T echnical Assistance Consultant’s Report ______

Project Number: TA: PRC 4325 May 2007

People’s Republic of China WTO-Policy Reform Support to Ministry of Railways (Financed by the ADB)

Prepared by TERA International Group (TERA) Virginia, U.S.A.

For Ministry of Railways

This consultant’s report does not necessarily reflect the views of ADB or the Government concerned, and ADB and the Government cannot be held liable for its contents.

ASIAN DEVELOPMENT BANK AND GOVERNMENT OF THE PEOPLE’S REPUBLIC OF CHINA MINISTRY OF RAILWAYS

TA PRC 4325: WTO-POLICY REFORM SUPPORT TO MINISTRY OF RAILWAYS

MAIN FINAL REPORT

This consultant’s report does not necessarily reflect the views of ADB or the Government concerned, and ADB and the Government cannot be held liable for its contents. All the views expressed herein may not be incorporated into the proposed project’s design.

Prepared By:

TERA INTERNATIONAL GROUP (TERA) 107 E. HOLLY AVENUE, SUITE 12 STERLING, VIRGINIA 20164, U.S.A. TELEPHONE: ++1-703-406-4400 FACSIMILE: ++1-703-406-1550

April 16, 2007

TERA INTERNATIONAL GROUP, INC. TA PRC 4325: WTO-POLICY SUPPORT TO MOR

CURRENCY EQUIVALENTS (as of 24 April 2007) Currency Unit – CNY (yuan) CNY1.00 = $0.12928 $1.00 = CNY 7.7349 The exchange rate of the yuan is determined under a floating exchange rate system. In this report, the rate used is the rate prevailing at the above date.

ABBREVIATIONS AAR American Association of Railroads ADB Asian Development Bank BNSF Burlington Northern & Santa Fe Railway Co BR BRB British Railways Board CN Canadian National Railway Company CPI Consumer Price Index CPR Canadian Pacific Railway CR Chinese Railways CRCTC China Railway Container Transport Company DB AG Deutsche Bahn AG DECOs Diversified Economy Companies EA Executing Agency EC European Commission EU European Union FCTIC Foreign Capital Import and Technology Center FRA Federal Railway Administration FYP Five-Year Plan GATS General Agreement on Trade in Service JNR Japanese National Railway JVs joint ventures MFN most favored nation MOF Ministry of Finance MOFTEC Ministry of Trade and Economic Cooperation MOR Ministry of Railways NDRC National Development and Reform Commission ORR Office of Rail Regulation PKM passenger kilometers PRC People’s Republic of China PSOs public service obligations RCF Railway Construction Fund SNCF Société Nationale des Chemins de fer Français TA Technical assistance TERA TERA International Group, Inc. TKM ton kilometers TU Traffic Units UIC the Union Internationale des Chemis de Fer UP Union Pacific Railroad Co. WTO World Trade Organization

NOTES (i) The fiscal year (FY) of the Government and its agencies ends on 31 December. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2005 ends on 31 December 2005. (ii) In this report, “$” refers to US dollars.

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TABLE OF CONTENTS

EXECUTIVE SUMMARY ……………………………………………………………………………………. i

CHAPTER 1: BACKGROUND OF THE STUDY ...... I 1.1 COMPARISON OF CHINESE RAILWAYS WITH FOREIGN RAILWAYS...... 1 1.2 MAJOR CHALLENGES FACING MOR...... 6

CHAPTER 2: REALISTIC SIGNIFICANCE OF CHINA’S COMMITMENT TO WTO ...... 12 2.1 COMMITMENT MADE BY CHINA ON ACCESSION TO WTO ...... 12 2.2 OTHER COUNTRIES’ COMMITMENT TO WTO ...... 14 2.3 CHANGES WTO COMMITMENT WILL BRING VIS-A-VIS CURRENT STATUS ...... 15 2.4 RESISTANCE TO IMPLEMENT SUBSTANTIVE WTO COMMITMENT ...... 15 2.5 REALISTIC SIGNIFICANCE OF WTO COMMITMENTS TO THE RAILWAY SECTOR ...... 16

CHAPTER 3: RAILWAY’S PROBLEMS AND DEVELOPMENT TRENDS IN THE WORLD ...... 18 3.1 PROBLEMS FACED BY MOST RAILWAY SYSTEMS...... 18 3.2 DEVELOPMENTS FOR COMMERCIALIZING RAILWAYS ...... 21 3.3 COMPETITIVE STATUS OF RAILWAYS IN THE PRC ...... 23 3.4 CRITERIA FOR NEW RAILWAYS AND NEW RAILWAY ENTERPRISES ...... 25

CHAPTER 4: MAJOR CHALLENGES FACED BY CR...... 27 4.1 CAPACITY CONSTRAINTS ON CR ...... 27 4.2 PRESSURE FOR DEVELOPMENT...... 28 4.3 DIFFICULTY FOR GOVERNMENT TO FULFILL ITS OBLIGATIONS ...... 30 4.4 CONDITIONS FOR PRIVATE CAPITAL TO INVEST IN RAILWAYS ...... 30 4.5 CONDITIONS AND MODALITIES OF PRIVATE INVESTMENT IN RAILWAYS ...... 34

CHAPTER 5: OPPORTUNITIES AND CHALLENGES BROUGHT BY ACCESSION TO WTO...... 37 5.1 ATTRACTING INVESTMENT, TECHNOLOGY, MANAGEMENT AND INSTITUTIONAL CONCEPTS...... 38 5.2 SPEEDING UP RAILWAY DEVELOPMENT THROUGH RAILWAY REFORM ...... 39 5.3 RAILWAY SECTOR RESTRUCTURING AND COMPETITION ...... 40 5.4 SIGNIFICANT CHANGES NECESSARY FOR CR SUCCESS...... 42

CHAPTER 6: PROBLEMS TO BE RESEARCHED AND RESOLVED ...... 44 6.1 SEPARATION OF GOVERNMENT AND ENTERPRISE FUNCTIONS...... 44 6.2 SEPARATION OF INFRASTRUCTURE FROM OPERATIONS...... 46 6.3 MONOPOLY OPERATION ...... 48 6.4 TARIFF REFORM ...... 49 6.5 PUBLIC SERVICE OBLIGATIONS...... 50 6.6 OPENING OF RAILWAY SECTOR - WORLD EXPERIENCE...... 51

CHAPTER 7: OVERVIEW OF RECOMMENDATIONS ON ADJUSTING CHINA’S RAILWAY POLICIES...... 53 7.1 COMMERCIALIZE THE ENTERPRISE ...... 53 7.2 SEPARATION OF REGULATION...... 54

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EXECUTIVE SUMMARY

1. INTRODUCTION

1. This report summarizes the activities and outputs of an Asian Development Bank (ADB) Technical Assistance (TA) Project (TA 4325-PRC) provided to China’s Ministry of Railways (MOR) with the objectives of (i) assisting the MOR to review the potential impacts of China’s accession to the World Trade Organization (WTO) on the railway sector; (ii) assess MOR's preparedness to address these impacts; and (iii) recommend actions and policy reform support needed to meet these challenges.

2. The TA has been structured to utilize a range of resources both from within China as well as from around the world to provide analysis and commentary on the current status of MOR’s WTO- related reforms and their possible future directions which are aimed at improving the efficiency and performance of the rail sector. While global lessons learned can indicate the successes and pitfalls of reforms initiated in other countries, each WTO member has unique characteristics, and China is no exception.

3. China is a large country in which the rail sector plays a key role in carrying a considerable share of both freight and passengers, and no other large country can make this claim. Given rail’s significance in China, rapidly introducing initiatives that have succeeded in smaller countries or in countries in which rail predominately carries either freight or passengers, implies creating an unnecessarily high level of risk to long-term successful performance.

4. Addressing issues in a timely manner is always important. But it is more important to “get it right” in terms of identifying what needs to be done to improve efficiencies and laying out a realistic strategy to implement these measures: the benefits of reform should be substantial but the cost of instituting actions that are inappropriate or do not fully reflect the unique role of the rail sector in China could be immense.

5. This report summarizes lessons learned from other countries attempting rail sector reforms. The report also addresses what reforms MOR needs to implement as well as the impediments to implementation. Finally, the report charts a course for MOR to consider as it develops appropriate mechanisms to improve rail sector efficiencies. The TA’s Final Report consists of two volumes: (i) Main Report; and (ii) Supplementary Final Report. The Main Report is structured in five sections including:

¾ Section 1 is the Introduction. ¾ Section 2 discusses the WTO and the General Agreement on Trade in Services (GATS), China’s membership in the WTO, and the specific commitments and general obligations under the WTO Agreement. ¾ Section 3 addresses the opportunities and challenges for the rail sector arising from WTO membership. ¾ Section 4 details the issues facing the rail sector within the context of MOR’s commitments under the nation’s WTO accession. ¾ Section 5 summarizes conclusions and recommendations.

2. CHINA’S WTO MEMBERBHSIP AND COMMITMENTS

6. The WTO came into existence in 1995 as the successor to the General Agreement on Trade and Tariffs (GATT) that was established in 1947. The WTO is the only international organization dealing with the global rules of trade in goods and services between nations. Its main function is to ensure that trade flows and services are provided as smoothly, predictably and freely as possible, without favoritism or discrimination.

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7. The WTO’s Council for Trade in Services operates under the guidance of the WTO General Council and is responsible for overseeing the functioning of the General Agreement on Trade in Services (GATS)1, which is open to all WTO members. The objective of GATS is to expand global trade in services under transparent and progressively liberalized conditions by means of establishing multilateral rules.

8. GATS sets common rules governing trade in services among member countries that include provisions on obligations, general principles, and exceptions. As part of the agreed obligations for market liberalization, GATS stipulates that when market access is granted, the member countries must treat foreign and local services and service providers equally within the commitment framework. GATS addresses trade imbalances between members, allows the members to adopt appropriate administration over the trade in services, and also encourages developing countries to improve their service sectors’ efficiency and competitiveness. It covers all measures taken by members of the WTO affecting trade in services. The general obligations under the GATS include nondiscrimination, transparency, predictability, market access, fairness and judicial review.

9. As stated in China’s Protocol of Accession to the WTO, China formally became a member of the WTO on December 11, 2001.2 Each accession to the WTO is a unique event, and China’s accession has been particularly noteworthy. China had been one of the 23 original contracting parties to the GATT in 1947. However, China’s application process for readmission to GATT’s successor WTO, took 15 years from its submission in July 1986, making it by far the longest and most arduous accession negotiation in the history of the GATT/WTO.

10. Railway transport services are a component of trade in services, and must follow the principles of GATS. GATS requires that the member country implement its commitments on the basis of the general obligations and specific commitments in services that the country has committed to open. What hinders free trade in services and the opening of markets are the various regulations for related service activities in the domestic markets of member economies. Therefore, so far as the trade in services is concerned, GATS requires the member countries to confirm opened areas and opening conditions in line with its commitments and modify its domestic legislation accordingly.

11. Under the WTO accession agreement, China is committed to progressively provide market access in rail freight transport and storage services. The transition arrangement under the WTO agreement provides that for the first three years, from December 11, 2001 to December 11, 2004, China would allow foreign operators to take minority shares in Chinese-foreign rail freight transport joint ventures. For the next three years from December 11, 2004 to December 11, 2007, foreign operators have been allowed to take majority positions in rail freight transport joint ventures. After December 11, 2007, there will be no restriction on market access by foreign operators/companies. They will compete in a fair and open rail freight transport market, without any limitations with regard to number of service providers, value of service transactions or assets, quantity of output, number of foreigners hired by the operator, types of legal entity or joint venture, or amount of capital. 3

1 GATS is the first and only set of multilateral rules governing international trade in services. Negotiated during the Uruguay Round, it was developed in response to the huge growth of the services sector over the past 30 years and the potential for trading services via the internet. Services represent the fastest growing sector of the global economy and account for 60% of global output, 30% of global employment and nearly 20% of global trade. GATS provides the legal framework for trade in services. 2 The negotiations on China’s accession to the WTO were concluded with the acceptance of the accession package at the conclusion of the Working Party meeting on September 17, 2001. The WTO Ministerial Conference subsequently approved the terms of China’s accession in Doha, Qatar, on November 10, 2001. The Chinese Government notified its acceptance on November 11, 2001. In line with customary practice and as set out in China’s Protocol of Accession, China formally became a Member of the WTO 30 days later on December 11, 2001. 3 GATS covers all internationally-traded services, including for example, banking, telecommunications, tourism, and professional services. It also defines four ways (or “modes”) of trading services: (i) services supplied from one country to another (e.g. international telephone calls), officially known as “cross-border supply” (in WTO nomenclature – mode 1); (ii) consumers or firms making use of a service in another country (e.g. tourism), officially “consumption abroad” (mode 2); (iii) a foreign company setting up subsidiaries or branches to provide services in another country (e.g. foreign banks setting up operations in a country, foreign companies in transport operations), officially “commercial presence” (mode 3); and (iv) individuals traveling from their own country to supply services in another (e.g. fashion

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12. In addition to rail freight transport, China agreed to provide market access in warehousing, freight forwarding, and express mail services.4 In warehousing, establishment of solely foreign- owned subsidiaries was permitted with effect from December 11, 2004. In freight forwarding and express mail services, establishment of solely foreign-owned subsidiaries was permitted with effect from December 11, 2005.

13. China’s WTO commitments in rail freight transport and related sub-sectors are based on the China-USA bilateral agreement of November 15, 1999 on China’s entry to the WTO. The bilateral commitments made by China became part of the multilateral agreement for China’s membership in the WTO.

14. In addition, China has significantly reduced its tariff and non-tariff barriers as part of its bid to join the WTO. China has also committed to abide by the WTO’s transparency requirements, including the uniform application of its trade regime and independent judicial review. In services, China has made a more comprehensive set of initial commitments than those offered by most developed countries during the Uruguay Round.

15. A review of other countries’ commitments in rail transport shows that of 149 member countries,5 only 7 members (Brazil, Canada, China, Kyrgyzstan, New Zealand, Nicaragua, and United States) made a commitment for 100 percent foreign ownership and operation of rail freight transport services. In addition, 5 other members (Finland, Hungary, Philippines, Sierra Leone, and Switzerland) committed to commercial presence by foreign investors/operators in rail freight transport with some restriction. Some 41 countries made commitment in services auxiliary to all modes of transport and a majority made a commitment in the maintenance and repair of rail transport equipment. In repair and maintenance services, the regime offered appears extremely liberal as full market access in consumption abroad (making use of a service in another country) has been granted in 16 cases out of 18 and in commercial presence (foreign company setting up subsidiaries or branches to provide services in another country) in 12 cases. It may be noted that 12 countries considered the supply of these services in cross-border mode (services supplied from one country to another) as not technically feasible, while five others deemed it feasible.

16. In summary, other member countries have made only low level of commitments on rail transport. Some members which made commitments in railway transport are either too small or the scale of rail transport operations is relatively insignificant with respect to their impact on the national economy. In all cases except China the members’ commitments were de facto confirmation of the existing conditions in their respective rail transport markets prior to accession to WTO. In this respect China occupies a unique position among WTO members.

17. The commitments in rail transport by some countries, for example Brazil, Canada, and the U.S. would have relevance to China in terms of scale of operations. However, in these countries, regulatory and operational conditions for foreign investment and private sector participation in rail operations existed prior to their accession to WTO. Some member countries, including Japan, Korea, India, France, and Germany, in which rail transport services are important to the national economy, did not make WTO commitments on rail transport. None of these countries took any specific action or made any change in their existing regulatory or operational environment consequent to their membership of the WTO. In sum, the commitments in rail transport do not appear as a frequent or high-visibility item among the commitments by WTO members.

18. Therefore, in comparison with other member countries, China’s WTO commitments in rail freight transport are the most comprehensive. The commitments are expected to have profound

models or consultants), officially “presence of natural persons” (mode 4). 4 Under the WTO agreement, rail passenger transport is in the excluded category and will not be affected by China’s WTO membership. 5 As of 7 November 2006, 149 countries were members of the WTO.

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impacts on the Chinese rail sector that has so far been dominated by one national carrier, which is owned and operated by the government through MOR.

3. CHALLENGES AND OPPORTUNITIES UNDER WTO: THE WAY FORWARD

19. Accession to WTO presents both opportunities and challenges for MOR. The opportunities include:

¾ Membership in WTO will facilitate increased trade and economic development, which will increase the demand for rail transport. ¾ China’s commitments for market access will accelerate institutional reforms in the railway sector. ¾ Foreign enterprises will be able to participate in the rail freight transport market, including providing bulk freight heavy haul, container transport, and specialized transport for refrigerated goods, in which these enterprises have demonstrated efficiencies and may have a comparative advantage over MOR and other domestic operators. ¾ Foreign enterprises will thus introduce advanced technologies and best management practices that will improve overall efficiency of railway operations and productivity. ¾ Liberalizing rail freight transport will foster market-oriented operations and commercialization of the sector. ¾ Commercialization will lead to competition that will further increased efficiencies based on integrated transport services that meet consumer demands rather than services based on those supplied by MOR.

20. There will be challenges to realizing these opportunities including:

¾ How to seamlessly end monopoly operations that have provided a successful basis for China’s rapid economic growth. ¾ Separating government’s role as operator and regulator. ¾ Confronting the increasing inland waterway, coastal shipping and truck freight transport competition through complementary intermodal transport services. ¾ Shifting from a network focus to meeting consumer demands while at the same time not allowing investors to dominate lucrative market niches that have provided the revenue to cover the costs of network operations. ¾ Reducing network capacity constraints by significant capital investments that have to be financially justified. ¾ Maintaining, even improving railway safety.

4. ISSUES FACING THE RAIL SECTOR

21. One of the implicit challenges facing MOR is to shift from a “monopoly mentality” that is based on a supply-driven approach to a “commercial mentality” that is based on meeting customer demands. MOR has traditionally invested in network development and provided services according to its plan, generally a 5-year or a 20-year plan. In the future, investment in the network and the provision of services will have to be market-driven. While this transition should result in more efficient allocation of capital and other resources, it is not without potential pitfalls.

22. For example, MOR is currently undertaking an aggressive network expansion program. While this may sound logical given capacity constraints and the unmet demand for freight services,

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there are already indications that the modal shares of inland waterways and truck transport are increasing at the expense of rail. MOR will have to devise complementary intermodal transport services rather than competing with other modes of transport. This can be accomplished if railway transport adapts to market needs and provides the services that the customers need.

23. In order to transition to a “commercial mentality” several issues need to be addressed. First, there has to be a separation of government from enterprise (or commercial) operations. Under existing arrangements, the identity of the national railway (China Railways) has become synonymous with MOR. If MOR continues to manage and operate the national railway it cannot be taken to guarantee fairness and impartiality to other competing operators. Therefore, separation of operations of the national railway from government functions performed by MOR will be necessary. The existing system should be replaced by an arrangement that ensures an arms-length relationship between the national railway and MOR.

24. In broad terms, MOR should be separated into a government function and an enterprise function. The government function would oversee rail transport policy, supervise the safe operation of railway infrastructure and services, regulate those aspects of the railway network that cannot be left to market forces to control, identify railway infrastructure and operating services which market forces will not provide (e.g., social passenger tariffs, light density rural freight and passenger services, and services to strategic areas), and to provide adequate support for these services. The enterprise function for management of the national railway would be responsible for responding efficiently to market forces and ensuring financial sustainability, and to provide social services (i.e., Public Service Obligations, or PSOs) that the government requests and compensates. The enterprise function could be assigned to a Board of Directors of China Railways that would be appointed by the government. The MOR (on behalf of the government) would be administratively in charge of the railway sector including oversight of the independently managed China Railways (CR).

25. GATS does not require any service to be deregulated. Commitments to liberalize do not affect a government’s right to set levels of quality, safety, or price, or to introduce regulations to pursue any other policy objective. Under the WTO agreement, the regulatory function for market access need not be separated from the national railway. However, as a second issue, in the interest of fairness and nondiscrimination, the regulatory functions should be separated from the management of the national railway. A new Rail Regulation Office could be established under the Minister of Railways, which would be responsible for economic and safety regulation of the rail sector. This arrangement would help build confidence among potential investors and other railway stakeholders by presenting an open and clearly defined structure aimed at ensuring public safety and economic sustainability.

26. A second issue is that market access on the national railway network will mean that all transport operators (including CR as an operator) will need infrastructure services for operations. These need to be provided to all operators in a fair and nondiscriminatory manner.

27. The functions of the Rail Regulation Office would include: (i) economic regulation of operators; (ii) determination of infrastructure access charges; (iii) instituting measures to monitor and control anti-competitive behavior; (iv) ensuring satisfactory safety regimes for all operators; (v) determination of compensation and performance criteria for PSOs; (vi) providing feedback to the government for control of rent-seeking activities that tend to make goods and services more expensive and less competitive; (vii) establishing mechanisms to provide line capacity and train paths for all operators; and (viii) resolving disputes between private operator(s), CR, and other concerned parties.

28. One of the major changes resulting from WTO accession will be a change in tariff setting policies, which is a fourth issue. Currently, tariffs are set by the government irrespective of actual operating costs and supply-demand relationships. Under the WTO agreement, rail freight transport is subject to government guidance pricing. This is understandable given existing socioeconomic conditions and the need for poverty alleviation and complementary development initiatives in China’s poorer western regions. Thus, tariff regulations will remain an important characteristic of

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China’s rail sector but there has to be a range of pricing that meets both investor and consumer needs.

29. However, tariff regulation under government guidance pricing should not mean a rigid control of the rates but should aim at providing a pricing range that fulfills the revenue requirements of competitive commercial operations. Revenues (including compensation for PSOs mandated by the government) should be sufficient to fully cover the cost of operations including a reasonable rate of return on the investment.

30. Tariffs have to reflect that railways have very high fixed costs based on investments in infrastructure and because of substantial economies of scale the marginal costs of train operations are relatively low. In order to achieve financial sustainability, it is not just the marginal cost of the track infrastructure but the full costs that need to be recovered. This can only be done if rail enterprises engage in some form of price discrimination. That is to say different end-users should be charged different prices, according to the demand of that end-user. Lower prices may be charged for routes which face more inter-modal competition or higher prices at peak times when demand is more inelastic. It may also mean charging different prices for business or leisure travelers or different prices according to the length of stay at a destination, or other factors. Similarly, the prices for freight traffic could be differentiated according to the type of goods carried, the origin and destination of the cargo, the speed or reliability of the service, and other region specific factors.

31. Collectively, a range of factors can be accommodated into the tariff but the keys are to ensure that these factors are transparently detailed and provide commercial operators with the necessary incentives to make long-term commitments (and investments) in China’s rail sector.

