90117 China Transport Topics No. 10 August 2014 Private Capital for Railway Development Martha Lawrence & Gerald Ollivier World Bank, Washington & Beijing China is considering ways to attract additional capital to finance investment in railways. Worldwide, private capital has been attracted to the railway sector through a range of mechanisms including (i) private sector provision of specific rail services or assets such as rolling stock; (ii) public private partnerships, (iii) leveraging commercial value of rail assets and increased land value around stations; and (iv) debt and equity financing of railway companies. Private sector investors seek to earn a return on their investment that is commensurate with the risk of the investment. Therefore they will be attracted to profitable opportunities with manageable risk. Steps China could take to attract private capital for railway development include: (i) creating a policy and legal environment that protects the interests of different types of investors in the railway sector; (ii) identifying and creating profitable railway markets and entities that are suitable for private sector investment; (iii) managing the perception of risk in railway activities and assets; (iv) promoting asset sharing opportunities; and (v) expanding PPPs in rail assets and services. CHINA’S INTEREST IN ATTRACTING PRIVATE railway sector. 1 The Opinion discussed CAPITAL TO RAILWAY INVESTMENTS broadening the base of ownership of railways, creating new financing mechanisms, adjusting China has explored a number of ways of for the tariff and subsidy structure, and leveraging attracting financing to the railway sector. land owned by railways. Starting in the 1960’s, local railways (short branch lines connecting to the main railway This Transport Topics note looks at the ways network) were jointly financed by the Ministry of private capital has been attracted to the railway Railways (MOR) and local government. By the sector throughout the world, seeks to identify mid-1990’s, MOR and Provincial governments common characteristics of the more successful financed joint venture railways, sometimes also experiences, and suggests how those successful involving local shippers, for example for the characteristics might be replicated in China. Shuohuang line. Shippers have also financed While this note discusses attracting private railway construction. For example, Shenhua capital for railway development, attracting Group, a large scale state owned energy equity financing can also contribute to de- company, owns and operates nine coal hauling leveraging a rail entity’s balance sheet by railway lines. 1996 saw the first public trading of substituting equity for debt financing. stock in a Chinese regional railway (Guangshen Railway). Since then, Daquin Railway and several INTERNATIONAL EXPERIENCE WITH PRIVATE railway construction entities have floated shares. INVESTMENT IN RAIL The challenge is to broaden and scale up these The experience of private investment in railways approaches, attracting private sector investors has a long history and is very broad. to railways in a broader set of markets. In August Governments have sought private investment in 2013, the State Council issued an Opinion that railways for different purposes, including (i) sought to identify ways that additional capital 1 could be attracted to finance investment in the Opinion of the State Council on Reforming the Railway Investment and Financing System and Accelerating Railway Construction (Aug. 9, 2013). China Transport Topics No. 10 2 World Bank accelerating network development; (ii) lease it to someone else). Therefore, this form of increasing efficiency in asset development, financing tends to be relatively low cost. management and operations; (iii) improving service delivery through commercial focus and Leasing allows railways or shippers to pay for the innovation; and (iv) reducing public sector asset over its life as it generates profit rather financial exposure. than all at the beginning. It also allows for matching of various railways demands for rolling This note discusses four mechanisms for stock to the time period and type of rolling stock attracting private investment: (i) private sector needed. For example, in Britain, the terms of provision of specific rail assets or services; (ii) most passenger service franchises were shorter public private partnerships, (iii) leveraging than the life of the rolling stock needed to commercial value of rail assets and increased execute them. Leasing allows a franchise land value around stations; and (iv) financing operator to rent rolling stock only for the period railway companies. These mechanisms are of its franchise and provides for smooth transfer discussed separately, but they overlap and can from one franchise operator to another. be combined as circumstances require. Considerable private investment in railway equipment has been attracted through leasing. Provision of Rail Assets & Services In North America, for example, the Union Pacific Private investment is attracted to provision of Railway leases 29 percent of its locomotives railway assets or services in cases where a (over 2,400 locomotives) and 45 percent of its market is created for the provision of the asset freight wagons (30,000 wagons).2 or service and a private sector provider can make a profit providing it. The railway or railway Wagon Operations. In 2003, Russia allowed customer will purchase the service when it private companies to own and manage freight benefits from lower cost, better service, or wagons and changed the tariff rules so that this financing provided by the private sector. activity could be profitable. This created a Examples include leasing of rolling stock, vibrant market for private financing and contract track or rolling stock maintenance management of freight