Analysis of the European Transportation Industry

Analysis of the European Transportation Industry Abstract The European transportation industry has been evolving for the last century but the pace of change accelerated in the recent years with the deregulation and intensification of competition between different modes of transport. The new agenda of the European Commission for the future of the industry after 2010 comprises of policies that try to establish sustainable transport that will meet the challenges of the current market environment the growing concern on gas emission, lack of funding as a result of the financial crisis, increasing oil prices and aging population in continental Europe. This paper analyses the current situation in the transport industry in Europe and the expected change in the competition between different modes with particular focus on the rail and road passenger transportation as a result of the policies for creating a fully integrated European transport network. Using the scenario analysis three possible outcomes have been identified as a result of the anticipated developments in regulations as well as feasibility of implementing those measures. Most reasonable of the three scenarios is the one where implementation will be taking place with mixed rigor in different member states, in addition the expected shift in passenger transport from road to rail will commence but at relatively slow pace. The result of the successful implementation of the new regulatory developments will be increased competitiveness between rail operators as new entrants will come to the market, increased efficiencies in the ex-monopolistic companies, and better service for the end-consumer both quality and price. The above scenarios provide a long-term perspective on the development of the intermodal competition in the passenger transport in Europe, since the time horizon for assessing the effect of a particular regulatory takes at least 10 years. The starting point is the current situation on the market which unfortunately has to go a significant change before the head-to-head competition between rail and road starts. The implications from the current study can be used as the basis for future research and scenario development with more sophistication. Regulations will definitely be in the core of transport industry development and the future trends as discussed in Chapter 3 will influence those policies with different degree. It is worth trying to understand and better prepare for the future both from business and social perspective. Thus the current study tries to bring the reader one step closer to that point. 1. Introduction Transport network is considered the backbone of the economy. It is a complex system that is influenced by multiple variables like population consumption, settlement patterns, organization of the production processes and the capacity of the infrastructure. As a major sector of the European economy transport has a top priority in the strategic agenda for building the single European Union market. The history of the sector is characterized with the key features of network industries natural monopolies, vertically integrated players, heavy investments in infrastructure, public subsidies, regulated prices. The globalization of economic activities and the gradual liberalization of the transport market, had led to changes in the business dynamics and structure of the sector. The environmental impact of transport became a priority in the development of policies and regulations for the industry. One push in the direction of more environmentally sustainable solutions is seen in promoting rail transport as a substitute for road transportation. The existing literature gives strong case in support for this scenario. This paper tries to explore the future scenarios in Europe and analyze the expected effect from the introduction of the new transport policy on the intermodal competition of passenger transport between rail and road. Chapter 2 presents the basic characteristics, development trends and economics in the network industries. Giving a starting point for understanding what has shaped the transport industry so far. In Chapter 3 are discussed the trends and challenges in the development and implementation of regulations in the transport industry in Europe. The focus here is on to rail and road passenger transport and the existing intermodal competition between the two modes. The following Chapter 4 includes analysis of the current competitive landscape of passenger transport in Europe. The market subject to analysis is defined as â€Å"transportation of passengers in the geographical boundaries of Europe† and it does explicitly exclude the transportation of freight which is characterized with different product/service specifications. The players who compete in this market are assumed to be only the providers of land transport rail and road operators. In addition the road mode comprises of bus and coach, while the rail mode includes railways, metro and tram. The purpose of the analysis is to give possible answers to the questions: Is rail the future transportation mode for passengers in Europe? Are regulatory policies the main tool for introducing intermodal competition? As a tool for conducting the analysis is used the traditional Porters five forces framework with a main focus on the barriers of entry representing the main competition force looking from the current market perspective into future scenarios. Using the results of the competitive advantage/disadvantage of each mode further scenario building is conducted applying a framework on industry scenarios and competitive strategy under uncertainty (Michal Porter). The results of the scenario analysis are taken in light of potential recommendations to both regulatory bodies and the providers of land passenger transport in Europe. Finally the conclusions derived are summarized in Chapter 5, including the possible implications, future research areas and limitations of the current study. 