It's the end of the line for the hopes of the Sverdlovsk region

07.10.2010 — Analysis

The Second Freight Company public corporation that obtained a residence permit for Ekaterinburg in September of 2010, has announced the start of its business operations. Players in the market have been awaiting this moment with great anxiety. They are certain that this company, Russian Railways's newest subsidiary, will pursue the same goal as the First Freight Company, the company after which it was modeled. That goal is to extract as much profit as possible, regardless of the economic situation. The First freight company's insatiable appetite for fees has already forced cargo shippers to tighten their belts, and with the birth of the First freight company's "clone," they may have to give up eating altogether. Two correspondents for RusBusinessNews tried to find out if these fears are really justified. 

The creation of the Second Freight Company fits neatly into Rossiskie Zheleznye Dorogi's proposed structural reforms of the Russian railway system. In accordance with these reforms, the Russian railroad monopoly will gradually transfer most of its railroad cars to its non-state-owned subsidiaries. The First Freight Company (created in 2007) got more than 200,000 pieces of rolling stock, and its younger "sister" got about 180,000. Together, these "daughter" companies now have about 60% of Russian railways's fleet. By 2010, the First freight company controlled about 20-22% of the market for Russian rail shipments, and the Second freight company is hoping for an equivalent piece of the pie. The Second freight company could earn 10 billion rubles in revenue this year, and ten times that in five years.

Russian railways's structural reforms are based on the need to update its fleet of railroad cars. The company has repeatedly claimed that it cannot compete with private shipping companies because the state regulates the rates that Russian railways can charge. This chronic "pennilessness" prevents them from investing the money to modernize their rolling stock. Of course, Russian railways's net profits in the first half of 2010, according to IFRS, were as high as 58.4 billion rubles.

Its non-state-owned "daughters," whose rates will be free of government oversight, will be able to earn money and invest those funds in infrastructure. Russian railways's press office told RusBusinessNews that the Second freight company will invest more than 140 billion rubles in its rolling stock by 2015. This will take seven years off the age of its fleet (the average age of one of its railroad cars will go from 22 years old to 15). And, at the same time, this should solve the problem of the freight car shortage. Russian railways is also certain that both "daughters" will be able to compete against each other and against private carriers, which should help push shipping rates down and improve the quality of service.

Other players in the market do not share the monopoly's optimism. They are afraid that Russian railways's beautiful daughters won't look so good close-up. Before the birth of this youngest "daughter," the non-commercial partnership, Russkaya Stal (a consortium of major Russian steel producers), claimed that none of these wonderful goals would be met. "The creation of the Second Freight Companywill strengthen Russian Railways's daughters' dominant positions on the market and increase the costs of shipping and receiving cargo," claimed Aleksei Mordashov, the head of Severstal, in an official letter to the first deputy prime minister of Russia, Igor Shuvalov. The businessman is certain the First freight company and the Second freight company will be able to manipulate the market together, and Russiam Railways's monopoly will be transformed into an oligopoly of its "daughters."

Russkaya Stal thinks an acceptable price range needs to be established for the Second freight company, in order to protect freight shippers from out-of-sight prices. The steel industry points to the fact that shipping costs did not decline after First Freight Companywas established - in fact, they rose by 20-25%. The Union of Industrialists and Entrepreneurs of the Sverdlovsk region cites even more impressive numbers; they claim increases of 30-45%. In response, Vladimir Chernykh, the former director of the Ekaterinburg branch of the First freight company, accused the Union's representatives of lying. Without batting an eye, he claimed that the First freight company had never exceeded Russian Railways's price ceilings.

Industry colleagues claim that Vladimir Chernykh wasn't being completely truthful. Rail shipping rates are truly the same for everyone. However, once Russian Railways's "daughters" got their freedom, they found a very simple way to make money. "The shipping rates didn't go up, but the shippers' transportation costs did. In addition to the shipping rates, they now have to pay Russian Railways's ‘daughters' to supply the railroad cars. When the ‘railroad car fee' is added, the shipper's costs go up by 30-50%, and it'll be the same story with the Second freight company," confidently claims Vladimir Prokofiev, the president of the Association of Carriers and Operators of Rolling Stock and Rail Transportation.

Operators in Ekaterinburg back him up. Sergei Khaidarov, the director of the MS-Trans company described how this pseudo-market will be set up. He thinks that the monopoly's "daughters" will divide up the shipping business and focus on serving the large and medium-sized cargo owners. Second freight company will inherit most of these businesses from its parent structure. It is possible that some of the First freight company's customers will move to the Second freight company. "These companies will set the tone for the pricing, and smaller operators will find their costs quickly going up in accordance with the prices on this pseudo-market," he noted.

Meanwhile, Russian Railways is not trying to hide the fact that the Second Freight Company will give preference to high-paying freight, such as coal, metals, oil, construction materials, and chemical fertilizers. Hence the conclusion that rail reforms will be of no benefit to the producers of low-yield cargo such as wood and gravel.