32. A fifth issue is that it is an accepted principle in market economies that a commercial service provider should be compensated for providing PSOs. The government should institutionalize a transparent PSO policy that provides a framework for compensation to cover the losses of the operator. The Rail Regulation Office would need to identify specific PSOs (mandated by the government) to operators, who in turn would provide an estimate of losses (supported by actual costs whenever possible) incurred in providing these services. The PSO system should not be open-ended to prevent inefficient and uneconomic outcomes. The contracted services should be reviewed on a regular basis to reaffirm their need as well as to see if these can be substituted by more economic alternatives.

5. CONCLUSIONS AND PROSPECTS

33. Overall, the Chinese economy has more to gain from membership in WTO than it will lose by opening its markets. This should also be the case for the rail sector. Some have expressed reservations about implementing the WTO commitments due to lack of preparedness to compete with foreign operators and the perceived negative impacts on the national railway.

34. However, these reservations have to be considered within the context of China’s success stories. Importantly, the airlines and container shipping lines have been established as separate and competing enterprises. Business in both of these transport sub-sectors is thriving, with record levels of passengers (for the airlines) and containers hauled. Operators in these sub-sectors successfully compete on price and with services offered.

35. Another successful example is the Port of Shanghai’s joint venture with a foreign maritime operator, which provides customers with a range of price competitive intermodal transport services. Important here is the concept of a partnership for a specific service or on specific routes that meets investor as well as customer needs. This is mentioned because as the implementation of WTO commitments accelerates, this form of market entry and operations could prove a valuable and viable means to increase railway competitiveness, provide efficient integrated services to the consumer, and still retain the overall integrity of the rail network.

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36. Fulfilling WTO commitments will not occur overnight or without some dislocation. MOR has demonstrated that it can successfully operate one of the largest and most complex railway networks in the world. This demonstrated capacity will provide the basis for its transition to a “market mentality” that responds to customer and investor needs while at the same time meeting its social obligations as an engine for development.

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CHAPTER 1: BACKGROUND OF THE STUDY

1. This Final Report (FR) on WTO-Policy Reform Support to the Ministry of Railways (MOR) of the People’s Republic of China (PRC) is prepared by TERA International Group, Inc. (TERA) pursuant to the terms and conditions of the Contract for Consulting Services COCS 05-219 (Contract), between the Asian Development Bank (ADB) and TERA. The Executing Agency (EA) under the Contract is the Foreign Capital Import and Technology Center (FCTIC) of MOR. The Contract is funded by ADB pursuant to a Technical Assistance (TA) agreement with the Government of PRC. The FR consists of two volumes: (i) This Main Report; and (ii) The Supplementary Final Report which contains further details on the topics included in the Main Report. 2. The principal objectives of the TA Project from the Terms of Reference (TOR) included in Appendix A of the Supplementary Final Report (SFR) are to: ♦ Help the MOR review the potential impacts of PRC’s accession to the WTO; ♦ Assess MOR's preparedness to address those impacts; and ♦ Recommend actions and policy reform support needed to meet these challenges. 3. The TOR delineates four examination areas to achieve the TA objectives. The TA will review the impacts of WTO accession on the PRC railway sector and examine: ♦ Existing management functions, and how to separate the enterprise and government functions; ♦ Access to railway markets, including the PRC railway's current status in the transport market and the challenges due to competition and pricing; ♦ Differences and gap analysis between the current railway management function, including regulation, and methods based on WTO rules; and ♦ Suitability of laws and regulations for safety, access to railway markets, service quality, price, and investments. 1.1 COMPARISON OF CHINESE RAILWAYS WITH FOREIGN RAILWAYS

4. In order to understand the characteristics and distinctiveness of the Chinese Railways (CR), an analytical comparison with other railways in the world has been done using a common set of data reported by UIC (Union Internationale des Chemins de Fer).6 The most recent UIC report covers information for 2003. The comparison is provided in this Section. 1.1.1 Railway Route Length versus Surface Area 5. The coverage of railways in relation to the country’s surface area is expressed in terms of route km per 1000 sq. km. of surface area. This is generally high among world railways in developed economies with a relatively small land mass. The highest coverage is to be found in Western Europe and Japan (Figure 1.1). Generally countries with a large land mass, regardless of their level of development, score low coverage. United States, Canada, and Australia, for example, have a coverage of less than the world average. So does India, PRC, Kazakhstan, and Russia. In the case of China, the coverage is about one-fourth of the world average. Considering the vast areas in the west of China that are yet not served by railways, there is scope for further expansion of the railway network in the country.

6 UIC International Railway Statistics 2003, Paris 2004. Several indicators are shown and illustrated graphically in the Main Report. The graphics in the Main Report include only a limited set of countries roughly comparable to CR and the lowest, the highest, and average values in the world. More detailed graphic and statistical data are available in Chapter 1 and Appendix B of the SFR. UIC statistical data covers the largest number of countries in the world, but does not include data from railways which are not members. UIC members are largely state railways.

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Figure 1.1: Network Density

Route km/1000 sq.km. 0 25 50 75 100 125 Czech Rep. 122.94 Germany 103.29 United Kingdom 70.78 Italy 55.38 Japan 55.05 France 53.21 Ukraine 38.11 Spain 28.53 WORLD AVERAGE 25.50 United States 25.47 India 21.23 South Africa 16.50 Canada 6.55 China 6.48 Kazakhstan 5.10 Russia 5.01 Iran 3.76 Brazil 3.39 Australia 1.23 Mali 0.60

6. Undoubtedly, the need to expand the network and increase coverage must be considered in conjunction with the utilization of the existing network (i.e. traffic density) and the geographic distribution of economic and industrial activity within the country. Low network utilization is indicative of structural weakness in the nation’s railway sector, which need to be addressed before expansion of the network is considered. Concentration of economic and industrial activity in a few areas of the nation implies a geographically unbalanced development potential, which can be addressed through selected government policies to encourage economic dispersion such as special tax breaks, low cost loans, assistance with employee training, heavy public investment in infrastructure to stimulate economic and commercial development, subsidies, and other measures. PRC’s Western development strategy is a good example of government initiative to overcome the imbalance in the level of regional development between the coastal and western areas. 1.1.2 Railway Route length Versus Population 7. The coverage of railway routes expressed in relation to population, Figure 1.2 shows a comparison among selected countries. This indicator does not appear to relate to a country’s level of economic development: There are as many developed and developing countries above as well as below the world average. In general, however, the value of the indicator tends to be lower than the world average for counties which have both a high population and a high population density. United Kingdom, Italy, and Japan, for example, have a higher than world average railway coverage in terms of area and a lower than world average railway coverage in terms of population. In the case of the Former Soviet Union (FSU) countries included in Figure 1.2 (Kazakhstan, Russia, and Ukraine), the high railway coverage indicates to the proliferation of railway routes due to historical reasons and the FSU policy of emphasizing rail transport.7 In the case of PRC, there is, on average, about 50 meters of railway route length for every 1000 people, which is 14.3% (or one-seventh) of the world average. On a general basis it may be said that there is scope for expansion of railway coverage particularly because of the very high utilization of the existing network.

7 In the FSU any movement of freight for a distance of 50 km or more had to be shipped by rail. This policy resulted in a relatively large build up of railway networks in relation to population.

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Figure: 1.2: Route Density

Route km/1000 People 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 2.00

Canada 1.89 Kazakhstan 0.92 United States 0.79 Russia 0.60 France 0.49 Australia 0.47 Ukraine 0.46 South Africa 0.44 Germany 0.44 WORLD 0.35 Spain 0.35 U.K. 0.29 Italy 0.28 Brazil 0.16 Japan 0.16 Iran 0.09 India 0.06 China 0.05 Uganda 0.01

1.1.3 Railway Traffic Density 8. Figures 1.3 and 1.4 show the railway traffic density in terms of ton kilometers (TKM) per route km and passenger kilometers (PKM) per route km, respectively. Some railways such as United States, Australia, Canada, South Africa, and Kazakhstan are heavily oriented towards freight transport, while Western European and Japanese railways are oriented towards passenger transport, and others such as PRC, India, Russia, and Ukraine provide mixed freight and passenger transport service. 9. PRC has the highest freight density in the world, surpassing the second-ranked Russia by 40% and the third-ranked U.S. Class I railways by 137%. PRC’s freight density is 10.5 times the world average of railway freight density.

Figure 1.3: Freight Traffic Density

Thousand TKM/Route km 0 5,000 10,000 15,000 20,000 25,000 30,000 China 27,257 Russia 19,456 United States 11,509 Kazakhstan 10,724 Ukraine 8,748 Brazil 6,374 India 5,595 South Africa 5,275 Canada 5,155 Australia 4,361 Iran 2,934 WORLD 2,585 Germany 2,052 France 1,600 Italy 1,408 United 1,163 Japan 1,126 Spain 994 Nigeria 11

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Figure 1.4: Passenger Traffic Density

Thousand PKM/Route km 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 Japan 12,018 India 8,160 China 7,648 Italy 2,847 France 2,458 United 2,412 Ukraine 2,289 Germany 1,931 Russia 1,837 Iran 1,514 Spain 1,446 WORLD 1,313 Kazakhstan 776 Australia 142 South Africa 50 Canada 47 United States 39 Mexico 4

1.1.4 Employee Productivity 10. The productivity of employees is expressed in terms of output in Traffic Units (TKM+PKM) per employee engaged in railway transportation. Figure 1.5 shows comparative statistics in terms of TUs/employee.8 CR’s employee output efficiency is far below U.S. and Canada. Considering that CR is the largest railway in the world in terms of total traffic output in TUs, its lower rank in employee productivity is a consequence of relatively high employment. This disadvantage is somewhat offset by the labor cost difference particularly between PRC and U.S. and Canada.

Figure 1:5: Employee Productivity

Million Traffic Units/Employee 02468101214 United States 12.95 Canada 8.86 Australia 3.06 South Africa 3.05 Iran 1.91 Japan 1.83 Kazakhstan 1.61 Russia 1.49 China 1.46 United Kingdom 1.22 Spain 0.99 WORLD 0.91 Switzerland 0.80 France 0.68 Italy 0.66 Ukraine 0.66 India 0.59 Germany 0.58 Congo (Dem. Rep.) 0.04

1.1.5 Employees per Route-KM 11. Historically there has been high employment on the PRC railways., In terms of average number of employees per route km, as shown in Figure 1.6, CR holds the first rank in the world, followed closely by India. Even the FSU railways (Ukraine, Russia, Kazakhstan) have lower average employment per route km. Railways of developed economies in Western Europe and North America are lower than the world average, with Canada and U.S. having the lowest employment levels.

8 TU refers to Traffic Unit which is defined as the sum of TKM and PKM. A synonym of TU is converted ton-kilometer

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Figure 1.6: Employment Level

Employees/Route km 0 5 10 15 20 25 30 China 23.88 India 23.32 Ukraine 16.83 Russia 14.29 Japan 7.20 Kazakhstan 7.14 Germany 6.92 WORLD AVG 6.62 Italy 6.41 France 5.99 United Kingdom 2.93 Spain 2.47 Iran 2.33 South Africa 1.74 Australia 1.47 United States 0.75 Canada 0.59

1.1.6 Reliance of the Economy on Rail Transport 12. One measure of reliance of the economy on rail transport is generally expressed in terms of traffic units (TUs) per Dollar of GDP as illustrated in Figure 1.7.

Figure 1.7: Importance of Railway in GDP Formation

Traffic Units/$ of GDP 012345 Mongolia 4.93 Kazakhstan 3.89 Ukraine 3.74 Russia 3.13 China 1.28 India 1.25 South Africa 0.50 WORLD AVG 0.42 Canada 0.32 Brazil 0.30 United States 0.19 Iran 0.17 France 0.07 Australia 0.07 Japan 0.06 Germany 0.05 Italy 0.04 Spain 0.04 United Kingdom 0.03 Saudi Arabia 0.01

13. Generally the developed countries in which services or the tertiary sector contributes substantially to GDP, show a lower value than other countries including those in the former Soviet Union. The world average of 0.42 TU/$ of GDP indicates a relatively low dependency on rail transport. However, the world average is influenced heavily by the large GDP of developed countries. At 1.28 TU/$ of GDP, PRC is more than 3 times the world average. India is high mainly because of the relatively high PKM in its TU value. However in the case of Japan and Western European countries in spite higher proportion of PKM in the value of TU, the TU/$ of GDP is a fraction of the world average. 1.1.7 China’s Railway Network Shows Highest Need to Expand 14. When the traffic density is considered in conjunction with route density the traffic stress factor (TSF) on the network can be computed as a comparative index. For purposes of this computation, TSF is defined as the [inverse of the ratio of a country's route km/1000 sq.km. to the

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world average] multiplied by the [ratio of traffic density expressed in TUs/route km to the world average]. Comparative TSF values for selected railways for 2003 are shown in Table 1.1. Table 1.1: Index of Traffic Stress on Network Route km/1000 sqkm TU/Route km Traffic Stress Country Inverse of Ratio Km Million Ratio to World Index to World WORLD AVERAGE 25.50 1.00 3.82 1.00 1.00 Australia 1.23 20.68 4.50 1.18 24.37 Brazil 3.39 7.53 6.37 1.67 12.56 Canada 6.55 3.89 5.20 1.36 5.30 China 6.48 3.93 34.90 9.14 35.95 France 53.21 0.48 4.06 1.06 0.51 Germany 103.29 0.25 3.98 1.04 0.26 India 21.23 1.20 13.75 3.60 4.32 Iran 3.76 6.78 4.45 1.16 7.90 Italy 55.38 0.46 4.26 1.12 0.51 Japan 55.05 0.46 13.14 3.44 1.59 Kazakhstan 5.10 5.00 11.50 3.01 15.05 Russia 5.01 5.09 21.29 5.57 28.37 South Africa 16.50 1.55 5.33 1.39 2.15 Spain 28.53 0.89 2.44 0.64 0.57 Ukraine 38.11 0.67 11.04 2.89 1.93 United Kingdom 70.78 0.36 3.58 0.94 0.34 United States 25.47 1.00 9.75 2.55 2.55 Source: Consultant

15. It should be emphasized that TSF does not recognize geographic variation of network density and traffic within a country since it assumes a uniform geographic distribution of these values. It also does not distinguish between levels of efficiency in railway operations inherent in a country’s railway system. It is assumed that the world average of 1 is a “normal” or balanced to need railway network. The lower the index the less is the need to expand the rail network coverage. The reverse is true for index values higher than 1. Comparatively, the relative need for network expansion is highest in the PRC. The value of 35.95 means that the pressure to expand the network length in PRC is about 36 times higher than the average pressure for same felt by other railways in the world. 1.2 MAJOR CHALLENGES FACING MOR

16. In China the railway sector is particularly important because it constitutes the main form of transport for both bulk transport of goods and of large numbers of passengers at prices accessible to the majority of the population. CR has made and continues to make a significant contribution to the rapid growth of the country’s economy. However, because of underinvestment in the past, there are capacity constraints and bottlenecks, because of which CR is not able to meet the demand for rail transport of the growing economy. This is by far the biggest challenge faced by CR. Similar to the situation in some other countries, the railways are increasingly facing competition from road transport particularly in moving high-valued freight that also provides the most revenue for transportation. 17. CR has played a very important role in the development of the national economy and the country's industrial revolution. China is vast in territory, unbalanced in distribution of resources, industries, and has a huge population. Thus the railway is crucial to the passenger and freight transportation needs of the country. The railway can continue to be the mainstay of the Chinese transport sector for a very long period of time if it reforms and restructures itself as a commercial organization operating under market principles. Given the high reliance of the economy on rail transport, reform must be carried out with great care to obviate the risk of disrupting services which will adversely affect the national economic growth. 18. A special problem for China has been the uneven distribution of the benefits of rapid economic growth. Even though poverty has been remarkably reduced overall, inequalities of income distribution both between the rich and the poor and between urban and rural populations have been exacerbated by rapid economic growth. Typically, China’s worsening pattern of income inequality has a strong geographic component in that the coastal areas are increasingly growing

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richer while the vast interior regions and rural areas remain relatively poor. Moving prosperity west is important both as a national goal, and as a major component of CR’s development. 19. Currently, railway transportation is one of the most tightly controlled sectors in the PRC. The accession to WTO is expected to encourage the reform process in the railway transport and economic system of the PRC, especially quickening the pace of reforms in China’s railway enterprises. The Government is currently considering alternative approaches to separation of government functions from enterprise management and the realization of a commercialized operation. Following is a discussion of the major issues currently facing the PRC railway sector. 1.2.1 Railway Investment Financing 20. According to the 11th Five Year Plan (FYP) covering the period from 2006 to 2010, some CNY 250 billion is needed for railway investment every year in order to meet the plan’s goals of: ♦ building 17,000 km of new lines, including 7,000 km of passenger dedicated lines; ♦ double tracking 8,000 km of single track lines; ♦ electrifying 15,000 km of existing lines; ♦ total network length reaching more than 90,000 route-km; ♦ more than 45% of lines to be electrified and double-tracked; ♦ the total length of higher speed passenger network reaching more than 20,000 km; ♦ coal corridor carrying capacity to reach 1.8 billion tons; ♦ western railway network to reach 35,000 km; and ♦ establishing nationwide international container transport system.

21. The 11th FYP envisages total investment of CNY 1,250 billion on capital construction compared with about CNY 320 billion invested during the 10th FYP. Current funding sources include the railway construction fund, 9 profits from operations, national construction bonds for western development, local and provincial governments and their enterprises, national retirement funds, private sector, loans from domestic and multilateral banks (ADB, World Bank) and bilateral assistance. The quadrupling of the investment level will require substantial expansion of the existing resources, and development of market sources to support the railway’s investment needs. 22. Recently MOR announced that the railway sector is now opening up to domestic and foreign investors and operators. The announcement made on July 21, 2005 indicates that according to the principle of equal entry and fair treatment, the domestic private capital shall be allowed to invest in whatever is allowed for foreign capital in such areas as rail construction, operation and transportation equipment manufacturing. Private capital is encouraged to invest in the construction of rail trunk lines, branch lines, local railways and bridges, tunnels and ferry facilities thereof by way of buying shares or project financing in the form of cooperation and co-management. 23. There are additional possibilities for domestic and foreign private investment in railway development which need to be developed including ♦ Investment in Railway construction bonds, ♦ Long term commercial bank loans, ♦ Public offerings of common and preferred stock, and ♦ Investments in joint ventures. 24. The opening up of rail freight transportation to private investment should be viewed by the Government and MOR as a means to further expand rail transportation to meet the growing demand in the context of economic growth. Foreign investment that is usually accompanied by

9 Generated by a surcharge on railway freight tariffs.

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foreign management, transfer of technology and experience will benefit the development of the logistics industry necessary for increased levels of foreign trade. 1.2.2 Competition and Emerging Age of Logistics 25. China’s WTO accession is increasing foreign trade through opening up new markets and sources. The demand for efficient and cost effective rail transportation is expected to increase – particularly for international freight and container transport. The accession requirements will force the introduction of internal competition mechanisms within the railway sector, impelling the government to ease and standardize the control of the railway operations, as well as facilitate the development of a competitive rail transport market. Especially the competitive pressure from the entry of foreign railway organizations will force existing state-owned rail enterprises to improve service quality, reduce costs and optimize resource allocation. 26. CR has been facing increasing competition from road and water freight transport.10 With the WTO accession requirements, competition may become even fiercer involving various railway companies as well as other modes of transport. 27. China has been very successful in turning itself into a production powerhouse in just about two decades. Given that Chinese exports have by now captured a sizable share of the world market for consumer goods, cost competitiveness alone will not be sufficient to guarantee further success. Logistics (that includes transportation) management is expected to become an indispensable competitive tool for industry in foreign and domestic markets. Efficient integration along the supply chain will be necessary. 1.2.3 Current and Planned Improvements to Logistics Infrastructure 28. The Chinese government recognizes that transportation and logistics limitations have the potential to become a bottleneck for future economic growth. This is reflected in the heavy commitment made toward modernization and expansion of the transportation infrastructure in the government’s main investment planning document (the Five Year Plan). In setting its plans, the government has identified three key tasks. (i) Development of infrastructure for rail and other modes. (ii) Standardization of regulatory requirements. (iii) Increased foreign participation in logistics and distribution. 29. China’s government is relying on foreign participation to help lower costs and increase competition. Under its WTO accession agreement, Beijing committed to open the distribution and logistics sectors to foreign participation by 2007. Increased foreign competition is expected to hasten consolidation within the industry, and hopefully will work to reduce long-standing problems of inefficiency, substandard equipment, poor management and poorly trained labor. 30. The superior economic performance of the United States over the past decade has owed much to advancements in logistics management. It is estimated that logistics in China's industrial production take almost 90 percent of the whole production cycle time and 40 percent of general production costs. China has much room for improvement in supply chain efficiency and reduction in wastage, and needs to make significant and rapid improvements. 31. CR will need to effectively participate in the logistics sector interfacing with various modes of transport and in the supply chain services. Market competition is expected to be intensified by the increased participation of foreign players, which will have strong impact on China's external trade regime and internal trading and businesses. In this context the CR will need to look for foreign partners with experience and market share who can provide the necessary impetus to the railway- foreign joint ventures. CR has already taken some initiatives in this regard. 32. Beijing China Railway United Logistics Co. Ltd., (BCRUL), a leading logistics company and a division of China Railway United Logistics (CRUL),11 has joined up with the Descartes Systems

10 Between 1978 and 2005 the rail modal share expressed in TKM decreased from 72.8% to 49.9%; for road transport it increased from 3.7% to 20.9% and for waterway transport (inland waterways and coastal shipping) it increased from 17.6% to 27%. Despite a decrease in modal share, in absolute terms the rail TKM increased almost fourfold from 534.5 billion to 2,072.6 billion during the same period. 11 CRUL is one of China's top 10 logistics providers (2002).

