A regulatory framework for Pakistan Railways - II

Pakistan Railways (PR) has been working more or less like a monopoly with very little participation of private sector. Hence, there is very little competition being faced by PR. In these circumstances, it should be the responsibility of the proposed Economic Regulator of Railways (EROR) to regulate rail tariffs and services, and in turn, set the standards under which prices would be regulated in a transparent and objective manner.

Although, price regulation is important in an uncompetitive environment, the goal of the economic regulator should be to incentivize competition. This is because competition is a lot more efficient than regulation. It is therefore important that EROR should work with the Competition Commission of Pakistan in evolving an environment that attracts private sector, and removes entry and exit barriers. After all, the ultimate objective of the economic regulator is to involve enough competition that allows it to relinquish determination of prices to market determination under a deregulated environment.

According to the World Bank's (2017) 'Railway reform: toolkit for improving rail sector performance' report, "If third-party access to railway infrastructure is allowed, competition among railway undertakings should lead to lower prices, increased innovation, and the development of new markets." Having said that, in experience, it has been indicated by usually state-owned railways that involving third-party access, for example, in infrastructure, brings its own challenges, and which include "...new market entrants 'cherry pick'-that they enter or compete in only the most profitable markets, leaving the incumbent [state-owned railways] to serve the least profitable markets, which it may be under an obligation to serve. Another possibility with passenger railways is that new entrants may schedule their services just before the incumbent's. The consequent reduction in profitability can lead to reduced investment, thus leading to increased need for government support."

These challenges need to be addressed by the economic regulator, where experience highlights the fact that bringing adequate competition-related rules of the game to deal with these challenges are "...more difficult to develop competition for passenger services than for freight. This may explain why regulations often differ between freight-dominated railways and passenger-dominated railways, which often rely on franchising."

Another matter for EROR is to create a level playing field between state-owned railways - PR - and the private sector being engaged to boost the competition, and overall efficiency and capacity of railways. It is therefore important that a) All licensed undertakings must have equitable access rights to track, under specified conditions; and b) creating multi-party access to 'last-mile' facilities, which include connections to rail networks, depots, and stations, but it is important for EROR not to create a condition which "could discourage investment as companies do not want to invest to benefit their competitors"; here, it may make greater sense to learn from "Annex II of EU Directives 2001/14 - Services to be supplied to railway undertakings", especially to understand the difference between essential and non-essential facilities.

An important matter for EROR is to determine the access charges, which means calculating the 'cost of providing infrastructure services' to third-party. This is a complex issue for the economic regulator since it requires separating infrastructure-related accounts from accounts concerning rail operations. Secondly, the EROR will need to make a choice in determining access charges, and that is to decide which of the following principles/practices need to be adopted, and which include, a) marginal cost pricing, although the infrastructure-related marginal cost is a lot less than average cost, and hence would require more detailed thinking by EROR; b) full cost recovery; c) 'second-best' solution, where mark-ups are allowed above marginal cost "to permit differentiated charges and improve cost recovery" but this approach has received limited success so far because "many infrastructure managers measure direct costs inaccurately and lack market segment data on the sensitivity of traffic volumes to changes in access charges"; and d) imposing "a two-part tariff with a fixed charge to reflect fixed costs, including the longer-run costs of providing capacity" but contains the challenge of properly establishing fixed charges. It puts the right kind of burden on both "the larger incumbent railway undertaking and smaller new entrants to the market."

The investments in the railways are generally lumpy, that is, "large investments are needed all at once", which makes it a difficult task for the economic regulator to attract the right amount and type of private investment for rail infrastructure. This is "because railway assets have long lives, because of the importance of sunk costs since rail infrastructure rarely has alternate uses and cannot be moved, and because of the large number of ultimate beneficiaries of investment." Hence, the important challenge for EROR is to reach a framework - something which could not be evolved effectively by Ministry of Railways (MoR) or PR up till now - that induces infrastructure-related investment from the private sector.

