearly 100 separate organisations linked by a complex regulatory and contractual matrix. Under the current model, some organisations (including the infrastructure company and the passenger franchises) are subject to economic regulation whilst others (the freight and rolling stock leasing companies) are not.

The rail freight operations were sold, rather than franchised, since it was not considered necessary for the public sector to specify what freight services should be provided.

BR’s profitable Trainload Freight business operated in two distinct markets. The short-distance, high-volume flows were relatively free-standing, and could easily be opened up to competition. By contrast, longer-distance, lower-volume traffic could be served most economically by a national network and would be more inefficient if broken up.

Although consultants had recommended that open access should be introduced only for the short-distance, high-volume business, the government decided to optimise the trade-off between the benefits of competition and the loss of economies of scale by splitting Trainload Freight into three regional companies.

When these were put up for sale in 1996, the most attractive bid came from a consortium led by Wisconsin Central, which argued that the key competitor was road haulage and it did not make sense to have three rail operators competing for a relatively small proportion of the total market. The consortium bought all three companies and the parcels business, later adding Railfreight Distribution (non-bulk traffic) to give its new subsidiary English Welsh & Scottish Railway almost 90% of the UK rail freight market.

The sixth operator, Freightliner was sold to a management buy-out. Initially it only ran intermodal services and there was no real competition between the two companies. Freightliner moved into heavy haul in 1999, and GB Railfreight, now a subsidiary of FirstGroup, began operations three years later. Both players initially relied on Railtrack, and later Network Rail, to enter the market, securing contracts from the infrastructure manager to carry materials around the network. This provided the business justification to invest in rolling stock and a base from which each operator could expand into other markets.

The other significant open-access operator is DRS, now a subsidiary of the Nuclear Decomissioning Authority. DRS was established to provide specialist services to the nuclear generating industry, but like First GBRf it later expanded to serve third parties. These two now have about 7% of the market, and further open-access players are starting to emerge.

Table II summarises UK market share by operator. EWS has fallen from 86% in 1997 to 64% in 2006. If the infrastructure manager had not awarded contracts for materials haulage to other operators, EWS might have been expected to retain a greater market share. Open-access operators might have found other ways to enter the market, but in this case vertical separation may well have assisted the growth of competition.

However, it can be seen that the greatest challenge to EWS dominance has come from the other privatised incumbent, as Freightliner’s market share has increased from 14% to 29%. Initially Freightliner expanded its core intermodal business, notably containers to and from the deep sea ports, but in 1999 Freightliner Heavy Haul was established to compete in the bulk sector. Part of its success in taking business from EWS is because FHH has not been encumbered by legacy assets and operating practices.

Fig 1 shows how the overall size of the UK rail freight market has increased. After declining from 23 billion net tonne-km in 1972 to 13·3 billion in 1996, traffic has recovered to 22·1 billion in 2006, an increase of 66% over the decade. However, nearly all of the growth is due to longer distances moved, with total tonnage increasing by only 3%.

Growth since 1996 has been from a low base, partly because of a sharp fall in traffic due to uncertainty in the privatisation period. However, traffic levels are now 22% higher than in the UK’s previous economic boom of 1989 and close to the levels of the mid-1970s.

External factors include changes in the coal mining and power generation sectors which means imported coal is being transported over longer distances from ports rather than from mines. Increases in road congestion and the costs of road haulage are also significant. However, road speeds were declining before 1997 when rail freight was stagnating. Some of the increase can therefore be attributed directly or indirectly to railway reform.

Since 1996 there has been considerable investment by the private operators and their customers in rolling stock and terminal facilities, which has encouraged growth in rail freight directly or indirectly.

However, despite efforts to reduce costs and expand the market, the UK rail freight industry is still not sufficiently profitable. Over the financial years 2001-05, EWS profits averaged £43m on an annual turnover of £505m. This is not enough to provide a normal return on capital invested, although interestingly the margin is better than that achieved by either DB’s rail freight business or Green Cargo.

Freight cannot be viewed in isolation from the railway industry as a whole. In the UK, rail industry costs have increased, decisions on investment have been made without adequate reference to the market, and operating performance has been erratic to say the least.

The UK model differed from the other countries in that two incumbent freight operators were formed, one for bulk freight and the other for containers, and these subsequently began to compete with each other. In other countries there was only one incumbent, and the development of competition has been dependent on new entrants.

Given that new operators still only transport 7% of UK rail freight, it seems unlikely that competition would have developed as quickly without the second incumbent. It can be argued that this is a further benefit of vertical separation. It would clearly have been unbalanced to establish a vertically-integrated operator and make the second incumbent dependent on its main competitor for access to the network.

Consider local conditions

Evidence from these three countries shows that open access for rail freight has allowed new operators to win traffic by offering a better combination of services and rates. In both Germany and the UK rail freight traffic has grown much faster than in other EU member states, suggesting clearly that competition has benefited customers.

The evidence on separation is less clear-cut. The dominant operator in Germany, where infrastructure and freight operations are part of a holding company, has a greater share of the rail freight market than the dominant operators in either Sweden or the UK, where there has been complete vertical separation. This is despite a geographical position which should encourage greater competition from operators in neighbouring countries.

However, the situation is not directly comparable. In Sweden, some of the open-access operators are not in direct competition with Green Cargo. In the UK, most competition to the dominant operator comes from the other incumbent. On the other hand, competition here might have been far less had the infrastructure manager not encouraged the emergence of competition. Similarly, the complaints by new operators in Germany suggest that competition might have been greater had there been clear vertical separation.

Advocates of the German model argue that it retains the benefits of integration whilst allowing competition. Vertical separation has clearly led to additional system costs in Sweden and the UK which appear to have been avoided in Germany. However, both the benefits and the costs of separation may be expected to vary, both between countries and between regions within countries. They depend on a number of conditions: markets, capacity constraints and how the railways are regulated.

Whilst lessons can always be learnt from the experience in other countries, any government considering reform as a means to encourage rail freight needs to consider its options carefully in the light of local conditions.