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Group Inc., (Nasdaq:DSGX), a trusted provider of supply chain services, to build and operate a comprehensive real-time logistics information platform that will leverage the nation's extensive railway network and offer integrated logistics services for sea, air and land transportation in China. It is the objective of CRUL that the logistics information platform will help the company achieve its strategic objective of becoming a prominent third-party and fourth-party logistics provider in China. We commend these developments which are timely, and will encourage similar associations by rail logistics companies with reputed foreign logistics providers. 1.2.4 Foreign Investment Reform and Implications for CR 33. MOR and CR have made important progress in the last several years in modernizing their attitudes toward markets in freight and passenger transport and in private domestic and foreign financing. 34. On July 16, 2004 the State Council issued its Decision No. 20 on Reforming the Investment System (SC-20) and NDRC its Order No. 22 outlining Interim Measures for the Administration of Examining and Approving Foreign Investment Projects (NDRC-22). The reform aims to: ♦ Fully bring into play the basic role of the market in resource allocation, separate government and enterprise functions, and reduce administrative intervention; ♦ Establish the position of enterprises as investors whereby enterprises can make their own decisions on investment and be responsible for their own profits and losses, while banks can make their own decisions on loan approval and bear the risks; ♦ Rationally define the functions of government investment and guide social investment through the formulation of development plans and industrial policies and the use of economic and legal means; ♦ Improve the decision-making rules and procedures for government-funded projects, make investment decisions more scientific and democratic, and establish a strict system of accountability for investment decisions. 35. Despite major capacity expansion and changes in market structure, the railways are still unable to meet the demands of a liberalized and decentralized economy. Many bottlenecks remain in the economically active coastal areas, and access to the railway system in the inner provinces is sparse. The main trunk lines including the Beijing-Guangzhou, Beijing-Shanghai, Harbin-Dalian, Beijing-Shenyang, and Longhai Line have been operating in saturated or over-saturated condition for a long time. The average traffic on these lines is about 100 million TKM/route-Km per year, which is about 2.5 times the average traffic density on the network. The Da-Qin Railway, a major coal transportation route, was designed for an annual transportation capacity of 100 million tons; this line's actual annual transportation volume reached 203 million tons in 2005. Presently 10,000-ton freight trains are being operated on this railway. Precedence to the transportation of high priority coal (for power plants), usually crowds out high value cargo that has higher propensity to pay in terms of freight revenue. For example, in Shanxi Province, coal transported by railways increased from 77% among all the goods in 2003 to 88% in 2004. In order to transport more coal, the transport of many other goods had to be suspended. Transportation of goods with high added value such as steel and chemicals has been delayed and this is seriously hurting the economic development of the province. There are no published statistics of the unmet demand for rail transport. However, media reports on numerous occasions in the past have highlighted the failure of the railways to carry all the traffic offered.12

12 2004: During the first quarter of 2004, the average number of daily requests for freight cars increased nearly 100 percent to about 300,000 cars (it averaged 160,000 freight cars daily in 2003), while the railway system can only load around 100,000 cars per day, or less than 35 percent of the demand. Chinese railways bursting at the seams. http://singleplanet.blogs.com/single_planet/2004/05/chinese_railway.html. In July and August 2004, priority movement of coal for power generation seriously affected the transportation of other commodities. Due to lack of rail transportation, coking coal stocks piled up in the industry and the benchmark coking coal price decreased from CNY1,150 per ton to CNY1,000 per ton. Some suppliers shifted to trucks for short haul shipments. The transport charge by truck increased from CNY0.40/TKM to CNY0.67/TKM; truck transport price hikes made longer distance deliveries uneconomic. Therefore, the railway’s inability to move freight resulted in loss of production and increased logistics costs. Recourse to highway transport was uneconomic and environmentally less sound.

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36. Capacity increases alone will not address these problems. Accelerating the institutional restructuring and policy development, which simultaneously increases system capacity and inter- modal transport facilities and improves customer service, will be required to help CR compete with other modes of transport. Therefore, change is likely to proceed in various areas and stages. 37. Reform is a continuous process, particularly for entities that operate in a competitive market environment. Although a number of important reform initiatives have been implemented, CR needs to continuously change in order to successfully adapt to emerging conditions in the transport market and to efficiently respond to the larger changes in the country’s economy. 1.2.5 Institutional Structure in a Competitive Market 38. Many countries throughout the world are in the process of changing the centralized government-owned and controlled model of the railway sector in favor of commercial models that offer more flexibility in order to operate successfully in a competitive market environment while ensuring financial sustainability. 39. Because of the particular socioeconomic conditions in China and the significant role that the railway system plays in the social life and economic well being of the country’s population, private sector orientation of the national railway based solely on profit motive is not recommended. However, further liberalization of the national railway monopoly is imperative to bring the advantages brought about by competition to the benefit of freight shippers and passengers. The traditional railway organizational model must be transformed to satisfy the changing needs of customers and investors in a competitive market economy. Rail transportation in China needs to be configured as a joint enterprise of the government with private and public sector enterprises, thereby combining the strengths of the private and public sectors so as to make rail transportation more efficient, productive, cost effective, financially self supportive, and more responsive to customer needs. 40. If the need for change is accepted, it is important that the CR system satisfy certain bare minimum requirements to operate in more efficient, productive and financially sustainable manner. The following are considered as the necessary requirements: ♦ Separation of the government (regulatory) functions from the operational functions of the railway. This separation does not have to divest any function from MOR. Both functions can remain under MOR’s purview but are clearly separate with an “arms-length” relationship. ♦ Creation of Specialized Profit Centers: CR should consider the creation of specialized departments i.e., freight, passengers, high speed, long distance, regional passengers, and maintenance as profit-centers each responsible for its commercial activities but sharing common costs with the other departments on the basis of analytical accounting based on realistic costs. The accounting for these departments should be separated. ♦ Freedom and flexibility in the setting of tariffs while duly taking cognizance of the socioeconomic responsibilities in the public interest. Railways should be authorized to conclude confidential contracts with shippers on the basis of price and service requirements. ♦ Modification of the existing system-wide revenue redistribution in favor of more direct control of revenue and cash flow by the profit/cost centers based on negotiated agreements between companies.

2005: Authoritative sources have indicated that in 2005, against the demand of 300,000 freight cars per day, CR can load only half as much. 2006: According to statistics released by ‘Chinese Railways’ magazine, passenger trains in China provide only 2.41 million seats but sell 3.05 million tickets a day (4.2 million tickets at peak days), leaving many passengers no choice but to stand in the aisles; railway transportation authorities can provide 110,000 freight cars a day, but the nation's daily average demand for freight cars is 280,000, with over 60 percent of the demand left unsatisfied. http://en.chinabroadcast.cn/2946/2006/10/07/[email protected]

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♦ Addressing public service obligations (PSO) under market conditions. There is need to identify more clearly the public service obligations and reach a consensus that government authority, particularly local or regional authorities (which demand the service) should be called on to finance the obligation to provide regular train services in a clearly-defined way adapted to each situation. The financing should be based on PSO contracts with the operator. ♦ Creating competition in operations for improving efficiency and service quality and encouraging establishment of intermodal transport operations with a focus on door-to-door service in support of customer logistics needs.

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CHAPTER 2: REALISTIC SIGNIFICANCE OF CHINA’S COMMITMENT TO WTO

2.1 COMMITMENT MADE BY CHINA ON ACCESSION TO WTO

41. As part of the WTO accession process, each government negotiates a unique “Schedule of Commitments on Services and List of Article II MFN Exemptions”13, detailing what the government pledges to do, and what practices other nations agree will be exempt from normal WTO rules and principles. Each government also commits to harmonizing its laws with the WTO and the WTO commitments it has made. 42. Following on the PRC’s commitment to open the market to foreign companies after joining the WTO, the PRC allowed foreign companies to enter into joint ventures in the domestic railway freight transport market. As a first step towards progressively opening the market, foreign companies were allowed a minority share with Chinese firms holding a majority stake in all joint ventures during the initial period from December 11, 2001 to December 11, 2004. From December 11, 2004 to December 11, 2007, foreign companies are allowed to own a majority of shares in these joint ventures. After December 11, 2007, there will be no restrictions on foreign firms and all operators will compete in a fair and open market. Different from the cargo business, railway passenger transportation will remain in the excluded category and is not affected by China’s accession to the WTO. Other than the restrictions during the transition period, PRC has included no limitations for market access in the railway sector with respect to number of service providers, value of service transactions or assets, quantity of output, number of natural persons, types of legal entity or joint venture, or amount of capital. 43. The background to PRC’s commitments in the railway sector is that during the negotiations for China’s entry into the WTO, the Government of the PRC committed to opening up the railway freight transport market in a phased manner. On November 15, 1999, a bilateral agreement on China’s entry into WTO was concluded between China and the United States, in which China agreed to open the railway transport market in three phases. 44. Further, the commitments made by China have to be implemented within the context of the following fundamental principles of GATT and WTO: ♦ National Treatment is the principle that citizens and enterprises of other WTO members must be treated in the same way as domestic citizens and enterprises. Domestic parties may not have an advantage. ♦ Transparency is the principle that all processes in making decisions which affect participants in the market be open to view by all. There shall be no hidden policies for protection of some. ♦ Non-Discrimination means that some parties should not have restrictions or prohibitions applied to them which are not applied to all. Foreign entities are treated the same as domestic entities. State-owned enterprises have no advantages and receive the same treatment as private enterprises. ♦ Market Access means that the domestic market is open to all. Countries cannot adopt restrictive measures not specified in the Schedules of Commitments and Exemptions. ♦ Fairness means that there is justice in the way all entities in the market are treated. ♦ Judicial Review means that decisions by governmental departments and agencies are subject to review and judgment by the nation’s courts. 45. A summary of how China’s accession fits within the context of the five fundamental principles of GATT and WTO is discussed in the paragraphs below.

13 For China, this document is World Trade Organization, Addendum, Schedule CLII – The People’s Republic of China, (WT/MIN(01)/3/Add.2), 10 November 2001.

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2.1.1 Non-Discrimination 46. Two types of nondiscrimination are of interest: the most favored nation (MFN) principle and the national treatment principle. Under the MFN principle, a member may not discriminate between its trading partners: goods, services, and service providers are to be accorded MFN, that is, equal treatment. At the same time, a member must provide national treatment: it may not discriminate on its internal market between its own and foreign products, services, and nationals. China, like other members, has committed itself to abide by all WTO agreements, including those provisions requiring application of MFN and national treatment. In its Protocol of Accession, China has agreed to undertake additional commitments to ensure the smooth phasing in of these nondiscrimination principles. All foreign enterprises, including those not invested or registered in China, are to be accorded treatment no less favorable than that accorded to enterprises in China. 2.1.2 Market Opening 47. China has significantly reduced its tariff and nontariff barriers as part of its bid to join the WTO. The breadth and depth of the cuts are evident. China’s willingness to progressively and substantially open up its services sector to foreign competition also is undeniable. Moreover, China has already demonstrated its intention to play a significant role in the Doha Development Agenda. 2.1.3 Transparency and Predictability 48. These are key elements of the multilateral trading system. The basic transparency principle, contained in GATT Article X, calls on member governments to promptly publish all trade-related laws, regulations, judicial decisions, and administrative rulings of general application; to administer all such measures in a uniform, impartial, and reasonable manner; and to provide for independent judicial review procedures for the prompt review and correction of administrative actions. The predictability principle is ensured through a legal hierarchy giving preference to tariffs over less transparent and less secure non-tariff measures such as quotas and licenses, and through encouraging members to “bind” their market opening commitments in goods and services. 49. China has committed to abide by the WTO’s transparency obligations across the board, including uniform application of its trade regime and independent judicial review, and has made additional commitments in each of these areas. In services, China has made a more comprehensive set of initial commitments than those offered by most developed countries during the Uruguay Round. 50. There is no doubt that the Chinese government is committed to carrying through the necessary reforms to implement these obligations in a uniform and impartial manner. The more open the Chinese economy becomes, the more China will benefit from the legal security of the rules-based trading system. Not just foreign investors, exporters, importers, and service providers but also all Chinese citizens, will benefit from the more open, nondiscriminatory reforms China is undertaking. 2.1.4 Undistorted Trade 51. The WTO system also promotes undistorted trade through the establishment of disciplines on subsidies and dumping, allowing members to respond to unfair trade through the imposition of countervailing or antidumping duties. The treaty allows individual members to impose temporary safeguard measures. China has indicated its intention to join the multilateral Agreement on Government Procurement, which is aimed at ensuring fair competition rules in purchases by government procurement agencies. 2.1.5 Preferential Treatment for Developing Countries 52. This principle permeates the entire WTO Agreement, providing transition periods to developing countries and countries in transition to market economies to adjust their systems to many of the new obligations resulting from the Uruguay Round. A Ministerial Decision gives additional flexibility to the least-developed countries in implementing the various Uruguay Round agreements and calls on developed country Members to accelerate their implementation of market access commitments on goods exported by the least developed countries. Although China has not

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been granted across-the-board preferential treatment as a developing country, it has negotiated specific transitional arrangements in certain areas of its trade regime. 2.2 OTHER COUNTRIES’ COMMITMENT TO WTO

53. A review and analysis of other countries’ commitments under the railway transport sub- sector has been conducted. Appendix D of the SFR provides a detailed list of railway transport commitments by each member country. Table 2.1 provides a summary of the data included in Appendix D. As shown in the Table, of the 148 member nations, only 7 members (Brazil, Canada, China, Kyrgyzstan, New Zealand, Nicaragua, and United States) made a commitment for 100% foreign ownership and operation of rail freight transport services. In addition, 5 other members (Finland, Hungary, Philippines, Sierra Leone, and Switzerland) committed to commercial presence by foreign investors/operators in the railway freight transport services market with some restriction. Almost all of the 41 countries listed in Table 2.1 made some commitment in services auxiliary to all modes of transport and a majority made a commitment in the maintenance and repair of rail transport equipment section of the rail transportation services. In summary, commitments in rail transportation services do not appear as a high-visibility item among WTO members’ commitments.

Table 2.1: Commercial Presence Commitments of WTO Members Under Rail Transportation Services and Services Auxiliary to all Modes of Transport

Rail Transportation Services Services Auxiliary to All Modes of Transport

Rental Maintenance Freight Rail Freight Rail Transport Services of and Repir of Storage and Freight Country Rail Passenger Pushing and Cargo Inspection and (GATS Service Support Equipment Rail Transport Warehousing Forwarding (7111) Towing (7113) Handling (741) Other Services Code 7112) Services (743) With Operators Equipment (742) (748) (749) (Part of 743) (8868)

Albania √√√√ Armenia √√√√√ Australia √√√ Austria √√ Benin √√ Brazil √ √√ Bulgaria √√√ Canada √√ √√√√√ China √ √ √ √ Croatia √ √√√√√ Czech Republic √ Estonia √√√√√ EC-12 √ √√√ Finland √ √ √√√ FYR Macedonia √√√ Georgia √√√√√ Hungary √√ √ Japan √√√√ Jordan √√ Korea RP √ Kyrgyz Republic √√ √ √√√√√ Latvia √√√√ Liechtenstein √√√√ Lithuania √√√√√ Mexico √ √ Myanmar √ New Zealand √√ Nicaragua √√√√ √ Nigeria √ Norway √√√ √√√√ Oman √√√√ Philippines √√ √√√√ Sierra Leone √√√√ √√√√ Slovak Republic √ Slovenia √ √√√ Sweden √ Switzerland √√√ √√√√√ Thailand √√√ United States √√ √ √ Uruguay √ Venezuela √ √ Source: Compiled by Consultant from WTO database. A √ indicates presence of a commitment. For details for each country see Appendix D. Foreign participation limited to 49% in Bulgaria and 40% in Philippines Only to international shipping companies. Only in Pusan and Pukok Intermodal transport only Only companies from Nepal. Foreign share up to 80%. Through JVs only. Foreign share participation not limited Foreign participation limited to 51% Through concession (affermage) contracts only At least one member of management must be U.S. citizen with a Customs Broker license Companies owning and operating entity in Vermont must be incorporated in Vermont or in an adjacent Excluding petroleum, oil, and lubricants (POL); Customs clearance services only state. Passenger transport excludes high speed rail

54. Most WTO member states which made commitment in railway transportation services are too small with relatively insignificant railway operations in terms of scale or importance to their national economy. Therefore, a comparison of these states with PRC would be inappropriate. These include Finland, Hungary, Kyrgyz Republic, Mexico, New Zealand, Nicaragua, Philippines, Sierra Leone, and Switzerland. In many cases their commitments were a de facto confirmation of the conditions in the railway transportation market which already existed in the country before their accession to WTO. The remaining countries which made a railway transportation service commitment and have some relevance to PRC in terms of scale of operations are Brazil, Canada,

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and the U.S. Again, conditions (both regulatory as well as operational) for foreign investment and private sector participation in railway operations were pre-existing in these countries prior to their accession to WTO membership (many of these countries were founder members). In summary, our investigations concluded that no country took any specific action or made any change in their existing regulatory or operational environment related to the railway transportation sector as a consequence of their accession to WTO. 2.3 CHANGES WTO COMMITMENT WILL BRING VIS-A-VIS CURRENT STATUS

55. In the case of PRC, conditions are vastly different. WTO accession commitments of PRC necessitate significant change in the regulatory and operational environment in China. From the point of view of the phased opening of railway transportation services, foreign enterprises will enter into the market mainly through establishing Sino-foreign joint ventures or cooperative transport enterprises. Foreign businesses may operate by either renting the operating lines, locomotives and cars of the railway transport enterprises; using their privately-owned locomotives and rolling stock or other transport means (containers); or through the construction or purchase of railway lines for corresponding freight services. The SC-20 and NDRC-22 promulgated in September 2004 provide guidelines and rights for foreign investors to participate in the funding and operation of railways in China with 100% ownership more than three years before PRC’s WTO commitments for full foreign ownership come into effect on December 11, 2007. 56. This indicates clearly that the Government is committed to following WTO rules and to opening the railway freight markets and other services auxiliary to transport services in general such as warehousing and freight forwarding to foreign companies. Because of the far reaching implications of the commitments to the railway freight transportation in China and the national carrier, Chinese Railways, it is imperative that MOR and CR are fully prepared to meet the new challenges under the WTO regime. The current study launched as a cooperative effort by the Government, MOR and ADB is timely. It is unique in the sense that a similar endeavor focused on international commitments in the sector has not been attempted in the past. 57. The accession to WTO means that the CR, in the course of being integrated into the global economy, must be consistent with the internationally accepted market economy principles. Currently, the commercialization process of CR is lagging and much remains to be done. This is demonstrated in such aspects as: (i) MOR’s government functions are yet to be separated from its enterprise management; (ii) the corporate entity status of railway transport enterprises are just in the process of being established; (iii) multi-sourcing mechanisms for investment financing need to be developed to meet market demand for rail transport; and (vi) government controlled administrative examination and approval play a pivotal role in the allocation of railway resources rather than a market-based outlook guided by commercial principles. 2.4 RESISTANCE TO IMPLEMENT SUBSTANTIVE WTO COMMITMENT

58. Our view is that, given the ‘right conditions’, foreign transport industry would in all probability consider commercial presence in the Chinese market when they are in a position to operate as wholly foreign owned entities. It is important to emphasize on ‘right conditions’ as being the precondition. A foreign enterprise would undertake business in the rail transport market only if it sees that the rate of return on the investment is comparable with opportunities in the market. Revenues, and profits and rates of return depend substantially on the tariff rates, and other charges and taxes. China is committed to applying government guided prices for the liberalized services. However, any foreign enterprise venturing into the Chinese rail transport market would first want to know what the government guided pricing would be, so that the financial viability of the business can be evaluated. Other conditions that would determine the risk are entry and exit conditions, property rights, regulatory oversight, and complaint and dispute resolution mechanisms. 59. Having said that, it is important to give the experience on other (foreign) railways consequent to adoption of open access policies. The early experience with vertical separation schemes suggests that encouraging entry by independent train operators is harder than expected. Where an integrated railroad was broken into separate infrastructure and train operating companies, the incumbent train operator has typically faced few successful challengers. And where an

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integrated company was left intact but with a mandate to open access (as is the case in China), there have been few access seekers. Only a handful of new international freight services have emerged in continental Europe, for example, despite over a decade of EC directives to encourage them. In Australia, relatively few competing freight services developed since 1995, and the most important were operated by existing freight forwarders who took the not-very-risky step of shifting their own freight to their own trains. Similarly, incumbent train operators have lost only a small fraction of the passenger train service contracts that have been tendered in Sweden and Germany, although the challengers are gradually becoming more successful. 60. Anti-competitive, defensive strategies tend to have an underlying assumption that the prospective rail operator to be denied access will be a general purpose operator offering to move all freight for all customers, and not a JV specialist dedicated to the freight of particular customers who probably would own a share of the railway operating enterprise. Such JVs, especially if they contain members that are large domestic and foreign companies, would be more problematic for the state railway to cope with, as these enterprises would have substantial resources to pursue their case through legal channels. 2.5 REALISTIC SIGNIFICANCE OF WTO COMMITMENTS TO THE RAILWAY SECTOR

2.5.1 Sharing of the Rail Transportation Market 61. Following implementation of WTO commitments and liberalization of rail freight transportation services, CR’s monopoly in providing these services will cease. The most significant impact on CR will arise from the fact that where there was one operator, with monopoly over operations, theoretically there is the possibility of multiple operators who will collectively share the rail freight transportation market. 62. In recent years, competition between the rail, road, and waterway transport services in China is getting increasingly intensified. There has been a decline in rail’s share of the total transportation market. China’s accession to WTO has provided the policy basis for foreign enterprises to enter the Chinese logistics market. Presently foreign investors may establish joint- ventures in China and may establish rail freight transportation enterprises and compete with other operators, including CR. The presence of foreign transportation companies in the domestic market could have a significant impact on the national enterprises. 63. Chinese transportation enterprises including CR will face competition particularly in the fields of specialized transport, as for example transportation of containers, refrigerated goods, speedy and time-sensitive transportation of special goods, and intermodal transport. Significantly, these are the value-added segments of the rail transportation market that have increased profit margins. These are also the areas in which CR will explore future growth. The foreign transportation enterprises will be advantaged in comparison to CR, by way of their access to improved and more efficient technologies and equipment, modern management and links with logistics supply chains and multinational customers who ship substantial volumes of cargo to/from China. CR is lagging in these areas and unless measures are taken to upgrade, CR will lose out to the competitors in the market place. It may be mentioned that a change from the former position of a monopoly operator to one of competing operators in the market place would mean a significant cultural change for CR. Loss of market share by CR in the total rail freight transportation market because of other operators will impact CR’s revenues and profitability, which has at best been only marginal. 2.5.2 Effects on Intermodal and Intramodal Competition 64. The Chinese commitments to WTO allow the road freight transport market to be opened faster than the railway sector. The price for road transport is completely based on the market. Road freight transportation activities by foreign investors will provide significant competition to other freight transportation operators in the market which have limited flexibility to establish market based rates. This will particularly apply to CR. Their being equipped with advanced technology and equipment, and modern management with business experience in market economies will advantage operations by foreign enterprises. The impact on the CR of their full scale engagement in road transport should not be underestimated. Railways in Europe and North America have faced

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this situation resulting in the decimation of railway operations. It is imperative that CR take appropriate measures in a proactive manner to the developing situation. 2.5.3 Likely Impact on CR Human Resources 65. With the entry of foreign transportation enterprises in China, there will be increased market demand for qualified and experienced railway staff. Historically, employee compensation in public railways at government levels is much below market levels. As foreign enterprises start operations in China, they will compete with the CR in attracting qualified technical and management staff. CR may face an exodus of experienced and skilled staff. 66. At the same time the public railways will face serious competition for attracting new staff of appropriate quality. Such possibilities should be considered and effective solutions should be sought considering that development of human resources for railway operations through training and retraining is a time consuming and expensive process. The importance of developing human resources in a timely manner is underscored. 2.5.4 Other Impacts 67. The existing freight tariff of CR already allows open access although it is rarely used in practice by large shippers.14 China’s WTO commitments expand the beneficiary population of this access regime to foreign companies from WTO member countries. With the Government having agreed to provide open market access to foreign transportation enterprises, can such opportunity be denied to the domestic enterprises? Our view is that denial of such opportunity will be tantamount to discrimination against the domestic enterprises, which would perhaps not hold in law. If domestic companies can participate, perhaps they will be the first ones to enter the market. This will open up additional areas of competition for CR. 68. Considering another scenario, can a joint venture railway (there are about two dozen joint venture railways in China with more JVs being established in partnership with provincial governments), which is operating a few hundred kilometers of track, be denied access on the national network for rail freight transportation under the policy of competitive open access. Most of these railways are jointly owned by MOR and provincial governments, who may obviate this possibility. However, the question is that if open access is good policy for business of the joint venture company, it should not be denied to them. This has implications for CR. 69. Consider another eventuality in which a foreign transportation enterprise buys a majority stake in an existing joint venture railway. Can this foreign-Chinese joint venture railway undertake rail freight transportation on the national network? Our view is that this should be possible under the MOR Provisional Regulations. This opens up new possibilities in railway investment and operation with implications for CR. 70. Following up on these possibilities, it can be said that enterprises making investment in railway infrastructure, as for example new railway lines, freight terminals, container terminals, and others, can benefit under the policy of competitive open access on the national network (although such investment in infrastructure is not a precondition for open access). This arrangement could open up the possibility of increased foreign direct investment in building railway infrastructure because of the enhanced scope of operations on the national network.

