WORLD BANK INSTITUTE Promoting knowledge and learning for a better world 20742 June 2000 X _~~~~~~~~~~~~~~~~~~. ,1 X "-I WS~~~~~~~~~~~~~~~~1 'A ; Y,jj I ~~~~~~~~~~~~~~~~~~~~~~~~~0 = I ~' -,, j « if i Other WBI Development Studies (In order of publication) Principles of Health Economics for Developing Countries William Jack Chile: Recent Policy Lessons and Emerging Challenges Edited by Guillermo Perry and Danny M. Leipziger Curbing Corruption: Toward a Modelfor Building National Integrity Edited by Rick Stapenhurst and Sahr J. Kpundeh Resetting Price Controls for Privatized Utilities: A Manual for Regulators Richard Green and Martin Rodriguez Pardina Preventing Bank Crises: Lessons from Recent Global Bank Failures Edited by Gerard Caprio, Jr., William C. Hunter, George G. Kaufman, and Danny M. 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All rights reserved Manufactured in the United States of America First printing June 2000 The World Bank Institute (formerly the Economic Development Institute) was established by the World Bank in 1955 to train officials concerned with development planning, policymaking, investment analysis, and project implementation in member developing coun- tries. At present the substance of WBI's work emphasizes macroeconomic and sectoral policy analysis. Through a variety of courses, seminars, and workshops, most of which are given overseas in cooperation with local institutions, WBI seeks to sharpen analytical skills used in policy analysis and to broaden understanding of the experience of individual countries with economic development. Although WBI's publications are designed to support its training activities, many are of interest to a much broader audience. This report has been prepared by the staff of the World Bank. 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All otherqueries onrights and licenses shouldbe addressed to the WorldBank at the address above or faxed to 202-522-2422. The backlist of publications by the World Bank is shown in the annual Index of Publications, which is availablefrom the Office of the Publisher. Antonio Estache is principal economist in the World Bank Institute's Governance, Regula- tion, and Finance Division. Gines de Rus is a professor at the Universidad de las Palmas de Gran Canaria in Spain. For information on the Regulatory Reform and Competition program at the World Bank Institute, visit: http://www.worldbank.org/wbi/regulation/books.htm. Library of Congress Cataloging-in-Publication Data Privatization and regulation of transport infrastructure: guidelines for policymakers and regulators/edited by Antonio Estache, Gines de Rus. p. cm. - (WBI development studies) Includes bibliographical references. ISBN 0-82134721-7 1. Transportation-Planning. 2. Transportation and state. 3. Transportation-Deregulation. 4. Privatization. 5. Competition. I. Estache, Antonio. n. Rus, Gines de. III. Series. HE193.173 2000 388-dc2l 00-036493 Contents Foreword ix Acknowledgments xi 1. Introduction 1 2. The Regulation of Transport Infrastructure and Services: A Conceptual Overview 5 Antonio Estache and Gines de Rus Why Economic Regulation of Transport? 6 The Diversity of Objectives Reflected in Economic Regulation 10 Natural Monopoly, Competition, and the Unbundling of Activities 12 Unavoidable Restrictions to Entry and Regulation 14 The Main Elements of Contract Design from a Regulator's Viewpoint 16 Public Service Obligations, Competition, and Equity 41 Regulatory Institutions 44 Conclusions 49 3. Airports 51 Ofelia Betancor and Roberto Rendeiro Airport Services 51 Privatization and Regulatory Trends 63 Price Regulation 78 Quality and Safety Regulation 92 Performance Indicators 101 Conclusions 110 iii iv Contents 4. Seaports 113 Lourdes Trujillo and Gustavo Nombela Characteristics of Seaports' Services: The Multiproduct Nature of the Activity 115 Seaport Infrastructures 116 Seaport Services 117 Coordination of Activities: Port Authorities 119 Privatization and Regulation of Seaports 123 The Traditional Seaport Organization 123 The Movement toward Privatization 128 Concession Contracts in Ports 134 Africa 151 The Americas 151 Asia 153 Price Regulation 155 Quality and Safety Regulation 161 Performance Indicators 165 Conclusions 168 5. Railways 171 Javier Campos and Pedro Cantos Characteristics of Railway Services 171 Privatization and Regulatory Trends 177 Price Regulation 201 Quality and Safety Regulation 212 Performance Indicators 226 Conclusions 233 6. Toll Roads 235 Antonio Estache, Manuel Romero, and John Strong Toll Road Services 235 Privatization and Regulatory Trends 245 Price Regulation 279 Quality Regulation 285 Performance Indicators and Information Requirements 289 Conclusions: Recent Innovations and Emerging Issues 292 References 293 Index 307 Contents v Boxes 2.1 Organizational Forms for the Delivery of Transport Activities 8 2.2 Price Caps in Practice 33 3.1 ATC: The Case of New Zealand 62 3.2 ATC: The Case of Canada 65 3.3 The RPI-X Formula for BAA Airports 84 3.4 Details of Applying the Price Cap at Manchester Airport 86 4.1 Levels of Port Development 131 4.2 Concept of Long-Run Marginal Cost 157 4.3 Concept of Generalized Cost 163 6.1 Contracting Out Road Planning and Management 238 6.2 Increasing Private Participation in Roads: Argentina's Experience 253 6.3 How Should a Regulator Consider Risks? 261 6.4 Preparing for a Toll Road Program: A Lesson from Peru 266 6.5 Rule-Based Renegotiations: Lessons from Chile 272 6.6 Why Were Consortia Initially So Optimistic About Road Projects? 277 6.7 A Brief Lesson in Engineering for the Price Regulator 283 Figures 2.1 Natural Monopoly and Competition 13 3.1 Airport size and revenue sources: the Spanish case, 1997 55 3.2 Runway Costs Functions 59 4.1 Scheme of Seaport Structures 117 Tables 2.1 Types of Private Sector Involvement in Transport across Regions in Developing and Transition Economies 10 2.2 Relation between Privatization Objectives and Auction Award Criteria 25 2.3 The Division of Labor Between Regulator and Government 48 3.1 Classification of Airport Activities 52 3.2 Airport Size and Revenue Sources: The Spanish Case, 1997 54 3.3 Traffic and Revenue Distribution: Selected Airports 56 3.4 Scope of Competition in Airport Services 66 3.5 Monopoly Power in Airport Handling and Commercial Activities 67 vi Contents 3.6 Inventory of Airport Ownership Structures in Selected Countries 74 3.7 Structure of Some European Airports 76 3.8 Privatization Processes in Latin American Airports 79 3.9 Airport Charges at Selected Airports, 1998 81 3.10 Application of a Price Cap at Manchester Airport, 1993/94-1997/98 85 3.11 Elements for Quality Assessment at Airports 93 3.12 Quality Survey Monitoring Scores: Departure and Arrival areas at Selected BAA Airports, 1995/96 95 3.13 Quality Survey Monitoring Scores: Retail Value for Money at Selected BAA Airports, 1995/96 96 3.14 BAA Check-In Queue Targets 96 3.15 Percentage Availability of Critical Equipment at Selected BAA Airports, April 1995 to March 1996 97 3.16 Average Fault Repair Times for Critical Equipment at Selected BAA Airports, April 1995 to March 1996 97 3.17 Average Levels of Pier Service at Selected BAA Airports, 1995/96 98 3.18 Standards for Maximum Baggage Delivery Times at Selected BAA Airports 98 3.19 Components of the Airport Security System 100 3.20 Financial Performance Indicators 105 3.21 Economic and Productivity Indicators 106 3.22 Quality of Service Indicators 108 3.23 Examples of Reference Standard Levels 109 3.24 European Airports: Best and Worst Practice Values 110 4.1 Typical Civil Works Unit Costs for Port Infrastructure 116 4.2 Port Services 120 4.3 Type of Ownership of 50 Main World Ports, 1997 122 4.4 Financing of Port Infrastructure in Different Countries 124 4.5 Containers: World Regional Traffic, Selected Years 126 4.6 Threshold Values to Determine the Type of Competition: Container Traffic 133 4.7 Term of Port Concession Contracts in Practice 139 4.8 Chilean Ports: Distribution of Cargo by Port Type 147 4.9 Port of Buenos Aires Indicators, 1991 and 1997 150 4.10 Relative Weights of Different Port Charges 155 4.11 Comparison of Container Handling Charges Across World Regions, 1996 160 Contents vii 4.12 Concession Fees for Different Ports, 1997 162 5.1 A Summary of the Economic Characteristics of the Rail Industry 176 5.2 Market Shares of Different Transport Modes, Selected Years, 1970-94 177 5.3 Deregulation and Privatization Experiences in Railways 180 5.4 Alternative Organizational Structures in Railways 187 5.5 Different Rail Regulatory Scenarios and their Objectives 191 5.6 Key Variables in Designing Rail Concession Contracts 194 5.7 Quality Dimensions of the Rail Industry 216 5.8 Role Assignment in Railway Quality of Service Regulation 217 5.9 Instruments for Quality Control in the Rail Industry 225 5.10 Contextual Indicators in the Rail Industry 229 5.11 Management Indicators in the Rail Industry 230 5.12 Best Practices in Railway Management Indicators 232 6.1 Divestitures, Concessions, and O&M Contracts in Developing and Transition Economies, 1990-97 246 6.2 Tolled and Other Roads in Selected Countries 247 6.3 Characteristics of Organizational Options for Toll Roads 251 6.4 Award Criteria in Selected Latin American Toll Road Concessions 275 6.5 Toll Design and Levels in Selected Latin American Toll Road Concessions 280 6.6 Reporting Requirements for Road Concessions 291 Foreword The provision of transport services has changed dramatically during the last two decades. At the end of the 1970s, most countries relied on the pub- lic sector both to produce transport services and to build their basic infra- structure, namely, airports, roads, railways, and ports. The role of private firms in transport was secondary, and governments tackled the main tasks. This arrangement has been turned upside down. After almost two de- cades of privatization, the private sector has now become the main actor providing many aspects of transport infrastructure and services. Publicly owned companies have been sold, and from Asia to Latin America, many transport services have been concessioned to private operators. Remark- ably, the private sector is also starting to build and finance the develop- ment of basic infrastructure, although public sector financing will continue to be important, especially in the road sector and in activities that carry strong social implications. Getting the private sector involved may be the easy part of transform- ing the sector. Having governments effectively take on their new role as regulators may be the toughest challenge. For instance, in some cases a dominant firm may use its powers not only to raise prices, but to deter entry, and government policies must be designed so as to restrict preda- tory actions and restraints to trade. The objective of this book is to help governments learn about this new role. The issues discussed are timely. In many countries private operators have now become a critical mass, and regulators need to take effective ac- tion if private participation is to yield sustainable, efficient, and fair out- comes in the transport sector. Transport sector regulators must learn how to promote competition to obtain low fares and efficient services and how ix x Foreword to safeguard users' interests when competition is weak or nonexistent. A major challenge in this connection is to strike a balance between retaining public ownership of the infrastructure assets and promoting efficient con- struction and operation of such assets by private firms. Joseph E. Stiglitz Professor of Economics, Stanford University Acknowledgments This work has benefited from comments by and the experiences of many participants at a course on transport regulation organized several times by the World Bank Institute. Our thanks to all of them. We hope that this book will help them and other transport regulators in their daily tasks. Please note that we are most interested in receiving feedback from readers and learning more about experiences with transport regulation around the world that could be included in a future edition. We would also like to express our gratitude to several colleagues who read earlier versions of the manuscript and provided us with insightful comments, especially Ian Alexander, Nils Bruzelius, Jose Carbajo, Darius Gaskins, Jos6 A. G6mez-Ibanez, Andres G6mez-Lobo, Jose L. Guasch, Jan Hoffman, Jos6 L. Irigoyen, Marc Juhel, Alfred H. Nickesen, Emile Quinet, and Louis S. Thompson. The editorial skills of John P. Didier, International Communications, Inc., and Erin Farnand helped tremendously in polishing the chapters and giv- ing the book its present shape. Any remaining errors or omissions are, of course, our exclusive responsibility. Antonio Estache Gin6s de Rus World Bank Institute Universidad de Las Palmas de Gran Canaria Aestache@worldbank.org gderus@empresariales.ulpgc.es Tel: +1 (202) 458 14 42 Tel: + 34 928 45 18 08 Fax: +1 (202) 334 83 50 Fax: + 34 928 45 81 83 xi 1 Introduction The 1990s saw a dramatic increase in the liberalization of transport policies and a strengthening of the role of private operators and investors in trans- port infrastructure worldwide. This increased private sector participation has often reflected changing ideologies about the role of the state and dis- satisfaction with publicly provided services. The main driving force be- hind it, however, generally has been the pressure to look for private fi- nancing imposed on governments by lasting fiscal crises. This change in the financing of the sector is also providing an opportunity to restructure it in an attempt to improve its efficiency and sustain these improvements. In the minds of many policymakers, this search for sustained improve- ment in efficiency is probably secondary to the need to find additional financing, but it is at the core of the new role of the government in trans- port. Indeed, in addition to the important responsibilities of defining policies and strategies, monitoring safety, and financing some of the less attractive segments of the sectors, for example, rural and secondary roads, governments must also now be ready to become fair economic regulators of many of the privately operated transport services and infrastructures. The restructuring process often creates new monopolies or oligopolies in which the price, investments, and service quality commitments of opera- tors must be supervised to protect transport users. Moreover, fair regula- tion is also needed because these operators have rights and the govern- ment must be held accountable to the commitments it makes to them as part of the restructuring process. To implement this economic regulation, most reforming countries are creating new regulatory agencies or units. These regulatory bodies must be effective to ensure that prices are neither excessive nor inadequate, that services meet the desired standards, and that governments and investors I 2 Introduction comply with the commitments they make. To be as effective as possible, these concerns must be addressed as part of the overall organization of sector reform. First, the regulatory concerns must be addressed during the privatization stage.' Ideally, the future regulators should be involved in the preparation of the sector reform and ensure that their regulatory needs are built in as part of the obligations imposed on the operators during the transfer of responsibilities. Regulators must at least understand the consequences of the restructuring and contract design choices made by the privatization teams. These choices define the constraints and limitations as well as the opportunities that the regulators have to interact with the regulated com- panies of the sector. Second, to ensure fairness in regulatory decisions, regulatory bodies that are independent from political interference, but that are also held ac- countable for their decisions, should take on regulatory concerns. Just as important, regulatory staff members with sufficient skills to be fair while making the most of their autonomy should address regulatory concerns. This is why they must understand the regulatory options available to regu- late prices and quality. They must also understand the minimum set of indicators that are used not only to monitor the performance of the regu- lated companies, but also to increase the transparency of the monitoring process, and hence the accountability of the regulators. Unfortunately, the government's transition into this new role generally is proving to be more challenging than anticipated, requiring significant ad- justments to ensure that efficiency and financial gains are achieved. When it comes to regulation, public sector governance often is weak. In some coun- tries, "regulatory capture," a process in which the regulatory body ends up identifying mostly with the concerns of the industry, is rampant.2 In other cases, excessive government interference with the regulatory process has amounted to what some would argue is partial expropriation. This poor regu- latory governance is becoming a concern for all governments, for the follow- ing reasons. First, the international financial crises of 1998-99 have made potential investors much more aware of the risks involved in investing in 1. Throughout this book, the concept of privatization is used in a wide sense and includes many types of public-private collaborations that do not require any change in ownership of assets. Most so-called privatization transactions that have taken place in the transport sector are concession contracts, as explained in chapter 2. 2. Although consumers or labor can also "capture" agencies. Antonio Estache and Gines de Rus 3 sectors that are sensitive to the overall macroeconomic economic situation, and the transport sector is clearly one in which a good share of demand is derived from overall economic activity. More than ever, privatization teams and regulators must ensure that investors receive fair treatment and retums on their investment. If investors lack that confidence, they are very likely to demand higher retums to hedge against regulatory risk or further increase the risk that they will simply not choose to invest enough. Second, governments often are worried about the emotional load sur- rounding many privatization processes and are aware of the need for protection from excessive or abusive prices or declining quality of ser- vice. This is why it is just as important to ensure that the regulatory re- gime and process will allow users to enjoy visible gains from sector re- forms. Moreover, the regulatory process must be designed to allow these users to voice their concerns through formal channels rather than leav- ing them to informal channels that are more susceptible to manipulation by political or business interest groups. Increasingly, governments are also recognizing that one of the main rea- sons for this poor regulatory govemance is that the civil servants recruited to staff these agencies do not have the necessary technical skills to trans- form them into effective economic regulators. Demand for training and train- ing materials to develop regulatory skills in the transport sector is unmet. The main purpose of this book is to contribute to the development of these regulatory skills. To that effect, the book takes stock of what practitioners and academics know about the major challenges that governments are likely to face in taking on their new role in transport. Tlhis book has two parts. The first consists of chapter 2, which provides an overview of what economic theory has to say about why economic regu- lation is important. Its objective is to introduce potential regulators to some of the key underlying concepts. It may seem too basic for most regulators with recent graduate training in economics, but it may be a useful over- view for many of the other professionals who can be recruited to serve as the staff of regulatory bodies. It provides theoretical support to the sector- specific chapters that constitute the second part of the book. The second part covers four subsectors: airports, ports, railways, and roads. Each chapter can stand apart from the rest of the book and be read on its own, but to facilitate comparisons across subsectors, they all follow exactly the same structure. The first section provides a snapshot of the key economic characteristics of the sector and discusses their relevance from the viewpoint of a regulator. The second section summarizes the main privatization and regulation trends that have been observed in the sector. 4 Introduction The idea is to give an overview of the main options offered by interna- tional experience and to cover a few case studies that illustrate these op- tions. The third section covers price regulation and highlights the price- related issues that characterize the sector. The fourth section does the same for quality regulation. The fifth section discusses the main performance indicators that the sector's regulators should be able to rely on to be effec- tive in their jobs. Because space is limited, we have not been able to address every issue. One key omission is the recognition that many viewpoints are represented in the privatization process and that the outcomes often reflect the biases of the privatization team heads. In an attempt to address this omission, and despite the many common elements, we wrote each chapter with a somewhat different emphasis. In its discussion of airports, chapter 3 em- phasizes the restructuring options and their consequences for the various regulatory issues. With ports, chapter 4 emphasizes contract design and its importance for a regulator. Chapter 5 analyzes the rail industry and high- lights many of the issues relating to longer-run competition and the strate- gic needs of the sector, such as intermodal competition and access pricing. Chapter 6 explores roads from a clear project finance viewpoint and tries to show why and how regulators can enhance project finance contracts to ensure that the longer-run regulatory needs are covered. 2 The Regulation of Transport Infrastructure and Services: A Conceptual Overview Antonio Estache and Gines de Rus Transport services have traditionally been subject to tight economic regula- tion with respect to entering and exiting the market, as well as with respect to the quality of prices and services. In many countries, the public sector itself has traditionally designed, built, and operated road and rail networks and airport and port systems, which is the ultimate form of regulation. This type of government intervention has generally resulted in excessive costs that are not usually matched by prices or quality, creating an outcome that reflects the interests of the sector's civil servants of contractors, unions, and other interest groups more than the preferences of the users and taxpayers. In addition, political interference in pricing and employment decisions has also often resulted in public deficits in the sector. Because these deficits are increasingly difficult to finance through government resources, service ra- tioning has become common, despite growing demand and willingness to pay for more and better services. These are some of the problems that lead to the changes in the sector. These changes, however, do not imply that the government is no longer needed. The government does have to take on new responsibilities. This chapter discusses the theoretical justification for a government role in transport and explains when and how the new re- sponsibilities in economic regulation are justified. 5 6 The Regulation of Transport Infrastructure and Services: A Conceptual Overview Why Economic Regulation of Transport? Most countries continue to justify strong public intervention in transporta- tion for specific local, political, and strategic reasons despite frustrations with the quality of service offered by public operators. Generally, govern- ments make this justification out of the need to guarantee access to mar- kets for both goods and populations. This is quite legitimate, because it is the main way that lagging regions can catch up with the faster-growing regions of a country. Governments are also concerned about national secu- rity, which is historically why airports and ports have often been under tight military control in many countries. While these justifications for a strong government presence have a value on their own, many governments also argue the demand-side and supply- side economic foundations of their involvement. On the demand side, many governments have long recognized that transport users are exposed to se- rious risks because transport of goods and people has few substitutes, even imperfect ones. In technical jargon, the demand for transport service is cap- tive to the operators. The fear that these captive users could be exposed to abuses by uncontrolled, monopolistic service providers has been the most common justification for government intervention. While this risk clearly justifies some type of government action, it does not necessarily imply that the government has to take over the provision of the service. The most highly demanded transport activities also are politically sen- sitive for governments, but no reason exists in principle for the private sector not providing them. Their characteristics tend to make them what economists call "private goods." For a transport service or infrastructure to be a private good, it must fulfill two conditions. First, the excludability condition: the operators should be able to exclude from the service or the use of the infrastructure potential users who are not willing to pay for the service or access to the infrastructure. Second, the rivalry condition: the operators should not leave the other users indifferent because it may result in a deterioration of service or may exclude potential users. Bus services, congested toll roads, ports, and airport infrastructures all meet these two aspects of this definition because they are in high demand. A rural road does not meet these criteria because it lacks demand. In general, setting up a tamperproof system to recover tolls on these roads would be costly, al- though with technological improvements, it should be a realistic option in the foreseeable future. Until then, due to the lack of enforceability and ri- valry, they will remain a prime candidate for public sector responsibility- although not necessarily a provision-as will many of the activities for Antonio Estache and Gines de Rus 7 which exclusion and/or rivalry are difficult to obtain or for which demand is financially unjustified for private investors.' If these distinctions have been well understood in the academic world for some time, their implications for the specific role of the government in the transport sector are only recently coming to light. Until not too long ago, policymakers did not appreciate that under some circumstances, the private sector can be the main provider-and financier-of a transport ser- vice or infrastructure, and that the participation of the private sector can be structured in many different ways (see box 2.1 for a brief summary of the various organizational forms of transport services). To a large extent, the recent recognition of the potential new role of the private sector in trans- port stems from technological changes that have altered the nature of the supply side of the transport market, although not evenly across modes. Transport activities generally present characteristics that influence the structure of a specific transport market. One of the characteristics most commonly used to justify a strong government role or public monopoly are the economies of scale generally assumed to prevail in the sector; that is, the average costs are "always" decreasing as the volume of traffic oper- ated by a firm increases, implying that it will make sense to have a single operator running all of the traffic, and that provision by a single firm will always be cheaper than by more firms. For many transport activities, this makes more sense at first sight than after more scrutiny. Much more room is available for multiple players than common wisdom would suggest among practitioners. Airports, for instance, have scale economies in land- ing operations and scale dis-economies in the handling of passengers at the terminal, which can be addressed through more competition. The larger the airport, the longer the passengers have to wait to get service. Similarly, in ports the average cost per dock declines with the volume of traffic. This suggests economies of scale, but when considering waiting times there is a clear role for multiple docks. Recognizing that the possibility of unbundling transport services pro- vides more scope for competition in the sector is critical. It implies that the initial rationale for a single provider progressively disappears. This 1. Conceptually, many of these goods are not strictly private goods, but what economists call club goods. The service provider can exclude users from joining the club (in other words, entering the bus, taking the plane, or driving on the road), but the optimal size of the club is, in general, relatively large to make the business worthwhile. Few people have their own road and this is why the govermnent will continue to be in the road business. 8 The Regulation of Transport Infrastructure and Services: A Conceptual Overview Box 2.1. Organizational Formsfor the Delivery of Transport Activities A variety of options are available in between the strictly public or strictly private operations of the sector resulting from a divestiture of assets or from a build-operate- transfer or similar contract for greenfield projects. They are differentiated by the dis- tribution of responsibility for the various aspects of the business (management/op- erations and investment) and for the commercial risks associated with this business between the public sector and the private sector. * Programs/performance contracts. These contracts are an agreement between an autonomous public enterprise and the ministry or agency with which it is affiliated. The managers of the public enterprise commit to specific objec- tives, generally output targets, productivity indicators, or costs cuts, within a specific period of time. These contracts tend to be quite short-two to five years-and renewable. Payments to the public enterprise are generally through subsidies to finance investment needs, seldom to operations. They generally fail to reach their goals in the medium and long run. Experience suggests that this stems from the political temptation to interfere with the management of public enterprises in sensitive sectors. This is why their use is declining in developing countries. * Management contracts. The assets of the transport company continue to be pub- lic, but operational management becomes private. The private operator is paid through a fee (generally a fixed component plus a success fee depending on the revenue from the business) and is not responsible for either investment or commercial risk. This has the advantage of bringing in private management skills, and any associated innovations, for a period of two to five years. This should also be seen as a transitional solution because, from a fiscal point of view, it is not attractive as the government continues to take on all risk and finances all investments. * Concessions/licenses/ranchises. Although assets continue to be public and are "rented" to the private operator for use during the contract period, this opera- tor can also bring its own assets. The concessionaire takes on operations and investment as well as commercial risk within the limits set in the contract, for a period that generally varies from 10 to 30 years. Subsidies can be part of the agreement, in particular when demand is not strong enough, implying that commercial risk is very high. Subsidies also can arise as a result of the contrac- tual imposition of heavy service obligations. Because this is the most common form of contract, it is discussed later in this chapter. * Service contracts. These are quite common in transport and deserve to be sepa- rated from concession/license /franchise contracts despite their strong contrac- tual similarities. The main difference is one of scope and duration; both are smaller than for concessions/licenses. The government bids out the right to deliver a specific service and sometimes provides the assets needed. The win- ner can be made responsible only for costs. These are gross costs service con- tracts in which the government pays for the service rather than allowing the operator to collect revenue directly. The main disadvantage is that the pro- vider is not interested in the demand for the sector, because it has the guaran- tee of public payment. This is why many governments prefer net costs con- tracts in which the winner is responsible for all revenue collection and costs (net cost service contracts). The main risk here is the temptation on the part of the winner to render the integration of a network difficult when it results in a more competitive provision of services. Antonio Estache and Gines de Rus 9 means that there is now a choice of provider. Previously, governments argued that they were the only option, thereby holding users captive. It also means that the government's role in the sector must be revised. Be- cause it clearly no longer has reason to be the single provider of most transport infrastructures, it has to focus on promoting competition among the various potential providers, rather than on micromanaging a strong monopoly as a regulator. The new regulatory responsibilities are not that simple. Strong techno- logical constraints still limit the opportunities for full competition in trans- port infrastructure. In the end, regulators must face the replacement of a "global" public monopoly by smaller, more specialized, private or even public monopolies. The limit to the size of this smaller monopoly is driven by the presence of strong indivisibility, joint production, and the difficulty of storing transport services.2 This is essentially what drives the cost struc- ture of transport infrastructures. These technological characteristics result in a joint cost component that makes specific tariff design quite challeng- ing. Indeed, when some of the activities are delivered with the same in- puts, the regulators have to be able to separate the costs of providing dif- ferent goods and services to different classes of customers to identify undue tariff discrimination, cross-subsidies, and costs of universal obligations. This is because most of the required information is controlled by the op- erators, who often have little incentive to reveal it to the regulators. This is why these cost structures often are subject to arbitrary-and controver- sial-allocation rules across service lines, types, and user groups. Regula- tors face the challenge of minimizing the arbitrariness and the resulting inefficiencies of the allocation rules. A final point is the importance of this challenge depending, of course, on the specific restructuring-the extent and ways in which competition is introduced in the sector-adopted for the sector and on the specific form of private sector participation adopted. Table 2.1 summarizes the major forms of private sector participation observed in the transport sector in developing and transition economies in this decade. Concessions are clearly 2. Indivisibility is the characteristic of an input into the production of a ser- vice that prevents its use below a certain minimum level. This is why firms tend to be large in sectors in which indivisibilities are common. Joint products are goods or services with the characteristic that a change in the rate of production of one brings about a similar change in the other; an increased number of terminals in a port requires an increased number of machinery and equipment to make the most of these terminals. 10 The Regulation of Transport Infrastructure and Services: A Conceptual Overview Table 2.1. Types of Private Sector Involvement in Transport across Regions in Developing and Transition Economies (number of projects per contract types between 1990 and 1997) Types Airport Port Rail Roads Total Divestiture 2 6 4 7 19 Greenfield 5 32 6 24 67 O&M projects 3 21 4 7 35 Concessions 15 31 23 170 239 Total 25 90 37 208 360 Source: World Bank PPI database. the most common for infrastructure and services for private goods with strong demand. The remaining sector-specific chapters provide more de- tails on the options and international experience. The Diversity of Objectives Reflected in Economic Regulation The main task of a regulator is to control prices and service quality and to make sure that the residual monopolists in the sector do not over- charge or cheat on the quality of service provided to the users. The regu- lators' role is to settle issues as specified in the charter or law creating the institution. In a nutshell, their decisions have to result in outcomes mimicking that of a competitive environment. This means that the regu- lator is concerned with efficiency and minimizing costs, while ensuring that investment decisions are consistent with demand at unbiased prices. In that process, a regulator must also ensure that the monopolistic op- erators get a reasonable return on their assets. Though it seems simple enough in practice, it is often more complex because governments face a multiplicity of objectives. Efficiency (stimulating cost minimization and pricing at cost) and fairness are only two of the objectives reform- ing governments seek. They also have strong fiscal and distribution concerns they want to address through the reforms. When this objec- tive dominates the others, it can reduce the scope for efficiency, which can be quite constraining for a regulator. To understand this better, consider the case of a port without any signifi- cant competition from other ports in its area of influence. The incentive of any operator would be to keep prices as high as the users are wiling to go, generally much higher than the opportunity cost. When the price is much Antonio Estache and Gines de Rus 11 higher than the cost of providing services to a new user, the economy is wasting resources, that is, it is inefficient. The regulator can impose a price cap to avoid or minimize this waste. How high should this cap be? Clearly it should be higher than marginal cost so that it covers the cost of fixed assets. How much higher will tend to depend on the government's specific goals. This needs to be spelled out when privatization takes place to ensure that all potential operators know the rules of regulation. If the government wants the bids for the right to operate this monopolistic port to generate a huge fiscal revenue, it should probably allow a high residual monopoly power in the hands of the private operator. This power will allow the operator to en- joy a large wedge between cost and prices, which is what is going to make the operator bid a good deal to obtain access to this potentially large profit. The government wins, the operator wins (if the wedge between cost and price is not fully passed on to the government in the bid), but the users lose. The regulator cannot do much but enforce the commitments to a high cap that have been made by a government with a dominating fiscal concern. Similarly, for firms delivering multiple services, setting the tariff in accordance with the opportunity cost will often imply different tariffs for different products. For instance, in the case of railways, the cost in- creases with the distance. For buses, the cost is inversely proportional to the traffic speed. These considerations imply that operators should be allowed to charge more to users in rural zones or in mountains where speed has to be much slower. This may not be politically desirable.To address the distributional concerns, the government may impose a mix of service-price requirements. This violates the efficiency concerns on which a regulator is supposed to be focusing. Most economists would argue that the government has better instruments to address these dis- tributional concerns, but politicians often tend to adopt the solutions with the highest short-term payoffs. Imposing service obligations at the wrong price seems to be a common temptation that regulators will have to live with for some time. More generally, these examples suggest that multiplicity of objectives is likely to be quite common and that regulators have to try to do the best they can under these constraints. Their job will be to make the consequences of these multiple objectives as transparent as possible. This will highlight the need for subsidies in some cases. In fact, some of the players will have to pay for the others when they impose inefficient decisions for fiscal or equity reasons. In some cases, this will show that short-term solutions hurt the incentive to invest, penalizing future generations of users in favor of the current generation. 12 The Regulation of Transport Infrastructure and Services: A Conceptual Overview Natural Monopoly, Competition, and the Unbundling of Activities As already hinted at, competitive markets can provide most transport ser- vices, and they are likely to require little or no economic regulation other than what falls under the realm of competition policy. Conceptually, the presence of decreasing costs associated with scale economies or indivisibility of assets, and hence the case for a monopoly and for its regulation, is almost exclu- sively associated with transport infrastructures. However, infrastructures are not monolithic. To assess regulatory needs and scope for competition, we distinguish between the fixed components-infrastructure in the strict sense- and superstructure. For instance, in a port, access roads to the ports are infra- structure while warehouses and mobile and immobile loading equipment are superstructure. Figure 2.1 shows the logic to follow to assess what type of competition is desirable, according to the degree of technical integration of the activity concerned and the desirability of allowing its provision by a mo- nopoly. Whatever the response to the question asked, the ultimate outcome is to map the type of competition available to the technical characteristics of the activity. Indeed, if competition in the market cannot work-what most non- specialists think of when they think of competition-competition for the mar- ket can be quite effective to obtain efficiency from a monopoly. Competition in the market guarantees free entry and exit and lets de- mand and supply determine prices and quality mixes. Although introduc- ing quality standards is often useful, this can be done without altering the nature of competition. This form of competition is effective in ensuring the long-run sustainability of efficiency gains. Competition for the market is organized through an auction used to force potential monopolists to com- pete with each other for the right to be the single provider of a service. The challenge is to design the auction to ensure that it forces the bidders to pass on many of the efficiency gains they should be able to achieve to the users, and to achieve results similar to those that would be achieved through competition in the market. How does one decide how far to go in the restructuring of the sector to pick the right form of competition? It starts with a rather simple question: is it cheaper to produce with a single firm than with more firms? In theory, the question should apply to both the short run and the long run. In practice, the short-runconcerns tend to dominate thelonger-runneeds of future generations. If two or more companies can do better than a single firm, interfering with competition in the market is not necessary. The ordy role of a regulator may be to ensure compliance with service obligations and government delivery on its promises to compensate the providers for these obligations. Antonio Estache and Gines de Rus 13 Figure 2.1. Natural Monopoly and Competition In the short run, is it cheaper to produce with a single firm than with 2 or more? If competition is allowed, are the Free entry, exit, and comTetition in long-ruin efficiency losses serious? the market should be a owed I Is itpossble toseparate activities withot 1 C s hort-runntshodancyklosss? jCompetitionfor the market IYes No ffi 1Activities with decreasing costs: keep the monopoly Consider opportunities for vertical and horizontal unbundling of activities, resulting in a separation of activities with anid without decreasing costs Activities without _ decreasing costs Source: Authors. Even when leaving production to a single company garners efficiency gains, one may wonder whether these short-term gains are significant enough when compared with the longer-run gains that could be achieved through some degree of competition in the market. If these gains are not particularly impressive, one may try to push for competition to avoid having to deal with a monopoly, and to try to prepare the sector to reap the longer-run gains from competition. A first way to push for competi- tion is to unbundle vertically and separate infrastructure and superstruc- ture. This provides an opportunity to introduce competition in some spe- cific activities. Horizontal unbundling also can help. For instance, this 14 The Regulation of Transport Infrastructure and Services: A Conceptual Overview means separating passengers and freight in rail services. This separation between competitive and monopolistic activities is, of course, not that clean-cut. Some activities imply sunk costs,3 but their economic impor- tance is minor and generally insufficient to impede the entry of new firms in the market. Competition still has a role to play once the activities have been sufficiently unbundled and the remaining natural monopolies have been identified-in other words, those bundles of activities for which the potential cost savings resulting from coordination and integration are significantly larger than the gains that could be achieved through competition. Competition for the market allows the regulator to try to get some up-front efficiency gains in the sector. Unavoidable Restrictions to Entry and Regulation Relying on competition for the market to assign responsibility for trans- port services not produced by a competitive market is an improvement over past practices, but it is also challenging, that is, the promise of im- provement made by the private operator before it takes over the business. The main challenge from ensuring that the gains achieved ex ante through the auction mechanisms are maintained ex post (once this operator is actu- ally in charge) stems from the exclusivity generally granted through the concession contract. The regulator must assess the specific implications of these conditions for whatever efficiency, equity, and fiscal goals the gov- ernment may have. If too generous to the concessionaire, it may mean that the initial gains from competition for the market are probably not sustain- able over the longer run. To a certain extent, the regulator and the govern- ment are captive to the concessionaires once the auction has been closed. Once a contract has been awarded, the concessionaire becomes the sole coun- terpart of the regulator. The concessionaire has a significant incentive to negotiate on anything that restricts its profits. This is one of the reasons why it is extremely important for the regulator to ensure that the concession contracts also include explicit rules for renegotiation of the terns agreed to when the concessionaire participated in the auction. It is also the main rea- son why it is important to make sure the government has identified a clear and valid reason for granting exclusivity, and to reject it if it is not needed. 3. Sunk costs are costs that cannot be recovered when an operator leaves the industry. Antonio Estache and Gines de Rus 15 From the government's viewpoint, granting exclusivity may make sense for three main reasons as follows (Kerf and others 1998): * When cross-subsidies among different users are denied. This happens in three types of situations involving cross-subsidies.4 First, certain user groups may be required to have tariffs lower than costs, and other user groups may then be allowed to have higher tariffs to compen- sate. Second, a concessionaire may be required to have a unified tar- iff for all users, despite differences in costs to serve across user groups. Third, existing users may be asked to subsidize the expansion costs needed to have more users in the network. In each of these cases, the exclusivity avoids unfair competition from firms able to focus only on new users without the burden of having to deal with the cost constraints imposed by the contract on the concessionaire. The ex- clusivity guarantee makes cross-subsidies viable for governments un- able to assist unfavored user groups through direct subsidies. * When the initial risk levels in the sector or the country are high. Because competition tends to reduce benefits, exclusivity makes a concession more attractive in an auction, which can improve competition for the market because more bidders are likely to show interest in the auc- tion. In many developing countries, temporary exclusivity conditions are sometimes the only way to ensure participation in an auction. • When the service the concessionaire will provide is a natural monopoly. Firms are sometimes interested, for strategic reasons, in entering a market in which, technically, there is room for only one firm. This is a case when the government should rely on exclusivity to avoid un- desirable entry into the business. Once more, these are valid restrictions on competition that governments may decide to adopt. A regulator cannot do much but take them into ac- count. A major responsibility these specific restrictions impose on the regu- lator is the measurement of the importance of the cross-subsidies allowed. This, in turn, requires close monitoring of the costs of service of the various user groups, which is one of the toughest challenges a regulator will face, because the providers have control over the cost information per user group. The privatization design needs to anticipate this to require the monopolistic 4. This is not an endorsement of cross-subsidies. It is simply a recognition that cross-subsidies sometimes arise when governments cannot rely on targeted subsi- dies for fiscal reasons. 16 The Regulation of Transport Infrastructure and Services: A Conceptual Overview operators to reveal enough cost information to allow the regulator to mini- mize the misallocation of resources that can result from the exclusivity. The Main Elements of Contract Design from a Regulator's Viewpoint While writing a contract that is "all encompassing" is often difficult, every contract muist address a minimum set of issues if this contract is to be a useful tool for directing and supporting regulatory decisions. This section summarizes the minimum requirements. Basic Coverage of a Contract The contract is the legal instrument spelling out the key economic elements that the government wants to cover in its agreement with the private op- erator. The coverage of the contract must then be all-encompassing and in- clude a detailed description of the object of the auction, the obligations and rights associated with this object, the processes to follow, and contingencies in case of unforeseen events. All parties involved-privatization commis- sion, investors, operators, users, and taxpayers-should have clear legal support for the economic and financial agreement. This is particularly im- portant in countries in which the legal system is not oriented toward con- tract law. Regulators need to be able to rely on the contract to shortcut ex- cessively complex legal systems designed when governments wanted to support the public operation of infrastructure services and exclude all pri- vate roles in these sectors. Contracts also need to provide a set of instru- ments for the new regulators of the sector that allow fair and efficient regu- lation within the constraints explained earlier. From a regulator's viewpoint, a contract must cover the elements discussed in the following paragraphs.5 DEscRawnON OF THE SPECIFIC AcTVrrN COVERED BY THE CONTRACTUAL AGREE- MENT. This is the coverage of the services and the size of the market, which is much more subtle than it first seems. It needs to be specific and answer such questions as, "Does the contract cover service/traffic lines or geographic 5. See, for instance, Crampes and Estache (1998); Gwilliam (1998); Kerf and others (1998); and Shaw, Gwilliam, and Thompson 1996. For a more detailed over- view of what contract design is in practice, with an illustration of water and sanita- tion contracts, see Brooke and others (1997). Antonio Estache and Gines de Rus 17 zones?" and, "Is the contract covering all zones to be contracted or only parts of these zones?" The first question tells the regulator whether it will have to take on the coordination of the physical network (the timetable for the use of rail tracks or for bus services, for example) while promoting the development of a network of operators capable of competing with each other and providing a spectrum of services. Will it be the responsibility of the single operator for all lines included in a region? The second question also tells the regulator whether it will be able to easily compare the perfor- mance of activities in various regions (road or port concessions in different provinces) or lines (various intercity train or bus services) or whether it will have to interact with a single monopolistic provider of all services. In a nutshell, this first item in a contract is the outcome of the form and extent of horizontal and vertical unbundling that the privatization team has adopted, and it defines the limits and scope of the regulatory activities. EXCLUSIVIIY. As mentioned earlier, what can make or break competition for the market is the degree of exclusivity over the right to provide a specific ser- vice (for example,track or road maintenance, among all the services required from the contractor for the operation of a train service or road concession) and not necessarily all services granted by the contract for a specific period of time. The contract draft passed on to potential bidders must be quite clear on the specific activities, services, or geographical zones for which there is exdusiv- ity, both to ensure the effectiveness of this form of competition and to ensure that the regulator has clear terms of references over its assessments of the rights and obligations of the contracted finns. It is also a key instrument for a compe- tition agency that has been asked to assess the legality of restriction to entry in the sector introduced by the incumbent. In general, the shorter the exclusivity period, the lower the risk of conflicts. When the exdusivity period is for the duration of the contract, and the contract is long, the risks are much more serious of having frustrated potential entrants exduded from a market in which consumers would benefit from entry as a result of cost reductions. AssEr OwNERsiH1 AND VALUATION. Being able to assess the assets is quite important for the privatization team, because it sets the minimum price the government is willing to accept for the activity it is contracting. But it is also important from the regulator's viewpoint and matters enormously at the end of a contract or during conflicts. If the assets are public and little new investment has occurred during the contract period, the regulator is only accountable to the government when controlling that the state of the assets returned to the government is consistent with the contractual demands. This 18 The Regulation of Transport Infrastructure and Services: A Conceptual Overview in itself is a challenging task, because private operators generally have little incentive to spend money to properly maintain assets they will soon no longer need. When investment takes place and/or the private operator brings in assets, the regulator also becomes accountable to this operator to ensure that it is properly compensated for all investments or assets not yet amortized through tariffs. This means that the asset valuation methods adopted have to be quite clear to all parties involved, which is a complex and controversial matter (see Burns and Estache 1998). In many countries a particularly troublesome component of this pro- cess has been the assessment of demand. The incentive of privatization teams is often to overstate demand to increase the value of the business. This is why regulators in so many countries are faced with contract rene- gotiation requests because the private operators end up finding out the hard way-on the job-that the user's willingness to pay is not as high as initially anticipated. To remedy this risk, privatization processes are now increasingly relying on specialized consulting firms to carry out the de- mand studies. In addition, many of these firms are now starting to sell insurance to cover the demand risks. This is a significant improvement from a regulatory viewpoint, because a key source of conflict should dis- appear with the creation of a market for insurance. DURATION. As a rule of thumb, the shorter the duration of the contract, the stronger the potential for competition for the market, because the activities object of the contract will be subject to more frequent auctions. This is par- ticularly true for activities involving few sunk costs and little asset specific- ity, and for those facing a lot of uncertainty. Urban bus services are a good example, because buses can be easily relocated to other cities or used for other types of services. So why are all two-to-three-year contracts not subject to frequent auctions? The main reason is the difficulty of convincing the win- ners of short-term contracts to make investments for the long term. The ideal contract duration is long enough to allow the amortization of investments made and a fair return on the investment for the given pricing rules spelled out in the contract. This will remain a major concern as long as asset valua- tion remains a source of conflict between regulators and operators, and as long as investors are not convinced they will get a fair compensation for investments made, but not amortized, at the end of the contract.6 6. One cannot discard the concern for political risks and fear of political inter- ference with the implementation of the contractual commitments that are more likely to arise with long contracts, because they expose investors to more political cycles. Antonio Estache and Gines de Rus 19 This concern is valid whether the government is responsible for com- pensation at the end of the contract or whether the winner of the next auction for the contract is responsible. Moreover, in addition to the ob- vious high transaction costs associated with frequent auctions that have to be balanced against the gains from competition, short contracts can be a major source of concern when demand is uncertain. The Mexican toll road experience has become the standard example to illustrate that well-intended short-term contracts can fail when demand is very sensi- tive to toll levels. Because short contracts with strong unsubsidized in- vestment obligations will generally mean high tolls (needed to recover the investment during the contract period), a careful assessment of whether the willingness to pay is high enough is important. In many cases, demand will not follow and contract duration will have to be adjusted through a renegotiation.7 This is why one solution for certain types of activities is to adopt vari- able-duration contracts. The difficulty of forecasting demand with long lead times (and hence of estimating long-term revenue) and of anticipating de- mand shocks that are uncontrollable by the operator (recessions, financial crisis) is addressed by a methodology Engel and others (1996) proposed for the road sector. Various Latin American countries have adopted it, start- ing with Chile. The idea is to have the regulator set the toll and the dis- count rate, in addition to all the service and investment obligations, and to have the potential operator compete in an auction in which the winner demands the lowest net present value for the future revenue to be col- lected through the contract. The duration becomes variable because the operator returns the road to the government only when it has cashed in the revenue bid. When demand is strong, the contract can be short. When it is not, it can be long. Moreover, if for any reason the government wants to change anything (such as expanding the road), one can easily assess the financial conse- quences in terms of the net present value. The outcome is an automatic adjustment in the contract duration. This flexibility has reduced the risk premium demanded by investors, and hence the required rate of return. This arrangement, which works well for simple activities such as roads or 7. Remernber that the privatization process generally leads to a situation in which users end up paying for a service for which they were either not used to paying (roads) or for which they were hardly paying anything (trains and buses, which tended to be paid for by taxpayers). This often leads to strong user reactions that initially can curtail demand if the operator cannot tailor the service price mix well as a result of excessive contractual requirements for the contract period allowed. 20 The Regulation of Transport Infrastructure and Services: A Conceptual Overview airport runways, is not foolproof. Its main problem is that because revenue is guaranteed, the operator does not have much incentive to maintain the infrastructure quality. That is why in these types of contracts, quality re- quirements (essentially maintenance) and the related penalties for noncom- pliance are important. INVEsTmEn AND OrHER OBLIGATIONS. The contract can also be used for spe- cific investment projects or increases in capacity that the winner needs to provide. New investments often have a strong temptation to be quite spe- cific about all the technical parameters of the investment. This often results in the regulator micromanaging the operator's investment decisions. The trend in government bias is generally to push for overinvestment in quality, inconsistent with demand. More specifically, there is always a risk that this overinvestment will result in tariffs that the users are not willing to pay. The general advice given to governments is to focus on outputs, in terms of service coverage and quality, and not on inputs. However, the regulator wants some guidance when monitoring compliance with these obligations. General targets are useful in this regard. This is particularly important at the end of the contract when the regulator must ensure that investments have been properly maintained. Without specification of what proper main- tenance should be, the odds of conflict with the operator are high. A common criterion is to rely on third-party assessment of technical quality. One can also use this third party to assess when cases of force majeure justify delays in construction or delivery of service commitments. Finally, a particularly common event to avoid, one that has gotten regu- lators in tough situations, arises when investments and service obliga- tions are contingent on financing possibilities. In risky situations, bid- ders should have financing for their investments lined up. When the government shows unpredictability in handling a privatization program or when the global environment becomes too chaotic, this financing may not materialize. Often it will also be reasonable for the government to minimize the risks of having to organize a new auction and specify in the contract appropriate contingencies when this risk is serious. The government may also want to specify performance guarantees in the contract to provide the regulator with a clear instrument to penalize in cases of nonperformance not covered by the contingencies. REVENUE, TARIFFs, AND REGULAIRY REGIME. This is probably the most com- plex element of the contract from an economic perspective. It covers both Antonio Estache and Gines de Rus 21 generic and technical questions that influence the effectiveness of the contract. Prices are clearly driving revenue. The main point to address is often a technical "pricing" annex attached to most contracts, because this annex is one of the main instruments of any regulator. In addition to the definition of the pricing rules, including indexing and the decision to con- trol average versus individual tariffs, investors may need to get clear guid- ance about some basic concerns to assess their revenue prospects and flex- ibility. The first concern to clarify is whether they can be paid offshore. This has multiple implications from the investor's viewpoint, not the least of which are tax liabilities. It is also a difficult issue for the host govern- ments because they do not want to risk conflict with the country of the investors. At the same time, this can be an effective risk mitigation strategy resulting in a lower required rate of return by the investors. The regulator will have to account for this input in calculating the rate of return. A related concern that needs to be addressed early on is currency: which accounts must be held, are the tolls in dollars or in local currency? Finally, this annex must clarify the technicalities: it must spell out the regulatory regime (price cap or rate of return, or a hybrid?) and the extent to which price differentiation is allowed or imposed (for example, to meet social concerns). These more technical questions on the choice of the regulatory regime, and on the extent to which tariff design can and should be covered by the contract, are discussed in detail later. CONTROL AND SANCrIONS. The discussion so far has made it clear that the operators and regulators face many uncertainties, because contracts will often not be able to cover aU contingencies. Moreover, the regulators wiU not always be able to control everything on a continuing basis. Operators know much more about the business than regulators do and excessive control would be equivalent to micromanaging the business. The operator must be left to work on delivering its contractual commitments at a reasonable, regulatory compli- ance cost. Some degree of control is needed, but it will only be effective if the regulator has a clear set of sanctions to apply. For example, performance bonds or guarantees are part of the standard kit of sanctions for operators who do not deliver on time. But what happens when assets are not maintained prop- erly or when service quality (such as unacceptable delays) or safety standards are not met? The ideal sanction is one that compensates the victims of the operator's failure to deliver on its obligations for the equivalent of the loss incurred by the victim. This raises complex methodological issues as well, but it can be reasonably approximated for most minor contractual violations. 22 The Regulation of Transport Infrastructure and Services: A Conceptual Overview In general, sanctions cannot be so low that the operators ignore them and treat them just as built-in operational costs. Similarly, they cannot be so high that they force the operators to close shop as soon as they do not comply with the contract. Note that to ensure the fairness and transpar- ency of the process, this section of the contract must also be clear about the public hearing and appeal process when sanctions have to be decided. This is important, because in transport, the nonrespect of obligations is often not necessarily the operator's fault. For instance, unexpected traffic can cause delays due to public works that were not expected at the time the contract was signed and that could not be built into the original timetable. A solution to stimulate operator creativity in addressing these unexpected events is to combine incentives for meeting quality indicators with sanc- tions for the most obvious deviations from commitments. RENEGOTIAITON. This happens quite frequently, and the contract should clearly specify its terms. It often occurs because demand is much lower than expected and the operator wants to slow down the investment pro- gram. This has been the experience for many toll roads. However, demand may also be higher than expected and investments have to be accelerated and/or tariffs increased. These cases are relatively easy to assess. Often, however, the regulator has to make a fair assessment of the need to renego- tiate, assess the costs and benefits, and determine the winners and losers. Governments commonly ask for faster investments and lower tariffs as an election comes closer. In that case, a fair regulator will often have to ask the government to compensate the operator for the financial consequences of its renegotiation request. As a rule, the party asking for a renegotiation will have to compensate the other for the consequences of its demand. As a second rule, the renegotiation should generally not change the net present value of the business for the investor. As is becoming increasingly clear, the legitimacy of the privatization processes depends, to a large extent, on the way in which governments leave regulators to handle the renegotia- tion, and on the way in which these regulators perform. What seems clear is that allowing renegotiation under broad or vaguely defined circumstances makes a mockery of the competitive bidding for concessions. TERMINAnON CONDITIONS. A final, basic aspect of a transport contract is the definition of the termination conditions. Is the renewal of the conces- sion or service contract automatic? Is this negotiable? If it is negotiable, what will be expected from the regulator in terms of asset or business valuation? Increasingly, however, privatization commissions are Antonio Estache and Gines de Rus 23 recommending that new auctions be organized to select the new contrac- tor. Under any renewal strategy, the contract must be clear on the condi- tions of transfer of assets. This means specifying the expected state of the assets, and whether they will be returned to the state or to the new con- tractor. Finally, this part of the contract must also address the possibility of an unanticipated end to the contract. The contract must recognize that the unanticipated termination may be due to either the government, the contractor, or to a mutual agreement. Under any scenario, whoever initi- ated the early termination will be required to make compensation. Ide- ally, these payments should be formula-driven, and they should consider the associated residual asset value and transaction costs. Criteria for Organizing an Auction and Picking a Winner Organizing an auction and picking a winner can be done in many ways. Choosing the winner at an auction for a concession or a service contract requires a good understanding of the trade-off involved. In practice, how- ever, in countries in which the governance structure is not reliable or well tested, the rule of thumb to follow is straightforward: keep it simple, fair, and transparent to maximize the number of bidders, ensure the success of competition for the market, and minimize the risks of corruption or unfair decisions. The process is generally as follows. The government provides informa- tion on the state of the assets, the value of the business, and its contractor requirements to identify the potential bidders. For large projects, this can take the form of a road show to allow a prequalification procedure, which is essentially a marketing trip to the regions where most potential investors are located, often France, Germany, Japan, Spain, the United States, and the United Kingdom. This stage also includes criteria for a technical and finan- cial prequalification of the bidders. The potential bidders are told the type of sanctions the regulators may impose if they do not deliver once they have won the contract. This prequalification is not always necessary, but it is recommended. It minimizes the risks of having incompetent, risk-taking investors trying to get into a business they do not know, or of competent operators trying to commit to financing they cannot deliver. In instances in which this stage had not been taken seriously, governments have been em- barrassed, having to declare the auction invalid after finding out that the winner could not deliver and was just trying to get a contract that it hoped to immediately renegotiate. Generally, the prequalification criteria result in the creation of consortia, pulling together investors and operators. 24 The Regulation of Transport Infrastructure and Services: A Conceptual Overview The next stage is the definition of the auction itself. It is organized around two criteria: technical and financial. These can be assessed in three ways as follows: * A two-stage selection that first eliminates the weakest technical proposals, then picks the best economic offer among the remain- ing candidates. * A single-stage proposal that ranks the offers according to a weighted average of the technical and financial proposals. This is often very tricky and can result in unfair decisions when there is a choice between widely differing technologies with different financal consequences. * A procedure in which the government specifies the technology and all the engineering aspects desired, and the bidders only compete on the financial dimension. To actually pick a winner, more specific criteria are needed. This de- pends on the specific objectives the government is trying to achieve. Table 2.2 suggests the optimal selection criteria for a spectrum of possible objec- tives. While several of the objectives are closely related, they are separated because they reflect different terminology politicians use when justifying the privatization strategy adopted. The table shows that trade-offs do indeed exist. For instance users are not guaranteed to benefit from lower tariffs if the government has fiscal objectives in mind. Indeed, the best way for a government to maximize the willingness of bidders to pay in an auction is to offer a strong monopoly, which implies large potential profits through high tariffs. This strategy makes it particularly difficult for a regulator to ensure efficiency and fair- ness because the contractor gets contractual protection for the right to use its monopoly powers. Governments often justify this as a temporary nega- tive point in return for the longterm good of the nation. This ensures that the private sector will make the investments that the public sector could not finance. In cases of conflict, however, this is often a sore point, and it threatens the credibility of the privatization program. At the other extreme, the government wants to minimize political conflicts with the unions, for instance, by imposing the retention of unneeded workers simply to increase the costs of the service. Users continue to pay for the failure of the local labor market to absorb excess employees. Remember that multiple award criteria usually do not work. They re- quire arbitrary weights for the various criteria, which tends to lead to arbi- trary selections. Any arbitrary selection criterion will introduce a risk of corruption. In sum, the individual circumstances of a country or a sector Table 2.2. Relation between Privatization Objectives and Auction Award Criteria Auction award criteria Maximum Maximum Minimum net Shortest Minimum payment number of Best present value Privatization contract Lowest subsidy to the employees investment of revenue objectives duration tariff requested government retained plan requested Ln Competition Infrastructure quality and capacity Benefits to the users Reduction in fiscal deficit Minimal political conflict * Indicates that the linkage is close. Source: Authors. 