ESMT No. WP-109-01 ESMT WHITE PAPER Railway Alliances in EC Long- Distance Passenger Transport: A Competitive Assessment Post- Liberalization 2010 Hans Friederiszick, ESMT CA Tseveen Gantumur, ESMT CA Rajshri Jayaraman, ESMT Lars-Hendrik Röller, ESMT Jens Weinmann, ESMT CA ISSN 1866–4016 Citation: Hans Friederiszick, Tseveen Gantumur, Rajshri Jayaraman, Lars-Hendrik Röller, and Jens Weinmann; Railway Alliances in EC Long-Distance Passenger Transport: A Competitive Assessment Post-Liberalization 2010; ESMT White Paper No. WP-109-01; ESMT European School of Management and Technology, 2009. Acknowledgements: This white paper was initiated and has been supported by Deutsche Bahn AG. The opinions expressed are exclusively those of the authors. The authors of this study would like to thank a number of individuals and organisations who have been instrumental in allowing this project to be accomplished. In particular, we would like to express our gratitude to Joachim Fried, Corporate Representative for European Affairs, Competition and Regulation of Deutsche Bahn AG, Dr. Helge Sanner and Nonthika Wehmhörner of Deutsche Bahn AG, Wettbewerb und Regulierung (MEW), for their valuable advice and professional management of this project, as well as Dr. Silke Kaulfuß, head of "CRM und Vertriebsprojekte (KSV)" of Deutsche Bahn AG, Christiane Warnecke, Hans-Joachim Luhm Ralf Bruns and Marko Kelsch of DB Fernverkehr AG for helpful insights and data provision. In addition, we would like to thank Manfred Kuhne and his team at the Arbeitsgemeinschaft Deutscher Verkehrsflughäfen (ADV) for their continued support in the flight data collection process. The authors also wish to place on record the timely assistance rendered by several low-cost airlines, whose staff assembled data on entry and operations of their carriers on individual routes, especially Air Berlin/DBA, Germanwings, TUI Fly, Germania Express, easyJet and Intersky. Copyright 2009 by ESMT European School of Management and Technology GmbH, Berlin, Germany, www.esmt.org. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopy, recording, or otherwise—without the permission of ESMT. White Paper 3 Railway Alliances in EC Long-Distance Passenger Transport: A Competitive Assessment Post-Liberalization 2010 Contents Tables 5 Figures 6 Abstract 7 Management summary 9 1. Objective of the study 17 2. Literature review: Intra and intermodal competition 19 2.1 Theoretical approaches to entry 19 2.2 Intramodal competition 26 2.3 Intermodal competition 31 2.4 Alliances 35 2.5 Implications and conclusions 37 3. The regulatory environment and recent decisioins 39 3.1 The ongoing liberalization process 39 3.2 Market definition in the railway transport cases 41 3.3 Asessment by the Monopolkommission 41 3.4 Market definition in the airline transport cases 45 3.5 The Ryanair/Aer Lingus case 48 3.6 The British Airways/Eurostar case 50 3.7 Implications and conclusions 52 4. The legal framework & existing co-operations 54 4.1 The legal framework: Article 81 54 4.2 Existing and past co-operations 56 4.3 Implications and conclusions 60 5. Analysis of competition for long-distance passenger transport 61 5.1 Overall methodology 61 5.2 The data set and competitive situation within the O&D universe 62 4 White Paper Railway Alliances in EC Long-Distance Passenger Transport: A Competitive Assessment Post-Liberalization 2010 5.3 Panel data analysis 66 5.4 Scenario analysis 81 6. Final assessment and the role of alliances in the railway sector 111 Appendix 1 References 114 Appendix 2 Panel data analysis 121 A2.1 Econometric issues 121 A2.2 Unobserved heterogeneity: The specific problem 122 A2.3 Data 123 A2.4 Overview of regressions tables 128 A2.5 Summary of results: Control variables 129 A2.6 Summary of robustness checks: Long-term effects of LCA entry 131 Appendix 3 Cases in the railway sector and intermodal cases 152 Appendix 4 Mergers and alliances in the airline sector 155 Appendix 5 Data sources on railway and airline statistics 158 About ESMT 166 About ESMT Competition Analysis 167 White Paper 5 Railway Alliances in EC Long-Distance Passenger Transport: A Competitive Assessment Post-Liberalization 2010 Tables Table 1: Barriers to entry: Review of the relevant literature 21 Table 2: Reduction of average air fares due to alliances as indicated in various studies 36 Table 3: Descriptive statistics of the complete sample (January 2006–October 2007) 72 Table 4: Descriptive statistics of sample (additional controls) 74 Table 5: Long Term Effect of LCA Entry on DB outcomes 76 Table 6: R&C model: Example of cost assumptions 88 Table 7: Definition of variables 125 Table 8: Entry of low cost airlines in the sample, January 2006–October 2007 127 Table 9: Summary of RE results for control variables 129 Table 10: Estimation results and robustness check: Second class log (passenger numbers) 131 Table 11: Estimation results and robustness check: Second log (average price) 134 Table 12: Estimation results and robustness check: Second