In a monopolistic context, cross subsidisation constitutes one of the biggest problems of public governance9. In the rail sector, long distance services (national intercity services, overnight services, etc.) present operating deficits on some links and extraordinary profits on others: the passengers on the first type of link subsidize the passengers (or the empty trains!) on the others. This solution isn’t necessarily unacceptable, but a democratic and transparent debate is needed.
On one side, the rail companies use “social” arguments to defend this policy; on the other side the regional (or national) administrations obtain “free” services across their territories. The result is a kind of “free riding” policy of the local administration in subsidising non-commercial passenger services.
A correct approach should transfer the extra profits from the rail companies to the state that in turn can decide to subsidise non-commercial services. Other allocations of these funds are possible: the state can decide to subside schools, hospitals, or other transport services. In particular, on non commercially viable links it can decide to subsidise the existing rail services, or alternative services, for example bus or air services; the “border line” solution is to provide no service at all. In this case, the state can defend the consumers of the high-traffic services eliminating the extra profits on the profitable links through a standard regulatory act (i.e. a price/subsidy cap or a competitive bidding policy), forcing down the fares in this way. But a democratic decision-making system is necessary, and every decision must be rendered explicit, with the different actors involved showing their real objectives. In particular, the state must show its specific social strategy, and every trade-off must be supported by an explicit and public debate.
This political transparency seems necessary both within a SC approach and within a PC approach. In a SC approach, this should be so since there are important “market failures” in the sector, and the ensuing “corrections” would require a specific political debate. In a PC approach, on one hand, because through cross subsidisations (and the related extra profits, in case of private operators) the incumbents can “capture” the regulatory agencies, improving their monopolistic positions; on the other hand, if the regulators are elected (or too strictly depending from elected officers), because their motivations can be distorted by the need to obtain support for the next
election. Further specifying this point, an elected decision- maker couldn’t possibly motivate service reductions in his region, damaging his electorate, in order to get equity results aimed at other social groups, although the latter decision may well increase total welfare10.
To avoid cross subsidisation and “capture” phenomena, it is necessary to separate commercial from the non-commercial service operations. The two kind of services must be operated by different companies or, if operated by the same company, at least separate budgeting procedures are needed in order to avoid the permanence of a dominant position through political “exchange of favours”.
Now, some example cases will be analysed; at the end, some recommendations and solution will be put forward.
2.2.1 Sweden
In 1988 Sweden began transport reform. In the rail sector the separation between the infrastructure and the rail services has been the most important innovative element11. Banverket (BV) is the new company of rail infrastructure. The passenger services have been divided into two groups: regional services and national ones. Regional services have been regulated in concurrence with the market and “gross cost” contracts: in the first round the incumbent Staten Järnvägern (SJ) won twelve of sixteen lots auctioned, and all the lots in the second round. The national services have been further separated into commercial and non-commercial services. The incumbent operates the commercial services as an unregulated monopolist and also decides on the division of the national services into the two above-mentioned groups. Apparently, a “moderation of competition” principle defends the incumbent, as a “national champion”.
The national non-commercial services have been regulated like the regional services, but with “net cost” contracts. This railway managerial set-up is supposed to be capable of avoiding cross subsidisation. Formally, SJ could not subside non-commercial services through profits deriving from commercially profitable lines, particularly if new entrants operated regulated services. In reality, this was never the case since SJ won all the services on non-commercial links. The biggest problem lies in the SJ group structure: the same firm provides commercial monopolistic services and participates in the awarding of the regulated services. So, SJ can subside non-profitable services trough monopolistic profits (made in previous periods) on commercial links. Dumping is formally forbidden by the Swedish antitrust authority, but nevertheless SJ can offer services strictly at short run marginal costs; here as a borderline case, SJ does not cross-subsidise other activities. SJ can have profits, however, and can hide, for instance, depreciation allowances on commercial links while its competitors, operating in isolation, must at least cover their average costs. In the end, the competitors’ costs exceeded SJ’s costs in bidding for the contracts of service, even if they are potentially much more efficient than SJ. In Sweden, BK Täg (the new entrant who won four lots for regional services) appealed to
P O N T I - E R B A
Konkurrensverket, the antitrust authority, against SJ. BK Täg accused SJ of bid-dumping in undercutting other offers, thanks to the expected extra profits on other services.
2.2.2 Italy
In Italy, cross subsidisation can be seen explicitly only in national passenger services and, maybe, between passenger and cargo services12. As we will see, some commercial lines subsidise non commercial ones.
After the beginning of the deregulation process, Trenitalia Holdings has been articulated into three different companies: regional transport (RT), long distance passenger services (LD) and freight services (Cargo).