26 The Regulation of Transport Infrastructure and Services: A Conceptual Overview should clearly determine the choice of the specific award criterion. The net present value criterion offers many advantages when awarding contracts for the operation, maintenance, and development of simple infrastructure such as roads, runways, or ports. Risk Assignment An important component of the information transmitted to the potential bidders through the draft contract is the allocation of risks among the government, the operators, and the users of the service. This is a complex matter. This brief section can hardly do justice to its importance but will highlight it from a regulator's viewpoint. Indeed, identifying the various types of risks, and their distribution across the various agents, is impor- tant because it influences the incentives these various agents will have to behave in one way or another on regulatory matters. For instance, if a concessionaire is allowed to pass through all increases in costs because of changes in safety legislation, it will have little incentive to pick the most cost-effective technologies, because it does not bear the costs of its choice. This is why the British airport regulator only allowed a pass-through of 95 percent of these costs when a new safety norm was introduced for airports in 1996. The competition agency's initial recommendation was actually 85 percent. A full pass-through makes sense only for failure to comply with the contract resulting from risks completely out of the concessionaire's con- trol, such as floods, national strikes, or earthquakes. Otherwise, the risks should be assigned to the agents most capable of their assessment, their control, and their management so that their cost is minimized (Kerf and others 1998). Depending on the specific risk and its source, some standard recommendations are available for risk assignments in concession contracts (World Bank 1997). They are summarized here because regulators may have to assess the nature of risk and assign its responsibility in cases of conflict. * During the design stage, specification failures do arise in the bid- ding documents that the government provides, and they are clearly the responsibility of only the government. If the failure is in the de- sign proposal as part of the bids provided by the bidder, it is the bidder's fault. * During the construction stage, legal changes or difficulties and de- lays in expropriations of land can increase the costs of a project, but the contractor is generally not responsible. The government or an Antonio Estache and Gines de Rus 27 insurance company should thus cover this risk. Construction diffi- culties caused by technical failures in the choice of material or equip- ment are, of course, the constructor's responsibility. * During the operational stage, cost risks should be the the operator's responsibility unless cost overruns are due to the government's failure to deliver on a specific commitment (such as delivering a permit or providing inputs promised on time) that results in costs increases. Revenue risks should also be the operator's responsibil- ity unless the contract specifies otherwise,8 or when the failure to generate the expected revenue is the result of a government action (such as failure to increase tariffs according to formulas specified in the contract). * The contract should also specify the responsibility for financial risk and exchange rate risk, which is often a subject of negotiation be- tween potential bidders and the government. Only in cases of the introduction of convertibility restrictions is the government clearly responsible for indemnizations. For the rest, governments have of- ten been too willing to cover these risks, promoting careless behav- ior on the operators' part as a result. * The responsibility for environmental risks should rest on the con- cessionaires or their insurance companies (as many of the risks of force majeure that insurance companies are willing to take on). * Expropriation risks should generally be the government's responsi- bility. The challenge lies in the enforceability of this risk allocation. Price and Quality Regulation The main reason that direct competition between potential transport ser- vice providers is increasingly viewed as desirable is that the freedom these providers have to set prices tends to benefit users (who can pick among a wider range of price-quality mix). In addition, it ensures that the providers will have an incentive to minimize costs while setting prices that guarantee their financial equilibrium. All this can be achieved with- out a regulatory authority drastically controlling prices in a competitive environment. If an airline or a trucking company does not generate enough revenue because it is not competitive, it goes bankrupt. This 8. Which may be the case when governments perceive that without some shar- ing, the private sector will not be interested at all. 28 The Regulation of Transport lnfrastructure and Services: A Conceptual Overview occurs because its costs are too high, demand is weak, or technological changes have taken place.9 When competition in the market is not possible and competition for the market results in a legal private monopoly, as is the case with most conces- sion programs, regulating the prices that this monopoly will be allowed to charge is one of the mechanisms that make the defense of the users' inter- est consistent with the tolerance of a private monopoly, including one with exclusivity rights over a specific market. If the regulator had all the neces- sary information, it could ensure that the users would get an outcome close to the one that would emerge from effective competition by allowing prices to cover the average cost. Unfortunately, the regulators do not have access to the same details of information about technology, cost structure, and demand that the airport, port, and road operators do. This is why one of the main tasks of a regulator is getting the operator to reveal enough infor- mation to demonstrate that it is not abusing its power over the market. Financial Equilibrium and Prices Consider the case of the most common regulator. What is it supposed to do when the contract does not specify prices precisely enough? It is trying to get the operator to minimize costs and allocate resources to where they yield the most to society (static efficiency in economic jar- gon), and at the same time trying to stimulate the right amount of inno- vation and investment to ensure that the operator can meet future de- mand (dynamic efficiency). This regulator knows that it has to allow the operator to at least break even, in other words, guarantee cost re- covery. It also knows that it is likely to have to meet some social con- cerns and cannot end up micromanaging the operator and imposing excessive regulatory compliance costs. The challenge comes from the fact that the monopolistic operator's interest is not quite the same. The monopoly wants to maximize profits. The prices it will prefer to charge will be compatible with cost minimization and cost recovery. It will be higher than what is needed to achieve an efficient 9. The practice of competition is, of course, more complex, and many per- verse forms of competition can arise from some firms strategically trying to ex- clude potential entrants from their markets. Serious risks of collusive behavior be- tween potential competitors also exist that could offset the potential gains from breaking a monopoly. This is why goverrments have a major role in monitoring the behavior of competitors through an effective competition agency. Antonio Estache and Gines de Rus 29 allocation of resources, to meet demand, to promote investment decisions consistent with demand, or to meet social concerns. In general, the regulator will have to introduce a system that reduces prices or changes the price structure to reconcile the monopolist's right to a reasonable rate of return on its investments with the interests of society. To ensure the regulated operator's financial equilibrium, the total al- lowed revenue must be at least equal to its total costs. A disaggregation of the components of revenue and costs most relevant to the regulator sug- gests the following simplified formula: (2.1) price x quantity = operational costs + (asset value x the cost of capital) This equation shows that the cost structure of the operator has two main components: operational costs and capital costs. The first set of costs in- cludes all the standard inputs and the volume of production generally al- located to each activity, for instance, the cost of bus drivers can be assigned to each line. They can also be common costs, which are much more diffi- cult to allocate across activities, for instance, administration costs for the management of this bus company.'0 The variable costs are usually well handled by standard accounting procedures. Common costs are generally handled in a much less satisfactory way by financial accounting. For regu- latory decisions, regulators need to strongly guide their accounting. T1he second set of costs is capital costs. These are even more complex to deal with from a regulatory viewpoint because they are much more diffi- cult to assess. First, the value of the assets must be estimated. A base value is usually set during the privatization process, but it is often subject to revision once the private sector has taken over the business. Next, the regu- lator must provide guidance on how to calculate the costs of capital-es- sentially the minimum rate of return that makes it worthwhile for the firm to stay in business. Both values are subject to serious controversies. The main problem in assessing the value of the assets stems from the fact that various methodologies exist, each with clear biases, that are hard to quantify: historical value, market value, and replacement value. In ad- dition, the privatization commission often tends to overstate the value of the assets when it passes on the business to the private sector to increase the fiscal payoffs. The operator has a similar incentive because a high initial value leads to high recoverable costs and reduces the risks of a 10. Common costs are costs that are common to various business lines of the company. 30 The Regulation of Transport Infrastructure and Services: A Conceptual Overview high capital gains tax when it resells the assets. The losers in this case are the users and the taxpayers. The regulator is the only champion they have to defend their interests. This defense takes place every time a tariff revi- sion occurs, because it provides an opportunity for a transparent reas- sessment of the assets' value. The cost of capital can be set in relation to the opportunity cost of the resources invested, but no single value to assess this opportunity cost is available, because it is project-specific and depends on the risk allocation among the operator, the users, and the government. The lower the risk sharing, the higher the variability of revenue and costs expected, the higher the costs of capital will be. In general, the regulator is going to have a double, long-term objective: the first to ensure that the operator gets a reasonable rate of return on investment, the second to make sure that this return is not excessive. The first objective is needed to ensure that investment actually takes place. Indeed, without a rate of return or, equally, a cost of capital sufficiently high, no investment will take place. The second objective is to ensure that the operator with monopoly power does not abuse this power. These objectives can be achieved in many ways. The two extremes are rate of return regulation and price caps. The other options tend to be hybrid solutions. Rate of Return Regulation Until recently, the main approach to monopoly regulation was the control of maximum rate of return allowed from investment. It is essentially an indirect way of controlling prices, because prices above the competitive prices will result in an above-normal rate of return of the sector. The al- lowed rate of return determines the allowed profits of the firm, as illus- trated by equation 2.2: (2.2) allowed rate of return x assets value = prices x quantities - operational costs T1his expression implies that a firm will not be interested in the business unless (2.3) prices x quantities 2operational costs + allowed rate of return x assets value. Both expressions illustrate the difficulties of the regulatory process. They show that rate of return regulation requires, first, detailed infor- mation on costs. Once operational costs have been assessed, the regula- tor has to assess both the assets value and the cost of capital to assess the minimum profit compatible with private investment. Because the Antonio Estache and Gines de Rus 31 objective is to allow a normal rate of return, which is assessed ex ante, the revenue must at least cover total costs. This is quite attractive for investors because the regulator will generally allow a risk-adjusted rate of return, implying that the cost of risk is passed on to users. Indeed, given a forecast of the volume of traffic, the price allowed is determined as a residual to ensure that the equation holds. The main problem with this indirect form of price regulation comes from perverse incentives built into equations 2.2 and 2.3. The larger the value of the asset, the larger the benefits allowed, and hence the higher the prices will be. This can result in an incentive to overinvest (the Averch- Johnson effect), or simply to overstate the value of the assets when their correct value is difficult to assess precisely. In addition, equation 2.3 shows that the operator does not have much incentive to cut costs, because the larger the costs, the larger the benefits allowed. The system penalizes ef- forts to cut costs, because they would have to be passed through to users immediately through price reductions. A final drawback is excessive com- pliance costs. Every year the regulator demands detailed information on costs, assets, and investments to assess the required price adjustment. These problems have led some regulators to adopt adjusted versions of the rate of return approach, allowing the operator to share in the profits resulting from cost or price reduction, generating a significant increase in demand. Price Cap Regulation The United Kingdom introduced an alternative to rate of return regulation as part of the privatization of the 1970s and 1980s in various sectors, and it is now becoming common worldwide. It increases the cost incentives and reduces the incentive to overinvest. It is based on the control of maximum prices or, in economic jargon, the imposition of price caps. In a nutshell, a price cap allows an operator to increase its prices with inflation, less a "discount" reflecting all or part of the average increase in productivity (a factor X) in the sector. This factor is introduced to ensure that the gains from technological improvements are not simply an increase in the monopoly's profit, but they also benefit the users. In the case of industries with little capital, X can be negative, allowing increases in real prices intended to stimulate new investments or to improve quality of service as imposed by the contract. To present the conceptual elements of what the price cap is al about, equation 2.4 describes the basic principle for a monopolist providing a single product: 32 The Regulation of Transport Infrastructure and Services: A Conceptual Overview (2.4) price in year I 0 I = SR +3 percent if K, < 0 I = SR. SR (specified rate) is the average of the discount rate for public funds (expressed as a percentage). The Bank of England publishes this value weekly for a 12-month pe- riod starting at the beginning of October of year t - 2 through the end of September year t- 1. the field of regulatory reform in the United Kingdom, where approximately 50 firms are under this sort of regulation. This system consists of a pricing structure subject to specified maximum fare increases, expressed in terms of percentages that cannot exceed the difference between the Retail Price Index and a given factor X. This index is preferred to an industry-specific one be- cause the regulated firm cannot manipulate it. After an established period (usu- ally five years), prices and limits are revised. The X factor, which is exogenous to the firm, may vary for each year of the regulatory period. Notably, the number of processed passengers is not the only output at airports. This type of regulatory system (revenue yield) does not consider aircraft that carry cargo and mail. An alternative regulatory application is the tariff basket approach, in which the regulatory mechanism is applied to a weighted average of each component of the fare structure. This approach takes different airport outputs into account by weighting each element of the fare structure based on the revenue it generates. The British CAA, Ofelia Betancor and Roberto Rendeiro 85 however, recommends regulation based on passenger revenue. No evidence yet points to the existence of serious problems in applying this method. Applying a price cap formula may also allow part of the costs to pass directly to users. For instance, at the BAA's London and Manchester air- ports, 95 percent of the additional security costs the Ministry of Transport imposes are permitted to pass through, with a one-year lag period. The regulator may opt to allow a high price to compensate for the risk of losses, or it may reduce the period of regulation as a means of minimizing risk. This last alternative aims to protect airports against unexpected cost changes. Table 3.10 is an example of applying the price cap formula at the Manchester airport for a five-year period. As the table shows, the formula is adjusted to allow 95 percent of security costs to pass through to users. A correction factor based on passenger traffic forecasts also permits the adjustment of forecasting errors that might lead to differences between allowable and actual rev- enues obtained. Box 3.4 explains in detail the calculations and terms used to construct table 3.10. Table 3.10. Application of a Price Cap at Manchester Airport, 1993/94- 1997/98 Variable 1993/94 1994/95 1995/96 1996/97 1997/98 X (percent) 3.0 3.0 3.0 3.0 3.0 RPI (percent) 1.8 2.2 3.9 2.1 3.5 RPI - X -1.2 -0.8 0.9 -0.9 0.5 £ per passenger based on RPI - 3 (M, without including S, and K,) 7.675 7.614 7.683 7.614 7.652 Security costs adjustnents (St in £) n.a. n.a. n.a. 0.172 0.173 Correction factor (Kt in £) n.a. n.a. 0.265 0.379 0.911 Maximum allowable revenue per passenger (M, in £) 7.675 7.614 7.948 8.165 8.736k Revenue obtained per passenger (£) 7.435 7.278 7.136 7.192 7.505, Difference -0.240 -0.336 -0.812 -0.973 -1.231a Revenue losses (million £) 3.1 4.8 12.0 14.2 19.0 n.a. Not applicable. a. Estimated values. Source: Monopolies and Mergers Comnmission (1997). 86 Airports Box 3.4 Details of Applying the Price Cap at Manchester Airport Applying the formulas in box 3.3 permits the generation of the values in table 3.10. Figures were obtained starting with a base year reference value of revenue per pas- senger of £ 7.768. According to the formula, for correction factor K, this only makes sense from year three onward. The period considered goes from 1993/94 to 1997/98. Year 1993/94 Y,, = 7.768 K, = 0 M93,94 = [1 + (1.8 - 3.0)/100] 7.768 = (0.988) (7.768) = 7.675 Year 1994/95 Y,_ = 7.675 K, =0 M./,= [1 + (2.2 - 3.0)/100] 7.675 = 7.614 Year 1995 /96 Y,, =7.614 K, = 0.265 MK/%6 = [1 + (3.9 - 3.0)/100] 7.614 = 7.683 Year 1996/97 Y,_l = 7.683 K,= 0.379 S, =0.172 M%6/97 = [1 + (2.1 - 3.0)/100] 7.683 = 7.614 Year 1997/98 Y,,= 7.614 K, =0.911 S, = 0.173 M97s, = [1 + (3.5 - 3.0)/1001 7.614 = 7.652 Note: M, values do not include S,and K, It corresponds to the fourth row of table 3.10. When limits on prices are imposed, profitability may be increased at the expense of service quality. For instance, an airport may reduce costs by not cleaning the terrninal building regularly or by allowing congestion and de- lays. Hence, when prices are regulated through a price cap, monitoring quality by establishing reasonable standards is always necessary. This was a crucial element when airlines evaluated the quality of service at BAA airports. Car- riers argued that the absence of standards might be an incentive for the BAA to increase profits by reducing the quality of service. A regulator must also consider that airports may try to cross-subsidize aeronautical activities when subject to regulation. With the presence of joint Ofelia Betancor and Roberto Rendeiro 87 costs, they are tempted to allocate a great part of these to the regulated activity, or to charge monopolistic prices for unregulated commercial ser- vices in which price control is more difficult. In this sense, the BAA has argued that cross-subsidization from commercial services was necessary, because as a result of the strict control, regulated aeronautical fares were quite low. The main consequences of this were the diversification of pro- vided services and an emphasis on commercial activities. Another element to take into account is that an efficient fare structure requires great flexibility in its application, due to the changing nature of demand for airport services. According to the BAA, price controls clearly affected the efficiency of its services. The BAA also asserts that severe regu- lation may result in financial difficulties for the airport operator, bringing unforeseeable consequences for profits. Finally, according to the CAA, the main benefit derived from regulation was that it obliged airports to keep costs low. In other words, airports were minimizing costs to reap higher profits. Other important conclusions were (a) the regulator must clearly know what its goals and responsibilities are; and (b) the regulator must have direct access to all the necessary informa- tion, including confidential material, to carry out its work properly. The Problem of Airport Costs As we have pointed out, some aspects of the airport industry are difficult to incorporate into the regulatory structure. Nevertheless, if regulation through an RPI-X formula is to be efficiently applied, these elements must be taken into account. Factors that may cause greater problems when regu- lating airport charges are, among others, congestion, externalities such as noise (see earlier section), investment indivisibilities, and quality of ser- vice (see Forsyth 1997 for more on the problem of airport costs). CONGESTION. The costs of processing an additional passenger or aircraft at an airport that operates below available capacity at any time are close to zero."3 Under these conditions, additional passenger or aircraft charges should be established according to the airport's short-run marginal cost. If demand increases, however, causing a large concentration of traffic during peak hours, the corresponding marginal cost would be much higher than the one appli- cable during off-peak periods. In this case, price discrimination would be 13. This section assumes a price cap directly applied on airport fares. 88 Airports justified because the price charged for peak periods could be much higher than the one applied to off-peak intervals. If the goal of investment is to increase capacity, fares must also incorporate this goal. In summary, an opti- mal fare structure that accounts for congestion problems needs to be flexible. If price controls take the form of price caps, however, rigidities will not per- mit changes in prices over time. In practice, this regulatory mechanism lim- its the use of prices as a tool for managing the problem of congested airports. Two important aspects relate to congestion at airports: (a) determining optimal capacity and (b) determining its efficient allocation. Regarding the former, the existence of a price cap implies that the airport has no incentive to optimize the available capacity because it faces a fixed fare structure for which revenues increase only if traffic flow also increases. This type of price regulation breaks the link between congestion reduction and revenue gen- eration. In other words, the airport does not gain from reducing congestion. A possible solution may be incorporating congestion costs into the price regu- latory formula. Nevertheless, finding an adequate indicator of congestion is not easy, and including a variable for it in the price cap would be even more difficult. A possible way around this is a regulator that establishes the opti- mal level of capacity as the result of a cost-benefit analysis that compares congestion costs to the benefits that arise from a larger available capacity. Once optimal capacity has been determined, it must be efficiently allo- cated. This usually consists of determining a price that equilibrates market supply and demand. Those airports with traffic volumes exceeding capac- ity at certain times should apply different charges at peak and off-peak periods. The high level of traffic during peak periods justifies price dis- crimination. A high enough level may lead to a need for additional capac- ity investments. Yet the above-mentioned conflict still remains. Price cap regulation limits this possibility because its goal is to keep fares low. This is incompatible with peak pricing because peak fare is necessarily higher to allocate capacity more efficiently. A possible way to reconcile the application of a price cap regulatory formula with the efficient allocation of capacity at congested airports con- sists of applying the price cap to average fares or average revenues, as in the BAA case. In addition to the price formula, a mechanism for allocating slots and/or establishing a slot market may be applied. For instance, avail- able capacity as determined by the regulator could be allocated through a public auction, after which resale would be permitted. The main problem with this procedure is determining who obtains the rents from the sales. If the regulator allows the airport to take the money, the airport has an incen- tive to keep capacity scarce and prices high. This experience, however, seems to have worked relatively well at airports in London. Ofelia Betancor and Roberto Rendeiro 89 EXTERNALMES. Noise is one of the most important negative externalities generated at airports. Because aircraft noise affects a large number of people, the internalization and incorporation of its effects into total airport costs is needed. In order to proceed, one must estimate the external marginal costs and then establish a fare structure. The main question, however, is how to jointly consider the external effects and the regulatory framework. In this sense, two main problems exist: first, how to incorporate noise control de- vices, for instance (through a special fare to mitigate excess noise into the regulatory formula); and second, how to reconcile permissible noise levels and airport capacity. In general, three alternatives for regulating noise level are consistent with the RPI-X formula: (a) incorporating a noise index into the formula, (b) charging a special fare paid by the airport or its users, and (c) establish- ing quantitative limits. The first procedure would allow airports to charge higher fares for lower noise levels, in a way that airlines would be penal- ized for succeeding to reduce noise. Hence, airlines would have the incen- tive to collude and operate in the opposite direction. The second entails airports being penalized according to the noise generated by their custom- ers. Given that it is not the airport itself that generates noise, however, but its users, the airport should be in the position to pass on these costs to the users. An altemative is to directly charge air transport carriers. Finally, the establishment of quantitative limits (altemative three) involves restricting certain types of airplanes or banning air traffic operations at certain times of the day. This may be complemented by a charge aimed at reducing noise during peak hours. For example, night restrictions might be complemented by another charge that would limit noise during the day. Such a combina- tion can be found at the Sydney airport, where a noise charge is combined with the application of quantitative limits. Capacity may be increased by choosing different aircraft approach routes, which also leads to increased noise levels. One can study this trade-off through a cost-benefit analysis. The regulator needs information regarding the costs of noise for different routes and to compare it to the benefits arising from the availability of additional capacity. The regulator is then in the position to select the most efficient combination. This is only possible, however, if the regulator controls other airport aspects, including environmental impact. QUALITY OF SERVICE Quality of service is an important aspect that must be controlled when implementing price regulation. An airport that faces a regulated price will try to reduce its costs to obtain a higher profit margin. Hence, the regulator must closely supervise elements related to quality of service. Four mechanisms control quality: First, the regulatory agency can 90 Airports ask the airport to publish certain quality standards. Second, a quality in- dex can be incorporated into the RPI-X formula. A third option consists of compensating users for low-quality services. Finally, a fourth possibility is fixing minimum quality standards. Airports that do not comply are fined or subject to a revision of regulatory conditions. Ad hoc methods are usually applied to control quality. For instance, in the British and Australian telecommunications industries, the regulator col- lects information through quality indexes. Those firms with quality indica- tors below required levels are subject to regulatory pressure. Developing good quality indicators for airports, however, is not easy. Nevertheless, within the context of regulation, taking steps to evaluate quality of service and en- sure that it does not deteriorate is crucial. Fixing minimum quality standards and enforcing compliance may be the most effective means, because this implicates airports in the attainment of quality. As the main users of airports, however, air carriers also play a large role in airport quality, and they fre- quently work jointly with airports to provide services. Concessionaires of airport services such as passenger and luggage handling in many cases are the airlines themselves or other outside companies. Consequently, attaining quality of service standards must be the responsibility of both the airports and their main operators. Another quality-related aspect is the existence of enough airport capac- ity to offer services at an acceptable level of quality. As previously men- tioned, incentive is lacking for investing in new capacity at airports subject to price regulation. Uncertainty about the coverage of additional capacity costs leads to the belief that certain adjustments should be allowed in or- der to charge higher prices when investment takes place. This means, how- ever, that the regulator must use ad hoc solutions that move away from the simplicity of the single application of a price cap. INvEsTmENis. The provision of airport infrastructure is subject to the ex- istence of significant indivisibilities, meaning that capacity can only be augmented by adding large, indivisible units. In this context, an important relationship exists between airport charges and the need to amplify capac- ity, which is an additional problem for the regulatory framework. When an airport disposes of excess capacity, the optimum price is given by the short-run marginal cost. If demand increases, the use of capacity needs to be rationalized through a significant price increase, which can then be equal to the long-run marginal cost. This is the efficient way to proceed when capacity is scarce. In other words, users demanding more capac- ity pay the marginal cost of obtaining it. Nevertheless, once additional Ofelia Betancor and Roberto Rendeiro 91 capacity investments have been carried out, and considering that indivisibilities will again lead to excess capacity, the efficient use of resources will indicate a need to charge lower fares. Hence, an efficient price system usually will lead to low revenue levels. This aspect of capacity is trouble- some for the design of an RPI-X formula, because this regulatory system imposes rigidities that do not allow the necessary fluctuations to charge effi- ciently, nor do they permit the airport to break even. Notably, when privatized airports forecast future investments, they take into account the actual price system upon which regulation is applied. Therefore, such a price system has to be consistent with the coverage of additional investment costs. Establishing a regulatory system that per- mits private airport operators to cover actual costs as well as those gener- ated by future investments is needed. The British experience with regula- tion was such that the regulator was unable to design a regulatory mechanism that allowed investment decisions to rest entirely in the hands of private concessionaires. The regulator had to intervene to evaluate the impact of price regulation on investment plans. In this sense, the regula- tor adopted a managerial role. Design of the Regulatory Mechanism The British experience with regulation indicates that price cap regulation may impose certain risks on the regulated firm, making profits more vola- tile. This implies that regulated prices have to be frequently revised. There- fore, the regulator cannot establish a unique limit that is binding for a sub- stantial period of time, and consequently, the rnain advantage of this regulatory procedure cannot be properly exploited. Apart from congestion and externality problems, complications also relate to the implicit incentive to degrade quality of service to increase profit margins. The lack of incentive to invest in new capacity further complicates regulatory prospects. In the United Kingdom, the regulator has frequently had to intervene to compensate for the effects of the price cap formula. For example, adjust- ments in capital expenditures are often needed, and additional security costs need to be passed on to users. Other adjustments necessitated by in- accurate traffic forecasts that affect factor X are also common. If traffic in- creases are markedly above predicted levels, incrementally increasing in- vestment expenditures may be necessary to avoid congestion problems. This would have clear repercussions on the airport's financial results. In other words, the regulator is often compelled to apply an ad hoc regula- tory price mechanism. 92 Airports An ad hoc regulatory mechanism may be a partial solution to the troubles that arise from purely applying a price cap. In this sense, Forsyth (1997) proposes using a mixed system, designed to combine regulation through the RPI-X formula with the rate of return. Fares are established with refer- ence to the price cap formula and real airport costs. The weights given to each of these elements depend on the importance of different sources of inefficiency. For example, if quality is a serious problem, more emphasis is placed on airport costs. Airports are allowed to recover a great deal of the costs incurred by the provision of better quality of service. This mixed rule opens up the possibility of adjusting airport gains and losses in an ad hoc manner. Furthermore, it softens the crucial aspect of establishing an initial price upon which the regulatory mechanism is applied. Hence, applying a mixed regulatory system in the airport industry may be desirable. This means a more active role for the regulator, however, be- cause it is not possible to simply establish price regulation and leave the airport to make the rest of the decisions. The regulator needs to establish the necessary capacity at congested airports and, perhaps, the creation of a slot market. It should also estimate noise costs, establish charges for their internalization, and try to reconcile allowable noise levels with airport ca- pacity. Finally, as a result of the importance of these quality-related aspects and the presence of these externalities at airports, the regulator has to di- rectly decide on industry investment plans. Quality and Safety Regulation The main reason for regulating quality is market failure. Consumers are imperfectly informed about the quality of products at the time of pur- chase, and they are therefore unable to distinguish a poor-quality pro- vider from a good-quality one. In general, regulation is needed to over- come this informational asymmetry. Nevertheless, the quality outcome may differ with the type of market and the temporal dimension. In com- petitive markets, firms that produce low-quality products and sell them at high-quality prices will acquire a bad reputation and will be excluded from the market (Klein and Leffler 1981). In monopoly situations, the quality of the product is always lower than in a perfect information set- ting. Imperfect information causes quality deterioration (Shapiro 1982). Regulators, however, face similar asymmetric information problems re- garding product quality. As discussed previously, privatized airports are usually subject to a regu- latory pricing mechanism. Quality regulation is less common, despite the likelihood for exploitation of monopoly power in some airport operations. Ofelia Betancor and Roberto Rendeiro 93 For instance, the BAA is subject to price capping,"4 but it does not have to comply with a level of quality specified by the regulator. The BAA itself tracks its quality by periodically conducting quality survey monitoring. Being subject to CAA scrutiny seems a sufficient incentive for high stan- dards of quality without any specific regulatory provision. Nevertheless, the BAA and the airlines agree on the level of service to be provided. The main areas of discussion usually are check-in, security queues, jetty avail- ability, stand availability and cleaning, project development, and depar- ture and baggage transfer. The final service agreement includes performance measures, service standards, and compensation in cases of nonfulfillment. Monitoring Quality: The Case of BAA Self-Regulation To evaluate quality performance at airports, distinguishing between the different recipients of airport services and the different ways of assessing quality is necessary. The main airport customers are the airlines, which in tum depend on paying passengers. For this reason, performance mea- sure standards must distinguish between services directly provided to passengers and those intended for airlines. At the same time, two main approaches assess quality. The first is subjective, based on quality sur- veys that capture the quality perceptions of passengers and airlines. By contrast, more objective approaches measure performance in relation to standards (see table 3.11). PASSENGER SERVICES. As mentioned above, the BAA controls the quality of passenger services through quality survey monitoring (the subjective approach). It measures passengers' perceptions of services in departures, Table 3.11. Elementsfor Quality Assessment at Airports Recipients of airport services Passengers Airlines Others Alternatives for quality Subjective approach: Quality survey monitoring assessment Objective approach: Establishment of standards and measurement of performance Source: Authors. 14. Price caps might induce quality cost cutting, as operators choose to reduce quality, and hence costs, rather than increase efficiency. 94 Airports arrivals, and retail areas. It interviews more than 250,000 passengers each year. The interview takes 8 to 12 minutes, and passengers assess services on a five-point scale from "extremely poor" (1) to "excellent" (5). At Heathrow, Gatwick, and Stansted, the BAA has collected information over a six-year period on customers' perceptions of 12 basic aspects of depar- ture services and 7 basic aspects of arrival services. It interviews departing passengers as they enter the gateroom, arriving passengers as they exit the terminal. In a similar way, it also collects perceptions about various aspects of service and value for money at retail outlets, car parks, and restaurants. Tables 3.12 and 3.13 present results for those areas that are common to all three BAA airports. Each table shows the constituent factors for each airport, ranked according to the quality survey monitoring. Results show that, on average, passengers perceive most areas to be at least "average." Many areas are ranked between "good" and "excellent," and no areas are assessed as "extremely poor." Overall, Stansted scores consistently well, and Gatwick scores slightly better than Heathrow, although Heathrow has shown more improvement than Gatwick since 1991. In addition to record- ing subjective measures about passengers' perceptions, the BAA also has established various performance standards. Table 3.14 presents an example of check-in queue targets. Services provided to passengers are sometimes perceived as inadequate. Airports often devise a mechanism to treat com- plaints. The sensitivity of airport authorities to complaints, however, de- pends on their monopoly power and regulatory provisions.'5 Passenger complaints and suggestions may arrive in a variety of forms: comment cards, letters, phone calls, e-mails, or in-person visits. Their processing and treatment may be subject to regulation. Usually, a customer service depart- ment handles complaints, but the regulator may be the ultimate arbitrator. Additionally, targets may be fixed for prompt responses. AIRUNE SERVICES. To completely assess quality, one must also take into account services directly provided to airlines. Although the BAA is not subject to quality standards, some airlines have requested the MMC to es- tablish standards regarding the availability of key operational equipment such as baggage belts, jetties, stands, moving walkways, and lifts. Despite a lack of quality regulation, the BAA makes direct measurements of its service delivery by recording objective data on the availability of criti- cal equipment. Table 3.15 shows 24-hour availability data for passenger- sensitive equipment from April 1995 to March 1996. Other performance 15. Monopoly power here refers to the existence of competing airports. Ofelia Betancor and Roberto Rendeiro 95 Table 3.12. Quality Survey Monitoring Scores: Departure and Arrival areas at Selected BAA Airports, 1995/96 Items studied Heathrow Gatwick Stansted Departures Security queue 4.1 4.2 4.4 Telephones 4.0 4.0 4.1 Check-in queue 4.0 4.0 4.3 Departure lounge cleanliness 4.0 4.1 4.5 Flight information 3.9 4.0 4.0 Toilets 3.9 4.0 4.4 Trolleys 3.9 3.9 4.2 Airside seating 3.7 3.9 4.2 Announcements 3.7 3.7 4.0 Check-in crowding 3.6 3.8 4.1 Landside seating 3.5 3.8 4.1 Departure lounge crowding 3.5 3.8 4.3 Average 3.82 3.93 4.22 Arrivals Immigration queue 4.2 4.3 4.5 Disembarkation 4.0 4.0 4.1 Trolleys 3.9 3.8 4.2 Telephones 3.9 4.0 4.2 Baggage claim queue 3.8 3.9 4.0 Toilets 3.8 3.9 4.4 Concourse crowding 3.5 3.8 4.3 Average 3.87 3.96 4.24 Note: A score of 1 is "extremely poor," 2 is "poor," 3 is "average," 4 is "good," and 5 is "excellent." Source: Monopolies and Mergers Cormrission (1996). indicators the BAA developed are the number of faults per unit (a measure of the effectiveness of preventive maintenance) and the time to site and time to repair (measures of reactive maintenance). The set target is repairing 95 percent of faults within four hours. Table 3.16 shows average fault repair times for passenger-sensitive equipment. Other aspects considered are the percentage of passengers boarding or disembarking via jetty, coach, or steps (table 3.17); planned and unplanned stand outage (in hours per month); and maximum delivery times for baggage (table 3.18). A regulator that is concerned about the exploitation of monopoly power must also consider a mechanism for registering ailine complaints in the 96 Airports Table 3.13. Quality Survey Monitoring Scores: Retail Valuefor Money at Selected BAA Airports, 1995/96 Items studied Heathrow Gatwick Stansted Duty-free shopping 3.8 4.1 4.1 Tax-free shopping 3.7 3.8 3.8 Other shopping 3.6 3.7 3.7 Catering 3.4 3.5 3.5 Bureau of change 3.3 3.5 3.4 Long-term parking 3.3 3.6 3.4 Short-term parking 2.7 3.1 3.5 Average 3.4 3.6 3.6 Note: A score of 1 is "extremely poor," 2 is "poor," 3 is "average," 4 is "good," and 5 is "excellent." Source: Monopolies and Mergers Commission (1996). Table 3.14. BAA Check-In Queue Targets Length (persons queuing) Gatwick Maximum wait time (minutes) Scheduled Heathrow Gatwick Stansted Short-haul Long-haul Charter 20 20 15 10 18 18 Source: MMC (1996). event that the airlines are disappointed with airport services. For instance, in the case of the BAA, the CAA is responsible for addressing the com- plaints of airlines and other agents such as tour operators and concession- aires. Other airports that might feel damaged by anticompetitive practices may also refer to these authorities or to the MMC. Many of the most crucial aspects of airport operations are not always the direct responsibility of the airport authority. The punctuality of aircraft landings and takeoffs is also determined by visual and approach air traffic services. To keep up with published timetables, the airport authority and the air traffic control must closely coordinate, particularly when they be- long to different organizational bodies. All the above-mentioned variables represent possible regulatory qual- ity targets (even in terms of scores or standards). Standards may be appli- cable when full divestiture has been applied or when a concession contract Ofelia Betancor and Roberto Rendeiro 97 Table 3.15. Percentage Availability of Critical Equipment at Selected BAA Airports, April 1995 to March 1996 Departure baggage Passenger Loading Passenger Airports systems lifts bridges conveyors Escalators Heathrow Terminal 1 97.8 99.2 99.0 99.1 98.9 Terminal 2 98.8 99.5 99.3 - 99.3 Terminal 3 98.4 99.4 98.7 98.5 99.3 Terminal 4 98.6 99.5 99.4 99.7 99.8 Gatwick North Terminal 98.1 99.4 98.5 99.2 99.5 South Terminal 97.5 99.2 97.9 98.8 99.2 Stansted 99.4 99.4 99.5 - 99.9 - Not available. Source: Monopolies and Mergers ComLission (1996). Table 3.16. Average Fault Repair Timesfor Critical Equipment at Selected BAA Airports, April 1995 to March 1996 (hours) Departure baggage Passenger Loading Passenger Airports systems lifts bridges conveyors Escalators Heathrow Terminal 1 1.52 3.18 2.31 1.92 1.79 Terminal 2 0.14 2.35 1.31 - 3.24 Terminal 3 0.55 4.53 4.24 4A5 1.82 Terminal 4 0.63 3.75 0.83 0.68 1.09 Gatwick North Terminal 0.92 2.04 1.25 1.49 1.29 South Terminal 1.60 1.97 6.27 1.57 1.81 Stansted 0.12 1.64 0.46 - 0.31 - Not available. Source: Monopolies and Mergers Commission (1996). 98 Airports Table 3.17. Average Levels of Pier Service at Selected BAA Airports, 1995/96 Percentage of passengers boarding/disembarking via: Arrivall Airports departure Jetty Coach Steps Heathrow Terminal 1 Domestic a Arrival 87 9 4 Departure 89 7 4 Terminal 1 International Arrival 79 17 4 Departure 81 15 4 Terminal 2 Arrival 95 2 3 Departure 94 2 4 Terminal 3 Arrival 89 7 4 Departure 90 4 6 Terminal 4 Arrival 94 3 3 Departure 93 4 3 Gatwick North Terminal Arrival 83 13 4 Departure 75 21 4 South Terminal Arrival 83 3 14 Departure 83 3 14 a. Including Channel Islands and Ireland. Source: Monopolies and Mergers Commission (1996). Table 3.18. Standards for Maximum Baggage Delivery Times at Selected BAA Airports (minutes) Airports First bag Last bag Heathrow Terminal 1 16-20 30-34 Terminal 2 21 25 Terminal 3 24-28 49-53 Terminal 4 11-20 22-41 Gatwick North Terminal 20 35 South Terminal 20 35 Stansted 15 33 Source: Monopolies and Mergers Comnmission (1996). Ofelia Betancor and Roberto Rendeiro 99 is intended. The regulator should study the convenience of intervening to fix quality levels. A scrutiny mechanism and agreements with air transport carriers about prices and corresponding quality levels may be adequate to ensure high standards of quality. Safety and Externalities Airport safety plays an important role in determining quality. Its objective is to ensure that passengers have a normal wait and flight, with a minimal possibility of a terrorist or criminal attack. These safety standards and pro- cedures impose costs on airlines and passengers. Table 3.19 shows differ- ent components of the airport security system. Security queues are considered an important determinant of airport quality. The BAA reports that among Heathrow, Gatwick, and Stansted airports, 95 percent of passengers waited fewer than 10 minutes and 90 percent waited fewer than 5. Airlines suggest that a maximum waiting period of 5 minutes for a security search at London airports is desirable. In economic jargon, externalities are considered a market failure, hence intervention is regarded as necessary wherever they appear. The main nega- tive externalities at airports are noise, congestion, and pollution, as dis- cussed earlier. Traditionally, airport operators and the corresponding regu- lators have left externalities aside. It is only recently that have they started worrying about their environmental impact. Today, it is common for air- ports to ban night operation or to restrict it to less noisy aircraft. Charging noisier planes higher fares is another technique to reduce the social cost of noise. Peak pricing is also spreading as a practice for relieving congestion. Air pollution has not gotten much importance. Increasing sensitivity about environmental concerns has led to special treatment for externalities in most infrastructure project contracts. Usually, an environmental impact study is required as a prerequisite for airport infra- structure construction. This study should also consider monitoring possible negative impacts during the operation phase. In general, the environmental impact study will reflect environmental law. Investment Obligations As shown earlier, the possibilities are numerous for private sector partici- pation in airports. If this involvement does not fulfill its long-term objec- tives to maintain the facilities and invest in the future, however, airports 100 Airports Table 3.19. Components of the Airport Security System Security component Functions Predeparture gate screening Screening passengers, body search, screening airport and airline personnel, X-ray inspection of carry-on luggage. Parked aircraft control Screening airport and airline personnel, alarm systems for parked aircraft, aircraft security survey. Aircraft movement Screening airport and airline personnel, alarm systems for parked aircraft, aircraft security survey. Crew screening Background checks, training, predeparture screening. Ramp security Surveillance of jetway access, ramp doors, alarm systems, fire sensors and protection, screening personnel. Perimeter security Fencing, posts, gates and other openings, light placement and protection. Terminal security Surveillance of jetway access, ramp doors, alarm systems, fire sensors and protection, screening personnel. Passenger screening Visual, body searching, X-ray inspection, location. Passenger flow control Flow holding, camera surveillance, predeparture screening. Baggage and cargo screening X-ray inspection, carry-on luggage screening, luggage surveillance from drop-off to loading, personnel screening. Intelligence and Telephone and radio communications, communications emergency power, bomb threat contingency plans, evacuation plans. Source: Flemning and Ghobrial (1993). could deteriorate or become obsolete. Fortunately, this has not been the case in airport infrastructure concession contracts. On the contrary, investment plans are usually an essential part of the contract. For instance, a recently prepared concession contract for the op- eration of Argentine airports required the operator to present a detailed investment plan. The concessionaire is obliged to invest a minimum of more than US$2 billion in addition to other planned investments (includ- ing a new airport for Buenos Aires). Such a plan must clearly specify in Ofelia Betancor and Roberto Rendeiro 101 physical and monetary terms the works that will be carried out during the concession period. BAA investment plans are also subject to CAA scrutiny. The BAA peri- odically presents projected investments, which are expected to be broadly in line with reality. Additionally, the BAA is required to consult airlines on future development plans. Performance Indicators The privatization of a firm leads to an increase in productive efficiency, because in the absence of regulation, the firm pursues profit maximiza- tion. If the firm also exerts monopoly power, however, it is possible that allocative efficiency is reduced as well. In this case, regulation could be a means for limiting market power, although it may also affect economic efficiency. Its impact would depend on the implemented regulatory sys- tem. In the airport industry, most regulation takes the form of price inter- vention. If charges are established independent of profits, productive ef- ficiency is feasible, although prices are usually fixed in such a way that firm profits are under control. Price controls permit an improvement in allocative efficiency by reducing monopoly power. They can also reduce productive efficiency, however (Forsyth 1997). Hence, regulation may affect the economic efficiency of the airport industry, making it necessary to develop performance indicators that monitor airport activities liable to be affected by regulation. Evaluating airport efficiency is not a trouble-free task. The geo- graphic, economic, political, and social features of the airport's region complicate any assessment of industry efficiency. Doganis (1992) points out that evaluations tend to be based on profit margin analysis. Obvi- ously, this criterion is inadequate because it does not incorporate any information about the resources that go into obtaining such a margin. Therefore, establishing indicators is essential both to assess the effec- tiveness of resource utilization and to serve as control tools for airport managers seeking to identify problematic areas that require prompt corrective measures. Indicators are also a great help for governments concerned with regulation. For example, they could be used to ensure that national resources are being used in the most efficient way, that airports are not exerting their monopoly power, and that they are pro- viding the required services at reasonable prices. Given the trend toward airport privatization, government responsi- bility should be directed at the creation of a regulatory policy that chan- nels private sector performance to match public interests. In this sense, 102 Airports using indicators may contribute to evaluating this accomplishment. In the British case (BAA), privatization brought clear management efficiency improvements, mainly at airports in London. Nevertheless, the MMC may carry out controls at these airports to determine if their monopoly power is being exerted against public interests. The main criticisms relate to the following three areas: (a) service quality, (b) fare levels and structure, and (c) investment levels and quality. The commission also controls other el- ements that are not subject to regulation, such as rents, licenses, and com- mercial concessions. This was of great importance due to the tough regu- lation applied on BAA airports, which resulted in aeronautical charges that were below associated costs and a need to cross-subsidize these ser- vices with revenues arising from commercial activities. As a consequence, users had to pay monopoly prices in commercial areas to complement the aeronautical-side deficit, and thus subsidize air transport carriers. According to the literature on airport industry management, financial and economic indicators are usually the most utilized (Ashford and Moore 1992; Doganis 1992). Given that one of the main objectives of a private firm is cost minimization, a useful measure of efficiency must cover financial aspects. Economic objectives such as input productivity are also important to any industry. Therefore, a menu of economic indicators is also neces- sary. Nevertheless, as indicated above, these indicators should be comple- mented by other measures that allow the evaluation of airport services and activities that may cause problems for users. Elements such as quality of service and negative airport externalities should be considered as well. For instance, waiting times and congestion in the terminal building are of primary importance to users' perceptions of quality of service. Elements That Determine Indicator Design Before proposing a set of indicators, we should note that some aspects directly affect their utilization. First, airports develop similar activities for different objectives. In addition, these objectives may conflict with one another. For example, an increase in airport runway capacity through the establishment of additional approach routes also raises the level of noise. Furthermore, each airport has a different social, economic, and political environment. For this reason, proposing a set of indicators with- out taking the special features of each airport into account is a risky task. Indicators ought to adapt to the social, economic, and political character- istics of each airport. Disparities among airports need to be considered when fixing reference standards. Of elia Betancor and Roberto Rendeiro 103 Second, the information used in calculating the indicators must comply with certain requirements, such as easy access, clarity, and accuracy, so that nonspecialists can understand them. This should cover most aspects of airports (ICAO 1991). Such an evaluation and control process should be carried out as an integral part of the airport planning program, not as an assessment of the private manager's responsibilities. A conflict due to in- formation asymmetry exists, however, because the private operator has an incentive to hide relevant information from the regulator. This situation might be softened by reasonable service standards and periodic controls that allow continuous supervision. A troublesome element in the evaluation of airport performance and productivity is defining the output used. An airport output is not homog- enous. It can be defined in terms of the number of planes, passengers, and cargo volumes. Each of these output measures, however, only relates to a part of the infrastructure. Runways relate to the number of landed aircraft, and terminal building size depends upon the number of passengers and cargo processed. Therefore, no single measure can entirely explain airport costs and revenues. Doganis (1992) argues that the choice of output must be in accordance with its economic importance in terms of revenues and cost generation. In this sense, for most airports around the world, the greatest proportion occurs in activities developed in the terminal building, such as passen- gers and cargo handling. Therefore, an output measure that combines both variables would cover the largest proportion of airport revenues and costs. Passengers and cargo volumes are an indirect measure of the total number of processed aircraft. Actually, one frequently uses the vari- able work-load units (WLU) as an adequate measure of airport output. A WLU corresponds either to a passenger (80 kilograms average weight plus 20 kilograms of luggage) or to 100 kilograms of cargo. Notably, though, one passenger and one unit of cargo do not require the same use of physical and financial resources, nor do they generate the same revenue. By contrast, some indicators demand a given output measure. For example, when assessing revenues that arise from commercial ac- tivities, using traffic units in the denominator does not make sense. Obtaining output measures is relatively easy; consequently, obtaining the necessary data required by the indicators should not be any problem. Input measures, however, cause more serious problems. The most impor- tant inputs at airports are labor and capital. The easiest measure of the former is the number of workers. This is not homogenous, however, be- cause it includes both part-time and full-time personnel, whether skilled 104 Airports (technicians and managers) or unskilled. Because different types of work- ers carry out different tasks at airports, developing a more comprehensive and accurate measure for determining the labor input is necessary. A solu- tion may be to consider the financial value of the input (Doganis 1992). Nevertheless, this measure also presents considerable problems because it reflects not only the quantity of the input applied, but also the relative wage differentials among airports. This further complicates the use of in- dicators that serve as standard references. Consequently, using the num- ber of workers as a measure of labor input is advisable. The number of workers, however, must be properly classified in order to evaluate a par- ticular area. For example, only those workers directly involved in aeronau- tical activities should be used in the denominator when calculating rev- enue per unit of labor input. Regarding the capital factor, the situation is even more complicated. This is essentially due to the diverse nature of capital inputs. For instance, the differences between small capital resources with short economic lives and large, long-term investments (runways and buildings) make posterior input allocation very difficult to measure. The ICAO recommends using asset values to measure capital. The existence of diverse accounting meth- ods, however, means one must be careful. For example, if capital goods investments are financed by government funds, depreciation is likely not entered into the account. This procedure is common at airports that have traditionally operated as public firms. Determining asset value at these airports is misleading because of the variation in accounting practices. Nevertheless, no alternative exists to trusting financial measurements of capital. For a more reliable evaluation of inputs, the whole industry needs to adopt a common accounting system. Infrastructure Performance Indicators This work presents performance indicators commonly used in the air- port industry. In some cases, however, it might be necessary to make a selection or an ad hoc design according to the special airport features and services that need to be assessed. Although the proposed list is not ex- haustive, it covers those aspects or areas that might be problematic for regulators and managers. Particular areas are more likely to infringe upon public interest. For example, at airports subject to price regulation, prob- lems arise regarding incentives to invest in new capacity and with the quality of service. This is the result of strong operator tendencies toward reducing costs at the expense of service quality. Therefore, having a set of Ofelia Betancor and Roberto Rendeiro 105 financial and economic indicators available that helps analyze airport performance is important. These could include cost coverage, profitabil- ity, asset investments, and the use of available resources. Table 3.20 presents a set of financial indicators. The first group, the stra- tegic indicators, is needed to evaluate the medium-and long-term effects of policies, such as return on capital investments. Second, otherfinancial indi- cators include measures such as cash flow, and they accurately evaluate the day-to-day financial situation of the airport. Table 3.21 shows economic efficiency indicators. These are classified into six distinct categories: overall cost performance, labor productivity, productivity of capital employed, revenue-generating performance, per- formance of commercial activities, and overall profitability. To assess the economic efficiency of an airport through time, or to check whether regu- lated standards are being met, specific indicators are required. For ex- ample, we may need to explore labor and capital productivity to deter- mine the most efficient use of resources. Alternatively, to gauge the performance of commercial areas, having specific revenue indicators is necessary (Doganis 1992). Revenues from leasing, licenses, and concessions derive from activi- ties that are not subject to regulation. These activities, however, must also be evaluated. For example, if rents paid by commercial area tenants are excessive in comparison to other rents in the market, imposing controls may be necessary. Aeronautical charges are determined by the single till approach, in which airport costs and revenues are viewed by taking all Table 3.20. Financial Performance Indicators Type Examples Strategic indicators Return on capital investment Payback period Current assets/liabilities Self-financing ratio Ratio of debtors to creditors Other financial indicators Cash flows Revenue flows Expenditure flows Actual and budgeted revenues and expenditures Outstanding debtors and location of debt Source: Lemaitre (1997). 106 Airports Table 3.21. Economic and Productivity Indicators Type Examples Overall cost performance indicators Total costs per WLU (after depreciation and interest) Operating costs per WLU (excluding depreciation and interest) Capital costs per WLU Labor costs per WLU Labor costs as percentage of total costs Capital costs as percentage of total costs Aeronautical costs per WLU Capital costs to value added ratio Labor costs per employee Labor productivity indicators WLU per employee Total revenue per employee Value added per employee Value added per unit of staff plus capital costs Value added per unit of staff costs Productivity of capital employed Value added per unit of capital costs WLU per £1,000 net asset value Total revenue per £1,000 net asset value Revenue generation performance Total revenue per WLU Adjusted revenue per WLU Aeronautical (or nonaeronautical) revenue as a percentage of total revenue Aeronautical revenue per WLU Nonaeronautical revenue per WLU Performance of commercial activities Concession plus rental income per passenger Concession revenue per passenger Rent or lease income per passenger Concession revenue per m2 Rent or lease income per m2 Airport concession revenue as percentage of concessionaires' turnover Profitability measures Surplus or deficit per WLU Revenue to expenditure ratio Source: Doganis (1992). Ofelia Betancor and Roberto Rendeiro 107 services into account. Aeronautical charges are fixed to permit a given profitability level that, in turn, depends on previous cost and revenue estimations. Once the regulatory pricing formula is in place, the private operator could increase rents above those charged in commercial areas, therefore acting against the public interest. As already mentioned, if airports are subject to price regulation, they may also be tempted to reduce service quality in order to reduce their costs. Therefore, investigating users' perceptions about the services pro- vided at airports is crucial. Before carrying out a quality assessment, defining a standard level of service that is both feasible and reasonable is necessary. These standards allow the airport regulator, under the threat of penalty, to demand the attainment of a certain level of service. In the British case, air carriers have argued the need to reach an agree- ment regarding the standard level of services, as well as for provisions that entitle them to compensation in the event of nonfulfillment. They maintain that any deviation from standards affects their service quality and that with- out compensation, this mechanism is not effective. The BAA, however, ar- gues that airport services are jointly provided by airport operators and air- lines and, therefore, the level of service does not depend entirely upon its performance, but also upon air carriers and handling staff. Carriers, in turn, argue that penalties must be applicable only to the BAA, because airlines operate in a competitive environment that gives them strong incentives to maintain and improve their quality. Either way, a key aspect of this compen- satory mechanism is identifying who is responsible for not achieving the standards. Reaching an agreement regarding quality standards is essential to guarantee a certain level of service within the context of regulation. The procedures are complex for evaluating the factors that determine the service levels in terminal buildings. This leads to the use of variables such as time of service and level of congestion as proxies for the quality of services provided. Table 3.22 shows a set of quality indicators for most of the conflictive aspects of airport activities. A study carried out at the Birmingham airport (see Mumayiz and Ashford 1986) established that users' perceptions of time of service depended on the type of market. For European flights, a check-in waiting time of 7.5 minutes or less was considered satisfactory, and a time equal to or greater than 14 minutes was perceived to be intolerable. For charter ffights, these limits were 11 and 21 minutes, respectively. According to the same study, a general wait- ing time of not more than 12 minutes indicates a satisfactory level of service. A trade-off can be found, however, between the level of service offered and its costs. The higher the level of service, the higher the amount of resources required. If we could identify all or some costs associated with the time wasted 108 Airports Table 3.22. Quality of Service Indicators Type Examples Delays Time of service: check-in time, luggage delivery time, and so forth Waiting time Waiting time variability Service reliability Baggage service reliability Number of luggage incidents Number of passengers delayed at departures Required time before departure Connecting time Costs Costs for passengers of food and drink Departure fee Connecting fee Other services fees Comfort and entertainment Crowding at the terminal: number of square meters per occupant Clarity and level of noise Temperature and humidity levels Choice of leisure activities Sociability Cleanliness Air pollution Source: Adapted from Lemaitre (1997). by passengers in queues, and the economic resources wasted as a consequence of this wait, assessing the losses arising from the level of service provided would be possible. In summary, establishing an inadequate level of service could negatively influence users and even airports. An example is the check- in service: the more time passengers spend in front of check-in counters, the less time available for shopping in the commercial areas. Using indicators as tools for assessing a given activity is ineffective if no reference standards delineate acceptable performance margins. Once taking the particular features of each airport into consideration, however, these de- sirable or best practice reference standards should only be regarded as pro- visional guides. No unique optimum level exists for a given indicator. The appropriate and optimal reference level depends on the circumstances of each airport. Furthermore, conflicts could be possible among the different Ofelia Betancor and Roberto Rendeiro 109 objectives pursued. For example, an improvement in the level of quality may require a substantial increase in costs, which would eventually be translated into higher fares. With these arguments considered, reconciling the estab- lishment and implementation of indicator reference standards is important. Table 3.23 gives some examples of indicators and their associated standards. Doganis and Graham (1995) have carried out evaluations of the economic and commercial aspects of 25 European airports through the application of a set of performance indicators.16 The authors emphasize the comparison prob- lems due to differences in the activities developed at each airport in the study, which they tried to lessen through corrections that consider the whole group as operators of the same activities.17 The sample indudes airports with dif- ferent ownership structures and of varying sizes: private airports such as Glasgow, partially privatized ones such as Copenhagen, publicly owned but commercially oriented airports such as Geneva, and airports like Stockholm, which is part of the Swedish Civil Aviation Authority. The main objective of this study was to analyze the trends and development of industry perfor- mance and identify the relationship between profitability and type of air- port. Table 3.24 summarizes the results. Finally, note that the use of indicators is complicated because of differ- ences in the types of services developed at airports, in the degree of public intervention, in accounting systems, in financial sources, in subsidies, and in standards. All of these elements, combined with the geographic, economic, Table 3.23. Examples of Reference Standard Levels Type Indicator (example) Best practice Financial Return on capital investment >1.0 Labor productivity Passengers per employee 2,000 to 5,000 Service quality Number of square meters per 25-35 (international); occupant at peak hours 16-20 (national) Source: Authors. 16. Airports included in the study were Amsterdam, Barcelona, Basel, Mulhouse, Bilbao, Birmingham, Cardiff, Copenhagen, Dublin, Dusseldorf, East Midlands, Frankfurt, Gatwick, Geneva, Glasgow, Heathrow, Lisbon, Madrid, Manchester, Milan, Newcastle, Nice, Oslo, Stockholm, Vienna, and Vigo. 17. Adjustments that the study carried out indicate that results must be care- fully analyzed. Comparability problems are still present, and consequently, one should consider each airport in its own context. 110 Airports Table 3.24. European Airports: Best and Worst Practice Values Value Best Value Indicators Worst practice (US$) practice (US$) Cost indicators Total costs per WLU Basel-Mulhouse 14.3 Oslo 2.94 Operating cost per WLU Vienna 10.58 Oslo 1.94 Capital costs per WLU Basel-Mulhouse 6.51 Oslo 0.99 Labor costs per WLU Vigo 7.07 Oslo 0.73 Productivity indicators WLU per employee Vigo 4,367 Oslo 48,808 Total revenue per employee Vigo 17,930 Oslo 389,053 Value added per employee Vigo 9,280 Oslo 329,997 Value added per unit of staff costs Vigo 0.30 Oslo 9.23 Revenues indicators Total revenues per WLU Vigo 4.11 Vienna 19 Aeronautical revenues per WLU Vigo 2.38 Vienna 9.9 Nonaeronautical revenues per WLU Lisbon 1.67 Vienna 9.1 Rent and lease income per passenger Vigo 1.55 Gatwick 8.8 Concession revenue per passenger Vigo 1.12 Gatwick 7.65 Financial indicators Revenue to expenditure ratio Vigo 31 Oslo 272 Source: Doganis and Graham (1995). social, and political characteristics of the airport region, hinder the assess- ment of airport performance. Conclusions Public utilities infrastructures have been traditionally regarded as natural monopolies. Public ownership was unquestionably the management style in terms of fares charged and quality provided. The underlying assumption was that both variables were set so as to maximize social welfare. Airport infrastructures provide an example of what improvements can be made when Ofelia Betancor and Roberto Rendeiro 111 the economic system no longer can bear the burden of inefficiency. Taking into account the variety of activities carried out at an airport, the range of possibilities for private sector involvement may be as wide as the range of airport activities themselves. Nevertheless, no best practice model has emerged, and each country implementing airport privatization measures has selected the scheme that most adequately suits its needs. The alternative of concessions (in any of its variants), however, appears to be the emerging model. It allows the government to retain the property and facilities at the end of the concession period, and furthermore, it provides a financial wind- fall for governments with restricted budgets. Still, airport privatization pro- cesses are not cost-free. If public monopolies are being turned into private monopolies, a regulatory cost will be charged. Either discretionary or con- tractual, regulations will mainly affect airport charges, quality of service, investment obligations, externalities, and safety control. 