Here, EROR could evolve a framework based on rate-of-return (or cost-of-service) regulation; for example, as was developed by the United States for utility rates or prices which "are based on an efficient firm's costs for providing service, including a return on capital. The standard of an efficient firm is used because basing tariffs on all capital invested encourages wasteful investments, and basing it on all operating costs provides little incentive to reduce these costs." Another way is to base this framework on "Price-cap or incentive regulation [which] is common among utilities in Europe, but for railway infrastructure, it exists only in Britain where it was introduced when railways were privatised in 1996. The Office of Rail Regulation applies a five-year price cap to infrastructure supplier's charges (Network Rail) and the infrastructure supplier retains any efficiency gains for the five-year period."

Having said that, both approaches have weaknesses, which include a) estimating efficient firm costs; b) "no transparent method of comparing the cost and efficiency with which infrastructure is being maintained and thus there is no effective incentive for infrastructure providers to be efficient"; and c) in-country benchmarking of railway companies is difficult and complex. International experience of Europe indicates two sets of experiences, whereby "Ministries set annual budgets for state-owned infrastructure suppliers; this means the supplier retains any efficiency gains for only one year. However, several European countries have introduced multi-year contracts between the state and infrastructure suppliers as an alternative to regulation". Here, the European Union (EU) "is considering a requirement for member states to offer infrastructure managers multi-year contracts or to enact regulations to improve budgeting certainty and provide incentives to infrastructure managers to improve their efficiency."

The second regulator, Safety Regulator of Railways (SROR), within the overall ROR, needs to establish a regulatory framework to improve both the details on safety standards in railways, and also the level of implementation of these standards. Traditionally, "Rail industry incentives are inadequate to improve safety because railways do not bear all of the costs of accidents. Consequently, safety cannot be left entirely to the industry, particularly if the railways carry passengers." Hence, SROR needs to evolve both a list of measures, and also an implementation strategy to ensure that the rail industry - PR and the involved private sector - implements the standards evolved in the safety framework.

Overall, the regulation to be adopted by SROR should be based on the following guiding principles, whereby "Safety regulations should not be too burdensome, so safety rules should be more relaxed on railway lines with little traffic or low speeds. Regulators should establish safety standards and railway companies should establish systems for implementing the standards. Regulators should then review, approve, and audit the system to ensure adherence. Appropriate regulations are more likely than inappropriate and illogical ones to be accepted by the industry and to be implemented without too much supervision. Safety regulation should not be intrusive and the regulator's primary focus should be to ensure adequate processes are established to meet standards."

As an example of safety measures, and which the proposed SROR should look to learn from, are the ones adopted by the EU under its 'Safety Directive (2004/49)', which requires "railway operators to maintain a safety management system (SMS) and hold a safety certificate or authorization indicating the safety regulator accepts the SMS." Moreover, the principles formulated under this Directive include, "(i) railway companies are responsible for the safety of their portion of system; (ii) safety regulators are responsible for managing, regulating, and enforcing safety rules; and (iii) national accident investigation bodies must be established and can be part of the safety regulator."

Then there is the Environmental Regulator of Railways (ENROR), which should coordinate with the country's environment/climate related authorities to evolve a regulatory framework to ensure environment related standards are being prescribed to and implemented by the rail industry. At the same time, ENROR should also conduct environmental impact assessments of all new projects conceived in the rail industry, which should be approved, among other things, only if they are cleared by ENROR. Here, ENROR should ensure that the framework evolved should meet international standardization; in the same way, as for instance, an "EU Directive (2004/26) aligns diesel locomotive emission limits with US standards to help create a competitive global market for rolling stock."

Overall, as an important initial step, ENROR should look to include in the environment-related framework of rail industry, the following three broad areas with regard to rail-specific regulations that are typically a part of such frameworks, and which are "[a] soil pollution, for example, from engine lubricants, oil leakage from wagons, sewage from passenger trains, pesticides, and creosote from wooden sleepers; [b] noise from rolling stock, which can be a major concern in urban areas; and [c] local air pollution from diesel trains; pollution from freight (e.g., coal dust)."

(To be continued)

(The writer holds PhD in Economics from the University of Barcelona; he previously worked at International Monetary Fund)

He tweets @omerjaved7

Copyright Business Recorder, 2019