14 The CR Freight Tariff effective 1 April 2005 provides a rate of CNY 0.2055 per axle-km for customer owned wagons and locomotives as a line charge (base tariff) plus the RCF surcharge of CNY 0.099 per axle-km. If the customer owns either wagons or locomotives the charge is 20% less than the commodity based basic tariff. As of 10 April 2006 the base tariff is increased to CNY 0.2165 per axle-km for customer owned wagons and locomotives.

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CHAPTER 3: RAILWAY’S PROBLEMS AND DEVELOPMENT TRENDS IN THE WORLD

3.1 PROBLEMS FACED BY MOST RAILWAY SYSTEMS

71. Railways today face challenges from: (i) the traditional (monopoly) railway mentality and traditional patterns of railway organization; (ii) challenges from other transport modes; (iii) globalization of manufacturing and markets; (iv) failure to adopt more efficient technologies; (v) inadequate funding of public service obligations; and (vi) over-regulation. 3.1.1 Traditional versus Commercial Focus 72. The purpose of traditional railway organizations is to run trains. The purpose of commercial railway organizations is to profit through satisfying the needs of their customers. Since the focus of traditional railways is on running trains, they are usually run by professionals who have production criteria foremost in their minds as they make decisions. In contrast, commercial railways put emphasis to satisfying customer needs and profitability of operations.. They are run by teams of marketing, operations, finance, legal and other professionals who must work together to devise and deliver financially sustainable service packages that satisfy the needs of their customers. 73. Generally, every management trainee in a commercial railway spends his/her first year or two rotating through all of the major departments of the railway and all of its major geographic divisions. Everyone in top management, regardless of profession, must understand what customers want from the railway, how the railway delivers its services, how it keeps its books, how it finances projects, how it deals with its people, and how it operates within the legal and regulatory structure. Only with this common background across professions can management work as a team.15 74. Traditional railway organizations originated with the first railways – a time when the only other forms of land transport were powered by horses and human legs. Railways as a transport mode, had a monopoly on land based transport faster than 5 km per hour that lasted over 100 years. Customers back then had no real options. There were no airplanes. There were no highways or motor vehicles. Inland and coastal waterway transport was largely wind, steam and horse-powered and existed in relatively few corridors. 75. Traditional railways have tended to see their customers as captives who had to take whatever services the railway wanted to provide. Customers had no options. The railway attitude toward customers was “Take It or Leave It.” 76. Commercial railway organizations began to evolve in response to the pressures generated by the end of the railway monopoly on fast transport between points on land. These attacks on the railway monopoly occurred largely because of the development of competitive transport technologies. Governments funded investments in highway, waterway, and air transport infrastructure. Motor vehicles were developed both for passengers and freight. Highways were built, then expressways. Investments were made in inland waterway infrastructure resulting in bigger, faster diesel powered vessels and greater reliability. Airplanes appeared, then jets and large jets, moving passengers and express freight much faster than trains between major cities. 77. These government investments, coupled with advances in other transport technologies, encouraged many railway customers to adopt choices and options, different from what the railways offered. 78. Railways lost both freight and passenger business to other transport modes. Private railways slowly began to meet the challenges by beginning to transform themselves into commercial organizations.16 Some state railways17 became more commercial. Many state railways

15 Cross-department assignments continue throughout an executive’s career. For example, the current Chief Executive Officer of Norfolk Southern in the U.S. is a lawyer who has held management positions in operations and marketing during his career. The current Chief Operating Officer of Burlington Northern Santa Fe in the U.S. is an engineer who served for several years as Vice President of Marketing for Carload Business (non-unit train, non-intermodal traffic), and before that as Vice President Administration of Santa Fe. 16 The transformation process took decades and has not been uniform. Some private railways are further along the

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continued to operate as traditional railways and sought increasing government subsidies to maintain their existing organizations. By the late 1980s and through 1990s, some governments began to respond to continued railway requests for increased subsidies by privatizing the state railway and limiting future subsidies to those uneconomic services necessary for the public good.18 79. To be successful commercially, all decisions of traditional railways with regard to operation, budget, investment, equipment, pricing must be focused on finding the most efficient, effective and financially sustainable means of satisfying the customers’ needs. 80. Customer service and customer satisfaction are central to success in a commercially oriented, competitive environment. Railway customers with international experience, such as steamship companies, logistics companies and freight forwarders, expect to receive transport services which meet their needs. As Chinese customers of the railway constantly gain international commercial experience through their business dealings abroad, they become more and more like international customers in their expectations of the quality and reliability of railway service. What railway customers increasingly want are: ♦ The most reliable transportation; ♦ The best total price; ♦ No loss or damage to their goods. 81. With globalization, customers everywhere have a better understanding of their needs, higher expectations of transport service providers, and are more and more willing to consider a broad range of competitive alternatives. 3.1.2 Challenges from Other Modes 82. Intercity rail passenger service has endured competition from buses and private autos operating on expressways and from commercial airlines. Rail passenger transportation services have proven viable in a number of countries in corridors between major urban centers where passenger train times from city center to city center are competitive with air travel times.19 The market potential of longer distance rail routes is limited to tourist traffic and traffic linking relatively isolated small cities without economic air service. 83. In some countries short distance rail freight service has suffered from competition from trucking companies using modern highways and expressways and from waterways. Short-haul lighter weight goods tend to move in trucks20 and those margins have largely been lost to rail, especially in geographically small markets such as most European countries and Japan. 84. Railways compete best for longer haul traffic, while trucks have much of local and short-haul traffic. Railways have advantages in moving large volumes of bulk commodities, especially in unit (or block) trains which move as a fixed unit from origin to destination. 3.1.3 Globalization 85. Many railways in the world are facing a serious crisis due in large part to their continuation of the traditional, monopoly mindset in face of globalization, commercialization and rapid change. This results in a failure to timely adapt to radically changed economic conditions by identifying and exploiting the relative strengths of railways in the evolving, complex transport market.

transformation, while others still exhibit some traditional characteristics. 17 Canadian National, for example. 18 The UK, Mexico, Brazil, Argentina, Peru, Chile, Japan, for example. Canadian National was also privatized, but long after its transition from a traditional railway to a commercial railway. For a detailed discussion of private sector participation in railways see Best Practices for Private Sector Investment in Railways, Final Report to Asian Development Bank by TERA International Group, Inc., Sterling, Virginia, U.S.A., 31 July 2006. 19 Examples include in North America: Boston-New York-Washington, Chicago-St. Louis, Los Angeles-San Diego, Windsor-Toronto-Montreal-Quebec City; and many corridors in Europe and Japan as major cities are relatively close to one another. 20 For more detail, see the extended discussion in section 3 of the SFR.

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3.1.4 Failure to Adapt More Efficient Technologies 86. Closely related is a failure to understand customer needs and adopt proven technology, which would substantially increase reliability, efficiency (potentially keeping prices competitive) and reduce loss and damage to goods.21 Much of this failure is a consequence of a traditional mentality. Traditional railways look at new technology as involving only purely technical choices. If considered at all, cost is considered only after the decision is made on purely technical grounds. 87. Commercially oriented railways look at the new technology’s potential benefits to customers (and to the railway’s ability to satisfy the customer’s needs), and weigh those benefits against the technology’s costs. They particularly seek to understand if the technology will pay for itself within a commercial framework, by directly benefiting customers and the railway economically. 3.1.5 Inadequate Funding of PSOs 88. In developed countries railways generally offer both services under commercial terms, and less commercially viable services required by government and necessary for the public good under PSO agreements.22 Commercial railways argue that government should reimburse railways for the difference between the revenue received in operation of a PSO and the full cost of operating the service in the most efficient manner. Other railway customers should not subsidize loss-making PSO services23 and that such involuntary use of customer money can lead to higher, uncompetitive tariffs, weakening the ability of the railway to retain its existing, commercially viable, customer base. 89. Many traditionally oriented state-railways, however, are either required to cross-subsidize loss-making operations through revenues from profitable operations or receive government subsidies to enable the continuation of loss-making operations along less efficient historical and traditional patterns. As globalization progresses, and economic efficiency increases in the larger world, the cost of maintaining traditional railway practices grows with ever larger government subsidies. 90. Railways are capital-intensive when compared to other transport modes,24 and need large amounts of dedicated capital investments. Capital investment decisions of traditional railways may generally be based on engineering criteria. However, in some traditional railways, investment alternatives receive detailed technical examination and are compared on the basis of cost-benefit analysis. The best alternative from an engineering perspective is selected and then a full calculation of the costs involved completed. 91. Commercial railways examine the engineering benefits of different alternatives through the prism of customer needs and profitability, and then weigh the benefits against the costs to determine the most efficient acceptable alternative – that is, the alternative with the highest payback.25 Generally the commercial process yields less expensive capital projects with higher payback (in added revenue and/or cost savings) than the traditional process. A less expensive project with greater payback is generally more attractive to finance from either private or government sources. Given railways’ large capital needs for equipment and infrastructure, Over- Investment can be a larger threat to the financial well-being of a railway than under-investment.26 It is imperative that investments are made after due diligence that establishes the financial viability of the investment.

21 By, for example, increasing axle loadings, train length and otherwise substantially increasing the capacity of existing lines, as well as using specialized freight wagons which can be loaded and unloaded more quickly and more economically by customers. 22 For an extended discussion of PSO see Study on the State Allowance Policy for the Railways PSO, a report to the Ministry of Railways of PRC by TERA International Group, Inc., Sterling, Virginia, U.S.A., 30 June 2003 23 Most North American passenger operations are operated by public and quasi-public corporations that compensate commercial railways when their track or other facilities are used. The operating losses of the passenger operations are covered by PSOs, with service levels reflecting the level of public subsidies. 24 Airlines, for example, need investments in terminals (airports) at each end of a journey as do railways (stations and yards). Airlines need to pay for transport equipment (airplanes) as do railways (trains). Railways, however, need to construct and maintain expensive, dedicated corridors on land between terminals. Airlines do not have to construct or maintain the sky. 25 Calculated as Return On Investment (ROI). 26 Under-Investment can be repaired with additional investment at a later date. Over-Investment is wasted.

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92. Projects which cannot be commercially justified and financed may be desirable for other than purely economic reasons. Burdening of railway customers to pay for uneconomic public service capital projects may well damage the competitiveness of the railway in a freight or passenger market. If a project promotes a public good, the investment should be financed by government, whether obtained on a project basis, or through an ongoing fund. 3.1.6 Over-regulation 93. In addition to uncompensated PSOs, over-regulation of railway passenger and freight tariffs can financially damage both the railway and the railway’s customers. Tariffs set too high drive customers from the railway to more competitive transport modes. Tariffs set too low deprive the railway of funds necessary to pay for operations, maintenance and capital improvements and may result in financial distress of the railway over time. 94. Tariff regulation (mainly through government controls) developed during the period when railways had a monopoly of land transport, and were necessary to protect customers in a situation where they had few or no transport alternatives. With the development of alternative modes of transport that situation is largely changed. With competition between transport modes, and between different carriers within most modes, situations where monopoly power still exists are best handled by a regulatory framework allowing aggrieved customers to appeal excessive tariffs to a regulatory board having the power to order carriers to reduce rates to levels similar to those found in markets with full competition. Rate flexibility (within boundaries to prevent abuse) can further the development of commercial orientation in railways, increase revenue, and improve the financial condition of railways. 3.2 DEVELOPMENTS FOR COMMERCIALIZING RAILWAYS

3.2.1 New Prospects of North American Railways 95. A major impetus to commercialization of US railways was the Staggers Act of 1980 which deregulated railway pricing, eliminating published tariffs, “allowed railroads to establish their own routes, tailor their rates to market conditions, and differentiate rates on the basis of demand.”27 Deregulation of railway pricing took limited steps in Canada with the passage of the 1967 Transport Act and was more fully implemented in regulations of the National Transport Agency in 1987. 3.2.2 Streamlining the network 96. Most railway lines in North America were built before automobiles and trucks when goods and people moved to and from railway stations by foot and by horse and wagon. In the grain growing areas of the Midwest and Great Plains, branch rail lines were built every 15 to 20 kilometers for passengers and to move grain to urban markets and bring goods and supplies to farm families. Once automobiles and trucks became widespread, this dense network of rail lines was no longer needed as grain, goods and people could easily be moved 50 or more kilometers over the flat landscape. 97. As North American railways became more commercial in the 1970s and 1980s they began to review the economics of the old branch lines. Some lines were abandoned with customers asked to load and receive their traffic at stations on more important lines. Some lines were sold to small railroad companies. Some that were either profitable or important to large customers with many locations were kept. 98. Since track maintenance costs increase exponentially with track speed, and cost control is important in every commercial operation, some railways lowered track speeds on branch lines to reduce both track maintenance costs and fuel costs in order to improve the profitability of the branch line. Wasting money in uneconomic branch line maintenance, however, reduces potential investment funds for necessary capital projects. 99. The streamlining of track networks by the large North American railways beginning in the 1970s reduced operating costs and freed up resources such as rolling stock for deployment in more

27 Association of American Railroads, “A Trip Through Railroad History,” Available at http://www.tomorrowsrailroads.org/industry/history.cfm.

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profitable traffic. Over time, many large railways have divested themselves of non-core business lines,28 and have contracted to other companies some maintenance functions. As locomotives have become more complex and more computerized, many large railways have contracted management of their locomotive repair operations to the manufacturer of the locomotives.29 100. It is mentioned that the measures taken to streamline the network were appropriate to the political and commercial environment in the respective countries. Similar measures in other countries and particularly in China will need to be considered in the context of the prevailing socioeconomic and political conditions. 3.2.3 Centralization 101. With improvements in information technology and communication, operational management of railways has further centralized. Regional offices and dispatching have been eliminated and their functions centralized. Entire networks in excess of 50,000 km of line are dispatched from a single central dispatching office. Divisional offices are much smaller and are more focused upon frontline supervision and implementation than on local decision-making. Central office departments are smaller, but more effective and efficient. 102. The same technological improvements increasing management span have made feasible mergers between very large railways.30 These mergers have reduced total overhead expenses largely because they enable reductions in management employment. 103. Traffic is growing on each of the six large North American railway systems and they are financially healthy. The latest numbers available show annual revenue growth ranging from 7.2% on CSX to 18.6% at BNSF. Return on equity31 ranges from 9% on Union Pacific to 17.5% at Canadian National.32 104. Traffic growth has been achieved over the last few years by building cooperative relationships with shippers, such as automobile manufactures and growers of perishable crops, and with transport companies in other modes like container steamship lines.33 105. In the last 20 years in North America, major long-haul trucking companies became large railway customers by containerizing much of their long-haul truck freight. Railways can profitably move a container long distances at rates below the cost of trucking the same container. By switching to rail for long-haul moves, trucking companies have reduced their operating costs, their equipment purchases, and door-to-door transit time in very long-haul corridors. Working together, the trucking company provides the retail service for particular customers and the railway provides wholesale transportation for the trucking company. 106. The experiences of North American Railroads in commercial freight transportation operations have important lessons for CR. These may however, not be of direct relevance to CR because of different political and socioeconomic conditions in the two countries. Also the aspects mentioned in the foregoing paragraphs may not provide a full critique of the private sector operation of freight railroads in the U.S. on the foremost consideration of profit only for the limited constituency of the shareholders of these railroads. As for example the U.S. Department of Agriculture has leveled allegations of adverse impacts of Class 1 railroads’ transportation policies since consolidation (post-Staggers Act) on agricultural producers in regions of the U.S. where there is limited rail competition.34 Some of the allegations are as follows: 107. Since 2003, rail rates for grain shippers have increased much more rapidly than rail rates for other products. The average freight revenue per carload for major grains has increased 27 percent

28 For example telephone companies, hotels and real estate companies. 29 BNSF, for example, has two locomotive shops, one for GE locomotives that is managed by GE, and one for EMD locomotives that is managed by EMD. Non-management employees continue to be railway employees. 30 For example the mergers of Burlington Northern with Santa Fe, Union Pacific with Southern Pacific, Canadian National with Illinois Central, and the division of Conrail between Norfolk Southern and CSX. 31 Profit as a percentage of the equity capital invested in the company’s stock. 32 Investor.Reuters.com, July 12, 2006. No longer available in the internet. 33 For more detail, see the extended discussion in Section 3 of the SFR. 34 STB Ex Parte No. 665, Rail Transportation of Grain, Remarks during open hearing by the Under Secretary of Agriculture for Marketing and Regulatory Programs, 02 November, 2006.

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since 2003 while the average freight revenue for all commodities (including grain) increased only 13 percent. 108. Increases in transportation costs typically result in decreased agricultural producer incomes. In turn, lower producer incomes can adversely affect the ability of individual producers to borrow funds or to purchase inputs such as fertilizer and machinery, potentially reducing economic prosperity in rural areas. Higher transportation costs also hinder the competitive position of U.S. agricultural products in highly competitive export markets. 109. Due to railroad emphasis on unit trains, shippers have had to make significant capital investments in sidings, inventory, storage capacity, and loading facilities to retain cost-effective rail service. 110. Railroad consolidation has resulted in railroads having the ability to dictate the terms of rail service – even though those service terms do not meet the present and future needs of many agricultural shippers. Class 1 railroads, for example, encourage unit-train movements of grain, even though the emergence of specialty markets will require specialized handling in much smaller quantities. 111. Due to lack of adequate rail to rail competition, the quality of service by Class 1 railroads has not been sufficient for some agricultural shippers. Captive shippers, even though paying the highest rail rates, often receive the worst rail service because Class 1 railroads may choose to first serve those shippers having competitive options. 112. Rail capacity for agricultural products has been extremely tight during the last three years. 113. Unquestionably, the situation in China has been very different. For the facilitation of agricultural producers the Government and CR have applied reduced rail tariffs and surcharges, so that those in rural areas may be able to generate higher incomes so as to establish social equity. We have tried to give both sides of the picture as to the operation of U.S. Class 1 railroads in the hope that the experiences and good practices will be adopted by the rail sector duly considering the peculiarities in the Chinese situation. 3.3 COMPETITIVE STATUS OF RAILWAYS IN THE PRC

114. In competition with other transport modes, railways have both natural advantages and natural disadvantages. Rail transport has significant competitive advantages over truck transport for heavy, bulk commodities (such as grain, cement, fertilizer, liquids not transported by pipeline, and minerals) which are not time sensitive and are moved in large volumes. Rail freight’s advantages over trucking for these commodities are multiplied by use of large capacity, commodity specific freight cars, and by operating long, heavy freight trains. Rail freight’s advantages are weakened when general purpose freight cars (such as boxcars or high side, open top gondolas) are used for bulk commodities, and when rail freight service is not door-to-door and is not entirely by rail. Handling bulk commodities by transferring them between trucks and freight cars at railway stations increases product loss35, transit time, and overall costs, and decreases efficiency for both customer and carrier. In general rail can have a competitive advantage over truck transport for long haul movements with transit time greater than 8 hours. 115. Trucks have significant competitive advantages for short-hauls, for infrequent and seasonal movements, for multiple small shipments to multiple customers in multiple locations, for customers without a rail siding at their facility, for fragile goods, for high value goods, and when very low transit times are required. Currently in China, operation of large trucks over long distances are hindered by differences in provincial licensing regulations and by toll structures that favor small, 5- and 10- ton trucks. These restrictions have been somewhat reduced in recent years. 116. Generally, it is the experience in many countries that once the initial investments in pipelines are made and construction finished, pipelines run at or near their practical capacities. Several roles remain for highway and rail in transport of products moved by pipelines: transporting production in excess of pipeline capacity, back-up (or temporary replacement) movements in cases of pipeline failure, and feeder services to and from pipeline terminals – often short-haul services.