2. Characteristics of network industries One of the simplest ways to describe a network industry is by picturing good or services delivered through a set network both physical and virtual to an end customer. The network is established through the connection of numerous nodes which subsequently define the character of commerce in the industry. What is common in these types of industries is that the infrastructure which is comprised of many different elements links upstream supply units with the customers who are downstream. The basic components of a typical network industry comprise of: 2.1. Common structure in the network industries Although the industry structure varies across countries and different industries, the following cases are considered the most common ones: Vertical integration and monopoly in this case a single company operates the network infrastructure and both upstream and downstream components. Vertical integration with competition in the downstream or the upstream components -this case is similar to 1 but the company faces competition in the downstream and/or upstream components. Vertical separation with upstream and/or downstream competition, but the company that operates the network infrastructure does not operate in either the upstream or downstream components. Joint ownership in this case the infrastructure is owned jointly by companies competing in the upstream and/or downstream components. Infrastructure (facility-based) competition means competition among vertically integrated firms. 2.1.1. Historical background of the network industries in Western Europe In order to gain better understanding of the current developments in the network industries a short historic flashback is presented. The period of the 19th century Even in early 19th century when the free trade was dominant philosophy the government involvement was visible especially in the network industries. The triggering factor was the rights of way for railway tracks, gas and water, telegraph lines. After expropriation of the rights governments ease their way in establishing control over prices and profits by monitoring the engineering and financial stance of the respective companies. Overall the intervention of the government was limited more to arms length regulations and subsidies. The end of the 19th century is characterized with developed networks in telecommunication, rail, electricity supply which calls for more market opportunities and new entrants in the sectors. But the collapse of capitalism in 1930s brought distrust in governments ability to control private monopolies only through arms length regulations and subsidies. Thus alternative model was sought especially in network industries like telecommunication, railways and electricity. The time of the public ownership has come with the classic example of nationalization of the railways in France, Sweden, Spain and the UK in the period from 1937 to 1947. The period of the 20th century The main goals of the new state-owned enterprises were to provide service in the public interest along with break-even financially. The big challenge came from defining what is â€Å"public interest†. Eventually the solution was found, particularly for the network industries, in the so called â€Å"universal service† which comprises of standardized prices and service quality in the whole country. As a result of this approach the price of a product was fixed regardless of its point of distribution or delivery location for example electricity tariffs per kilowatt hour in different parts of the country were the same irrespective of the varying costs of supply. The second objective for the state enterprise was to break-even financially. The goal turned to be more difficult to achieve than initially planned having no clear guidance or support from the respective government authority. The â€Å"universal service† approach was not able to provide enough profits from areas of growth so as to compensate for the unprofitable ones. The period after 1960s is characterized with growing pressure on managers to meet the financial targets of â€Å"break-even† and beyond. The hope that the â€Å"universal services† will be able to cope with the unprofitable sectors by sustaining the profitable ones proved unsuccessful. Further, competition was growing and state owned enterprises were not flexible enough to respond adequately. Governments were worried with increased budget deficits coming from the rising public sector borrowing requirements. All of these contributed to the wave of privatization in Europe which had different timing across countries. In summary, the era of state owned enterprises was coming to its end. Its primary goal was to secure social and political unification and by the time of the second half of the 20th century much of this has been achieved. The technological developments changed much of the industries. New means of communication sprang apart from the traditional railways road, airlines, telecommunications. Although the strategic significance of a particular recourse was still the same, there was no need to keep it monopolized, for example one national air carrier. Financial returns from national resources like oil and gas were put into different legal forms thus allowing for concessions and tax schemes to be more profitable in the long-term. The Western European network industries had gone through tremendous changes for the last two centuries. The heritage left is the current surge for establishing more competitive regimes by allowing customer to benefit from improved quality and higher security standards. 