4 Seaports Lourdes Trujillo and Gustavo Nombela The relevance of seaports to the efficient working of an economy cannot be understated, because all goods and passengers transported by sea require the use of ports' facilities. In most countries, maritime transport basically handles the export and import trade and, in some cases, also a large share of domestic trade. For long-haul shipments, with the exception of high- value and small-volume cargo, for which air transport offers the advan- tage of speed, there is no alternative mode of transport to ships. The United Nations Conference on Trade and Development defines the role of a modem seaport as follows: Seaports are interfaces between several modes of transport, and thus they are centers for combined transport. Furthermore, they are multi-functional markets and industrial areas where goods are not only in transit, but they are also sorted, manufactured, and distributed. As a matter of fact, seaports are multi-dimensional systems, which must be integrated within logistic chains to fulfill properly their functions. An efficient seaport requires, besides in- frastructure, superstructure and equipment, adequate connections to other transport modes, a motivated management, and sufficiently qualified employees. This definition stresses one of the main characteristics of seaports: a seaport is not merely an organization that provides a single service, but multiple activities. Studying all those tasks in detail is therefore interesting to evaluate the most efficient provision of these activities from an economic 113 114 Seaports point of view. Moreover, because all port activities take place in a limited area, studying how they are coordinated is also relevant, as is the role that port authorities-or any other responsible institutions-must play in regu- lating seaports' infrastructure and activities. In recent decades we have witnessed profound changes in maritime transport that have modified the balance between capital and labor at sea- ports. Ports are now increasingly becoming capital-intensive industries, while in the past they used to be labor-intensive. This change has gener- ated an excess of employees in most ports worldwide. The development of containerized transport is another factor that has significantly modified ports' operations. Containers have achieved significant cost reductions in cargo handling, but they have also imposed new needs on ports in terms of equipment (gantry cranes, improved pavements, and so on). However, the transport of large quantities of containers and bulk cargo has yielded econo- mies of scale, which have led to the building of increasingly larger special- ized ships that require new infrastructures and equipment. All these technical changes have generated a highly competitive envi- romnent in the seaport industry, especially between large ports with facili- ties for serving regular deep-sea traffic from liners. Modem ports no longer have a monopoly over the transport of goods to neighboring regions (hin- terlands). The development of integrated transport chains has reduced transport costs to such an extent that it is now often preferable for a ship- per to use a distant port instead of a closer one, provided that the former has better facilities and connections than the latter. Therefore, modem ports must be extremely competitive to be able to offer optimal combinations of time and price for firms demanding their services. Technological changes and the competitive environment have induced a reconsideration of the role that the public sector must play in the running of seaports. In most countries, public institutions have traditionally owned and managed ports. Public ownership in the industry was justified by the argument that seaports play a key role in national economies, and they exhibit characteristics that can easily provide firms with market power (such as specialized assets, sunk costs, indivisibilities, and economies of scale). Even though the public sector has usually been present as port orga- nizer, however, it is not evident that public organization of this industry is necessarily the best option. In particular, tighter public budgets and increasing fiscal needs have led many countries to seek private participa- tion in seaports. Private involvement in ports is not new for the provi- sion of services, because many firms were already present in ports around the world, but it is innovative in the construction of port infrastructure. Lourdes Trujillo and Gustavo Nombela 115 International experiences have shown that private participation in both these aspects (operations and infrastructure) has significantly improved the outcomes of some seaports. These experiences make a case for a revision of the traditional organization of seaports worldwide, changes that will prepare ports for a more competitive market and less financial help from governments This chapter offers a revision of characteristics of all different services that seaports provide, and it describes the approaches used worldwide to introduce private participation into the port industry. The challenge that modem ports now face is to design more adequate regulatory mechanisms to guarantee efficient outcomes in a context of tight public budgets, par- ticularly in developing countries. No universal answers apply to every port; therefore, this chapter provides a panoramic view of the feasible models a port can follow, and the best practices observed worldwide. Characteristics of Seaports' Services: The Multiproduct Nature of the Activity In broad terms, a seaport can be considered a single organizational unit that provides a service to ships. When its internal workings are analyzed in detail, however, multiple services clearly are being produced and de- manded within a port area (services to ships, to cargo, and to passengers). Even for such a service as cargo handling, technologies can vary enormously depending on the type of cargo, up to the point that, for example, con- tainer loading can be regarded as a different service from bulk cargo han- dling. Therefore, instead of a single unit, a seaport is better characterized in economic terms as a multiproduct organization. Two basic characteristics define the organization of seaports' activi- ties. The first is that the infrastructure in which these activities are per- formed-berths, quays, storage areas, and so forth-is expensive to build (see table 4.1) and it exhibits the problem of indivisibility: enlarging a port in a continuous way is not possible. Port infrastructures must be built with determined minimum dimensions, and in general, their full design is strongly conditioned by the physical characteristics of the coast where the port is located. The second characteristic is that because of high construction costs and physical conditions, the areas available for performing seaport activities are generally limited. This space limitation implies that the number of op- erators that can provide services within a port area is, by definition, re- duced. In particular, depending on the port's total size, some small ports 116 Seaports Table 4,1. Typical Civil Works Unit Costsfor Port Infrastructure Type Cost Dredging (confined space restricted by existent berth requirements) $7.5/cu.m Quayside (35m-wide berth) $54,000/m Container yard paving and infrastructure $63.8/sq.m Open storage yard $55/sq.m Sheds $375/sq.m Note: 1997 data, for a 14-meter draft, 500- to 600-m-long berth. Source: Drewry Shipping Consultants (1998). only have enough room for a single firm to provide services. Market size and physical restrictions are two factors that often preclude the possibility of competition at some ports. Because many aspects are involved, dividing seaport activities among three groups is useful: (a) infrastructure; (b) services provided by the port, which require the use of the former; and (c) coordination among different activities performed at ports. The main characteristics of these three ele- ments are analyzed below. Seaport Infrastructures The European Union uses an interesting definition of what is considered port infrastructure (European Parliament 1993). The port area is defined as a complex of berths, docks, and adjacent land where ships and cargo are served. To reach that area, infrastructures related to both maritime access (channels, locks, aids to navigation, and so forth) and land access (connec- tions to roads, rail network, and inland navigation) are required. Figure 4.1 shows a scheme of the different types of required infrastructures at a port. Therefore, the area where seaport activities take place encompasses both the infrastructure within the port (berths, quays, docks, storage yards, and so forth) and the so-called superstructure. Among the elements forming the superstructure, one can distinguish between fixed assets built on infra- structure (sheds, fuel tanks, office buildings, and so forth) and fixed and mobile equipment (cranes, van carriers, and other port equipment). When discussing port infrastructure, precisely defining the included elements is convenient. As can be observed, infrastructures outside the port area are essential for the use of a port (maritime and land accesses). In general, port authorities have responsibility over some of the maritime ac- cess infrastructures-breakwaters, lights, buoys-and all elements within Lourdes Trujillo and Gustao Nombela 117 Figure 4.1. Scheme of Seaport Structures Maritime access infnastruchkre n Channels, approximation zones * Sea defense (breakwaters, locks) * Signaling (lights, buoys) I Port infrastructu r e usin pucfuna Port o Berwis, docks, basins p g rallyones,idre d area t Storage areas g howevrs, istwd i oItepral connections (roads, others) Tru inaof stuur ntng access infrastructure *Roads, railways p Inland navigation channels Source. Authors. che port area. Meanwhile, the state or local government generally owns and maintains connections to land networks and the remaining forms of maritime access (channels, locks). In almost all countries, port authorities have traditionanu y designed and mantyined port infrastructure directly using public funds to finance the building of new infrastructure. People generally considered that the public sector should own these assets to avoid the risk of monopoliza- tion by private firms. A current global trend, however, is toward increas- ing participation of private capital in the construction of infrastructure, generally through the use of concessions. Seaport Services In addition to providing basic infrastructure for the transfer of goods and passengers between sea and land, different agents provide multiple services at ports. Some agents may even work outside the port area. These services cover all activities that connect port users to the port, from the moment that a ship approaches a port until it ends all its operations. During this period, agents provide services to the ship, to passengers, to the crew, and to cargo (De Rus, Roman, and Trujillo 1994). First, a group of services relates to berthing, which includes pilotage, tow- ing, and tying. Port authorities can directly provide these services, or private 118 Seaports firms can offer them. Pilotage is defined as those operations required for a ship to enter and exit a port safely, and it usually implies the presence in the vessel's bridge (or at least a radio contact) of an expert with sufficient knowl- edge of the zone to avoid risks. In some ports, pilots are independent private agents, licensed by the port authority, while in other cases they are public employees. Towage is the operation of moving a ship using small powerful boats (named tugs) to steer it more easily. Again, private firms could provide the services for these operations at some ports, while at other ports the port authority directly hires tugs and their operators. One of the more important services provided to cargo ships is what is generically labeled cargo handling. This encompasses all activities related to the movement of cargo to and from ships and across port facilities. A historic separation exists between the movement of goods from the ship's side to safe storage within the vessel (stevedoring) and those movements from berth to ship's side (loading). This separation occurs as a result of different workers traditionally performing these operations. Today, how- ever, specialized firms provide all cargo handling services, using equip- ment such as cranes and surface transport elements. The cargo handling process varies according to the type of goods in- volved. The specialization of firms according to type of cargo is becom- ing a trend, because the equipment required can then be specifically de- signed to be highly cost-efficient. This leads to the formation of terminals, which are specialized berths in which operations concentrate on a given type of cargo. Container terminals constitute the best example of this trend, because the handling of containers requires large gantry cranes, and land storage is relatively easy with adequate trucks and lifts, but is highly space- consuming. All these factors make a specially designed berth more effi- cient for handling containers than general cargo berths. Of the total costs involved in moving goods through a seaport, cargo handling charges are the most important (approximately 70 to 90 per- cent of total cost, depending on the type of goods). Therefore, this is one of the services that a regulator must closely supervise to ensure cost-efficient port operations. Another type of service that port users demand is related to administra- tive paperwork and permits (sanitary certificates, import/export documents, taxes, and so on). Specialized agents or consignees usually perform this service, hired by shipping companies to prearrange paperwork and all mat- ters related to the use of port facilities by a ship. Before a ship calls at a port, consignees work to ensure that all required services (handling, repairs, Lourdes Trujillo and Gustavo Nombela 119 supplies, and so forth) for the ship are contracted to be performed in the shortest possible time. Modem ports must have systems that minimize the paperwork burden for port users, because delays due to inefficient administrative procedures cause large economic losses for both shippers, which have to alter their productive plans when they do not receive their goods on expected dates, and shipping companies, which have to keep their ships in port longer than necessary. In the European Union, established guidelines promote ports' investments in developing electronic data interchange systems that are designed to speed up administrative paperwork and reduce wait times for ships and for the land transport that delivers goods to and from ports (European Commission 1997). Finally, different agents and firms that work in the port area perform other ancillary services. These include all supplies for ships, of which fuel and water are probably the most important. Also included are services to crew members (such as medical) and general common services such as cleaning, refuse collection, and safety. Some ports also offer repair facilities to ships, which may involve the use of some special infrastructures. In summary, a port offers many different services. A combination of public and private initiatives can perform these services, and several port models show how private participation is introduced. Table 4.2 shows a summary of all services described in this section. From the regulatory point of view, ensuring an adequate provision of infrastructure and cargo han- dling is the more relevant issue, because the efficiency of seaports hinges on these two services. Coordination of Activities: Port Authorities Many different activities are performed simultaneously within the limited spaces of port areas, as ships constantly enter, are serviced, and exit. There- fore, an agent is needed to act as coordinator to ensure the proper use of common facilities and to take care of safety and the general design of port facilities. In most seaports, an organization called the port authority per- forms this function. Generally, these are public institutions that represent local interests, but this configuration is not unique, and finding examples of purely private port authorities is possible. One can characterize several types of port organization, depending on the role of port authorities. These are usually referred to as landlord port, tool port, and services port (Juhel 1997) as follows: 120 Seaports Table 4.2. Port Services 1. Infrastructure provision 2. Berthing services Pilotage Towing Tying 3. Cargo handling Stevedoring Terminals Storage Freezing (fish, others) 4. Consignees Administrative paperwork for ships and cargo Permits (sanitary, customs, and so forth) Service hiring 5. Ancillary services Supplies Repairs Cleaning and refuse collection Safety Source: Authors. - Landlord port. In this model, the port authority owns port infrastruc- ture and is also in charge of its management. Private firms that own the assets of the port superstructure and all equipment required for service provision (such as cranes, vans, and forklifts) provide the remaining services. Examples of this type of port organization are Buenos Aires (Argentina) and Rotterdam (Netherlands). This is gen- erally the most common form of organization for large ports. * Tool port. As in the landlord model, port authorities are the owners of infrastructure, but they also own the superstructure (such as build- ings) and the equipment (such as cranes). Private firms provide ser- vices by renting port assets through concessions or licenses. Examples of this category are Antwerp (Belgium) and Seattle (United States). * Services port. In this model, port authorities are responsible for the port as a whole. They own the infrastructures and superstructures, and they also hire employees to provide services directly. The port of Singapore used to be the best example of this type of organization, with its port authority (PSA) being the owner of all assets and provid- ing all services. In 1996, however, PSA was split into two separate entities: Maritime and PortAuthority, landlord and regulator, and PSA Lourdes Trujillo and Gustavo Nombela 121 Corporation, the port operator. Even though the law now authorizes the entry of private operators and the privatization of PSA Corp., the port of Singapore is still run by public institutions. Its model of orga- nization, however, is converging toward a landlord port model. To establish a connection between the type of port and ownership, in landlord and tool ports, the port authorities generally are public institu- tions, while the port operators are private firms. Therefore, these two types could be classified as mixed ownership, because the basic infrastructure is generally public, but operators can own many elements of the port. Ser- vices ports are more likely to be privately owned, with a single private firm operating the port as a single unit. Even though this is the general pattern, finding examples in the port industry in which ownership and mode of organization do not follow the above scheme is possible. For example, services ports that are fully public can be found-such as Singapore, although as mentioned above, this port will likely transform soon-as well as landlord ports in which infrastruc- ture is privately owned. Table 4.3 shows the type of ownership for the 50 largest world ports according to container traffic. In this ranking, one can observe a trend in the seaport industry toward ports with mixed owner- ship, at least for large ports. Some port facilities have traditionally been regarded as public goods (lights, access channels, and so forth). A seaport considered as a whole, however, does not exhibit public-good characteristics. For ports, exclud- ing users is possible, and producing services to more users without in- creasing costs is not feasible. Therefore, seaports are organizations that from an economic point of view do not necessarily have to be in the public sec- tor. They can be run as commercial institutions. Some countries regard many port activities as public services in the sense that authorities consider that these services should be available to any user, but there is no reason for the public sector to be obliged to provide them directly. Only in particular situations, as in the case of extremely small seaports serving isolated communities, can conditions be found in which public intervention would be required to guarantee the provision of port services, because the seaport would be vital for the community's basic welfare. However, even in this case, a public com- pany should not necessarily be strictly providing port services, but in- stead subsidized private firms could offer them through competitive bidding for concessions with negative payments. 122 Seaports Table 4.3. Type of Ownership of 50 Main World Ports, 1997 TEUs Port thousand Public Mixed Private 1 Hong Kong (China) 14,539 2 Singapore 14,135 3 Kaohsiung 5,693 9 4 Rotterdam 5,445 0 5 Pusan 5,234 0 6 Long Beach 3,505 0 7 Hamburg 3,370 a 8 Los Angeles 3,000 a 9 Antwerp 2,969 0 10 Dubai 2,600 0 11 Shangai 2,527 12 New York/New Jersey 2,457 0 13 Tokyo 2,383 9 14 Yokohama 2,328 0 15 Felixstowe 2,251 16 Keelung 1,981 0 17 Kobe 1,944 0 18 SanJuan 1,781 8 19 Bremen 1,526 0 20 Colombo 1,687 21 Kelang 1,684 22 T. Priok 1,671 0 23 Algeciras 1,538 9 24 Oakland 1,531 & 25 Nagoya 1,498 26 Seattle 1,476 27 Gloa Tauro 1,449 28 Manila 1,358 29 Hampton R. 1,232 30 Osaka 1,200 31 Le Havre 1,185 32 Genoa 1,180 33 Tacoma 1,159 34 Charleston 1,151 35 Bangkok 1,099 36 L.Chabang 1,036 37 Melbourne 1,029 38 Durban 984 39 Barcelona 972 40 Tianjin 935 (table continues onfollowing page) Lourdes 7Tujilo and Gustavo Nombela 123 Table 4.3 continued TEUs Port thousand Public Mixed Private 41 Jeddah 921 a 42 Southampton 891 43 Montreal 870 0 44 Taichung 842 a 45 Valencia 810 0 46 Santos 829 0 47 Shaijah 815 a 48 Houston 798 0 49 Sidney 765 0 50 Miami 761 0 Source: Cass (1996). Privatization and Regulation of Seaports During the past years, the world has observed a trend toward an in- creasing participation of the private sector in seaports. The traditional mode of port organization, with substantial public intervention, has become obsolete and unusable for adapting to the rapid changes in the industry. Due to unsatisfactory performance by public ports (high tar- iffs, inefficient services, overstaffing) and to tight fiscal constraints, many countries have opted for changing the legal frameworks for port opera- tions and promoting the entry of private firms to invest in ports and to provide services. Even if ports are privatized, the public sector must keep a role as a regu- lator of the activity of private operators. The regulatory activity of govern- ment in ports has two dimensions. The first one relates to safety, environ- mental issues, and quality of port services. The second dimension is the economic regulation of private port operators. As discussed below, the need for this type of regulation depends on the conditions of each port. While in some cases governments should keep control over tariffs and performance of port operators after privatization, in some others port services can pos- sibly be provided under market conditions. The Traditional Seaport Organization Many different types of port organization can be found around the world (see table 4.4). Northern Europe uses a municipal model and southern 124 Seaports Table 4.4. Financing of Port Infrastructure in Different Countries Maritime access Port area Port area Land access Country infrastructure infrastructure superstructure infrastructure Argentina P.A./Private PA./Private Private Most port authorities are Tesponsible for Belgium State Public Private road and other transport connections Cyprus P.A. PA. Concession within port areas. Denmark PA. PA. Private Connection to the hinterland is usually Finland PA. PA. Private the responsibility of France State/P.A. Public/P.A. Concession governments. Germany State Public Private Regarding railways, Greece State Public/PA. Concession responsibility can be Hong Kong, (China) PA. Private Private national (Belgium), Ireland PA. PA. Concession the port authority's Italy State/P.A. Public/P.A. Concession (Germany), or the railway Malta State PA. Concession concessionaire's Mexico PA. PA. Private (Argentina). In the Netherlands State PA. Private case of Hong Kong, China the private Portugal P.A. PA. Concession sector is responsible Spain PA. PA. Concession for infrastructures Sweden PA. PA. Concession within the port area. United Kingdom P.A. PA. Concession Venezuela PA. P.A. Private Note: 1. P.A.: port authority (financed with own resources). 2. Public: Financed by central, regional, or municipal governments. 3. Concession: In cases indicated, superstructure is publicly owned but operated by private firms. 4. This dassification refers to the main seaports in each country. It is always possible that within the same country, ports with alternative modes of infrastructure financing not shown here may exist. Source: European Parliament (1993); ESPO (1996). Europe and South America follow a state model, in which governments control all main ports. A private model is when private firms or port au- thorities pay investment costs through charges on port users. This is more common in countries with a British tradition, where ports are regarded more as commercial rather than as public institutions. Some point to examples illustrating a lack of relationship between sea- port efficiency and type of ownership. A comparison between Singapore and Hong Kong (China) is often made: both are highly efficient ports; the Lourdes Trujillo and Gustavo Nombela 125 former is completely public, and the latter private. Even though some ex- ceptions may exist, however, finding a gap between private and public seaports is common in terms of efficiency. One can usually characterize a traditional public seaport, before the introduction of reforms, by the following features: * State or local government budgets are used to finance construction of large infrastructures, but these public budgets are becoming tighter. * A public port authority finances the maintenance and repair of in- frastructure. * The port authority is financed partly with public funds and the rest by port tariffs and fees from private firms operating in the port. * An excess of employees work in the port who have a high degree of unionization and strong positions at collective bargaining. * Port efficiency in terms of tariffs and waiting times for ships is rela- tively poor. This list of stylized facts does not reflect the exact situation of all public ports in the world, but merely pinpoints the main issues facing those sea- ports that have started introducing reforms. Other ports that are still run exclusively within the public sector will surely have to respond to similar challenges in the near future. Some changes have occurred in the maritime transport industry in the past decades, which are irreversible and affect all world ports. These are basically technological innovations in the transport of cargo. The two most remarkable are the containerization of cargo and the development of large specialized ships. These transformations have forced seaports to modernize their infra- structures and to buy new equipment capable of providing new services demanded by shipping companies. One can observe the trend toward con- tainerization in figures for world traffic of cargo. The fast growth of the use of containers started in Europe, Japan, and the United States, but it is now spreading elsewhere. Table 4.5 presents figures for different regions of the world. The spectacular growth rates in Asia, South America, and India, and in general, all developing countries, is remarkable. Four of the five largest world ports in terms of container traffic are located in Southeast Asia: Hong Kong (China), Singapore, Kaohsiung (Taiwan, China), and Pusan (Republic of Korea). Changes in the types of ships that maritime transport companies use become evident when studying the increase in the size of ships perform- ing long-haul services. Economies of scale are evident in the use of larger, 126 Seaports Table 4.5. Containers: World Regional Traffic, Selected Years (millon TEUs) Change 1980-95 Region 1980 1986 1990 1995 (percent) Southeast Asia 9.08 19.10 32.42 61.84 581 Europe 11.49 17.76 23.25 33.06 188 North America 9.92 13.42 16.49 21.85 120 Caribbean/Central America 0.96 2.68 3.56 5.39 461 South America 0.38 1.04 1.44 2.76 626 Middle East 1.38 2.32 2.90 5.40 291 India 0.26 1.08 1.83 3.17 1,119 Australia 1.61 1.95 2.33 3.46 115 Africa 1.27 1.74 2.42 4.66 267 Total 36.35 61.09 86.64 141.59 290 Source: OSC (1996). specialized ships, which allow them to transport larger volumes of cargo at lower unit costs. This has led to spectacular rises in the capacity of ships. At present, the latest generation of container ships, Post-Panamax, with a capacity of between 10,000 and 12,000 TEUs (20-foot equivalent units, a standard measure commonly used in the container industry), and a width of 20 containers abreast on deck, is now at the design stage (Hayuth and Hilling 1992). These huge ships will likely start operations in a few years, requiring drastic adaptations of handling equipment in terminals. For the transport of oil and other liquid cargo, most of the world's tanker fleet is now above 300,000 gross registered tons. These two "revolutions" in the maritime transport industry have forced seaports to start rapid facilities renovations to serve the new needs of shipping companies, especially the growing demand for container handling services. Seaports now face a more competitive situation than in the past, and so they must have the required facilities as well as low prices, or they risk losing traffic to rival ports. However, shipping com- panies are increasingly working with hub-and-spoke networks; there- fore, they demand the services of large ports that act as connection nodes (hubs) where cargo is transferred to smaller ships that perform regional- based services (feeder services). Lourdes Trujillo and Gustav Nombela 127 To make the necessary investments to meet the growing demand, the seaport industry has strong capital needs. Some large ports have the possi- bility of becoming hub ports at a regional level, and thus attract large vol- umes of traffic. The following is a list of the challenges that this situation poses for modem ports, especially in the context of reduced public subsi- dies, which are due to tighter fiscal conditions among governments. * The need to seek financing for infrastructure renovation and build- ing of new facilities * The need to achieve high efficiency levels in costs and operation times and to keep prices low * The reduction of excess of labor, aggravated by the trend toward intensive use of capital at seaports. Thompson and Budin (1997) have identified several reasons for in- troducing private participation in transport industries through the use of concessions. First, the private sector can provide services at lower costs than the public sector, because it usually is more productive and efficient. Second, if private capital is used to finance costs, the public sector can devote its scarce resources to other priorities. Last, the pri- vate sector is generally more able to search for business opportunities and to respond more swiftly than the public sector to changing condi- tions in competitive markets. Introducing private participation in seaports appears to be a response to the challenges pinpointed above. This is a worldwide trend: ports in general are adopting the landlord model. As described earlier, this model allows port authorities to retain ownership of the infrastructure to avoid the risk of monopolization of essential assets by private firms. The private sector then operates these assets. Concession contracts between port au- thorities and private firms are the most common instrument to allow pri- vate participation in ports. The role of port authorities is thus transformed from their traditional concept as institutions in charge of all port activities (see table 4.3) to a new one in which they only coordinate these activities. When introducing pri- vate firms into seaports, designing regulation systems to monitor the be- havior of private operators is a new need. This regulation would usually take place in asymmetric information conditions (firms know their costs and market conditions better than the regulator does). Port authorities are not strictly required to perform this regulatory role at seaports, however. Instead, an independent institution could perform this task. 128 Seaports The Movement toward Privatization In the choice of best form for introducing private participation in the organi- zation of port services, several alternatives are possible, depending on port size, initial conditions, and type of service. These include the following: * Full privatization: Selling the seaport as a whole. Justified by serious fiscal needs in the public sector, this method transfers all assets and liabilities to the private sector. * Build-operate-own: Transferring parts of the seaport to private opera- tors for development. Short-term financial needs justify the use of this form of privatization. * Build/rehabilitate-operate-transfer: Introducing private participation in the port to build or renovate facilities required for service provision. In this case, the public sector does not lose ownership of the port infrastructure, and new facilities built by private firms are trans- ferred to the public sector after a specified period of time. This is the case of classic concessions. * joint ventures: Creating a new, independent company by combining the efforts of two or more firms. This type of agreement arises when two parties with common interests join forces. For example, in some cases, one firm supplies technology and know-how, while another has knowledge of market opportunities and customer contacts. * Joint ventures not exclusively between privatefirms: Creating collabora- tions between, for example, port authorities and private firms, as in the cases of Shanghai (China), Kelang (Malaysia), and other Asian ports with large investment projects, where port authorities have formed many joint ventures to develop and operate new terminals. In other cases, collaboration may be between several public firms, as in the Singapore PSA Corporation with the port authority of Dalian to develop and operate a container terminal in the port of Dayaowan (China). However, a port authority's participation in joint ventures regarding projects within the port that it regulates raises some con- cerns. The most important is that the port authority has to regulate and at the same time be a part of the regulated firm. The joint ven- tures between port authorities and private firms should then be only a temporary solution to promote development when private par- ticipation is lacking, but port authorities must return quickly to their primary role as regulators. * Leasing: Port authorities simply renting port assets to private opera- tors for a fixed period to obtain income from contract fees. Contrary Lourdes Trujillo and Gustavo Nombela 129 to concession contracts, firms that lease are usually not required to make investments, therefore they only assume commercial risk. Port facilities such as storage buildings and cranes are frequently leased to operators. * Licensing: Port authorities allowing private operators to use their own equipment to provide some services for which the required equipment is relatively simple. Private operators generally own these assets, and the infrastructure (as well as some superstructure ele- ments owned by the port authority in some cases) is made available to them at a specified fee. Stevedoring companies, pilots, tug opera- tors, and consignees can work under this type of agreement. * Management contract: Introducing private participation in a port in a simple form by contracting out the port management. In this situa- tion, the port authority is the owner of the infrastructure and port facilities, but a private firm can provide a more commercial approach to operations. The public sector in this case faces both investment and commercial risks, because managers do not invest their own capital in the port. The port of Bristol (United Kingdom) is an ex- ample of this type of contract, where facilities are owned by the lo- cal government, but the port is privately managed. When looking at the foregoing options to determine which is the best alternative for a particular port, one must evaluate the port's objectives and consider the constraints that the port authority faces. The type of ser- vice may determine the possible degree of private participation. A basic determinant would be to consider whether or not the service requires the exclusive use of a port's fixed assets. SERVICES THAT DO NOT REQuIRE EXCLUSIVE USE OF INFRASTRUCTURE OR SUPER- STRUCTURE PoRT FACILIIEs. Within this group are services such as pilotage, towing, consignees, and other ancillary services to ships and crews. In many ports, as a result of safety arguments, the public sector traditionally pro- vides some of these services. In particular, berthing services are usually considered a public service obligation-in other words, every port user has a right to be provided with these services-and port authorities there- fore directly provide them to avoid the possibility of disruption of service. Pilotage is a typical example of a compulsory service organized on a monopolistic basis in many ports. Pilotage is required for ships above a given capacity or length, and for dangerous cargo. Most ports have ex- emptions, such as for regular passenger services (ferries). The degree of 130 Seaports public intervention in pilotage varies across countries. In some, pilots are civil servants. In other cases, they are organized as independent agents, basically self-regulated by their own associations. Regarding other berthing services-towage and tying-diverse solu- tions can be found among ports. Both are generally considered public ser- vice obligations, and port authorities perform them directly or grant li- censes to private operators. A single firm can provide towing services exclusively, or in large ports, having several competing companies (De Rus and others 1995) is feasible. Some ports do not strictly control these ser- vices, only setting minimum standards (technical capacity, safety and en- vironmental standards, and so forth) for private operators to obtain licenses. In this case, market conditions determine towage tariffs, which are not fixed by the port authority. Therefore, one can conclude that this set of auxiliary services to ships can work reasonably well through a system of licenses by which several operators are authorized to provide services within the port area. These operators' activities can be regulated in terms of prices and quality of ser- vice. In some cases, having several competing operators (such as consign- ees or pilots) is possible. Then, strict price regulation would not be required, unless collusive practices are detected. For other services, such as towage, having several operators can be com- plicated, because they are limited by port size. In the case of medium or small ports, establishing limits on prices and service conditions is needed to avoid market domination by a few firms that could exploit their posi- tion to extract rents from port users. SERVICES THAT REQUIRE ExcLusIVE USE OF ASSETS. These services require the use of one of the most scarce resources at seaports: space. They include terminals for cargo handling, storage areas, repair docks, and fuel suppli- ers. Introducing private participation in these services is more complicated, because operators need to use assets that are considered to be optimally owned by the port authority. Therefore, concession contracts need to be written carefully to reconcile private operators' interests with port authori- ties' objectives. At the same time, contracts must include incentives for pri- vate operators to maintain or enhance assets as required. The number of operators for these services is by definition extremely limited, although it will vary according to port size. Similarly, the need to establish some price and quality regulation depends on what type of port it is and how many alternative ports are available in the area. For example, in the case of a port in a highly competitive region, the port Lourdes Trujillo and Gustaw oNombela 131 authority or the institution in charge of regulation does not need to be extremely concerned about excessively high charges by private opera- tors. In that situation, private firms self-regulate prices to avoid the risk of losing their market share to competitors. The Need for Port Regulation Box 4.1 presents a possible characterization of the different sizes and de- grees of development that a seaport can reach. Depending on port size, having economic regulation of ports where private operators use fixed assets is more or less required. We can broadly distinguish two types of situations according to the degree of development reached by a seaport. First are those ports with a reduced market size-port types 1 and 2- that do not require more than a general cargo terminal, which can serve all kinds of goods and containers, or they possibly have one terminal specializing in dry bulk goods. For these small ports, one can consider introducing some form of com- petition among those firms that are willing to operate in the port. Thus, establishing a system of auctions is possible in which private firms bid for Box 4.1. Levels of Port Development 1. Small local ports: These serve small communities; therefore all kinds of general cargo and containers pass through them, usually transported by relatively small ships (short sea shipping services). The basic facilities are general-use berths with storage areas nearby. 2. Large local ports: As traffic reaches a certain level, investing in specific equipment is profitable, such as a dry-bulk terminal with berths to serve deep-draught ships. Some investments are probably also made to improve land access and buy con- tainer-handling equipment, although general cargo berths would still be used. 3. Large regional ports: A seaport that handles a significant level of long-haul traffic requires large investments in specialized terminals, such as container terminals and facilities for specific goods (coal, oil, grains, and so forth). These ports can serve huge ships, more than 60,000 gross registered tons, used in long-haul bulk transport. 4. Regional distribution centers: The world's largest ports-Rotterdam, Hong Kong (China), and Singapore-are collections of highly specialized terminals that only serve particular traffic. They have excellent equipment for transport interchange among all modes (railways, road, inland navigation). Their role is to act as hubs for huge long-haul ships to conduct transshipment operations. From the hubs, smaller ships or other transport modes distribute cargo to the region. Source: Stopford (1997). 132 Seaports the right to operate the terminal. Once the bidding process is over and a single operator is chosen, having some regulation over the charges that this firm imposes on port users is necessary, because it would otherwise enjoy a monopoly position. Price-cap systems or rate of return regulation are alternative options for regulating the behavior of private operators, depending on the information and experience that the regulatory institu- tion has in the type of service subject to regulation. This need for regulation, however, is less strict if competition exists among ports. In cases in which a region offers alternative ports for shipping compa- nies, regulating prices is less necessary, because the market mechanism makes the private operator either keep prices low or risk losing traffic. If alternative ports do not exist or do not have adequate facilities, the private operator enjoys market power that must be controlled by regulation. For example, users of the Mexican ports of Veracruz and Manzanillo complain about high tariffs, arguing that operators enjoy market power. Although alternative ports exist both along the Atlantic and the Pacific coasts of Mexico, the antitrust institution of the country has imposed regulation on prices for the operators of container terminals at both ports. In the case of large seaports-types 3 and 4-the volume of traffic is large enough (for example, more than 100,000 TEUs) to allow competition to exist within the port. If a large port is divided into several independent terminals, inducing competition between operators is possible for traffic that calls at the port. Here, price regulation is less of an issue, because if the market mechanism works reasonably well, private operators will restrain price increases themselves. Some form of supervision is still needed, how- ever, because the situation is prone to collusion between competitors (due to the small number of parties involved). As an example, Argentina recently split the port of Buenos Aires into five different concessions for independent companies to operate its ter- minals. Although some problems occurred initially, and the number of operators has been reduced, improvements in port outcomes have been substantial. Worker productivity rose from 800 tons in 1990 to 3,100 in 1997, and waiting time for containers was reduced from 2.5 to 1.3 days over the same period. Therefore, this analysis concludes that introducing private participation in the seaport industry appears to be the most attractive option for ports trying to develop and adapt to the new conditions of the maritime transport market. Modem ports are in need of huge investments to enhance their fa- cilities, to be able to provide the services that shipping companies demand. Because the financing of required investments is increasingly difficult for Lourdes Trujillo and Gustavo Nombela 133 governments in all countries, the optimal solution is to try to attract private capital for investment in ports, and to improve efficiency through the liber- alization of port practices and the introduction of competition. The role of public sector institutions then changes from direct provider of services to regulator and supervisor. The cornerstone of port systems is now the correct design of concession contracts for collaboration between the public and private sectors. As dis- cussed above, the existence of competition determines the need for the regu- lation of private operators, but even when competition is present and regu- lation is not required port authorities still need to have some degree of control over the infrastructure assets that private firms are using. Figures in table 4.6 indicate the feasible degrees of competition between operators in different situations so as to assess when regulation is required. Establishing universal threshold values for all ports and types of cargo is diffi- cult, except for containers, on which experts seem to come to a consensus. These figures show that if the volume of container traffic in a port is less than 30,000 TEUs per year, having several terminals and operators does not make sense, because the market is extremely small. The best solu- tion is having a single operator and regulating its charges. If traffic is greater than 30,000 TEUs but less than 100,000, having several operators, possibly sharing a single terminal, is feasible. This would be a situation of intraterminal competition, with cargo handling services provided to port users by various stevedoring companies that would make use of the equip- ment (cranes) the port authority owns, or they would employ their own equipment, depending on their financial positions. If traffic is greater than 100,000 TEUs, the port has the possibility of open- ing different terminals, which several companies can operate; they make use of separate berths and manage them better. Competition is easily implemented between terminals. When a company serves all ships using a given berth, port authorities also can make the private operator responsible for collecting port Table 4.6. Threshold Values to Determine the Type of Competition: Container Traffic Type of competition Level of traffic (TE Us) Intraterminal 30,000 Interterminal 100,000 Interport 300,000 Source: Kent and Hochstein (1998). 134 Seaports tariffs from users (charges for the general use of the port, different from the prices the operator charges in the concept of cargo handling) and transferring revenues to the port authority. In this range of traffic volume, providing incen- tives for private operators is also possible to finance projects for infrastructure enhancement, or even for the building of new facilities. Finally, in a region where container traffic is greater than 300,000 TEUs per year, the market allows for several alternative ports to exist and com- pete for traffic. Interport competition is likely, which reduces the need for control over private operators' prices. Even in this case, however, paying attention to the drafting of concession contracts is necessary, because pri- vate operators must be compelled to fulfill their obligations not only re- garding service conditions and charges, but also regarding equipment maintenance, safety, service quality, and all other matters that are costly for the concessionaire and could be underprovided. Concession Contracts in Ports The different seaport services that private operators can offer are subject to a variety of possible contracts. As discussed above, port size is one of the key variables in determining the type of private participation that one can choose. For those ports with insufficient demand to allow for the existence of several terminals, the best idea is probably to transfer the port as a whole to the private sector. If desired, keeping public ownership of the infrastruc- ture would be feasible, but a single operator could run the port, providing both the infrastructure and cargo handling services (stevedoring, storage, and so forth). The port operator could also provide the rest of the comple- mentary services (such as berthing), or if demand is sufficient, it could be open to competition among different firms. In the case of larger ports (the landlord type), introducing private par- ticipation in more sophisticated forms is feasible. It is in these ports that infrastructure can be split into separate terminals, generating competition within the port. For services that are easy to specify in a contract and do not involve the use of substantial infrastructure, private firms operating under licenses could provide them. For other port services that require the exclusive use of infrastructure or superstructure, private operators must be subject to concession contracts, in which conditions are stipulated to de- termine when a private operator can use assets, and what its obligations are. One can specify license contracts relatively easily, because in general, the operator owns the equipment required to provide the service. The role of the port authority or any other regulating institution is limited to Lourdes Trujillo and Gustavo Nombela 135 imposing minimum standards (for example, professional qualification for pilots, or number and power of tugs for towing companies) and es- tablishing some rules for service provision. A concession contract is, by definition, more complex than a license, because it involves not only questions about service provision, but also about adequate maintenance of assets, investments to be made, and risk allocation between the regulator and concessionaire. All these aspects are discussed in detail later. Concession contracts can be regarded as an in- termediate solution between public ownership and full privatization of a port. Private participation is introduced to achieve efficiency gains in the industry, and at the same time political concerns are safeguarded by al- lowing society to retain ownership of essential assets (Crampes and Estache 1997). Other industries involving expensive infrastructures (elec- tricity, water, gas) have extensively used these contracts, for collabora- tion between public and private sectors. When designing a concession contract, one must carefully tailor sev- eral aspects: the object of the concession, exclusivity in the use of assets, the concessionaire's obligations and payments, the term of the concession, penalties and fines, and risk allocation (Crampes and Estache 1997; Kerf and others 1998; Thompson and Budin 1997). When writing concession contracts, one also must consider the problem of excess of labor, common to almost all ports worldwide. Another relevant feature is to carefully de- sign the selection method to determine the winner of the concession. OBJECT OF CONCESSION. The first question to be answered when draft- ing a concession contract is what is to be concessioned. Even though this may sound like a simple question, the contract must be precise about the assets that are to be transferred to the concessionaire, the services that it must provide, the services that will be left to the public sector, and those other services that are subject to open competition. Thus, in the case of the concession contract for a terminal, the contract must describe in de- tail the limits between the infrastructure that is concessioned (berths, surfaces, inner access roads, and so forth) and what is not (such as gen- eral roads for intraport connections), to clearly establish the concessionaire's responsibilities. The port authority, or the regulatory institution signing the contract, must guarantee that the assets are transferred to the concessionaire free from any other contractual obligations, and that they are available for the agreed terms and times. Avoiding delays in the transfer of assets is important, particularly those owed to the negligence of the port authority in fulfilling the terms of 136 Seaports the contract, because this may impede the concessionaire from promptly starting its operations. A concession contract must explicitly define those services to be pro- vided by the concessionaire, and on what terms. For example, the con- tract prepared for the concession of terminals at Puerto Nuevo in Buenos Aires established that the concessionaire is the exclusive provider of the following services: * Reception, delivery, stevedoring, and storage of cargo * Administrative control of loaded and unloaded cargo * Safe berthing and unberthing of ships * Any other service to ships or cargo promoting efficiency of the terminal. In this example, the ambiguity of the last point is remarkable, because it opens a door for a concessionaire to interpret what has or has not been included, and thus to claim for itself the exclusive provision of some ser- vice that, in principle, the port authority did not plan to concede. One should carefully avoid this type of ambiguity in concession contracts to avoid liti- gation problems with private operators. ExcLusIVI. A concession contract must specify what services the conces- sionaire is to provide exclusively, and what other services are open to other firms. For example, in the case of the concession contract of the port of Mar del Plata (Argentina), which is a small port concessioned as a whole to a single company, it explicitly states that the berthing and other complementary ser- vices to ships (energy and water supply) should be regarded as public ser- vices. The concessionaire does not have the right to exclusively provide those services. It could offer the services to its customers, but it must also allow access to any other interested company. Conversely, some services are left ex- clusively to the port operator (cargo handling, marketing, and so forth). Regarding this question of exclusivity, the rule should be to guarantee port users an efficient provision of services. For services in which the pres- ence of a competitor could be positive, one should allow access to any in- terested party. Meanwhile, for those activities in which competition can result in a deterioration of services for users, exclusivity is desirable. For example, consider the case of a container terminal that is concessioned to a private operator, but other operators are allowed to enter to handle gen- eral cargo with their own cranes. Even though competition in the general cargo segment could improve, avoiding interference with the container operations by allowing a single operator to exclusively perform all cargo loading services (general and container) is probably preferable. Lourdes Trujillo and Gustavo Nombela 137 For services that involve some public service obligation (providing de- sirable but nonprofitable services), having a single firm provide them ex- clusively is usually simpler. If several operators are forced to offer these services, subsidies must be paid to all of them, which will probably raise the administrative costs of controlling the system. In small ports, concessionaires must be offered guarantees that they will be able to recover their investment costs. To do that, one commonly includes provisions for the concessionaire to obtain some compensation in the event that during the contract term, another facility is built within the port and it reduces the traffic level the concessionaire expects. These provi- sions may take the form of minimum traffic guarantees or priority for the concessionaire in the bidding process for the building of new facilities. OBLIGATIONS AND PAYENTS. A concession contract must explicitly men- tion the concessionaire's obligations in terms of level and quality of ser- vice. It also should clearly specify how charges to users are to be deter- mined, who owns the revenue obtained from those charges, and what payments are to be made between the parties. The norm is for the concessionaire to pay a fixed annual fee (some- times called a canon) to the port authority or the institution responsible for the concession. The contract can be designed with a negative fee. In that case, the concessionaire receives a payment from the port authority, as a payment for public service obligations, if revenues from port users do not cover costs. Concessionaires' fees can sometimes be linked to the level of traffic served by the terminal or the infrastructure subject to concession (for ex- ample, making it proportional to tons or TEUs handled), including a guar- anteed minimum payment to the port authority. Concessions for container terminals granted in the port of Buenos Aires and in Brazilian ports have used this system of fees proportional to port activity. In some cases, the concessionaire can be made responsible for collect- ing port dues charged on ships and cargo for the general use of the port and transferring the revenue to the port authority. When performing that task, the concessionaire acts as an agent for the port authority, because the level of port dues is determined by the latter. Meanwhile, the level of charges for services the concessionaire provides (cargo handling, storage, and so forth) is usually freely determined, although it is subject to some form of external regulation. As discussed in the previous section, the need for regu- lation is more important for small ports with a single terminal, but it is not so relevant if intraport or interport competition exists. 138 Seaports Concession contracts in the seaport industry are usually associated with building or rehabilitating facilities (build/rehabilitate-operate-transfer type of contracts). In those cases, the contract must clearly specify the starting and completion dates of the operation, as well as the moment when own- ership of the assets is transferred to the port authority. Technical issues about infrastructure building (materials, methods, and so forth) also should not be left to the concessionaire; instead, the concession documents should specify them in detail. TERM. No universal rules about the proper length of a concession exist. Economic theory on regulation indicates that the longer the life span, the more incentives the concessionaire has to make adequate in- vestments to enhance assets, because profitability depends on the state of the facilities. The longer the period between two concessions, how- ever, the less information the regulator has on cost and demand condi- tions. Therefore, a trade-off exists between incentives and information for optimal regulation of a concession. In addition, concessions associated with large investments must al- low sufficient periods for operators to recover construction costs. In prac- tice, concessions with large projects are usually longer than those with no investment requirements. The average term of a concession contract is more than 15 years, and those with large projects can be around 25 years. Sometimes, provisions also allow operators to obtain the automatic renewal of concessions if they fulfill investment or rehabilitation plans. Table 4.7 shows examples of the concession terms for some contracts signed in ports around the world. EXCESS OF LABOR. One of the common problems shared by many ports worldwide is an excessive number of port workers, generated partly by unionization and partly by the technological changes introduced in cargo handling procedures. In a relatively short period, seaport activities have been transformed from being labor-intensive to being capital-intensive, a process that has made a large number of employees redundant. The tra- ditional public organization of seaports has exacerbated this problem, because port workers are civil servants in some countries and therefore have certain rights, in general, enjoying significant social benefits that must be respected. The transformation of a port has to deal with this problem, because worker resistance can block any reform. Port workers can have significant political influence in some countries, Brazil, for example. Solutions include Lourdes Trujillo and Gustavo Nombela 139 Table 4.7. Term of Port Concession Contracts in Practice Port Period (years) Buenos Aires terminals 1-4 and 6 (Argentina) 25 Buenos Aires terminal 5 (Argentina) 18 Mar del Plata (Argentina) 15 Manzanillo (Panama) 20 Karachi (Pakistan) 20 Le Havre (France) 50 Kelang-Westport (Malaysia) 30 Manila-South Harbor (Philippines) 15 Santos (Brazil) 25 Maputo (Mozambique) 15 Source: Authors. providing funds to offer redundancy compensations and anticipating re- tirement schemes for workers. Generally, public budgets partly finance these funds, but private operators are also required to share the financial burden resulting from the labor problem. Different countries have searched for different solutions to this prob- lem in the concession contracts for their terminals. For example, in Panama, the port authority has offered to unions to employ a fraction of the income generated by concession fees to redundancy programs. In Mexico, the gov- ernment and unions reached an agreement in which terminal operators have a right to negotiate only with the workers they employ, instead of forcing them to bargain with a single centralized port union (Brennan 1995). PENALTIES AND FINEs. To guarantee adequate compliance with the terms of a concession agreement, the contract must specify a series of penalties and fines that the concessionaire must pay to the port authority in the event of default. For example, if a private operator does not fulfill its obligations in terms of investment requirements or quality of service, the port author- ity might have the ability to raise the concessionaire's fixed annual fees. For this mechanism to be valid, the port authority must regularly per- form some inspection tasks to verify if the concessionaire is providing the required services and keeping assets in the stipulated conditions. If a port authority is excessively permissive with defaults from the concession, it 140 Seaports could damage its reputation with other operators for future concessions. Because concession contracts have long lives, port authorities should es- tablish strong positions from the start of the concession. In addition, the imposition of sanctions on one operator will usually have a demonstrative effect on other operators within the same port, or in other ports regulated by the same institution. RIsK ALLOCAnON. One of the more complicated aspects of designing a concession contract is the adequate allocation of risks. As in any other sec- tor in which this type of contract is being implemented, the ideal rule is to allocate each type of risk to the party that can take better actions to avoid it, so that all agents are provided with incentives to behave optimally. Ac- cording to Kerf and others (1998), the following types of risk are involved in a concession contract: Design/construction risk: This type of risk appears in contracts that require the concessionaire to make investments on a building or rehabilitation project. Once construction starts, the concessionaire may try to renegotiate the contract, arguing that unforeseen cir- cumstances have arisen or costs were incorrectly estimated. The concessionaire tries to obtain financing from the public sector to proceed with the project, or at least a reduction in the fees that it pays to the port authority. In this case, the advice is to study the origin of the forecasting errors. When errors can be attributed to defective information or mistakes in the bidding process granting the concession, the gov- ernment or the institution responsible for ports should assume re- sponsibility and pay the concessionaire for the extra costs. A com- pletely different situation arises if cost deviations are caused by poor estimates on the part of the concessionaire. In that case, the port authority's position should be strong, to make the operator cover the extra cost plus any penalty established in the contract if the build- ing is not completed by the stipulated dates. For investments in new, commonly built infrastructures, such as container terminals, international standard designs allow for the es- timation of reasonable costs and completion periods for berths of a given length and width, providing that normal subsoil conditions exist (DSC 1998). Therefore, this type of risk is relatively low for standard investments and should be allocated to builders. A differ- ent situation arises if geographic conditions are not standard, or a Lourdes Trujillo and Gustavo Nombela 141 project has special characteristics, in which case the builder can be allowed some margin of error. Operating cost risk: Another source of risk is the existence of higher than foreseen costs for providing service. Again, the concessionaire should assume all excesses of costs that can be reasonably predicted. If the bidding process was correctly designed, all bidders had the same information, and therefore they must have carefully devised their cost estimations. With that in mind, the bidding process must arrange for all candidates to have permits to inspect the involved infrastructure and receive as much information as required. If this provision is made, any excess costs discovered thereafter should be the concessionaire's responsibility. The possibility that the port authority can cause some excess costs must also be considered, however, in which case the concessionaire should be allowed to renegotiate the contract or be compensated accordingly. For example, some cost rises could be due to delays in obtaining required permnits, terminating existing contracts with other firms that have rights over elements included in the concession (such as occupied buildings), or disposing of obsolete assets that the port authority had agreed to remove. In all of these cases, if the delays the port authority imposed on the concessionaire result in losses or higher costs, the latter should be able to receive compensation. * Revenue risk: This is one of the more dangerous risks in the seaport industry, as in any other sector in which the concession contract is valid for a long period. If demand forecasts used to compute the expected income flows are too optimistic, the concessionaire could eventually end up with much lower revenue than expected, and could even go bankrupt. The general rule for this type of risk is to allocate it to the concessionaire, to provide incentives for candi- dates to properly estimate the expected demand levels in the bid- ding process. Furthermore, if regulations on charges allow the op- erator to lower them freely, the concessionaire could minimize this risk by reducing charges to attract more traffic during a period of low demand. A strict application of this rule, however, implies that in some cases, an operator should be allowed to go bankrupt, because otherwise the system would lose its credibility. In that situation, the port au- thority must consider what the options are after the private opera- tor ceases its service provision. In large ports, other operators could supply those services, until a new bidding process is launched, but 142 Seaports in the case of small ports, the port authority must be able to provide services directly or quickly replace the operator, or the port will suf- fer a long period of inactivity. Another situation that one should carefully study is whether the risk could be mitigated in some low-demand situations by intro- ducing flexibility in the regulation systems. In some cases, price limits imposed on concessionaires could result in low revenue flows to the operator, not allowing it to adequately recover its costs. If that is the case, and the operator is proven to be not negligent in letting its costs rise excessively, the regulator should be more flexible and res- cue the financially strained concessionaire. * Financial risks: In developing countries, currency values are usually subject to wide oscillations. Therefore, all seaport projects imple- mented in these countries are subject to exchange rate risks, espe- cially for those with longer terms. Relatively easy solutions can re- duce this risk, however, such as nominating all monetary references of the contract in a hard currency, or buying insurance to cover it. Similarly, interest rates can also suffer large variations that could substantially alter operational or building costs. Even though both parties should privately cover this, concession contracts may also include provisions on financial risk. * Environmental risks: Some of the circumstances that one has to con- sider when drafting a concession contract include accidents within a port area or in its access zones, which can have disastrous effects for the port and adjacent areas (for example, oil spills). For private operators to minimize those risks, they should be strictly liable for any accident caused by negligence in maintaining adequate signal- ing devices or in not fulfilling required operations such as dredging. Even though the port authority should have subsidiary responsibil- ity in compensating affected parties for those costs not covered by the concessionaire, it should supervise private operators to ensure that they are properly insured to cover their civil responsibilities. In the construction phase, the concessionaire must be strictly su- pervised so that it takes care of any negative environmental effects that it might cause, such as dumping of dredging materials or im- pacting adjacent areas. The contract should explicitly include these aspects to ensure the correct allocation of responsibility. SELECrION PROCESS. One of the more important elements for a concession contract is carefully designing the selection process, deciding which firm Lourdes Trujillo and Gustavo Nombela 143 or consortium will be granted the concession. This process must pursue the objective of determining, in conditions of asymmetric information, which candidate can more efficiently run the assets that are the object of the concession, and whether that candidate has the ability to implement the associated building/rehabilitation projects. The usual practice is to design a selection process based on two con- secutive phases as follows: * Prequalification: In the first stage, those firms satisfying several crite- ria are selected to be evaluated on their proposals. Criteria used for prequalification include experience in the seaport industry and a minimum financial capacity. This prequalification reduces the can- didates to a small number, so their proposals for the project can be studied in great detail. Generally, candidates present the informa- tion required for this first stage separately from the economic pro- posal (usually enclosed in different envelopes), and it is evaluated objectively. For example, in the case of the concession for the port of Mar del Plata (Argentina), the information about experience and fi- nancial capacity was condensed into a single index, and only those consortia above a certain minimum value qualified for the next stage. * Concession award: In the second stage, the proposal that is closest to the objectives the port authority is pursuing is selected. Thus, in gen- eral, the winning proposal is the one that offers a higher fee pay- ment to the port authority (if financial need is the basic reason be- hind concessioning port assets) or the one that offers the lowest charges to port users (if port efficiency is primarily sought). If the concession involves investment projects, including an evaluation of the best project, or the one that has the lower cost, is also possible. In the example of Mar del Plata, the solution was to summarize all three of these criteria on a single index. The final decision was then based on the information from this index, to which the first index calcu- lated in the prequalification stage was added. This example consti- tutes a sophisticated system of firm selection, because it uses all of the information provided by candidates. In summary, one must design the process of selecting a concessionaire according to the objectives of the government or the port authority. The process should be as transparent as possible, and try to avoid allowing candidates to collude on their bids. In the case of the concessions for the terminals of the port of Buenos Aires, the selection process was designed so that a candidate was only allowed to win one terminal, as a way to 144 Seaports promote competition in the bidding process (not all terminals had the same characteristics, and therefore all bidders were supposed to tailor the bids to win the more attractive assets). RENEGOTIATION OF CONCESSION CONTRACTS. Finally, a relevant aspect that one must consider when drafting a concession contract is that, in all prob- ability, during the life of the contract some unpredicted circumstances will arise and force parties to renegotiate. This statement is true for any kind of contract, but it is especially important in the case of concessions. This is due first to the long period of the contract, which makes anticipat- ing all possible contingencies unfeasible for any party. Unforeseen con- tingencies also occur because concession contracts for port facilities are related to expensive fixed assets that cannot be easily removed and re- deployed in another location. One must study renegotiation, because in the case of disagreement, the owner of the asset is the agent that has rights over its use. If renegotiation is not anticipated, the port authority can find itself in a weak position, allowing concessionaires to extract ex post additional rents. For example, consider the case of a small port that is concessioned as a whole to a single operator. After the concession is granted and opera- tions start, the concessionaire tries to renegotiate the contract to obtain better conditions by using the threat of stopping the provision of services to ships and blocking the use of assets by an alternative operator. If the concession contract does not precisely define who owns the assets and when they can be transferred between parties, the concessionaire could claim valid rights over the assets granted by the concession, and litigate against the port authority (hold-up problem). If the contract clearly states that the port authority owns the assets, however, in the case of renegotia- tion, the concessionaire would never be in such a strong position, be- cause, as owner, the port authority can always "rescue" the assets and keep the port working. Renegotiation of a concession contract is probably the rule and not the exception, and one should not perceive it as a failure. Because concession contracts are typically long-life documents, the parties could not foresee all possible future contingencies at the moment of drafting the contract. Know- ing this in advance, the parties should consider several future conflict sce- narios and ensure that some provisions are included to establish at least ba- sic renegotiation rules. Nevertheless, a concessionaire should try to avoid renegotiation at early stages as much as possible, because the credibility, trans- parency, and fairness of the bidding process can be put in jeopardy. Lourdes Trujillo and Gustavo Nombela 145 International Experiences In general terms, the process of privatization and liberalization of the main seaports worldwide has been characterized by the use of concession con- tracts, rather than by selling seaport assets to the private sector. Through concessioning, port authorities reduce their functions and are transformed into landlords responsible for coordinating all activities performed at the port. Consequently, they receive all rents accruing from asset renting. The seaport industry is experiencing several patterns of privatization and deregulation, depending on the region and the initial situation of the ports. In Europe, the model increasingly seems to be the introduction of private firms in the provision of port services, but in general, infrastruc- ture is kept within the public sector, and in some countries, governments continue to finance investment costs. A debate is going on within the Euro- pean Union, however, on a plan to create a self-financing port system that would not receive subsidies from governments (European Commission 1997). The idea is that port authorities should adequately design port tar- iffs to finance infrastructure expansion or else seek private participation. In this region, limitations on the use of public funds are not motivated by the states' lack of financial capacity, but by competitive considerations. Some argue that in order to have a single market in which all ports compete on equal terms, having some states subsidizing ports, with other seaports self- financing their facilities, is not a fair scenario. The United Kingdom has introduced the most radical reform in Eu- rope, by fully privatizing most of its ports. In 1996, private institutions handled around 70 percent of all cargo. The process started by privatiz- ing the Associated British Ports, an institution that had owned all former state ports. Subsequently, ports under a different legal status (trust ports) were transferred to the private sector. Results seem to be positive; invest- ment figures have risen and private operators are making substantial profits (Ferrer 1997). Some critics have pointed out, however, that the British experience does not clearly benefit port users in the long run. Pos- sibly, port authorities and regulatory bodies will again be required. In Eastern Europe, the transition economies have some ongoing re- forms of seaport systems, aimed at introducing private participation. Some ports have been transformed into state companies with worker partici- pation, such as the St. Petersburg port, where employees own 51 percent of the port. Another example is the container terminal in the port of Vostochnyy (Russia), which is operated by P&O Australia, SeaLand, and a local Russian firm. Another example is the case of Polish ports, where a 146 Seaports new Port Law, enacted in 1997, established port authorities as joint-stock companies, with 51 percent of shares remaining in public hands (state, treasury, local governments and municipalities) and 49 percent open to private participation. In some Asian countries, private participation in financing infrastruc- ture building began long ago in Japan and Hong Kong (China), where pri- vate firms build and operate infrastructure under long-term concessions. In other Asian countries (China, Korea, Malaysia, and the Philippines), shipping companies such as Maersk and P&O are also actively participat- ing in the development of seaports. Latin America is one of the more dynamic regions in terms of seaport concessioning, the building of new facilities, and most importantly, the reha- bilitation of existing ports. The model of mixed public/private financing of seaports is successful in this region for three reasons. First, seeking capital is strongly needed to finance investments, because most governments have highly constrained budgets because of debt service payments. Second, rapid economic growth is generating new traffic that demands new facilities and more efficient services. Third, fierce competition makes upgrading of port facilities necessary or the ports risk being displaced by rivals. The experi- ence of three countries in the region (Chile, Argentina, and Brazil) is dis- cussed in some detail, while a summary of other experiences for Latin Ameri- can countries and other regions of the world is presented later. THE CASE OF CHILE. Chilean international trade is served by 38 sea- ports, of which 11 are publicly owned and organized by the public agency Empresa Portuaria Chilena (Emporchi), while 27 belong to the private sector. Of the latter, 11 are private (owned by mining and other companies), and 16 are privately owned but publicly used. Table 4.8 shows the distribution of cargo between ports. In 1997, Emporchi handled 94 percent of container cargo, 69 percent of general cargo, 18 percent of dry-bulk cargo, and 11 percent of liquid-bulk cargo. In total volume, the 11 public ports handled 37 percent of total tons that passed through Chilean ports (Tortello 1998). In 1978, seaports in Chile were characterized by the split of cargo han- dling between two different groups of workers. Specialized port workers performed stevedoring operations, while Emporchi employees did load- ing and unloading operations. Both groups enjoyed some monopolistic positions. Stevedores had strong limitations on increasing their numbers, because each worker was required to have a special license (matricula) to be able to work as a stevedore. This practice transformed stevedores into Table 4.8. Chilean Ports: Distribution of Cargo by Port Type Containerized cargo General cargo Dry-bulk cargo Liquid-bulk cargo Total cargo Port type Tons Percent Tons Percent Tons Percent Tons Percent Tons Percent Private 1,702 0 194,501 2 12,394,187 49 6,870,439 75 19,460,829 38 Privateb 427,347 6 2,900,055 29 8,247,183 33 1,334,878 14 12,909,463 25 Emporchi 6,375,130 94 6,804,283 69 4,481,230 18 987,764 11 18,648,407 37 Total 6,804,179 100 9,898,839 100 25,122,600 100 9,193,081 100 51,018,699 100 a. Private ports for exclusive use by owners. b. Private ports for public use. Source: Tortello (1998). 