35 Grain or coal lost during transfer and reloading between truck and rail car, for example.

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117. Water carriers and rail carriers have similar terminal and pickup and delivery costs (in both time and money). Water transport is the slowes1t of the three modes. Thus it must also be the cheapest in order to be the most cost-efficient choice for the customer. The greater the difference in total time between rail and water, the greater the price difference needed between water and rail for water to hold the business. 118. Containers are moved by both rail and highway when on land. Rail and trucks both compete with one another in moving inter-city containers and cooperate with each other in intermodal container movements. Trucks are used to bring long-haul containers to rail intermodal terminals and for delivery from intermodal terminals to customers. Other trucks compete with railways for long-haul business, with the advantage that they run directly between the origin and destination, often a shorter distance than running via two intermodal terminals. 119. Generally, railways are able to compete with trucks for container traffic in markets where truck transit time is greater than eight hours. Generally also, the geographic area served by a modern intermodal rail terminal is an area that can be reached by feeder trucks36 with trips of four hours or less. Large intermodal terminals mean more frequent intermodal block trains to and from major destinations, thereby increasing service levels. To compensate for being slower relative to trucks, the total price paid for all costs related to a rail shipment must be lower than total truck charges for the same movement. 120. Railways generally have lower operating costs on a ton-kilometer basis than do trucking companies. Inland waterway carriers generally have operating costs far lower than railways. Price is important to customers, but it is not the only factor weighed in the freight transport customers’ decision process as discussed above. 121. The cost advantage of waterways over railways is such that railways cannot compete on price with waterways for the movement of bulk commodities such as coal, grain, stone, oil products, and chemicals. Railways can compete successfully for high value traffic, if the railway can deliver carloads and containers with high value goods to their final destinations much more quickly than could waterway carriers. A well functioning railway can move shipments much faster than they can be moved by waterway, and can charge its normal, truck competitive rates and win this traffic from waterways. 122. Reliability is important to customers in addition to total price. Customers will accept slower total transport time if they can be sure that their shipment will arrive at destination by a particular time. That way they can plan their business and manage their inventory. 123. In container transport as in truckload freight, less handling is involved. Because trucks go directly from customer’s origin to customer’s destination, truck transport is generally very reliable. Rail and water container movements and rail carload movements are more complex, involving local pickup and delivery and terminal handling. Reliability of service can be ensured only through proper planning of logistics of movement and their monitoring.. 124. Customers want transport without loss or damage to their goods. The more times that goods or containers are handled in the transport process, the greater the possibility that goods will be lost or damaged. Mishandling of goods in terminals causing loss or damage to goods can happen in both waterways and rail container transport and in regular freight operations of both railway and waterway terminals. Sudden shocks during rail transit and in terminal and yard switching and hump operations and the running in and out of coupler slack during train operations can also result in damage to goods and are an added concern for rail customers. However, this will be obviated by CR’s plan to run container trains between central container terminals. 125. As with reliability, customers will accept higher risk of loss and damage only if total charges (including full insurance, if necessary) are significantly lower than transport modes with lower loss and damage. Generally, truck is the least damage prone mode of transport, while rail is the most damage prone mode.

36 Picking up or dropping off containers at customers’ facilities.

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126. Customer service and satisfaction are central to success in a commercially oriented, competitive environment, whether in transport, manufacturing, retail, or hospitality and tourism. Railway customers need reliable, predictable transport for inbound materials and outbound products, at reasonable total cost, and without loss or damage to their goods in transit. 127. As railways are capital-intensive, it is crucial that both investments and operating expenses be in balance with actual and potential revenue (from transportation charges and PSO compensation). While there are minimum levels of business and revenue necessary for the viability of each railway line,37 size alone (including potential revenue, traffic intensity, length of mainline, etc ) is not the most important factor. It is important that complete financial evaluation is undertaken that balances capital investment and operating and maintenance levels with revenue potential for ensuring financial sustainability of operations. 128. The real economic danger for many railways, especially traditional railways, is in over- investing (and consequently over-spending on maintenance) to create much more capacity than can be economically justified by the actual and potential revenue of a rail line. While it is sometimes possible to correct (or reduce) over-spending on maintenance and other operating costs, there may be no way out of over-investing of capital, especially in infrastructure and facilities. 129. The health and survival of railways also depends upon a fair and efficient system of government regulation to insure public safety, allow market-based pricing on the same basis as trucks and waterways, and protect customers with limited transport options from monopoly pricing practices by the railway. It also depends upon a climate of mutual respect and fairness between railway management and railway employees. 3.4 CRITERIA FOR NEW RAILWAYS AND NEW RAILWAY ENTERPRISES38

130. In looking at new railways and new railway enterprises from a commercial point of view, it is important to specify whether construction of new main track infrastructure is required. New railway enterprises tend to be of two types, service businesses such as maintenance companies and train operators who rent the infrastructure assets of others, and financial businesses, such as leasing companies, which invest in liquid, moveable assets like railway cars, locomotives and self- powered track maintenance equipment. These companies, themselves, are not capital-intensive like vertically integrated railway operators, and their risks are relatively low. 131. Construction or purchase of existing track structure requires much greater levels of capital investment, and much greater risk, than equipment leasing and maintenance and other service enterprises. Purchase of existing railway lines involves much less risk than construction of new lines, as traffic levels and revenue levels are known, and the physical plant exists and may be inspected and realistically evaluated. 132. New railway lines may be constructed by existing railways or by new companies organized to build and operate rail lines. In the absence of sound evaluation of financial viability, if an existing railway borrows money to over-build a new line, it will struggle to repay the loan using profits made on other lines. The railway’s ability to serve customers will decline and the long-term health of the railway will suffer. If a new railway enterprise over-invests, whether in new construction or in purchase of existing railway infrastructure, it will likely go bankrupt with its remaining assets seized by its creditors. 133. In analyzing the potential purchase or lease of an existing railway, the prospective buyer must carefully and realistically project revenue and traffic levels, and then calculate operating, maintenance and overhead costs necessary to move the traffic while meeting customer needs. If

37 Minimums vary from place to place with employee wage levels, track structure (bridges, tunnels, curvature, grades, drainage, rail weight, etc.), safety standards, etc. 38 For the purposes of this discussion “New Railways” are defined as involving significant new rail line construction, or purchase of existing railway lines. “New Railway Enterprises” are defined as new enterprises which operate on track structure managed by others, or are ancillary (support) enterprises such as equipment leasing, contract maintenance of equipment, track, signals, or bridges, etc. Some of these enterprises may need incidental construction to modify or expand terminals, but they are not construction projects.

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the financial evaluation shows full cost recovery including a reasonable rate of return on investment the project may be considered commercially viable.39 134. Analysis of the commercial potential of a new railway line begins with consideration of the type and volume of existing traffic that can be diverted from existing modes of transport to the new railway, yielding potential revenue. Then, using preliminary assumptions about the characteristics of the line, operating costs can be estimated, yielding projected operating profit. As with purchase of an existing line, projected operating profit will indicate the level of capital investment that can be supported by the project. This is the maximum investment that can be commercially justified and thus, the maximum cost of design and construction permitted.40 135. When new line construction cannot be fully justified by the commercial potential of the line, government may decide that the public good requires construction and provide the additional capital necessary. In such cases the government investment should be secondary to the railway’s investment from commercial sources, and should fully cover the gap between total construction costs and the amount commercially justified. 136. Railways are capital-intensive. Nothing is more important to their future than having capital investments and operating expenses in balance with actual and potential revenue.

39 Including operation and maintenance costs, depreciation and debt service charges in excess of depreciation, and a reasonable rate of return on investment that compares favorably with alternative investment opportunities in the market. 40 It is, of course, possible to adjust the financial projections by substituting revenue projections that justify traditional construction. This would be disastrous for the long-term financial health of a commercial railway dependent upon its own competence for its survival and success.

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CHAPTER 4: MAJOR CHALLENGES FACED BY CR

137. In addition to the need to focus on improving customer service and customer satisfaction discussed in the previous Chapter, CR faces challenges in increasing capacity and developing rail operations in additional corridors. These challenges are made more difficult by the low level and highly regulated structure of railway tariffs. 138. Railway freight tariffs are tightly regulated by the government and kept very low – lower than the railway could reasonably expect to charge if tariffs were set by the market. Two possible consequences are: ♦ Earnings from operations are significantly reduced. As a result, the railway has much less internally generated funds to invest in projects to increase its capacity.41 ♦ Pricing a product or service significantly below the market will increase demand for the product or service which may strain the enterprise’s capacity to deliver the product or service. 139. Low rates, divorced from market forces, are principally responsible for CR’s operating profit42 being about 2.4% of total transport revenues (the profit excludes the amount collected as construction surcharge, which is available to CR for investment in capital construction). In contrast, the large North American railways had operating profits ranging from 13.2% to 36.2% for 2005.43 Much of these profits are invested in railway capital projects. In the US in 2006, the large (Class I) railways will invest $8.3 billion in laying new track, improving infrastructure and buying new equipment. Over the past 10 years, Class I “railroads put an average of 17.8 percent of their net operating profit into capital expenditures.”44 140. It may be mentioned that the financial results on US Class 1 railroads may not be compared directly with those of CR because of major differences in the areas of surcharges collected from the railway’s customers (about CNY 47 billion in 2005) for supporting capital construction, burden of service obligations on CR (estimated at over CNY 20 billion in 2005), and taxes paid by CR (that aggregated to CNY 18.5 billion in 2005). 4.1 CAPACITY CONSTRAINTS ON CR

141. CR faces a situation arising from recurring capacity constraints on most parts of the national network linking major industrial and commercial areas with major cities and the ports and other centers. The development of railway infrastructure has lagged behind the growth of the nation’s economy and the growth in total traffic. Capacity constraints and underinvestment in the railway sector has adversely affected productivity. The CR currently is operating close to or at capacity, and there are already indications that transport capacity is becoming a binding constraint on further economic growth. The high density of traffic on CR underscores a good record of performance and asset utilization. However, it is indicative of relative scarcity of railway infrastructure with undesirable adverse conditions. 142. At present, whenever one mentions the shortage of rail transportation capacity in China, almost everyone explains that “it is due to the slow construction of the rails.” This is partly true, but it

41 CR’s freight tariff (including RCF) at $ 0.009 per TKM is the second lowest in the world after Egypt ($0.008/TKM) and 19% of the world average. If CR’s tariff was one-third of the world average, the additional funds generated for investment would be approximately $90 billion over the 1996-2005 ten-year period. This amount is approximately equal to 1.5 times the total investments made by all Class I U.S. railways during the 24-year period from 1980 to 2003 or 60% of the planned investment in the railway sector in China during the 11th FYP (2006-2010). 42 The difference between Operating Revenue and Operating Expenses. 43 UP 13.8%, CSX 17.6%, BNSF 22.0%, CP 22.8%, NS 24.8%, CN 36.2%. US Surface Transportation Board, Office of Economics, Environmental Analysis, and Administration, 2006, from data reported by class I railroads in Annual Report Form R-1 Schedule 250 and summarized in “Statistics of Class I Freight Railroads in the United States 2004. Available: http://www.stb.dot.gov/econdata.nsf/ 66a333195e0491c885256e82005ad319?OpenView 44 AAR News, “Major Freight Railroads to Invest $8.3 Billion in Infrastructure in 2006,” posted at www.aar.org 16 March 2006. Available: http://www.aar.org/Index.asp?NCID=3582

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is only one side of the coin. There are so few people who mention the role of the tariff. The capacity shortage issue should be resolved by raising the tariff to an appropriate level which will allow larger investment in capacity expansion projects. 143. The overly low tariff set by the government and the operating route length of the Chinese railways fail to meet the needs of the economy which develops at a fast rate (average growth of GDP during the last 20 years was 9% per year, whereas railway route length has grown by 1.5%/year). This has already resulted in many problems in China’s economy: (i) rail economic return is low but not due to improper management. The rail operating revenue in 2005 was CNY 254.6 billion, with a net profit of CNY 6.1 billion, the rate of return is about 2.4%; (ii) RCF is short of railway investment needs; (iii) it is difficult to finance railway projects from the private sector due to low rates of return; (iv) the rail transportation capacity is seriously short, the freight owners find it very difficult to book cars, the passengers find it hard to get a ticket, and the situation is getting worse.45 144. Some large North American railways distinguish between physical capacity and procedural capacity. Physical capacity refers to the estimated capacity based on infrastructure, facilities and rolling stock. Procedural capacity refers to the capacity achieved through appropriate management of human and physical resources. Procedures are improved and investments made to improve procedural capacity.46 Expanding procedural capacity can be as important as expanding physical capacity for increasing the total capacity of railways. Expanding procedural capacity, though, often requires less financial investment. It may be mentioned that the considering the high average traffic density on CR and the high indices of asset utilization, the performance of CR comes out far ahead of the railway systems in other countries. 4.2 PRESSURE FOR DEVELOPMENT

145. Railway development in China in recent years has been guided by: (i) the Government’s agenda for alleviating poverty by opening routes to inland and more economically disadvantaged areas or minority regions,47 (ii) construction of new railway lines in pursuance of the Government’s ‘Go West’ policy,48 and (iii) other developments that follow the demand for rail transportation to keep the Chinese economy moving. Developments in the last category include adding additional track on heavily trafficked routes, removing line capacity constraints, and others. 146. A common criticism voiced has been that the agenda for railway infrastructure development is not market driven. In this context it may be mentioned that as a service provider, institutionalized traffic accounts for more than 80 percent of the total freight traffic.49 These services are provided in pursuance of the Government’s wider objectives to service the needs of the industry and public in a cost effective manner minimizing inflationary pressures. Another government objective which does not relate to market conditions is railway infrastructure investments due to social, poverty, and regional integration purposes. Admittedly the government’s railway development strategy would be guided by these requirements. In these circumstances, pursuing a for-profit market agenda that does not support this traffic would not be within the framework of the government’s policy. In these cases appropriate government support to the railway sector in the form of PSO contracts is an acceptable mechanism simulating market conditions. Nevertheless, there is still substantial traffic that is related to the market. Developments in these areas should be guided by market criteria.

45 As RCF receipts go to MOF, not MOR, commercially oriented investors may see the RCF as a tax on freight shippers levied by government, and not as railway operating revenue available for spending by CR management to help meet commercial needs of the railway and its customers. In part, RCF can be seen as a tax on railway freight customers to fund PSO capital spending. In this context, an adequate increase in CR tariffs should be seen as a means for the railway to generate its own funds for capital expansion projects under commercial principles. 46 Burlington Northern Santa Fe Corporation: “BNSF Financial Analysts’ Presentation” Denver, Colorado, June 5, 2006, p.135. Available: http://www.bnsf.com/investors/presentations/pdf/FinAnalysts_color.pdf. 47 An example of this is the December 1997 completion of the 898 km Nankun line from Guangxi's Nanning to Yunnan's Kunming. Dubbed "China's largest poverty relief project of the 1990s," the Nankun line links two of China's most depressed provinces. 48 Under the ‘Go West’ policy, the government is investing some $86 billion on infrastructure development. Although economic growth in inland provinces has improved in the last few years, high logistics costs and uncertainties in the supply chain have somewhat discouraged investors. 49 Institutionalized traffic refers to traffic generated from large shippers.

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Even in an environment of overwhelming volume of institutionalized traffic, it will be appropriate for MOR to introduce more market mechanisms in its operations. This will be helpful for sustaining traffic as the country progresses to a competitive market economy. 147. The CR has witnessed continuous development coupled with reforms and liberalization. Railway construction has been accelerated, the railway network has been further expanded, technological upgrading of railway equipment has taken place, national container and coal transport networks and a dedicated passenger network are under development, and railway transport capacity has been increased. The CR have experienced five successful speed-ups for passenger and freight transportation and the quality of service has been improved. Safety equipment, facilities and supervision have been increased and safety of operations have been enhanced. 148. As a result of these measures productivity indices have improved, and the revenue from transportation operations has greatly increased. In 2005 the national railway (CR) moved 2,318 million tons of freight, an increase of 6.4% over 2004, with transportation volume of 1,953 billion TKM, which was 7.3% more than in 2004. Also in 2005, 1,106.5 million passengers (3.1% more than 2004) were transported with total traffic volume of 583.3 billion PKM or an increase of 5.8% over 2004. In 2005, the total revenue from transport operations was CNY 254.6 billion or 12.4% more than 2004. The operational performance of the CR, which is the largest railway under one management in the world, has been a significant achievement. 149. As in the past, in the foreseeable future, CR will experience heavy transportation demands while being faced with limited railway capacity, resource constraints, and institutional deficiencies relevant for speedy transition from a planned to a market economy. It will face increasing challenges in the years ahead. The main challenges relate to the role of the national railway, capacity constraints and investment reform, logistics, and others. 150. In the present, and in the foreseeable future, CR cannot be viewed as a simple business operation that should be conducted on commercial principles. As a national carrier, CR has socioeconomic responsibilities that go beyond the ethics of a for-profit business. Considering the dependence of the Chinese economy and social structure on CR, we are of the view that the integrity of CR as a national carrier must be preserved and the unified vertically integrated control of the national railway must be continued. This view is strengthened by the outlook of the U.S. Class I railroads, the only wholly privately owned and managed railway systems in the world that are operating successfully in a market environment. The trend of privately owned and managed freight railways in the U.S. is clearly in the direction of consolidation, and creating large railways to serve the market through centralized operations. Europe has gone for the vertically segregated model because of the emergent situation due to declining rail freight traffic share and congestion on the roads, so as to facilitate competitive open access in the hope of winning more traffic to the rail. The impetus for change in Europe (decline of freight traffic share from 27% to less than 6% in 20 years and high truck congestion on the road) is not the same in China. Similarly, the impetus for change in the railway sector in Latin America (heavy losses and large and no more affordable government subsidies) is not the same in China. 151. The system of management of MOR must conform to the boundary conditions for railway operations in China. On the one hand, the economy demands efficient and cost effective transportation in the given situation of constraints imposed because of the country’s size, differential development in coastal and inland regions, poverty in some regions, and the social responsibility to provide transport at a price accessible to the majority of the population. On the second hand, as a commercial entity it is imperative that CR remain efficient and financially self sufficient in a competitive market environment. In the wake of these two requirements, it is our view that the national railway should be operated as one system with two operating characteristics. These characteristics are: ♦ Commercial operations in a market environment in competition with other private sector providers of transportation services (both within the railway sector and vis-à-vis other modes of transport); and ♦ Socially obligated freight and passenger operations that may not satisfy commercial criteria but are necessary in recognition of CR’s wider social

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responsibilities. The performance of these functions necessitates compensation from the government to cover CR’s losses. 152. We are of the view that CR’s restructuring should be guided by this “One System-Two Characteristics” principle in the conduct of its operations, as well as CR’s (as an enterprise) relationship with the Government. This should be pursued in a transparent manner for the market’s understanding, acceptance, and confidence. The resolution of compensation due to CR for providing socially obligated services is considered important for rationalizing the financial relationship between CR and the government. 153. It is clear that the railway network is insufficiently developed. Liberalization under the WTO regime is expected to further increase China’s international trade, resulting in increasing strains on the domestic rail transportation infrastructure. Therefore, one of the most urgently needed reforms in the railway sector relates to investment financing. 4.3 DIFFICULTY FOR GOVERNMENT TO FULFILL ITS OBLIGATIONS

154. The PRC Government faces competing demands for investments in a rapidly growing and changing economy pursuing goals in important areas such as energy, health care, education, highways, environmental preservation, rural and western development, and railways, which all require sizeable investments. Public financial resources are not sufficient to satisfy the funding requirements of all infrastructure investments and social services. 155. In addition to attracting non-public investment in infrastructure and expanding private sector participation in railway transport, CR itself can become a potential source for funding new railway investments through its own resources. In order to increase capacity, continue its development, and contribute to the further commercial development of China (especially western China), CR needs the central government to take the following actions: ♦ Fully cover CR operating losses of PSO lines and services, and subsidize PSO construction to the extent it is not commercially justified. ♦ Deregulate CR tariffs 50 so that CR can charge market rates and increase profits that can be used to fund much of its own commercially justified capital needs. 156. Covering PSO operating losses and subsidizing PSO construction will require substantial financial support from the central government. 157. Deregulating tariffs may not have significant financial consequences on the government itself, except that it will result in increased rail freight bills for some state-owned enterprises. 4.4 CONDITIONS FOR PRIVATE CAPITAL TO INVEST IN RAILWAYS

158. Financing for the railway sector is primarily sourced from MOR’s internal sources, comprising profits from operation and surcharges on freight moved by rail. In addition, the MOR capital construction program is supported by loans from domestic financing institutions, and loans from multinational development banks that are borrowed by government and re-lent to the MOR. More recently MOR has increased joint ventures with provincial and local governments and the National Council for Social Security Fund initiated a trust investment program with MOR.51 159. MOR has been making efforts over the past decade to attract foreign investment for the railway sector. The number of cases in which railways have raised financing from the capital markets is still in single digits. Considering the excellent response of foreign investment in most other sectors, the performance of the railway sector so far has been far from satisfactory. A deepening of reform is needed in order to broaden financing channels for railway infrastructure construction and development to meet the demand for rail transportation in the country. 160. As commercialization in operations, planning and the selection of capital projects increases, commercial investors will be more and more attracted to railway projects. As CR gains experience

50 With continued regulatory protection against monopolistic abuse of customers. 51 China Daily, Beijing; 27 December 2005, p.11.

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in dealing with potential commercial investors, it will be better able to recognize and court the types of commercial investor most attractive to and most likely to invest in CR. 161. Commercial investors in railways come in many different types and many nationalities. As globalization progresses and commercialization spreads, national differences become less important. However, the differences between types of investors – in their goals, investment requirements and time frames – become important to understand. 162. There are a variety of investors with a large difference among them with respect to their investment goals, criteria they use in their investment decisions, how and for how long they invest their funds, how they deal with risk, and exit strategies they use. Table 4.1 provides a summary of these characteristics for 5 major types of investors ranging from commercial banks to long-term strategic investors and railway freight customers. The suitability of each type of investor for different types of investment needs for CR will be discussed in the next Section of the Report. 163. Understanding the goals, interests, and other characteristics peculiar for an investor is important for determining the type of investor which can be successfully attracted to a railway project and devising project presentation and promotion strategies accordingly. It would be a futile effort, for example, to offer an investment in a new railway construction project which requires a relatively long period to germinate a satisfactory return to a speculator or a venture capitalist. 164. A deepening of reform is needed in order to broaden financing channels for railway infrastructure construction and development to meet the demand for rail transportation in the country. Railway industry is characterized by a large amount of investment and a long term of cost recovery. Railway business in PRC is too complex for outside investors to understand and appreciate. Added to this is the lumpy nature of the investments and the long pay back period. The long term nature of developing rail transport infrastructure leads to uneasiness on the part of investors and commercial lenders. Because of the long term payback, there is concern as to whether politics will not take a hand in interfering with agreements reached for implementing the projects. In addition there are concerns with regard to project revenue streams because of government-determined or -guided pricing.

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Table 4.1: Major Types of Commercial Investors and Their Essential Characteristics

Investor Commercial Banks Speculators Venture Capitalists Long Term Investors Major Railway Freight Customers Description Invest their depositors’ money at a rate Invest in startup and other new enterprises, grow Improve their railway service to speed exceeding the interest they pay depositors, plus Long term growth in the company’s business them quickly, and then sell their stake in the deliveries, increase reliability, reduce transport, Investment Goals their expenses, plus a profit, plus a risk Make large profits very fast. resulting in increased value of its stock and larger company to a competitor or to the public production and operating costs and open new premium if the borrower does not enjoy the bonds. through a public stock offering. markets. highest credit rating.

