Open Access to Rail Networks Introduction

Open Access to Rail Networks Arthur S. De Vany Department of Economics Institute of Mathematical Behavioral Science University of California Irvine, CA 92717 W. David Walls School of Economics and Finance The University of Hong Kong Pokfulam Road Hong Kong. November 1996 Forthcoming in Transportation Quarterly

Introduction The success of open access in natural gas and the impending opening of access to the transmission grid in electrical power are part of a wave of deregulation and reorganization that is sweeping over many network industries in the United States and other parts of the world. Open access is coming in some form or other to the railroad industry which is gearing up for a battle over the form and terms under which open access will come to the industry.

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Railroads tend to see open access as mandating ”compulsory” access to their rail networks. Shippers tend to see it as an opportunity to forge their own terms in a market where they may have limited local alternatives to a railroad and a few may even see it as an opportunity to operate their own railroads. Many point to open access gas pipeline transportation as the future of the railroad industry. Others argue that the many differences between gas and rail transport make the comparison inaccurate. Certainly, both industries are configured as networks. Both have high fixed costs relative to marginal cost. There are differences in how gas pipelines and railroads are regulated, though they are not as great as they once were. Now that gas pipelines have become contract carriers, rather than the merchant carriers they used to be, the differences between rail and pipeline transport have narrowed. Railroads are still considered to be common carriers, even though most of their traffic is carried under contracts, as in natural gas. In some sense, the opportunities for railroads to become a competitive industry are greater than they were for natural gas, which has become highly competitive in gas and transmission pricing. This is because there is a greater diversity of origin and destination points for freight movements, a wider range of products, and more flexibility in rail movements and routing than in natural gas.

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Open Access in Railroads How would the railroad industry be organized when shippers, forwarders, and just about anybody has access to trackage? What is involved is a separation of trackage and right of way, and the associated control structures, from rail movements. This affords a wide range of alternative configurations of railroads, interconnections, and networks. One would soon see railroads granting trackage rights to one another in ways that improve track and rolling stock utilization and extend rail networks over broader territories. An artificial constraint – railroad workers are guaranteed, by law, 6 years of income in the event they lose their jobs in a trackage rights or line-sale transaction, unfortunately, creates a strong disincentive to these highly efficient transactions between railroads. The industry may have to find other ways to allocate trackage rights in order to avoid these penalties. On the other hand, the gains in efficiency may enhance the comparative advantage of the railroads so that employment is not impacted heavily. Europe has some experience with open access. The Swedish rail industry separates infrastructure from traffic and their operations make it clear that some form of open access can be applied to railways (Hansson and Nilsson, 1991). European Union directive 91/440 (Commission of the European Communities, 1991) requires the railways of all EU member states to provide trackage rights for international passenger service. To be sure, the concept of on-rail competition has been challenged, but the technical obstacles can be overcome without losing the ability to coordinate train service (Starkie, 1993). European railways have already begun to adapt to the new environ3

ment of open access trackage (Hafner, 1995).

Implementing Open Access through Trackage Rights Consider how trackage rights and train movements could be separated and then how the industry would be organized when there is open access to trackage rights. A trackage right has to specify the rights to move trains of cars over a given segment in some meaningful way. It is not the track that is allocated, but its capacity to carry train or car movements that is to be allocated. Capacity is subdividable, even when the rail lines are not. So, the indivisibility problem is solved by defining a trackage right as a right to movements per some unit of time, say each month, over a rail segment. This is similar to what is called an undivided interest as used in oil pipelines and natural gas. Under this concept, a railroad is a supplier of movements over its right of way and trackage. It may retain some of its capacity to move its own trains, contract out some portion, and put the remainder in a spot market. Shippers could contract for movements or buy them in the spot market. Each month, holders of contracts for movements nominate the number of movements they intend to use. The railroad coordinates these movements according to accepted rules, known to all parties, and then puts the remaining capacity in the short term market, acting a broker for its own capacity and its shippers. Shippers get spot market prices for the capacity they release each month, as does the railroad. As it happened in natural gas, this short term 4

aftermarket became a major competitor to contract movements and both short-term and long-term pricing became highly competitive. Price making is decentralized to the market and there are so many suppliers of movements that no one has any market power. So, prices can be unregulated as soon as the aftermarket gains wide participation and liquidity. Railway customers—shippers, utilities, or industrial users—can own a portion of a rail line’s capacity or they can purchase transport rights from others. Users can contract for freight movements of whatever dimension, such as cars, trains, ton-miles, etc., is the appropriate way to organize the transaction, on a line whose track connects with theirs. The carrier would acquire a fractional interest in the capacity of the line over some segment. Carriers would have the ability to route shipments over their extended system with a single point-to-point tariff. The concept of capacity rights to a fixed and indivisible facility is analogous to a fractional merger, but the interests are both cooperative, as reflected in the agreement, and competitive, because another carrier has been put on existing right-of-way. Captive shippers could be granted extended options, including contracting for movements on specific rights-of-way.