148 Seaports monopolists for those services, which resulted in high tariffs and low pro- ductivity. Emporchi was by definition a public monopoly, working at the state level, and its workers constituted an important pressure group. In 1980 the government decided to change the status quo. It introduced legal changes in 1981 by passing the new Seaport General Law, which ef- fectively eliminated the monopoly of Emporchi in cargo-loading opera- tions, allowing private participation in those services. Almost simulta- neously, a different law abolished the system of licenses for stevedoring, allowing any worker to perform those services for shipping companies. The state made payments to compensate the 2,700 workers who lost their privileges and who were clearly opposed to any reform. These regulatory changes permitted the significant entry of new pri- vate operators, establishing a competitive market for cargo handling. The impact on costs was substantial: cost savings of US$17.7 per handled ton for general cargo and US$1.43 per ton for dry-bulk goods, though liquid cargo had no improvement (Tortello 1998). The different cost savings for each type of cargo is interesting; it is explained by the presence of private participation in those ports specializing in bulk cargo. At the end of 1997, Chile passed a law seeking to modernize state ports and transform the Chilean port system to the new needs of maritime trans- port. The law intended to introduce more private participation to achieve the objective of modernizing the ports. The law sought to split Emporchi into 10 autonomous public companies to run the 11 state ports, from Arica in the north to Punta Arenas in the south. These new companies act as port authorities, managing infrastructure, but they are not allowed to handle cargo or berthing. The idea is for new port authorities to contract those services with private operators through licenses and concessions. Even though the actual division of Emporchi did not take place until January 1999, the process of introducing private participation started be- fore then. The main container terminals of the country, located at the ports of Valparafso, San Antonio, and San Vicente, were concessioned to the pri- vate sector in August 1999, for periods of 20 to 30 years. TBE CASE OF ARGENTINA. The reform in Argentina also began with a revision of legislation, with the introduction of significant changes in 1992. Among these changes, decentralization is probably the more remarkable, and Argen- tina achieved it by closing the central public agency responsible for ports (Administraci6n General Portuaria), and transferring ports to regional gov- ernments. It transferred small ports to municipal governments, while splitting the large port of Buenos Aires into three separate zones: Dock Sud, transferred Lourdes Trujillo and Gustavo Nombela 149 to the province of Buenos Aires; Puerto Sur, which is still to be developed; and Puerto Nuevo, which remains in the hands of the central government. Other characteristics of the reform process were the deregulation of all port services and the elimination of restrictive working practices. Most important, the reform has introduced significant private participation in building and operating port infrastructure. Given its special role within the maritime transport industry, special attention has been devoted to the development of container terminals, and the reform has attained large im- provements in terms of the volume of traffic and productivity. The port of Buenos Aires has been one of the more innovative world experiences in port reform. The central government-owned infrastructure (Puerto Nuevo) was split into six terminals and concessioned for periods of 18 to 25 years. Initially, the proposed structure was to have five different operators, because a single concession included terminals 1 and 2. As men- tioned above, the selection process was designed to avoid a concentration of terminals in the hands of a single operator, forcing bidders to win, at most, only one concession each. In 1998, market conditions changed, and now only two terminals com- pete in the container market (terminals 1-2 versus five) within Puerto Nuevo. Terminal 4 is relatively small and dedicated to general cargo, while termi- nal 3 is multipurpose (general cargo, cars, and passengers). Terminal 6 was forced to close down. Even though the reduction in the number of opera- tors indicates that the process could have been designed better and was probably implemented too quickly, its results in terms of port outcomes have been extremely positive, as can be observed in table 4.9. The success of seaport modernization in Argentina is in great part due to changes in working practices. In Buenos Aires, private firms have been providing stevedoring services since 1970, but those companies never ob- tained good results in terms of productivity. Managers were not invest- ing enough in infrastructure and equipment. Plus, seaports unions were strong and kept a separation between stevedoring and loading services, similar to the case of Chile. The Administraci6n General Portuaria was responsible for loading operations, while stevedores had such power that the public agency could not install any new technology that would re- duce labor requirements (Raciatti 1998). THE CASE Op BRAZIL. The situation of the seaport industry in Brazil prior to the reforms introduced in 1993 can be characterized by problems of inef- ficiency, low productivity, an excess of bureaucracy, and chronic underinvestment. The results of combining all of those problems were port 150 Seaports Table 4.9. Port of Buenos Aires Indicators, 1991 and 1997 Indicator 1991 1997 Cargo (thousand tons) 4,000 8,500 Containers (thousand TEUs) 300 1,023 Capacity (thousand containers per year) 400 1,300 Cranes 3 13 Operations area (ha) 65 132 Productivity (tons per employee, annual) 800 3,100 Average container time at port (days) 2.5 1.3 Charges per container ($/TEU) 450 120 Source: Estache, Carbajo, and De Rus (1999). tariffs three to six times higher than international levels, long waiting times for using port facilities, and deficient service provision, which translated into delays in goods' deliverance and reception. The process of reform started in 1990 with the dismantling of the public agency Portobras and the decentralization of the system. In 1993 Brazil passed a law to establish the general framework of the new re- formed port system. This law grants autonomy to all seaports and it allows private participation in cargo handling services, a practice pre- viously prohibited. A movement also started toward the liberalization of port tariffs, with the objective of promoting competition between ports at a regional level. Reforms have faced strong resistance from port unions, which has been the main factor conditioning and delaying the process. Even though solu- tions are being implemented to ease that opposition, many ports still have large excesses of workers. Each port now has an institution (Orgao Gestor de Mao-de-Obra) formed of unions and port operators, which is in charge of managing the use and payment of temporary port workers. Plans call for privatizing 36 state ports, some of which are well advanced, especially for small ports (Itaji, Laguna, Cabedelo, and Porto Velho). The main ports of the country (Santos, Rio Janeiro, and Rio Grande) have been subject to important reforms, and substantial private participation has been introduced through the concession of terminals. At the moment, about 75 percent of infrastructure has been passed to the private sector through con- cessions. Productivity has increased, ship waiting times have decreased, and the ports have become more competitive. Labor stoppages and other disruptions have been reduced. Lourdes Trujillo and Gustavo Nombela 151 In addition, private concessionaires are planning US$1 billion in new in- vestments for the next few years, many of which are contractual obligations and have already been initiated. These investments are mostly destined to modernize or build specialized terminals (coal, minerals, sugar, and so forth) and to buy container handling equipment. Most of the rest of the public ports in the country are relatively small, because the main export goods pass through privately owned facilities. There are opportunities for the development of new regional hubs for con- tainerized cargo. Two ports could play that role: Rio Grande and Sepetiba. In the near future, both could attract cargo with final destinations in Ar- gentina and Uruguay, and potentially become hub ports for MERCOSUR. Competition for transshipment and final cargo in southeastern Brazil is expected to increase between these new emerging ports and the traditional facilities of Santos and Rio de Janeiro. SUMMARY OF OTHER INTERNATIONAL PoRT EXPERIENCES. This section provides a brief overview of other international port experiences. Africa * Kenya: Hutchinson Port Holdings signed a contract in 1996 to manage and operate the container terminal at Mombassa. This is considered a first step toward further introduction of private participation at the port. - Morocco: The government's agenda includes seaports' reform, and it is considering allowing private capital into ports. The first stage has been the transformation of the public agency R6gie d'Acconage du Port de Casablanca into a new, autonomous public corporation. This change is aimed to improve the efficiency of 11 ports, starting with Casablanca and Mohammedia. A project the World Bank financed has led to a cargo handling productivity increase of 25 percent, and the average dwell time of containers at the port was reduced by 40 percent. e Senegal: The port of Dakar is transforming into a landlord type of or- ganization. Stevedoring services have been transferred to the private sector. The Americas * Bahamas: The first phase of its modernization project had an objective of providing capacity for container traffic (400,000 TEUs). Now it is try- ing to start competing against Miami and other Caribbean ports. 152 Seaports * Colombia: Seaport laws authorized 25 private ports to handle only spe- cific cargoes. Colombia passed a new general law in 1991, allowing these ports to work on any type of cargo from that date onward. The central public company in charge of state ports, Colpuertos, has started to be dismantled. The objective is to introduce competition among the main ports of the country: Buenaventura, Barranquilla, Cartagena, and Santa Marta. Privatization of the port of Cartagena was initiated after 1991, and since then it has improved its efficiency. The container terminal at that port, Cotecar, has plans for enlargement of its capacity up to 500,000 TEUs/year. * Costa Rica: Private firms perform stevedoring services at the ports of Lim6n and Moin. At the port of Caldera, however, those services are still under public organization (Alvarado 1998). * El Salvador: The state port of Acajutla is starting its reform process, with plans to introduce private participation. * Guatemala: The ports of Quetzal and Barrios have transferred stevedor- ing services to the private sector. The process of privatization of those services also has started at the port of Santo Tomas de Castilla (Alvarado 1998). * Honduras: The program for the general reform of the transport sector include plans to privatize seaports. At the moment, Honduras is con- sidering full privatization of all ports, with the exception of Puerto Cortes, which is the main port of the country. The idea is to keep this last port under public control, but to introduce private participation at terminals (Juhel 1994). Private firmns have been already authorized, how- ever, to operate stevedoring services at Puerto Cortes (Alvarado 1998). * Mexico: The new 1993 seaports' general law has redefined the role of the state in the industry. The government is relinquishing port admin- istration, terminal operation, and provision of other port services. Privatization started with 26 projects, including the cargo terrninals at the ports of Lazaro Cadenas, Manzanillo, Altamira, and Veracruz. The bidding process of seven small ports (Acapulco, Topolobampo, Mazatlan, Puerto Vallarta, Guaymas, Ensenada, and Campeche) fol- lowed. The objective is to reach a system of landlord type of ports. Port authorities at each port are planned to manage those publicly owned assets that will be concessioned to them. The decentralization program aims to end up with 22 port authorities running the main ports of the country, with plans to privatize them in the future. * Nicaragua: The public sector performs stevedoring services at the ports of San Juan del Sur and Puerto Cabezas. Authorities at the ports of Lourdes Trujillo and Gustav Nombela 153 Sandino, Bluff, Arlen, Rama, and Corinto are starting to concession those services, however, to private firms organized by port workers (Alvarado 1998). * Panama: This country intends to partly transfer those ports controlled by the state public agency Autoridad Portuaria Nacional to the private sec- tor. Thus, the ports of Balboa and Cristobal were privatized in 1996, and now the Panama Ports Company, a subsidiary of Hutchinson Port Hold- ings, runs them. Plans also call for an international consortium to invest US$600 million on a project for the construction and operation of a con- tainer terminal on the Atlantic side of the Channel at Telfers Island. * Uruguay: The general seaports' law passed in 1992 introduced signifi- cant reforms in the ports' activity. The main reform was to make more flexible the use of labor at ports. Uruguay plans to grant a concession of the country's only container terminal to the shipping company Maersk. This proposal is somewhat risky, because the concessionaire should be strictly supervised not to discriminate at the terminal against some ri- val shipping companies that may compete for import/export traffic. This same company has a concession at the Spanish port of Algeciras for a transshipment terminal, however, and no problems have been re- ported so far. Both cases differ, though, because other independent al- ternative terminals exist at Algeciras. • Venezuela: This country initiated a port reform in 1991 by dismantling the public agency Instituto Nacional de Puertos. In 1992, it transferred responsibilities from the agency to the eight port authorities now in charge of ports. These port authorities now have the task of introduc- ing private participation through the concession of container terminals. The new system specifically limits the possibility of any public sector institution (national, regional, or municipal governments) providing services at ports. Caracas and Puerto Cabello were the first ports to introduce private participation (Juhel 1994). Asia * India: The Indian Ports Association is opening doors to private par- ticipation at seaports, though the process is very slow. The only rel- evant plans are to grant three-year build-operate-transfer contracts to private operators. * Philippines: One of the first concessions in the Asian region was the Ma- nila International Container Terminal, granted in 1988 to a consortium for 25 years, and involving investments for $54 million. Plans call for 154 Seaports enlarging further the capacity of Manila up to 1 million TEUs/year, with a fifth berth. Regarding other ports, Asian Terminals Inc., a joint venture formed by P&O and a local firm, has a 15-year contract to operate the South Harbor of Manila; Hutchinson Port Holdings won a bid to de- velop and operate a container terminal at Subic Bay, but the deal was thereafter rescinded among political turmoil over lack of transparency. * China: Shanghai's port authority and the private firm Hutchinson Whampoa Ltd. formed in 1993 a joint venture to create the company Shanghai Container Terminals Ltd., which owns and operates the con- tainer terminals at the port. During its first year in operation, the com- pany handled 25 percent more containers than in the previous year, and productivity increased more than 30 percent. Investment plans of $673 million are being completed. Hutchinson Whampoa is also in- volved in the development of the Yantian port, a location intended to become one of the four China hubs, together with Dalian's Daiyo Bay, Beilun, and a port in the Fujian province. In Dalian, PSA Corporation has formed a joint venture with the port authority to operate the con- tainer terminal. The parties that are more interested in developing Chinese ports are shipping companies with regular services in the re- gion and private investors based in Hong Kong (Peters 1995). For ex- ample, Maersk has a preferential agreement as the main user at the port of Yantian, and P&O has made significant investments in the con- tainer terminal at Shekou and in the development of the Tianjin port. * Malaysia: This country initiated privatization in 1986 at the port of Kelang, when the container operations were granted for 21 years to the joint venture Kelang Container Terminal (KCT), formed by the port authority and private investors. In 1992, a second privatization phase launched, concessioning the rest of the port's infrastructure to another private company (Kelang Port Management, or KPM). Al- though the port authority does not have participation at KPM, it holds a golden share to keep control over essential issues. The KPM con- tainer terminal thus competes with the KCT terminal within the port of Kelang. A project is developing new facilities at Westport, located also in Kelang. The government designed the initial plan to reduce congestion at existent facilities, and it intended to finance it with pub- lic funds. But eventually it was concessioned to a private consortium (Kelang Multi-Terminal Consortium) with a 30-year term contract. These new facilities that the consortium is developing will compete against those of KCT and KPM, reinforcing even more the competi- tive framework of the Kelang port. Lourdes Trujillo and Gustavo Nombela 155 Price Regulation The economic regulation of ports aims to put some limits to the market power that private port operators may enjoy by having exclusive rights. This type of regulation basically is performed by establishing some limits on the tariffs that are charged to port users, or on the total revenues that private firms obtain. Because the types of tariffs involved in the use of ports are diverse, analyzing separately the regulation over port dues, over charges for cargo handling, and over fees that concessionaires pay for the use of infrastructure, is convenient. Port Tariffs In seaport activity, the users of a port must pay diverse charges for the ser- vices they receive and for the use of facilities. Port tariffs (or port dues) are charges on ships for the use of the general infrastructure of a port. Port au- thorities impose these tariffs, although they do not always directly collect revenues, a task that in some cases concessionaires perform. Apart from in- frastructure, port dues may include charges for the use of compulsory berthing services (pilotage, towing), particularly at ports where the port au- thority is in charge of those services. Another part of the total fee stems from tariffs on all cargo that passes through the port's facilities. Shipping compa- nies partly pay these tariffs, and the rest is directly charged to shippers. Although port tariffs are relevant when shipping companies and ex- porters/importers choose between ports, their weight is relatively small compared to the total cost that port users must bear. Table 4.10 shows that the largest part of the bill is cargo handling (loading/unloading, stevedor- ing, storage, and so forth). Table 4.10. Relative Weights of Different Port Charges Type of charges Percentage of total bill Port tariffs on the use of infrastructure 5-15 Berthing services 2-5 Cargo handling 70-90 Consignees 3-6 Source: Suykens (1996). 156 Seaports Port industry experts are generally of the opinion that the elasticity of the demand for port services with respect to port tariffs is relatively small (Slack 1985). For shipping companies, relevant factors when choosing a port are the general quality (equipment, waiting times, operating times, and so forth.) and the existence of business opportunities (demand for cargo transport from exporters and importers). For the shipper, the important variables would be the charges on cargo handling, the frequency of regular services (liners), and the existence of charter services from the port for special shipments. As a consequence of these behaviors, one can conclude that port authori- ties can raise and lower port tariffs within a wide margin, without affecting their demand levels. An exception would be a region with fierce competi- tion among ports with similar facilities and inland connections. In that case, it is possible that a slight variation in port tariffs could lead to traffic devia- tions, and thus render port tariffs as a strategic variable for competition. In theory, the optimal rule for determining port tariffs for the use of port infrastructure is to make users pay the marginal costs that they gen- erate. As with other industries in which infrastructure is publicly used (such as airports and roads), however, marginal costs are very small, be- cause they only consist of maintenance and repair expenses. These costs are small when compared to construction costs. Therefore, cost recovery is a problem if employing the social optimal pricing rule. A classical solution to this problem is the public sector paying for infra- structure costs, and thereafter, the users only being charged the marginal cost. The argument for the use of this system is that whether users pay full costs, some of them could be driven out of the market, even if they are prepared to pay the marginal costs. But because the option of public sector help for seaports is not available in most countries, new solutions to deter- mine port charges are needed. One possible alternative is to use the con- cept of long-run marginal cost, which keeps the idea of social optimality, and at the same time, achieves full cost recovery (see box 4.2). In practice, port tariffs are determined by rule of thumb and do not neces- sarily relate to investment costs or opportunity costs for the use of infrastruc- ture. As a general rule, port authorities seek real return rates on assets of around 8 to 12 percent during the economic life of the infrastructure (DSC 1998). Tariffs charged on ships for the use of infrastructure usually depend on some capacity measure, such as gross registered tons or some other alter- native. At some ports with high demand levels, one can establish port tar- iffs on ships on other criteria that better reflect the opportunity cost for the port authority of having a given ship use a piece of infrastructure (for ex- ample, at the port of Rotterdam, ship tariffs partly depend on their total Lourdes Trujillo and Gustavo Nombela 157 Box 4.2. Concept of Long-Run Marginal Cost The concept of long-run marginal cost (LRMC) has been used in sectors with expen- sive infrastructure assets, such as roads or public utilities (water, gas, and so forth). The problem all these industries share is that significant investments are needed to build infrastructures, which constitute large sunk costs, while marginal costs of opera- tion are relatively smalL If the socially optimal pricing rule is applied-price equal to marginal cost-recovering investment costs is not possible. A second-best alternative to set low prices, and to avoid excluding potential users, is to use LRMC as a basis for pricing. LRMC is defined as the sum of short-run marginal cost (SRMC) plus marginal cost of capacity (MCC): LRMC = SRMC + MCC For the case of seaports, the marginal cost of capacity would be the additional cost of infrastructure required to service one more unit of cargo above the maximum port's capacity. For ports with excess capacity, each additional user does not require new infrastructure, so in that case, MCC = 0, and long- and short-run marginal costs would be equal. Meanwhile, for the case of a port with congestion problems, the marginal cost of capacity is positive, and therefore, LRMC > SRMC. For ports, SRMC is formed only of maintenance and infrastructure repairing costs. Some difficulties in practice exist for LRMC pricing: (a) infrastructure cannot be con- tinuously enlarged (indivisibilities are derived from berths' minimum sizes), and (b) infrastructure assets have long economic lives. If the rule of setting price equal to long- run marginal cost is applied, port tariffs could oscillate dramatically between years, because users calling at a port in periods of capacity enlargement would then be paying for assets that are thereafter used during long periods. In practice, a solution is to use some formula to distribute the cost of construction, plus its associated financing cost, during the economic life of the asset. Thus, what part of total cost of capacity port users should pay each year is estimated, so that port tariffs do not vary too much, and at the end of the period the users have financed the infrastructure's construction. length). Imposing extra charges for ships with special requirements is also possible, in terms of draught or other characteristics. For tariffs on cargo, port authorities usually discriminate among types of goods, in some cases following complex classification schemes (in European ports, one can find countries with lists of up to 56 different types of cargo and charges). The origin of these systems of charges is the idea of extracting as much rent from users as possible (the traditional practice of charging what the market can bear). Therefore, prices are more or less related to the value of the goods passing through the port. A trend, however, at least in Europe, is toward reducing tariffs on cargo to attract shippers, and increasing tariffs on ships to balance port authorities' total incomes. In terms of regulatory needs, because most world ports are going to a landlord type of model and not to full privatization, imposing regula- tion, in principle, is not needed on port prices. Nevertheless, in the case 158 Seaports of ports without competition in their region, a regulator should possi- bly supervise the charges on the use of infrastructure, because in such cases the ports enjoy a monopoly position. The need for regulation arises even if the port authority is a public institution, because a risk of cap- ture by third parties is still possible, which can lead to a nonoptimal tariff set by the port authority. Meanwhile, regulating charges on port users for complementary ser- vices (such as berthing) is needed in cases in which private operators pro- vide these without guaranteed competition. A system based on maximum prices is usually employed to regulate this type of service, because no sig- nificant problems occur in estimating their costs. Cargo Handling Charges As mentioned earlier, charges for cargo handling services are the most rel- evant for port users. Therefore, because these charges affect ports' com- petitive position, relating these charges closely to the real costs of service provision is crucial. The whole process of privatization and liberalization is aimed at making these charges to be in accordance with market mecha- nisms, instead of set by public institutions, as traditionally was the case in most ports worldwide. The liberalization process does not guarantee that market mechanisms will prevail, however, so regulation is still needed in ports where competition is absent. In general, large ports tend to liberalize their cargo handling charges so that private operators can freely set them. Regulation is not required in those cases, because operators must adapt their charges to market condi- tions. Port authorities usually keep some form of control, however, such as setting a maximum level of charges. The need for regulation is greater in the cases of medium and small ports, because the size of the market only allows for a limited number of operators, a situation that can easily result in collusive practices among them. One should study in detail the maximum charges authorized to port operators by port authorities or the regulatory institutions, because this is the basic instrument of regulation over private operators. In practice, concession contracts that port authorities and private firms sign are usu- ally not too precise on determining those authorized maximum charges. Generally, contracts state that the private operator will be allowed to obtain an adequate rate of return (as in the concession contracts in Buenos Aires), but they do not specify how this principle will be imple- mented in practice. Lourdes Trujillo and Gustavo Nombela 159 Concession contracts should explicitly include rules that a regulator is going to follow when setting maximum charges. Because one knows that port operators are going to adapt to the type of regulation, and the effects of price caps and rate of return regulatory systems are not the same, the regulator must choose a mechanism according to both the information avail- able and its own objectives. Thus, for example, if port operators are in- tended to make substantial investments in equipment, establishing a rate of return type of regulation is adequate, because that will provide incen- tives for them to invest in capital assets. Difficulties in evaluating the costs of concessionaires operating at ports can, in principle, be overcome by establishing some form of regu- lation based on comparisons between different operators (yardstick com- petition). This implies analyzing cargo handling charges among similar seaports in a given region, and trying to derive conclusions in terms of cost efficiency and charging practices. Some established international reference values already exist for some types of cargo, which regulators can use to get an idea of the outcomes that should be expected from a private operator. Nevertheless, these reference values must be adapted according to local conditions (average wage levels, interest rates, and so forth). Charges on cargoes may vary greatly across ports, according to the type of technology and the age of the equipment employed for cargo handling. For example, with containers, the price charged per TEU is an easy vari- able to obtain, and a regulator can use it after some adjustments for local conditions. The reference values can serve as a benchmark for the efficiency that a private operator should be able to achieve, which then can be used as a limit for imposing price cap regulation (see table 4.11). In the case of the container terminal at the port of Santos (Brazil), regulation has been imposed on the new private concessionaire in the form of a target for the charge per TEU. In a period of three years, the price must be lowered from US$550 per box to US$150. Concession Fees A relevant question when introducing private participation in seaports is to determine the payments that the operators must make to the port au- thority or the agent that owns the infrastructure assets (named concession fees or canons). Even if those fees do not directly affect port users, evi- dently the higher the payments private operators make for the use of infra- structure, the more income port authorities receive, and port tariffs can 160 Seaports Table 4.11. Comparison of Container Handling Charges Across World Regions, 1996 Region Port Price per loaded TEU (US$) North Europe Antwerp 120 Felixstowe 173 Hamburg 182 Rotterdam 156 Zeebrugge 123 South Europe Algeciras 193 Barcelona 211 La Spezia 240 Marseilles 233 Pireus 203 Asia Pusan 175 Kaohsiung 140 Manila 118 Singapore 117 North America Halifax 168 Los Angeles 256 Australia Melbourne 199 Source: DSC (1998). then be reduced accordingly. Private operators will then try to pass their higher costs to users through their cargo handling charges, however, so port authorities should establish a careful balance regarding those prices that they can directly control. An advantage of this mixed forn of revenue for port authorities (from port tariffs and concession fees) is that part of the demand risk is left to the private operators, which then have correct incentives to provide efficient, low-priced services to minimize that risk. In addition, concession fees pro- vide port authorities with a safe, continuous cash flow, therefore providing the possibility to finance general port costs or even part of the facilities' con- struction/rehabilitation costs. In European ports, revenues obtained from port tariffs are in gen- eral higher than revenues from concession fees, with these latter aver- aging 37 percent of total income received by port authorities. Examples exist in other regions, however, as in the case of the port of Baltimore (U.S.), where more than half of total income is obtained from conces- sion fees (58 percent), therefore indicating a higher presence of private operators (PDE 1998). Lourdes Trujillo and Gustavo Nombela 161 No established procedures determine the level of concession fees for private firms to pay. An optimal rule should be to relate payments to the opportunity costs of the infrastructure and those superstructure elements with which the concession might be associated. For infrastructure, an ap- proximation for the opportunity cost could be the market price of the port's adjacent land, modified by the specific characteristics of the surface used by the concessionaire. Meanwhile, the opportunity costs of equipment granted by a concession are easier to estimate, because they are equal to their price in a rental market. One can add other aims to the basic objective of concession, for example, sharing the risk of demand fluctuations between operator and port au- thority. This risk could be shared by making concessionaires' payments dependent on their level of activity, with some minimum guaranteed pay- ment. The optimal system to determine concession fees is a mixed combi- nation of opportunity costs and risk allocation objectives. In practice, however, port authorities do not often use any market crite- ria to determine the opportunity cost of assets. Concession fees are usually fixed payments per square meter used, which are periodically revised (see table 4.12). Fees usually depend on the service the concessionaire provides, so that the price per square meter is different if the surface is used for con- tainer handling than if it is devoted to specialized storage areas. In some cases, fees depend on the volume of demand attended to by the operator, therefore achieving the objective of risk allocation. For example, in the case of the concessions of the port of Buenos Aires, concessionaires pay accord- ing to the total volume of cargo handled, with a guaranteed minimum pay- ment for the port authority. Quality and Safety Regulation As important as the economic regulation, the public sector must keep an eye on quality and safety issues at privatized ports. This is an important task, because the activities performed at ports are prone to cause externalities to the environment and to other port users. Private concessionaires are not likely to properly consider these externalities unless they are forced to by some established, clear rules. Congestion Problems The waiting time of ships is one of the port characteristics that shipping companies value when choosing between ports. The total time that a ship stays at a port is equal to the sum of the time employed to obtain 162 Seaports Table 4.12. Concession Feesfor Different Ports, 1997 Annual price Revision Port per sq.m. (US$) frequency Revision mode Baltimore 6.5 Annual Variable Bremerhaven 2.3 5 years Price index Bordeaux 4.5 Annual Price index La Spezia 5.7 Variable Variable Le Havre 3.8 Annual Price index Lisbon 15.0 Annuala Price index Oslo 61.5 Variable Variable Rotterdam 3.2 Variable Variable a. It also charges a variable fee on volume: US$0.3 per ton or US$5.5 per container. Source: PDE (1998). the required services and supplies, and this time must be considered as a cost for port users. The generalized cost paid by a ship using a port is equal to monetary charges (port tariffs + cargo handling charges + other services' prices) plus the time spent in the provision of services (see box 4.3). Therefore, the shorter the waiting time, the lower the generalized cost of port use, and the more attractive the port is to users. The first part of total ship waiting time is the time spent at the port maritime access zone waiting for a berth to be available. Two scenarios are possible. First, the port could suffer from no congestion problems; there- fore, the waiting time is equal to zero. The second situation occurs in ports with congestion problems, which can result in relatively long waiting peri- ods (up to several days). In the latter situation, the long-term solution is to enlarge the port's capacity, but in the short term, using port tariffs can establish some de- mand rationing. Raising these tariffs could induce some users to seek alternative facilities, therefore decreasing average waiting times and im- proving the welfare of the remaining users. During the construction pe- riod of new infrastructures, however, the port authority should try to minimize the disruption for port users, because otherwise some traffic segments can permanently deviate to rival ports. If one does not correctly manage congestion periods, investments in new facilities could only re- sult in excess capacity. For ports that are contracted out to private management, or that are fully privatized, a regulator should be concerned with guaranteeing that decisions Lourdes Trujillo and Gustavo Nombela 163 Box 4.3. Concept of Generalized Cost As in other transport modes, when analyzing the cost that users incur, we have to consider not only the monetary cost of the fare or tariff, but also the value of time spent to obtain the desired service. In the case of seaports, ships are charged by differ- ent concepts (such as use of infrastructure, berthing, cargo handling services, and other supplies), but they also spend considerable lapses of time at ports waiting to be served. In a broader definition, we should also include such things as costs suffered from cargo damages or losses, but by considering only prices and time, we can define the generalized cost for port users as follows: Generalized cost = price + time x value of time = (port tariffs + services' charges) + t ,P x V, In the expression above, t,P would be the total time spent by the ship in obtaining port services, from when it enters the port until it exits, and V,,hp would be the oppor- tunity cost of the ship per unit of time (rent that is lost when the ship is not providing transport services). on port capacity are made sensibly. A private manager, in principle, will not have a long-term perspective on running the port if the management contract has a fixed term and no renovation is expected. Thus, if the performance of the port is measured by its financial results, a private manager could leave con- gestion problems unresolved, and simply obtain extra income from high port tariffs (which some users are prepared to pay in the case of congestion). Quality of Service The second relevant component of cargo ships' waiting time, and there- fore of their generalized costs, is the time spent being loaded/unloaded, which an efficient port should try to minimize. Moreover, safety proce- dures also should be followed to avoid damage to cargo. Therefore, regu- lation on private concessionaires should not only be concerned with prices, but also include quality of service provisions in the contracts. In principle, a private operator would be interested in cargo handling services being provided quickly and safely, for its clients to be satisfied. However, in some cases, a profit-oriented operator may not care exces- sively about safety and only value speed (at terminals with high demand), or spend too much time servicing ships with expensive cargo that are pre- pared to pay high charges, which raises costs for other clients with low- value cargo waiting to be serviced (cream-skimming problem). To provide incentives for loading and unloading services to be done as efficiently as possible, and to avoid situations such as the two examples 164 Seaports above, the concession contract can include minimum standards on safety and servicing times. For example, including a variable part on the conces- sion fee is possible, which could depend on ships' average waiting times. By using this instrument, the private operator would have incentives to service ships optimally, and to invest in the required equipment to reduce those waiting times as much as possible. Similarly, one could impose pen- alties if a safety standard indicator falls below a certain minimum (for ex- ample, amount of cargo damaged or lost). The quality of cargo handling services also involves some technical aspects such as spending adequate amounts on the maintenance and repair of equip- ment. Periodic revisions must be performed on the equipment to guarantee the minimization of accidents and disruptions. Because these revisions are costly but can improve the general efficiency of the port, the concession con- tract should explicitly include some conditions. Other safety aspects that a well-designed contract must include are obligations for the concessionaire to maintain sufficient lighting in the terminals for night services, adequate ramps for passenger services, and separate facilities for cargo and passenger services. Safety A high density of vessel traffic in the access zones of a port and within its area increases the risks of collision and ship stranding, especially in stormy conditions. Given the negative externalities that maritime accidents cause on other port users, and the potential environmental consequences, regu- lation on general port safety and quality of services related to ships' move- ments must be strict, and compliance closely monitored. All ports generally make pilotage use compulsory for vessels above a certain capacity or dimension and for ships transporting dangerous cargo. When pilotage is imposed, a technical expert with a knowledge of port characteristics (a pilot) should be on the ship as it enters and exits, or at least the captain must follow instructions by radio. When the port authority does not directly provide pilotage services, but independent agents offer them, the port regulator must somehow con- trol this activity. First, some economic regulation must be made on the tar- iffs that pilots charge for their services to shipping companies, particularly when sufficient competition among several agents is not guaranteed. Sec- ond, technical capacity must be ensured by requiring pilots to demonstrate their ability to perform the required tasks. One can use a system of licenses to regulate these safety aspects. In addition, setting minimum equipment standards (such as boats and radios) is recommended. Lourdes Trujillo and Gustavo Nombela 165 Pilots are the agents who determine the number and power of tug boats that a vessel requires to perform movements to enter and exit the port. Therefore, collusion between pilots and towing firms is a risk, and users may be forced to buy extra services that are not necessary. To prevent this, ports must have clear regulations on the minimum requirements for tow- age services available to all port users (De Rus and others 1995). In ports where private firms provide berthing services (safe tying of ves- sels to berths), port authorities should provide regulations to guarantee that safe procedures are correctly followed. Incidents have occurred in which insufficiently tied ships have drifted within the port area, causing accidents. This problem is especially serious for tankers, because sudden unberthings when delivering or receiving supplies can lead to dangerous spills. Finally, port authorities must always have emergency plans in the event of accidents, and port workers must be trained on evacuation procedures. Concessionaires should be obliged by their contracts to fulfill minimum safety requirements in their buildings and superstructure elements: emer- gency exits, fire-fighting devices, signs, and so forth. Performance Indicators To evaluate the outcomes for a seaport, several types of indicators can be used. These indexes are useful if they can be easily computed with avail- able information (from port authorities and concessionaires), they can be updated regularly to study the evolution of the port over time, and they have some regional benchmarks against which they can be contrasted. Using these indicators, a regulator can assess the performance of a port, and evalu- ate if the results that concessionaires achieve are satisfactory. Because one can compute many indexes from ports' information, clas- sifying the possible indicators into three separate groups is useful, accord- ing to the aspects that they aim to measure: (a) physical, (b) factor produc- tivity analysis, and (c) economic and financial. Physical Indicators The type of information that this set of indicators tries to measure is con- ceptually simple. The idea is to measure how much cargo is moved by a port, how fast ships are serviced, and how quickly cargo is transferred to other transport modes. Therefore, the basic indicators are time measures and, indirectly, the total volume of traffic that the port receives. The most commonly used physical indicators in the seaport industry are as follows: 166 Seaports * Ship turnaround time: This is the total time that a vessel spends at a port, from entrance to exit. One can divide this turnaround time into two parts: time at berth and time outside. If a port does not have this detailed information for all vessels, computing some average turn- around time is always possible by dividing some estimated total vessel stays over the number of vessels calling at the port during a particular period. * Waiting rate: Using the two types of times described above, one can figure the waiting rate as the time in the port outside the berth di- vided by the time at berth. This index provides information about congestion problems at the port. A high value indicates that ships must spend a significant part of their port time waiting for a berth space to be available. * Berth occupancy rate: This represents the percentage of total available time that berths are in use by ships. This is a useful indicator for obtaining an estimate of the level of a port's activity. It must be complemented with additional information, however, such as the turnaround time, because a high value for the berth occupancy rate is a positive indicator (showing that a port is busy most of the time), but only if the turnaround time is low. Otherwise, this could be re- garded as an extremely inefficient port, whose users spend too much time berthed but not serviced. * Working time over time at berth: This is another indicator that comple- ments those above. A value close to 1 indicates that a ship is being serviced for most of the time that it spends in port. A smaller value reveals that the ship is idle most of the time that it is berthed (with the corresponding opportunity cost). If detailed information is available, knowing the distribution of the remaining time (time at berth minus working time) is also interesting. Some ports have records on the idle- ness due to rain, strikes, equipment failure, and other reasons. Because most factors affecting this list of indicators depend on the type of ship and cargo, providing benchmark values valid for every ship and port is difficult. A solution to have valid reference values is to compute them separately by vessel type: bulk carriers, containers, and general cargo. For example, for the waiting rate, the best values observed in the world are 5 percent for container ships and 20 percent for bulk carriers. These are obtained in large ports that operate as regional hub centers (Rotterdam, Antwerp, Felixstowe, and Singapore). Lourdes Trujillo and Gustavo Nombela 167 Another interesting performance indicator, from the viewpoint of ship- pers that export/import goods, is the time required for cargo to pass through the port: Cargo dwell time: This is the time elapsed from when cargo is un- loaded from a ship until it exits the port, or vice versa. It is usually measured in days, and naturally, the smaller the value of the index, the higher the port's efficiency. A high value for this indicator reveals cargo management problems, and although knowing the cause of a long stay for shipments at a port would be extremely interesting, having information in that much detail is usually difficult. The best practices are generally obtained in the container market, where large ports exhibit values around 4.7 days. Meanwhile, the dwell times are longer for general cargo, averaging 7 to 12 days. Causes for delay can be due to the poor performance of administrative services, such as customs or sanitary inspections, or they could originate through poor coordination between ship and land modes of transport. The presence of delays that increase the cargo dwell time can be disastrous for some kinds of goods, such as fruits, vegetables, and fish. Finally, other types of indicators that the physical group could include are those related to safety concerns, such as the number of accidents or incidents suffered by ships at a port. In order to be accurate, these indica- tors preferably should be expressed relative to an exposure-to-risk vari- able, such as the total number of ship movements to and from the port. To evaluate the safety commitment of concessionaires, computing the invest- ments on safety over total expenditures, or over a volume of cargo han- dling, is recommendable. Factor Productivity Indicators In addition to physical indicators that provide information on ports' efficiency, having some knowledge of labor and capital productivity is important, so that when one detects low efficiency, identifying the rea- sons causing it is possible. Some simple indicators to measure produc- tivity are as follows: * Tons per worker-hour or per gang-hour: These measures are aimed at measuring labor productivity, but when making comparisons across ports, one must be ensure that conditions are similar, because, for 168 Seaports example, the size of a gang can vary between two ports. Similarly, when comparing worker productivity, one should do this only for equivalent types of cargo. Moreover, the information would have to be complemented with indexes for the state and type of equipment employed, because labor productivity varies according to a port's capital stock. * Tons per crane-hour: This simple indicator evaluates the productivity of the main equipment for cargo loading and unloading. In order to make comparisons across ports, one should guarantee some homoge- neity on the type of cranes. For containers, comparing ports is easier, because both cranes and cargo are basically homogeneous. For this type of cargo, using TEUs as the unit of reference is preferable. * Tons per linear meter per year: This indicator provides a measure of a port's efficiency in using its basic infrastructure to provide services to ships. * Tons (or TEUs) per ship-hour: This indicator gives an idea of the total productivity of a port in cargo handling. A reduced value for the index will indicate low efficiency and the imposition of longer times on ships. Economic and Financial Indicators Lastly, a third group of indicators can be calculated to provide regulatory institutions with a complete picture of a port's situation. The objective of all of these indexes is to reflect port finances and level of charges to users: * Operating surplus over gross registered tons/net registered tons or operat- ing surplus over handled ton. * Total income (expenditure) over gross registered tons/net registered tons. * Charge per TEU. An index to evaluate the efficiency of a port in han- dling containers is the total charge per TEU. This is becoming an in- ternational reference benchmark, though one recognizes that local conditions over some particular costs (such as labor) may vary con- siderably. Therefore, using this indicator on a regional basis is recom- mended. Overall, best practices worldwide indicate that the minimum for this index can be between US $120 and $150 (see table 4.11). Conclusions Many international experiences have shown that the effects derived from the introduction of private sector participation in ports are highly positive. Lourdes Trujillo and Gustavo Nombela 169 Improvements at the operational level are obtained (better and faster ser- vices, reduced waiting times, and so forth), in addition to significant in- creases in investments that are reported after a port is reformed and its activities are transferred to the private sector. In fiscal terms, many port systems worldwide that once drained resources from public budgets have changed. They now maintain sound finances, which in most cases allows them to contribute positive revenues to the treasury. Options for the participation of private firms at ports are diverse, but probably the most typical today is the use of concessions for port termi- nals (either through leases or build-operate-transfer contracts). Because the number of terminals within a port must be necessarily reduced, the challenge for the new port systems is to promote an adequate competi- tive environment for private concessionaires to provide port services ef- ficiently and to set tariffs according to real costs. In some cases, the size of the port will allow competition among operators within the port. Regu- lators have important tasks, however, for small and medium-size ports. The first is to promote competition for the market by designing an opti- mal auction to award contracts. Regulators must also study if competi- tive conditions exist at a regional level (users may have the option of alternative terminals at other ports if a private operator imposes high tariffs). If that is the case, the task of port regulation will be much easier than in situations in which competition is absent. Concessions for port terminals are, by definition, long-term contracts, so correctly designing and monitoring all the details required for a suc- cessful partnership between the public and private sectors is important. This chapter has reviewed all the necessary elements to be included in a concession contract for a regulator to promote the maximum degree of competition and to choose the best options according to the objectives pursued. Some indicators of port activity are provided, which in the fu- ture should be improved and incorporated as a standard toolkit for regu- lators. A database for these indicators, calculated for different ports around the world, would be extremely useful for the work of port regulators, who could use the indicators as reference benchmarks to impose targets on private concessionaires. 5 Railways Javier Campos and Pedro Cantos With the rail industry transformed worldwide, regulation of the sector should remain simple and flexible to protect its share of transportation markets. Apart from providing a stable legal and institutional framework and fostering competition and market mechanisms, regulators should re- frain from intervening in the market-unless the goal of economic effi- ciency (subject to the socially demanded level of equity) is in jeopardy. This chapter reviews these ideas. Characteristics of Railway Services The rail industry poses a number of specific problems for transport econo- mists and regulators that are only partially shared with other transport modes. These elements are the multiproduct nature of the activity, the par- ticular cost structure of railroad companies, the role of infrastructure and networks, the existence of indivisibilities in inputs and outputs, the orga- nization of rail transport as a public service, and the existence of externali- ties in the transport system as a whole. According to Button (1993), these characteristics define a descriptive framework for this sector, and they jointly determine the main factors that one should consider when studying in detail the appropriate economic regulation for the rail industry. The Multiproduct Nature of the Activity Rail companies are, in most cases, multiproduct firms that provide differ- ent types of freight and passenger transport services. In the case of freight, 171 172 Railways along with the usual transport of bulk freight, rail operators also supply complete cargo wagons or trains, parcel and postal services, and other ser- vices of intermodal transport. In the case of passenger transport, long-dis- tance traffic usually coexists with local services (suburban and commuter trains), regional services, and in certain cases, even with high-speed trains.' The multiproduct nature of railways has different implications. In ac- counting, for example, allocating total operating costs among services is often difficult. Different types of traffic share many of the costs of running a long-distance train (including not only infrastructure costs but also vari- able costs), and these joint costs coexist with other costs not affected by changes in output. For instance, the common costs of signal maintenance along a line section usually do not increase if the proportions of traffic of the different services change. Although some cost elements may be attrib- utable to a particular traffic (for example, passengers), most of them (wag- ons, energy, staff, and so forth) are not. Thus, cost interdependence requires simultaneous decisions on prices and services, which, in practice, make any regulatory task much harder. At the cost level, another important aspect to consider in the multiproduct setup of the rail industry is the sub-additivity of the cost func- tion faced by a railroad. According to Baumol (1977), a cost function is sub- additive when the provision of services by a single firm is more efficient (in terms of a lower unit cost) than the same production carried out by two or more companies. This idea conveys two relevant implications for the rail industry. First, is it more efficient for a single firm, rather than two separate firms, to supply both infrastructure and transport services? Sec- ond, if the infrastructure and services are separated, is the supply of such services more efficient within the context of a monopoly, or should two or more firms participate? This analysis, connected to the advantages and disadvantages of the separation of infrastructure from services, will be dis- cussed in depth. Railway Costs Waters (1985) broadly distinguishes four railway cost categories: (a) train working costs, including the cost of providing transport services (fuel, crew, maintenance, and depreciation of rolling stock); (b) track and signaling costs 1. This chapter will not analyze commuter and suburban passenger traffic, be- cause they should be studied within the more general framework of urban transport. Ja7iier Campos and Pedro Cantos 173 (including operation, maintenance, and depreciation of infrastructures); (c) terminal and station costs; and finally, (d) administration costs. The first two categories are prevalent in most companies and change ac- cording to several factors.2 Among train working costs, for example, rolling stock costs depend on both their number and the distance they run. Fuel costs depend on car-kilometers run for each type of vehicle, while train crew costs vary according to train-kilometers run. Track and signaling costs usu- ally rely on the length of the route (because they typically request a single, standard-quality track). The amount of track and signaling needed, how- ever, changes with the number of trains requiring paths, although this rela- tionship is not constant. Terminal and station costs depend on traffic vol- umes, but they vary considerably with the type of traffic. For instance, bulk freight handling requires more terminal expenses than parcel services. Simi- larly, long-distance passengers require more services (ticketing, reservations, luggage, and so forth) than short-distance users. Administration costs fluc- tuate depending on the overall size of the firm, although the precise nature of this dependence is generally difficult to determine. Allocating all these costs to the multiple outputs or inputs is complex. It often involves a degree of arbitrariness that demands, from a regulatory point of view, a clear distinction between avoidable and unavoidable costs. The avoidable costs are uniquely associated with a particular output: were this output not produced, no cost would be incurred. Avoidable costs may therefore be considered as a regulatory price floor (if any), because charg- ing less would be equivalent to operating at an economic loss. Rail Infrastructure Since the birth of the rail industry in the 19th century, mainstream econo- mists have always considered that the larger the size of a railway com- pany, the greater its efficiency. The existence of substantial fixed costs (par- ticularly those associated with infrastructure) traditionally led economists to assume the presence of important economies of scale, and thus to regard rail transport service as a textbook example of a natural monopoly. This notion has been heavily challenged in recent decades, however, by the introduction of new ideas into the industry's economic analysis. 2. Nash (1982) finds that train working costs in European firms (with the no- table exception of high-speed passenger traffic) accounted for 44 to 45 percent of total costs, whereas track and signaling was just 23 to 26 percent. 174 Railways Particularly, the upheaval of the theory of contestable markets (Baumol, Panzar, and Willig 1982) contributed to clarifying the proper definition of the natural monopoly concept in terms of the sub-additive cost func- tion. This concept implies that duplicating rail infrastructure is generally inefficient (and is therefore subject to natural monopoly conditions), but once the network has been deployed, more than one company can effi- ciently cover the cost of operating rail transport services and rolling stock, either as actual or potential competitors. Therefore, from the regulatory point of view, the conclusion is that one can deal with infrastructure and services in different ways: the former, as a natural monopoly (at least, when the infrastructure has not yet been built, although not necessarily after that moment), but also as a potential pro- vider of adequate access to any willing-to-serve operator; the latter, as any other competitive economic activity that could be provided by multiple competing operators or by a single firm under some sort of concession or license arrangement. Asset Indivisibilities Even though this potential vertical separation alleviates some of the natu- ral monopoly problems, the rail industry remains extremely capital inten- sive, with several other indivisibilities within its productive process. Spe- cifically, the capital units (rolling stock, tracks, and stations) can only be expanded in discrete, indivisible increments (the addition of a train or wagon, for example), while demand fluctuates in much smaller units. Con- sequently, increases (decreases) in supply can exceed increases (decreases) in demand, resulting in excess capacity. This lumpiness has several impor- tant implications for investment and pricing. For example, the transporta- tion costs of an additional unit of traffic (freight or passengers) may be insignificant when capacity is idle, but they may become substantial when the capital is being used to its fullest. Firms can also be forced to employ fixed assets with differing economic lives, whose reliability spans over a long time horizon and heterogeneously affects the cost items described above, modifying investment decisions and requiring a complete accounting and management information system. There- fore, dynamic price and output considerations become crucial in order to recover the real costs associated with each period of activity. A final implication of the indivisibilities in the rail industry's capital assets is that innovation and infrastructure improvement projects are Javier Campos and Pedro Cantos 175 usually deferred and only carried out in small, discrete amounts. Rail- way firms seldom change the entire definition of their existing network, which in most countries corresponds to an inherited burden from past decades when the traffic structure was very different from today. Instead, they opt for partial renovations that often introduce technical asymme- tries between tracks within a country or region, and accentuate indivisibilities and inflexibilities (Boyer 1997). Railway Transport as a Public Service Although not derived from historical and organizational reasons and not from technical characteristics, the concept of rail transportation as a public or social service, irrespective of profitability, is another defining element that has determined the industry's organization and performance around the world. The low rolling resistance of steel wheels on steel rails made railroad transportation extremely fuel efficient and relatively cheap. This allowed railroads to rapidly grow as the first mass transportation system, particu- larly for passengers, beginning in the years of the industrial revolution. For military and industrial reasons, most countries envisaged some form of public control, and many imposed their control by legal mandate. Public control over the rail industry occurred both with or without accompanying subsidies, public service obligations to transport providers in the form of com- pulsory (often unprofitable) routes, organized timetables, and particular ser- vices for strategic products or areas. The ultimate reason behind this control, which remains the same today, is that this industry is regarded as an integral mechanism to overcome geographical barriers in certain areas, to aid in the economic development of undeveloped zones, and even to guarantee mini- mum transport services for a particular segment of the population. Externalities in the Transport System The policy goal of public service obligation is often supported by the idea that rail transportation contributes less to negative externalities than other transport modes, especially roads. Abundant empirical evidence shows that under high demand conditions, transferring a substantial part of road traf- fic to rail could reduce the external costs of traffic congestion, accidents, and environmental impact (noise, visual impact, pollution, and so forth). The current intermodal misallocation (more road users than rail users) arises from the fact that road transport does not fully internalize all of the 176 Railways social costs that it generates. Economists often recommend the use of con- gestion and/or pollution rates to account for this. When these mechanisms are not feasible or politically viable, however, decreasing railway fares to improve the overall intermodal balance might be preferable, which is an additional consideration for rail regulation. In summary, all the foregoing characteristics, shown in table 5.1, suggest that regulation of railway transport should be analyzed within a general context, taking into account the industry's technological and organizational features, beginning with a detailed evaluation of recent performance. Table 5.1. A Summary of the Economic Characteristics of the Rail Industry Characteristics Economic consequencesfor regulation Multiproduct activity Accounting problems Coordination of decisions Integrated or differentiated management Between infrastructure and the services? Between different rail services? Structure of rail costs Problems in the definition of rail costs Problems in the cost allocation Implications on pricing policies Role of infrastructure Optimum size of railways? Separation between infrastructure (with natural monopoly characteristics) and operations (competitive market)? Access fee to the infrastructure? Indivisibilities Problems implementing optimal price and service levels Dynamic price policies are required Investment policies Public service obligations Financial problems Definition of price and service levels Externalities Implications for optimum (social) prices Externality control: accidents, pollutants, energy waste, and so forth. Intermodal implications Source: Authors. Javier Campos and Pedro Cantos 177 Privatization and Regulatory Trends Table 5.2 summarizes the overall evolution of rail transportation in re- cent years as compared with other transport modes for Organisation for Economic Co-operation and Development (OECD) countries. The 1970s and 1980s saw a substantial fall of market share in both freight and pas- senger markets, which stabilized during the 1990s. The decline is par- ticularly relevant because it was during a period when the total volume in both markets grew about 50 percent, implying that the rail industry was not able to take advantage of growing demand in the past 25 years. This substantial reduction in market share is not specific to OECD countries, but is a common trend worldwide. It can be attributed to both exogenous and endogenous causes. The former include the rapid devel- opment of alternative modes of transport, especially road. For passen- gers, economic growth fostered the development of the automobile mar- ket, leading to enormous growth in motorization. In freight transport, the expanding, competitive trucking sector gained a growing percentage of transport in many countries. For example, in 1970 in Europe, the num- ber of cars per 1,000 inhabitants was 150, a figure that now is 424. Simi- larly, the number of heavy vehicles and trucks increased from 7 million to 17 million from 1970 to 1994. The endogenous causes of the decline can be summarized in the inabil- ity of the sector to adapt to the changing conditions of the economic envi- romnent. Regulation remained obsolete and the rail industry was slow to react. The policies adopted during the 1980s did not halt the steady loss of Table 5.2. Market Shares of Different Transport Modes, Selected Years, 1970-94 (percent) Type of transport 1970 1980 1985 1991 1994 Passenger Rail 10.4 8.6 7.3 6.9 6.9 Private car 77.3 80.0 83.4 84.4 84.4 Bus 12.3 11.4 9.3 8.7 8.8 Freight Rail 31.3 23.2 21.2 17.9 15.5 Road 55.2 65.9 69.3 74.0 76.2 Waterways 13.5 10.9 9.5 8.1 7.9 Source: CEMT (1996). 