2.2. The liberalized landscape in the network industries Coming from the state-owned natural monopolistic regime, the companies in the network industries had a structure where a non-competitive component of the industry was vertically integrated with a potential competitive component or activity. The separation of the two components by main sectors is summaries in a report by the Organization for Economic Cooperation and Development as illustrated in the Table 1. Scope for competition varies depending on geography and nature of demand, amongst other things. Services in lower-density, lower volume residential areas are less likely to be competitive than services to high-density, higher volume commercial areas. Source: OECD report â€Å"Restructuring Public Utilities for competition†, 2001, p.9 The natural monopolistic structure has evolved both as a result of the deregulation and the innovation that came with technology development. Once non-competitive components started being replaced by new components competition was spread in a broader sense. An example of such change in the competitive landscape of an industry is the break-through in mobile technology. The new mobile vs fixed communication has brought competing models in the same market segment. The European Union experience in liberalization of network industries continues with the enforcement of Community law; different directives and specific regulations designed to harmonize the newly liberalized markets in member states. The expectations for the future are to have one unified market which promotes rivalry among companies that deliver better choice for customers both in quality and price. 2.3. Overview of the economics of network industries The basic features used to describe the specifics of the economics in the network industries are investments, production, pricing and regulations. 2.3.1. Investments Compared to other types of industries in this case the initial investment is higher as the infrastructure costs are significant but necessary requirement for the successful delivery of the product to the customer. In addition the structure of the existing network influences its modification or extension thus allowing for extra costs compared to green field investments in other industries. For example in the railway transportation building the network meaning tracks is both expensive as an initial investment and subsequent maintenance costs. First, the main condition for laying the tracks is to have property right on the land which might be expensive to obtain, or to regulate. Second, the track technical execution is costly and third the future maintenance requires long-term commitments and highest quality of service provides which again is at a significant cost. 2.3.2. Production Economies of scale are realized when a product becomes standardized and an addition unit produce reduces the average cost of production. The complexity of network industries allows in certain businesses for such economies to be achieved but the variable cost component is less obvious than in other industries. The more popular concept in the network industries is the so called â€Å"surface/volume effect† in which case the available infrastructure provides for lower unit cost when output is increasing with the plant production. For example, when there is a large scale industrial or transportation equipment the costs for manufacturing are related to the surface of the equipment while the output from it is function of the volume to be transported (cases of oil, gas etc.). As a result the surface increases with the square of the equipment scale while on the other hand the volume increases with its cube. The ratio of surface/volume representing the average cost is a decreasing func tion of the scale. In practice, this leads to very large equipment being built. Economies of scope exist when a company is able to produce several goods at a total cost smaller than the sum of the costs of these activities when they are isolated one from the other. A business in a network industry might own a piece of equipment and the workforce that can produce large quantities of goods/services with similar specifications. For example, the building of information database which subsequently can be used for various activities without additional costs. Vertical integration exists in the case when a single company performs a number of successive distinct operations in the production process of a particular good or the provision of a service. In the context of network industries, especially those involved in the so called â€Å"public service†, the vertically integrated structure of a company can be justified if it manages to provide cost reduction in the service/product. Some sources of these cost benefits can come from technical complementarities, like better co-ordination between successive stages in the production process, also another social benefit might come from the removal of successive private profit-margins that are realized by intermediaries. On the other hand, the vertical integration in an upstream direction can be used by a company as a control mechanism on its customers, suppliers and competitors. The risk in this scenario comes from the fact that by controlling the delivery of certain strategic inputs, the com pany can gain dominant position on the end market. Example from the network industry is when a company owns both the control of the access to transport infrastructure and at the same time is a user of the infrastructure. 