In rolling stock to be used in their shipments, captive track structure directly serving their Long-term secured loans, and/or corporate Generally in publicly traded stocks, bonds, real Generally in stock of company before an offering facilities, purchase of existing lines, and How they invest In stock and long-term corporate bonds. bonds. estate, corporate loans and foreign currency. to the public. construction of new lines and rehabilitation of existing lines and facilities alone or in joint ventures with carriers and other investors.

Confidence in the capability and character of Potential major change in valuation (either up senior management, the soundness of the or down) in a financial instrument such as company's long term business strategy, the Return on investment (from the investor’s cost Confidence in the loan recipient, its business stocks or bonds that can be exploited to Generally looking to increase the value of their honesty of its accounting, and in the long term reductions and/or operating profits) at or above Criteria for Investment plan, and the value of the assets pledged to produce large, quick profits. No interest investment by 5 to 10 times in their time frame. demand for the company's products and the corporate criteria for capital expenditures secure the loan. whatsoever in the business involved or in the services. Generally looking for long term (generally in excess of 10% per year). long-term prospects for the company involved. returns per share to average at least 10% per year.

Typical Time Frame 5 to 20 years. 1 hour to 6 months. 2 to 5 years 5 to 20+ years 5 to 20+ years

Sell the venture capitalists’ stake to the public or Successful repayment of loan, or, in case of to a competitor after the business has been made Determined by the business strategy for the Sell fast – get out fast – take your profits Hold until the stock price reflects the long-term Typical Exit Strategy default, seizure of assets or dominant position to look sound and with good prospects; get out as facilities served by the rail lines in which they and/or limit your losses. market potential of the company, and then sell. in the bankruptcy proceeding of the borrower. quickly as possible once it is determined that the have invested. investee won’t grow at the desired rate.

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Investor Commercial Banks Speculators Venture Capitalists Long Term Investors Major Railway Freight Customers Description

Stock holdings are large enough so that venture Tight, legally binding contracts including Comprehensive investigation of the company’s Legally binding contracts which allow the capitalists from one or more investment firms penalties; preference for sole ownership with Failure is an accepted part of financial financial condition, management and long-term lender to seize the pledged assets in the case control the company’s board of directors. Failure lease to rail operator containing specific How they Deal with Risk speculation; profits from successes need to business strategy. Focus on long-term of a default by borrower on repayment or on of some investees to grow rapidly is expected performance measures and incentives; if joint be large enough to cover the costs of failures. potential, not current quarterly or annual profit other terms of the contract. and generally results in replacement of that venture, prefer situations with multiple owners, numbers. company’s founders none of which have a majorit

Venture investments are not made for long-term Wild fluctuations in valuation, made worse by and sound business purposes, but largely to Downturn in the business cycle that could speculators, can severely damage investor increase the stock price of the investee so that Continuous detailed scrutiny of management, Incompatibility between the railway’s strategic Risk for Investee affect revenue, making repayment difficult, confidence and impact a company’s ability to investee can be sold by its venture capitalist business and business strategy by investor. goals and the customer’s strategic goals. causing loss of assets and/or solvency. raise money in credit and equity markets. investors at a much higher price. Investee is under pressure to rep

Norfolk Southern’s program for divesting Electric utilities in the US: purchase of coal cars The infrastructure operating company in secondary lines was consciously structured to and locomotives to move their coal in their own the UK. The US regional railway Wisconsin Foreign exchange currency traders during the encourage long term operators and investors trains, construction of support yards for their Example Central in its own operations and in its Asian financial crisis in the late 1990’s. and discourage investors with a short term traffic, construction of rail lines to connect investments in the New Zealand and British Rail focus by purchase contracts calling for existing mainlines with new mines and power Freight (EWS) privatizations. payments to the NS if buyer sold or trans plants, construc

Source: Consultant

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165. A number of factors should be weighed when deciding whether private sector participation in railway infrastructure investment should occur through the stock market or through JV with a strategic long-term investor. Private investors make decisions based on their assessment of risk and return in their customary line of business. A Morgan Stanley analysis of financial performance in surface transportation in 2003 has shown that the average return on capital for 44 publicly-listed companies in Europe, North America, and Asia was 9% and the average cost of capital for the same companies was 6.5%, resulting in a spread of 2.5%.52 The highest return and spread was observed in non-asset intensive companies such as freight forwarders and logistics management firms (6.9% cost of capital and 14.1% return on employed capital, or a spread of 7.2%) and the lowest in asset intensive railways (5.6% cost of capital and 6.1% return on employed capital, or a spread of 0.5%).53 166. A strategic partner with a cost of capital and return of 5.6% and 6.1%, respectively would be satisfied with a spread of 0.5% in a mature market environment such as North America or Japan, which carries relatively lower risk. However, as risk increases such as in China (mainly due to unclear separation of government and enterprise functions, continued government control over price setting, uncertain interline traffic practices and rules with the national network, de facto lack of open access due to mainline capacity limitations, and other uncertain conditions affecting operations and profitability) the minimum spread required by the investor would also increase, which results in projects becoming attractive with more than a 10% return on employed capital. 167. Unless investors see some specific advantages by way of higher rates of return on investment compared with other sectors, they may not come to railways. The investment packages need not necessarily rely on the rate of return based on the project’s revenue stream. Incentives would need to be built into the investment package to make the project attractive for the private sector. The incentives, inter alia, may include income tax exemptions, provision of soft loans from government sources for supplementing investment from private sources, provision of preferential policies for the construction of railway projects – this method has been extensively used in the U.S. Taxes and duties often increase capital costs. If a transport infrastructure project meets economic viability criteria, capital inputs should be exempted from levies of all sorts, in order to reduce capital costs and improve the financial viability of the project. 168. Considering that investor interest in rail investment has not been significantly generated so far, it would appear that investors perceive lower returns and higher risks from such investment when compared to competing alternatives. A deeper understanding of the benefits and risks of railway infrastructure investment is necessary. The government will need to consider ways to promote and appropriately reward private investment in rail infrastructure. Also there is urgent need to increase the awareness of the private and public sectors of the benefits and risks associated with railway investments and how these would compete with alternative investment opportunities. 4.5 CONDITIONS AND MODALITIES OF PRIVATE INVESTMENT IN RAILWAYS

169. Commercial investments are generally made in two ways: ♦ Funding specific projects – often large scale construction projects. ♦ Funding enterprises as a whole. 170. Generally, specific projects are funded with debt such as loans or bonds. The lender to a specific project has recourse on the project, but may also require that the recipient of the funds guarantee repayment of the debt by putting some or all of its other assets at risk. Enterprises can be funded with stock and debt. Stock and debt may be issued to raise money for a particular project but are obligations of the enterprise as a whole. 171. The most likely investors in railway projects are commercial banks with secured loans and major railway customers. Different kinds of railway enterprises are more likely to attract different

52 Morgan Stanley Equity Research, Surface Transport: Global Insights; September 8, 2003. 53 The railways included in the Morgan Stanley analysis were Arriva and FirstGroup from U.K.; Central Japan Railway, East Japan Railway, and West Japan Railway from Japan; Burlington Northern, CSX, Norfolk Southern, Kansas City Southern, and Union Pacific from the U.S.; and Canadian Pacific and Canadian National from Canada.

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kinds of commercial investors. Long established, successful railways will be attractive to long-term investors, commercial banks, major railway customers and speculators (if their stock is publicly listed). Newly established railways will be attractive to commercial banks, venture capitalists and major railway customers 172. The most desirable investors from the point of view of railways themselves are those investors with a long-term commitment to the railway business and to the development of the particular enterprise – long-term investors, commercial banks, and major railway customers. 4.5.1 Private Sector Investment in Railways - Opportunities and Conditions54 173. Following on the PRC’s commitment to open the market to foreign companies after joining the WTO, the PRC allowed foreign companies to enter into joint ventures in the domestic railway freight transport market. Different from the cargo business, railway passenger transportation will not be affected by the WTO entry. 174. MOR Provisional Regulations issued in August 2000 55 set out the procedures and qualifications for investment in, and operation of, companies with minority foreign ownership. No application was received from a foreign potential investor as a result of the August 2000 regulations although some inquiries were made by foreign companies for further information. 175. The national investment regulations were superceded in October of 2004 by SC-20 and NDRC-22 regulations for approving foreign investment.56 MOR implementation regulations for SC- 20 and NDRC-22 governing investment in and operation of majority foreign owned rail operators or of wholly owned foreign operators have not been issued. 176. On 22 July 2005, MOR announced the opening of four areas in the railway sector for domestic private investment. These areas are: (i) construction of new railway lines; (ii) investment in railway operations; (iii) railway transportation equipment manufacturing; and (iv) railway diversified economy. Since mid-2005 with the active promotion by MOR with potential private investors, investor interest in new line construction projects and specialized facilities such as intermodal container terminals has increased. It is, however, too early to make a general observation on the success or failure of these initiatives. 4.5.2 Obstacles to Commercial Investment in Railways in China 177. The following list provides major obstacles perceived by foreign private investors in railway enterprises and projects in China: ♦ Most commercially oriented foreign railways make money on freight, not passengers. CR’s artificially low freight tariffs are a barrier limiting its capital accumulation, including the ability to compensate commercial investors at competitive rates for CR projects. Regulation of freight tariffs by the government discourages commercial investment, as tariffs are low and demand for transport services is high in relation to capacity. ♦ Perceived lack of transparency in CR’s financial reporting is another obstacle . Commercial investors feel that they lack the full financial information they normally require when making investment decisions. Commercial investors expect to see detailed financial statements with railway operating income and expenses shown separately from that of non-operating units. ♦ Unfunded, non-economic factors in railway investment decisions leading to subsidy by CR of the government’s public service obligations and a resulting dilution of potential return to investors.

54 Rail areas opened to foreign private capital under WTO are discussed in Section 5.1. 55 See Appendix C of the SFR for Interim Regulations for Review, Approval and Management of Foreign Investment in Railway Freight Transportation Sector, MOFTEC and MOR, 2000. 56 Interim Measures for the Administration of Examining and Approving Foreign Investment Projects, NDRC, 9 October 2004.

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♦ The structure of new enterprises formed to build new lines is problematic for commercial investors as the new enterprise where they would put their money (whether equity or debt) is a paper holding-company and not an operating enterprise. The new enterprise’s railway assets are operated by Regional Administration(s) which likely make decisions based on what is good for the administration, rather than on what is good for the enterprise. In the mind of many commercial investors, such a structure increases the level of risk in the investment, since the enterprise they are investing their money has little or no actual control over the use and productivity of the assets created by the investment. ♦ Internal revenue distribution rules used in MOR’s accounting practices does not represent a realistic cost and revenue structure under market conditions where these issues are settled through arms-length negotiation.57

57 For example, freight and slow (100km/hour and less) passenger trains are charged the full cost of capital and maintenance of higher speed tracks over which they operate at slower speeds (rather than the capital and maintenance cost of tracks maintained only to those trains’ maximum speed). Track maintenance costs increase exponentially with speed increases. If passenger speed is 200 km/hr and freight is 80 km/hr, under the current system of cost allocation, freight customers subsidize the extra 120 km/hr of track speed capability which freight trains do not use and from which freight customers receive no benefit.

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CHAPTER 5: OPPORTUNITIES AND CHALLENGES BROUGHT BY ACCESSION TO WTO

178. China has committed to give access to the national rail network to non-CR operators for rail freight transportation, for the operation of complete trains and to have their equipment hauled by CR. Since December 11, 2004, these operators may be majority-foreign owned. After December 11, 2007, they may be wholly foreign-owned. Fully exploiting the possibilities imbedded in WTO58 will require that CR, from senior management down through the ranks to the lowest level workers: ♦ develop a commercial mentality with customer service at its core, ♦ act strongly and consistently to put that mentality into daily practice, and ♦ communicate its commercial strategy to current and potential investors and customers. 179. An idea of the strategy of commercial railways may be had from the following example that provides the areas of ‘Strategic Focus’ that were discussed by one of the major U.S. Class 1 railroads with financial institutions in June 200659: ♦ Balance resources to promote growth and support stable products and services; ♦ Develop new products and services; ♦ Enter into relationships, partnerships, alliances and mergers that improve our company; ♦ Meet customer expectations (damage-free, ease of dealing, service, etc.); ♦ Minimize service time, to increase capacity, and improve customer service; ♦ Invest in the right asset at the right time to keep core network strong and to increase capacity; ♦ Achieve sustainable returns by business unit (by major commodity) that exceed the cost of capital to justify investment; ♦ Lead the rail industry in efficiency measured in terms of operating ratio; ♦ Utilize our resources to maximize velocity; ♦ Promote sound regulatory and public policy; ♦ Achieve the safety vision of eliminating accidents and injuries; ♦ Achieve alignment with front line workforce; ♦ Champion programs that attract, retain and motivate employees (compensation, diversity, work/life balance, etc.); ♦ Develop and transition the workforce; ♦ Lead in public safety performance and environmental stewardship in surface transportation; and ♦ Proactively participate in and support communities where we operate.

58 Possibilities for CR, for the railway sector generally, for domestic freight transport, and for the Chinese economy as a whole. 59 Burlington Northern Santa Fe Corporation: “BNSF Financial Analysts’ Presentation,” Denver, Colorado, June 5, 2006, p.5 Available: http://www.bnsf.com/investors/presentations/pdf/FinAnalysts_color.pdf

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5.1 ATTRACTING INVESTMENT, TECHNOLOGY, MANAGEMENT AND INSTITUTIONAL CONCEPTS

180. The possibilities for foreign investment in railway freight services break into several types of investments: ♦ CR itself (debt and/or equity, tied to specific projects and assets); ♦ JVs for specific lines or specific business segments between CR and foreign operators, forwarders, financial institutions, provinces, and local government units; ♦ Non-CR railway freight services whether operating on owned, dedicated rail lines on CR, or on both types of lines: ♦ JVs between Chinese railway customers, perhaps also including foreign operators and foreign investment; ♦ JVs between customers who are themselves JVs with significant foreign investment; ♦ Pure foreign investments. 181. For some of all of these investments to be attractive to foreign investors depends upon the potential financial return and progress by MOR, CR and the national government in lessening the obstacles to commercial investment in railways and railway investments discussed in Section 4.5 of Chapter 4. 182. The ability to obtain foreign investment financing for specific projects and JV line construction will increase as MOR and CR increase the commercial understanding and justify projects to potential investors based upon credible commercial potential of the project, and upon credible financial return for investors. 183. Much foreign railway technology is now available in China. Foreign investment by manufacturers in joint ventures or Chinese subsidiaries, and loans by foreign banks could speed widespread adoption of well established technologies. The technology CR would need to modernize and commercialize most of its operations is available to CR. The obstacles to its adoption are largely with CR’s structure and institutional culture. 184. Some leading-edge railway technologies, however, may not be available for export to countries other than Canada, Western Europe and Australia. Some railway suppliers such as locomotive manufacturers have been reluctant of putting their latest products in the developing world. While this refusal to export leading-edge, high tech railway products has been justified by arguing that adequate, highly technical service is not possible in the excluded countries, the real fear is difficulties in protection of intellectual property rights (IPR). Manufacturers will not sell their latest technology to customers in countries perceived to be without effective legal systems to protect their technology. 185. Adoption of foreign management concepts and institutional systems is not dependent upon foreign investment. Foreign investment is not a necessary precondition for MOR and CR to explore, study, and then adopt appropriate commercial management concepts and institutional systems. Examples of management concepts and institutional systems found in commercial railways, largely in North America and Europe, have been under study by MOR for sometime through numerous contacts and exchange programs, including study tours and visits. 186. CR has business relationships with large commercial North American railways (such as BNSF, CN, and NS) that are active in transporting traffic to and from China. Moreover MOR has executed cooperative agreements with foreign government agencies on technology, management practices, safety, and other major issues facing all railways. Discussions of the experiences of these railways and foreign institutions in transforming their organizations and the strengths and weaknesses of various organizational structures could provide valuable practical experience to CR as it develops its own plan for change within the context of a rapidly growing and commercializing China.

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5.2 SPEEDING UP RAILWAY DEVELOPMENT THROUGH RAILWAY REFORM

187. A major problem with the current MOR structure is span of control. Research into organizational structure for more than 50 years has shown that senior executives function best, and their organizations perform better, when there are no more than seven managers of departments reporting directly to an executive. 188. MOR has 15 Departments, 18 Regional Administrations, and 11 companies reporting to the Minister and to 4 Vice Ministers for a total of 44 direct subordinates.60 In the current structure, the Minister and Vice Ministers have regulatory units, political units, and numerous units of the enterprise (CR) reporting directly to them. 189. For CR to have the focus to reform and restructure itself as a commercial organization, it needs a railway chief executive responsible to the Minister for the entire enterprise and with the authority to impose organizational and commercial discipline throughout the enterprise. Similarly, MOR’s regulatory and policy functions could be headed by senior executives who report directly to the Minister. The number of senior managers reporting directly to the Minister would then be reduced to a more manageable structure of authority for the Ministry. 190. To properly develop commercially and to foster accountability, all of the MOR enterprises need fully functioning accounting and finance departments responsible to their chief executives. Understanding and controlling the enterprise’s revenue and expenses are key to the ability of each enterprise’s accounting and finance department to function successfully in a market economy. 191. With all of the various, organizationally separate railway operating enterprises brought under one roof, and with control of its finances and accounting in a central department, the railway chief executive could then begin to implement a modern, commercial railway organizational structure. 192. Implementation of an advanced management concept for the railway operating enterprise requires senior management to lead the way in making the necessary organizational changes in MOR possible. Then restructuring the institutional system of CR as a commercial enterprise can begin. 193. One way to advance commercialization in CR is through lateral induction from the market of experts who are well trained and experienced in commercial operations, and can also provide different professional backgrounds. 194. One way to inject modern, commercial thinking into CR would be to recruit commercially minded young managers into CR – people trained in marketing, management and finance at the master’s degree level at major western and Chinese universities. After hiring and training to give them an understanding of the full range of CR’s functions, these people should be given responsible tasks, ♦ to give them experience in the current system, and ♦ to begin implementing small steps in the process of commercializing CR. ♦ Some of these people will prove themselves and emerge as managers to shoulder wider responsibilities. 195. MOR has been making efforts over the past decade to attract foreign investment for the railway sector. The number of cases in which railways have raised financing from the capital markets or from the private sector is still in single digits. Considering the excellent response of foreign investment in most other sectors, the performance of the railway sector has been unsatisfactory.61 A deepening of reform is needed in order to broaden financing channels for railway

60 Subordinates directly reporting to the Minister include 4 Vice Ministers, the Foreign Relations Bureau, Political Department, and the Discipline Committee. An extended span of control makes management less effective particularly to judge the performance of each unit and hold the person in charge of it (the direct subordinate) fully accountable. It is equally difficult, to have sufficient knowledge of all units to anticipate problems and provide guidance. Research into organizational structure indicates that senior managers with many units reporting to them (that is, with span of control much too broad) spend most of their time putting out fires, and far too little time in preparing the whole organization for the long-term changes it will face. 61 In the roads sector, total investment in 2004 was CNY 470.2 billion, an increase of CNY 98.7 billion or 26.6% more than 2003. In the railway sector the total investment in 2004 was CNY 78.38 an increase of CNY 4.55 billion or 6.2% over

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infrastructure construction and development to meet the demand for rail transportation in the country. 196. Reform and restructuring focused on commercialization are necessary if CR is to be attractive to investors as an investment hub. The faster, more thorough, and more commercially sound the process is, the faster would be the availability of private capital . 197. Currently, financing for the railway sector is primarily from MOR’s internal sources, comprising proceeds from operation and surcharges on freight moved by rail. In addition, the MOR capital construction program is supported by loans from domestic financing institutions, and loans from multinational development banks that are borrowed by government and re-lent to the MOR. 198. In accordance with the government’s 11th FYP, infrastructure improvements in the railway sector over the next 5 years are estimated to cost approximately CNY 250 billion per year.62 This amount includes MOR plans to build an additional 7,000 km of railways by 2010. Thus the financial outlay for capital construction will be increased four-fold compared with the average outlay of about CNY 65 billion per year during the 10th FYP from 2001 to 2005. It is clear that this amount of investment funds cannot be fully met from government and internal generation sources only. 199. Private investors will demand that projects pass commercial and financial tests as well as engineering and design tests. A thorough, objective, detailed financial analysis of projects will be necessary to convince potential lenders and investors that a project has an acceptable level of risk and return. 5.3 RAILWAY SECTOR RESTRUCTURING AND COMPETITION

5.3.1 Competition from outside CR 200. With increasing market access under the WTO regime, CR will face competitive challenges, and have corresponding opportunities to develop cooperative relationships. Categories of challenges facing CR with the opening of freight transport markets under WTO include: ♦ Open access challenges ♦ Pricing challenges ♦ Reliability challenges ♦ Loss & damage challenges. 201. The challenges will come from other modes of transport and from within the rail sector from competitors offering lower total costs, greater reliability, and/or less loss and damage. CR will need to recognize these challenges, rethink its ways of serving customers, and seek new answers. Some within CR understand the challenge as summarized in the following quote from a 2002 article by Guo Xiao Guang63: “As compared with the same industrial enterprises in foreign countries in the labor productivity, the level of technical equipment and quality and reliability of the products, the railway transport industry in China still has a long way to go, the related laws, rules and regulations are not perfected, and the management system is not adaptable, so that the railway transport industry is facing a severe challenge brought about by the open transport market.” 202. Changes in market access in competing freight transport modes will lead to new competitive challenges from other modes as well as to new opportunities to cooperate with carriers from other

2003. In 2004, the investment in the railway sector was less than one-fifth of the investment in the road sector. For comparison, in 1995, investment in the road sector was CNY 45.2 billion, less than the investment of CNY 52.6 billion in the railway sector. During the period from 1995 to 2004, the growth rate of investment in the railway sector was 4.3% per year, whereas in the roads sector it was 30.1% per year. This amount of resource mobilization was the result of reforms in investment financing in the roads sector that helped to tap a nearly inexhaustible source of financing from the capital markets. Consequently, during 1995-2004, growth of road infrastructure (in terms of the length of new roads built) was on average 5.75% per year, whereas the route length of the railway increased by an average of only 1.3% per year. 62 The World Bank has estimated the annual investment requirement at $ 15 to 20 billion until 2020. 63 Guo Xiao Guang “Measures that the Railway Freight Traffic Department Should Take after Accession into WTO” MOR, November 2002.