178 Railways market share, the growing financial deficits, and, in some countries, the impossibility of raising the low productivity indexes of the industry. Thus, more radical restructuring processes were put into practice. The Traditional Model and Regulation of the Industry During the past 50 years, the most common market structure in many coun- tries' rail sectors was a single, state-owned firm, entrusted with the unified management of both infrastructure and services. Despite some differences in their degree of commercial autonomy, the traditional methods of regu- lation and control of this sort of company have been relatively homoge- neous. In general, it was assumed that the monopoly power of the national company required price and service regulation to protect the general inter- est. In addition, the companies were obligated to meet any demand at those prices. The closure of existing lines or the opening of new services required government approval. Thus, competition was rare and often discouraged, and preservation of the national character of the industry was considered the key factor governing the overall regulatory system. Under this protective environment, most national rail companies in- curred growing operating deficits during the 1970s and 1980s. Furthermore, social obligations to their staffs made it nearly impossible to reach any agree- ment on redundancies or even wage adjustments. In some countries, the companies were forced to finance their deficits by borrowing, so their ac- counts lost all resemblance to reality. The main problems associated with the traditional policies for railways were (a) increasing losses, which were usually financed by public subsidies; (b) a high degree of managerial inef- ficiency; and (c) business activities oriented exclusively toward produc- tion targets rather than commercial and market targets.3 These distortions did not come from any artificial reduction in the range of services provided, or from excessively high fares, but more commonly from an unjustified increase in the supply of services (and hence, of costs). Such behavior implied larger public subsidies. In many cases, the lack of commercially oriented tariffs and investment policies explained many of the difficulties faced. Together with the burden imposed by the technical 3. On this point, Oum and Yu (1994) and Gathon and Pestieau (1995) have empirically shown that the companies that achieve the greatest efficiency are those that have been run with a higher level of autonomy and independence from state intervention. Javier Campos and Pedro Cantos 179 characteristics of the sector, this placed most railways in a weak position to compete against alternative transport modes. Fierce intermodal competi- tion, however, was not able to improve the competitiveness of the railway system by itself. Adopting measures affecting the internal behavior and struc- ture of the sector itself was necessary. Therefore, the sector's overall decline sparked a widespread restructuring movement around the world. The Movement toward Privatization The worldwide restructuring process of the rail industry began with timid reforms. For example, many countries began by replacing their national railways with autonomous commercial bodies possessing in- dependent, realistic balance sheets, in which the government could ex- plicitly subsidize public service obligations. Other countries opted to substitute their old geographically-based management with a multidivisional structure, defined by the companies' different lines of business or services. Table 5.3 allows us to compare similarities and dif- ferences among several countries. A common feature of these processes is that some countries have car- ried out a relatively long-term restructuring, whereas others have pre- ferred quicker implementation. For example, Japan and New Zealand phased in privatization over several years, while Argentina and the United Kingdom took less than two years. Another common characteristic is that all restructuring processes were undertaken to make the companies at- tractive to private investors, although full privatization has been less pre- ferred than concessioning. The changes have involved revising laws and other regulations affect- ing railways, reducing staff, dealing with pension issues, and deciding how much property the state should sell and how much it should retain. In addition, several arrangements for paying for unprofitable (but socially needed) train services were put into place, together with a precise defini- tion of the concession contracts and their main terms. With regard to re- sults, in general, most of the restructuring experiences detailed below seem to have been positive. Most countries achieved the objectives of stopping the industry's drain on the state's resources and stabilizing market share for both passengers and freight. Likewise, the companies succeeded in rais- ing their levels of productivity. Nevertheless, one must take into account two important caveats for future regulation. First, the process of privatization each country chooses depends on the basic objectives sought: to maintain an industry with one operator or a Table 5.3. Deregulation and Privatization Experiences in Railways Separation between Market Ownership Ownership of infrastructure Regulatory Reasonsfor Country structure of railways infrastructure and services framework deregulation Argentina Before restructuring Public monopoly Ferrocarriles State owned Unified Prices are regulated High public Argentinos (FA), management under subsidies, reduce public enterprise FA FA's deficits with little autonomy Improve traffic After restructuring Franchise system for Private companies State network open Management of Free prices with levels 6 freight and 7 Operating in each to third parties companies maximum level Improve passenger franchise Trackage rights exist Minimal frequencies productivity concessions (4-5 and quality service operators) Brazil Before restructuring Freight RFFSA Public companies Public ownership Unified Regulated prices Antiquated, Passenger: CBTU management inefficient railway After restructuring RFFSA and CBTUJ RFFSA privatized Public ownership Management by the Prices control industry divided into companies Reduce state sub-networks Trackage rights exist contributions Favor development and regional equilibrium (table continues onfollowing page) Table 5.3 continued Separation between Market Ownership Ownership of infrastructure Regulatory Reasonsfor Country structure of railways infrastructure and services framework deregulation Chile Before restructuring EFE (83 percent of EFE, public EFE and mining Unified Regulated prices Reduction of state network) and private company companies management of subsidies mining companies Private mining the existing Improve effidency (FEPASA) companies companies of system (FEPASA) Increase market After restructuring EFE and subsidiaries, EFE and subsidiaries, Spread among EFE Separation of Liberalized prices share and mining private companies and other companies services and companies infrastructure on public lines l}ackage rights exist Japan Before restructuring Monopoly (JNR) Public State owned Unified Regulated prices Reduction of state management subsidies After restructuring 6 passenger Only 3 in process Owned by the 6 new Unified Free prices Improve companies (regional of privatization passenger companies management productivity monopolies), (passenger 1 freight companies) Trackage rights (4 freight companies) (table continues onfollowing page) Table 5.3 continued Separation between Market Ownership Ownership of infrastructure Regulatory Reasonsfor Country structure of railways infrastructure and services framework deregulation New Zealand Beore restructuring Monopoly in hands Public agency State owned Unified Prices and service High public of New Zealand management level regulated subsidies and Rail Ltd. (NZRL) reduce NZRL's After restructuring Monopoly Private (private Lease Unified Free prices defidts groups that bid management highest to buy the company) Sweden Before restructuring Publc monopoly Statens Jarnvagar State owned Unified Controlled prices High public (SJ), government management subsidies and department reduce SJ's deficits After restructuring Monopoly on SJ, public company Managed by a Separation Control over tariffs Improve traffic infrastructure and with wide autonomy, public agency, Services run by SJ has been reduced levels quasi- monopoly and presence of Banverket (BV) and small Not on access prices Improve in services small private companies productivity companies Infrastructure by BV (table continues onfollowing page) Table 5.3 continued Separation between Market Ownership Ownership of infrastructure Regulatory Reasonsfor Country structure of railways infrastructure and services framework deregulation United Kingdom Before restructuring Public monopoly British Rail, public State owned Unified Freedom of prices, High level of public body with management except in some subsidy managerial services Improve traffic and autonomy productivity levels After restructuring Competition for the Private concessions Private company Total separation Free prices market and rolling stock (Railtrack regulated) RPI-X in access System of 25 leased to private pricing franchises in firms passengers and 2 companies for freight United States Before restructuring Competitive situation Private companies Owned by railways Trackage rights exist Price control and no Loss-making dosures of loss- companies making lines Loss of markets After restructuring Competitive Private companies Owned by railways Trackage rights Price freedom and situation with exist (Amtrak), but dosures of loss- concentration of big 25 percent of making lines companies and trackage with many small ones several freight operators Source: Authors. 184 Railways small number of operators, or to faclitate a process of competition on the track. Second, legacies from the traditional mechanisms of regulation should be avoided. In particular, one must deal with the two common problems of high debt levels and overstaffing before starting any privatization policy. Experiences in Railway Privatization The separation of infrastructure from operational services in railways is relevant in this sector, and it conditions the concessioning process in many countries. Vertical unbundling, aimed at solving the natural monopoly issue described earlier, not only promotes greater allocative efficiency, it also encourages some other relevant regulatory questions, which become particularly important as the degree of private participation in rail infra- structure management increases. In this case, the economic regulation of infrastructure should be governed by the adequate combination of three standard principles: fair access to the infrastructure, cost recovery, and efficient access pricing. AccEss To RAIL INFRAsTRucrURE. Regulation of rail infrastructure includes not only simple pricing principles, but also access rights and long-term development provisions. Each country addresses these differently: most have opted to retain infrastructure in the public sector, creating state man- agement agencies (Sweden's Banverket) to regulate private train operators (as in Argentina). Others (France and Germany) have established indepen- dent state-owned enterprises to manage rail tracks. Only the United King- dom has privatized infrastructure and operations. Whether in public or private hands, rail industry infrastructure regula- tion must include minimum investment requirements to prevent short-term myopia and ensure that key investments are given priority over increasing dividends or defending against a potential takeover. Regulation must also address the issue of access, which is particularly relevant in the case of highly integrated transnational networks (as in Eu- rope) or privately or publicly managed dense networks (as in Canada, the United States, and some Asian countries). In the European Union, for ex- ample, Directive 91/440 directs each member state to grant international access and transit rights to international groups in which stakes are held by railway undertakings in that or other member states. No directives or resolutions have been related to domestic traffic, although the European Commission advocates the extension of these provisions to all freight and international passenger services. Most countries simply charge (monopo- listic) train operators for the use of (public) rail infrastructure. Javier Campos and Pedro Cantos 185 In the wholly privatized structure of the United Kingdom, open access to passenger services has been limited by a number of provisions that mod- erate competition. Initially designed to protect rail franchisees from new entrants and from each other, these provisions were anticipated to be gradu- ally reduced over time. In other countries, the contract also clearly speci- fies access rights, as mentioned later for Argentina, Burkina Faso, and C6te d'Ivoire. In certain large cities, such as Mexico City and Buenos Aires, op- erators share a common network under a unique transport authority. The final aspect regarding access rights to rail infrastructure lies in re- moving existing or potential barriers to entry that might distort competi- tion by favoring some competitors over others. These barriers include tech- nical requirements (for example, those related to incompatible rolling stock and tracks) and safety standards (in terms of a common minimum level). In summary, the general rule should be to promote open access as widely as possible once the separation between the natural monopoly infrastruc- ture and train operations has been effectively achieved. This process, how- ever, must depend upon a detailed analysis of infrastructure costs and the prices charged to cover them. COORDINAnON AND INTERMODAL COMPETITION. A relevant issue when con- sidering the pricing of rail infrastructure is intermodal competition. As mentioned earlier, modal choices can be heavily distorted because of dif- ferent cost coverage ratios and the use of different cost input bases.4 A solu- tion is to follow an integrated, multimodal approach. Basic principles will have to apply to all transport operators, irrespective of the mode in which they operate. For example, countries such as Argentina and Chile consid- ered the extent of road freight transport when designing rail concession contracts. The general rule was that operators undertaking business at their own commercial and financial risk should not be at an undue disadvan- tage in relation to those who enjoy public aid or indirectly benefit from huge externalities. In the case of natural monopoly infrastructures, the principles envis- aged to avoid these distortive effects should be solidified in the coordina- tion of existing networks (particularly in dense rail areas) and the estab- lishment of mechanisms that facilitate interoperability and international 4. One of the reasons for the decline of the rail industry is the fact that road transport did not internalize its social costs (in terms of pollution or safety, for ex- ample). More important is the fact that some countries, such as the United States, provide cross-subsidies that benefit heavy trucks. 186 Railways links. Not even the most advanced infrastructure regulations (such as the Swedish and the British systems), however, offer much help, because they were conceived for a single-country environment. In other countries, such as Argentina before the restructuring process, railways attempted to solve national transport problems by offering underpriced passenger services or subsidized low-quality freight transport. As a result, their financial perfor- mance rapidly deteriorated in an isolated framework. Therefore, the infra- structure pricing strategy in these areas should be compatible with the achievement of both local and international objectives, by establishing, if needed, a system of slot assignments in more congested corridors. VERTICAL SEPARATION. According to Kopicki and Thompson (1995), one of the most clearly defined patterns emerging from deregulation and re- structuring is that they carry out two critical dimensions, summarized in table 5.4: the degree of vertical separation between infrastructure and ser- vices, and the involvement of private management in the sector. With respect to the first dimension, the vertical organization of the rail- way industry has three main options: (a) vertical integration, (b) competi- tive access, and (c) vertical separation. The first option corresponds to the traditional, historic model of rail- way organization described above, in which a single (usually public) entity controls all of the infrastructure facilities as well as the operating and administrative functions. Less frequent, competitive access is char- acterized by the existence of an integrated operator required to make rail facilities, such as tracks and stations, available to other operators on a fair and equal basis through the trading of, for example, circulation rights. This has the advantages of integration (economies of scope, coor- dinated planning, and reduction of transaction costs), but its overall ef- fectiveness may be jeopardized if the integrated company has incentives to leave out other operators. Alternatively, in the complete vertical separation scenario, the man- agement (and, possibly, the ownership) of facilities is fully separated from other rail functions. This is attractive because, although infrastructure may remain a natural monopoly, it is separated from rail services, where potential competition among different operators is possible. In general, the main advantage of this vertical unbundling is that rail transport is placed in a similar situation as road transport, especially regarding the tariff system and infrastructure planning. Governments could study in- vestment proposals on the basis of a cost-benefit analysis, while pricing Jazier Campos and Pedro Cantos 187 Table 5.4. Alternative Organizational Structures in Railways Vertical unbundling Private Total vertical Competitive Vertical participation integration access separation Government India, China, department former socialist countries Public enterprise European railways Reformed public Many European Sweden enterprise railways at present Service contract Japan (HSR) U.K. (rolling with private U.S. (rolling stock) stock) sector Pakistan (ticket sales) Management Nigeria (1980) U.S. small contract with railways private sector Leasing to Amtrak (U.S.) private sector (track) VIA (Canada) (track) Japan (track) Cameroon (baggage) Leasing from U.S. and Europe private sector (wagons and cars) Concession Argentina, Brazil, U.K. (passengers) (franchising) Chile, C6te d'Ivoire Joint Canada U.K. venture U.S. (pipe and wire) Private company New Zealand Japan (in U.K. (freight, progress), U.S. infrastructure) (Class I), Canada Source: Galenson and Thompson (1993). 188 Railways policies could be based on social cost.S In addition, separating infrastruc- ture from services greatly facilitates the entry of more than one operator on a single route. For profitable services, this would permit notable im- provements in efficiency by allowing direct competition among opera- tors. For nonprofitable services, infrastructure separation can be accom- panied by tendering to stimulate increased efficiency through competition for the market, to promote the introduction of innovations, and to en- courage marketing improvements. The vertical unbundling of the rail industry, however, also implies sev- eral disadvantages. The main problem is the potential loss of economies of scope derived from the joint operation of tracks and services. Often noted is that the relationship between the services supplied and the rolling stock used, as well as the quality, quantity, and technical characteristics of the infrastruc- ture, is so close that both aspects need to be planned together. Thus, assign- ing different services to several operators may decrease the utilization of the sector's staff and physical assets. Another negative factor is that the new system has a higher risk of becoming less attractive to the user than an inte- grated system.6 Also mentioned is that vertical separation requires such a complex institutional arrangement that the resulting transaction costs often are prohibitive for many countries. A final disadvantage of vertical separa- tion is the reduction of investment incentives. For example, an infrastructure owner considering an investment on a facility with only one potential buyer will anticipate bargaining away some of the benefit from the new service once it comes on-line. This problem becomes less relevant with more compe- tition in the market, because competition weakens the bargaining position of individual operators by reducing the specificity of the assets. PRIVATE PARiCIPAnON. With respect to the dimension of private participa- tion in the industry, Galenson and Thompson (1993) provide a list, ordered 5. Note that an important problem here is the difficulty of defining the social cost of railway infrastructure use. Determining the marginal or incremental costs of the use and wear and tear of one additional train is not, in principle, any more difficult than the equivalent calculation for road transport. The problem, however, is greatly complicated for the railway when one evaluates this cost in a congested environment. In pure economic terms, this cost is the opportunity cost of the stretch of track in question, but in practice, quantifying this opportunity cost is difficult, especially if a mixture of social and commercial services exists. 6. For example, because of the lack of interchangeable ticketing, an integrated national network, and so forth. Javier Campos and Pedro Cantos 189 in terms of increasing private participation, of the different situations found in the world's rail industry. The first situation is a government department, in which the government fully controls and finances the railroad, which there- fore is subordinated to its interests. The second example is a public enterprise, in which the railway is characterized by a higher managerial autonomy, but it still requires gov- ernment approval for many decisions. Normally, these railways sign contracts (or have sectoral laws) with the government, specifying each party's objectives and attributions and the financing rules. Similarly, the case of a reformed public enterprise corresponds to a situation in which the railway is incorporated (into a shareholding company), com- mercialized (financially and managerially autonomous), and made sub- ject to the country's company law. The government, however, as the main owner, determines pricing policies and investment levels, while guaranteeing the supply of noneconomical social services with the nec- essary subsidies. Other situations include mixed forms of cooperation between private and public capital. For example, some countries have rail service provided through a service contract with the private sector, in which governments or public enterprises, maintaining full ownership, can contract activities to be performed by private sector entities, including food catering, medical services, ticket sales, and maintenance of physical assets. Related to these are management contracts with the private sector, in which the contractor assumes responsibility for the operations and maintenance of certain ac- tivities. One variation is leasing to the private sector, in which the contrac- tor pays a fee for the use of the fixed assets. The lease contractor has more autonomy than in management contracts, controlling aspects such as the working capital and staff, but also assumes more risk. The owner main- tains responsibility for investment and debt service. In many countries, locomotives and wagons are sold or leased to nonrailway entities for trans- porting extremely specialized goods. Concessions are a broader form of lease in which the contractor also agrees to make certain fixed investments and maintains the use of the as- sets for a longer period. This is currently the preferred restructuring method in the rail industry and will be extensively discussed in the rest of this chapter. Finally, joint ventures entail the largest degree of private partici- pation. Private partners contribute development capital and planning and management expertise to develop land or other real estate owned by a railway. Also, under full private ownership, private firms operate certain services or whole companies. 190 Railways NEW REGULATORY SCENARIOS. The vertical separation/private participa- tion bidimensional space creates a new regulatory framework in the rail sector. It introduces significant new roles and functions for the regulator and modifies the number of possible regulatory structures and models. In practice, choosing a particular method for railway restructuring depends on a number of objectives or goals that the government must balance ac- cording to the economic environment in which it operates. One of the first elements to consider is the existence of financial con- straints. If they are important, maximizing the proceeds obtained from the restructuring process will be a primary goal. A second element to consider is the pursuit of internal (or cost) efficiency in terms of providing services at the lowest possible cost, and therefore generating an efficient use of resources. Similar is the goal of attaining external (or allocative) efficiency by setting optimal prices equal to the marginal social cost, which from an intermodal viewpoint, facilitates the best distribution of traffic. The objective of dynamic efficiency requires the long-run minimization of cost through active, tech- nology-improving investment policies. Equity objectives also are possible, such as facilitating transport for all citizens independent of income level. Finally, the government can also consider the optimal allocation of capacity, which favors management of railway capacity, coordination with other modes of transport, and overall minimiization of risks in terms of service mainte- nance over time, risk of default, and so forth. Table 5.5 presents the combina- tion of these objectives, creating at least eight different possible regulatory scenarios, grouped in increasing order of private participation. Not included are some additional scenarios, such as the mixed forms described previously.7 The objectives this table enumerates could be given a different weight. For example, financial and cost-efficiency objectives are now valued above all others, which explains the privatization boom, through concessions and direct sales to the private sector. In addition, as the degree of privatization increases, a trade-off occurs between social and financial efficiency objec- tives. The public company scenarios serve social objectives (equity, reduc- tion of risk on the service, intermodal coordination, and so forth), but are inefficient, leading to huge commercial deficits, which was the main rea- son for restructuring the sector. 7. This is because many of these forms of private participation are related to very specific services (for example, the case of service or management contracts), and some of the forms of contracting (such as leasing) are occasionally similar to those established in a concession or franchising system. Table 5.5. Different Rail Regulatory Scenarios and their Objectives Objectives Internal External Dynamic Risk Capacity Scenario Fiscal efficiency efficiency efficiency minimizing allocation Equity 1 Vertical integration and government department X X v V v v v 2 Vertical integration and reformed public enterprise X X v v v v v 3 Vertical separation and reformed public enterprise X X v vV V X 4 Competitive Access and concession regime v v v unclear unclear X v 5 Vertical separation and concession regime V V v unclear unclear X v 6 Vertical integration and private enterprise v v X unclear X v X 7 Competitive access and private enterprise V v X unclear X X X 8 Vertical Separation and private company v v X unclear X X X Source: Authors. 192 Railways The deregulation measures that define scenarios 4 and 5 (concessions) have the advantage of favoring the efficiency and solvency of the compa- nies as well as reducing the state's financial burden (although these effects are possibly not as great as with direct privatization). In addition, conces- sion contracts allow the cushioning of some of the negative effects that may arise from the private company's actions. Thus, establishing maxi- mum prices and minimum service levels, so that impact on equity can be minimized, is habitual. Likewise, many routes that, though not profitable, are beneficial from a social viewpoint can continue to be served: concessioning them to operators that request lower public subsidies meets both efficiency and equity objectives. In regard to dynamic efficiency, the first results of the investments that the restructured companies or bodies implemented are ambiguous. In Ar- gentina, the investment levels of some operators have been below those foreseen in their concession contracts, although at the aggregate level, in- vestment levels seem to have improved. Something similar has occurred with some passenger franchises in the United Kingdom. At any rate, one should compare the effective investment levels with those that existed in the regulated context. In this sense, other experiences have indeed led to a substantial recovery in investments in both infrastructure and rolling stock, as well as an improvement in service quality. In other countries, such as Japan, privatization does not seem to have slowed the technological devel- opment of the railway industry (Fujimori 1997). Apart from other considerations, operational risks are minimized when entrusted to a public enterprise. A greater risk of closure of certain ser- vices, or of larger instability, is obvious with a private company. Again, concession systems allow the risks inherent to the action of private enter- prise to be reduced. Finally, the problem associated with managing capacity is easily elimi- nated in the case of vertically integrated companies, although this is not so simple for systems of competitive access or separation. In this case, the problem is increased for companies with high traffic densities and conflict- ing capacity demands. Modem computer technology can reduce the prob- lem through real-time management of electronic systems, but when con- necting systems have different informational qualities and dispatching priorities, planning and managing integrated services across several sys- tems is difficult for anyone. CoNcEssIoN CONTRACIS. Despite the number of potential regulatory sce- narios just described, few railways around the world have been fully Javier Campos and Pedro Cantos 193 privatized. Instead, most countries have opted to concession rail services, and even rail infrastructures in some cases, to private firms in exchange for a fixed payment. This has been the favored form of restructuring because it allows the government to retain ultimate control over the assets, while the private sector carries out day-to-day operations according to prespecified rules devised in a contract, which transforms the problems associated with traditional regulation into issues of contract enforcement (Thompson and Budin 1997).8 Because many variables need to be considered, one cannot reduce rail concession contracts into a single standard model. Based on ex- perience, however, table 5.6 proposes six key variables to consider. The first critical aspect of a concession is determining its type, both in vertical (functional) and horizontal (geographical) size. Recent concessions in the rail industry have created smaller horizontal packages throughout the country. For example, rail freight systems in Argentina, Brazil, Colom- bia, and Mexico were split into several regional companies, and Chilean railways were broken down into four passenger companies and two freight companies with a separate infrastructure firm. All these countries also used economic criteria to design the size of the concessioning package, account- ing for the profitability of different lines. Preferred in Europe is functional separation between infrastructure and services, especially since the pro- mulgation of European Commission Directive 91/440. The privatization of British Rail used this form of concessioning at its most extreme, and also included the private provision and management of rail infrastructures. Sweden and other European countries have developed a less extensive vertical separation, when infrastructure has not been auctioned off to pri- vate firms (Lundberg 1996). The second key issue in designing rail service and infrastructure con- cession contracts is defining the award process and duration of the con- cession. This includes the auction rules and, particularly, the criteria de- fining how each concession will be awarded to a private operator. The award criteria can be chosen from a number of possibilities, for example, maximum payment to government or minimum tariff. One can also choose between unrestricted bidding and bidding that could involve some preselection (Guislain and Kerf 1995; Kerf and others 1997). In the 8. The list of countries with actual or planned rail concessions includes Ar- gentina, Bolivia, Brazil, Cameroon, Chile, Colombia, Congo, C6te d'Ivoire-Burkina Faso (international link), Guatemala, Jordan, Malawi, Mexico, Mozambique, Peru, and the United Kingdom. Table 5.6. Key Variables in Designing Rail Concession Contracts Features Variables Type of contract Package size depends on economies of scale/scope and existing potential for competition Horizontal concessions (geographic) according to country's characteristics Vertical concessions (functional) according to network's characteristics (including current state of infrastructure and new investment needed) Mixed packages depending on profitability and bidders' financial constraints Freight versus passenger concessions depending on relative traffic shares Award and duration Prequalification requirements to reduce risks Type of auction (sealed, one-shot) and explicit rules for auctioning Selection based on government's objectives (fiscal, equity, or efficiency) Short periods (favor competition; diminish investment incentives) versus long periods (favor invest ment; diminish enforceability) Termination: re-auction preferable to automatic renewal Contents Concessionaire: * Obligations: services (with adequate performance) and payments * Rights: exclusivity and compensation for public service obligations Government: * Risk sharing (net cost/gross cost mechanisms) * Asset ownership (table continues on following page) Table 5.6 continued Features Variables Price control Price control depending on monopoly power and social objectives Ideal criterion: marginal cost rules Practical mechanisms: rate of return regulation and price cap schemes Other schemes: price discrimination and cross-subsidization a~ Quality regulation Quality of service Safety and externalities Dynamic quality: investments Instruments for quality control Infrastructures Access to rail infrastructures Access pricing Coordination and intermodal competition Source: Authors. 196 Railways privatization of the former British Rail, for example, the concession pro- cess began with a prequalification stage, followed by a formal invitation to tender for a particular package. After indicative bids were received, four bidders were short-listed. One of these was subsequently named the preferred bidder, and was given two weeks to complete financing and other organizational arrangements before being confirmed the winner. At that point, the regulator gave public details of the bid, in terms of the required subsidy and promised service improvements. With respect to bidding mechanisms, extensive literature is available on experiences and results in different auction forms. Single, sealed- envelope bids is the simplest, avoiding collusion and obtaining higher bids. More complex approaches, however, such as real-time auctions, have been used in some transport concessions. Once the rules have been set up and the bids requested, bidders should have a study period to form their own evaluation of the potential gains to be extracted from the concession. Early research by Preston and others (1996) for the United Kingdom indicated that key issues for bidders were the length of franchises, the level of com- petition they would face from other operators, the separation of infrastruc- ture from services, the costs (including new investments) associated with maintenance, and the selection criteria for the bidding process. Although the guiding principle should be to maximize competition so that the most efficient firm ends up winning the award, clearly no single method stands out for selecting the winner once bids have been submit- ted. The final choice depends on the government's objectives, which should be explicit and built on transparent criteria. Thus, if the government in- tends private participation to be a means of reducing the burden on the public sector, it must use fiscal benefits as the main criterion, looking at who requires the lowest subsidy or who offers the highest auction price. For example, Brazil successfully auctioned the six regional rail concessions to the highest bid above the government's minimum price. Concession- aires were required to make an up-front payment immediately after the auction, followed by a stream of predetermined payments over the life of the concession. Similarly, in Britain, minimnizing subsidy payments appeared to drive the choice of bidders, especially in the first concessions. Other cri- teria were the financial position of the tenderer, its managerial competence, and its operational proposals. Alternatively, if the contract defines tariffs and quality of service, bids can be evaluated on the basis of the lower cost provider, simultaneously including penalties for not achieving certain performance objectives. One can also target social objectives by focusing on the bids that propose to lavier Campos and Pedro Cantos 197 monopolize the industry for the lowest number of years or to charge the lowest fare to final users. Sometimes, as in the case of rail freight, the traffic mix makes the price structure complex, so that this mechanism becomes impractical. Moreover, using tariffs as an award criterion for rail conces- sions limits the later possibility of regulatory intervention in prices and demands an adequate definition of quality standards. The rail industry has awarded many concessions using formulas with multiple criteria, which can account for a larger number of objectives. For example, in Argentina, the bids for the six freight packages that were concessioned were evaluated using the net present value of the canon to be paid to the government during the first 15 years of the concession, the qual- ity of business and investment plans, the staffing levels, the proposed track fee for passenger trains, and the share of Argentine interest in the consor- tium. The weights of these criteria reflected both the importance attributed to investment in the railways and political compromises on employment. For the award of metropolitan commuter railways, however, the Argentinean authorities kept things simpler to make the bidding process and final selection as transparent as possible. They learned from the freight concession that selecting the winning bid through numerous cumbersome criteria with discretional weights was more likely to reduce the efficiency of the bidding process than to improve it. Instead, the terms of the conces- sion should be made clear to all potential bidders, and bidding should take place on the basis of a single parameter encompassed in the bidders' eco- nomic assumptions in terms of the concession.9 With regard to the optimal duration of the concession contract, the trade- off is evident in terms of efficiency, because the shorter the concession, the more immediate the competitive pressure, but the less the incentive to in- vest and develop the business. Longer concessions, in contrast, tend to di- minish the regulator's enforcement capacity and soften the incentives to promote efficient outcomes. The general rule is to adapt the concession pe- riod to the economic life of the assets and to make this compatible with the government's objectives. This balance often creates conflict: while conces- sionaires generally argue for long contracts that provide them with incen- tives to build up the business and purchase or replace long-lived assets, 9. In the case of the metropolitan railway concession, for instance, each con- cessionaire calculated his or her expected revenue from operations, then compared it with the capital investment programs and finally estimated the subsidy amount to be requested (World Bank 1996). 198 Railways concessioning authorities prefer shorter lengths to favor the achievement of efficiency (by the implicit threat of nonrenewal) and fiscal goals (because the canon or auction price may be increased after the first few years of the concession). Only if sunk investments are minimal, and asset reutilization is possible, are shorter periods advisable for particular rail services (those related to signals, track, and station maintenance). Shaw, Gwiiliam, and Thompson (1996) point out that the average dura- tion of a rail service concession is 5 to 10 years, increasing up to 30 when network investment and development are included. In Argentina, for ex- ample, the six freight packages were concessioned on a 30-year term, with an optional 10-year extension, due to the poor state of infrastructure and the huge investment that was required. For similar reasons, the interna- tional rail link between Burkina Faso and C6te d'Ivoire was awarded in a 15-year concession. Conversely, train operating companies in the United Kingdom were granted a concession to run passenger services for a period of only 7 to 15 years. After the duration period expires, the contract must also specify sev- eral termination arrangements to avoid any disruption in services. One possibility is to make automatic renewals in the event that new candidates for the concession do not exist. The regulator should not compromise on this before the concession ends, in order to ensure that the incumbent has the correct incentives. New auctioning seems to be the standard procedure after a concession has ended, but most rail operators will seek a renegotia- tion of duration terms while the contract is still in force. An example of this strategy is U.K. rail franchises arguing that they had made long-lived in- vestments in high-quality wagons and locomotives when they asked for a license extension. Because renegotiation costs money, but a lack of renegotiation might cause performance deterioration, concession contracts should specify the circumstances for renegotiation, and which party should initiate the pro- cess. If intermediate objectives are achieved, a prescheduled revision pro- cess might help to reduce both parties' risks. Although the contract will always be incomplete, standard clauses should include behavior in un- foreseen changes in demand conditions, responses to unanticipated rises in energy or labor costs, and so forth. For example, in Argentina, freight concessionaires could not fulfill their promise to invest US$1.2 billion in the rail network over 15 years due to unexpected falling traffic levels. A flexible contract renegotiation mechanism is a good idea in any case because the government may face the dilemma of enforcing contracts to the detriment of the operating companies and the national rail system or Javier Campos and Pedro Cantos 199 rescheduling investment and making other compromises at the cost of un- dermining its credibility for enforcing future agreements (Carbajo and Estache 1996). This is why one of the most critical issues in designing a rail concession contract is specifying its contents with detail, in terms of the attribution of rights and obligations to the parties. On the one hand, the private operator pays a regular canon or receives a subsidy and is awarded the right to operate train services and/or manage their infrastructure (including fu- ture investments) with total or partial exclusivity rights that protect it from other competitors. On the other hand, in exchange for the payment or the compensating subsidy, the overall performance of the sector is monitored by means of a regulatory activity, and a stable framework for current and future rail operations is provided. These operations may include infrastructure provisions if they were auctioned off to private firms. In fact, a large part of railway activities might be concessioned. These include infrastructure such as track, signals, sta- tions, yards, and shops; operating equipment such as locomotives, wag- ons, and carriages; and general service access to track, route, and schedule information and maintenance. The exact form in which this process is de- veloped in practice depends on the parties' risk-sharing agreements. Ac- cording to a service contract, for example, train operators provide rail trans- port services for passengers or (rarely) freight according to specific routes, levels of quality, and technology as established by the regulator. The op- erators may cover some investment costs and carry some commercial risk, which can be integrated into a net cost contract, in which the operator keeps all revenues generated by passenger or freight traffic. This type of contract, in which the operator carries revenue as well as cost risk, often generates more traffic and is let to the most attractive bid, but it offers a higher incen- tive to predate. Alternatively, gross cost contracts specify that all revenue accrues to the government and that the contracts are let on the basis of the least total cost supplier, so operators carry cost but not revenue risk. The experience in the United Kingdom with regard to passenger franchises suggests that gross cost contracts generate more bids per tender (particu- larly from new entrants), offer greater incentives to public revenue genera- tion, reduce the administrative cost for the regulatory authority, and sup- port any fare scheme with modal integration and quality control. The regulator may retain control over and responsibility for common func- tions, and its main roles should be restricted to regulating quality (in terms of service, safety, environmental, and technical standards), controlling mo- nopolistic behavior (in terms of abusive prices or services), and determining 200 Railways the overall characteristics of the sector's function (in terms of coordination at the national and international levels), according to established competition rules or rights and antitrust and commercial legislation. The implementation of rail concession exclusivity rights varies in each country. In Argentina, freight concessionaires have exclusive use of tracks but must grant access to passenger operations in return for a compensa- tory track fee. In Chile, passenger services and infrastructure initially re- mained in public hands, while freight services were privatized. The 15- year concession for the C6te d'Ivoire-Burkina Faso transnational railway was awarded with a 7-year exclusivity period, after which the operator should grant access to third parties specified by the regulator for an agreed-upon fee. Thus, exclusivity rights should be viewed as another instrument for regulatory control, and not taken for granted by the firms ex ante. Limiting the duration of the monopoly period balances the regulator's desire to reap the benefits of competitive access to the tracks with the private train operator's preference for full control of the market to generate profit and facilitate revenue forecasting. In general, most rail- ways have been concessioned on an exclusive basis in geographical ar- eas, as in Argentina or Brazil, possibly with some access rights for con- necting railways to certain central or strategic track segments. This has been due to the geopolitical configuration of the country, the density of the existing network, and the need to promote competition in major mar- kets (as in Mexico) or for noncompeting services (such as passenger ser- vices on freight tracks in Chile). With respect to the concessionaires' obligations, the private provision of rail transport services, particularly in less developed areas or zones with a structural lack of network, cannot always be separated from public sub- sidization or reciprocal compensation for politically motivated public ser- vice obligations. Concession contracts must include arrangements for these loss-making but socially necessary services, in terms of detailed perfor- mance levels to be attained by the firm. They may even possibly be de- signed to be awarded to the company willing to provide the specified ser- vices for the lowest level of subsidy (negative concessions), as in Argentina. A final feature of defining the rights and obligations of the concession- aires, the current experience of rail concessions in South America shows that restructuring has often lowered employment levels. This is, in practice, one of the toughest obstacles hindering the private participation process in cer- tain countries and often requires difficult political decisions. In Brazil, for example, large redundancies were inevitable and were dealt with in two phases. Before concessioning, incentive schemes for early retirements were lazver Campos and Pedro Cantos 201 in place; after the concession was awarded, the former national rail operator paid involuntary separation grants to the remaining staff not hired by the concessionaire. After that point, compensation for additional laid-off em- ployees is the responsibility of the private operator. Undoubtedly, the auc- tion price of the concession will reflect any such employment constraints. In summary, in its general form, a rail concession is the most advanta- geous solution to the challenges posed by the current regulatory environ- ment of the rail industry. It usually adopts the form of a long-or medium- term contract in which a vertically or horizontally integrated package of passenger and/or freight rail services is auctioned off to private firms, while economic assets remain public property. This section has described three of its key features-type, duration, and contents-but other aspects of the rail industry's concession contract design deserve treatment, based on their importance, in the following sections. These include price regulation, in terms of defining the most important issues for effective and well-oriented price control mechanisms; quality regulation, in both its static dimension (quality of service, safety, and environmental issues) and dynamic dimen- sion (rules for infrastructure investment and financing); and coordination between infrastructure and superstructure. Price Regulation According to standard economic principles, prices for rail transport ser- vices should match the opportunity cost of providing them so as to make the most efficient use of the economy's resources. This is the economic effi- ciency or first-best criterion, which has defined the traditional regulation of the rail industry during the past 50 years. The main focus of government regulation was to control market power by setting prices that limited the monopolistic abuse of any particular railroad. The exact form of tariff con- trol (official approval of rates with little or no degree of financial autonomy) in each case depended on the nature of the industry, the ownership of the assets, the complexity of the regulated service, and the social and political pressures to maintain financial equilibrium in the medium and long run. In practice, however, opportunity cost pricing presents measurement difficulties and often conveys economic losses, especially in industries with large economies of scale (Amstrong, Cowan, and Vickers 1994). Therefore, this form of regulation was complemented by a number of standard price mechanisms that economic theorists devised to substitute the ideal efficiency criterion of pricing each unit of service at the exact cost of its provision. 202 Railways Price discrimination policies, either by type (student and senior prices, frequent traveler and commuter passes), number of consumers (group dis- counts), type or volume of freight (cargo rebates for some goods), or time of day or season (peak-load prices), have always been common in trans- port. Using two-part tariffs, with fixed and variable components, is also a common tariff policy in which each unit of consumption (for example, a single trip) is priced differently. These mechanisms allow greater flexibil- ity for railways and increase revenues without a great effect on costs. Their social acceptability and information requirements, however, can limit the extent of their application. In the new regulatory environment in which separating infrastructure from services can be relatively easily achieved, and a notable degree of pri- vate participation in rail management exists through concession contracts, pricing principles must be put into practice by means of concrete rules within the contract. Because rail concessionaires are now able to set prices relatively freely, the concession contract should include a procedure to control the prices set by operators. One should generally set these price control mechanisms according to three key factors: (a) the degree of monopoly power effectively conferred to the operator; (b) the extent of government noncommercial ob- jectives in the concession award procedure; and (c) the possible existence of limiting factors, such as intermodal competition. This latter element is rel- evant in rail freight operations (intermodal competition from trucking),'° but in the case of passenger traffic (especially commuter and regional), social pressure for low fares usually dominates many price interventions. In prac- tice, the most common alternatives (second-best criteria) for price control in rail concessions are rate of return regulation and price cap mechanisms. Rate of Return Mechanisms Railroads in Canada, Japan, and the United States use rate of return regula- tion. The principle behind this type of regulation is to constrain prices so that the regulated rail transport operator earns only a fair rate of return on its capi- tal investment. The regulator typically determines a revenue requirement based on a firm's total costs during a test year, according to the variable costs and an estimate of the cost of capital to the firm, given by a "reason- able" rate level multiplied by a base rate (Liston 1997). 10. For example, in Argentina, railways only carried 8 percent of total freight ton-kilometers at the time of concessioning. Javier Campos and Pedro Cantos 203 Revenue requirement = total cost = (variable cost) +4 (rate level x base rate) Thus, rate of return regulation has three components: the base rate, the allowed rate level, and the rate structure. The base rate refers to the invest- ments that are allowed to earn a rate of retum, the rate level refers to the relation of overall revenues to costs, and the rate structure determines how individual prices are set for different services or customers. Determining the first of these three components is often the most important regulatory task under this form of regulation, because inadequate calculations of the base rate may either jeopardize the survival of the firm or allow it to earn excessive profits. In practice, the base rate usually indudes most fixed costs less depreciation and working capital. Three characteristics should govern the definition of the asset base rate. First, with respect to the treatment of past investments carried out by the railroad before the regulatory period, it should be consistent and transpar- ent in order to ensure that assets are not expropriated ex post by opportu- nistic regulatory behavior, which would increase the cost of capital required by investors. This is often the case in restructuring processes when a former state-owned railway transfers its assets to private concessionaires. Second, one should consider future investments and expected operating expendi- tures and costs in the asset base definition inasmuch as they do not imply "excessive" investment and only when they are fully incorporated into the firm. Finally, with respect to current investments, a problem lies in deter- mining the value of the firm's capital. If the existing assets were transfer- able to other activities without cost, then the conceptual problem of deter- mining their value would be simple: their replacement cost or resale value. At the other extreme, and more frequent in the rail industry, is that existing assets are sunk, so the opportunity cost of using them in their present ac- tivity is zero. If the regulator seeks maximum efficiency, it should ensure that the rate of return structure (and, indirectly, prices) is set to cover fu- ture avoidable costs. Because most of the assets railways currently use are sunk and financed before the concessioning process, both of these solutions are troublesome. Market values are much lower than replacement costs, so this valuation would yield large price increases and windfall gains for private sharehold- ers at the expense of consumers. By contrast, in attributing a zero value to the existing assets, windfall gains would go in the opposite direction and the proprietors would be reluctant to finance future investments with such a lower real return. A possible way to address this problem is to use some average procedure that considers either a financial projection of what will 204 Railways happen with the future base rate or calculates indicative values by estimnat- ing the cash flows that the firm would have earned had the regulatory regime remain unchanged. Despite its advantages within the traditional price regulation mecha- nisms (mainly its simplicity), three additional problems are associated with this sort of regulation. First, it gives little incentive for productive efficiency, because firms can pass production costs on to final users in the form of higher prices; second, it leads to excessive investment and capi- tal use because the firm is guaranteed a return on investment; and, fi- nally, the high degree of discretion the regulator enjoys in determining the base rate and the rate of return reduces the incentive for rent-seeking behavior by the regulated firm. This is the so-called Averch-Johnson or capital bias effect, which is not particularly adverse in developing econo- mies whose capital needs are seldom fulfilled. Price Cap Regulation Mechanisms The most common alternative to the standard rate of return regulation is using cost-plus incentives that, in practice, take the form of a menu of cost reimbursement rules that firms themselves select according to their prefer- ences for sharing operating costs with the regulator."1 These mechanisms basically aim to achieve dynamic efficiency (in the sense of the regulated firm achieving the lowest unit cost in the long run) by sharing some of the efficiency improvement rents between the firm and the regulator. Several ways are possible to accomplish this goal and implement its results. For example, the sliding scale plans that the United Kingdom's Railtrack regulation uses consist of a price adjustment mechanism through which the actual rate of return the firm earns is adapted to changes in pro- ductivity according to a variable parameter. Price cap regulation is another incentive that both railways and other privatized utilities use. In its most standard form, it consists of setting tra- ditional maximum price schemes based on long-run marginal costs in or- der to offer a firm an incentive to achieve the goal of dynamic efficiency while maintaining all or part of the gains associated with the firm's future increases in efficiency. This mechanism came as a consequence of the criti- cism directed at the lack of cost minimization embedded in rate of return regulation and other traditional price regulation mechanisms. One has to balance its efficiency gains, however, with the higher information rents that it implies (De Rus 1998). 14. See Guasch and Spiller (1996) for detailed examples in other industries. Javier Campos and Pedro Cantos 205 The price cap system has a number of minor variations. In the rail in- dustry, one of the most developed is the RPI-X formula. In this setup, the price for a basket of the firm's prices can increase in any one year by no more than the increase in the retail price index (RPI) for that year, minus some fixed-cost (efficiency-related) parameter X. price ,2wr 1) < price (year 0) x (RPI - X) In the case of multiproduct activities, one can easily adapt this expres- sion by requiring that a certain weighted average of percentage price in- creases not exceed the rate of growth of the RPI less X percent. The weight for each price can be defined according to the share in total revenue of each product, or, alternatively, it can be imposed that the average revenue (cal- culated with accounting figures) can grow at most by RPI-X. Thus, the regu- lator can control the prices of multiproduct firms by focusing on their rev- enues and correcting them according to adequate weights. It starts with a reference price, often calculated with rate of return criteria, and sets the price for a certain number of years. The United Kingdom, for example, has applied the price cap mecha- nism, in its RPI-X formula, to passenger traffic franchises. Commuter fares are regulated with respect to a basket containing all relevant fares, weighed broadly by the income that the operator derives from each. For three years from January 1996, increases in the capped fares were not permitted to be more than the retail price index increase from the 1995 base price; after January 1999, the price cap was planned at RPI-1 percent. The goal of this method is to increase the efficiency of the regulated rail operator, allowing the firm to earn substantial profits by improving efficiency while simultaneously financing current and future operations. This implies that, in practice, when setting the level of a price cap, the rail regulator must consider several factors: the cost of capital, the value of the existing assets, future investment programs, expected changes in productivity, estimates of demand growth, and, perhaps, the effect of X on actual and potential competitors. Some of these are common to other price regulation mechanisms, and, in particular, they are needed when using rate of return regulation, as described above. Different procedures and rules can be used to deal with each mechanism. The cost of capital and the value of existing assets are calculated using stan- dard financial techniques. The future investment program and its implica- tions depend on both expected changes in productivity and estimated demand that can be obtained from econometric techniques or simpler projection and analysis of historical data. Finally, the effect of the price cap on the future shape of the market is conjectured from past experiences or yardstick comparisons. 206 Railways One of the most critical issues is the setting and resetting of the pro- ductivity X-factor. A possible method consists of using indexes or indica- tors (as described below) to measure the difference between aggregate rates of growth of outputs and inputs, and therefore calculate productiv- ity from the residual. Econometrics also provides alternatives for esti- mating cost functions and their corresponding productivity parameters (see Borts 1960 for a classic reference). Once the X-factor is determined, the initial price ceiling imposed on the firm after a switch of regime is critical. If the caps are too high, then too little surplus is transferred to consumers and deadweight losses are huge. If they are set too low, the firm may not be able to break even and may then have difficulty attract- ing capital, leading to a deterioration of service quality. Another important element of RPI-X regulation is the existence of cost pass-through provisions, through which the firm can transfer to customers unexpected increases in certain factors outside of its control. Although these clauses are standard in the regulation of other utilities, they are not in the rail industry. Energy costs could give the most plausible case, for which a certain percentage (100 percent or less) of the cost pass-through onto cus- tomers could be established in the concession contract. In summary, the traditional pricing principles in the rail industry are not particularly different from standard economic principles. On the con- trary, they are extensively used as examples for other economic sectors and transport modes. Rate of return regulation and price cap mechanisms are the most common price regulation schemes in the rail industry today. They represent a form of price control in which, as opposed to traditional regulation, some commercial freedom is given to the regulated firm. Al- though rarely implemented in their purest forms, rate of return regulation and price caps (in their most developed form of RPI-X) center most of the debate on practical experiences in rail concessions. These methods are valid not only for limiting monopoly profits earned in passenger or freight traffic, but also in controlling infrastructure access prices (discussed later). Finally, because tariff controls can easily be cheated on quality grounds, quality requirements become essential for monitoring overall performance of rail concessionaires. The Problem of Rail Infrastructure Costs As described earlier, rail infrastructure provision and management are characterized by a high ratio of fixed to marginal costs, the existence of avoidable costs, and unavoidable or common costs. Avoidable costs are uniquely associated with a particular output: if this output is not produced, Javier Campos and Pedro Cantos 207 no cost is incurred. This guiding principle relates to the idea of cost recov- ery for particular outputs. Avoidable costs may thus be considered as a floor to regulated prices (if any), because charging less than the avoidable cost is equivalent to operating at an economic loss. This makes standard pricing rules inoperable in this sector, because first-best or efficient prin- ciples of marginal cost pricing may result in large deficits that jeopardize the long-run survival of the firm. Three particular problems then arise with respect to allocating the rail infrastructure costs: cross-subsidization issues, cost-recovery problems, and the possibility of setting inefficient prices (Talley 1988). Illustrating the cross-subsidization problems in pricing rail services or infrastructure produced in the presence of common costs is the case of a profit-regulated railroad connecting two large cities and also providing rail service to a smaller town along the route between the two cities. The fares charged for passage from the small town generate revenues exceed- ing the additional cost of serving it, such as ticketing and station costs, but not sufficient to cover an equal or proportionate (however defined) share of the common costs, such as trackage, signaling, and train yard costs. The issue is how to allocate common costs among customers and services. In many cases, cost sub-additivity and efficiency require joint production and allocation of fixed costs among all services, without cross-subsidization (accounting for externalities whenever present). Cross-subsidization is not only an equity problem for rail services, as in this example, but also a relevant issue for efficient pricing of infra- structure such as rail beds, signals, and stations. The standard procedure is the so-called fully distributed costs method, under which common costs are allocated on the basis of some common measure of utilization, such as gross tons/kilometer, or other measure of relative output or gross rev- enue. Alternatively, one can allocate common costs in proportion to costs that can be directly assigned to the various services (Braeutigam 1980). The arbitrary nature of fully distributed cost methods and their lack of a conceptual foundation have been criticized, but they remain a useful measure for recovering common costs. The treatment of the cross-subsidization problem should not be based on excessively rigid criteria, however, particularly for developing coun- tries with few alternative finance mechanisms. The analysis should be made on a case-by-case basis, because, for example, stand-alone cost tests do not apply if railroads are not allowed to abandon unremunerative facilities or services (Kessides and Willig 1995). If that freedom is denied, a railroad cannot earn adequate revenues if its rates on potentially remunerative ac- tivities are constrained by stand-alone cost ceilings. 208 Railways The cost recovery principle should be a central issue in the design of any rail infrastructure pricing procedure. The theoretical and political debate focuses on two options. Many public firms still advocate the use of the efficient price mechanisms described earlier in this section and propose marginal cost rules with the simultaneous use of public subsi- dies to cover fixed costs. Alternatively, a growing literature patronizes the use of full-cost recovery prices, including price discrimination, mul- tiple-part tariffs, or cross-subsidization schemes, if needed. Although one considers the possibility of it yielding inefficient outcomes for the theoretical efficiency principles, it constitutes the second-best available alternative in most cases. Similarly, with respect to access pricing of a rail network, it should clearly be based on marginal cost pricing rules in a first-best world. In practice, however, achieving this objective is difficult due to at least three reasons: the above described cost structure of the rail network, which cannot al- ways be recovered with simple price rules; the asymmetric information problem the regulator faces with respect to these costs; and the subsidy level that can be sustained in the long run. Many econometric studies have shown that in the case of the rail in- dustry, the marginal cost of those railways that are still vertically inte- grated lies in the range of 60 to 70 percent of average cost; where rail services are separated from infrastructure, the marginal social cost of rail infrastructure alone often is well below the 60 to 70 percent range (Fried- lander and others 1993). Price discrimination, if feasible and politically acceptable, may help to raise cost recovery to around 60 percent of total cost without driving demand off the market. Thus, full cost recovery would require a further price markup of more than 60 percent above the efficient price. Economists have defended alternative proposals, in terms of the so-called Ramsey pricing principle, for infrastructures with high fixed costs and low marginal costs.'2 They rarely work in practice, how- ever, because they arouse consumers' suspicions of unfair treatment and undue discrimination. Moreover, under Ramsey pricing rules, all unattributable fixed and common costs are apportioned on the basis of the services' demand characteristics. 12. Ramsey pricing refers to charging higher prices above unit costs to more inelastic market segments. When infrastructure and services are separated, their use becomes more complicated and still is not clearly solved, because one must estimate different demands for services as well as for tracks. Javier Campos and Pedro Cantos 209 In the current debate, a reasonable conclusion is to advocate a balance between the cost recovery issue and the efficient pricing rules, giving preferential treatment to one according to the case. The issue remains unsolved, however, and depends on how different countries have faced their access pricing problem. Whether or not a country's government is willing to assume these differences is, in most cases, a political question. In many cases, the ultimate challenge is how to price access to rail infra- structure in a transparent, efficient, and nondiscriminatory way. In Eu- rope, for example, Directive 95/19 requires infrastructure managers to balance revenues with expenditures. In countries where revenues from operations and compensation from government for public service obli- gations are insufficient to provide a surplus for depreciation and invest- ment, railways will be dependent on the state to fund or guarantee re- payment of investment loans. This continues to be the case in many of the countries of Central and Eastern Europe. The Access Pricing Problem The development of tariffs for accessing rail infrastructure varies greatly among different countries according to the stage of their railway restruc- turing process. Some countries have already identified procedures for set- ting fees, and a number of them have laid down precise rules for the struc- ture and level of fees. In others, business unit or infrastructure companies (either in public or private hands) are responsible for setting charges. Ac- cess charges are mostly relevant in countries where traditional railroads have been vertically unbundled by the separation of the potentially com- petitive area of service operations from the naturally monopolistic area of infrastructure management. Apart from the already discussed problem of cost recovery, access pric- ing may create a market structure problem because of its effects on compe- tition and barriers to entry. This problem arises in network industries in which a single, vertically integrated dominant firm (either private or pub- lic) controls the supply of a key input (in this case, railway tracks) to its competitors. In these cases, the firm obviously has incentives to set prices high to raise rivals' costs, but the case is also possible that the regulator sets access prices too low in order to favor the entrants. Depending on the discretion allowed to the integrated firm, one can determine potentially distortive effects on access prices in several ways. First, when infrastructure is still publicly owned or managed, the regula- tor can determine the price as an integral part of the access terms defined 210 Railways in a contract with one of several private train operators. Second, the regu- lator may allow the firm to choose from a menu of alternative regulatory schemes, usually rooted in incentive-based price regulation mechanisms (to favor the firm that achieves higher levels of efficiency). Third, the firm may have discretion over aspects of access pricing subject to some overall regulatory constraint. Finally, the firm may have full discretion over the price and only be restricted by the country's antitrust law. In all these cases, two main approaches exist for setting access prices when the principles of cost recovery plus the normal rate of return are required. First, some countries use the current dominant paradigm for set- ting access charges: cost-related charges, which are based on the optimal first-best principle of pricing according to marginal cost (considered the forward-looking long-run incremental cost). The higher the proportion of common costs, the more complex the principle. It is based on the so-called efficient-component rule, which determines that optimal access charge is equal to the direct cost plus the opportunity cost of providing access (given by the reduction in the dominant firm's profit). To compute these costs, the regulator has to consider economic depreciation (physical depreciation plus technological progress) and forecast future usage. The first problem to be solved is that of the actual value of capital as- sets: nominal value versus potential to generate cash. While the latter is clearly a function of the privatization and regulation methods and the ex- tent of competition envisaged in bidding for the right to operate concessioned infrastructure services, the former is more likely to reflect a past situation that domestic reforms are trying to overcome. The second method of setting access prices consists of developing us- age-related charges. Once-avoidable costs are covered by increasing prices that are inversely related to demand elasticity. Another, less controversial, option is using a two-part tariff to avoid service cuts by train operators to save charges even when the network has no cost saving. The British infrastructure provider, Railtrack, is a well-studied example of access prices functioning in practice. The main targets in the constitu- tion and privatization of this firm were set to obtain a better organization of transport services, reduced costs, and higher efficiency. In a context in which operating companies have also been franchised, Railtrack manages the infrastructure (track, signaling systems, electric power supply, and sta- tions) and is responsible for its maintenance, new investments, and train operations (timetables, coordination, and so forth). It also sells access to infrastructure to passenger and freight operators. Javier Campos and Pedro Cantos 211 Railtrack owns the rail network and sets track charges upon which the rail regulator must agree under the criteria openly published in a number of regulatory policy statements. The price control system operates through a simple RPI-X formula that is revised every five years, remaining fixed between revisions. For example, in January 1995, the regulator announced the price controls that would apply to franchised passenger services from April 1995 to April 2001. The structure of Railtrack's access charges for franchised passenger services is based on the usage-related charges made up of multiple-part tariffs that have at least four elements.'3 First, track usage charges tend to reflect short-run effects on maintenance and the renewal costs of running trains of different types for different distances. Second, traction current charges recover the costs of electric current, varying geographically and temporally and reflecting distance covered and type of vehicle. Third, the long-run incremental cost indicates the long-run costs imposed on Railtrack in delivering the total access rights of a train operator. Finally, the remainder of the fixed charge are common costs, designed to recover the rest of Railtrack's costs at the subzonal, zonal, or national level. This is apportioned among train operators on the basis of budgeted passenger vehicle miles for subzonal costs and budgeted passenger revenue for zonal and national costs. The first two elements amount on average to only about 9 percent of total track access charges, and given the current struc- ture of charges, these are the only elements that vary directly. The re- maining 91 percent of the aggregate charge is in the form of a fixed charge, which does not vary with the number or type of trains run or with pas- senger revenue. In the case of freight services, access prices are more flexible. The rail regulator has simply established several principles for Railtrack to consider in its relationship with private operators. First, prices must cover the avoidable costs Railtrack incurs as a direct result of carrying that particular freight flow; second, prices must be lower than the stand- alone cost that a national efficient competitor would incur; third, no undue discriminatory charges are possible; and finally, charge struc- ture should reflect the value to users of access to the rail network and enable Railtrack to recover its total cost. 13. See Dodgson (1994) and ORR (1997) for a detailed description of the British system. 