Regional authorities decide on local services and subsidise them. The incumbent TL provides all the services as a monopolist, with some feeble regulatory pressure coming from locally negotiated fares; this situation will not change before January 2006, with the first competitive bidding (the previous deadline of 2004 has been recently further postponed). As stated, regional governments subsidise all local services, through large fixed subsides per train- kilometre, equal for every train (independent from its own characteristic and patronage).
So, there is no pressure on LD to subsidise RT. The real problem lays inside the LD services: LD is the only company to provide long-distance passenger services13, and new entrants up to now couldn’t enter the market, although the actual law does not seem to be completely clear. Some studies14 demonstrated very large extra profits for LD on some lines (e.g. Milan–Venice and Milan–Naples intercity links). But LD declares a balanced budget. If this is true, there must be other lines whose revenues are far lower than their costs: an evident case of cross subsidisation emerges. The decision whether long-distance, non-profitable services have to be provided is taken by Trenitalia according to its business strategy, and not by political decision-makers (or by a specific planning agency) after due public debate, with the related political and equity problems put on the table. LD strategy seems clear: as is generally the case of public incumbents with extra profits, it tries to derive from them maximum benefits in terms of guaranteed protection from competitive pressures. In a liberalised context, this behaviour will be equivalent to an entrance barrier. In fact, every possible new entrant on the non-profitable services would have to offer these services at least at short run marginal costs, while LD could sell below that limit.
In fact, at present, new entrants cannot “invade” the profitable part of the rail market also due to the saturation of the most profitable lines15, over and above, as we have seen, the absence of any mechanism of capacity allocation different from “grandfather’s rights”.
So, LD “captures” the political decision makers via a “preventive action” against competition, providing “free” services instead of forcing an explicit debate on the social worth of the low-patronage services. In this way, LD tries to create a political entry barrier. By providing non-profitable
services, LD acquires political protection against liberalisation in general, and against the menace of new entrants in particular. The political decision makers have little incentives to accelerate the deregulation process, in order to keep the above-mentioned “benefits” while LD can more easily defend its monopolistic position. A severe equity problem emerges, however, concerning the passengers of the profitable services who de facto subsidise other services, due to a managerial decision taken by Trenitalia and not following any public debate.
2.2.3 Some solutions for the cross-subsidy problem for
passenger services
The Swedish case and the Italian case seem to be very different. Nevertheless, in a few years, the Italian rail regional transport will be regulated with an approach based on competition for the market. The actual Italian incumbent could have a dominant position due to political reasons, and it could be motivated by the competitive pressure to cross- subsidise the regulated services with the profits of the unregulated ones16. In Italy too the “Swedish problem” may well show up.
Some different generalised recommendations are possible. 1. “Open entry” in the national commercial services. So, if
that market works properly, no competitor can have extra profits, distorting regular competition for regulated services, at the same time providing efficiency incentives in commercial services. The incumbent may lose its dominant position. The State must subsidise social (or non profitable) long-distance services after a democratic and transparent debate. The worst “capture” phenomena can be avoided.
2. If large scale economies emerge also for LD services, this sector should also be regulates for the market as well. In fact, this solution is similar in its effects to open entry. Also the social issue concerning long-distance unprofitable services can be solved via competitive bidding. A preferential position may well result for the incumbent (again, the “national champion”), but this risk is always present.
3. In case of only partial opening of the passenger market (for example, only for non-profitable services17), the incumbent should be split into two completely separated companies: the first one operating long distance profitable services with a price-cap regulation, and the second producing local and long-distance unprofitable ones, exposed to competitive bidding. The LD incumbent cannot cross-subsidises other services; nevertheless its dimension could be so large as to generate “capture” risks for the regulator, in particular if the regulatory agency is not able to value correctly the incumbent’s conditions, given the large information rents existing at present. The only advantage left to the incumbent in the competitive bidding sector will be the possible information rents.
Note that the third solution seems to be the minimal one (both in Swedish and in Italian cases) when regulated and monopolistic services coexist, or during the temporal gap between different stages of the liberalisation process. Furthermore, it has to be noted that in general the incumbent, in order to reduce entry risks in its own market, is motivated to transfer the largest possible share of costs from services under competition to monopolistic ones, taking advantage from the information rents generally related to the “historical” subsidy mechanism. This may well constitute a special case of cross-subsidisation.
All these suggested approaches promote an acceptable level of transparency in the decision making process. No decision concerning the social services to be provided can be taken by the operators; the regulator (and its elected “principal”) are the only subjects enabled to decide. “Capture” phenomena can thus be minimised. Some problems may still exist as to the role of vocal interests in obtaining an unreasonable level of subsidised services; but this goes far beyond the scope of this analysis.