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. Last Updated: 07/27/2016

Russian Railways Seeks Overhaul of Cargo Pricing

VedomostiUnder the current rules, freight transport prices are based on the cargo’s value, not on the costs to transport it.

Russian Railways is seeking a complete overhaul of the way it charges companies to deliver freight, including an end to subsidies for certain goods, which could make rail transport too expensive for some of its current clients.

The proposals, which would allow RZD to make money on all of its cargo operations, are contained in a report prepared by McKinsey, a copy of which was obtained by Vedomosti. A representative for the state rail monopoly said it was essentially a jointly produced report, and that RZD agreed with all of its conclusions.

The report proposes basing prices on expenses to organize a particular delivery. Currently, all cargo is listed under one of three classes, with prices based on the goods’ value rather than the costs to transport them.

As a result, RZD ends up subsidizing certain goods at the expense others. For example, the margin on earnings before interest and taxes for coal cargoes in 2007 was negative 90 percent, according to the report, while the EBIT margin for ferrous metals was positive 50 percent.

Additionally, there are masses of discounts for certain products, with some 250 different pricing adjustments in place as of last year.

The proposal suggests a gradual shift to help protect shippers. For inexpensive cargoes, where the delivery costs represent a large part of its overall cost, RZD suggests moving to at least three-month shipping contracts that would include volumes, routes and schedules for the shipments.

As necessary, the state can continue to subsidize particularly important industries, but it should be done directly, rather than through the railroads, the report says.

A revolution in pricing is essential if RZD is to survive, according to the report. The company expects to carry 15.4 percent less cargo this year, compared with 2008, and RZD does not expect to reach precrisis volumes before 2013 or 2014.

The state has been limiting RZD’s requests to raise rates to keep up with inflation. In 2009, the company sought an 11.4 percent increase but was only allowed 8 percent. Next year, it will be allowed to raise them by 9.4 percent instead of 11 percent to 11.5 percent. But the government has also been directly subsidizing RZD, including 41.7 billion rubles ($1.4 billion) from this year’s federal budget and a planned 50 billion rubles in 2010.

If the rate increases remain at or below inflation rates and expenses continue to rise, RZD’s operating profit from cargo will fall to between 2 percent and 5 percent by 2015, down from its precrisis levels of 15 percent to 25 percent, the report says.  

RZD is also warning that it could have trouble raising loans to finance its investment program by then because of a high debt burden. The resulting decrease in investment could lead to irreversible consequences for the country’s rail infrastructure and trains, the report says.

A McKinsey spokesperson declined to comment. The proposals are being discussed with the relevant government bodies, none of which has expressed major concerns, an RZD spokesperson said.

Vitaly Yevdokimenko, a deputy head of the Federal Tariffs Service, said it was hard not to agree with RZD’s ideas and that it’s essential to reduce the amount of cross subsidies. “Not a single country with a developed rail cargo system has been able to completely get rid of cross-subsidies. In the United States, the maximum rate is 2.9 times the minimum rate, while in Russia it’s 2.7 times,” he said.

The service will complete its joint analysis of the proposals with the Economic Development, Agriculture and Industry and Trade ministries by the end of 2010, Yevdokimenko said.

 Like any normal company, RZD is looking to boost its earnings, but it’s very difficult given the current pricing system, said Georgy Tarakanov, an analyst at VTB Capital. With a more transparent system to form prices, it will be easier to control costs and profitability, and simpler to justify the need to increase rates, he said.

It is impossible for regulators to efficiently run a company as enormous as RZD, said Sergei Guriev, rector of the New Economic School. Instead of changing the rates, they should split RZD into several vertically integrated companies, he said.

“In that case, there would be real competition for cargo shipments, and you wouldn’t have all of these questions about the size of rate increases. They would be set by the market,” he said.

But companies that ship inexpensive cargoes are unhappy with the plan. Rates for transporting grain are already more expensive than in other countries, and the service leaves something to be desired, said Kirill Podolsky, co-owner of Valars Group.

“If the rates are raised even more, we’re going to ship grain in KamAZ trucks,” he said.

He said some grain companies have already started using trucks to transport grain over considerable distances.

Georgy Kutovoi, a former chairman of the Federal Energy Commission and an adviser to the president of industrial holding OMK, said the country would never be able to get rid of cross subsidies for rail cargo. If the real prices were paid for all cargo, the country would fall apart into individual regions, he said.