212 Railways As opposed to the British case, the setting of access charges in other European countries is still underdeveloped. In 1995, the European Union passed two directives concerning the application of Directive 91/440 on the separation of infrastructure management and transport operations. Directive 95/18 regulated the licensing of railway undertakings, and Di- rective 95/19 established several general principles on allocating railway infrastructure capacity and infrastructure fee charges. These principles were designed to ensure an optimum, nondiscriminatory use of infrastruc- ture and guarantee an access charging policy according to European Com- munity rules, but member states received them with varying degrees of enthusiasm. The objective of most governments that have set rules for infrastructure fees is to cover costs and differentiate fees to reflect differ- ent cost factors. France, for example, introduced several principles for giving access to railway infrastructure to licensed international groupings of transport ser- vices and operators of combined transport, but present arrangements seem more inclined to promote conventional international rail groupings rather than new entrants into the rail market. With centrally planned timetables, only the domestic operator pays a fixed amount to the (also public) infra- structure manager. User fees are fixed, accounting for a wide set of criteria, including infrastructure costs, the transport market situation, supply and demand characteristics, imperatives based on optimized use, and standard conditions for intermodal competition. Similarly, in Germany the federal government owns the track infrastruc- ture and is responsible for its preservation and for securing a certain level of public transport service by means of the Deutsche Bahn, an indepen- dent joint-stock holding whose sole shareholder is the state. The Deutsche Bahn's infrastructure division bears operating and maintenance costs and is in charge of stations, ticket sales, passenger attention, and so forth. It is also responsible for setting charges for track usage, which are supposed to cover all infrastructure costs, including investment. These charges are based on prices per train/kilometer on the different line sectors, resulting in a number of different fee combinations (Hafner 1996). Quality and Safety Regulation Quality performance is important when society evaluates the economic contribution of the rail transport sector to the social welfare. The particular level of quality that train operators achieve, and the particular features of lat4er Campos and Pedro Cantos 213 three main dimensions that broadly define quality in the rail industry (ser- vice, externalities, and investment), critically determine the value added by this transport mode. The first questions that naturally arise are why quality regulation is needed at all in this industry, and to what extent this regulation relates to the standard price regulation mechanisms described in the previous section. Economic theory provides a well-known argument to answer these questions: real-world transport activities are characterized by market failures due to information problems. In an ideal world with a large number of competitive rail transport ser- vice providers and well-informed consumers of passenger and freight ser- vices, quality regulation would not be required because market forces would adjust consumer demand (in terms of prices, levels of output, and quality of service) to firm supply. If no price correction took place, less reliable rail companies would be driven out the market and only those whose price- quality ratios were in accordance with demand would remain. When full information does not exist, however, markets cannot exert this disciplin- ary role on firms and purely competitive solutions do not always posi- tively affect quality, prices, or output. Pure competition may result in un- safe, unreliable, or unpleasant services because limited availability of resources and lack of adequate control mechanisms make it impossible to adjust consumer and producer interests. In the traditional organization of the rail industry some years ago-a monopolistic structure with a single firm providing services at the na- tional or local level-price-quality adjustment problems may have in- creased because the monopoly's privately optimal level of quality may not have coincided with social standards. Simple price regulation is sel- dom a solution. Any regulated, multiproduct monopolist in an environ- ment of asymmetric information tends to degrade quality to achieve higher profits once it enters the market. Railway firms are not immune to this temptation, for example, in terms of punctuality and cancellation standards. The quality outcome of any monopolist, not just in the rail sector, heavily depends on the specific regulation adopted. For example, with rate of return regulation, overinvesting in nonrequired technologi- cal quality may accentuate the Averch-Johnson effect. Alternatively, with price cap regulation, a subtle cut in quality can be a tempting way to cut costs (Carbajo, Estache, and Kennedy 1997). Therefore, the price regulation mechanisms analyzed above are consid- ered incomplete if they do not include quality provisions. This is not al- ways easy, because adjusting price mechanisms by quality may render them 214 Railways inoperative or excessively difficult for the firm to manage or the regulator to monitor. Therefore, most regulators set quality standards or targets for train operators instead of correcting price control mechanisms. Definition of Quality Targets In setting up the quality standards incorporated in concession contract designs, the regulator often uses the principles of yardstick competition.14 One may construct these quality standards at the national or regional level with inter-industry comparisons (as in Brazil and Chile for many of their public utilities) or by establishing international benchmarks or best prac- tices (as in Australia for transport services and infrastructures). One considers three elements in detail when designing this process. First, as in other transport modes, quality is mainly measured in concrete service levels or specified service standards. This measurement, however, is suited more for factors such as train punctuality, the reliability of aboard services, and the waiting time at stations or platforms than it is for other factors."5 Simultaneously, the services provided before the transport itself, such as tick- eting, reservations, and luggage or cargo handling, are often ignored as part of the rail industry's value chain, although they may constitute relevant as- pects of both intramodal and intermodal competition. For these reasons, the first element to consider in designing a quality control in the rail industry is an integrated vision of transport service that includes not only the ride itself, but all aspects related to infrastructure (track and stations), stations, and pre- and post-transport services provided to clients. A second aspect of quality regulation that is particularly relevant to railways is the flexibility with which scheduled services can be changed and new services introduced in response to changes in demand. Here, the rail industry has always been at a disadvantage to roads and air because of the need to coordinate working timetables and operations with certain technical requirements due to the lack of alternative routes between points. 14. This is done to avoid the problem of regulator's capture and the discre- tionary nature of the regulatory action. Making undue comparisons between dif- ferent rail systems, however, is a risk. 15. For example, railway tracks can deteriorate with respect to the smoothness of the ride or the noise or vibration generated to passengers and third parties (build- ings close to tracks), even though punctuality or safety are not jeopardized, so there may be an incentive to reduce maintenance standards in this respect. lazmer Campos and Pedro Cantos 215 Hence, for rail transport to offer on-demand services to passengers (for example, as charter airlines do) or to freight customers (door-to-door services) is usually not easy, with a few increasing exceptions in many countries. Thus, coordination is relevant for quality of service regulation within the rail firms, and it must also be considered in the design of the industry structure. For example, one potential disadvantage of the split between infrastructure and operations is that coordination might be even more difficult when changes have to be negotiated between different or- ganizations, especially when timetable approvals also need to be secured from other train operators using conflicting train paths. Intermodal coordination with other industries is also necessary, because social quality performance is always evaluated in relation to feasible alter- natives. Saturated corridors (where investment in roads, railways, and air- ports clearly overcomes demand) are a waste of resources that few econo- mies can assume. This almost general equilibrium approach to evaluating quality constitutes the third element of the quality regulation process, al- though, in this case, it is not particular to this industry. The sociopolitical implications of quality regulation (in terms of equity or public service ob- ligations and the social acceptance of quality standards) determine the over- all quality targets to be established in each industry. Taking into account these three characteristics, table 5.7 summarizes the five most important quality dimensions for the railway industry (ve- hicle, route, service, social, and dynamic quality) along with a number of standard performance measurement instruments for them. The first three (vehicle, route, and service) are related to what is usually named quality of service, whereas the last two refer to static and dynamic externalities. QUALrrY OF SERVICE. Different countries have dealt in different depths with regulating the quality of rail transport services in regard to vehicle quality, the transport service itself (aboard trains), and the pre-and post- transport services, although, as described earlier, a positive correlation exists between the extent of the restructuring activity in the rail industry (in terms of private participation or separation of infrastructure from ser- vices) and the quality regulation requirement imposed on the industry post-restructuring. In general, countries in which the sector is still heavily dependent on government or public agencies (such as in Asia and Eastern Europe) have done less to establish separate quality control frameworks than those in which private participation has been significant (such as the United King- dom) and detailed quality control systems have been set up. In all cases, 216 Railways Table 5.7. Quality Dimensions of the Rail Industry Dimension Definition Measurement variables Quality Vehide Aboard quality Age of vehicle/number of service (wagons, locomotives) of years in service Vehicle size and load factor Availability of seats Accessibility Travel comfort * noise * vibration * temperature * tidiness Route Route quality Distnbution and numberof stations (travel of passengers Timetable and cargo) * peak trains * first-last train * weekend-commuter services Frequency (number of trains perhour) Punctuality/reliability (waiting at stations) Cargo services (reliability) Service Pretransport and Ticket sales/reservations post-transport service Handling quality(added Staff adequacy and competence value to service) Inquiries and general information Response to complaints External quality Externalities Public service obligations (safety and Safety procedures environment) Liability regimes Environrnent protection (noise, pollution) Congestion Dynamic quality Investment policy Fleet and track renewal rates T-rack and stations maintenance Itvestment obligations Source: Authors. the basic principle governing the design of quality mechanisms is that customer service should be paramount if railways are to maximize prof- itability and compete with altemative modes of transport. The economic relationship between separate units in a railway enterprise should be structured to ensure the preservation of incentives for maximizing cus- tomer service (Swift 1997a,b). This is particularly relevant to the separation of infrastructure and op- erations. Vertical unbundling in railways distances infrastructure manage- ment from the end-user customer and could yield undesirable side effects or contradictions. For example, the density of traffic (trains per day) that maximizes returns on infrastructure investment is likely to be greater than Javier Campos and Pedro Cantos 217 the optimal level from the operators' point of view. This is because at high densities, passenger service is likely to suffer due to congestion. Therefore, no matter whether the separation is institutional or only financial, one must incorporate mechanisms to compensate infrastructure units that run be- low optimal capacity into contracts to maximize end-user customer per- formance as a whole. Because the particular characteristics of the rail in- dustry in each country require fine-tuning of any regulatory or contract enforcement mechanism, table 5.8 proposes a simple scheme that identi- fies and separates the roles to be assigned to the regulator and the operator (either franchisees or public or private monopolies) with regard to quality of service regulation. After the reform of the United Kingdom's rail system and the full privatization of its services and track provision, that system constitutes one of the most practical examples of a detailed quality of service regula- tory framework (see table 5.8). For example, in the case of passenger trans- port, the regulatory agency (Office for Passenger Rail Franchising, or OPRAF) defines what level of service is tendered for particular routes and corridors and sets the minimum level of service for every route in the coun- try (not only timetable specifications, but also journey time, first and last Table 5.8. Role Assignment in Railway Quality of Service Regulation Role Regulator Operator Both Design of adequate quality of service standards / X X Level of application of these standards / X X Punishments, fines and sanctions / X X Information to passengers about quality standards / / / Variables to be controlled / X X Inspection and reporting procedures , / / Responsibility for achieving quality standards X / X Risk sharing of service quality fluctuations / / / Technical quality / / / Source: Authors. 218 Railways departure times, and so forth). If franchises operate a poorer service than specified, then OPRAF reserves the right to withhold the grant. Operators awarded with licenses-the train operating companies- are obliged to include in their timetable certain passenger service require- ments that the franchise agreement sets out. These are the minimum stan- dards of quality that operators need to achieve to ensure the basic provision of services. To avoid excessively limiting the freedom of the operators, however, these requirements do not specify detailed timetables for each route, but instead set parameters within which each company must design its own timetable. Passenger service requirements are set out by route and are largely based on the former British Rail timetable, specifying frequency of trains, stations to be served, maximum journey times, first and last trains, weekend services, through services, and load factors/peak train capacity (for commuter services). Passenger service requirements also include limits on the number of train cancellations and, where applicable, the level of capacity that needs to be provided. These limits apply in any 28-day reporting period, with three levels determined: (a) a call-in level, in which OPRAF reviews the operator's performance; (b) a second level, in which the operator is in breach of the franchise agree- ment; and (c) a third level, which can trigger default of the agreement. For example, one measures load factor requirement compliance by the ratio of passengers exceeding capacity to the total number of passengers. The maximum acceptable level is 3 percent for morning and evening peak together, or 4.5 percent for either peak considered alone. If extra capacity is needed to meet load factor specifications, the operator and OPRAF share the cost, according to the following criteria: (a) up to a certain capacity limit, the franchise payment does not change; (b) between the initial limit and a second limit, OPRAF bears a share of costs; and (c) above the second limit, OPRAF pays all costs. In practice, one cannot incorporate all the quality dimensions defined in table 5.7 in the same proportion to any service quality mechanism. The British system mainly focuses on the route dimension and is based on its extensive experience with deregulation. When the role assignment that table 5.8 proposes is not considered, or its components cannot be easily sepa- rated, several quality regulation failures may arise. The most important is the failure to define adequate independent quality measures. This is the case of several rail concessionaires in Argentina, where the level of vertical integration between the train service providers and the maintenance firms (in the form of subsidiaries or units integrating a larger industrial group) has distorted the incentive to provide the optimal price-quality ratio in favor of more frequent repairs and technical updates. Javier Campos and Pedro Cantos 219 SArETY AND EXTERNALmES. Regulating the quality of service is only one of the two static aspects of quality regulation to be considered in designing a global framework for quality regulation in the rail industry. One also must consider the social or external dimension of quality regulation, including all issues related to safety and externalities (such as pollution and conges- tion), and it specifically differs from level of service quality regulation in at least four aspects. The first element is the scope of regulation. Because noncompliance with social quality standards may affect users and nonusers of transport services, these standards should always be exogeneously set, by national or suprana- tional legislation with intermodal implications, in the case of the rail indus- try. This is not always the case for timetables, load factors, or vehicle size, variables that usually have simple intrafirm consequences. In the European railway industry, for example, one can find three levels of quality regulation. Directive 91/440 detennined the overall principles, and the obligation to comply was envisaged in mode-specific regulation (for example, the Rail- ways Act in the United Kingdom) or in legislation that applies to all sectors of the economy (for example, the Health and Safety Act). The second factor that makes service quality regulation different from social quality regulation in the rail industry is that one must use a regula- tory approach in the latter. Because the risks associated with accidents or potential environmental damages not only directly affect the private ben- efit, but also the social benefit of this transport mode, an external regulator or agency is needed to coordinate safety and reliability. This coordination is particularly important when firms move from a public to a deregulated system, as described earlier. Furthermore, in the rail industry, separation of infrastructure from services and the introduction of open access have made it necessary for a rail track controller to ensure safe coordination between different operators that are using the same tracks or stations. Again with the British railway system as an example, the safety regula- tor is the health safety executive, who informs and advises the Office of the Rail Regulator. Operators of railway services, stations, and networks must have an accepted safety case before the office approves their license. A safety case is a complete resource, control, and management plan for delivering safety and defining safety procedures, organizations, and systems. The private infrastructure provider, Railtrack, must have its own safety case, a fundamental component of which is Railtrack's Safety Management System, which is a system of operational and technical standards to ensure safety and safe interworking in Railtrack's infrastructure. The third aspect of particular interest to safety regulation in the railway industry is the assessment and assignment of risk. Given the inherent 220 Railways difficulties associated with strict monitoring, incentives exist for quality- regulated private providers of rail transport services to place compliance with safety requirements below the attainment of financial objectives. Despite tragedies in 1998 and 1999, railways traditionally have a good reputation for safety, a perception that converges with statistical proof in most countries. Therefore, one could conclude that safety levels and man- agement are quite sufficient and no particular safety precautions or mea- sures should be taken. Public outcry, negative social effects, and adverse public opinion from a single catastrophe, however, together with the per- sistence of regular fatalities (staff accidents, passengers joining and alight- ing trains, and so forth), make it impossible for the regulator to avoid de- signing measures and policies for diminishing individual and social risk. One of these policies relates to the compulsory insurance against third- party liability, because it may correct the operators' incentives to take ex- cessive risk. In Europe, for example, Directive 95/18 required that opera- tors of train services obtain, together with the operating license and path allocations, a safety certificate and insurance. The insurance arrangements in the privatized British railway industry provide another example of scope of liability cover: the basis and conditions for self-insurance. In this case, licenses for the private operators of railway assets (passenger trains, freight trains, stations, and maintenance depots) contain a condition requiring the operator to maintain insurance against third-party liability for licensed activities. The type, cover, leveL and identity of the insurer need the ap- proval of the regulator, who sets guidelines on minimum insurance require- ments that operators must meet. Operating licensed activities without in- surance approved by the regulator is considered a breach of the license. Finally, the fourth element in which service quality regulation differs from social quality regulation is externality issues and, in particular, those connected with the environment (such as engine pollution, noise, and trans- port of hazardous goods). Again, in this case, social quality regulation should be concerned with rail operators' internal and external factors, and it should have several differences and similarities to other transport modes. For example, air pollution is one of the most regulated areas in the road and air transport modes, but is not a critical issue in the rail industry, how- ever, with a few notable exceptions in certain countries and routes. Noise pollution in suburban neighborhoods, areas close to stations and depots, and delicate countryside ecosystems has attracted more attention from both the public and regulators. Most countries, therefore, incorporate into their regulation the design and specification of measures to reduce noise pro- duced by rolling stock and stationary sources (fans, compressors, and gen- erators) and shunting noise. Javier Campos and Pedro Cantos 221 The final issues related to environmental regulation are measuring, ana- lyzing, and predicting the emissions of chemical substances (heavy metals, lubricants, dust, and so on) where railway lines are present and assessing the risk of rail-related activities (such as transport of dangerous goods) to the safety of local residents. In these cases, most countries subordinate their social quality standards and the role of their regulators to the overall techni- cal principles emanating from supranational organisms or professional as- sociations. Private and public rail transport operators are obliged to comply with national and supranational environmental standards. Europe, for ex- ample, has European Community directives on vehicle air pollution that specify environmental standards for vehicle engines and fuel qualities that apply to both vehicles (wagons, locomotives) and transport operations. DYNArs(c QuAury: INVESTMEmTS. Table 5.7 lists a third dimension in quality regulation of the rail industry. Because the regulatory process is by itself a dynamic relationship between the regulator and the regulated transport pro- viders, firms, and passengers, one must take into account the dynamic links in this relationship when certain quality standards are controlled. In particu- lar, the investment policy of the railroads is the most important dynamic element to be considered in the design of concession contracts, particularly with respect to the implications that these investments will have on the fu- ture performance of the firms. A complete quality regulation regarding the investment policy must first define who decides the investment objectives in terms of fleet and track renewal rates, track and station maintenance, and future investment obligations. When the regulator assumes this role, it must also set up adequate mechanisms to monitor the progress of the investment stages, and provide the incentives for avoiding abandoning projects before they reach conclusion. When the regulated rail transport provider is in charge of its invest- ment policy (with respect to the renewal or maintenance of its fleet, for example), a quality control should also be imposed to avoid, for ex- ample, inadequate planning or excessive unnecessary repairs as a means of earning extra revenues from subsidiary companies. Some countries, notably the United Kingdom, exert this control by isolating noncom- mercial investments and investment planning and making them the subject of specific public grants. One of the most controversial issues in the concession contract is the rela- tionship between this investment and the prices set to recover it, because ex ante prices are decisive in determining the extent and mix of investment in new rail infrastructure. Uneconomic investment decisions have historically been imposed on railways, which in most countries has been the main cause 222 Railways of accumulated debt. As described earlier, insulating railway operators from such debts has been a central aim of the railway reform and restructuring processes. Thus, in principle, the simplest decision according to standard economic principles is to proceed with projects whose net present value, calculated according to a suitable discount rate, is positive. In theory, the most obvious discount rate to use in public sector projects is the interest rate on long-term government bonds. In practice, however, this bond rate may not be appropriate in several circumstances, and governments that choose a discount rate lower than this rate invariably find they cannot proceed with all of the projects with positive net present value."6 This means that in certain cases, specifying a hurdle rate (which determines whether the project will in fact be imple- mented) to test against the project's internal rate of return is more useful. Therefore, on pure economic efficiency grounds, if the selective process is strict and calculations are correct, only projects that do not generate losses on new investments should proceed, in order to avoid later problems with cost recovery relating to infrastructure pricing. On social grounds, how- ever, few rail investments would pass this strict cost-benefit analysis, and subsidies to pay for the fixed costs may be required at the investment point. For investment financing, the more important consideration from the viewpoint of quality regulation in the concession contract design is the monitoring of the operator's financial health to prevent possible cheating incentives (for example, lowering the quality of building materials in tracks, signaling mechanisms, or stations). In principle, rail investments do not have specific criteria according to which the regulator should im- pose particular rules with respect to the firm's capital structure. When the size of the investment is large enough, the private concessionaire seeks the adequate mix between debt and equity that enables him or her to carry out the project. Only if there is government or other public participation in the new investment, should the concession contract regulate the condi- tions and terms under which the asset transfer (if any) takes place. Alternatively, when the main (or sole) source of funding for the infra- structure provider is revenue from track charges, one uses different criteria to reflect two basic circumstances: to maintain existing standards or to in- crease capacity and quality of service. In the former, the regulated access 16. See, for example, Layard and Glaister (1994) for a description of standard cost-benefit analysis procedures. Javier Campos and Pedro Cantos 223 charge is set to provide the regulator's cost of renewal. The performance regime provides the incentive for the infrastructure provider to undertake investment. When expansion or improvement of capacity is required, the track manager is expected to finance investment with increased revenue, so that train operators and infrastructure providers share both the risks and benefits of an improved infrastructure. Finally, as mentioned in previous sections, the clarity and simplicity of the negotiation and renegotiation rules are relevant to the dynamic rela- tionship between regulators and operators. A common situation, for ex- ample in Argentina, is that once licenses have been awarded, rail operators use fake or real (but possibly not required) quality investments to improve their position and demand changes in license conditions. Instruments for Quality Control Once establishing objectives for service, social, and dynamic quality, the next step in devising a quality regulation system for railways is designing control instruments. In principle, the rail industry has three alternative mechanisms for regulating quality. First, the regulator can simply require the firm to publish and report measures of quality every predefined period. This information can also be made public to inform consumers or actual or potential rivals about the operator's current performance. As in any other type of regulatory pro- cess, access to public information is a delicate issue because it can serve as a disciplinary device for the rail provider and as a strategic instrument to undermine or strengthen the ability of the firm to survive in the market. A second quality control mechanism is including a direct, explicit mea- sure of quality in the price control mechanism. For example, when subject to rate of return regulation, a rail service provider may be obliged to calculate its asset base according to certain average values or obtain authorization to carry out certain technological improvements in order to avoid overinvestment and make use of the Averch-Johnson effect. Similarly, under price cap restrictions, the basket of products whose average price increase is controlled by the regulator can be defined to avoid changes in quality (and consequently, cost reductions) that the regulated firm could use to increase profit, even if maintaining the same price caps. The third mechanism that can be used to control quality is a customer compensation scheme, in which grants or payments are awarded to people affected by noncompliance with quality standards. In practice, these 224 Railways mechanisms only work if one can easily verify quality failures. This re- quires a detailed regulation not only of quality standards, but also of monitoring rules and guarantees for both the regulator and the regulated that the inspection process will be transparent and objective. Moreover, if the compensation is distributed to consumers, either directly by the firm or through an intermediary body, sharing rules must be also de- fined. The practical difficulties associated with this quality control mecha- nism have led many countries to instead specify minimum quality stan- dards for certain parameters of the rail industry, backed by explicit legal sanctions that may include fines or the revocation or withdrawal of the operating license. Finding the adequate mix of these control mechanisms is often the most difficult task in designing the quality regulation process. Table 5.9 outlines most countries' approach, with a summary of the most important instruments. In conclusion, the quality regulation process consists of three stages. First, before entry into the market (stage I), the goal is to anticipate and minimize future conflicts between the regulator and the concessionaire.17 Licenses must specify the expected characteristics of the service in terms of, for example, routes and frequencies of trains or timetables. For passen- ger services, particularly in the case of urban and suburban trains, one can also set vehicle capacities and punctuality. Finally, so as not forget the dy- namic dimension of quality described above, stage I must also specify in- vestment plans and financing rules. Afterward, during market operation (stage II), instruments for quality control in the rail industry should mostly be related to the direct monitoring of the firm's performance. Thus, this is the time to introduce quality incentives in price mechanisms, to establish the firm's obligation to reveal information and the auditing (external or internal) processes to be carried out. In most cases, using technical control instruments (such as tacographs or track electronic controls) complements the standard instruments. Finally, after the transport activity has already occurred (stage III), the regulator can implement compensations or pun- ishments according to any of the schemes described above. Both penalties and incentives must be graded according to the expected future evolution of the relationship, because severe fines or large subsidies may alter the behavior of the operator in the market. 17. To achieve this, one can use pretender qualification requirements to ensure a minimum level of technical and practical expertise and financial solvency, as de- scribed in the previous section. Table 5.9. Instrumentsfor Quality Control in the Rail Industry Regulation stage Instrument Additional characteristics Stage I: Before entering the market Pretender qualification requirements Experience Financial strength Technical ability Specification of service characteristics Routes and frequencies in licenses Timetables Vehicle capacities and load factor Punctuality and reliability Specification of financing rules and Investment plans investment plans Fleet and track renewal rates t Stage 11: During market operation Quality of price-control mechanisms Rate of return regulation versus price cap regulation Information revelation obligation Control of access to critical information Audit processes Internal and/or external Company reporting Frequency Format Regulator's direct monitoring Setup of monitoring mechanisms and rules Technological control Tacograph readings, electronic controls Stage III: After market operation Incentive payments Customer compensation schemes Penalties Fines for underperformance Enforcement and binding rules Contract withdrawal as a last resource Source: Authors. 226 Railways Performance Indicators The rail industry uses performance indicators to monitor the behavior of one or more regulated firms to evaluate the effectiveness of the regulatory measures to which they are subjected.18 The main advantage of these indi- cators or indexes is that they provide a periodical assessment and control of the firm's activity and continuously update information, simply, quickly, and at a relatively low administrative cost for the regulator. The most important disadvantage of performance indicators is that their use is only valid when constructing comparisons (whether between different firms or the same firm over time) on a similar basis. For interfirm compari- sons, the companies must belong to countries with similar characteristics (for example, the participation of transport in the economy as a whole, the degree of economic development, or the regulatory framework). For intrafirm com- parisons, indicators must account for external and internal changes produced during each period (for example, new management or changes in demand). Comparisons across companies usually provide interesting, persuasive results that can help the regulator set objectives and design future license contracts. Extreme care should be used, however, in drawing normative conclusions from these results. What constitutes a benchmark of desirable practice for some objectives may differ among companies. For example, countries with very liberalized frameworks in their rail industry (the United States, for example) could set desirable productivity indicator levels (or quality of service) that clearly differ from the levels in other more regu- lated frameworks (such as in Europe). Similarly, simple indicators should be carefully interpreted over time to avoid contradictions and inappropriate measurements. For example, in the assessment of railway output, the number of trains/kilometer may be relatively high, while passengers/kilometer or tons/kilometer may be relatively low (if the firm specializes in one type of traffic). Given this conflict, overall performance can be ambiguous. The most practical solution is to jointly interpret the indicators and the objectives that they serve. For example, a service quality objective, such as the number of trains per hour, may conflict with both financial objectives, reflected in a high cost recovery rate, and objectives based on the maintenance of low prices. 18. For example, one can establish quality indicators, as defined in this section, in a contract and review them regularly to confirm that the terms of the license are being fulfilled. Javier Campos and Pedro Cantos 227 Thompson and Fraser (1996) point out that monetary and productivity variables should be carefully defined for interfirm comparisons. Fares, wages, outputs, and inputs vary widely among countries for many reasons that are not necessarily related to the firm's operations, but to measurement or statis- tical errors. For example, average passenger fares are based on the overall mix of passenger classes (each with a different price). Tariffs are often higher per passenger/kilometer for short trips than for long ones, and they must also depend on the existence of government subsidies or artificial compen- sations. Similarly, common freight tariff mistakes include not accounting for the different mix of commodities, size of shipment, or length of haul. The latter also affects passenger traffic and is particularly relevant because some costs (ticketing, billing, and station maintenance, for example) are fixed with respect to the length of the trip but vary with size or distance. These difficulties are increased when measuring productivity, because a simple comparison among partial measurements of output cannot capture the complexity of relationships or the variety of productive structures that take place within a rail operator. For example, a commonly used productiv- ity indicator, the number of passengers-kilometer or tons-kilometer per em- ployee, depends on such diverse factors (for example, regulatory environ- ment, structure of the labor market, availability and quality of infrastructure, or altemative transport modes) that it could be seriously misleading if in- terpreted without care. The term employee can refer to terminal staff, ad- ministrative staff, train crew, or maintenance staff. Similarly, capital can be disaggregated into trains, wagons, terminals, platforms, routes, and so forth. To elude these sorts of problems, the construction of performance indi- cators should avoid excessively simple data management and use statisti- cal techniques that account for the different relative environments of each company. Oum and Yu (1994), for example, estimated different efficiency levels for a sample of OECD railway companies by introducing intemal factors (such as the characteristics of outputs) and extemal factors (differ- ence in the legal and regulatory framework between companies). Main Types of Indicators Despite these difficulties, a large number of indicators are commonly used to monitor the performance of firms within the rail industry worldwide. The definition of each particular indicator depends on its objectives and its informative value. Several extemal factors that vary widely from country to country and firm to firm substantially influence comparisons. Contextual indicators 228 Railways assist in comparative analysis and define desirable performance levels. They include social and economic characteristics of the railways as well as other elements associated with the economy as a whole. Directed mainly at the regulator, they control for the exogenous factors in interfirm and intrafirm comparisons. Table 5.10 presents several examples from international sta- tistical sources."9 Simultaneously, many indicators (particularly those for prices and quality of service) are informative to transport users and pro- vide input for the regulator's control tasks. Jointly with the contextual in- dicators, these management indicators provide the necessary instruments for judging the management and behavior of the company, and one can group them at three different levels, summarized in table 5.11. Some final practical rules that could be helpful in this process are as follows: (a) each indicator should have at least a function or objective; (b) the relationship between each indicator and its objective must be clear and direct, although (c) multiple indicators (ointly interpreted) can address multiple objectives; and finally, to assure the utility of the indicators, (d) appropriate data must be provided and (e) the management of the indica- tors' information should be part of the regulatory process. For the regulator, price indicators can be a control mechanism over the activities of the operators, despite the difficulties mentioned. This control may be established not only in terms of the comparison between compa- nies with similar characteristics, but through monitoring over a period of time. In any event, the regulator must ensure that any variation in price corresponds to a proportionate variation in costs or level of efficiency. The operational and efficiency indexes therefore are instruments that help the regulator. Improvements in company productivity and efficiency levels combined with increases in price levels are clear signs of abuse of market power on the part of railway operators. Indicators of service quality that were highlighted earlier should serve the same way as price indexes to establish evaluations of different companies, as well as dynamic or time evaluations. These measurements should be analyzed together with price indexes because of the possibility of finding different fea- sible combinations of price and service quality. For example, a high number of trains per hour-in other words, a high traffic density-could only be financed by means of high prices. 19. In particular, the International Union of Railways publishes an annual sum- mary of the main statistics of its affiliated railways, although not all of them are always available for all railroads. Javier Campos and Pedro Cantos 229 Table 5.10. Contextual Indicators in the Rail Industry Type Examples Overall economic GDP activity GDP per capita Urbanization degree Industry structure Energy costs Private cost of capital Transportation sector Participation of transport in GDP importance Intermodal market share (passengers and freight) Overall rail sector Output indictors * Passenger trains-km * Freight trains-km * Passengers-km * Ton-km Revenues * Passenger revenue • Freight revenue Network indicators * Length of line * Length of track : Electrified track (percent) * Route-km/km2 Density and service • Train routes-km per capita * Trains-km per routes-km • Average size of shipment : Average length of haul Organization of the industry * Regulatory agencies (number) * Separation of infrastructure and services (type) e Access and entry system (type) Regulatory and State involvement in economy (in percent of GDP) institutional system Tax and judiciary system (corruption index) Source: Authors. The simultaneous implementation of control systems for prices and ser- vice quality may limit the firm management and reduce operability. Plac- ing an emphasis on price control or service quality depends on whether the regulator prefers services at the lowest possible price or services with 230 Railways Table 5.11. Management Indicators in the Rail Industry Type Examples Commercial Prices * Average passenger fare (revenues per passenger-km) * Average freight price (revenues per ton-kmn) Quality of service * Average train-speed (in passengers and freight) * Delayed arrivals or departures (as percent of scheduled) * Percent of lost or damaged freight * Average passenger load factor * Traffic density (trains per hour) Pollution and safety * Rate of fuel usage (per train-kmn) * Level of noise * Level of emission of pollutants * Number of accidents or incidents Operational Labor productivity * Passengers-km per employee * Ton-km per employee * Passenger trains-km per employee * Freight trains-km per employee * Total trains-km per employee Capital productivity * Number and km traveled by locomotives * Locomotive availability (in percent) * Ton-km per wagon-km * Wagons-km per wagon - Tons-km per wagon Financial Efficiency * Costs per employee * Costs per unit of capital * Unit cost (per passenger-km, ton-km, train-km) Profits * Revenues/costs * Subsidies Source: Authors. certain standards of quality. All these indicators allow the regulator to monitor the operators' activities as defined in stage II of table 5.9. Unjusti- fied or systematic breaches of quality standards (insufficient number of trains per hour, lack of punctuality, unreliability, very high indexes of load Javier Campos and Pedro Cantos 231 factor, and so forth) should be accompanied by an appropriate system of penalties, as described earlier. Best Practices Taking into account the above comparison caveats, the remainder of this section compares some of the most relevant (or most desirable) perfor- mance indicators for the rail industry with the best results actually achieved. Table 5.12 shows this procedure, which many governments around the world use as a yardstick mechanism. The last two columns show the best practice values for a sample of European, Australian, and American rail companies and the values considered desirable according to a World Bank study by Gannon and Shalizi (1995) and the Australian Bureau of Industry Economics.20 One of the most useful insights that these examples can provide is the clarification that setting desirable values for indicators is a difficult task. One should put extreme care into making exclusionary comparisons. For example, according to figures, the unit revenue ratio has a desirable value below US$0.04 in passenger traffic and US$0.03 in freight. Lower val- ues, such as those in several European countries (0.036 and 0.019, re- spectively), could indicate lower prices or low fare collecting efficiency. In either case, regulation in each country will notably affect the prices charged by each company. The measurement for average train speed should distinguish between passenger and freight transport and among their different categories (urban, regional, long-distance, international, and so forth). The desir- able indicator estimates an average speed of 60 to 100 kilometers/hour, but in each country it should depend on the type of traffic, the social and economic level of the country, and the relative importance of the railway in its development. Similarly, different regulatory policies, as well as other variables such as vehicle size and journey type, influence the measurement of the aver- age passenger load in terms of the number of passengers per train. In Europe, the Italian national company attained the highest level for 1994, with an average of 197.5 passengers per train over the year. Correspond- ingly, a European railway also attained the highest level of passenger 20. Every year, the Australian Bureau of Industry Economics publishes a benchmarking report (see BIE 1995, for example) that compares its main utilities (including rail transport) worldwide. 232 Railways Table 5.12. Best Practices in Railway Management Indicators Indicator (example) Best practice Desirable Commercial Revenues and prices Passenger revenue/passenger-km (in US$) 0.036 0.04 Freight revenue/ton-km (in US$) 0.019 0.03 Freight to passenger tariff ratio (percent) - - Commercial services: general Average train speed(in km/h) - 60-90 Arrivals with small delays (10-15 min.) (percent) 96 90-95 Ratio of lost plus damaged freight (percent) 1 1 Comnmercial services: passengers Number of passenger per train 197.5 - Passengers-km per route-km (total) 5237 - (in thousands per km) (136) - Conunercial services: freight Number of tons per train 604.13 - Tons-km per route-km (total) 2,819.19 >2,000 (in thousands per km) (352) - Operational Labor productivity Passengers-km per employee - - Tons-km per employee (in thousands) 11,000 >750 Passenger trains-km per employee - - Freight trains-km per employee - - Total trains-km per employee 4,434.84 - Capital productivity Availability of locomotives (percent) 914.28 - Tons-km per wagon - >80% Wagons-km per wagon Freight and passenger wagons availability (percent) - >90% Financial Cost coverage Costs covered with total revenue (percent) - >100 Costs covered with typical revenue (percent) - >80 Cost reduction required to reach break-even (percent) - <0 Note: Desirable values are only approxinate and should be taken as general references that rnight vary across countries and regions. Sources: BIE (1995); Gannon and Shalizi (1995). traffic density-5,237 passengers/kilometer per route/kilometer, for the Dutch operator. For freight traffic, the equivalent figures were 604 tons per train, for the Finnish national operator, and 2,819 tons/kilometer per route/kilometer, for the corresponding Belgian company. Javier Campos and Pedro Cantos 233 As mentioned above, the measurement of productivity is often grouped around the labor and capital indexes. Because many compa- nies do not detail by activity the volume of employees, however, usu- ally only the aggregate index of total trains/kilometer per employee is available. Previous studies (Nash 1985) have estimated that freight traffic is more labor-intensive than passenger traffic, so this measurement is clearly biased due to the different composition of the output of railway companies. Considering the aggregate index indicative of the volume of trains/kilometer per employee in Europe, the most efficient company in 1994 was the Dutch operator, with a volume of 4,434 trains/kilome- ter per worker. In North America, where many companies offer only freight transport, the most efficient companies transported about 11 million tons/kilometer per employee. One can divide measurements relating to the productivity of capital into those that refer to traction units, locomotives, or wagons. For loco- motives, an interesting index is locomotive availability (percent), which indicates the degree of overdue and deferred maintenance, for which Gannon and Shalizi (1995) recommend a value not less than 80 percent. Finally, financial indicators should not be less important to a regulator, even one who is more concerned with operational and commercial perfor- mance. For example, the ratio of revenues to total costs may indicate the degree of financial solvency, whereas the level of subsidization and subsi- dies as a percentage of total revenue or costs indicates the degree of finan- cial dependence on public bodies. These indicators are very important and should not be independently interpreted, because, as shown earlier and by empirical evidence (see Gathon and Pestieau 1995), the most heavily sub- sidized railway companies are often the most inefficient. The main conclusion is that performance indicators are useful but should be designed and interpreted with care. Reference levels and comparisons are only provisional guides and are not normative. Individual indicators must not be analyzed in isolation from others. A unique optimum does not exist for any indicator, nor is there an optimal profile for several. Their appraisal requires trade-offs that measure the relative cost of changing different indicators and the relative importance of the objectives that the indicators reflect. Conclusions In conclusion, this chapter has shown that no unique form of rail regula- tion can address these new challenges, but the general rule is to maintain flexibility and simplicity whenever possible. Two key issues in the new 234 Railways regulatory environment of the rail industry are that license contracts in- clude private participation and that the organization of the industry is adapted to each country's needs and characteristics. In turn, using these mechanisms also changes the role of the rail regulator, whose actions should now be governed by principles that foster competition and market mecha- nisms and simultaneously provide a stable legal and institutional frame- work for economic activity. The regulator should refrain from intervention unless the ultimate goal of achieving economic efficiency subject to the socially demanded level of equity is in jeopardy. 6 Toll Roads Antonio Estache, Manuel Romero, and John Strong Road transport has long been, and will be for a long time, the dominant form of transport for freight and passenger movement throughout the world.' In Latin America, for instance, road transport accounts for more than 80 per- cent of domestic passenger movements and more than 60 percent of freight movements-more than 85 percent in some countries such as Argentina and Brazil. In Africa, the proportions are even higher. Not only is the sector large, but it is still growing rapidly in many parts of the world. In Asia, from 1984 to 1994, the road networks of Indonesia, Korea, Malaysia, and Pakistan grew in length by more than 5 percent per year. In Eastern Europe, countries his- torically dominated by rail are now witnessing a rapid expansion in the de- mand for road transport. In Russia, the total freight moved by road is ex- pected to increase from just over 10 percent to almost 40 percent within the first decade of the collapse of the former Soviet Union. Toll Road Services Because most road projects require investments with slow amortization periods, and many of these projects will not generate sufficient demand to Notes: For additional information and more data, see the World Bank web site on toll roads at www.worldbank.org/html/fpd/tranport/roads/toll_rds.htm. Part of the discussion in this first section draws on J. A. Gomez-Ibanez' "Pricing," in Gomez-Ibanez, Tye, and Winston 1999. 1. See Heggie and Vickers 1998, chapter 2, for more details on the overall role of the sector. 235 236 Toll Roads make them self-financed through some type of user fee or toll, the road sector continues, and will continue, to be in the hands of the public sector to a much larger extent than the other transport activities.2 However, fiscal crises and competing demands from other sectors such as health and edu- cation are bringing changes in the extent of public-private partnership in the expansion and operation of road networks. Governments throughout the world, including many poor African and South Asian countries, are commercializing their operations to cut costs, improve user orientation, and increase sector-specific revenue.3 The search for increased private sector participation in the road sector applies to national, high-traffic roads (at least 15,000 vehicles per day is a good bet for viable tolling of roads) as well as to roads falling under the responsibility of all government levels. Many urban roads, often under the responsibilities of subnational governments, are now also facing strong increases in demand. From Argentina to Thailand, Australia to Canada, major arterial roads are being built under toll road concession schemes. Because in many of these countries the governments are increasingly find- ing it difficult to finance the costs up-front, they are giving the private sector concessions to construct and operate these urban roads for a speci- fied period of time before inheriting these assets at the end of the con- tract, typically at a zero cost. Toll roads (publicly or privately managed) can represent a large proportion of the high-traffic highway systems (up to 80-100 percent in some countries), but they generally represent a very small share (5-10 percent) of the total paved road network (but up to over 30 percent in such countries as Argentina, France, and Korea). To be effective, toll road projects must meet many requirements to ensure that a regulator's implementation and monitoring of these concessions is smooth. This chapter focuses on the lessons of the international experience with toll road privatization and regulation. It is oriented somewhat more toward project finance than the other chapters, to illustrate the importance of contract design for a regulator. An effective contract design at project time 2. In addition, pricing decisions in this sector tend to be influenced in many coun- tries by strong trucking lobbies that aim to keep cost recovery as slow as possible. 3. These partnerships not only aim to convince the private sector to finance its investment needs but also to participate in reforms to cut costs in its operation and maintenance. This chapter, however, focuses on toll roads. For a more detailed discussion of the commercialization of the sector and of other forms of public-pri- vate partnerships in the sector, see Heggie and Vickers (1998) and Ecole Nationale des Ponts et Chaussees (1998). Antonio Estache, Manuel Romero, and John Strong 237 is crucial, because often there is little more for a road concession regulator to do than monitor that all involved parties comply with their contractual com- mitments. Furthermore, in many ways, the renegotiation of a contract is of- ten a replay of the initial negotiation with a different distribution of informa- tion between the regulator and the concessionaire. Having full grasp of the basics of contract design in project finance is required for regulators. While toll roads in specific settings seem to be in demand, the problems that many of this first generation of road concessions have met, from Mexico to Thailand, have given toll projects a poor reputation. Many mnistakes were made. What is obvious is that tolling is not the best solution for every road. One can design a project in many ways to get the private sector involved without having to toll the road (see box 6.1). Most of these alternatives aim at improving efficiency (in other words, lowering costs). But many ways also exist for getting the private sector involved in toll roads and thus re- ducing public sector financing requirements. Understanding the context in which toll roads are viable is necessary both for their initial success and for their effective long-run regulation. The Broad, Relevant Economic Characteristics of the Activity When considering an increased role for private activity in the road sector, the most immediate challenge to confront is the enormous range in the development, quality, and performance of the sector in any given country. These varied settings create different operating and investment require- ments and hence potentially very different types of possible packaging to make roads attractive to private investors. This section summarizes the most relevant stylized economic facts surrounding the core decisions to make in designing toll road packages. THE OVERALL SUPPLY OF GOOD ROAD SERVICES IS STILL LIMITED. The overall market potential is good because the unsatisfied demand for good road services is great. Moreover, the need for improvements in networks is, in many countries, at least just as great. Indeed, many of the new public- private partnerships are for road upgrading and paving rather than for greenfield projects. Even if 100 percent paving of existing roads is un- likely to be a realistic target for many countries, the margin for improve- ments suggests a reasonably good market for private road operators and interested construction companies. Indeed, in developing countries, the proportion of the main road network that is paved averages to a modest 45.5 percent (it varies from a low of around 2.5 percent to a high of 100 percent). 238 Toll Roads Box 6.1. Contracting Out Road Planning and Management Road agencies are increasingly contracting out. * The planning and management of selected roads to consultants and contractors * Entire road networks * Donor-financed small infrastructure projects. Argentina, Australia, New Zealand, and the United Kingdom are using the first model. The United Kingdom started the process in 1986 when its Department of Trans- port (DOT) decided to package parts of the motorway network into commissions and then invited bids from consultants to take on the responsibility for maintaining all roads and related structures within the commission to a prescribed standard. The win- ning consultant then organizes a competitive term contract between the owner (DOT) and the contractor, which then carries out all work on instruction from the consultant. In one of the largest commissions (West Yorkshire, with 330 lane-kilometers, 305 bridges, 420 kilometers of drains, 950 road signs, and 3,400 lighting columns), costs fell by well over 15 percent, the consultant took on 29 of the 34 DOT staff who were made redun- dant (one moved to another job and four took early retirement), and quality and flex- ibility of the maintenance regime increased. The second model involves contracting out the management function for the whole network under the jurisdiction of a selected road agency. Industrialized countries gen- erally do this to increase efficiency and as part of the redefinition of the government's role. Developing countries mainly do it to ensure that a competent body that remains answerable to the local district council manages small urban and district roads. Some small municipalities in the United States at the county council, and at the district level in the United Kingdom (where it is called externalization), use this model. Zambia also uses it for both urban and rural district councils. These arrangements offer great potential for dealing with small road networks. Francophone Africa uses the third model extensively. The AGETIP is a contract ex- ecuting agency (like a private sector project implementation unit) set up to execute donor-financed infrastructure projects. The agency generally has a board composed of well-known figures (which do not indude government representatives), a general manager appointed by the board, other line managers (an administrative and finan- cial manager and a technical manager), and staff hired under private sector terms and conditions of service who are paid competitive salaries. The agency is set up as a pri- vate, nonprofit association and pays no taxes. It works on behalf of local authorities who delegate certain functions to the agency. The local government usually reserves the right to select the projects, and the agency then (a) recruits consultants to carry out detailed engineering; and (b) invites bids and awards contracts for supervision and works, manages the contracts, and pays the contractors directly from a special account opened in its own name. The agency is subject to bimonthly management and finan- cial audits and an annual technical audit. Source: Heggie and Vickers (1998). Furthermore, private operators can also easily improve road mainte- nance. In Latin America, for instance, over the past 15 years or so, most governments have spent roughly one-quarter of what they should have spent to maintain roads. This is why new private operators finding out that rehabilitation costs are higher than expected is not uncommon when Antonio Estache, Manuel Romero, and John Strong 239 they take over the responsibility from the government. This is often a sub- ject of dispute between regulators and private concessionaires once pri- vate operation has been in place for a while. Overall, from a strategic view- point, contracting out road improvements can provide a smooth phase-in or learning process into the development of a future relationship with po- tential private investors on new roads. THE DEMAND FOR HIGH-TRAFFIc ROADS IS STLL GROWING. The demand for road services will continue to grow, and hence so will the need for investment. Worldwide, the stock of motor vehicles is growing at nearly 3 percent per year. Because the number of vehicle-kilometers traveled tends to grow somewhat faster than the stock of motor vehicles, this implies that, at least for some segments of the road network, the de- mand prospects are quite good. The FAST urbanization of the developing world adds another dimension that cannot be ignored and explains the strong demand for urban access roads in many of the most populated countries of the world. The challenge here is betting on the right horses. Demand will increase, but only on some segments of the network, and a government may be tempted to oversell a specific road based on aggre- gate traffic growth prospects. Even with the effects of toll levels held constant, traffic volumes are sensitive to income and economic growth. The failure to recognize this may be one of the main reasons that so many toll road projects have failed or ended in bitter renegotiations. Motorization and vehicle-kilo- meters traveled tend to increase faster than income levels. This high in- come elasticity, especially for leisure trips, makes toll roads especially sensitive to macroeconomic conditions. For roads that serve export ac- tivities, exchange rate changes can dramatically affect trade, leading to major changes in demand patterns. Many toll road projects in the past decade have dramatically overestimated traffic levels. In some of the Mexican road concessions, traffic volumes were only one-fifth of the forecasted levels. In Hungary, the Ml Motorway attracted only 50 percent of its expected volume in its first year of operation. The Dulles Greenway, outside Washington, D.C., only attracted a third of its expected daily volume. Even after a toll reduction of 40 percent, the Greenway still was only able to achieve two-thirds of its originally forecast volume.4 4. The Dulles Greenway experience suggests a toll price elasticity of -2.3, a very high sensitivity. This result is due in part to the upgrading of a parallel alterna- tive route. Other estimates range from -1.4 to -2.5, quite income elastic in all cases. 240 Toll Roads THE DEMAND FOR SArY is GROWING AS WELL. Investment needs and types also will have to address the need for improved safety. Each year, more than 700,000 people are killed and more than 10 million are injured in road acci- dents, costing the global economy about US$500 billion. About 70 percent of these accidents take place in developing and transition countries, where road accident rates per 10,000 vehicles tend to be 20 to 30 times higher than in in- dustrialized countries and cost up to 2 percent of gross domestic product. This is a major concern for policymakers and is becoming a concern for private roads operators as well, because policymakers tend to indude requirements in concession contracts that address the need to drastically increase highway safety. A peculiar problem arises when governments change safety regulation in the course of a contract, thereby implicitly changing the investment require- ments and hence the terms of the agreement with the private operators. THE DEMAND FOR A NETWORK OFTEN DOMINATES THE DEMAND FOR A SPECIC ROAD. The demand for a toll, and hence the risk attached to a road, often depend on the fact that the toll roads have to be built into integrated net- works. Reformers often forget that the tolled part of a road network ben- efits tremendously from the existence of a public road network around it. In practice, the value of a specific road depends a great deal on the extent to which it benefits from a complement of public and private roads. More specifically, the network characteristics of the sector mean that benefits from investment at one point in the system can depend on service flows and capacities at other points. This implies that both public and private roads operators need to take into account a number of service obligations. THE MARKET FOR TOLL ROADS IS SENSITIEiTo GLOBAL FINANCIAL CONDITIONS. The financial crises that affected many emerging markets in 1996-99 had a dra- matic effect on the evaluation of toll road projects. Project sponsors and credi- tors experienced difficulties due to macroeconomic factors, and financing be- came much more costly and of shorter term, thereby adding refinancing risks. Many toll road projects that were required to generate returns of 15 percent in the early 1990s have been reevaluated in light of project experiences to date and because of macroeconomic uncertainty The result is that required returns for toll road projects appear to have risen to 20 percent or more. The key fac- tors are cost, average daily traffic volumes, and the willingness to pay tolls. Overall, average daily traffic volumes in excess of 10,000 vehicles per day seem to be required to attract private capital. Below this traffic volume, various types of government support, such as grants or guarantees, are likely to be required. The effect is to make many proposed concessions nonviable, or at least to cause Antonio Estache, Manuel Romero, and John Strong 241 their deferral until greater corridor demand is assured and a more stable fi- nancing environment exists. A project's ability to obtain financing, however, is not solely determined by its underlying cost and demand. The country and concession environ- ment and the nature of public-private risk management also have important effects on the viability of toll road programs. A stable economic and political context has been essential for a sustained toll road program. Because toll roads typically are high-performance highways, they are particularly de- pendent on income levels and economic activity. Moreover, because toll roads also tend to be politically visible, they may be subject to attempts to influ- ence project selection, implementation, and operation, especially through attempts to delay tariff increases and to evade toll collection entirely. The Specific Economic Characteristics of the Activity National characteristics are important in developing a greater private role for the road sector. At the same time, the privatization teams must clearly understand the economic characteristics of each toll road package to de- sign an appropriate public-private partnership. These economic character- istics are determined by a number of factors, including the project's func- tion, its physical characteristics, and the underlying market demand. THE PURPOSE OF A TOLL ROAD. The project's economic characteristics should be the starting point for designing the appropriate role for the private sec- tor. The first question to ask is: why is the toll road being put in place? In many instances, tolling is being considered for fiscal reasons. Governments often want new, stable sources of finance, and regulators must be aware that this can influence tremendously the choice of a toll road design and pricing form, as discussed later. One can classify toll roads as congestion relievers, intercity arterials, development roads, or bridges and tunnels. Their main characteristics are typically categorized as follows: * Congestion relievers are relatively short roads built to relieve traffic on existing urban routes. SR-91, for example, expands capacity of a major highway in southern California in the United States.5 Congestion 5. One can express capacity in terms of the variable passenger car unit (PCU). A PCU is a measure equivalent to the space occupied by a car, so a coach that occupies approximately twice the space of a car corresponds to 2 PCUs and a truck to 2.5 PCUs. 242 Toll Roads relievers, while expensive to build because of land costs, generally have significant revenue potential because they tend to serve heavy traffic demand. The high land acquisition and construction costs, however, may require high tolls if privately financed, so pricing decisions and regulatory oversight become important. In addition, because conges- tion may be concentrated at peak periods, time-of-day and other vari- able pricing schemes maybe required. Tolling is becoming more widely used as a mechanism to manage traffic demand on increasingly con- gested highways, a change made easier by advances in tolling tech- nology that have made tolling more efficient and more convenient. * Intercity arterial roads are built to improve access between major cit- ies, to airports, or to port/terminal complexes. An example is the Malaysian North-South Expressway, linking the Thai border through Kuala Lumpur with Singapore. These roads tend to be expensive because they are generally long, high capacity, and built to serve heavy truck traffic. Tolling decisions between different types of user groups are particularly important for these roads. * Development roads link more remote areas with urban centers or with major transport routes. An example is the Chilean South Access project that links a forestry region to the port of Concepcion and the Pan-American Highway. While development roads can provide a stimulus to economic growth, traffic volumes generally are not fi- nancially sufficient in the early years, and thus these are seen as speculative investments that require substantial public participation. * Bridges and tunnels are typically short, expensive to build per kilo- meter relative to roads, and, in most cases, serve high volumes of traffic. They are often built as congestion relievers and may have a similar strong financial capability due to traffic volumes. Examples include the Rio-Niteroi Bridge in Brazil and the Dartford Bridge outside London. THE CosTs OF A TOLL ROAD. Once reformers clearly recognize the purpose of the toll road, its costs must be identified. A project's physical character- istics are the primary determinants of its costs. Important aspects include whether the project is a new facility or an expansion of an existing road; the length, capacity, and design; geographic and geologic aspects; and toll collection mechanisms. New facilities are more costly per kilometer than expansions or rehabilitations of existing facilities. Rehabilitation and ex- pansion typically require less construction work than new facilities. Antonio Estache, Manuel Romero, and John Strong 243 Moreover, expansion projects that involve preexisting tolled facilities may be able to use the toll revenues to lower external financing requirements. For example, the Buga-Tulua expansion project in Colombia, which connects three major cities, was able to use existing tolls for about a third of project costs. Wider roads (number of lanes), their thickness and construction technique, and the type of geography traversed also are key determinants of project costs. As a result, project costs can vary over a wide range. The South Access project in Chile, which featured favorable geography and mostly rehabilita- tion work, cost about US$0.2 million per kilometer. By comparison, the Guangzhou-Shenzen highway in China, which involved six lanes through a region subject to flooding, cost more than US$15 million per kilometer. Bridges and tunnels, because of design requirements, tend to be much more expen- sive; the Dartford Bridge cost US$247 million for 2.8 kilometers, or US$88 million per kilometer (Mercer 1996). The proposed Colonia Bridge connect- ing Argentina and Uruguay was forecast to cost in excess of US$22 million per kilometer (over US$800 million in total costs). Finally, recognizing that road capacity presents high levels of indivis- ibility is important. For example, each lane in a highway typically repre- sents a maximum offer of 2,000 vehicles per hour, but it also represents the minimum offer per lane. If demand is about 3,000 vehicles per hour, capac- ity will end up being 4,000 vehicles per hour and the market will have excess capacity. So while a bus or train company can adapt the number of vehicles to fluctuations in demand, road service offers full capacity at all times. Therefore, if capacity is designed for peak periods, the road will be underused during off-peak periods. This means that if investment in road infrastructure capacity is carried out for long periods, schemes must be introduced across the board in the toll design to recover investment cost while preventing motorists from being overcharged. THE DEMAND FOR A SPECIFIC TOLL ROAD. Demand considerations deter- mine the next crucial component of the economic picture of a toll road. One can measure market demand in terms of actual or expected traffic levels, predictability of expected traffic, and the willingness to pay tolls. All these measures are critical to the design of toll road projects, be- cause they determine whether the revenue stream is large enough and predictable enough to obtain financing. The markets served, the num- ber and quality of competitive alternative routes, and the toll road's links to the rest of the transport network also affect traffic levels. Pre- dicting traffic levels is especially difficult for two reasons. First, new 244 ToIl Roads projects are unable to rely on existing traffic volumes as the basis for demand forecasts. As a result, they must turn to other methods of de- mand estimation, such as stated preference models, which may be less reliable.6 One must make judgments about the new road's ability to draw traffic from existing alternatives and to generate new traffic. The sec- ond reason is that in cases in which projects are to be stand-alone, the level of tolls required to cover costs and provide required financial re- turns may be far above existing toll levels, if tolls are levied at all. In these cases, estimates of price sensitivity and willingness to pay for new facilities become very hard. THE WILLINGNESS VERsus TBi- ABLrTY TO PAY FOR A ROAD. Often forgotten is that road investments must take into account the need to serve different user groups, including very poor users in rural areas who may not be able to afford the toll levels required to allow the operators to recover their in- vestments. This is important, because road investments are irrecoverable or sunk in the sense that, once built, they cannot be converted to other uses or moved elsewhere.7 While investors must be guaranteed the fair oppor- tunity to recover their investments, when preparing privatization, the gov- ernment must consider the ability to pay of all segments of the concerned population to avoid future tensions between users and operators. This is why the political challenge of introducing tolls is different for greenfield and rehabilitation/upgrading projects. For a given contract duration, tolls for new roads will often be much higher than for rehabilitation projects, because amortization costs tend to be much higher for greenfield projects. More generally, the experience of Latin America and Eastern Europe shows that the standard assumptions that toll road users are willing to pay high tolls to compensate for reductions in travel time and vehicle operat- ing costs are not as realistic as many would like them to be. This is a major problem, because the tolls that users in these regions are willing to pay may not be high enough to attract private equity (or debt, for that matter). Some practitioners argue that standard traffic models used to forecast the demand for the roads are too mechanical and do not recognize well enough 6. For a review of demand estimation methodologies, see Small and Winston (1999, pp. 11-56) or Trujillo, Quimet, and Estache (2000). 7. The fact that road investment is sunk, rather than subject to economies of scale, is an important distinction. Highway operating costs (with the possible excep- tion of costs imposed by heavy axle loadings) tend not to be very sensitive to volume. Antonio Estache, Manuel Romero, and John Strong 245 the behavioral changes that toll brings about. For instance, Piron (1999) reveals that for a series of toll road projects in France, the traffic forecast models had omitted a number of critical factors. These included the rela- tive importance of using the toll for the overall budget of the facilities' private or commercial users and the change in the user's willingness to pay with the distance covered. Privatization and Regulatory Trends The trend toward increased tolling of roads is clear. The precursors were in the United States and Europe. In the first half of the 19th century, pri- vate toll roads outnumbered public roads in the United States. But during the late 19th and early 20th centuries, the growth of the railways and prob- lems with toll evasion led to a decline in private toll roads. Toll road de- velopment in the United States further slowed after 1956, when the Fed- eral Highway Act established a federal gasoline tax to fund the interstate highway system and prohibited tolling on new, publicly financed high- ways. By the late 1980s, though, public funding constraints and infrastruc- ture demands stimulated new interest in toll roads, mostly as congestion relievers in metropolitan areas. European countries have had more experience with toll roads in re- cent decades, but with mixed results. Toll financing developed in Europe after World War II because of rapid growth and budget constraints. France used public toll financing in the 1950s and early 1960s, while it intro- duced private toll concessions in the late 1960s and early 1970s. Only one in four of the French concessionaires have survived, however. Spain in- troduced private toll financing for intercity motorways in the 1960s; 9 of the 12 original concessions continue to have a major role in Spain's road network. In Italy, more than 20 concessionaires have built more than 5,000 kilometers of toll roads. The largest of the Italian concessionaires, Autostrade, operates most of the highway network. Austria, Denmark, Greece, Norway, and Portugal also widely use toll systems. The Norwe- gian system is unusual in that it uses concession companies to collect tolls, while the government road administration retains responsibility for design, construction, and maintenance. The Movement toward Privately Financed Toll Roads The latest wave of toll roads is in developing countries, where economic and population growth and growing links with intemational markets 246 Toll Roads led to pressures for more highways. Mexico launched perhaps the most ambitious program of new roads, to build more than 5,000 kilometers of new roads between 1989 and 1994, the majority of which have not met projections and have had to be restructured with significant public contributions. Expansion of existing toll road systems has met better, although still mixed, success in other Latin American countries, most notably Argentina, Brazil, and Chile. China, Colombia, Ecuador, Hong Kong (China), Hungary, India, Indonesia, Malaysia, Peru, the Philip- pines, and Thailand also have pursued private or public-private toll concessions. Many of these projects are discussed in the context of par- ticular issues in the sections that follow. In terms of numbers, one of the publications monitoring the develop- ment of infrastructure projects, identified 121 projects in developed coun- tries between January 1985 and October 1998. The average project value was around US$750 million (driven by a number of EEC-sponsored megaprojects in Europe). A World Bank database for developing countries identified 280 roads projects in partnership with the private sector between 1990 and 1997. The average project size was around US$190 million, but with a large dispersion across regions. Eastern European projects have reached enormous proportions while South Asian projects have tended to be the smallest. As table 6.1 shows, the bulk of these projects were in East Asia and Latin America. Table 6.2 summarizes the scope of toll road provision in selected coun- tries. While toll roads are typically only a small share of the total road net- work, they tend to be located in the most densely traveled corridors and thus have the potential to play major roles in the transport network. Toll roads in many countries comprise a dominant share of the expressway Table 6.1. Divestitures, Concessions, and O&M Contracts in Developing and Transition Economies, 1990-97 East Eastern Latin South Africa Asia Europe America Asia Total Number of transactions 5 102 2 93 6 208 Value (million US$) 426 18,567 1,086 18,794.8 63.5 38,937.3 Average project size (million US$) 85.2 182 543 202 10.6 187 Source: World Bank Private Participation in Infrastructure database. Antonio Estache, Manuel Romero, and John Strong 247 Table 6.2. Tolled and Other Roads in Selected Countries (km) Tolled Tolled Total roads roads Total road expressway Tolled (percent (percent of Country network network road of total) expressway) Argentina 500,000 10,400 9,800 1.96 94 Brazil 1,980,000 - 856 0.04 - Chile 79,800 - 3 0.00 - France 966,000 14,886 6,305 0.65 42 Hungary 158,600 435 57 0.04 13 Indonesia 260,000 530 530 0.20 100 Italy 314,360 6,444 5,550 1.77 86 Japan 1,144,360 15,079 9,219 0.81 61 Korea, Republic of 77,000 1,880 1,880 2.44 100 Malaysia 94,000 1,702 1,127 1.20 66 Mexico 303,262 5,683 5,683 1.87 100 South Africa 525,000 1,440 825 0.16 57 Spain 343,200 7,194 2,255 0.66 31 - Not available. Sources: Heggie and Vickers (1998); PadeCo (1999). network and thus may play particularly important roles in urban areas and in intercity trade. Experiences with "Privatization" Many toll road projects have been undertaken, each with different design and investment demands and political and organizational arrangements.8 Many toll roads have been negotiated quite loosely and have often been the outcome of informal agreements between the government and a construc- tion company. Other programs have been overly ambitious and have resulted in partial or total failures because they were implemented too quickly. Sound toll roads require good planning. The government should consider funding preliminary studies that demonstrate public commitment, increase the fu- ture regulator's knowledge base, and help reduce the costs of delivering road services. These studies might involve such matters as environmental and land acquisition needs, indicative traffic and revenue projections (which are essential preparation for both contract design and renegotiation), and 8. This section draws on the World Bank toll road web site. 248 Toll Roads project design criteria. Design specifications can range from virtually no public sector responsibility for road features to detailed specifications with respect to route, alignment, capacity, locations of interchanges, materials, pavement, and so forth. A lower level of public involvement allows the private sector to provide potentially innovative solutions and better match infrastructure pro- vision to market demand. Allowing this flexibility reduces the ability to com- pare proposals, however, because different bidders may take different ap- proaches to project design. Projects that have limited opportunities for inno- vation should be more explicit in design and award criteria. Experience suggests that reformers should address three key project se- lection and design issues early in the concession process: whether a free par- allel road should be required, the feasibility of cross-subsidies, and whether concessions should be for a single road in a network or for a package of roads. REQuIRING FREE PARALLEL ROADS. While the idea of having competition between roads is a good one in principle, the evidence so far suggests that traffic levels in most developing countries cannot sustain duplication from free alternative routes. Toll road traffic in such cases has generally fallen well below projections. The Mexican toll road program illustrates the chal- lenges imposed by parallel roads. Launched in 1985, this program intro- duced a toll road development plan with a range of conditions, one of which was the provision of a free alternative parallel route. Traffic predictions for the concessioned roads suggested that trucks would form about 20 to 45 percent of the traffic. They turned out to be only about 5 percent. A black market in toll receipts was developed by truckers who used the parallel free roads yet produced toll receipts for their employers in order to reap financial benefits. This problem was overcome when the road operators agreed to exempt trucking companies from paying a toll, but this damaged the financial viability of the toll road. This experience suggests that the competition argument is difficult to implement in an environment where traffic is not strong enough and lob- bies are powerful. The best argument in favor of free parallel roads is one of social equity, to ensure that the poor can still have access to the road network, but this often detracts from the new toll road's effectiveness in alleviating congestion and may also cause problems for cost recovery if the toll cannot produce enough revenue. In general, tariff differentiation, as discussed later, will be a much better solution to help the poor, therefore reducing the case for a parallel toll-free road. USING ExIsTING CONCESSION REVENUES TO FUND NEW PROJECTs. In some cases, existing roads have been tolled in order to provide revenue for Antonio Estache, Manuel Romero, and John Strong 249 the construction of new segments in the network. The French pioneered this technique in which new roads with higher construction costs are supported by operating surpluses from existing toll roads (Papon 1998). The Japanese also have been committed to this concept, having used tolls to generate revenue for road construction since the mid-1960s.9 In 1972 they introduced a toll revenue pooling system. The pools are sepa- rate for urban expressways and for regional networks. Tolls are set equally on all routes and segments of the network, no matter what the construction costs or traffic levels. The Japanese felt that traffic fore- casts could only be achieved if the full network was in place, and that profitability of some routes would be improved by the opening of con- necting routes. Politically, establishing common tolls across the network was easier because it avoided confusion and was fair, because all roads provide essentially the same service. More generally, creating profit- ability to fund a new road or concession is common. Similar stories can be told about several Asian toll roads programs. While these examples illustrate that tolling can assist in releasing funds for new construction, from a regulator's viewpoint, the standard risks im- plied by cross-subsidies require dose monitoring of the cost structure of the various roads to ensure that the average toll is not higher than it needs to be. Monitoring the transfer of resources from one group of consumers to another is important, because those who are paying tolls on the existing road are thereby paying for the construction of a new road, which would otherwise have been funded by taxpayers and will provide benefits for other future users. This may be part of a government program of regional development that needs to be explicitly recognized. Toll roads are often developed in con- gested corridors of a capital citybecause good revenue streams there are easier to predict. Where this is the case, the investment in the road is benefiting more affluent areas of the country. If this crowds out other investments in less affluent areas of the country, then other regional equity issues are raised. SHOULD CONCESSIONS BE PACKAGES OR INDIVDUAL PRojEcTs? The project eco- nomics of toll roads suggest that traffic volumes must be in the range of 10,000 to 15,000 vehicles per day for toll revenues to be sufficient to cover construction, operating, and financing costs. In many countries, only a few 9. Operating and maintenance costs and interest costs on the construction loans took up 57 percent of the total pooled toll revenue on the 6,416-kilometer National Expressway Network in 1997. Approximately 50 percent of routes generated rev- enue in excess of their operating, maintenance, and interest costs (Matoba 1999). 250 Toll Roads such corridors exist. For other roads that may serve important transport roles, bundling a package of roads into a single concession may be pos- sible. The pooling of existing roads reduces the volatility of overall conces- sion cash flows and may thus increase financial viability. In some cases, this may involve transfer of an existing toll road or major untolled route that may need upgrading or expansion, along with an associated feeder network. If properly designed, the feeder network could serve to enhance the viability of the main toll road. Organizational Options One can design a road concession in many ways. Table 6.3 presents a spectrum of alternatives for involving the private sector in the provision of toll roads, ranging from maintenance contracts through full build-op- erate-transfer (BOT) concessions and corridor management. Each option is described in terms of the nature of public and private involvement and typical features (such as duration and project size). The principal respon- sibilities for toll road development include design, maintenance, toll col- lection, financing, and legal ownership. In practice, however, governments seldom follow a pure strategy and end up combining various types of contractual arrangements (illustrated by Argentina's restructuring expe- rience, discussed in box 6.2). Most widely used is the BOT model. This structure can be broadly defined to include variations such as build-own-operate-transfer, build- lease-transfer, rehabilitate-operate-transfer, and similar arrangements that are used to develop new facilities or rehabilitate existing roads. Under the generic BOT model, a private consortium receives a concession to finance, build, control, and operate a facility for a limited time, after which the facility is transferred back to the government. What makes the road sector so special in this context is that in most countries, the consortium includes a major foreign and/or local construction company mostly in- terested in the short-term use of its assets (essentially machinery) and skills. This often has an influence on the way in which contracts are drafted and also on the speed of the investments to be made. Govern- ments should pay close attention to ensure that investments are driven by demand rather than by the short-term concerns of a consortium mo- tivated by the opportunity for construction profits-as has been the case in too many toll roads projects. The consortium typically assumes primary responsibility for construct- ing the project, arranging financing, maintaining the road, and collecting Table 6.3. Characteristics of Organizational Optionsfor Toll Roads A: Maintenance management C: Operate F: Corridor Features contract B: Turnkey and maintain D: ROT E: BOT management Definition Maintain Design and build Maintain and Finance, rehabilitate, Finance, design, Finance, design, operate maintain, and construct, maintain, construct, maintain, operate and operate and operate Develop corridor/ network Examples New South Wales United States Argentina Argentina, * Malaysia, U.K. (DBFO) Chile, Brazil Hong Kong (China) Hong Kong (China) Colombia Philippines, Colombia, Brazil Thailand * Argentina, Mexico Direct cost recovery No No Some degree of toll Concessionaire may Government Government from users Payment from Fixed payment from revenue sharing pay government or investnent usually contributes existing government to government to with government vice versa required roads and other operator operator Ex-post subsidies investment usually not uncommon required Scale of private Very low Considerable for Low Medium High Medium/high investnent very short term Private sector risks Maintenance Design Traffic and revenue Rehabilitation Design Design Construction levels Traffic and revenue Construction Construction Political levels Traffic and revenue Traffic and revenue Financial Political levels levels Financial Political Political Financial Financial (table continues onfollowing page) Table 6.3 continued A: Maintenance management C: Operate F: Corridor Features contract B: Turnkey and maintain D: ROT E: BOT management Public sector risks Design Plannring Revenue Force majeure Planning Planning (land acquisition Construction Traffic and revenue Macro Some regulatory Macro Force maieure and relocation Traffic and revenue levels Some regulatory Some regulatory Macro risks always levels Some regulatory carried) t TIypical contract Small Medium/large Small/medium Medium/large Very large Medium/large size ($) US$50-US$800 c. US$100 nillion to c. US$90-US$300 million US$1 billion million Minimum size Small/local Small/local Construction firm Larger construction Consortium Consortium often concessionaire construction firm construction firm with mnanagement firm with induding major with major required skills management skills construction firms construction firms Typical duration 2-10 years Defined construction 2-10 years 10-20 years c. 30 years c. 30 years period Note: For more details and some differences, see also ADB (1999). Source: Authors. Antonio Estache, Manuel Romero, and John Strong 253 Box 6.2. Increasing Private Participation in Roads: Argentina's Experience The general privatization strategy was to unbundle financially viable roads into build- operate-transfer concessions awarded through competitive bidding. Most of the traf- fic is concentrated near major city nodes, such as BuenosAires and Rosario and C6rdoba to a lesser extent. The national concession program has so far focused on the multilane roads and freeways serving these cities, along with other intercity and major city ac- cess roads. It applies now to almost 9,500 kilometers of 38,000 kilometers of national roads. The concession program was complemented by an auction of management con- tracts (generally for five years) for rehabilitation and maintenance, now covering about 12,000 kilometers of national roads divided into 400 sections and auctioned out into 61 contracts. Also, nontoll concession contracts cover about 1,900 kilometers of national roads (six corridors) and allow the government to rely on a private financing of the initial rehabilitation in exchange for a commitment to future disbursements of monthly subsidies during the 10-year terms of the concessions. A more recent program called "km/month" covers basic maintenance and service contracts for 4,100 kilometers of less traveled roads. Overall, about 70 percent of the national road network is de facto under private operation. tolls, while the public sector retains legal ownership and regulatory over- sight of the concession contract. In most projects, design responsibflity is shared, with the public sector taking the lead in corridor identification and preliminary design, leaving specific details to the private sector, subject to government approval. In practice, the government often ends up sharing some of the demand risks through the payment of subsidies. Typical BOT concessions are 20 to 30 years in length, whereas maintenance concessions tend to be shorter, typically 5 to 15 years. They differ in length because of the different financial requirements. The duration of the concession may either be set in advance by the government or be part of the decision criteria in selecting the concessionaire. Overall, BOT concessions are most likely to be successful under the fol- lowing conditions: - Projects minimizing costs in existing high-traffic corridors, for ex- ample, projects with missing links such as river crossings, because they minimize land costs; inter-urban projects with low implemen- tation costs; and urban area projects at grade or elevated, because they keep construction costs low * Projects in countries where there is a tradition of paying public tolls, or at least where the willingness to pay the proposed toll level has been carefully assessed * Projects in which tolls are set at, or close to, the revenue-maximizing tariff and toll escalation formulas are invoked 254 Toll Roads Projects that have an existing income stream from which to draw rev- enues from day one, perhaps even during the construction period. Risk Allocation Options Choosing among the options for private participation shown in table 6.3 depends on the particular needs of a country and the nature of risk shar- ing between the public and private sectors. Risk allocation is a complex and difficult process, and for all practical purposes, it is a negotiated pro- cess (for a much more detailed analysis see Irwin and others 1997). Un- fortunately, these initial negotiations seldom involve the future regula- tors, even when their outcome is critically important to regulatory deci- sions. This is why one of the first tasks a new regulator has to address in its new position is to understand the distribution of risks to which each party is committed through the contract, because in many renegotiations or regulatory disputes, the responsibility will be based on the assignment spelled out in the contract. The rule of thumb is that private road infrastructure projects work best when project risks and responsibilities are assigned to the party that can best bear them. The private sector generally is better at managing commer- cial risks and responsibilities, such as those associated with construction, operation, and financing. In contrast, toll roads may also depend on public participation in areas such as acquisition of right-of-way, political risk, and in some cases, traffic and revenue risk. Successful projects have been char- acterized by a broad level of risk sharing between the public and private sectors. Privately supported toll road projects work best when experienced, well-capitalized firms have some discretion over design and confidence in toll policy to accept construction and some degree of traffic risk. The gov- ernment assumes the risks that it controls and considers giving financial support or guarantees if traffic levels in the early years are insufficient. In practice, this theory of risk allocation is often not applied. Part of the reason is that risk levels and types tend to change. The 1998 Asian crisis sufficiently increased risk levels worldwide, increasing the cost of capital to unbearable levels for many potential investors. Governments can also be subject to a fear-greed cycle in which they become afraid of program failure, and thus offer increasingly better terms. Prospective concession- aires may worry that they will be left out and end up making unrealisti- cally optimistic bids. Subsequently, the element of greed takes over and governments may fail to live up to commitments, and the private sector seeks ways to privatize gains and socialize the project risks. Antonio Estache, Manuel Romero, and John Strong 255 The main risks facing toll road projects are preconstruction activity, con- struction, traffic and revenue, currency,force majeure, tort liability, political risk, and financial risk. The privatization teams must address these risks in a satisfactory manner before debt and equity investors will commit to project funding. The standard risks that contracts identify are preconstruction, con- struction, traffic and revenue, financial, regulatory, and political. In addi- tion, contracts commonly address force majeure and legal liability because they have proven to be serious sources of cost overruns in the sector. PREcoNsTRucnoN RIsKs. Many projects are delayed because of the diffi- culties of acquiring right-of-way or environmental clearance that both the governments and the operators underestimated. The most relevant effect is cost overrun during project development. In general, the public sector often ends up taking on the responsibility for most of these risks, because acquiring the right-of-way, paying for it, and contributing this asset to the project are often easier for the public sector. Problems often arise when the government is not providing the road itself. If a private sector partner is undertaking construction, the delineation of responsibility and phasing of development by the different parties is particularly important. Regulators end up having to address this kind of risk, as seen in the fol- lowing typical experience. A new segment of the Don Muang Tollway in Bangkok, Thailand, will connect the airport with another toll road. In 1989, the Department of Highways gave the Don Muang Tollway Public Com- pany Limited (led by a German firm) a 25-year concession to build the US$407 million, 15.4-kilometer initial segment of the project. One clause in the con- cession agreement specified that the government would remove flyovers on a parallel road that competes with the toll road and would then construct new flyovers to allow radial movement. The government did not deliver for more than two years, however. In addition, it blocked toll rate increases until the completion of the new flyovers. As a result, toll revenues were almost 30 percent lower than had been forecast for the period. The sponsor ended up close to bankruptcy, which forced the government to provide significant com- pensation in exchange for a 40 percent stake in the company, thereby help- ing refinance the loans (ADB 1999). One way to reduce transaction costs would have been to come up with a clearer contractual commitment for the government to take on that risk, and possibly to have it put a guarantee fund together to establish the credibility of its commitment, in the same way that governments ask concessionaires to fund commitments through guarantee funds. The general principle is the same: credible, rule-driven decisions are always easier for the regulator to implement. 256 Toll Roads CONSTRUCTION RISKS. A common cause of cost overrun stems from de- sign changes and unforeseen weather conditions during the construction phase. For instance, between the time that a concession is signed and when the concessionaire takes over the business, a hurricane can significantly increase construction costs. Who should pay for the consequences of the hurricane? The private sector typically bears primary responsibility for such risks and may attempt to cover some of them through insurance. The pub- lic sector may assume responsibility for risks under its control, however, such as completing complementary facilities (connecting roads or inter- changes) or allowing cost increases associated with major design changes. Commonly, governments also at least share costs for projects that face major construction uncertainties, such as toil roads through mountains. Most cases, though, use fixed-price construction contracts, with some pro- vision for severe disruptions. For example, in Brazil, a financial equilibrium clause enables contractors to renegotiate contract terms if major design changes are required. When massive cost overruns occur, contract renego- tiation may be required in exchange for sponsors and creditors providing additional financing. This occurred in the Guangzhou-Shenzen project in China, where the private sponsors made an additional US$700 million eq- uity investment in exchange for an increase in the profit sharing agreement during the first 10 years of operation. Note that that the use of fixed construction prices in the contract is consis- tent with the idea of facilitating the work of regulators, but it also illustrates the costs and risks involved with accepting rules too readily. Concession units being staffed with members of the public roads department is not uncommon. In some countries, this staff has an established contact with many of the local construction companies through procurement and maintenance contracts for the public roads, and the bidding rules for these contracts are not as competi- tive as they should be, resulting in construction prices that are not consistent with best practice. Thus, the risk is that unit prices built into concession con- tracts are based on the wrong prices (in the best of cases), or that they reflect collusion between the concession unit and the concessionaires (in the worst case scenario). In other words, regulators should not always take construction unit prices for granted when they have the option to review them. TRAFFIc AND REVENUE RISKS. Demand uncertainty continues to be a major problem at the conception stage and ends up haunting many, if not most, projects. Traffic and toll levels may not be sufficient to cover all costs, in- cluding construction, operation, and maintenance. An approximate rule of thumb is that 10,000 to 15,000 vehicles per day (vpd) are needed to fully Antonio Estache, Manuel Romero, and John Strong 257 cover operating and capital costs. Coverage of operating costs alone gener- ally requires traffic in excess of 3,500 vpd. Recovery of toll collection costs requires approximately 1,500 vpd (Fayard 1993). The handling of traffic and revenue risks ranges from full private sector assumption to govem- ment-provided traffic and revenue guarantees. The policy issues involved with managing these risks are major strategic choices that this chapter later discusses in detail, and they vary tremendously depending on the time and location of the project. A regulator's main concern in this context is to make sure that it has ac- cess to the demand studies conducted in preparation for the tolling of the road network. As explained earlier, forecasting demand is a challenging task that privatization teams often underestimate. Overoptimism is common for privatization teams that focus on convincing private operators of the value of their business and for potential operators that want to make a deal and are convinced that they can renegotiate almost anything once they have taken over the business. To be somewhat credible, much more so than in most other transport studies, one has to combine analysis of the willingness to pay for a toll road with a study of ability to pay to fairly assess the traffic and revenue risks. In many toll road renegotiations, the regulator's main con- cern is to avoid boycotts of the road by users who are unwilling or unable to pay for the toll. The solution is often to cap the toll and adjust the duration of the contract, but the adjustment often entails significant transaction and po- litical costs that most regulators wish to avoid. CuRRENcY RisE$. The impact of exchange rate fluctuations on the value of the business drives the main currency risk. In addition, the toll concession can be subject to a convertibility risk that refers to the possibility that the operator may not be allowed to exchange local currency for foreign currency. These are major issues for toll roads that are financed with foreign capital, because revenues are commonly in local currency and adjustments for infla- tion and exchange rates may lag or encounter political opposition. Projects can reduce this risk by tapping domestic capital markets when possible. Most projects attempt to mitigate exchange risk by including provisions for index- ing to inflation, although in practice, the magnitude of exchange rate volatil- ity has made such requirements difficult to enforce. Peru, for instance, addresses and shares this risk in concession contracts in the following way. To begin with, the initial basic toll unit is expressed in dollars. This tariff is adjusted every six months in line with the consumer price index using a devaluation index that the National Statistics Office publishes. The devaluation adjustment only kicks in when the devaluation 258 Toll Roads rate is higher than inflation. The toll is adjusted by 50 percent of the differ- ence between devaluation and inflation. A general formula would look like this: PtMN =Pt-l MN * (1 + CPI_ * [1 + 0* (DEV,1 - CPI,-I)] if DEV 1>CPIt l where P, I MN is the toll base adjusted in national currency for the period t -1; 13 is the factor by which the difference between devaluation and infla- tion can be passed on through tolls, which essentially is the variable over which a negotiation takes place between the government and the conces- sionaire; CPI,-I is the consumer price index in the period t -1; and DEV_ 1 is the devaluation in the previous period. Having an explicit formula like this is always a blessing for regulators and is now becoming standard in concession contracts, so that when an explicit rule is not available, regulators only have to check compliance rather than arbitrate a negotiation between the government and the concessionaire. FINANCIAL RIsKS. Financial risk is the risk that project cash flows might be insufficient to cover debt service and then pay an adequate return on spon- sor equity. Financing constraints, especially the lack of long-term debt capi- tal, significantly hinder toll road development. Since the advent of financial crises in emerging markets, few projects have been able to generate returns on investment that are sufficient to attract private capital. Required debt ra- tios have fallen from 70 percent to 40-50 percent, with costs of capital rising to 20 percent or more. This suggests that until macroeconomic risk premi- ums decline and traffic growth is more established, only the highest-density projects will be undertaken without substantial government support. The financial crises will force many programs to slow down and force debt re- structuring of many existing concessions. The promotion of more secure fi- nancing structures is needed to reduce the risk of potential bailouts. Because toll roads are long-lived investments with high start-up costs, countries with local capital markets that can provide long-term financ- ing have many advantages in supporting toll road concessions. Of par- ticular importance is the available maturity of domestic finance. In many countries, new toll concessions have been unable to obtain financing for longer than five to six years, which creates a major refinancing risk that either renders the project nonviable or requires government guar- antees of such a rollover. In theory, financial risk is best borne by the private sector, but in toll road projects substantial government risk sharing is likely, either through rev- enue or debt guarantees, or through participation by state or multilateral Antonio Estache, Manuel Romero, and John Strong 259 development institutions. Cash grants or other financial contributions also may be available, which serve to improve the project's rate of return on pri- vate finance. REGULATORY RLsKs. Regulatory risk stems from the weak implementa- tion of regulatory commitments built into the contracts and the laws or other legal instruments that are relevant to the value of the transaction as it was originally assessed. Essentially, the question is whether the regula- tor will exercise its authority and responsibilities over prices, public obli- gations, competition rules, and similar rules that the contracts specify, and whether that will influence the value of the business. This risk is more common than it appears, and pressures on regulators are a major source of concern that investors incorporate into their required rate of return. In 1999, a major factor in the restructuring of Mexico's toll road program was the pressure on regulators to cut tolls. In Thailand, a simi- lar concern resulted in the government's decision to cut a toll level by 50 percent of what it had committed to in a BOT contract. The outcome was that the government ended up taking over the toll road. The solution is to try to make sure that regulators have rules to follow and that they are independent enough to be able to enforce them. First, the rules must cover the possibility of adapting the contract terms during the concessionaire's tenure. Toll road concessions tend to be long, and the le- gal environment in reforming countries tends to change during that pe- riod. For instance, environmental and safety concerns are increasing in many countries. New laws are introduced during the term of many toll roads. The rules that allocate the financial consequences of these changes among government, users, and operators are critical, yet often forgotten. Even if regulatory rules are clear, they are only as effective as the regu- lator. The best designed regulatory contract is useless if the regulator is not independent or fair, which has been a major source of concern in Bra- zil. For example, in a concession between the cities of Rio de Janeiro and Teresopolis, illegal access and egress has been estimated at 3,000 vehicles per day. The mayor of Mage, a small town along the route, has champi- oned this leakage, because he believes that his citizens should not have to pay what are perceived to be very high charges for local access users. Regulators have not been able to enforce the contractual commitments made to the operator. POLITICAL RIsKS. Political risk concerns government actions that affect the ability to generate earnings. These could include actions that terminate the concession, the imposition of taxes or regulations that severely reduce 260 Toll Roads the value to investors, restrictions on the ability to collect or raise tolls as specified in the concession agreement, and the preclusion of contract dis- putes to be resolved reasonably. Governments generally agree to compen- sate investors for political risks, although in practice, governments may cite justifications for their actions to delay or prevent such payments. Thus, private investors generally assume the risks that are associated with dis- pute resolution and the ability to obtain compensation if the government should violate the concession agreement. The issue of meeting financial obligations while disputes are resolved may be achieved by requiring debt service reserves, escrow, or standby financing. In Brazil local political interference has affected several toll road projects. A state-level concession in Parana is the most significant example to date. In this case, new tolls were introduced during peak harvest season and the governor forced the concessionaire to charge only 50 percent of the origi- nal tariff. The case is now nearing a decision in court, but all the other concessions are paying close attention. If the original toll contract structure is not fully upheld, accomplishing refinancing and attracting capital on favorable terms for a second wave of concessions will be more difficult. Investment bankers have cautioned that if these court issues regarding toll revisions in Parana are not resolved, an additional 200 basis points could be required for those projects in regions with particularly populist gover- nors or mayors. In total, including the costs of the spillover effect of the Asian crisis in the rest of the world, the costs of debt rose from approxi- mately 11 percent in late 1998 to 16-17 percent in early 1999. At this cost of debt levels, most projects are not viable at their planned toll levels. The govermment's credibility to uphold contractual obligations and its will- ingness and ability to provide compensation for political risks are key issues for private investors in toll roads. Issues with delays or denials of toll increases have made many prospective parties wary of entering into new projects. This is especially true for foreign capital, which is perceived as especially vulner- able to political risks. Some of the more risky emerging markets may require support from multilateral or bilateral financial institutions to reduce this risk exposure. In addition, political risk insurance may help manage issues of in- convertibility, transfer, and confiscation. Box 6.3 shows how a regulator might put together all these risks into a single quantitative indicator. OrmR RisKs. Force majeure refers to risks that are beyond the control of both public and private partners, such as floods or earthquakes, that im- pair the project's ability to earn revenues. While some private insurance is becoming available for catastrophic risks, the public sector generally is faced with the need to restructure the project should such disasters occur. This Antonio Estache, Manuel Romero, and John Strong 261 Box 6.3. How Should a Regulator Consider Risks? Risk factors can be pulled together in the concept of cost of capital, which represents the required rate of return that all investors blended together might expect on a project. For most regulatory decisions, a regulator will have to assess the impact of its deci- sions on the cost of capital through its impact on each one of the risk levels. Algebra- ically, we can simplify and write this as follows: Cost of capital = (required rate of return on debt) x (percentage of debt in the project) + (required rate of return on equity) x (percentage of equity in the project) Because interest expense typically is tax deductible, we can calculate the cost of capital either on a before-tax or an after-tax basis. It is important to understand that the tax rate that is relevant is the one that applies to project sponsors. The required rate of return on debt. The required rate of return on debt (that is, the borrowing cost) includes a number of risk factors, each of which commands a pre- mium that must be paid to investors in order for them to bear that particular risk: Required rate of return on debt = risk-free borrowing ratefor specified time horizon + premiumfor country/financial risk + premiumfor currency risk + premiumfor project or sector risk (including construction) + premiumfor regulatory risk The required rate of return on equity. Similarly, the required rate of return on equity investment can be seen as being equal to a risk-free rate plus a premium for the higher risk faced by equity relative to debt, as well as all four risk factors above. The equity risk premium is a function of how risky a specific sectoral investment is relative to equity markets overall. (This adjustment factor is known as beta and has an average value of 0.6-0.8 for toll roads.) Thus, Required rate of return on equity = risk-free borrowing ratefor specified time horizon + equity risk premium (adjusted by project beta) + premiumfor country/financial risk + premiumfor currency risk + premium for project or sector risk (including construction) + premiumfor regulatory risk While in many cases the risk premiums required would be similar for debt and equity, this will not always be the case. For example, regulatory lags in approving pricing decisions may have a greater effect on equity holders because creditors have a prior claim. may take the form of extending the concession term or providing addi- tional financial support. The rule is that contracts should state remedies in the event of force majeure risks, for example, cash compensation or an ex- tension of the concession term equal to the length of the disturbance. Fi- nally, tort liability refers to liability for legal awards as a result of accidents or negligence on the toll road. This responsibility is borne by the private sector and is typically covered through private insurance. Governments, 262 Toll Roads however, should make sure that such coverage is adequate and that the insuring party is financially sound. Regulatory Options for Mitigating Risk At the start of the concessioning process, the government has two main reasons to commit to supporting toll road projects at the beginning of a project: (a) to offset the financial or exchange risks by reducing capital expenditures, or to improve revenues to the extent necessary for a project to cover debt service and provide a reasonable equity return; and (b) to offset the demand and traffic risk and protect investors, especially lend- ers, from the risk that actual cash flows will fall below expected cash flows and thus be inadequate to cover debt service. When unexpected events occur and renegotiation of a contract arises, these two are often the main problems that a regulator must address. The name of the game is to come up with a mix of government actions that ensures that an ac- ceptable financial return can be generated, such as sorne redesign of the financing schemes to include guarantees, as well as redoing the project design, including its duration. THE VARIous INsmuRNUErS AVAILABLE TO A REGULATOR. If public financial support is appropriate, one can use a variety of mechanisms to support private toll financing. These instruments range from revenue enhancements to equity guarantees as follows • Equity guarantees: These provide a concessionaire with the option to be bought out by the government at a price that guarantees a mini- mum return on equity. Although the liability is contingent, the gov- ernment effectively assumes project risk and reduces the correspond- ing private sector incentives. a Debt guarantees: These guarantee that the government will pay any shortfall related to principal and interest payments. The government may also guarantee any scheduled refinancing. This creates signifi- cant government exposure and reduces private sector incentives, although it may decrease the cost or increase the amount of debt available to the project. * Exchange rate guarantees: These are when the government agrees to compensate the concessionaire for increases in financing costs due to exchange rate effects on foreign financing. Exchange rate guaran- tees expose the government to significant risk and increase the in- centive to use foreign capital. Antonio Estache, Manuel Romero, and John Strong 263 * Grants/subsidies: These are contrary to equity and debt guarantees that create contingent liabilities for the government. Alternatively, governments can furnish grants or subordinated loans at project in- ception, buying down the size of the project that needs private fi- nance. (In Chile, the size of the government grant was one of the criteria used in awarding the south access toll road concession.) Al- ternatively, explicit subsidies can be given as part of the renegotia- tion process. In Argentina, this subsidy took the form of the forgive- ness of accumulated payments due to the government for the right to operate the concession. In general, these grants or subsidies have no provision for repayment. * Subordinated loans: These can fill a gap in the financing structure between senior debt and equity. From the govermnent's perspec- tive, they also have the attractive feature that they can be repaid with a return if the road is successful. Subordinated loans improve feasibility by increasing the debt service coverage ratio on senior debt and by reducing the need for private equity, which requires a higher return. Because subordinated debt does eventually require repayment, however, it does not improve project feasibility to the same degree as a similarly sized grant. Another alternative would be for the government to contribute financing that has characteris- tics of both debt and equity. One such instrument would be a so- called reverse convertible contribution that would remain as eq- uity unless the project was successful, at which point it would con- vert to debt for repayment. As an alternative to these instruments, the regulator could rely on "playing" with the design of the contract. This involves consid- ering changing the time profile of toll revenue as well as the toll levels and types, or adjusting the investment specification and other service obligations or the contract duration as follows: • Minimum traffic and revenue guarantees:10 These are a relatively com- mon form of support for toll roads in which the government com- pensates the concessionaire if traffic or revenue falls below a mini- mum threshold. Typically the threshold is set 10 to 30 percent below 10. Note that some countries, such as Chile, jointly introduce minimum imcome guarantees to protect the operator with a revenue sharing scheme that allows the government a 30 to 50 percent share of extra profits (in other words, revenue that generates a return in excess of 15 percent) when traffic is consistently above what was forecast. 264 Toll Roads the expected volume, and relying on a revenue guarantee is gener- ally more desirable if the goal is to facilitate the operator's access to the financial market. This trigger reduces government exposure while providing sufficient revenue coverage to support the debt compo- nent of the capital structure. In addition, traffic and revenue guar- antees help retain financial incentives in the project, unless condi- tions deteriorate well below what was forecast. If the government shares downside risk with the private sector through guarantees, it should also consider seeking instruments that allow profit on the upside. One way to do this is with a revenue-sharing arrangement in which the government receives a portion of revenues above a maximum traffic threshold. * Shadow tolls: These are a way to provide subsidies in which the gov- ernment contributes a specific payment per vehicle to the conces- sionaire. In effect, they are an ongoing revenue stream from the gov- ernment in lieu of an up-front grant or loan. Because they are paid over time, they may be less of a burden on the public budget. The drawback of shadow tolls is that they may not provide investors with much protection from revenue risks. That is, shadow toll pay- ments are highest when traffic volumes are large. As a result, gov- ernment payments may be inadequate to protect investors when traf- fic is low and may be unnecessarily high when traffic volumes are high. In addition, the payment of shadow tolls over time creates a credit risk for concessionaires. One can reduce these inefficiencies in a number of ways, such as by implementing a declining payment schedule as volumes increase or a maximum traffic level beyond which shadow tolls are not paid. Because they tend to top off pri- vate revenues, shadow tolls may be particularly valuable as sup- port to low-volume roads that require upgrading or rehabilitation rather than new construction. * Concession extensions and revenue enhancements: These provide finan- cial support that involves limited public sector risk, but they do little to support or enhance private financing. First, a government can extend the concession term if revenues fall below a certain amount. Second, a government can restrict competition or allow the conces- sionaire to develop ancillary services. * Changes in contractual obligations: These allow the redesign of con- tractual obligations. Slower or less investment and fewer service obligations are ways to cut costs and transform a nonviable road into a viable one. Antonio Estache, Manuel Romero, and John Strong 265 CHOOSING AMONG THESE INSTRUMENTS. In general, the most advantageous types of support for the concessionaire are those that provide early funding streams (when toll road revenues are low or nonexistent during the con- struction period) and those that give guarantees for unexpected problems (for example, exchange rate guarantees). This is true at the time the contract is initially signed as well as whenever the regulator is asked to renegotiate to restore financial viability to a project that has lost its viability. The least sig- nificant are those that themselves are unpredictable, such as additional rights for development around the road. One can use these various mechanisms of government support in combination when a project is not feasible on its own and where revenue risk is substantial. In such cases, grant plus minimum revenue guarantees may be sufficient to induce private participation. Gov- ernments should avoid broad guarantees that reduce lenders' scrutiny and due diligence. In many cases, the availability of these guarantees have in- duced lenders to provide funds based on guarantees and sponsor strength rather than on underlying project risks and revenues. When assessing the value of these adjustments, regulators must rec- ognize that the value of government support also depends on the cred- ibility and credit risk of the government itself. Investors may be inclined to discount the value of various support mechanisms that have not been upheld in the past, or which are tendered for long periods. Governments also need to improve the management of their contingent liabilities in order to maintain their fiscal credibility, and thereby reduce macroeco- nomic risks that directly affect toll roads through traffic volumes and financing costs. However, governments are sometimes tempted to increase support far above expected levels when the sponsors are well-connected politically, have better advisers, or threaten to withdraw at the last minute. To prevent this, the government should be well prepared with the speci- fication and design of its part in support of that preparation. The upshot is that determining if a project requires government support and how such support should be structured requires a detailed analysis of project costs, revenues, and risk, as well as an understanding of what debt and equity investors require. Most regulators have ignored the importance of this information and have not been able to appropriately monitor or arbitrate disputes as a consequence. Before bidding a concession, gov- ernments should be aware of the project's critical elements, including environmental issues, traffic and revenue potential, preliminary design and costs, permit requirements, and the views of potential investors. Gov- ernments can improve the likelihood of having successful projects by undertaking studies of these issues and by working with experienced 266 Toll Roads advisers. Box 6.4 tells how Peru effectively prepared its toll road pro- gram. Unfortunately, a lack of political commitment to the program is still delaying its implementation. The regulators will, however, have all the required information once the program is implemented, thanks to effective preparation. Box 6.4. Preparing for a Toll Road Program: A Lesson from Peru Faced with rapidly growing motorization, in 1997 Peru decided to launch new initia- tives in road transport and to transform its public tolled highway network into a wider private tolled network. A special committee quickly began the process of selecting consulting firms to undertake studies of the existing national road facilities, as well as demand and detailed engineering studies for an expanded system of national toll roads to be offered through a system of concessions. Using the existing toll network as a base for expansion, the engineering and very preliminary demand studies led the special committee to designate 12 prospective concessions, totaling 6,750 kilometers. Estimated cost for the total network of improvement and expansion is US$1.1 billion. Most of the proposed concessions incorporate segments of the existing toll road system. Each new proposal develops a plan for upgrades and expansion, and then grafts an additional new segment on to this base road. The result is a set of concessions for which prospective traffic volumes will vary enormously over the different road segments. This creates concessions that, by design, have induded cross-subsidies of low-density segments with high-density ones. The essential assumptions of this preliminary study included a traffic growth rate of 3 to 5 percent per year; periodic maintenance costs per kilometer every five years between US$10,400 and US$14,500, depending on the road; rehabilitation costs around US$100,000/kilometer and reconstruction costs of US$350,000/kilometer. Tolls would be set at US$2/100 kilometers and would automatically be adjusted for inflation and exchange rates. (The precise mechanism for dealing with the interaction of inflation and exchange rates remains to be settled.) These assumptions allowed an estimate of the net present value of toll revenues (net of operating and maintenance requirements). Subtracting the estimated netpresent value of net toll revenue from the estimated net present value of the investment (ex- duding land costs) yields the estimated new present value of each road project. Only 3 of the 11 projects have positive net present values at a 15 percent real discount rate in dollars. Those three proposed concessions incorporate sizable amounts of the existing toll network, and as such, face relatively low expenditures on land and improvements. Notably, even on the perimeter of Lima, high investment costs overwhelm higher traf- fic density. The preliminary studies indicated that low traffic volumes and large required in- vestments would not allow concessions to be let on the basis of financial payments to the government. The result was the development of a negative concession plan. Con- cessions would be bid on the basis of the lowest amount of investment the central government would make, and they would run 25 to 30 years, with subsequent trans- fer of the roads to the government. The government's contribution would not be con- sidered part of the equity in the concession. The government would delegate the re- sponsibility for the enforcement of the contract to a transport regulatory agency that would resolve disputes or pass them on to the judicial system. Antonio Estache, Manuel Romero, and John Strong 267 Contract Design from a Regulatory Viewpoint The concession agreement is the principal contract governing a private toll road project. One can design it in many ways. (See also Fishbein and Babbar 1996.) In some countries the government provides many of the details in the information sets provided to the bidders, and the bids are for specific proposals. In other countries the.government asks the bidders to make many of the suggestions to implement the road. What- ever the sequence, the following is a minimum list that the overall con- tract package needs to cover to allow the regulator to referee in cases of conflicts between users and the concessionaire or the government and the concessionaire: * A definition of the legal context. Toll road projects, whether wholly private or mixed in character, require a clear legal context defined by well-drafted laws and regulations regarding concessions. The policy framework should address the types of roads targeted for tolling, the types of organizational structures allowed, and which government entities are responsible for overseeing the program. Because many different forms of toll road development exist, the legislation may be general in character, enabling different types of private participation. Why should a regulator care? Because these laws must clearly identify the respective rights and obligations of the private and public sectors, which is a crucial element of the settle- ment of any dispute between the concession agency and the conces- sionaires. Also fundamental is that these rights and obligations are seen as valid, binding, and enforceable through a legal process that is fair, timely, and not overly costly. In addition, the regulator needs to be informed how the toll road program is integrated with na- tional, regional, and local transport policies and is enabled by a con- cession law. For a toll road program to be effective it must be coordi- nated with broader transport and road policies. The entire process should be designed to be competitive, transparent, and based on reasonable evaluation criteria. * The administrative background. As with any type of contract, the regu- lator must be able to refer to a set of definitions for all the key con- cepts the contract covers . This includes such items as the definition of the concession area, the zone of added services, maintenance, what constitutesforce majeure, what constitutes basic or special ser- vices, the key monetary and technical units, the standards to be used, and the key players involved in the sector. From a regulatory 268 Togl Roads viewpoint, of particular importance is the contract specification of those events that would constitute default on the part of each party, including remedies and the procedures for obtaining compensation. Finally, the administrative requirement may also have to provide a definition of what constitutes the basic documents that give all the required information to all parties involved. The minimum set in- cludes the explanation of the administrative, technical, and finan- cial requirements. Increasingly, countries are also including in this definition any ulterior clarification to be issued as a result of mis- takes potential bidders identify when reviewing the documents. Taken together, these documents provide the basis of the informa- tion to be used by the regulator. * Estimate of the costs of the project. The regulator needs to get an idea of the value of the task at stake. In some cases, this results in the unit costs and the maximum cost of the project as estimated by indepen- dent engineers, which the bidding documents should also specify to provide a benchmark. Often the government will have several independent studies that include both demand and cost studies. * The asset valuation rules. The government should be interested how the assets are evaluated for fiscal reasons as well as for regulatory reasons. Indeed, the value of business will be at the core of many regu- latory decisions involving the toll level or the duration of the contract. * The economic content of the technical documents. The technical docu- ments must cover at least a few items that the economic regulator needs to sort out the financial and economic consequences of the operator's actions, whether imposed by the bidding documents or proposed as part of the bid. The main aspects are the investment and maintenance plan and timetable and the toll system description (including technology and location). They should also cover infor- mation on weights allowed for each type of vehicle, which is rel- evant for the calculation of the maintenance costs and related toll levels. The documents should also clearly define the rules of the game for the evaluation of these technical bids to allow the regulator to settle any related dispute. * The various types of guarantees and warranties. This section frequently includes requirements regarding insurance, performance bonds, mini- mum equity contributions, and corporate structure. They may apply to all stages of the process (offer, construction, and operation) and generally cover specific amounts for the various stages and apply to both the concessionaire and the government. For the government, they Antonio Estache, Manuel Romero, and John Strong 269 may include commitments regarding approvals and right-of-way per- mits, expropriations, and so on. These sections provide one way of telling the regulator how much is at stake in the decisions regarding compliance with obligations on all parties to the contract. In principle, the guarantees should have an economic meaning in the sense that the amounts involved should somehow be related to the risks of non- compliance, but in practice, they are seldom related. They tend to be somewhat arbitrary amounts, negotiated to be large enough to in- duce private participation or financing. * The identification of the various types of risks and their distribution be- tween the parties. This section typically covers each party's specific responsibilities for funding, acquiring, and preparing the right-of- way, including risks of delay or cost overruns. It also includes re- sponsibilities for developing and constructing the project, including environmental compliance, permits, and designs. The agreement should address the risk borne by each party in the event of unplanned delays, cost overruns, and so on. In addition, the agreement should address the possibility that financing will not be raised. The con- tract also should specify any rights or responsibilities of the conces- sionaire to modify or expand the road in the future beyond the re- quirements of the initial concession. The agreement should specify the conditions under which profits or revenues are shared with the government. For example, if using a maximum traffic or revenue ceiling, the agreement should state the maximum traffic or revenue threshold for each year of the concession, the revenue sharing for- mula, and the procedure for calculating and transferring the pay- ment to the government. If using incentive provisions, the agree- ment should specify the events that would trigger the incentive pay- ment and the size and timing of such payments. * Concession rights and obligations. These should include an explicit defini- tion of the concessionaire's exclusive right to design, build, finance, and operate the project during the concession period, which will provide the regulator with basic benchmarks to assess compliance with com- mitments. The contract should include the service obligations (for ex- ample, farmers can use some portion of the road for free) and related compensations to which the operator is entitled, the conditions under which the concession may be extended or amended, any payments re- quired either by the concessionaire or by the govermment, and specifi- cations as to who holds the legal title and how any transfer will occur. The concession contract should define the responsibilities of each party 270 Toll Roads for operations, including toll collection, maintenance, enforcement and safety, auxiliary services, and administration. The contract also should make explicit (and ideally, formula-driven) any mechanisms the gov- ernment commits to support the project, including magnitude, timing of payments, duration of support, and conditions under which sup- port is phased out or withdrawn. It should address specific facilities such as connecting roads or interchanges that the government or con- cessionaire is committed to provide, including dates and remedies in cases of delays or nonperformance. This section also should define the recourse of the concessionaire should the government not honor its fi- nancial commitments under the agreement. * The penalty rules. In addition to relying on the threat of cashing in de- posits for guarantees, regulators need to have access to a clear set of fines that relate the penalty for noncompliance on more operational matters to the damage resulting from the noncompliance. Here, the practice seems to be to set predefined amounts for specific types of violations to minimize the arbitrariness of regulatory decisions. The concession contract for Road 5 from Santiago to Talca, Chile, identifies and defines 81 types of violations and specifies the amounts involved and the application criteria (such as every day, every time, and so forth). To the extent possible, and to make regu- lation easier, established performance standards should relate to the penalties for noncompliance. * Vie regulatory regime. The contract must specify the regulatory approach and enforcement mechanism. If using rate of return regulation, the agreement must specify the basis for the regulation, the maximum rate of return allowed, and the calculations required to monitor the concession performance. If using toll rate regulation, the agreement should specify the maximum toll by vehicle type, the index used to adjust toll rates, and the time period for toll rate adjustments. Some degree of creativity is allowed here. Peru, for instance, adjusts the stan- dard formula to include a premium for improvements in safety over the targets the contract spells out. The contract also should include the specific procedure for calculating and revising the toll schedule (specific pricing rules are discussed later). * The information the operator will be required to provide to the regulator. The contract should specify the type and timing of information to be pro- vided to the government to monitor the agreement. The contract should also specify the conditions under which the regulator can ask for addi- tional information not covered by the contract. Typically, the regulator Antonio Estache, Manuel Romero, and John Strong 271 will ask the operator to provide monthly data reports on hourly, daily, and monthly vehicle flows, classified by vehicle type, as well as monthly data reports on congestion, accidents, and changes in regular traffic patterns. In addition, quarterly reports on auxiliary services will pro- vide sufficient information on any related service obligation the con- tract imposes. Every six months, the regulator should expect reports on maintenance costs, actions taken, and total and unit costs, as well as a report on paving progress if the contract specifies this. * The acceptance conditions. The contract should specify the conditions under which the government will accept the completed facility and approve the start of operation. This is particularly important when tolling is scheduled to begin before the project is completed. In Bra- zil this approach provided a way to generate early revenue, while allowing the public to see the improved road before having to pay for it through tolls. * Limitations on competingfacilities. The contract should specify the corridor, if any, under which the government is restricted from constructing, expanding, or granting concessions for competing roads or other fa- cilities. As mentioned earlier, the existence of free parallel roads is a matter of concern for many operators, and regulators may have to arbitrate challenges by governments to operate almost parallel routes. * Rights to access third-party operated facilities. The contract should spell out any specific rights of the concessionaire to access land or roads owned by third-party activities as part of the concession, including how to pay for this access. In most conflicting events, the regulator will be called to assess the access pricing rule demanded by the owner of the facility to be shared. * Assignment and termination of the concession. The regulator also needs to have clear instructions on the terms and conditions un- der which the concession may be transferred to a party other than the original concessionaire, including the specific conditions un- der which the concessionaire or the government can cancel the concession and the consequences of termination, including pen- alties and replacement. * The renegotiation rule. Renegotiation happens. It is actually quite com- mon and the contracts should be clear and try to have preestablished rules to avoid the conflictive situations that were frequently observed in relation to infrastructure contacts in the early 1990s. More recent contracts carefully spell out these rules in Latin America. Chile's example, which box 6.5 discusses, may be the best so far. 272 Toll Roads Box 6.5. Rule-Based Renegotiations: Lessonsfrom Chile To provide flexibility without compromising the concessionaire's interests, the Chil- ean contracts include detailed procedures to constrain and financially assess govern- ment requests for additional work. The government can demand additional work for up to a maximum of 20 percent of the initial official cost estimate of the project, up to two years before the concession ends. During the construction stage, the government can only demand additional work for up to 5 percent of the official cost estimate, and new investment at that stage is valued according to a unitary pricing schedule con- tained in the tendering documents. Bidders implicitly accept these unitary costs when they participate in the franchising process. The Ministry of Public Works and the concessionaire must agree on the valuation of new investments required during the operational phase. If they do not agree, differ- ences must be settled based on technical reports that consultants from each party pro- duce. The compensation can be through increased tolls, increased duration of the con- cession, or direct payments by the state. To avoid conflicts, the most recent concessions place explicit restrictions on the com- pensation mechanism. For example, in the Rio Bueno-Puerto Montt concession, tariff increases during the life of the contract cannot exceed 25 percent, and the increase in concession duration cannot exceed 120 months. Furthermore, the contract includes an explicit formula to calculate the required compensation. This is given by N,S Y1-T, N.S Ct i=k (1 + r)1- + i (1 + r)k where Ik = additional investment in period k, N = initial duration of concession, S = extension of contract, and Y1 = additional income due to increase in tariffs, where I pP,Q,+G t=k+l,...,N ' l(1+p)PQ+G, t=N+1, ,N+S and P, = tolls prior to compensation, Q, = projected traffic levels for new investment at initial toll levels, p, = percentage increase in tolls,G, = direct payments by state, C1 = operational and maintenance costs associated with new investment, T, = taxes due on additional toll income, and r = discount rate. The additional operational and maintenance costs, the projected traffic levels, and the discount rate must be based on an expert's report. If disagreements arise over these parameters, the Conciliatory Conunission must convene. The tender documents are usually more explicit on how to estimate the discount rate, however, and they place an upper limit on the risk premium that the concessionaire can receive. To avoid imposing additional traffic risks on the concessionaire, a payment is made at the end of the concession to compensate for the difference between the projected traffic levels used in the above calculations and the real traffic level observed. This compensation is calculated as (box continues on following page) Contract design should be as specific as possible with respect to such ongoing adjustments as inflation, so that these risks are handled routinely. Project risks and uncertainty in the economic and financial environment, however, will inevitably create situations that Antonio Estache, Manuel Romero, and John Strong 273 Box 6.5 continued RN+Si= I (1 +-k (I + p)N where the "" symbol indicates the ex post real value observed of the variable. No compensation exists, however, for operational and maintenance costs that differ from the original estimates. Otherwise, the concessionaire would have an incentive to in- flate these costs in order to receive extra compensation at the end of the concession period. These costs are usually small in comparison to investments, however. Differ- ences between the expert's estimate used to calculate the compensation and the real ex post costs are unlikely to have a significant effect on the concession's profitability. Source: G6mez-Lobo and Hinojosa (2000). require contract renegotiation. The concession contract should specify the conditions that would allow renegotiation of the contract terms, the types of events that could trigger renegotiation, and the frequency with which reviews can occur. The contract also should specify what remedies are available to the regulator for restructuring, for example, whether concession length might be extended or an investment pro- gram might be modified. Too often one initiates contract renegotia- tion for a specific issue and then expands it to other issues. This ap- proach is prone to corruption and creates incentives for sponsors to seek contract revisions on a regular basis. - Dispute resolution. The agreement should explain the procedures for settling disputes in a fair and timely manner, including provisions for arbitration or mediation. Foreign concessionaires may request that such disputes be resolved in a neutral jurisdiction. Peru recognized this in its recent draft contracts, and it now always includes a clause explain- ing how disputes will be settled and when international arbitration will be used. In a nutshell, an expert (picked randomly if the parties cannot agree to one) will resolve technical conflicts locally, and an international arbitration commission will resolve nontechnical con- flicts over a certain amount. Below that amount, they are resolved locally. All local decisions are made within specific time limits. In Chile the main dispute settlement mechanism is the Conciliatory Com- mission. This commission has three members, one nominated by the con- cessionaire, one by the authorities, and one by mutual accord. Commis- sion members must be nominated at the beginning of the concession be- fore any controversies have arisen. The commission is established when 274 Toll Roads one of the parties raises a demand. In the case of the state, contracts stipu- late an explicit and limited set of circumstances in which it can raise a de- mand to the commission. The concessionaire has more flexibility in this respect. The commission's initial task is to conciliate the diverging posi- tions. If an agreement is not reached, the concessionaire, and only the con- cessionaire, has the choice of either taking the matter to the judicial system or requesting the establishment of an Arbitration Commission. The same members of the Conciliatory Commission form this last commission, and its decision is binding and not subject to appeal in the courts.' Toll Road Auctions and Award Criteria As in most infrastructure sectors, competition in the road sector is essen- tiallyfor the market. Because the toll franchise has a degree of exclusivity, the auction is a crucial element to help ensure that services are being pro- vided efficiently. Given the complexity of road infrastructure projects and the diversity of objectives that road agencies tend to have for their projects, coming up with an ideal bidding rule is often difficult for governments. Table 6.4 shows the diverse approaches that have been used. Many coun- tries have adopted a two-stage process in which they evaluate technical proposals separately from and prior to financial proposals. They then se- lect the winning bidder from those that pass the technical evaluation. While technical validation helps reduce the risk of project failure, it may also have important drawbacks. It often involves considerable discretion and judgment by the evaluation committee, which reduces the overall transpar- ency of the process. Experience also has shown that changing market condi- tions after the contract award may require operators to make significant changes to the project. These changes reduce the meaningfulness of the initial technical evaluations to the extent that they rely on the base forecasts. To remedy this, many governments are issuing a preliminary set of technical standards to be achieved, which is subject to discussion and modification with prospective bidders. This has been Chile's experience (Gomez-Lobo and Hinojosa 2000). Interaction often takes place with the regulator, which is desirable because the regulator will eventually be re- sponsible for monitoring compliance. After this consultation, the bidding package is finalized so that the parties bid on the same technical specifi- cations and requirements and the winner is picked from the financial pro- posal. This is wonderful from a regulator's viewpoint, because if enough 11. For more details on Chile see Gomez-Lobo and Hinojosa (2000). Antonio Estache, Manuel Romero, and John Strong 275 Table 6.4. Award Criteria in Selected Latin American Toll Road Concessions Country Award criteria Concession duration Argentina-road corridors Highest lease fee paid to Fixed by government but government extended after renegotiation Argentina-urban access Lowest toll Fixed by government but extended after renegotiation Brazil-Federal Lowest toll Fixed by government Brazil-Sao Paulo Highest lease fee paid to Fixed by government government Brazil-Parana Largest network length Fixed (but likely to be extended as a result of politically imposed cut in toll) Chile-1Pt generation Multiple criteria Fixed by government Chile-2nd generation Least net present value Unknown Colombia-1t generation Multiple criteria Fixed by government Colombia-2nd generation Least cost to government Fixed by government Mexico Shortest term Fixed by bid Peru Shortest term Fixed by bid Peru Least subsidy Fixed by government Uruguay Shortest term Fixed by bid Sources: Irigoyen (1999); various World Bank internal reports. potential bidders participate in the discussion and the various bidders do not collude, the process converges toward what could be referred to as consensus engineering cost. The regulator now has some idea of what best practice investment, maintenance, and operation costs should be for a specific road. This is not the end of it. Many different options still exist for structuring financial proposals for road concessions. Some of the more common in- clude (a) the lowest toll level, (b) the shortest duration of the concession, (c) the highest payment to the government for existing infrastructure, and (d) the lowest subsidy that the government requires. Less common options include the lowest income guarantee that the government requests and the amount of new investment or its speed, as well as some innovative ideas discussed later. As regulators learn about past mistakes, the way that toll roads are being auctioned evolves. THE INITIAL EXPERIENCES WITH COMPETITION FOR THE TOLL ROADS MARKET. The earliest road concessions (such as the first generation of Argentine 276 Toll Roads and Chilean toll roads) were trying to be everything to everyone and were awarded following complex, weighted, multiple criteria picked from the list just described. This was a source of opaque and often subjective, if not corrupt, decisionmaking. Next, when governments started to see that simpler is better and decided to focus on a single criterion, bidding tended to be based either on the minimum toll (as in the second generation of Argentine toll roads) or, if the toll was specified, the shortest duration for the franchise (as in the initial Mexican toll road program). Both these ap- proaches presented significant incentive problems. Bidding on the basis of the minimum toll may result in poor price signals in congested corri- dors. If one sets tolls exclusively to cover investment, maintenance, and operating costs, then high tolls result when low traffic volumes are ex- pected and low tolls result in high traffic and congested conditions. Similarly, bidding based on the shortest concession period also has prob- lems, especially if tolls are not specified. In Mexico, where projects were ten- dered based on the shortest concession duration that firms offered for a given traffic flow, shorter concession durations necessitated the setting of higher tolls in order to finance the projects. The resulting high tolls produced im- portant traffic diversions and many complaints to regulators from users with a limited ability to pay. Mexico's requiring alternative freeways for each con- cession did not help. The ultimate outcome was a financial situation so cata- strophic that it required a subsequent government bailout for many roads. Bidding on the basis of investment commitments has been used to de- velop road networks, but this also has had problems that often result in operator demands for renegotiation. By locking in future investment lev- els, the concessionaire is prevented from adjusting investment to meet changing market conditions. Second, it may encourage overoptimism and excessive investment (see box 6.6). THE NEW, IMPROVED CoMPETmoN FOR THE TOLL ROADS MARKET. In the wake of the bailouts, new schemes have been developed to improve incentives and reduce the risks of road concessions. In Peru bidding has taken place in terms of the minimum amount of required government investment in each concession. This serves to buy down the size of the project and reduce the financial risk exposure of the concessionaire. In the United Kingdom, the design-build-finance-operate scheme establishes the government pay- ment of shadow tolls based on traffic volumes. This provides a long-term mechanism for government support that phases out as traffic volume grows. Chile has developed perhaps the most innovative road concession pro- grams-although it is facing its fair share of problems with many of the contracts being renegotiated in 1999-2000. As a reaction to the low bidding Antonio Estache, Manuel Romero, and John Strong 277 Box 6.6. Why Were Consortia Initially So Optimistic About Road Projects? Regulators also need to understand the motivation behind the optimism, because in many cases the outcome of excessive optimism is renegotiation. Indeed, many of the earlier road concessions have experienced problems. Concessionaires have been ei- ther overly optimistic or overly aggressive in bidding, leading to a host of restructur- ing and renegotiations. Firms pursue this strategy for several reasons, namely: * A "first mover" advantage to grab exists when several projects are going to be concessioned. By winning the first bid, firms signal their low cost or aggressive behavior to other bidders, with the goal of discouraging future competition. * Because construction firms are often the key consortium partner, construction contracts rather than the subsequent operation of the concession are the domi- nant interest, and bidding below cost secures the construction contracts, with disregard to the long-term financial viability of the concession, which will be the problem of the other consortium members or the creditors. * Firms may bid low just to win the franchise with the sincere intention of renego- tiating the contract as soon as possible. Few governments have refused to rene- gotiate. Indeed, if the concession runs into financial problems in the future, asso- ciated political problems occur as well as costs and delays in retendering the project. Therefore, bidding low and renegotiating afterward may be a viable strat- egy for a potential concessionaire (a phenomenon called "lowballing"). * Finally, one cannot rule out optimization mistakes on the part of bidders, possi- bly related to poor assessment of demand uncertainty ("winner's curse"), or the complexity of tendering mechanisms. Source: Based on Gomez-Lobo and Hinojosa (2000). problem, Chile tendered its Route 5 Temuco-Rio Bueno concession on the basis of a minimum toll, within a band set by the government. The floor of the band is set sufficiently high to guarantee a minimum revenue stream to the concessionaire. In addition, the bidding documents fix the contract du- ration. Setting this minimum toll level and the contract duration effectively puts a floor on the concession company's expected earnings. Therefore, the risk of future financial distress for the concession firm (which would force the government to renegotiate the contract) is minimized-although not eliminated, as seen in recent developments. If two or more firms bid the minimum value, the winner is the one that offers the highest transfer directly to the government.12 12. Because this transfer does not affect the concession firm's income or capital structure, sponsors can bid as much as they like without jeopardizing the concession's financial stability. If investors make a mistake and bid too much, the consequent loss will show up in the financial returns of the sponsor, not the conces- sion company. For more details see Gomez-Lobo and Hinojosa (2000). 278 Toll Roads In effect, this bidding mechanism significantly reduces the chance of renegotiation, but it does not lower the competitive pressure of the pro- cess.'3 If the concession firm is in good shape and no risks of disruption to its activities exist because of financial distress, governments should be bet- ter equipped to resist renegotiation pressures. This transfer mechanism from sponsors has served to generate close to US$150 million in the four conces- sions where it has been used. The proceeds are deposited in an infrastruc- ture fund that is then used to cross-subsidize other projects or pay for mini- mum income guarantees. THE NEWEST FoRMs oF COMPETITION FOR THE MARKET. Chile also has pio- neered, at least academically, another bidding approach that holds some promise for dealing with the fixed-term nature of traditional franchising contracts and that Colombia and Mexico are considering for both roads and airport runways.'4 The bidding variable, instead of toil levels or an- other conventional variable, is the present value of revenue throughout the life of the concession that firms are willing to accept to undertake the project. The firm that bids the lowest present value of revenue wins. The duration of the concession is then flexible and depends on the effective traffic levels encountered. Once the concessionaire has received (in present value terms) the amount that it bid, the concession ends and the infrastruc- ture reverts to public ownership. If real traffic levels are lower than ex- pected, the concession duration is extended automatically, while if traffic is higher than expected, the opposite occurs. Therefore, income uncertainty due to traffic variations is largely eliminated for the concessionaire. In addition, the LPVR auction reduces potential conflicts related to the early termination of a concession. In a 10- to 30-year contract, excessive traf- fic growth or other events may occur that require added investments. Can- celing the original contract and retendering the concession with the extended projects would be optimal, rather than negotiating the additional invest- ments with the existing concessionaire. This seldom happens, because it 13. Engel, Fisher, and Galetovic (1997a,b) in several of their articles point out that the lowest present value of revenue (LPVR) auction may also reduce the occur- rence of lowballing. Their argument rests on the assumption that the winning firm's LPVR bid offers the government a credible threat to terminate the concession quickly and compensate the firm if it tries to renegotiate. This is discussed later, in relation to the LPVR auction mechanism. 14. The United Kingdom was the first country to apply a variable-length con- cession with an LPVR flavor in the Severn, Trent, and Dartford bridge concessions. Antonio Estache, Manuel Romero, and John Strong 279 would require a difficult estimation of compensation for the forgone future income stream owed for an early contract termination. The LPVR auction reduces this problem substantially by giving the concessionaire the differ- ence between what it originally bid and what it has already earned. From a regulator's viewpoint, another important characteristic of the LPVR mecha- nism is that tolls can be adjusted without having to negotiate new terms with the concessionaire. If tolls are deemed too high or low, the authorities could change them without affecting the concessionaire's expected income stream and without engaging in a potentially protracted negotiation pro- cess. As stressed in Engel, Fischer, and Galetovic (1997a,b), this flexibility may be important in urban road concessions in which determining the op- timal tariff ex ante is difficult, especially during congestion periods. The LPVR mechanism also has its drawbacks. It may lower the incen- tive of concessionaires to make demand-enhancing investments such as quality improvements. The increase in demand from these expenditures results in an earlier termination of the contract, with little benefit to the concessionaire."5 Perhaps a more important difficulty is that the LPVR auc- tion does not resolve possible cash flow problems that a concessionaire may face when traffic levels drop. Another limitation occurs in cases in which operation and maintenance costs are relatively high compared with construction costs. A low-traffic situation then puts the concessionaire in trouble, because the extension of the contract generates increasingly high maintenance costs that eventually may make the project unsustainable. Hence, although the risk of demand is reduced under LPVR, it is not completely eliminated. Bidders still have to estimate the future level of traffic to compute their required revenue. A possible way to refine the LPVR mechanism is to require bidders to pro- vide separate offers for construction and average annual operating costs. (For more details on this refinement, see De Rus and Nombela 1999.) Price Regulation One of the main reasons why toll projects fail is that privatization teams have a hard time assessing demand prospects. In turn, one of the main rea- sons why demand prospects are hard to assess is that traffic levels often 15. Early termination of the contract would save the concessionaire the addi- tional maintenance and operation costs that would have been incurred during the original period, but these are usually small. 280 Toll Roads depend on what economists call the elasticity of demand with respect to price-in other words, how sensitive demand is to changes in prices. In prac- tice, this matters a lot, particularly in developing countries where the ability to pay is often limited and regulators are sometimes expected to make rec- ommendations based on the social impact of pricing decisions. This explains why so many differences in toll design and toll levels can be found across countries. In principle, they have to reflect costs, but the specific costs to be covered can vary (construction/rehabilitation, operations, maintenance, en- vironmental, safety, and congestion costs). In general, the toll calculation re- flects the first three types of costs, and the last two are beginning to be incor- porated. Environmental costs have tended to be included only to the extent that they entitle the operator to specific recoverable expenditures. Table 6.5 shows that in general, countries tend to fix the toll levels needed to recover investment, operation, and maintenance costs. It shows that the price cap is now a common form of regulation in the sector, just as in many of the others. The last column suggests that in many cases, governments end up restructuring the toll levels at some point (ointly with subsidies to the toll operators or the extension of a contract term). These contractual changes are such that price caps are transformed into rate of return regula- tion, because the main purpose of the adjustment is to shift part of the risk imposed on the operator through a price cap back to the users (through longer contracts) or to the government (through subsidies). Table 6.5. Toll Design and Levels in Selected Latin American Toll Road Concessions Per k1n car rates (in U.S. Restructuring Country Toll design cents) needed Argentina-road corridors Fixed 1.56 Yes Argentina-urban access Capped 3.5 Yes Brazil-Federal Capped 2.3-5 Yes Chile-1" generation Capped 2-3 No Colombia-1t generation Fixed 3-4 No Mexico-public toll roads Fixed 2-11 Yes Mexico-private toll roads Fixed 13-50 Yes Uruguay Fixed 3.5 Yes Venezuela Fixed 1 No Sources: Irigoyen (1999); and various World Bank internal reports. Antonio Estache, Manuel Romero, and John Strong 281 One of the main concerns that road operators have to address and regulators have to understand is the uncertainty about introducing di- rect pricing in the sector. In defining price regulation, the following chal- lenges must be tackled: * Question 1: How much should the operator recover through the toll sys- tem? More specifically, what is the level investment the operator should be allowed to recover, given current and forecasted traffic levels? Unfortunately, this investment is a moving target, because roads tend to alternate between excess capacity at off-peak times and congestion and capacity shortfalls at peak times. This problem also arises in a longer-term sense. Indeed, because building road capacity takes time, what appears to be excess capacity today may meet demand in five years' time. Also, it makes sense, to minimize costs over time, for an operator and a government to take some bets (for example, a four-lane bridge may only cost 50 to 60 per- cent more than a two-lane bridge). This also is, of course, often a political challenge that a regulator has to justify, because opposi- tion to tolls is sometimes based on the excess capacity observed at the beginning. One solution for minimizing the perception of over- charging is to allow the operator to look for alternative sources of financing from subconcessions such as gas stations, restaurants, playgrounds, or advertising, but these seldom yield much more than 5 to 10 percent of the revenue needed. * Question 2: Should tolls be fixed or should they vary greatly during the lifetimeof the investment?6 This is a complex regulatory questionwith multiple dimensions and viewpoints. - The economist's answer will be that when a facility first opens, the optimal price will be close to zero, or at least very low, be- cause it only needs to cover operation and maintenance. The road, which was sized for future traffic growth, will be uncongested in the early years and hence have a negligible marginal cost. Later, as traffic builds up, congestion and the optimal road price will grow as well. But when traffic reaches the maximum and new road capacity is added, the optimal price will again fall sharply. 16. Economists refer to this problem as the difference between short-run and long-run marginal costs. 282 Toll Roads - The typical politician's answer will be to keep the toll stable. The vast majority of fixed tolls identified throughout Latin America, as seen in table 6.5, reflect the domination of this position around the world. The consequence of fixed tolls is that road operators tend to overcharge in the early years and undercharge later.17 - The economic problem is, in practice, under control, because many contracts now have toll escalation clauses (generally sub- ject to regulatory approval, but in some cases automatic) that are related to a local consumer or construction price index, in- creasingly calculated in dollars, to offset the potential effects of a devaluation. - In addition, one increasingly recognizes that the option to price congestion is a good one, and this eases the possibility of future toll increases. In many countries, peak and off-peak tolls are already different. In the longer run, a larger share of the day will end up being considered peak time and hence ease the recov- ery of revenue needed to cover higher maintenance costs resulting from higher traffic. Once more, the ideal arrangement for a regula- tor is to ensure compliance with formula-driven adjustments. - The answer to this question depends largely on the amortization rules the road operator is allowed. If, for whatever fiscal reason, the operator can follow a fast-track amortization for investment in a road, the toll will be high at the beginning and lower once the road is amortized fiscally, because the only expenses left to recover are operation and maintenance. The regulator in this sector is respon- sible for monitoring and possibly defining these amortization rules, as in most of the other sectors. Without clear rules, using loose am- ortization rules is one of the instruments for operators to argue for toUl increases to strategically distribute costs over time. Question 3: Should the regulator require tolls to be differentiated across users? One can consider several dimensions to differentiation. - The different road damages that different vehicles impose. This arises because automobiles and trucks impose different requirements on roads (see box 6.7 for a technical explanation), which is why 17. Debt service requirements concentrated in the middle years of a facility's life make this pricing problem worse. Such financing burdens are even greater for developing countries with limited access to long-term capital markets. Antonio Estache, Manuel Romero, and John Strong 283 Box 6.7. A Brief Lesson in Engineeringfor the Price Regulator Costs, and hence toll differentiation, should be driven by the demands that different vehicles place on the shared road. One can divide highway costs into two types: the basic capacity to carry traffic and pavement durability and smoothness. Civil engi- neers measure the demands that different vehicle types place on capacity relative to that of a standard passenger car (known as PCEs, or passenger car equivalent units). The number of PCEs of capacity needed by a heavy truck varies according to terrain and other factors. For example, on a level road, a truck may only represent the equiva- lent of 1.2 cars, while on a moderate-grade road, the lower horsepower-to-weight ra- tio of trucks mnight make them the equivalent of 4 passenger cars. The number of lanes, lane width, grades, curves, and other factors determine the traffic-carrying capacity of a road. Pavement durability is determined by the type of pavement, its thickness, and the stresses to which it has been subject since construction. Road damage is a function not of the size of the vehicle but of the weight being borne on the axles of a vehicle. Road engineers measure the demands that different vehicle types place on roads in terms of the damage caused by the passage of a refer- ence axle weighing 18,000 pounds, approximately the weight on axles of many heavy trucks. This is known as an equivalent standard axle load, or ESAL. Pavement dam- age increases at the third or fourth power of axle weight, so that the 1,000-pound axle loading on a typical car produces only about 1/10,000 the pavement damage of a typical heavy truck axle. This nonlinear damage impact is offset to some degree by the fact that the number of ESALs that a road can withstand before it needs to be resur- faced or rebuilt is a power function of pavement thickness. For example, a pavement that is 11 inches thick is about twice as durable as one that is 9 inches thick, yet it costs only a fraction more to build. These can be major issues from a private operator's viewpoint, because car vol- umes dominate carrying capacity metrics and truck characteristics and volumes are key to pavement durability aspects. In essence, cars tend to be responsible for the number of lanes, while trucks are responsible for how thick each lane should be. In economic terms, road charges should have two components: one for pavement dam- age, based on ESALs; and one for congestion, based on PCEs. In practice, though, road pricing tends to use total weight rather than axle loadings for trucks, and attempts at congestion pricing based on PCEs are only beginning (such as in California, Singapore, and the United Kingdom). most concession contracts allow at least some degree of differen- tiation between cars and trucks and buses. In practice, unit tolls will vary according to the number of axles on the vehicle as an approximation for the wear and tear each vehicle imposes on the road's pavement. In general, trucks and buses are charged two to four times the level of automobile tolls, with the precise amounts varying depending on size, weight, traffic mix, and de- velopment objectives. - The political viability of differentiating tariffs across regions of a same country. Many governments impose the same tolls/kilometer across 284 Toll Roads a country, because some politicians find it difficult explaining that interregional toll differences can be justified by differences in con- struction and maintenance costs. As explained earlier, this means that explicit subsidies may sometimes be required or that cross- subsidies need to be tolerated for some operators, but this also means that regulators must have access to sufficiently detailed cost data to ensure that there is no abuse and that users are not over- charged. - Social pricing. In many poor countries around the world, the main inter-urban roads are likely to be important infrastructures for rural users who need to take their products to urban centers. This represents serious social concerns, as well as strong inter- est groups with political clout. This may be why governments commonly impose a special treatment of some user groups and have their use of the roads financed through some type of shadow toll or subsidy/voucher. Peru is considering this solu- tion, for instance, to address farmers' protests against the toll- ing of some highways. Similarly, for urban access roads, allow- ing lower tolls for public transportation users makes sense, be- cause often these are likely to include the poor. In addition, us- ing buses reduces congestion and pollution. * Question 4: How high can a toll really be? A limit exists, of course. A user's willingness to pay tolls is a function of income, the value as- signed to time savings, reductions in vehicle operating costs, and the cost and quality of competing alternatives. On average, toll rates have ranged from US$0.01 to US$0.10/kilometer/car. Some conges- tion-related tolls in Europe and the United States run between US$0.15 and US$0.20/kilometer/car, while some bridge and tunnel tolls may range up to US$0.50 /kilometer. Special situations also can be found in which toll levels are far above these averages (the result of high costs and legal requirements for inflation adjustments). In Mexico, tolls have risen to more than US$0.60 /kilometer in a couple of cases. This experience clearly shows that a ceiling exists to the willingness to pay, because in these cases, traffic volumes have tended to be low relative to capacity These concessions frequently have encountered severe financial problems, and congestion on al- ternative roads has not really been alleviated. Eventually, regulators have been forced to accept renegotiation. Antonio Estache, Manuel Romero, and John Strong 285 Question 5: How muchfreedom should the operator be allowed to differen- tiate its toll structure? As long as the operator stays within the al- lowed rate of return or overall price cap, and as long as no competi- tion exists (such as predatory pricing aimed at capturing business from a competing mode on a specific road), the regulator has no reason to interfere with a tariff structure design aimed at making the most of user willingness to pay or at expanding the regular cus- tomer base. An operator can design its tariff structure in many ways to achieve these goals and maximize profits: - Variation by time of day: This is commonly allowed. - Congestion pricing: This is becoming increasingly popular. - High-speed lanes: The idea of allowing the price of one lane to change with the degree of congestion to service users in a rush allows the operator to make the most of differences in the vari- ous users' value of time. - Discountsfor loyal customers: Tolling technology is now allowing the recognition of a frequent user basis among commuters; and to promote the growth of these clients, some companies are pro- posing special discounts to well-targeted groups, including local residents or car pool commuters. In Argentina, for instance, the users of an electronic toll get a discount on some segments. Their prices vary from US$0.80 to US$1.10, compared with the normal toll of US$1.40 to US$1.50. Quality Regulation For concession performance, an economic regulator must be concerned with three main quality issues: the technical quality of the road, compliance with contractual obligations, and safety and environmental issues. The Technical Quality of Roads One needs to consider road quality issues at the outset of concession design and technical specification. Technical matters such as pavement materials, thickness, and construction techniques must be specified from the begin- ning, because these aspects will help determine the facility's performance and future maintenance and investment needs. An inventory of the initial state of assets is a minimum requirement for effective economic regulation. 286 Toll Roads Asset quality indicators include pavement roughness and deterioration, con- dition of lighting, markings, signaling, quality of fire and rescue equipment, condition of maintenance, and weather-related equipment (such as snow- plows). The monitoring, inspection, and certification of the initial construc- tion and investment is essential and should include all related investments such as signage, pavement markings, toll collection facilities, fire and rescue services, and access points. It also may extend to ancillary and support facili- ties such as service stations and restaurant plazas. Once the toll road is in operation, quality aspects shift to ensuring that the assets are maintained, that performance standards are achieved, and that additional investments are made when performance triggers are reached. Performance standards, which should be established in the origi- nal concession agreement, should include asset quality, operating condi- tions, safety indicators, and emergency readiness. The regulatory authority should be prepared to audit records and in- spect equipment on a regular basis. It also needs to ensure that the conces- sionaire has reserved sufficient funds for maintenance and repair of the assets. This is particularly problematic in the later years of the contract, when incentives to maintain equipment and facilities are lower. Also, if subcontractors provide any of these services, the regulatory authority should be able to monitor the contract terms and the financial capability of all parties to the contract. In practice, what regulators generally do in an increasing number of coun- tries is to match performance against the established parameters and quality standards set in the World Bank Highway Management Program. This is ef- fective enough to identify performance outliers for most technical variables. Operating Quality of Road Services While quality service requires asset maintenance, the regulator should not forget that the goal is to provide transport services worth paying for. The operating performance of the system is central to public support and to determine at what point additional investment may be required. The concession contract should establish performance standards that cover the following: * Lane availability and shutdowns * Traffic volumes and average speeds, both peak and off-peak * Toll queue performance: waiting times and availability * Capacity, speed, and visibility during inclement weather * Access conditions and bottlenecks Antonio Estache, Manuel Romero, and John Strong 287 * Activity levels at service plazas * Response times and service aspects of emergency vehicles. The concessionaire should be required to provide data on these per- formance aspects on a regular basis (monthly or quarterly), subject to review and audit. If actual performance is below the standard, the con- tract should specify the nature and type of sanctions to be imposed or the nature and timing of investments to be undertaken in response. This can be tricky in practice. For example, not meeting a performance standard concerning the length and time in toll queues could be the result of traffic growth (requiring new investment) or poor maintenance of collection equipment (requiring improved performance by the concessionaire). This issue is particularly important when new investment requires revisions to the concession contract. Safety Aspects Safety regulation takes a number of different forms. First, the facility it- self must be designed to handle the anticipated traffic volume and mix under a variety of operating conditions. These dimensions include such technical factors as capacity, speed, grades, roughness, signaling, light- ing, and emergency services. Safety is not only a function of the physical characteristics of the road, however, but also the quality and operation of the vehicles using the road. In particular, speeding, unsafe driving practices, and poor vehicle inspec- tion practices can lead to accidents. Most road concessions, however, rely on existing police and motor vehicle registration/inspection services pro- vided by the government, usually on a reimbursement basis. Here again, performance standards can help evaluate whether safety problems are the result of the facility or are from traffic enforcement shortcomings. For ex- ample, if average speeds are above the statutory limit, this may indicate reduced or ineffective enforcement. Another aspect of safety involves vehide standards, especially truck size and weight requirements. Because revenues from trucking activity are critical to toll road viability, how trucking regulation is handled is impor- tant. In some cases, concessionaires operate truck inspection and weighing stations; in other cases, public authorities handle them on a reimburse- ment basis. Problems have arisen when stricter enforcement of weight regu- lations (overloading) has led truckers to avoid toll roads. If enforcement is relaxed, however, this leads to a much faster rate of pavement deteriora- tion and, in many cases, higher accident frequency and severity. 288 Toll Roads Overall, safety aspects of toll roads should be built in to design and operating standards. In practice, though, the nature of traffic and ve- hicle enforcement in the country will shape accident rates and safety performance. Because of this, countries should consider toll road initia- tives as providing an opportunity to improve public safety throughout the road network. Environmental Aspects Environmental issues first emerge in contract design during siting and plan- ning decisions and must take into account geography, construction tech- niques, and the facility's operating practices. Initially, mitigation measures could include adapting designs with respect to alignments, materials used, and standards for construction. During construction, the concession should specify particular investments required to improve environmental aspects, including noise barriers, retention ponds, and other remedial measures, as well as relocation and resettlement issues, if they arise. During both con- struction and operation, the regulatory authority should ensure compli- ance with environmental laws, including such aspects as use of salt and chemicals, runoff, and recycling of pavement materials. In practice, the environmental agency rather than the road authority often controls this aspect, although the two institutions have obvious interactions. Working with User Feedback In addition to monitoring assets and performance, road concessions should have a mechanism for public participation and feedback. This can be handled through a regular system of surveys as well as through the designation of a user group that can provide information on the qualita- tive aspects of the concession. Because toll roads tend to be highly vis- ible, and in many cases controversial, designing mechanisms for public input is important for evaluating performance, to extend public knowl- edge of the project, and to build public support. This has to be handled with some care, however. In Brazil, for instance, each concession is required to survey customer satisfaction every six months or so. Overall, user satisfaction with the toll roads has been quite positive, although it is deteriorating. The problem is that these results are biased because users have already demonstrated their belief in the value of the toll road by using it and continuing to use it increasingly, despite what appears to be a worsening of satisfaction. Indeed, users who were extremely Antonio Estache, Manuel Romero, and John Strong 289 satisfied with the immediate improvements in quality in the first year of road operation quickly forgot about the initial conditions of the road and started to focus on their unhappiness at having to pay for a (bad) road that used to be free. People are noticing improvements, but they are also being managed by customer service improvements, which have nothing to do with road services. Special events for children, presents for drivers, and similar campaigns just before the surveys can be effective in managing the emotions of the toll road users at the right time. Performance Indicators and Information Requirements We now have the new economics of private road concessions. We have learned about the extent to which road concessions are vulnerable to mac- roeconomic conditions, exchange rate shocks, and income growth. Demand has proven sensitive to toll levels, income, gross domestic product, and trade activity. These sensitivities, along with incentives to "buy in the deal and then figure out how to make it work" on the part of sponsors and creditors, have meant that many private toll roads have required public financial support. The challenge is to design new structures that take into account the reality of public-private linkages and a more activist role for the public sector in monitoring and regulating concessions. Regulators will not be able to work on such a structure unless they have enough information. Once more, the contract has a key role to play in this context. Road concession contracts should contain an annex that specifies specific reporting requirements (including clear definitions) for the con- cessionaire, the frequency of the reporting requirements, and their format to facilitate comparisons across projects. This information is required not only to monitor contract compliance, but also to identify when additional investments are needed and to help resolve disputes. Too often, public authorities have placed great emphasis on technical specifications and sponsor prequalification in contract design, but pay less attention to making sure they have good, timely information about the performance of the concession and the sponsor. However, even in situations in which technical and operating information is consistently supplied, governments have been faced with problems emerging from heavily leveraged projects or from weak sponsor balance sheets. In prin- ciple, nonrecourse project financing of toll roads should place primary emphasis on the economics of the project itself. The need for more equity capital in toll road projects means that profits from construction activi- ties are not enough, so that both project cash flows and the sponsor's 290 Toll Roads financial condition must be stronger than in the past. The 1990s saw a large number of construction company bankruptcies, however, so sound projects may be at risk because of weak sponsors. This could occur through a lack of investments being made due to a shortage of funds, to losses on other projects reducing the sponsor's equity capital, or to financial risks from exchange rate or refinancing. Thus, regulatory authorities need a range of technical, operational, and financial information not only about the project, but about the project par- ticipants themselves. This information is not intended to be used to micromanage the concession, but rather to serve as an early warning system to reduce the likelihood and costs of restructuring and bailout. Such infor- mation should include the data shown in table 6.6. The project operational indicators are intended to monitor the physi- cal aspects of the project, from pavement and equipment conditions to performance in terms of facility availability, safety, and technical efficiency. The revenue indicators are intended to monitor the performance of the contract, and they are especially important when the government is pro- viding revenue or traffic guarantees. Reporting of revenues across time periods and by user groups is needed to understand the structure of de- mand and to monitor sponsor efforts to raise revenues through discount- ing and so forth. Revenues from ancillary services are needed to under- stand the basis for rate of return or price cap regulation and to under- stand the interaction between direct toll and ancillary revenues. Cost data are needed to make sure that services are being provided at the lowest cost and to monitor costs to be included in regulatory calculations. Because many road concessions are designed to bring new investment, information is needed about ongoing investment activity compared to contract requirement and budget plans. This investment information should be compared with traffic volumes to validate prior forecasts and to determine whether these programs should be delayed or accelerated. Project financial indicators are intended to monitor the liquidity, sol- vency, and profitability of the concession. These indicators are similar to those contained in covenants that creditors impose and are needed for rate of return or price cap regulation. Regulators have tended to underappreciate the importance of detailed information about the quality and value of assets. First, the quality of as- sets is central to the performance of the road. Second, the long-lived nature of road infrastructure means that deferring maintenance is relatively easy in the short run to boost returns, allowing road and equipment to deterio- rate and accelerate major overhaul requirements. Third, the treatment of Antonio Estache, Manuel Romero, and John Strong 291 Table 6.6. Reporting Requirementsfor Road Concessions Concession Lane availability operating Average speed by time of day performance Toll station availability Toll station queueing time by time of day Accident and safety indicators Availability of emergency equipment Engineering quality indicators (roughness, signage, lighting) Revenue Traffic volume by vehicle class indicators Traffic volume by time of day (peak/off-peak) Revenue collected by vehicle class Revenue collected by time of day (peak/off-peak) Revenue generated by ancillary services Revenue from enforcement levies Revenue and volumes from different discount programs (commuter, high frequency) Cost indicators Operating expenses by activity: Toll collection Road maintenance Road operations Emergency services Cost of special services for particular users (for example, truck weigh stations) Investment Investment spending vs. budget (including variance indicators analysis) Physical investment (for example, lane-km resurfaced) Project financial Profit as percent revenues indicators Working capital Debt service coverage Debt service projections Debt-equity ratio Debt-assets ratio Return on assets Retum on equity Assets by class Road infrastructure (gross and net Equipment of both tax and Ancillary services regulatory Maintenance and renewal program amortization) Sponsor financial Income statement, balance sheet and cash flow statements information (audited) Working capital Debt service schedule and currency structures Source: Authors. 292 Toll Roads asset depreciation and amortization is important in determining the base from which rates of return are computed. In general, tax policies typically allow the write-off of road infrastructure on an accelerated basis or with a shorter tax life than economic life. This disparity means that after the facil- ity is depreciated for tax purposes, incentive is reduced to maintain the asset. Moreover, if regulatory accounting for the concession uses a longer amortization period than tax accounting, the higher regulatory net asset values at any point in time will lead to higher tolls to provide a specified rate of return on assets. The sponsor thus receives higher returns in the early years from tax depreciation, then higher returns from the regulatory accounting that includes asset valuations already written off for tax pur- poses. Thus governments need either to harmonize regulatory and tax treat- ment of assets or to make sure that regulatory rate of return calculations take into account tax benefits from accelerated depreciation. Finally, ongoing financial reporting is needed by the sponsors them- selves, beyond the specific project. The government should require spon- sors to provide audited financial statements to ensure that the prequalification status is maintained throughout the life of the concession. Debt servicing schedules and working capital positions should supplement standard financial statements. These data will help ensure that the specific project is not put at risk by financial troubles of the parent, a twist on the traditional concerns of nonrecourse financing. Conclusions: Recent Innovations and Emerging Issues We know a lot more about the challenges involved in getting highways and urban access roads tolled than we did at the beginning of the 1990s. 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Index (Page numbers in italics indicate material infigures, tables, or boxes.) Access charges, 39 Airport financial performance indicators, 105 Aircraft noise, 61, 62, 89 Airport industry, mixed regulatory systems Aircraft pollutant emissions, 61 in, 92 Airport activities and services. See Airport Airport input, 103-104 services Airport investment, 80-81 Airport asset values, 104 Airport investment obligations, 99-101 Airportbuild-operate-transfer (BOT) schemes, Airport joint ventures, 70 71-73 Airport lease-develop-operate scheme, 73 Airport build-own-operate-transfer schemes, Airport level of service, 107 72-73 Airport capacity constraints, 57-60 Airport management contracts, 70-71 Airportcapitalinput, 104 Airport market efficiency with full divesti- Airport capital input, 104 ture, 78 Airport charges at selected airports, 81 Airport output, 103 Airport compensatory agreements, 69 Airport ownership, 67-68; build-operate- Airport concession contracts, 71 transfer schemes and, 71-73; jointventures Airport congestion, 61, 87-88 and, 70; partial/majority divestitures and, 70; public ownership and operation and, Airport costs, 60-61, 87-91 68-69; public ownership and private op- eration and, 69-75; regional ownership and Airport demand, operation, 69; private ownership and op- Airport divestitures, 70 eration, 73; in selected countries, 74-75 Airport economic efficiency indicators, 105, Airport ownership and market structure in 106 some European countries, 76-77 Airport efficiency evaluation, 101-102 Airport ownership structures in selected Airport environmental concerns, 61-62,89,99 countries, 74-75 Airport externaities, noise and poUtion as, Airport performance indicators, 101-102, 61n2, 89 102-104, 104-105,106, 107-110 307 308 Index Airport price regulation, 78,80; quality of ser- Assessment of technical quality, 20 vice and, 89-90, 101 Asset base rate in rate of return regulation, Airport pricing systems and policies, 65, 80; 203 traditional, 80-82; in the United Kingdom, Asset ownership and valuation, 17-18,29-30, 8387 104 Airport privatization: in Latin America, 79; management efficiency improvement in tASe to propergly maintaie vl 8 overstating British airports and, 102; regulatory trends yale tof p93perly mitransfro, 182vesatn and, 63-73, 74-75, 76-77, 78 value of, 29-30,31; transfer of, 23 Airport quality assessment and monitoring. Auction award criteria, privatization objec- 107; British Airport Authority case, 93-96, ves ar 2 97, 98,99 Auctions. See Contract auctions Airport quality and safety regulation, 92-93 Australia: qualityindexes in telecommunica- Airportquality of serice, 89-90 tions industries in,90; quality standards in, Airport quallty of service, 89-90 214 Airport regulatory mechanisms, 91-92 Austria: toll systems in, 245; Vienna airport Airport revenues, 55-56; from activities not in, 70 subject to regulation, 105; size of airports and, 53, 54-55; type of airport ownership Bahamas, seaport modernization in, 151 and, 56 Airport safety and security, 99, 100 Baumol-Wiig rule, 40 Airport services, 51-52; classification of, 52; Belgium: railway freight in, 232; seaport or- competition and, 65, 66, 67; contracted to ganization in (in Antwerp), 120; seaport private sector, 69; demand for, 56-57; performance (Antwerp), 166 multiproduct nature of, 52-53; price- Bolivia, rail concessions in, 193 n.8 demand elasticity of, 82; quality indicators BOT. See Build-operate-transfer (BOT) for, 107, 108 schemes Airport waiting time, 61 Bottlenecks, 39 Air traffic control (ATC), 62 Brazil: airportownership and operationin, 68; Argentina: airport concession contracts in, 71, bridge to relieve congestion in, 242; conces- 100, 101; concessonaires' fees in Buenos sionaires' fees in, 137; minimizing the costs Aires seaport, 137; concessions for port of of universal service obligations in, 44; po- Buenos Aires, 143-44, 161; financing uni- litical influence of port workers in, 138; po- versal service obligations in, 44; prequal- litical interference in toll road projects in, ification for concession contracts in, 143; 260; port reform and privatization in, 149- private participation in roads in, 253; qual- 51; quality standards in, 214; rail concessions ity of rail service in, 218; railway conces- in, 193 n.8, 196, 200; railway deregulation sions and concession contracts in, 185, and privatization in, 180; regulation of 193n.8, 197,198,200; railway deregulation concessionaire in Santos in, 159; regulators' and privatization in, 179, 180; road trans- inability to enforce contract in, 259; renego- port in, 235; seaport concession contract in tiation of road construction contracts in, 256; (in port of Mar del Plata), 136; seaport or- road transport in, 235; transfer of railways ganization in, 120,132; seaport reform and to private operators in, 45-46 modernization in, 148-49; toll roads in, 236; Bridges and tunnels, 242,243 underpriced rail passenger services and subsidized low-quality rail freight trans- Build-operate-transfer (BOT) concessions, port in (before restructuring), 186 250,253-54 Index 309 Burkina Faso, 198 Concession contracts: in airport industry, 71; basic objectives of, 161; currency risks and, Cameroon airport management contract in, 257-58; fees for seaport, 162; international 70; rail concessions in, 193 n.8 experiences with, 145-55; length of term of, 138; most complex element of, 20-21; obli- Canada: air traffic control in, 64; rate of return gations and payments and, 137-38; penal- regulation in, 202; Toronto airport in, 72 ties and fees in, 139-40; in rail industry, 189; Capital: asset values to measure, 104; rates of renegotiation of, 14, 22, 32, 144, 198, 271, return on, 36 n.13 272; renewal of,22; risk allocation and, 140- return on, 36 42; in seaport industry, 133, 134-36; selec- Capital costs, 29-30 tion process and, 142-44; for toll roads, 236- Capital input, 104 37; in transport industry, 127; for urban roads, 236. See also Contracts Capital needs in seaport industryr, 124 Concession revenues to fund new projects, Cargo handling at seaports, 118 248-49 Cars and trucks per 1,000 inhabitants in Eu- Conflicts, length of exclusivityperiod and risk rope, 177 of, 17 Chile: bidding approach for road franchising Congo, rail concessions in, 193 n.8 contracts in, 278; development mads in, 242; quality standards in, 214; private participa- tion in port modernization in, 148; railway Contract auctions, 19, 23-24, 26 concession contracts in, 185, 193 n.8, 200; railway dereglation and prvatization ' Contract design, 272; basic coverage of the 181; rwad concession programs in, 276-7h contract and, 16-23; criteria for organizing le-based renegotiaon in,o272;ra in,26- a contract auction and picking a winner, tibof seaport system in, 148 23-24; financial equilibrium and prices tion of seaport system in, 148 and, 28-30; price cap regulation and, 31- China: containers for seaport cargo in, 125;joint 34; price and quality regulation and, 27- ventures in ports in, 154; private financing 28; pricing access to network and, 37-41; of seaport infrastruchtres in, 146; seaport rate of return regulation and, 30-31; risk performance (in Singapore), 166; seaports in assignment and, 26-27; service quality and, (in Hong Kong), 124-25; renegotiation of 34-37 woad contract in, 256; toil roads in, 246 Contracts: duration of, 18-20; renegotiation Club goods in transportation sector, 7 n.1 of, 14,22,32,271,272; revenue, tariffs, and Collusion with concessionaires, 256 regulatory regime in, 20-21; termination of, 22-23. See also Concession contracts Colombia: airport BOT scheme in, 72; com- petition and privatization in ports in, 152; Corruption, 256; risk of, 24,43 rail concessions in, 193 n.8; road tolls to fi- Cost accountin current, 39 nance expansion project in, 243; toll roads in, 246 Costa Rica, private stevedoring services in Compensatory agreements, 69 ports in, 152 Competition: constraints on, 9; in and for the Cost of capital, 261 market, 12,14; natural monopolies and, 13; Cost overruns, 256 picking the right form of, 12-14; promoting, Cost pass-through provisions, 206 37; restrictions on, 15; seaport regulation and, 133-34; unbundling and, 7,9,13-14 Costs; in airport industry, 60-61, 87-91; im- perfect information on, 39; incentive to cut, Compliance costs, 31,32 32; most common way to cut, 36; of service Concessionaires, collusion with, 256 of user groups, 15; operators', 29. See also 310 Index Fully distributed costs; Long-run incre- Fully distributed costs (FDC), 39 mental costs (LRIC); Sunk costs Cote d'lvoire, rail concessions in, 193 n.8,200 Germany, charges for railway track use in, 212 Cross-subsidies, 43 Government intervention, justification for, 6 Currency in which accounts are held, 21 Governments' new role in transportation, 1, Currency risks in concession contracts, 257-58 Greece, road toll systems in, 245 Deficits in transport sector, public, 5 Guatemala: privatization in ports of, 152; rail Demand: assessment of, 18; elasticity of, 280 concessions in, 193 n.8 Demand risks, 18 Highways: demand for safety on, 240; operat- Denmark, road toll systems in, 245 ing costs for, 244 n7. See also Roads; Toll roads Divestitures in airport industry, 70 Honduras, port partial privatization in, 152 Hong Kong, toll roads in, 246; seaports in, Economic efficiency, 105,106 124-25 Economic regulation of transport. need for, Hungary: overestimation of road traffic level 6-10; objectives of, 10-11; provided by comn- in, 239; toU roads in, 246 petitive markets, 12 Economies of scale, 7, 114, 125-26, 173-74 India: containers for seaport cargo in, 125; Ecuador, toll roads in, 246 slow privatization in ports of, 153; toll Efficiency: as an objective of regulation, 10; roads in, 246 stimulating improvements in, 32; two types Indivisibility of input into production of a of, 38-39 service, 9 n.2 Efficient component pricing rule, 40 Indonesia: road networks in, 235; toll roads El Salvador, reform of port in, 152 in, 246 Information: imperfect, 39; market failures E.ngland. See Unted Kingdom due to problems with, 213; regulators' ac- Environmental considerations, 61, 62, 89, 99 cess to, 28 Exdusivity: concession contracts and, 136-37; International Air Transport Association granting, 14-16; misallocation of resources (IATA), 59 and, 15-16; period for, 17 International Civil Aviation Organization (ICAO), 57,64 Fairness as an objective of regulation, 10 Investments, 20, 133 Financial equilibrium, prices and, 28-30 Investors: consortia of operators and, 23; in Financing possibilities, investment and ser- the transport sector, 2-3, 20; tax liabilities vice obligations contingent upon, 20 of, 21 Finland, railway freight in, 232 Ireland, Belfast International Airport in, 73 Fiscal crises, transport policies and, I Israel, ownership and operation of airports France: inaccurate traffic forecasts in, 245; rail- in, 68 way access dcarges in, 212; survival of toll Italy: private toll financing of roads in, 245; road concessionaires in,245; tollroads in,236 railway passengers per train in, 231 Index 311 Japan: joint venture of airport in, 70; private Monopoly powers, contractual protection for financing of seaport infrastructure in, 146; the right to use, 24 railway deregulation and privatization in,,Mor1 179, 181; railway rate of return regulation co, seaport reform n, 151 in, 202; toll revenue pooling system in, 249 Mozambique, rail concessions in, 193 n.8 Joint ventures in airport sector, 70 Multiple award criteria, 24 Jordon, rail concessions in, 193 n.8 Natural monopoly, 174; competition and, 13. Kenya, private participation in port operation See also Monopoly in, 151 Netherlands: AmsterdamSchipholAirportin, Korea: containers for seaport cargo in (in 68-69; port tariffs in Port of Rotterdam in, Korean),:125 co ersoad netorks cargo 2m sm 158-59; railway efficiency in, 233; railway Pusan), 125; road networks in, 235; stup- passenger load in, 232; seaport organiza- ping companies' participation in seaport hon in, 120 shipyard performance value development in, 146; toll roads in, 236 (Rotterdam) in, 166 Latin America, airport concession model in, Network access: approaches to, 40;pricing of, 78. See also names of specific countries 37-41; regulatoryprinciples for, 38. See also Access charges License contracts, 134-35 New Zealand: air traffic controlin, 63; railway Long-run incremental cost (LRIC), 40 deregulation and privatization in, 179,182 Long-run marginal cost concept, seaports Nicaragua, privatization in ports in, 152-53 and, 157 Norway, road toll system in, 245 Lowest present value of revenue (LPVR) auc- tion, 278-79 Operators, consortia of investors and, 23 Maintenance, cutting, 36 Operators' costs, 29 Maintenance requirements, 20 Opportunity cost of resources, 30 Malawi, rail concessions in, 193 n.8 Overinvestment, 20,35 Malaysia: privatization and concessions n Pakistan, road networks in, 235 ports of, 154; road networks in, 235; ship- ping companies participation in port de- Panama: dealing with port worker redun- velopment in, 146; toll roads in, 246 dancy in, 139; privatization in ports in, 153 Market failures due to information problems, Penalties and sanctions: for noncompliance, 213 20; public hearings and appeals and, 22 Mexico: bargaining with seaport workers in, Performance bonds, 21 139; overestimation of road traffic levels in, Peru handling of currency risk in, 257; nini- 239; privatization in ports of, 152; rail con- cesin in 19 n',20 ne .odi,26 mizing the costs of universal service obli- ctsoll inad 19rog in, 24 6 gations in, 44; preparation for a toll road toll road program in, 248 project in, 266; rail concessions in, 193 n.8; Monitoring for compliance, 37 toll roads in, 246 Monopoly: the case for, 12; information Philippines: seaport concessions and joint needed to regulate a, 28; main source of ventures in, 153-54; shipping company profit for a, 36; obtaining efficiency from a, participation in port development in, 146; 12. See also Natural monopoly toil roads in, 246 312 Index Port authorities, 119-21; landlord model of Rail access problem, 209-12 port ownership and, 127; regulatory role Rail industry: caveats for future regulation of, 127 and, 179, 184; concessions and, 189; coor- Ports. See Seaport entries dination with other industries, 215; cross- subsidization problems and, 207; economic Portugal, road toll system in, 245 sbizaonrobemad 0;eooi characteristics of, 176; economies of scale Price cap: for a bundle of services, 33; global, in the, 173-74; excess capacity in the, 174; 40; inposition of a, 11; price regulation in mixed forms of cooperation between pub- British airports and, 83-86; quality-sensitive, lic and private capital in the, 189; most com- 36; regulation of, 31-34 mon price regulation schemes in the, 206; Price-demand sensitivity, 33 movement toward privatization in the, 179, 180-83, 184; private participation in the, Prices: financialequilibrium and, 28-30;qual- 188-89; uneconomical investment deci- ity of service and, 89-90, 101 sions in the, 221-22 Pricing annex in contract, 21 Rail infrastructure, 173-74 Pricing one activity to finance another, 43 Rail network, access pricing and, 208. See also Pricing rules, 21, 27-28. See also Tariffs Rail access pricing problem Private investment in seaports, 133 Rail regulatory scenarios, 191 Private operators in transport sector, 127. See Railway asset indivisibilities, 174-75 also Contract design Railway assets: with different economic lives, Private sector participation, 7, 127; transport 174; market values vs. replaoement costs, 203 policies and, 1 Railway capital assets, value of, 210 Private sector participation in transport con- Railway concession contracts, 189, 192-93, cessions and, 127; in developing and tran- 194-95, 196-206 sition economies, 9,10 Railway cost recovery with price discrimina- Privatization: concept of, 2 n.1; regulatory tion, 208 concerns to be addressed during, 2; effi- ciency and (in airport industry), 102; Railway costs, 172-73 government's goals and, 11;inLatinAmeri- Railway fares, reducing (to improve balance can airport industry, 79; terminology to jus- of transportation modes), 176 tify, 24 Privatization contracts, universal service ob- Railway infrastructure costs, 206-209 ligation appendix in, 42 Railway infrastructure provider, funding for Privatization objectives, auction award crite- the,222-23 ria and, 25 Railway innovation and infrastructure im- Privatization teams: biases of, 4; contract de- provement projects, 174-75 sign choices and, 2 Railwayperformance indicators, 226-27,231- 33; best practices and, 231-33; contextual Priva ized airports, regulation of private sec- indicators, 229; main types of, 227-31; man- tor involvement in, 80 agement indicators, 230 Publicserviceobligations, 41,137;pricingand Railway price regulation, 201-202; access financing of, 43-44 pricing problem and, 209-12; price cap regulation mechanisms and, 204-206; rail Quality requirements and standards, 20, 27- infrastructure cost problems and, 206-209; 28,36 rate of return and, 202-204 Index 313 Railway privatization and regulation trends, Regulatory institutions, 44-45; desirable 177-78; concession contracts and, 192-93, qualities of a regulator and, 46-48; division 194-95, 196-206; experiences in railroad of labor between regulator and govern- privatization, 180-83,184-86,188-90,191, ment, 48-49; regulator's sectoral breadth 192-93, 194-95, 196-201; movement to- of authority and, 45-46 ward privatization, 179,180-83,184; new regulatory scenarios, 190, 191, 192; tradi- Regulatory mechaniss in airport sector, tional model and regulation of the indus- 91-92 try, 178-79 Regulatory staff: roles and responsibilities of, Railway productivity calculation, 206 2; skils needed by, 2,3 Renegotiation of contracts, 14,22,32,144,198, Railway quality and safety regulation, 212-14; 271,272 definition of quality targets and, 214-23; instuments for quality control, 223-24,225 Restictions to entry and regulation, unavoid- able, 14-16 Railway rate of return regulation, 202-204 Revenue cap, 34 Railways: alternative organizational structure of, 187; deregulation and privatzaion ex- Revenue-expenditure balance, 209 periences of, 180-83, 184-86, 188-90, 191, Risk, regulatory options to mitigate, 262-74 192-93, 194-95, 196-201; faUl in share of transportation market and, 177; financial Risk assignment 26-27 solvency indicator for, 233; infrastructure Road capacities, 243 pricing and, 208; as multiproduct enter- prises, 171-72; results of transfer of road Roadconcessions,reportngrequirementsfor traffic to, 175. See also Rail entries 291 Railway_servkes, characteristics of, 171-76 Road contracts in developing and transition Railway services, characterishcs of, 171-76 economies, 246 Railway organizational structures, 187 Road improvements, advantages of contract- Railway subsidies to pay for fixed costs, 222 ing out, 239 Railway transport as a public service, 175 Road maintenance, 238 Ramsay prices, 40, 208 Road networks, 240; need for improvement Rate of return regulation, 30-31,32,202-204 in, 237 Reform, worker influence on, 134 Road planning and management, contracting out, 238. See also Toll road entries Regulation: of maximum revenue, 34; of pri- Road projects: consortia optimism about, 277; vate sector involvement in privatized air- oadofr243cpriconsorinvolvm entwith; ports, 80; public sector governance of, 2- cost of, 243; private sector involvementwith- 9iultimate form of, 5. See also Economic out tolling, 237; selection and design of, 248, 3; ulation 249; use of existing concession revenues to regulation fund new, 248-49. See also Tol road entres Regulators: accountability of, 47-48; autonomy Road rehabilitation costs, 238 of, 47; desirable qualities of, 4-48;indepen Ra dence of, 46; micromanagement by, 20,37; Roads: congestion-relieving, 241-42; environ- resistance to political interference by, 45; mental aspects of, 288; growing demand for sectoral breadth of authority of, 45-46 high-traffic, 239; requirement for free par- Regulatory bodies, 1, multisectoral, 45, sec- allel, 248; in selected countries, 247; that tor-specific, 45 serve export activites, 239; urban, 236; will- tor-specific, ~hingness vs. ability to pay for, 244-45. See Regulatory contracts, inability to enforce, 259 also Highways and Toll road entries 314 Index Road services, supply of good, 237 Seaport privatization and regulation, 123, Road tolls: to finance expansion projects, 248- 128-30; attractiveness of private p.rtidXpa- 49; setting of, 280 bon in ports and, 132; need for port regu- lation, 131-34 RPI-X formula, 84,205 Seaport productivity in cargo handling, tons Russia: concession contracts in, 145; freight per ship-hour as indicator of, 168 moved by road in, 235 Seaport quality and safety regulation, 163-64; congestion problems and, 161-63 Sanctions available to regulators. See Penal- Seaport regulators, tasks of (for small and ties and sanctions medium-sized ports), 169 Seaport activities and services, 115-16, 117- Seaportworkers excessivenumberof,13839 19, 120; coordination by port authorities, S 119-21; private participation in, 128-29; as Seaports: as a capital-intensive industry, 114, public services, 121; that do not require 129, 138; cargo dwell time as performance exclusive use of port infrastructure, 129- indicator, 164; classified by size, 131; com- 30; that require exclusive use of port assets, petition among, 114,126,132,133-301; com- 130-31 petition within, 115-16; cost paid by ships Seaport berth occupancy rate, 166 using, 163; idleness time of ships in, 166; multiple activities of, 114-15; participation Seaport cargo handling, 118; containers and, of private firms in, 169; reduced pub]ic sub- 125; quality of, 164 sidies for, 127; role of modern, 113; waiting Seaport cargo management problerns, 167 times of ships in, 166 Seaport container-handling services, 126; Senegal, seaport reform in, 151 charges for, 160 Service-price requirements, 11 Seaport development, levels of, 131 Service quality regulation, 34-37; comparing Seaport economy of scale, 114, 125-26 rate of return and price cap, 36-37; penal- izing for noncompliance, 37; pricing access Seaport effidency, 124-25 to network, 37-41; service delivery with Seaport infrastructure, 116-17; cost of, 115; competition, 34; service delivery by a ma- financing in different countries, 124; funds nopoly, 34-35; service quality under price for building new, 117. cap regulation, 36; service quality lnder rate of return regulation, 35 Seaport organization, 119-21; traditional, 123- Shared facilities, 38 27 Share faiiies, 38 Seaport ownership and operation, 122-23; Ships, working time overtime at berth, 166 landlord model of, 120, 127, 157; private Ship turnaround time, 166 participation in, 114-15 Singapore: containers for seaport cargo in, Seaport paperwork and permits, 118-19 125; intercity arterial roads in, 242; seaport Seaport performance indicators, 165; bench- efficiency and ownership in, 124-25; sea- mark values for, 166; economic and financial port organization in, 120-21 indicators, 168; factorproductivity indators, Socially sensitive services, 33 167-68; physical indicators, 165-67 Spain: airport ownership and operation in, 68; Seaport pilots, 164-65 airport sizes and revenue sources in, 53,54- Seaport price regulation: cargo handling 55; private toll financing in, 245 charges, 158-59; concession fees, 159-61; Subsidies, 11, 127; for services delivered be- port tariffs, 155-58 low cost, 43 Index 315 Sunk costs, 14 rule-based renegotiations and, 272-73; traf- Sweden,railwayderegulationandprivatization fic and revenue risks and, 256-57 in, 182 Toll road quality regulation: of environmen- Switzerland, Zurich airport in, 70 tal aspects, 288; operating quality of road services and, 286-87; safety aspects and, 287-88; technical quality and, 2855-6; user Taiwan, containers for seaport cargo in, 125 feedback and, 288-89 Tariffs: high profits and lower, 32, 33; revi- Toil roads: cost overruns and, 256; costs of, sions of, 33; setting of, 11. See also Price and 242-43; demand for specific, 243-44; free Pricing entries alternative parallel roads and, 248; market Tax liabilities of investors, 21 for, 240; movement toward privately fi- nanced,245-47; organizational options for, Technological constraints on competition in 251-52; privatization experiences and regu- transport infrastructure, 9 latory trends and, 245-47; purposes of, 241- Technological improvements, 31 42; recent innovations and issues, 292; shadow tolls and, 264. See also Highways Thailand, toll roads in, 246 and Road entries Toll road activity, economic characteristics of, Toll road safety, 287-88 234--41,241-45 Toll road services, 235-37 Toll road auctions and award criteria, 274-79 Transport infrastructure, cost structure of, 9 Toll road concessions and concession contracts, 249; BOT, 253-54; organizational options for Transport modes: dominant, 235; market 250, 251-52, 253-54; renegotiation of, 237; shares of different 177 toll design in Latin America, 280 Transport sector, contract with private opera- Toll road engineering for the price regulator, tors in, 16 283 Transport service as a private good, 6 Toll road markets: improved competition for, Transport services, organizational forms of, 276-78; initial experiences with competi- 7,8 tion for, 275-76; newest forms of competi- Trucking lobbies, 236 n.2 tion for, 278-79 Toll road performance indicators and infor- Unbundling, competition and, 13-14 mation requirements, 289,291,292 Toll price regulation, 279-85 Uniform pricing requirements, 43 Urtited Kingdom: accessprices in, 210-11; air- Toll road privathzation and regulatory trends, Uite pri ces in, 210-11; air- 245; movement toward privately financed port privahzaton in, 67; air traffic contol toll roads, 245-47; organizational options in, 83; bridge to relieve congestion in, 242; and, 253-54; privatization experiences, British Airport Authority-operated airports 247-50; risk allocation options, 254-62 in, 73; compensationfor effect of price caps in airports in, 91; concession contracts in, Toll road projects: capital costs of, 261; con- 145,196,198,199; investment policy of rail- tract design for, 267-73; currency risk and, roads in, 221; London City Airport in, 73; 257-58; dispute resolution and, 273; finan- price regulation of airports through PRI-X cial risks and, 258-59; overesmation of formula in, 83-84; quality indexes in tele- traffic levels and, 239; political risks and, communication industries in, 90; quality 259-60; preparing, 2, 266; regulatory op- monitoring of airports in, 93-96, 97,98,99; bons for mintgahng rsks and, 262-74; regu- quality of rail service in, 217,219; rail track latory risks and, 259; risks facing, 255-62; regulation in, 204; railway deregulation 316 Index and privatization in, 179,183; regional air- congestion-relieving roads in, 241; source port ownership and operation in, 69; safety of airport income in, 55 and economic aspects of airports in, 83; Universal service obligations (USO), 41-43; safety regulation of railways in, 219-20; - ancing -irough sector-specific levies, 44 sharing of extraordinary profits in, 33 Unitedg States: fedralrdiny gsol sine 33 tUruguay, reform and concessions in ports of, United States: federal gasoline tax to fund 153 interstate highways in, 245; income from concession fees in, 160; railway deregula- Users' willingness to pay, 18 tion and privatization in, 183; railway rate of return regulation in, 202; regional own- Venezuela, portreform andprivatizationin, 153 ership and operation of airports in, 69; sea- port organization in (in Seattle), 120; short Worker influence on reform, 138-39 Continued from inside front cover Other WBI Development Studies (In order of publication) Monitoring and Evaluating Social Programs in Developing Counltries: A Handbook for Policymakers, Managers, and Researchers Joseph Valadez and Michael Bamberger Agroindustrial Investment and Operations James G. 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