2.3.3. Competition The network industries are characterized with strong externalities which result from the interdependence of the agents. The interdependence is described with the effect that the level of satisfaction of one member has on other members in the network. These externalities are both positive and negative. The case of positive externalities is when particular action of a member increases the utility of the others or the so called â€Å"club externalities†. The spill-over effect is another positive externality, when the existence of a network in a certain area â€Å"spills† its benefits outside of its boundaries. In the case of negative externalities called â€Å"congestion externalities† the entrance of a new user in the network affects negatively the existing users. In practice the size and composition of a network are the result of a trade-off between club benefits and congestion costs. The composition and size of the network might change and the set access price would make some members to leave and other to join. This means that the number of those who wish to be in the network depend on the number of those who are already in the network. In this case equilibrium is reached when demand is compatible with itself, namely when the number of the members is exactly the same as the number of the candidates. But because of the earlier described club effect, at the given price would exist several equilibriums. The competition discussed here is ex post, meaning actual competition between two or more companies in the market. As already described, the competition in network industries is characterized with multiple equilibrium configurations for a given set of competing companies which implies that the quality of the service provided by the companies is endogenously determined by the participation of the clients. Here, the expected quality not the actual one is what matters. Another key feature of the competition in a network industry is that it can evolve into some kind of co-operation by decisions of compatibility. Compatibility can be achieved through standardization and the reason for companies to resist it is that it leads to more homogenous products. As a consequence of the standardization, the competition is enhances and loss of profit margins for the incumbent players. For example, in the electricity industry, there is a long tradition of co-operation at both national and international levels for the frequent power exchanges through interconnections. The usual dynamics of competition between companies are modified in a network environment as a result of the endogenous quality of the network and the necessity to reach a critical size in order to survive. So competition at the initial stage is considerably fierce. Companies have to make significant investment to capture the critical customer mass then sustain the image of better than the competitor quality of service / goods which subsequently will enhance the quality of the network. Later, switching costs create a lock-in effect and competition between those companies that managed to get through the initial phase is softer. Because of these companies have an incentive to heavily invest in infrastructure at the entry aiming to create a momentum and realize higher profits on next stage. Competition becomes weaker with the maturity of the industry, companies with existing installed base have less incentives to invest in quality and the only factor that triggers competition may come f rom break-through in the technology. If, no such happens then new entrants will be hard to overcome the competitive advantage of the incumbents. Still in some network industries certain elements like infrastructure remain natural monopolies as a result of the strong economics of scale and scope and relatively high degree of lumpy capital investments. 2.3.4.Regulation of network industries The liberalization process in the network industries brought the co-existence of monopolistic and competition elements in most industries. The change in the market structure requires new developments in the regulatory regimes in those industries but the transition phase as illustrated in Figure 1 is pursued with various conflicting priorities in the sole task to establish competition on the market. Currently, the European Union agenda is to have a set of regulations that will facilitate and speed-up this process. The ultimate goal is to increase efficiency in the performance of the industries and promote higher quality with the introduction of new products thus providing for lower consumer prices. Still the liberalizing policies face certain constraints coming from: the monopoly control legacy in the network industries, the common state aid subsidies, the institutional diversity in various countries, private vs public services objective; the existence of bottlenecks in the network infrastructure and the need for establishing interconnections between rival networks. Figure 1: The evolution of regulation over the three phases of market structure. Source: Lars Bergman, Chris Doyle, Jordi Gual, Lars Hultranz, Damien Neven, Lars-Hendrik Roller â€Å"Characteristics of network industries in Europes Network Industries: Conflicting priorities† published in 1998 by Center for Economic Policy Research.† The next chapter focuses on the current and future regulations in the European transport sector. It emphasizes some of the implications from the development and implementation of the regulations on two specific modes of passenger transport rail and road and the effects on the intermodal competition between them. 3. The regulatory framework in the European transport system â€Å"Transport is the backbone of the European economy, accounting for about 7 % of GDP and more than 5 % of total employment in the EU. As a network industry, transport requires elements such as infrastructures, vehicles, equipment, ICT applications and operational procedures to interact smoothly in order to move people and goods efficiently.