Splitting Kiwirail into two entities makes sense

Every year it seems, Kiwirail is in the news for the losses that it makes. However, that need not be a bad thing, as I wrote in this 2014 post:

Having the natural monopoly make a loss (and this is an economic loss, so it includes opportunity costs, and would be greater than any accounting loss) may be a good thing because it increases total welfare. However, relative to profit maximisation, it entails a transfer of welfare from taxpayers (who ultimately end up paying the loss) to consumers of rail services (and ultimately, to consumers of stuff that is transported by rail).

It was interesting to see Kiwirail in the news this week for something slightly different, as the NBR reported (gated):

A proposal to split KiwiRail into two is still on the table but is not a pressing priority for the government.

Treasury made the suggestion in late 2017 after the Auditor-General’s office had raised concerns about the state-owned rail company’s financial reporting...

Under the specific proposal put forward by the Treasury in late 2017 and early 2018, one entity would be responsible for the tracks and be publicly funded, while the other would have a commercial State-owned enterprise responsible for all the above rail services. The SOE might get some government money but largely would be expected to fund its capital investment itself.

In a paper dated February 2018, and obtained by NBR under the Official Information Act, the Treasury said KiwiRail had an uncomfortable mix of profit-oriented assets and services and public-benefit oriented assets and services.

“This mix distorts KiwiRail’s investment decisions, operating and financial performance, and the Crown’s funding model and level of influence and control,” it said.

The Treasury said the “above rail” aspects of KiwiRail – its locomotives, rolling stock, ferries and commercial work with customers – were profit oriented and properly belonged in an SOE. But the “below rail” network assets – the rails, rail formation, bridges, tunnels, signalling and power infrastructure – were public benefit infrastructure.

The key problem with Kiwirail is, as I noted in that earlier post, that Kiwirail is a natural monopoly. It has a very large up-front (fixed) cost of production, which is the cost of the rail infrastructure, and the marginal costs (the cost of transporting an additional unit of freight) are very low. A privately-owned natural monopoly would profit-maximise, decreasing the quantity of its services and raising the price. A government-owned natural monopoly could do that too, but if government wanted to increase economic welfare, it would prefer the monopoly to set a lower price. And if it sets the price at the welfare-maximising level, the natural monopoly makes a loss (see my 2014 post for details).

Treasury's proposal is to split Kiwirail into two entities. The natural monopoly would remain a government-controlled public-benefit entity, in charge of the infrastructure. The for-profit entity would run its services on the lines owned by the public-benefit entity. The infrastructure could then be government-funded using a pure subsidy, like roads. The for-profit entity would (presumably) no longer make a loss, and look a lot better for the government (controlling the loss-making Kiwirail is not a good look, which is why it is in the media every year).

The parallel with the funding of roads is important here. Separating the infrastructure funding from the operators using that infrastructure seems to me to be an improvement. It would make the funding applied to rail infrastructure wholly transparent to the taxpayer, and allow us to have a better sense of the relative government spending on roads and rail. With the infrastructure coordinated centrally and separately from the commercial rail services, rail services could be opened to competition, with other rail service companies allowed to use the same rail lines (with signalling and scheduling handled through some centralised process). That could lower the costs of rail services further, and allow allegedly 'uneconomic' lines like the rail line from Gisborne to the Hawkes Bay to attract alternative providers if they can be made profitable. Competition could be good for rail passengers as well, with potentially lower fares and more on-time services. Although, care would need to be taken that we don't simply swap one set of problems for another, such as we are seeing with Wellington buses at the moment.

There are also parallels with how airports are run. They aren't owned by the airlines that use the airport infrastructure. Presumably the public-benefit entity will receive fees from Kiwirail (and any other rail service operators on the network), but it could also develop the stations and receive commercial rents from retail firms, hospitality, and so on. This could reduce the subsidy required from the government, and if successful enough, perhaps no subsidy would even be required (although I think this unlikely).

Finally, it would be interesting to know if Treasury has similar views about other state-owned or privately-owned natural monopolies. We have Transpower, which runs electricity transmission lines on a similar model. But what about telecommunications infrastructure? Or water supply infrastructure? In each case public or private firms could deliver services over those networks, paying a fee to a public-benefit entity for the use of the infrastructure under their control. Given the recently compounding issues with Wellington's water infrastructure, an alternative model is definitely worth considering. But first, Kiwirail.