Will Czech trains ever reach their destinations efficiently?

• Author: Otahal, Tomas
• Position: Company overview

The Czech Office for the Protection of Competition represents Ceske Drahy (CD, Czech Railways) as a dominant firm in the market for rail freight transport. It recently forced CD to pay 270 billion Czech koruna (CZK) "for abuse of dominant position on the market for rail freight transport of large volume substrates," alleging price discrimination "without objectively justifiable reasons" (2008, 1). It is obvious that this office sees CD as a profit-seeking firm in the market for rail freight transport. (1)

The Czech railway industry (2) is subject to the authority of the Czech Ministry of Transport, which regulates the market, finances investments in infrastructure, and subsidizes the passenger transportation. The Ministry of Transport (2005) justifies its policies on the following grounds: (1) because public transportation has a social aspect in that "inexpensive" and "accessible" transportation services must be provided for every citizen of the Czech Republic; (2) railway transportation saves space; (3) railway transportation has a favorable effect on the ecology; (4,) railway transportation promotes safety; and (5) railway transportation promotes the development of poor regions in the Czech Republic. Except the first and the last of these grounds, all rest on comparisons with automobile transportation, which is believed to cause greater negative externalities. Nevertheless, the first and the last grounds show that the Ministry of Transport considers CD a state monopoly that provides public goods and fulfills economic policy goals.

Thus, whereas the Office for the Protection of Competition sees CD as a firm maximizing its profit, the Ministry of Transport sees it as the state monopoly providing public goods and fulfilling state objectives. Yet the relevant infrastructure is the same. Despite a tendency to split the railway industry's vertical organization, this division does not solve railway transportation's chronic problem, which is dependence on the state budget because of inefficient operation. Even though CD is successfully sustaining the status quo, fiscal requests covering losses are obvious. Economists, therefore, are trying to find other solutions that stress the positive effects of competition. (3)

In this article, we consider recent suggestions for implementing competition in the railway industry based on vertical separation. We show that these suggestions fail to explain their institutional assumptions, which determine the market competitiveness that ensures efficient production; therefore, it is necessary to explain the incentives of firms operating in the railway industry. CD's incentives are confusing: on the one hand, it is considered a firm seeking profit under competition; on the other hand, it is considered a state monopoly providing public goods and fulfilling governmental objectives financed from the budget. We suggest a theory that absorbs such a paradoxical view of the organization of the Czech railway industry and provide evidence that our theory is applicable to the case at hand. More generally, we show that the suggested theory accurately explains the recent situation in the Czech railway market and yields reasonable implications for public policy because it does not stress the positive effects of competition. Rather, we argue that the road to efficiency must go through the reorganization of the entire industry's incentive structure. Our evidence from financial analyses supports the hypothesis that CD's organizational structure cannot improve efficiency unless government subsidies are cut.

We proceed as follows. In the first section, wc explain the evolution of the European railway industry to show that the problem of inefficient operation is not unique to the Czech Republic and that it is historically dependent. In the second section, we reflect critically on recent public policy, which is designed to ensure efficient operation in Czech railway transport. The third section is dedicated to the explanation of "soft budget constraint syndrome" theory, supported by empirical evidence based on financial analysis of firms operating in the Czech railway market.

Competition Suggestion

Before we explain the problem of CD's chronically inefficient operation and reflect critically on recently suggested public policy, we need to outline briefly the development of the European railway industry, which helps us to understand the core of the problem of inefficient railway operation.

Brief History

European railways emerged in the second quarter of the nineteenth century. The firms' microeconomic structure usually reflected the fact that building and operating railway lines were interconnected. In modern terminology, railways were vertically integrated. Railways offered a new and reliable service, and the intensity of competition from the other transport modes was low. Railways achieved huge profits and did not require state subsidies. Nevertheless, they sought and often received state subsidies for construction and operation. The main argument for state subsidy used to be strategic: the railway system was alleged to be the country's military, transport, and economic backbone. Private activities in the construction and operation of railways also fulfilled broader political goals. (4)

At the beginning of the twentieth century, the railways' situation looked very optimistic. However, during the following decades, important changes occurred that strongly affected the profitability of the business. Most important, road transport began to compete intensively with the railways. After the spread of motor vehicles and the road network, railways were handicapped by their high fixed costs and inflexible infrastructure. Road operators offered consumers more flexible and cheaper services. Railways lost market share and profits, and started to have problems in covering costs. The situation in Europe was worsened by the world wars and by the Great Depression, which undermined the railways' financial stability.

The adverse economic developments prompted mergers and acquisitions. Accelerated by state intervention, these reorganizations usually eventuated in the nationalization of Europe's railways. After World War II, the typical European railway company was a monopolistic state-owned company. However, the adverse market condition persisted, railways continued to lose market share, and their financial problems deepened. Their strategic and military importance declined even more than their economic strengths, so it might have seemed that they had less and less importance for governments, but nothing could be farther from the truth. The close connection between governments and railways intensified in the postwar decades. The topic of the day was public-service obligation, railways being obliged to offer cheap and frequent services to passengers. This activity became increasingly unprofitable in European countries owing to the high costs entailed by safety and comfort requirements. The result was a huge flow of subsidies from the state to railways to cover losses.

The monopolization and state ownership of railways had a negative consequence for their efficiency and profitability. The quality of services worsened, economic and marketing thinking was suppressed, resulting in huge losses and requiring high subsidies. General dissatisfaction with the state of affairs led to reform attempts. The reform strategy chosen in Europe has taken the form of vertical unbundling of the infrastructure and services. The authors of this reform believed that it would enable the emergence of competition on the track, lead railway firms to operate more efficiently, and as a result diminish losses. The strategy has been applied in the majority of European countries with varied amounts of energy and dedication. As a result, most European countries have the following railway industry structure: a state-owned infrastructure owner and an incumbent train operator with a strong relation to the state. This operator is subject to competition, but the level of competition in the industry is quite low. The major exception is the United Kingdom, where the unbundling has been followed by strong demonopolization and privatization of the incumbent operator in order to start a real change in the market for railway services. However, the other European countries have hesitated to follow this strategy.

The European strategy of railway reform has been based on the vertical unbundling of infrastructure and services. The theoretical reasons for this approach were simple. Prohibitively high fixed costs associated with construction of the railway infrastructure were supposed to restrict competition. If the services and the infrastructure were divided, competition might constrain the service companies' operations, and the economies of scale resulting from the railway infrastructure would be preserved. However, a question may be raised: When economies...