† 1 Figure 2: Transport growth compared to GDP growthEU-27 Source: European Commission: â€Å"EU Energy and Transport figures† statistic book 2009 As one of the main sectors in the economy of a unified European market, transport is subject to continuous efforts from regulatory bodies to bring efficiencies and better product/service to customers. The framework for strategic development of the sector is set in the White Paper issued by the European Commission for a period of ten years and mid-term review is conducted which gives up-dates on the progress and recommendations for future developments. In 2010 the current strategy is to be reviewed and next decade program will be set forth in a new White Paper incorporating the new policies in light of the future trends in transport sector development. _________________________________________________________________________________________ 1 Antonio Tajani, Vice-President of the European Commission, Commissioner for Transport. Report â€Å"A sustainable future for transport†. 3.1. Trends influencing the European transport policy The EU White Paper 2001 and the mid-term review in 2006 drew key conclusions and set the directions for continual work on the EU sustainable transport policy. The key conclusions to be put forward in the new paper include optimization of each transport mode to bring competitiveness and propensity, transition of all modes to more environmental solutions both resource consumption and external costs. In addition each mode should be used efficiently on its own and in combination with all other modes so as to achieve sustainable utilization of resources. Looking at the future prospects of the industry and its development the following trends will have a significant influence on shaping the regulatory regime of the transport sector in EU. 3.1.1. Environmental challenges Transport is one of the sectors that have a tremendous impact on the environment. It is the only sector that has constantly increased its GHG emissions in the recent decade as illustrated in Figure 1. The growing concern on the global climate change has led to the adoption of climate and energy package by EU with a target to cut GHG emissions by 20% compared to levels in 1990. The environment aspect will be the main external factor influencing all modes of transportation and the respective players in the market. 3.1.2. Urbanization There has been a clear trend in the growth of urban population which is predicted by 2050 to be 84% of total European population2. This trend increases the challenges on the transportation sector as more density is brought in the urban networks accordingly with more environmental issues and congestion problems. The costs of both environmental and structural problems increase with the growth of cities density as longer delays in traffic jams incur larger fuel costs respectively emissions of CO2 are higher. One of the greatest challenges in this context is the building of additional infrastructure within the cities while bringing collective modes of transportation in resolving the congestion problems. 3.1.3. Migration and mobility According to the data provided by Eurostat 3 in the next decade EU is expected to add another 56 million people to its population as a result of a migration trend. This could be a positive trend for aging Europe as usually migrants are relatively young and settle in the developed urban regions that mainly contribute for the economic development. Another factor affecting the structural change in the population density is the internal mobility of workers between member states. This would be more visible with the removal of certain administrative and legal barriers in the labour market. 3.1.4. Ageing of population As mentioned in the previous paragraph one of the challenges in the coming future of Europe is the aging population. Compared to the world trend over the next 50 years, the annual average growth rate in the EU-27 population will be constantly declining as shown in Figure 4: Source: Eurostat (demo_plan), United Nations, Population Division of the Department of Economic and Social Affairs 2. United Nations, Department of Economic and Social Affairs/Population Division (2008), ‘World urbanisation prospects — The 2007 revision. 3. Eurostat (population and social conditions), Statistics in Focus No 72/2008; and European Commission, ‘Demography report 2008: Meeting social needs in an ageing society. SEC(2008) 2911. This particular phenomena has a very deep impact on the transport sector on few dimensions. First the availability of resources (human capital) will diminish. According to the EC â€Å"2009 ageing report† in 2060 there will be only two active workers for every pensioner. In the long-term this requires more contributions for pension funds thus limiting public finances for the supply and maintenance of the transport infrastructure. Overall, the end result might be more costly transportation products/services for the society as a whole. Second, the elder members of the society although much more flexible than a decade ago do travel less than younger population. This has a direct effect on the demand side for transport services both regional and long-distance. Another characteristic of an elder customer is that he/she puts high priority on factors like safety and comfort which in its turn requires different focus on the future specifications of the products/services provided in the transpiration industry mainly safety and reliability which pushes further the quality standards in the sector. 3.1.5. The financial crisis and global trends It is hard to ignore the current and future impact of the recently started economic crisis. The economic growth as forecasted few years ago had dramatically slowed down and this has led to major restructuring in all sectors of the economy. Still the continual globalization trend serves positively the transport sector, with the increasing need for integration and deepening of the single European market. The growing world population expected to reach 9 billion in 20505 is seen as the main challenge for all sectors of the economy, including transport. The scares resources that should provide for the growth in consumers, requires better model for creating sustainable transport sy