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modes. Road transport access and pricing are both completely unregulated. While there are still barriers to efficient, inter-provincial fleet operations, these barriers are coming down and competition should be expected to intensify, both within trucking and between road and rail freight. 203. Long haul container traffic within China is increasingly being handled by long haul, inter- provincial trucking, as customers are unable to get rail cars for their containers, are unsure of transit times and reliability, and are unwilling to accept the level of loss and damage that rail service delivers. The long haul container traffic which has been lost is unlikely to return to the rail mode until rail service is significantly improved. This pattern of traffic shifting from rail to truck will likely happen in other commodity groups where short transit time, reliability and/or minimization of loss and damage are important to shippers. 204. The most likely sources of railway freight competition from outside of CR, but operating on CR’s tracks, will be major railway customers operating their own locomotives and freight cars to move their own goods between two points. Some examples are between coal mines and steel mills, coal mines and power plants, or coal mines and river or coastal ports. Other possibilities are automobile manufacturers moving auto parts and finished autos from factories to ports, and freight forwarders moving containers between inland points and ports. The motivation of these customers would be to guarantee freight car supply for loading, control the reliability and predictability of service, and employ more specialized equipment that can be loaded and unloaded more efficiently than the generic, multi-purpose equipment provided by CR. 205. Customer created freight railway operations can obtain railway operating expertise by being structured as JVs with foreign railway operating companies. Alternatively, customers could contract with foreign operating companies, or create their own freight railway operating companies by employing experienced former CR employees.64 However, it is highly unlikely that foreign freight railway operators will attempt to launch commercial operations on CR tracks without the support of one or more large current or potential railway customers, given current capacity constraints and low tariff levels. 5.3.2 Creating Competition within CR 206. Airlines were commercialized in China by establishing multiple companies (Air China, China Southern, China Eastern) that developed controlled competition. Airline modernization and commercialization in China has been rapid and Chinese air carriers are able to compete in international markets against the world’s best airlines. Similarly, Chinese container ship lines are successful commercial competitors, against each other and against carriers worldwide. 207. The experience of railways elsewhere in the world, and that of other transport modes in China, is that commercial competition for traffic between railways65 will likely result in ♦ improved service, ♦ greater efficiency, ♦ more reliability, ♦ less loss and damage, and ♦ increased rail market share.

208. The configuration of the CR network is such that it can best be operated as a unified carrier serving the entire network. Theoretically, one way to create competition within CR would be to follow the Canadian model by splitting CR’s freight service into two competing, vertically integrated freight carriers66 providing competition in selected commercial corridors and commodities. However, any such move will require detailed study, planning and preparation. If it were implemented, the two freight carriers would compete against each other for customers’ business. At first this

64 Operating managers, train crews and other experienced specialists necessary for their operations. 65 As with competition within other transport modes (airlines, trucks, waterways, etc.) 66 A separate vertically integrated passenger carrier could also be created to manage and operate the dedicated passenger lines as well as the multiple purpose lines that are substantially (over 65%, for example) passenger traffic and also operate passenger trains over the freight carriers’ lines under a trackage-rights agreement specifying operating practices and charges. In turn, where appropriate and necessary, freight companies would have similar agreements to operate their trains on the passenger carrier’s lines.

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competition would be largely in terms of reliability of service, elapsed time before delivery, and loss and damage experienced. If tariff regulation were relaxed they might also compete on price. The carriers would not only be competing against each other, but also against trucks and waterway operators. 209. Further the split of lines between the two carriers would have to be fair and balanced on the national scale. If one carrier had advantages in one major market, it would have offsetting disadvantages in other markets resulting in the two carriers having equal opportunities on a national basis. There would also need to be regulation to protect customers against monopoly pricing and to resolve disputes between the two carriers. Whereas the Canadian practice of creation of joint switching districts within 30 km of the center of major markets that allow customers a choice of line haul carriers regardless of which carrier is used for loading, initial shipment or final delivery, would provide useful background experience. However, any such move for creating intra-modal competition would have to be done considering the operating conditions and constraints of CR, while ensuring that such a move does not involve any risks that could adversely impact the pace of economic development. . 5.4 SIGNIFICANT CHANGES NECESSARY FOR CR SUCCESS

210. China continues to develop as a major force in the world economy. WTO can be seen as a test of CR’s desire to commercialize, reform and develop in harmony with other major segments of Chinese economy and society. Failure to act in harmony with WTO principles and China’s WTO commitments will have consequences for MOR and CR. Most of those consequences will have negative effects on the development of CR. Two important consequences are described below: 5.4.1 Consequences of Failure to Implement WTO Commitments 211. Protecting CR would violate WTO principles and could be challenged in Chinese courts and then appealed to WTO panels by enterprises which have been denied access. Chinese courts are becoming more transparent as shown in the writings of a senior Chinese judge: “[W]e should not . . . conclude that [China’s commitments regarding judicial review] are some kind of price or sacrifice that had to be made for China to enter the WTO. This kind of provision reflects the serious attitude and commitment of China to promoting the advancement of the rule of law. . . . It is completely in accord with China’s strategy of governing the country according to law and will advance China’s progress in establishing the rule of law. The beneficiary in the end will be China.”67 212. As transparency proceeds in the Chinese courts, they will become less likely to excuse tactics, even by government ministries, which violate WTO accession agreements. If the foreign party loses in Chinese courts, it could appeal to a WTO tribunal, which may result in wider repercussions at the international level. 213. Thus a dispute over open access between MOR and a foreign partner of a potential railway operator, could result in a WTO complaint against China by the foreign government. Since a service is involved and not a product, under WTO rules penalties against the country found guilty can be applied in retaliation as counter veiling duties on particular exports selected by the aggrieved country. The WTO tribunal would calculate the amount of the damage to the aggrieved party, and duties in that amount could be enforced. If China were found guilty of discrimination against a foreign company, then higher tariffs could be imposed by the foreign government on particular Chinese exports it selected. 5.4.2 Negative Impacts to CR of No Reform Option 214. While some aggrieved potential operators might chose to take their fight through the Chinese courts and then on to the WTO, others would simply look elsewhere for opportunities. If foreign enterprises and investors sense that MOR is obstructing implementation of WTO

67 Kong Xiangjun, a judge in the administrative tribunal of the Supreme People’s Court; “Establish a System of Judicial Review that meets the Requirements of the WTO”, Chinese Jurisprudence, no. 6, at 3, 8 (2001). Quoted in Clark, Donald C., “China’s Legal System and the WTO: Prospects for Compliance” Washington University Global Studies Law Review, Vol. 2:97, 2003.

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agreements, they may decide to invest in other sectors of the Chinese economy. Or they may decide to invest in another country entirely. 215. In addition, the US magazines “Logistics Management” and “Supply Chain Management Review” in a recent email announcing an online logistics conference on China, wrote the following about the program: With forecasts of superlative economic expansion, aggressive infrastructure development, increased foreign investment, and continued advantageous operating and labor costs, there’s little doubt that China will continue to be an intriguing trading partner for U.S. companies for years to come. But there is much U.S. shippers need to understand about the current logistics landscape before they can continue to successfully expand their supply chain operations to tap into the rich manufacturing possibilities the region has to offer.

In this two-part overview session, China infrastructure specialist Jon Monroe will lead off by offering shippers a thorough overview of the current status of the country’s port, highway, and river infrastructure.68 [underline added for emphasis]

216. It is noteworthy that railway freight and railway infrastructure are not mentioned. The relevant options for shippers do not include the railway – the main mode for land transportation. This attitude is consistent with articles in previous issues of “Logistics Management” magazine, where western logistics experts have this far ignored the possibility of using railway freight service in China. CR needs to change this image by adopting a more commercial attitude and improve customer service. This is notwithstanding the initiatives taken by logistics companies that specialize in railway transportation services as mentioned in Section 1. 217. Failure to implement WTO agreements may also affect foreign investors’ willingness to invest in the railway sector. Investors may conclude that the risk of investing in the rail sector is higher than in others.. 218. Many freight competitors in other transport modes, especially if their enterprises are very commercially oriented, attract foreign investment, and adopt proven, commercially viable equipment, technology and business practices. If MOR chooses to resist change and retain a traditional railway attitude, the railway freight market share in China may follow the example of Western Europe and decline precipitously. 219. In summary it may be mentioned that the cost of inaction or dilatory procedures with a view either not to implement the WTO commitments in letter and spirit or to unnecessarily delay their implementation will have serious national and international implications for the Chinese railway sector as well as the economy at large. Therefore, in our view this is not an option. The Government and MOR must implement the WTO commitments to the fullest extent as soon as possible.

68 E-mail from Logistics Management, “China – Online Logistics Conference from Logistics Management and Supply Chain Management Review,” July 20, 2006.

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CHAPTER 6: PROBLEMS TO BE RESEARCHED AND RESOLVED

6.1 SEPARATION OF GOVERNMENT AND ENTERPRISE FUNCTIONS

6.1.1 Why Separation? 220. The separation of the government and enterprise functions is a goal of virtually all railways with a focus on commercial operations. It is not a goal for traditional, noncommercial railways. This separation is necessary despite the exemption provided in China’s schedule of commitments and list of exemptions. The separation does not mean moving either government or enterprise functions outside MOR. Both functions can remain under MOR’s purview but are clearly separate with an “arms-length” relationship. 221. The following benefits are envisioned with separation: ♦ to ensure safety by creating an independent safety regulator, ♦ to improve management and focus of the enterprise ♦ to meet customer needs, improve customer service, and further improve the competitiveness of Chinese goods in world markets, ♦ to prevent loss of traffic to highways and waterways as they continue to develop, ♦ to have prices that reflect market conditions ♦ to create a regulatory body to establish rules and procedures to protect shippers from monopoly pricing power and other monopolistic practices, ♦ to improve the rate of return from operations, ♦ to gain more efficiency from operating expenditures, ♦ to undertake capital projects more economically and efficiently, ♦ to use internally generated funds for viable development projects, ♦ to attract private investment from domestic and foreign sources, ♦ to adopt economically justified modern technology, ♦ to increase total capital investment to meet the nation’s needs for transport

6.1.2 Separating Government and Enterprise Functions in the Railway Sector 222. Railway safety and regulatory oversight of CR’s monopolistic power should be separated under a railway safety and regulatory agency reporting to the Minister of Railways. The agency should combine roughly the safety functions of the US Federal Railroad Administration and the market regulatory oversight functions of the Surface Transportation Board. An alternative institutional structure is the UK model, in which the independent Office of Rail Regulation is responsible for economic regulation and safety regulation.69 223. Concurrent with the establishment of the railway safety and regulatory agency, CR should be organized as a commercial enterprise directly reporting to the Minister and operating under market principles with the basic autonomy, freedom, and responsibility described in the preceding Chapter, Figure 6.1 is a model of the centralized commercial railway organizational structure commonly used by North American railways. Train operations, civil engineering, maintenance of equipment, signals and communications and railway police, among others, are brought together in a unified and centralized operating department. Geographic regions, divisions and districts are subordinate to the various central operating units. Regional civil engineering organizations report to the central civil engineering unit, not to a Regional Administrator with authority over multiple technical specialties. Finance, Administration and Strategic Planning are the other three departments (in addition to Operations and Marketing) whose head would report directly to the chief executive officer of the centralized railway enterprise (who in turn would report to the Minister of Railways). None of the other four principal departments (Marketing, Finance, etc.) have their own operations at the regional level.

69 On 1 April 2006, in addition to the role of economic regulator, ORR became the health and safety regulator for the rail industry, following transfer of responsibility from the Health and Safety Executive (HSE).

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224. Some of these super departments are very large and have many employees (Operations) Others are much smaller and have relatively few employees (Marketing and Strategic Planning). Each has its own distinct function. Each of these distinct core functions is equally important to the success of the whole organization. Figure 6.1: Organizational Structure of a Commercial Railway Organizational Unit Main Responsibility Executive Leadership; Integration Marketing Selling Services Passenger Marketing Freight Marketing Customer Specialists Intermodal Marketing Operating Delivering Services Train Operations Operating Regions Central Dispatching Maintenance of Way (Civil Engineering) Operating Regions Signals & Communication Maintenance of Equipment Railway Police Safety and Training Finance Keeping Score Finance Audit Purchasing Statistics Administration Support Information Systems (Computers) Administration Human Resources Public Relations Government Relations Legal Real Estate Strategic Planning Adapting to a Changing World; Integration

225. Two features of this organizational structure were most important for the development of successful commercial railways in North America. First was the emergence of marketing from the organizational shadows to take its place at the highest level of the railway organization. During the monopoly period, the customer was not very important to the railway. The customer was seen as having no choice but to use whatever services the railway decided to provide. Today, if marketing cannot sell railway services, wheels do not turn. Customer needs and customer service are now high on the agenda of all railway departments. 226. The second important feature was the integration of technical specialties into a unified operating department, with one head, responsible for moving trains of customers and their goods – that is, delivering the customer services sold by marketing. 227. The traditional organizational structure of railways was decentralized with significant control of operations at the divisional level70. This structure was developed before the invention and widespread use of modern communications technology. Before this technology, railway operations could not be centrally controlled. With modern communications technology, decentralization no longer makes sense. Centrally controlled railways can be operated much more flexibly, efficiently and reliably.71

70 Sub-regional administration level in China. 71 As communications technology improved during the 1970s and 1980s, the large North American railways centralized operations at the regional level. In the 1990s, further improvements in technology led to centralization of operations at the headquarters of the railway.

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6.2 SEPARATION OF INFRASTRUCTURE FROM OPERATIONS

6.2.1 Pros and Cons of Separation 228. The British Rail (BR) is the premier example of separation of infrastructure and operations. It also separated equipment ownership and maintenance from operators, breaking each into a number of separate private operations. Separation and privatization happened during a period when the UK government was controlled by the Conservative Party. They argued publicly that specialization and competition would revive the railway and substantially reduce the need of the railway for government financial support.72 229. Today, the privatization of BR is generally seen as a colossal mistake, even by influential members of the British Conservative Party. The damage is well documented. As Simon Jenkins wrote recently in UK newspaper ‘The Guardian73’: “Within seven years [after privatization and separation] the railway was costing the taxpayer three times what it had cost before de-nationalisation (up from £1.3bn to £3.7bn). . . In the 1980s fares covered 76% of rail costs, last year 42%. The government has restructured the industry three times, so it is renationalised in all but name . . . Virgin's east coast [passenger] route, profitable under British Rail, runs on a subsidy of £400m a year, half what the whole of BR cost in 1989. The operators recently demanded yet more subsidy on the grounds that they expected to carry 30% more passengers in 10 years' time. Surely that should mean less subsidy.

. . . old BR executives . . . regarded the 1993 [privatization and separation] Act as stupid. They knew that creating a separate track company would destroy management discipline, unleash infrastructure costs and proliferate litigation and regulation. Their railway had its shortcomings, but it was the most cost-effective in Europe.

. . . The railway [today] is like a restaurant in which the kitchen is run by a different company from the dining room, while a lawyer controls the swing doors.”

230. In addition, as former BR and EWS executive Julian Worth argued in ‘The Guardian’ in 200274:

“If you think about it, road [highway] only has to take only one profit margin out of a piece of business, whether it's the freight customer's rate or the fare box from the passenger; the road haulier or the bus makes his profit margin, and the infrastructure he just buys through a licence. Under the Railtrack75 model there were two profit margins trying to be made out of the same piece of business: profit for the operator and profit for Railtrack.”

231. Worth also points out that Railtrack operations and finances were manipulated by its management to drive up the price of its publicly-held common stock so that top management would profit quickly. Maintenance of track and signals was radically decreased to inflate profits, leading to congestion, reduction in train speeds, and derailments. Profits were used for dividends to stockholders so that the stock price would go even higher, rather than for long term investments in capital improvements to the rail infrastructure. 76 In 2002, the government transferred railway

72 During the break-up and privatization process of BR, however, several consultants influential in designing the program, and several middle managers of the railway indicated (in private conversations with a potential buyer who is now a member the TERA consulting team) that the principal goal of the Conservative government was not economic, but to break the political power of the British railway labor union. To do this, the government split the railway into as many small pieces as they could so as to eliminate the possibility of a nationwide railway strike. 73 Jenkins, Simon, “Tories are starting to clear their clutter of inheritance,” The Guardian (UK), July 19, 2006. 74 Worth, Julian, “Railtrack was fundamentally lacking in people who understood the industry,” The Guardian (UK), February 5, 2002. There were additional profits taken out in rolling stock maintenance and by Railtrack’s track and signal maintenance contractors. 75 Railtrack was the privatized infrastructure operator in the UK. 76 See the “Speculators” in Table 4.1 of Chapter 4.

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infrastructure from Railtrack to , a government created corporation. Network Rail’s governance structure is responsive to railway operators, equipment suppliers, and infrastructure contractors as well as the general public. Its debt is financed through public and private markets and fully guaranteed by the government. It is a government enterprise, but not a government department. Separation, and its excessive inefficiencies and costs, remain in place. 232. In the EU, other than in Britain and Sweden, separation of infrastructure means only that the accounting for infrastructure in the state railway is entirely separate from accounting for the state railway’s operations and other railway activities. This separation of accounting meets EU requirements for separation without resulting in the creation of separate organizations under separate ownership, management, or control. Thus the separation between infrastructure and operations in much of Europe is only on paper – accounts and organization charts – and not in actual practice.77 233. The principal characteristic of the Swedish system, responsible for much of its success, is that it is entirely funded by the Swedish government and the infrastructure operator is a government organization. There are no user fees or access fees charged to train operators, and there are no economic incentives (as there were in the UK) for the infrastructure operator to under-maintain the railway and under-invest in replacements and upgrades. The only tension is between the operating companies (SJ, the national, but commercial, railway, and other operators), who want maintenance and investment priorities set by economic and traffic criteria, and the government infrastructure organization which instead follows political priorities set by the government. 234. The usual argument for separation is that a separate infrastructure operator will be neutral toward train operators, that competition among train operators will be enhanced, and that freight traffic will come back to railways through competition. Traffic did come back in Sweden, but largely because government payment of infrastructure costs reduced operator costs and allowed freight tariffs to become competitive. 235. The arguments against separation are that since the infrastructure operator and the train operator have different goals and incentives: ♦ operating inefficiencies abound, ♦ track maintenance, signal maintenance and train control decline, ♦ safety is jeopardized, ♦ operating costs increase significantly because of useless duplication and coordination, and ♦ prices (whether paid by users or government or both) increase substantially. 236. Additionally, train operators are not able to implement new technology that requires changes in track configuration, signaling and train control, or train control and dispatching. Infrastructure operators have no incentive to implement new or more efficient technologies. They have a monopoly and can ignore the needs of the train operating companies who are their customers. 237. Studies by the U.S. Association of American Railroads (AAR) show that in countries adopting open access virtually no competition among operating companies has resulted, spending on infrastructure and maintenance has been inadequate, productivity was far less than the productivity of U.S. railroads and freight rates were more than four times higher per ton-kilometer in the U.K. than in the U.S.. In contrast, the rail systems of Argentina and Mexico, which concessioned their state-run railroads, have shown very dramatic improvements in service and investments. 6.2.2 Separation of Infrastructure and Operations in CR 238. The enterprise function should include operation and maintenance of CR infrastructure as CR will remain the dominant carrier, both freight and passenger, on the system, even with aggressive competition from private operators. CR’s long term economic health requires that it be

77 There are, however, open access and independent train operations by private companies and shippers in several countries, most notably, Germany. Open access does not require actual separation of infrastructure from operations. Open access operators can exist and prosper in operation of trains on tracks belonging to, and managed by, other railway operators as long as a system of regulation is in place to enforce standards of safety and fairness.

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able to control its infrastructure costs78 as well as the rate of technological change. Particularly under current conditions of capacity constraints, separation of operations from infrastructure will be detrimental for the efficient and centralized control of access to track. Some may argue that another viable alternative is when the infrastructure remains government owned, and government pays all, or at least the vast majority, of infrastructure costs from its own funds (as in Sweden). Operators, then, have no costs, or very small costs, over which to lose control. They do lose control of the pace of technological change, however. 6.3 MONOPOLY OPERATION

6.3.1 Economic Monopoly in Railways 239. For the transport customer, competition is when there is a choice of several carriers to move its goods. Those carriers may be railway carriers, or they may be highway carriers or waterway carriers or a combination of modes. The customer does not buy a transport mode. The customer buys service. If the customer lacks realistic choices in obtaining needed transport service, the customer faces an economic monopoly. 240. If the customer lacks realistic choices among railways, the customer faces a railway monopoly. A railway monopoly is only problematic for the customer if other transport modes cannot handle his shipment economically. An example would be where a shipper is located: (i) far from navigable waterways, (ii) in an area with poor roads and highways, (iii) is shipping heavy, bulk goods (like coal) long distances, and (iv) has access to only one railway carrier.

241. In such a situation, the customer is vulnerable to practices of an economic monopoly and needs protection. In contrast, if another shipper: (i) is located near expressways; (ii) within several hours driving time of a navigable waterway;79 (iii) is shipping goods of any type and weight; and (iv) has access to only one railway carrier, he is not subject to an economic monopoly and is not harmed significantly by facing a railway monopoly. In this second case, the railway has the more significant monopoly problem. If it embraces the false security of the railway monopoly mentality and fails to recognize and respond to the competitive challenges of other transport modes, the railway will lose business to other modes and eventually disappear. 6.3.2 Monopoly in Railway Operation - Pros and Cons 242. Monopoly operation can work for customers if the following questions can all be answered with “Yes.” ♦ Is it regulated tightly? ♦ Is it regulated appropriately? Regulation needs to protect customers from overcharging and exploitation, yet allow reasonable profit to both satisfy the operator’s capital needs and provide a reasonable return (reflecting the relative lack of market risk in a monopoly operation) to shareholders and investors. ♦ Are tariffs in balance with tariffs in places where there is competition between railways? ♦ Are tariffs in balance with the general relationship elsewhere between rail, truck and inland waterway rates? ♦ Are tariffs reasonable (rather than excessive with customers suffering, or inadequate with the carrier suffering)?

78 Generally, maintenance of way costs in the U.S. and Canada are between 20% and 25% of operating revenues. With up/down separation of infrastructure from operations in the UK, maintenance of way costs in the form of access fees have been well over 30% of revenues which are significantly higher per ton-kilometer than North America. 79 In the US, coal, grain and other heavy bulk goods are routinely trucked to waterway terminals from distances as great as 200km in order to take advantage of lower waterway freight rates.

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♦ Does the railway have incentives to increase its efficiency -- to adopt and invest in new technology? ♦ Are adequate levels of customer service defined and enforced by the regulator? ♦ Can the monopoly be penalized by the regulator for failing to provide required levels of customer service, up to, and including, loss of franchise and mandatory sale of assets to an acceptable successor?