Pricing Trackage Rights The transportation rights contracts used in both oil and gas pipelines set a two-part tariff, one part to cover fixed cost and another marginal cost. Some type of multi-part price is essential. The contract lets the shipper move up to some maximum quantity per unit time, and the fixed monthly charge is to 5

maintain that option. Capacity rights that are exercised through use would bear an additional cost related to operating cost and the opportunity cost of displaced shipments. In all cases, even in the absence of congestion, price must exceed marginal cost. With zero congestion, the shipper pays the fixed charge for the movement option and a price that covers marginal movement cost. The fixed charge covers not only capital cost, but also the incremental delay imposed on others when the movement quota is factored into total movements. In this way, the pricing of capacity rights allows efficient use of trackage because the economies of coordination are maintained. Consider what happens to fixed cost when the railroad and other participants can buy and sell trackage capacity rights in a liquid market. Wide participation in a market for trackage rights would ensure the diverse interests of market participants are represented and that the market sets the price. Once price making is moved from tariff filing to a liquid market, it is decentralized and railroads have no market power. Moreover, if the market is characterized by a high degree of liquidity, the cost of a round trip transaction (buy movements, ship into a market, sell movements, exit the market) becomes small. The market for railway services would become almost perfectly contestable in the sense that hit-and-run entry imposes a competitive discipline on prices. Fixed costs, which are associated with fixed and specialized assets, vanish in the aftermarket. Railroads must be permitted to add new movement capacity when the market price warrants it and they see a profit opportunity. There are no guarantees, just market prices to organize the provision and use of rail ca-

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pacity. If the capacity is undersubscribed there is a loss for owners of unused capacity. If capacity is oversubscribed, the price rises and there is a profit. In any case, there is no market power to be exploited, just competitive prices and wholly decentralized price making. Capacity is reallocated from the the railroads to their customers, but the incentives for static and dynamic efficiency remain responsive to market price signals.

Lessons from Open Access in Natural Gas Pipelines The interstate natural gas pipeline industry has evolved a new form over the last fifteen years (see De Vany and Walls (1995a) for the whole story). Gas pipelines were previously merchant carriers who owned the gas they transported and sold to downstream customers. However, the structure of the natural gas industry changed dramatically when the federal regulator permitted pipelines to become contract carriers (not common carriers). As a contract carrier the pipeline was allowed to sell pure transportation to its customers. Natural gas became separated or unbundled from its transmission and markets emerged in both gas and transportation. The formal separation of gas from transmission that was institutionalized in contract carriage evolved a new organizational form for the pipeline firm that would lead to an efficient allocation of gas. Before pipelines were allowed to become contract carriers, regulators had organized the industry as separate monopoly pipelines, and this regulatory policy had suppressed markets for more than forty years. Under relaxed regulation, the industry participants created the institu7

tions required to support market exchange in both gas and in transportation. Gas markets began to function much like markets for any other commodity where the customer buys the good and arranges for its shipment. In the case of gas, there is no intrinsic reason that the pipeline should be constrained to own the gas it transports. There is little possibility for a moral hazard problem due to improper care while under shipment. Furthermore, units of natural gas are nearly homogeneous so that it does not matter that the molecules injected into the pipeline by the gas seller are not the same molecules withdrawn by the gas buyer. The changes in the gas pipeline industry’s organization were not designed by the regulators and imposed upon the industry. Quite to the contrary, the evolving market in natural gas and transmission created competition where regulation had previously institutionalized monopoly. Gas pipeline merchants voluntarily became contract carriers and began to supply an increasing proportion of their customers with pure transportation service. After a series of regulatory actions in the early 1980s, the regulators authorized markets and competition to be the forces that determine the price and allocation of natural gas. More recently, the federal regulators have required all interstate pipelines to stop selling natural gas completely and to become pure transporters. Pipeline deregulation is still incomplete, but it does provide an example of how an alternative form of market organization, namely contract carriage, can unleash competitive forces (De Vany and Walls, 1995b). Under complete deregulation, transportation would become a property right. The pipeline

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would then become the supplier of transportation rights and the holders of those rights would supply transportation. The holders of the rights would allocate supply through the market, as with any other property right. Under this form of organization, property rights in transport capacity would decentralize the control of a pipeline’s output while centralizing its production.

