Vertical or horizontal separation? - Alive2green

Vertical or horizontal
separation?
Rail regulation issues
21 September 2011

Introduction
• A number of policy initiatives are currently on the table for the South
African freight rail sector:
– Economic regulator
– Introduction of private participation
– Possible separation of track from operations
• The choice of structural model for rail has massive implications for the
complexity of economic regulation, and would merit more discussion
• Vertical separation of the track from freight operations is not the only
possible solution: horizontal separation of freight into a number of
competing, vertically integrated operators should also be considered
• Ideally all feasible alternatives should be considered before decisions
are made
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Contents
Outline of presentation
• Implications of vertical versus horizontal separation in rail
• Implications of structural choices for economic regulation task
• Current policy debate
• Conclusions
3

Vertical and horizontal separation

Competition in networks
• Not all markets are created equal
– Competition works best when a market can support many independent
firms, who can only affect each other by competing for customers
– In network economies, firms benefit from large network size – the more
they cooperate, the better
– Conversely, if a very large firm in a network economy refuses to cooperate
with others, it can drive everyone else out of business (especially if it is
either not possible to replicate the network, or would be prohibitively
expensive)
• Key problem of network economies: how do you ensure that enough
cooperation takes place between firms to support market
development, but without stifling competition?
5

Rail as a network economy
What characteristics make rail a network economy?
• The cost of building a rail network is very high in proportion to the
operating costs per trip
– the more volume that network does, the easier it is to cover the costs of
the initial investment in the track
• The usefulness of the rail network to freight customer increases as
interconnectedness increases
– the more destinations offered, the more likely customers are to use rail,
and the easier it is to get the volumes necessary to operate profitably
• Everybody who uses a piece of track affects everybody else
– have to coordinate speeds, maintenance, signalling, etc or the system
grinds to a halt
• Given these characteristics, running rail as a monopoly makes
intuitive sense
– but the cost is the loss of price and quality competition
6

Why separation?
• Vertical and horizontal separation models both attempt to introduce
competition in rail
– These models arguably decrease the operating efficiency of rail
– Pay-off is the increase in price and quality competition
– But: not certain that this pay-off will materialise if the regulator can’t cope
with the complex regulatory task posed by either form of separation
• Vertical separation: rail track should be housed in a separate
agency. It is a natural monopoly and should be run as a public utility,
possibly on a not-for-profit basis. The job of the track owner is to allow
operators to compete freely among themselves
• Horizontal separation: each operator owns its own track and rolling
stock, but is restricted to a given geographical area, and competes
with other integrated operators
• Which produces the best result?
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Vertical separation
• The goal of vertical separation is to level the playing field between
competing rail operators
– All operators face the same cost structure in using the network
– Customers can ideally then choose between different operators for the
same service, on the same track – enables competition
– Because all network facilities are shared, no single operator has the ability
to deny a competitor access
• This model has been used for freight rail in a number of countries,
including the United Kingdom and the European Union
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Substantial practical costs
Vertical separation & efficiency
• Some studies have suggested that the reduction in technical
efficiency associated with vertical separation can be in the region of
20-40% (Ivaldi & McCullough 2004, 16)
• Technical efficiency issues have a number of sources:
– Money spent on maintaining rolling stock helps to reduce damage to the
track and vice versa: separating ownership means both parties have an
incentive to under-invest in maintenance
– Scheduling and coordination affects efficiency – more difficult to
accomplish with multiple operators
– May create sequential monopolies anyway – single operators on certain
corridors
• Determining appropriate access fees and allocating scarce access to
track are also complex tasks for the track owner
• Potential for damaging favouritism
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Horizontal separation
• Under horizontal separation, each area is covered by only one
operator – establishes regional monopoly providers, with integrated
above track/below track activities
• However, some competitive constraints remain:
– Competition for concessions can be used to constrain pricing behaviour
over the term of the concession
– Competition to service key geographical destinations may be possible,
depending on geography
• The interchange points between different vertically integrated
operators become the focus of regulatory attention
• Countries using some form of horizontal separation in freight rail
include the United States, Canada and Mexico
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Geography is probably key
Horizontal separation & efficiency
• Horizontally separated operators are appropriately incentivised to
invest in optimal maintenance levels – efficiency improving
• Counter-balanced if the freight geography lends itself to bottlenecks
and natural monopolies
• Mexican example:
– Mexico City is a key freight destination
– It is landlocked and served by several rail freight corridors linked to
different ports
– Only area of shared track infrastructure is directly around Mexico City –
limits regulatory burden
– Horizontal separation is able to generate substantial competition for freight
• Geographical similarities to Johannesburg?
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Horizontal competitors?
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Market structure and regulation

When to regulate?
• Economic regulation is difficult to do, and even more difficult to do
well
– Requires intrusion into private business affairs that may be legally
contested: needs excellent legal framework and skill set to implement
– Requires enormous amounts of data and highly skilled interpretation of that
data to set prices and prevent anti-competitive behaviour
– Needs to be done continuously
• Logical implication: you only regulate when you absolutely have to
– Market failure which resists structural solutions
– Potential pay-off from regulation sufficient to compensate for costs of
regulation
– Intermodal competition insufficient to restrain prices
• Regulation should resolve market logjams and enable competition as
much as possible
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Vertical vs horizontal separation
Choice should be influenced by theory and facts on the ground
• Economic regulation is critical for the success of both vertical and
horizontal separation
• Size of the regulatory task depends on the characteristics of the
network concerned
– Do geographical conditions enable competition between vertically
integrated operators?
– Is there sufficient scale on existing corridors to ensure the viability of
competing vertically separated operators?
– Is there a historical relationship between the track and a given operator,
which would lead to favouritism issues under vertical separation?
– Would horizontally separated operators need substantial access to other
networks to effectively compete? (which would require an additional access
pricing regime – compulsory trackage rights)
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Devil is in the details
Policy intentions can be derailed by implementation choices
• The establishment of an economic regulator is not a cure-all – scope
of regulator to improve sector outcomes strongly affected by policy
choices
• For example:
– Does the chosen market structure complicate or simplify the regulatory
task?
– Does the regulator have sufficient control of the incumbent to offset its
competitive advantage over new entrants?
– Has the regulator been given sufficient independence?
• The choice of vertical or horizontal separation, or some mixture of the
two, plays a major role in determining regulatory viability – and thus
the net impact of regulation on market outcomes
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The South African policy debate

Way forward not clear
• Limited transparency in the rail policy debate to date:
– National Freight Logistics Strategy 2005 called for limited introduction of
private competition at operator level, with the track infrastructure retained
by the state – implied vertical separation
– Also commissioning of branch lines – mixed horizontal and vertical
separation?
– Concessionaires beginning to complain about lack of access to main lines:
does this imply that a vertical separation/track access model is not really on
the cards?
• Transnet has now also declared its opposition to splitting out track
assets and vertical separation in general
• Not aware of any publically available work that has been done on the
trade-off between horizontal and vertical separation in South Africa
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Conclusions

Good policy needs good research
• Something needs to be done to improve rail freight performance
• Exactly what that is, is an empirical question, that needs to be
resolved by careful analysis
• Based on what has been released to the public by policymakers in
rail, there is no evidence that this has yet been done
– Some preference seems to be shown for vertical separation
– Interpretation of vertical separation may also have horizontal elements, that
tend to further disadvantage new entrants
– Limited discussion of horizontal separation – not clear if it has been
considered and rejected, or not evaluated at all
• Would be extremely encouraging to see more consideration of this
issue going forward – evidence-based policy making techniques
would be of use, particularly regulatory impact assessment models
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