243. It should be emphasized that making a monopoly operator become fully supportive and responsive to fair and competitive performance in the market (including meeting customer needs) is nearly impossible and in the Consultant’s opinion has never been achieved. Therefore, the presence of any one of the above conditions inherently brings about the risks associated with monopolistic practices. In some instances the end-result may not be as harmful to customer interests as others. For example, the regulator may not clearly define adequate customer service levels (7th item in the above list), but this disadvantage could be offset by the presence of competitive tariffs (1st and 2nd items) with the end-result of no or little harm to customer interests. 244. In summary, if the conditions listed above are met a monopoly’s disadvantages are removed and no adverse results would be apparent. However, the absence of one or more of the above conditions brings forth the adverse effects (high prices, low levels of customer satisfaction, market abuse, lack of interest in technological advancement, inefficient operations, loss of traffic, etc) of monopoly operations. 6.3.3 Possibility and Difficulty of Introducing Railway Competition 245. The principal reason for introducing railway competition is to accelerate commercial development of the railway so as to increase efficiency, reward the adoption of modern technology, reward the development of modern operating and business practices, and increase the profitability of railways and their ability to invest in their future and to the nation’s benefit. 246. The principal reason for introducing railway competition is not to end monopoly behavior within the railway freight transport. Damage to customers from monopoly behavior by carriers is best controlled by independent government regulatory bodies. 6.3.4 Introducing Railway Competition 247. Introducing railway competition is quite possible. It does, however, take thorough planning. Two forms of railway competition discussed above in Section 5 are possible: ♦ Open access as similar to China’s WTO commitments, and ♦ Breaking up the single government carrier by following the transport example of the Chinese airlines and creating competing railway freight carriers from CR assets so as to achieve railway competition between all major markets in China. 248. For either to work fully, significant reform to the regulation of tariffs and market principles will be necessary. Railways will need to be able to compete with each other and with trucks and waterways for traffic. Customers will need protection against monopoly pricing power when they are wholly or very largely dependent upon one carrier. Carriers will need protections to prevent other carriers from charging below their cost of providing service.80 6.4 TARIFF REFORM

6.4.1 Deregulating Tariff 249. The existing situation of railway tariffs has been described in Chapter 4, Section 4.1. The need exists for deregulating tariffs because the market place is the rational arena for the railway operator and the customer can meet and settle the price based on realistic conditions of costs to

80 In order to take traffic away from the other carrier, drive that carrier from the market, and then raise tariff levels through exercise of monopoly pricing power.

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meet the specific needs of the customer. The government-controlled tariffs can not address all customer needs and the ever-changing market conditions in a timely and responsive manner. The overly low tariff set by the government and the operating route length of the Chinese railways fail to meet the needs of the economy which develops at a fast rate. 250. The principal pre-condition to deregulate railway tariffs is the presence of competition from other modes of transport which have the freedom to establish rates on market conditions. This pre- condition is already present in China. The waterway and road transport services are already competing against the railway and in the case of some large commodity shippers traffic is moved by their own equipment. 6.4.2 Objective of Tariff Reform 251. The direction and long-term objective for railway tariff reform should be: under the guidance of national laws and regulations, and should reform the government-controlled tariff system and gradually release the government’s control on the tariff and establish a market-oriented tariff mechanism to fit into the demand-supply relationship established in the railway transport market. Railways should have the right to decide the tariff. This will create conditions for further reform of the railway transport system. The reform should contain the following five aspects: ♦ The tariff should be based on the demand-supply relationship established in the competitive transport market. Without reflecting the competitive demand- supply relationship, it is not a successful reform and needs to be further improved. ♦ The railway enterprises should have the right of tariff decision. This is a fundamental right for enterprises participating in the market competition. It includes when and how the enterprises will have the right for making decisions. However, this right does not mean that the tariff will be free of any governance. ♦ The railway tariff should have structural differences. The tariff should have differences between monopoly services and competitive services, commercial services and public obligation services. For PSOs, the tariff should be strictly controlled (such as specifying the fixed rate and/or ceiling price, and the amount of government compensation needed), while for commercial service tariff, it should be decided by railway enterprises themselves by judging the market conditions and negotiating rates with individual customers. ♦ The railway tariff should be under effective governance. This will involve the methods to be taken by the governance authority. Either to specify a tariff float range or to set the floor and ceiling prices, it should follow the principles set for tariff reform. During the transition period, a tentative tariff control method may be implemented. ♦ The mechanism of railway tariff establishment should create favorable conditions for future railway institutional reform. Whatever structural realignment CR takes in the future, the tariff should follow the principle of meeting the requirements of railway transport system. 6.5 PUBLIC SERVICE OBLIGATIONS

252. One of the main problems of the CR is that there is no clear demarcation between social and commercial operations. CR has been fulfilling public service obligations (PSOs) in the broader social and national interest as mandated by the Government. These include providing affordable transport services to some categories of passengers (such as students, military personnel, and railway staff) and transporting inputs for agriculture (including fertilizers and pesticides) and disaster relief goods at low freight rates that are below the marginal costs. In addition CR is operating a large number of branch lines that do not cover the cost of operation, and which CR would not like to operate under a commercial mandate. Besides CR is operating new lines that have been constructed at government’s behest for fostering economic development of remote and less connected regions in Western China. Many of these lines do not cover their costs of operation and will not do so for a large number of years. As for example, the new line linking Turpan with Karshi in

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China’s Xinjiang Province, parts of which have been in operation for more than 10 years still does not cover operating cost. With the proliferation of such lines under the government’s program to build new railway lines in Western China, the losses to CR on this account would likely increase every year. Based on a study carried out in 200381, the total financial burden of public service obligations is currently estimated at approximately CNY 20 billion per year. 253. PSO are also provided by railways in many other countries. However, it is an accepted principle that the service provider should be compensated for these services. The European Commission (EC) has issued detailed guidelines for the compensation to be provided to service providers in the member states of the European Union (EU). Besides, PSO subsidies are established by law and funded in, for example, the US, Canada, Indonesia, Kazakhstan, and Thailand. A key challenge facing railways is for governments recognize the problem, recognize the unfairness of forcing some customers to subsidize other customers,82 and accept the responsibility to support public service operations so that they do not drain resources from the railway 254. Since CR does not receive any compensation for the PSO, the costs of the public service obligations are made up through cross-subsidization from other passenger and freight rates. If CR is to successfully operate in a competitive market environment the government must allow it to reorient itself on commercial lines. To begin with CR should identify specific PSO and estimate the losses incurred in providing these services. It should then enter into contracts with the government or proponent agencies indicating the amount of compensation as well as the type, intensity and quality of services to be provided. The contracted services should be reviewed on a regular (at least annual basis) to reaffirm their need as well as to see if these can be substituted by more economic alternative modes of transport. 255. Investors and operators who agree to provide rail transportation services in a liberalized environment will not be prepared to cover PSOs without adequate compensation being provided to them. Also it will not be reasonable to expect them to do so. Therefore developing of a PSO compensation regime is inescapable. In order that there is a level playing field it is also imperative that the PSO compensation mechanism is applicable to all operators including CR 256. It is important that the Government and MOR institutionalize a transparent framework for compensation to the operator for public service provided at government’s behest, including the burden of having to operate loss making new lines and branch lines. It is however, cautioned that the PSO system should not be open-ended to prevent inefficient and uneconomic outcomes. The arrangement under the PSO system should include appropriate responsibilities for railways to limit (if not eliminate) the operating losses. The PSO compensation system should be explicit and transparent. This may be done through PSO contracts between the proponent (government) and the operator. The contract should clearly lay down the responsibilities of either party to the contract. The contract should have provision for periodic review by both parties, including revising the requirements for maximizing benefits to the public. 257. PSO is an evolving subject and needs to be researched in the context of the characteristics typical to China. An essential complement of reform in the rail sector will be to establish appropriate PSO policies and implement these effectively and efficiently in a transparent manner.. 6.6 OPENING OF RAILWAY SECTOR - WORLD EXPERIENCE

258. A well established legal and regulatory environment and market conditions are the prerequisite to opening the railway transport market, which is characterized by the following: ♦ Market-oriented system. An open market will allow foreign investors to enter into the country’s railway market. It will have both domestic and foreign enterprises participate in the market-oriented economic activities. Since railways in many countries have carried out the separation of the government’s function from those of the enterprises, the railway enterprises have become

81 TERA International Group, Inc. Study on the State Allowance Policy for the Railway’s PSO; prepared for the MOR and the World Bank under Contract No. 2002KFEQA-2002US; June 30, 2003. 82 Who are sometimes their competitors.

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market players. Even when the outside operators compete in the railway market, it will not produce negative results. ♦ Completeness of law and regulation. The more mature the market-oriented system, the more complete is the legal system. The developed countries have established a legal system to ensure the functioning of the railway market under the protection of laws after it is opened to the outside. In light of WTO’s requirements, the domestic legal system is also improved. ♦ Effective government supervision. The purpose of governance is to ensure the normal functioning of the market mechanism and avoid unfair competition and monopoly. It is very important to develop the methods for opening to outside and the supervisory system, such as establishment of independent supervision organization, industry societies, safety management system, developing contract of franchise, tariff establishment, service quality, allocation of line capacity and transparency of pricing, etc. 259. Opening the railway sector must be a well thought out and deliberate process which must be carefully implemented because of the importance of railway transport to the economy. External conditions pertaining to the legal and regulatory environment must be monitored and when conditions are conducive to further opening of the railway market, actions must be implemented.

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CHAPTER 7: OVERVIEW OF RECOMMENDATIONS ON ADJUSTING CHINA’S RAILWAY POLICIES

260. In the preceding Chapters of this report, China’s railway policies have been reviewed with reference to the situation arising from of the opening of the rail freight transportation market, followed by suggestions and recommendations for reform. 83 The recommendations may be categorized into the following two broad categories, which have been summarized in this Chapter:: ♦ Commercialize MOR railway operations, and ♦ Separation of regulation from enterprise functions of MOR. 261. At its core, WTO is a commercial agreement designed to spread the free-market system across the world. Commercializing the enterprise is necessary for CR to adapt and prosper in the increasingly commercial environment both national (within China) and global. 262. WTO is also a legal structure based upon principles of transparency, non-discrimination, market access, fairness and judicial review. Separation of regulation is a means for MOR and China to harmonize their regulatory structures with basic WTO legal principles. 7.1 COMMERCIALIZE THE ENTERPRISE

263. The recommendations that follow are an overview of what needs to be done. They are not prescriptions for how to do it. MOR should consider taking a hard, thorough look at the structure and functioning of large successful, commercial railways in North America, and then make adaptations appropriate to the unique conditions of CR and China. 264. To commercialize the enterprise and develop CR to its full potential, MOR and CR should: ♦ Adopt a commercial attitude throughout the enterprise. ♦ Make customer service and customer satisfaction central to all enterprise functions. ♦ Give marketing a central position in the organization, and hire experienced marketing professionals from outside to lead it. ♦ Encourage cooperation, alliances and partnerships with other carriers, and with domestic and foreign logistics service providers, to improve both customer service and CR’s ability to compete in important, fast growing market sectors such as containerized transport of manufactured goods. ♦ Maintain vertically integrated operation. ♦ Transform the organizational structure of the railway operating enterprise so that it is highly centralized and commercially focused. ♦ Install and thoroughly exploit the power of the latest railway communications and information technologies84 in order to effectively control railway operations in all regions of China.85 ♦ Make the railway Chief Executive Officer responsible to the Minister for all aspects of the railway operating enterprise’s performance.86 ♦ Develop a detailed, thorough understanding of the costs of providing service (on each individual line and for each large customer) to be used by marketing,

83 Both are discussed in greater detail in the SFR. 84 Use existing systems. Attempts to write a new CR system with the features of existing foreign systems, or attempts to extensively modify an existing system would take years. CR needs modern systems now, not five years from now. 85 This transformation would involve merging the current 14 separate, train and track operating regional administrations (and the three specialized operators – containers, postal and parcel, and special freight) into a single, unified centrally controlled enterprise. Joint venture lines and local lines would continue as separate organizational structures. 86 If two competing carriers are created, each should have a CEO responsible to the Minister for that carrier.

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operations and finance departments in better understanding and making decisions. ♦ Ensure that all investments are made on the basis of financially sustainable operation that guarantees a reasonable rate of return..87 ♦ Attract government (national, provincial, and/or local) subsidies to cover losses of PSO traffic and operations in order to maintain or improve existing levels of service.88 ♦ Achieve freedom to price freight (as well as passenger) services subject to market forces, with effective control of monopoly practices through a regulatory framework that both protects customers and preserves competition. ♦ Become attractive to commercial financing, from both domestic and foreign sources, by transforming into a modern commercial organization. 7.2 SEPARATION OF REGULATION

265. Of the three typical forms of railway regulation, two in China, safety regulation and access regulation, are located within MOR. The third, tariff regulation, is controlled by NDRC and the State Council. 266. Enterprise and government functions need to be separate, but within the structure of MOR. Regulatory functions should be applied impartially and transparently to all track and train operators, including CR, joint-venture and local railways and all train operators. Within MOR safety regulation should be separate from regulation of access and licensing of operators. They are two quite different functions, though agreeing to and meeting safety standards must be part of the licensing process and be mandatory for all train operators. 267. As most MOR employees will be enterprise employees and most MOR spending will be enterprise spending, enterprise (CR) financial functions will need to be separated from MOR’s government financial functions. Organizationally, CR financial functions must be a part of the CR organizational structure. The enterprise organization and the government organization will each need its own finance and administrative units. 268. Safety regulation. Typically, traditional monopoly state railways establish their own safety rules and procedures and enforce them upon themselves. As railways become more commercially oriented, the danger arises that cost cutting driven by a desire for greater profits could imperil railway safety.89 Additionally, commercialization of railways, and the national economy generally, often leads to an increase in the number of railway operating companies. With multiple operators90 basic fairness demands that the safety regulator not be one of the players in the game.91 269. Independent, impartial establishment of safety standards and enforcement of safety standards by an adequate number of field inspectors92 is a government function that is necessary and important to protect the safety of the people and property. MOR needs to create an Office of Safety Regulation, independent of commercial and political influences, to establish and enforce regulations for railway safety including track standards necessary for operation at various speed

87 For both commercial operations and loss-making PSO operations. 88 Typically, commercial railways act to reduce, as greatly as possible, the costs of providing loss-making services. 89 Two days before the 2000 Hatfield rail crash, Railtrack Chief Executive Gerald Corbett said that the “British railway privatization had made the nation's railways less safe and more chaotic”. Privatization put a structure in place to produce maximum returns for Railtrack shareholders with profits taking priority over safety. Railtrack admitted responsibility for the accident, which was caused by un-repaired track, when it said that it knew the track section was in poor condition and that 81 more sections were in a similar state. At the time of the 1999 Paddington crash, Railtrack was making profits of £1.9 million a day but decided that better safety systems are too expensive to install. 90 Even if each operator runs trains only on its own tracks. 91 Railways serving different markets still compete with one another – for industrial development and the location of new factories and other traffic generating facilities on their lines. 92 In the US hundreds of inspectors enforce compliance with safety standards through unannounced inspection visits to railway facilities.

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levels, 93 minimum standards for rolling stock, signals, grade (level) crossings, and minimum qualifications of operating employees including train crews and dispatchers. 270. The Office of Safety Regulation should cover compliance with safety requirements, focusing on: ♦ operating practices, ♦ hazardous materials, ♦ signals and train control, ♦ motive power and equipment, and ♦ track. 271. Trained and experienced inspectors, who are specialists in these fields should be stationed in regional field offices to cover the railway network through out China.94 Inspectors should have the authority to order the immediate cessation of service when serious deficiencies are discovered and immediate reductions in speed when warranted. They should also be able to issue citations carrying substantial penalties to operators for violation of safety regulations. 272. Fair, transparent processes should be established for orders and citations to be appealed, with availability of recourse to legal measures for redress. 273. The enterprise (CR) will need its own safety department for training and internal monitoring of the safety of its own operations and those of all operations on the infrastructure it manages and dispatches. CR’s safety department is necessary in addition to external safety regulation by MOR. CR’s safety department should have the authority to take out of service unsafe track and rolling stock, regardless of the operator involved. CR as the operator of the infrastructure is responsible for the safe operation of its track. The external regulator (MOR) must also have this authority. 274. Access regulation. Government Order No.4 and MOR draft regulations indicate that a market system will be built in railway freight transportation with access available to non-CR operators. Regulation is necessary to insure that access decisions are transparent, not discriminatory and fair and that dispute resolution and judicial review are available. 275. The principal tasks of access regulation are: ♦ Licensing Operators ♦ Allocating Capacity ♦ Ensuring the fairness of Access Charges95 276. All freight train operators, new and existing, should be licensed to the same standards. Licensing operators involves establishing qualifications (including financial qualifications, possession of required government registrations and approvals, the railway experience96 of senior managers of train operations, and safety certificates) and then issuing licenses to those applicants which meet the qualifications. The qualifications must be neutral and the issuance of licenses fair and unbiased. 277. To insure fairness, allocation of capacity needs to be done by the regulator, not the dominant operator (CR), in a transparent manner applying the principles of capacity allocation established by the regulator. Allocation must be done by a neutral referee and not by one of the players in the game 278. As one example of the complexity of allocating capacity, if a shipper’s coal is currently moved over line A by CR, is it fundamentally unfair (and thus a violation of WTO principles) for the

93 For example, FRA, the US safety regulator, has established different maintenance standards for tracks with different speed maximums – Class I (freight 15kmHr/passenger 25kmHr), Class II (40/50), Class III (65/100), Class IV (100/130), Class V (130/145). 94 In the US (a country of similar size) inspectors are spread among 8 regional offices 95 Also called infrastructure fees and trackage rights charges. 96 Whether in China or on foreign railways. Qualifications must be unbiased.

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regulator (or CR) to tell the shipper97 that there is no capacity for the shipper to move the same coal in his own trains, but there is capacity if he continues to move it in CR trains. 279. To insure fairness in access charges they must be tightly supervised by the regulator and derived from actual CR costs. Access charges have two components: per gross ton/km hauled for use of the track structure, per train for each line or dispatching district used. The gross ton/km charge should be based upon the actual costs of maintenance for a line and the actual rate of depreciation taken for the line in CR’s financial reporting. Per gross ton/km charges should be based upon actual tons moved. Per train charges should be based upon allocated capacity and charged whether or not a train is actually operated in the allocated slot. The regulator must have to ability to audit the financial records of the infrastructure operator to insure the accuracy of the costs used and fairness of the calculation of charges. 280. The regulator’s primary responsibility is for the detailed specification of the means of calculating charges. Calculation of the individual charges per train and per ton/km for every railway line could be done either by the regulator or by the infrastructure operator under supervision of the regulator. 281. As an example of the potential complexity of access charges for track, a strong argument can be made that access charges should be based upon the type of track use by the operator paying the charges. According to this argument, freight operators should be charged for the level of expense and investment necessary to build and maintain the track for speeds actually available to freight operators.98 The substantial additional incremental cost of track maintenance for higher speed passenger trains benefits only some passenger trains. Those trains should bear all of the additional costs for speeds that only they use. As passenger trains are much lighter than freight trains, passenger trains pay a smaller proportion of the cost of maintaining the basic infrastructure (speeds) used by all operators. 282. Disputes will arise in all three tasks. The Office of Access Regulation needs to establish dispute resolution and an initial appeal process for each task. Further appeal to the courts should be available to ensure that the processes established are fair and non-discriminatory. Enforcement of the licensing falls largely to the capacity allocation task. Operators cannot operate without an allocation of capacity and the necessary allocation will not be made to a party lacking a proper license. 283. Both allocation of capacity and access charging need impartial enforcement by the regulator, with field inspectors monitoring both on a system-wide basis. Substantial penalties should be established by the regulator for denial of allocated capacity to operators who have received it, for train control and dispatching which favors the infrastructure operator’s own trains and for overcharging for access. Failure to pay access charges on time should result in penalties for late payment. Repeated, consistent failure to pay or pay on time could result in loss of access. 284. Tariff regulation is to define the conditions of government interference in market pricing by establishing boundaries which: ♦ protect customers by preventing abuse of monopoly power; ♦ protect competition by outlawing would be monopolists from charging prices that are below their costs with the purpose of driving financially weaker competitors from the market. 285. Government’s regulation of tariffs in China has resulted in a freight transport market where : ♦ Railway freight tariffs are heavily regulated and unresponsive to market conditions, while truck and waterway rates are virtually unregulated.

97 Assuming that the shipper is properly licensed as an operator or has hired a properly licensed operator. 98 The same point can be made about charging “Green” passenger trains restricted to 80km per hour the same track fees as Blue and Red trains which go twice as fast. The low fare, slow speed Green train would be subsidizing high fare, high speed Blue and Red trains.

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♦ Limited freight car and rail line capacity are allocated based upon the tariff structure rather than the needs of the railway’s most profitable lines of business or on management’s strategic goals for developing the railway. ♦ A “new line, new tariff” policy can be implemented to charge more for shipping on new lines with no regard for market conditions. The policy had the unintended (and completely predictable) consequence of diverting traffic from new lines to old lines, worsening congestion on old lines. 286. PRC’s rail and passenger transport tariff is among the lowest in the world and tariff adjustments have been infrequent and not adequate to cover CR’s rising costs. Railways by nature of their operation constitute just one part of the total logistics cost of the shipper. In the case in China, it is already known that the portion of the transport cost captured by the railway through the tariff is a small portion of the shipper’s cost with the difference generally accumulating to the benefit of the middlemen arranging for wagon transport service. At times of capacity constraints, the conditions of scarcity as a fact of market behavior result in extra rent which does not benefit CR. This market failure must be effectively addressed particularly when investment needs of the sector are substantially increasing and the government is facing large investment needs to be satisfied through increased borrowing or private sector investment. These pressures further increase the cost of capital. 287. Currently, tariff policy is used to implement political choices to transport some people and goods for low or no tariffs (or public service obligations), while the ordinary, non-discounted tariffs paid by other users contain a kind of tax on them by transferring some of what they pay for their service to subsidize these PSO services. 288. Structuring and financing public service obligations is not a function of tariff regulation in the commercial world.99 Such uses of tightly regulated tariffs may be seen as a violation of WTO principles such as transparency, fairness and non-discrimination. Instead those entirely defensible public service goals should be supported with direct, transparent PSO agreements so that the balance of the freight and passenger transport market may function according to market principles. 289. Regulation of railway freight tariffs could be located within MOR with the other two forms of railway regulation. It is important that its independence from non-economic considerations is maintained. It is that independence which allows the regulator to be an unbiased referee protecting both competition and customers from abuses of monopoly power.

99 Of course any government is free to levy a tax on railway passenger and freight tariffs to support public service obligations. That method is explicit and fulfills the principle of transparency.

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