Monopoly and the Role of Regulation The concept of natural monopoly vanishes or carries no weight when the railroad industry is organized according to the open access with market pricing of trackage rights. Consider how a right to move trains over track segments could be used to avoid the problem of natural monopoly altogether. If transmission can be provided at less cost on one rail line than on several, this does not imply that the entire transmission capacity must be controlled by a single firm. The rail trackage is indivisible, but its capacity can be divided among several owners by creating a property right in transportation. Because separate units of capacity can be individually owned there are many owners to supply the capacity of the line to the market. The owners of transport capacity simply hire a manager to coordinate the use of their individual rights. Under such an arrangement the scale economies of a single track are realized even though the control of output is decentralized. Regulation—and the natural monopoly problem—is predicated on the assumption that coordination and allocation are under the control of the railroad. When control of capacity is decentralized because transport rights holders compete with one another there is no monopoly; just many competing 9

sellers of movement rights on rail segments. Traditional regulation tends to create monopolies under the guise of serving the public interest. Acting under the natural monopoly model, regulatory commissions often restrict entry thus creating monopoly and making customers captive to the regulated firm. At the same time, the firm is constrained from being truly competitive and aggressively seeking new business and meeting the prices of its competitors. Thus, regulation constrains the firm and its customers, leaving no room for innovation and efficiency enhancing specialization. All these objections to regulation, and more, have been voiced by customers, regulated firms, and economists. Only regulators seem to like regulation anymore. Congress has been listening to these voices and has embarked on a pro-competition policy that is overtaking many industries. The evidence is impressive that deregulation pays. In the U.S., deregulation in the transportation, telecommunications, and energy industries is estimated to have resulted in a net gain to society of $36–$46 billion U.S. dollars (Winston, 1993). Consumers have been the primary beneficiaries of deregulation.

Conclusions and Policy Implications If open access were done right in the railroads, train and car movements on track segments would be sold by every railroad. They could be sold outright, or under contracts for specific time periods. Variations in capacity and movements would be taken up in a short-term market, much like the daily interruptible transmission trading one sees on natural gas pipelines. 10

Shippers, brokers, railroads and integrators would deal with one another in a broad market that permits flexible configuration of routes. Fixed costs begin to vanish because movements are traded in a liquid market. Rail capacity becomes less specialized because alternative routings become easier (just acquire short-term movements on other segments to connect your origin and destinations). Rail pricing becomes increasingly competitive when prices are made in a broad and liquid market. Railroads become more competitive because they can reconfigure their networks rapidly and flexibly to offer tailored and competitive services. Because unused capacity reverts to the aftermarket, no one, not even the railroad, is left with any market power. Long-term contracts would become a source of financing for expanded rail capacity. Railroads could make or lose money on new capacity they offer to an unregulated and competitive market in rail movements. A futures market or some other device would develop to allocate risk and provide signals about future values. Contract, spot and futures prices would guide investment and allocation decisions, not some tariff hammered out in a long and costly regulatory proceeding and which is based on irrelevant and stale cost information from the distant past. A property right in rail transportation, rather than saddling railways with the obligations of mandated access, is the right way to bring open access to the railroads.

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References Commission of the European Communities (1991). Council Directive on the development of the Community’s railways. 29 July, (91/440/EEC), Brussels. De Vany, A. S. and Walls, W. D. (1995a). The Emerging New Order in Natural Gas: Markets versus Regulation. Quorum Books, Westport, Conn. DeVany, A. S. and Walls, W. D. (1995b). The triumph of markets in natural gas. Public Utilities Fortnightly, 133(8):21–25. Hafner, P. (1995). Implementation of EU directive 91/440 in Germany. Rail International, pages 13–17. Hansson, L. and Nilsson, J. E. (1991). A new Swedish railroad policy: Separation of infrastructure and traffic production. Transportation Research, 25A:153–59. Starkie, D. (1993). Train service co-ordination in a competitive market. Fiscal Studies, 14(2):53–64. Winston, C. (1993). Economic deregulation: Days of reckoning for microeconomists. Journal of Economic Literature, 31(3):1263–1289.

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