class log (revenue) 137 Table 13: Estimation results and robustness check: Second class log (passenger kilometers) 139 Table 14: Estimation results and robustness check: First class log (passenger numbers) 141 Table 15: Estimation results and robustness check: First class log (average price) 144 Table 16: Estimation results and robustness check: First class log (revenue) 148 Table 17: Estimation results and robustness check: First class log (passenger kilometers) 150 Table 18: Cases in the railway sector 152 Table 19: Intermodal cases 154 Table 20: Mergers in the airline sector 155 Table 21: Alliances in the airline sector 156 Table 22: Railway data 158 Table 23: Airline data 160 6 White Paper Railway Alliances in EC Long-Distance Passenger Transport: A Competitive Assessment Post-Liberalization 2010 Figures Figure 1: Network effects in the rail industry 28 Figure 2: Existing co-operations in European railways 57 Figure 3: Selection of O&Ds according to four clusters 63 Figure 4: Modal shares in the O&D universe 64 Figure 5: LCA entry over time in the O&D universe, January 2006 – October 2007 65 Figure 6: LCA entry and second class passenger numbers on an exemplary O&D 68 Figure 7: Prototype representation of the calculation rationale of transfer and intermediate passengers 83 Figure 8: Total and operating profit of individual O&Ds, based on revenues, access charges, and cost estimates 91 Figure 9: Operating profit and total profit in the base scenario 2010 96 Figure 10: Entry scenarios 98 Figure 11: Operating profit and total profit of O&D universe in scenario Ia 100 Figure 12: Operating profit and total profit of O&D universe in scenario I without cabotage 102 Figure 13: Operating profit and total profit of O&D universe in scenario II 104 Figure 14: Operating profit and total profit of O&D universe in scenario III 106 Figure 15: Co-operations in the European high-speed rail market 112 White Paper 7 Railway Alliances in EC Long-Distance Passenger Transport: A Competitive Assessment Post-Liberalization 2010 Abstract In 2010 the legal barriers for international, intramodal competition in long-haul passenger transport in the railway sector will be abolished. This report analyzes the extent to which effective competition will arise in long-haul passenger transport after liberalization—from 2010 onward—and how co-operative agreements between European rail operators may impact the liberalization process. The study also provides an overview of the existing literature related to entry and intramodal competition in the rail sector, as well as intermodal competition between aviation and rail. In addition, it provides a review of the legal and regulatory environment of the sector at a European level and evaluates current organizations operating in it. The main conclusions are the following: • We find robust evidence for effective competition between low cost airlines (LCAs) and rail operators. A rail operator loses at least 7% of its passengers and 8% of its passenger kilometers due to entry by LCAs. We also find evidence of negative price effects of strategic LCA entry in both first class and second class. This demonstrates that LCAs are a significant competitive constraint for rail operators. • Based on a revenue & cost model (“R&C model”), only a minority of long distance origins and destinations (O&Ds) are profitable with respect to both operating profitability and total profitability from a pre-entry perspective— that is before entry by competing rail operators. This result does not change drastically even under optimistic but reasonable assumptions regarding future changes in demand, costs, and degree of intermodal competition. • An analysis of various entry strategies identifies the most profitable strategy as entry by an independent entrant with inferior technology. However, such a strategy is specifically vulnerable to legal and strategic limitations on exploitation of network effects (e.g. by imposing national levies or incompatibilities in ticketing or train schedules). 8 White Paper Railway Alliances in EC Long-Distance Passenger Transport: A Competitive Assessment Post-Liberalization 2010 • Overall, we find very limited evidence for intramodal competition arising on international O&Ds for long distance passenger travel after 2010, while past experience from airline alliances—although in a different competitive setting—promises significant efficiency gains as a result of international alliances. White Paper 9 Railway Alliances in EC Long-Distance Passenger Transport: A Competitive Assessment Post-Liberalization 2010 Management summary The European Parliament and the EU Council ratified the Third Railway Package in October 2007. Its main objective is to open up international passenger rail traffic for competition. The package was only ratified in the third reading, though, after the integration of major modifications, including the delay of the opening of international passenger transport until January 1, 2010, instead of 2008.