Monday, 3 August 2009

Strategic asset or strategic blunder?

In the July 2009 issue of Competition and Regulation Times put out by the New Zealand Institute for the Study of Competition and Regulation (ISCR) the question is asked, Kiwirail: strategic asset or strategic blunder? The article summaries an ISCR research paper "The history and future of rail in New Zealand" by Dave Heatley.

My view has, for awhile, been nearer the blunder end of the scale than the asset end. The Times article and the research paper argue along similar lines. Heatley opens his Times article by noting that back in 1999 one of the first projects undertaken by the ISCR was a study of the long-term economic performance of New Zealand railways.
Public rail ownership was characterised by declining performance, beginning in the 1920s and culminating in a very poor prognosis in the 1990s. There were signs that since 1993, privatisation had led to improved productivity and profitability; however, the business was still far from achieving financial sustainability. The ISCR report predicted that private-sector ownership would result in better incentives for productivity-enhancing decision making, but in the long run it was unlikely that in its current form the business would be able to generate returns sufficient to cover the costs of the very large sums of capital employed. Given these facts, a rational private owner would likely rationalise services and reduce the scale of the network to the point where it constituted a sustainable long-run business. Revenues freed up from repeated cycles of historic government-funded capital injections and operating subsidies could then be applied to more productive uses, to the wider benefit of the New Zealand economy.
Given that rail is again in the hands of the government it is timely to re-examine the assumption that government ownership will result in superior long-term outcomes for the long suffering taxpayer owners. Heatley writes
The 2009 analysis reveals little evidence to suggest that overall the economic outlook for rail has improved since 1999. Despite gains in operational productivity, rail's share of the land freight task has declined over the period examined. Profitability has remained poor, suggesting an ongoing lack of competitiveness vis-a-vis other freight modes.
and continues
Rail networks offer benefits from economies of density (increasing use of existing tracks), but not necessarily from economies of size (increasing size of the network).' In a rail network with uneven patterns of use, such as New Zealand's, the economics of density means that the closure of lightly used lines will, in general, improve the overall economic performance of the network.
Importantly Heatley notes that
It proved difficult for private owners to rationalise the size of the network efficiently, due to poorly aligned incentives and political intervention in operational decisions such as exiting from the provision of certain long-distance passenger services.

The retention of land ownership by the Crown at the time of privatisation muted private incentives to rationalise the network as the private operator was unable to access the potential land-sale benefits from closing unprofitable lines. Private-sector owners have been incentivised to persevere with a strategy (originating under public ownership) of retaining otherwise uneconomic lines for their current income-generating potential, but refraining from investing in replacement infrastructure such as sleepers, tracks and bridges.

A return to integrated land, infrastructure and operational ownership resolves the incentive misalignment, enabling its new owners to rationalise network infrastructure efficiently. Yet perversely, extensive recapitalisation has followed re-nationalisation. The government has invested $2.9 billion in rail since 2002, and has committed a further $0.9 billion through to 2013. It is unlikely that the government will earn a reasonable financial return on this investment, as the strong incentives of private owners for ongoing productivity improvements will likely be muted under government ownership, and the scope for political intervention in strategic and operational activities has increased.

The consequences of political intervention are evidenced in the targets set for a modal shift from road to rail freight in the New Zealand Transport Strategy. Any increases in rail freight's share must ultimately come from substitution at the margins away from competing transport modes. Extensive competition from both road and sea freight restrains the ability of rail to set prices. Rail exhibits few apparent cost advantages, even with subsidies from the written-off opportunity cost of capital. So modal shift can only be driven by increasing the level of subsidies in order to lower prices artificially and therefore induce movement of marginal freight away from more efficient road and sea freight. Such shifts will be to the detriment of the overall economic performance of the transport sector and the wider New Zealand economy.

There is little evidence that the real costs of the current government ownership and investment strategy have been adequately assessed in terms of foregone benefits in other taxpayer-funded areas, such as health and education.
After this, an obvious question to ask is, Is there light at the end of the tunnel? Heatley comments,
The 2009 analysis confirms that the issues identified in 1999 still remain, and are unlikely to be addressed by recent changes in governance, ownership and policy direction. Yet rail still remains a viable transport medium for those segments to which it is intrinsically well-suited - long-haul carriage of heavy, bulky freight (coal, logs, manufactured goods, etc.) and high volume urban commuter services. The challenge for rail's new owners is to find a viable subset of the current rail network. Given current and projected freight and passenger types and volumes, it appears a viable subset exists at around 1500-2000 kilometres in length - less than half the present size. Line closures and land sales could fund upgrading of the core network to 21st-century standards.
So, rail makes sense for a small portion of the current network. However I can't see the changes in government policy and public perceptions need for rationalisation of the network coming to pass any time soon. So the taxpayer gets stuck with yet another white elephant.

No comments: