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Unlocking efficiency – overcoming challenges in South Africa's rail freight sector

The South African rail freight sector is currently facing a crisis of operational efficiency, which is having a significant economic impact. In the bulk mineral corridors, reduced rail capacity has prevented South Africa from benefiting from recent mineral price booms. The general freight rail business is experiencing massive operational disruptions, and the associated shift in freight transportation to road is causing substantial infrastructure damage.

The recent rail white paper released by the Department of Transport proposes the introduction of competition in rail services as a central means of improving sector efficiency. Introducing competition in the provision of freight services has the potential to greatly improve service quality and shift freight back to rail, but implementing this process will be technically complex. One crucial aspect of introducing competition will be the development of an effective access pricing regime for rail. My SA-TIED working paper hopefully begins to articulate the principles that will be needed to guide access price regulation going forward, and to begin to build a predictable and evidence-based regulatory regime for rail.

Balancing access pricing for sector sustainability and competition

Access pricing levels affect the sustainability of the rail infrastructure manager, as well as determining whether new train operating companies are truly able to compete with the incumbent. Set the price too low, and the infrastructure manager will not make enough money to be able to maintain the asset base. Set the access price too high, and new entrants into the market will be unable to effectively compete with the incumbent (who experiences the ‘real’ cost of access).

To make matters more complex, there are also features of high fixed cost industries which make efficient pricing inherently difficult. The rule of thumb for efficient pricing is to set prices equal to the marginal cost of the very last unit of goods or services produced. At this price, the level of a good or service provided is socially optimal. Unfortunately, this theoretical model of pricing can be difficult to apply in high fixed cost industries such as rail, where enormous investments into network infrastructure are involved, and day-to-day operating costs are much lower. If prices in rail are set at marginal cost, they will only cover the operational costs of providing the service, leaving the cost of the network unfunded. On the other hand, if prices are raised to cover fixed costs, then the amount of rail services provided will fall below socially optimal levels.

Challenges in pricing high fixed cost industries

According to European Community guidance for member states, fixed investments in rail should ideally be funded by the state, allowing access prices to be set at marginal cost. However, even in the EU, many states find this unaffordable, and it is certainly not a feasible solution for South Africa. Since access prices need to cover fixed costs, the question then arises: how can such prices be best set to reduce market distortions?

International precedent from markets such as Australia suggests that the best way forward is price differentiation based on the end freight market. Ideally, prices are set in inverse proportion to customer demand elasticity. This means that captive customers with low price elasticities should be charged higher prices, while customers with high price elasticities should face lower prices. This price differentiation allows the infrastructure manager to maximize the volume of freight carried, because prices can be set low enough to make rail attractive to customers who would otherwise use other modes of transport. While these customers do not cover a ‘fair’ share of fixed costs, they nevertheless do cover some fixed costs, and thus help to spread the burden of fixed costs among a wider customer base.

Building a predictable and evidence-based regulatory framework

A system of price differentiation in rail will need to include safeguards to prevent customer abuses. All access seekers serving the same end market must be offered the same access price (albeit with cost-based price modifiers used to address operational differences between customers), and there should be some method of calculating a price ceiling to avoid excessive pricing outcomes for captive customers. Independent economic regulation of this market is thus crucial.

Implementing access pricing regulation will be a complex and data intensive task, which will take time to fully implement. While initial price regulation models are likely to be fairly simple, ideally the regulator should build towards a more comprehensive and accurate access pricing regime over time. Ultimately, well-designed and appropriately regulated access pricing is needed to facilitate the transfer of traffic from road to rail, which is, in turn, vital for the commercial sustainability of the rail network.

Sarah Truen is an independent regulatory economist with deep expertise in the South African rail sector. At present, she is involved in developing a roadmap for structural reform of the sector, on behalf of Operation Vulindlela, an initiative driven by the South African Presidency and supported by National Treasury.

The views expressed in this piece are those of the author(s), and do not necessarily reflect the views of the Institute or the United Nations University, nor the programme/project donors.