After the First freight company was created, businesses in the Central Urals were faced with a catastrophic shortage of railroad cars. Tens of thousands of cubic meters of wood rotted in warehouses in the spring and summer of 2010. One of the largest gravel producers in the Sverdlovsk region, the public corporation Pervouralskoe Rudoupravlenie, almost went bankrupt because of product delivery problems.

Sverdlovsk Railways had just one answer: try the First freight company or private operators. Russian Railways's "daughter" also openly gave wood and gravel producers the boot, claiming a lack of rolling stock. But, according to the manufacturers, all the while some of those railroad cars were sitting on the siding, gathering dust and waiting for more profitable freight. By the way, Vladimir Chernykh has repeatedly tried to fend off accusations of having created an artificial shortage of railroad cars.

In July, after the media in the Sverdlovsk region raised a fuss, the shortage miraculously disappeared, only to return in mid-September. "We haven't been able to ship any wood out in more than a week. We've got about 2,000 cubic meters of lumber piled up in the warehouses. They have platform cars, but we need open railroad cars. Sverdlovsk Railways once again told us to go to the First freight company and private operators, but they won't work with us," tells Sergei Kozmenko, a private entrepreneur from Verkhnaya Tura.

Manufacturers attribute the current shortage of rolling stock to the Second freight company being created and getting another third of Russian Railways's fleet of railway cars. According to information obtained by RusBusinessNews, the First freight company took advantage of the situation, and in September was ready to provide open railroad cars, but at twice Russian Railways's rates. Private operators, as was predicted, took a break until October. Following Vtoraya Gruzovaya Kompaniya's example, they expect to raise shipping rates by 30%. The carriers are confident that the Second freight company's claimed 5% reduction in charges for the first phase of its operations will not save the market from price escalations.

At the beginning of autumn, it wasn't just producers of lumber and road-construction materials who found themselves in a train wreck. According to a representative of a certain Central Urals cement factory, his company is being deprived of 10-15% of the rolling stock they need each month. They have lost 15-20 million rubles because of this. "Maybe the situation will change when the Second freight company gets up and running. We hope that since the Second freight company is now registered in Ekaterinburg, that might facilitate the negotiation process," one employee of the factory said hopefully. But he refused to give his company's name, for fears of "railroad car" reprisals from Russian Railways's "daughter." Obviously, it was for this same reason that some major industrial firms refused to comment on the situation.

Government authorities in the Central Urals have high hopes for the Second freight company's Ekaterinburg residence permit. The regional government put a lot of effort into getting the company to register their headquarters in the capital of the Urals. They had to offer the freight carrier some tax breaks in order to convince them to come here. The necessary law was passed in record time. That law provided incentives to any enterprise that begins running railroad cars in 2010-2011. For three years they (i.e., Second freight company) will not be required to pay property taxes. Vitaly Nedelsky, the acting Minister of Economy of the Sverdlovsk region, admitted that the region will lose about 540 million rubles in 2011 because of this change in the law. But he advised the deputies in the Regional Duma not to worry about such a significant revenue loss, promising that in 2012, the treasury would receive an additional billion rubles in tax receipts. The Cabinet believes that if one factors in taxes on profits, the additional amounts of money will be even more substantial.

It would seem that the Sverdlovsk region had finally gotten a seat in the right "railroad car," which would whisk it off to a financially rosy future. But a closer examination of the situation shows that the well-publicized governor Aleksandr Misharin and his team have come to the end of the line.

By helping the Second freight company, the government authorities in the Central Urals have at the same time created an unexpected problem for the company. The First Freight Company's shipping rates have hit some companies in the region pretty hard, and those businesses have taken the new law as a call to action. Anatoly Gredin, the head of the regional government, said that the public corporation NPK Uralvagonzavod, which manufactures rolling stock, is planning to create its own two shipping companies right away. Once they get on their feet, they will eventually be able to put some market pressure on the Second Freight Company.

Some of the deputies in the Sverdlovsk Regional Duma question the Cabinet's optimistic predictions about tax revenues. Nikolai Voronin thinks it is possible that the Second freight company's management might move its central office out of Ekaterinburg and apply for a different "residence permit," once their tax holiday ends. The company might be able to find a more favorable tax climate in a different region.

Even the Communist deputy Georgy Persky suggested that no one should be under any illusions about the Second freight company. "Look at the First freight Company. No one is trying to hide the fact that Second freight Company is modeled on it. They even have the same number of railroad cars and terms of transfer from Russian Railways. The taxes on profits that the First freight company pays are not nearly as high as they would have us believe. Considering that the railroad car transfer will take at least four years, for the first two years there won't be much revenue from the Second freight company, but think how much our Sverdlovsk regional budget will lose during that time! This law about providing tax incentives was created especially for the Second freight company. It's a blatant example of industry lobbying from the former head of Sverdlovsk Railways, the current governor Aleksandr Misharin."

Konstantin Dzhultaev and Marina Sirina