wagons. Currently about services, and operation of rolling stock. In each 85 percent of freight wagons in Russia (about 1.2 case, the private sector finances assets million wagons) are now owned by the private previously financed by the railway (rolling stock, sector. track maintenance machinery, depots or workshops). For services, the private sector also finances the working capital for operating the business. Rolling Stock Leasing. Leasing is a common way for railways to attract private financing for rolling stock. The lessor buys the rolling stock and rents it to railways or shippers for a price that, over time, covers the cost of the rolling stock plus a return on investment. The lessor Source: Harral Winner Thompson Sharp Klein, Inc. itself is typically an entity financed by equity shareholders and debt holders. The lease is 2 secured by the rolling stock so the risk for the Union Pacific, Form 10-K (2013). The present value lessor is relatively low (If the lessee fails to pay, of UP’s minimum capitalized leases for the period of the lessor can repossess the equipment and 2014 and beyond was US$ 1.7 billion. China Transport Topics No. 10 3 World Bank Public Private Partnerships and Spain. It was built by a consortium of private Investment and financing can also be attracted firms under a 53 year concession agreement in to the railways sector through Public Private which the concessionaire took financial risk in Partnerships (PPPs) in which public and private return for the right to charge a toll on sector cooperate to build and/or operate a passengers and freight that use the line. The railway. Between 1990 and 2012, some US$ 60 public and private sectors each provided about billion of investment has been committed half of the total investment of €1.1 billion. The through PPP projects in low- and middle-income line opened in December 2010. countries, with 56 percent through concessions of existing railway assets and 44 percent through Special Purpose Railway Concessions. Railways green field projects.3 are often the most economical way for mining product to be transported to end users or ports for distribution, so mining companies may invest PPP Investment In Railway (US$ billion) 9 in railway infrastructure and operations. Such 8 companies receive a financial return by providing New transport to support their own operations and 7 6 Existing typically to other shippers for compensation. For example, Vale S.A., one of the largest metals and 5 mining companies in the world, has invested in 4 shares of railway concessions in Brazil, 3 Mozambique and Malawi. In these concessions, 2 it pays a concession fee to government for the 1 right to operate the railway for a relatively long 0 period (e.g., 30 years) and becomes responsible 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 for investing in and maintaining the railway infrastructure and rolling stock. Source: World Bank PPI Database In China, Shenhua Group is an example of a Successful PPPs are structured so that the mining company that finances railway lines to private sector makes money by accomplishing transport its mining products. Shenhua Group the objectives of the public sector. Typically, the owns and operates nine railway lines totaling private sector has higher financing costs than the 1,765 km, with an additional 313 km under public sector, which must be offset by other construction. Shenhua Group railways carried benefits, if the PPP is to create value-for-money. over 200 billion ton-km in 2013. Thus careful analysis of each arrangement is necessary. PPPs work best when outputs can be Low Density Regional Railways. In Japan, low clearly specified and monitored. The three density railway lines are operated by so called examples described below demonstrate the “Third Sector” railway companies, which are range of such ventures in the railway sector. jointly owned by the public and private sectors (the local community owns half to three- HSR Concession. The Perpignan-Figueres Line is a quarters of the equity, while private investors 44 km high speed railway line between France own the remainder). Typically, the railway operations are modestly profitable, but cannot 3 Investment amount made or to be made by the support capital investment, which is provided by project company under the PPP contract (not the public sector partner. In cases where actuals). If the project company is jointly owned by operations do not cover costs, the public sector the Government and the private sector, this may subsidizes the service to make it attractive to the represent both Government and private financing. China Transport Topics No. 10 4 World Bank private sector investor. Many Chinese local arrangements. The value capture schemes varied railways operate on a similar model. based on location and stakeholders. In the case of the Tokyo Metropolitan Area, six types of land Leveraging Railway Assets value capture were applied. 4 Among those Railways often have assets that are valuable to methods, private railways were able to carry out the private sector as well as to the railway. land readjustment projects around stations, by Common examples, described below, include receiving land reserved for new town use of the railway right-of-way by development and by internalizing real estate communications companies and commercial capital gains to cover railway investments (e.g development of railway real estate. Tokyu Corporation Tama Denentoshi Line). They sometimes also managed to share part of the Right-of-Way. Railway rights-of-way are useful costs with private developers and building for many types of utilities—communications, owners (Yokohama MM21 Line). Former rail power, water. For example, in India, RailTel, a yards in central Tokyo were also transferred to wholly owned subsidiary of Indian Railway, has the Japanese National Railway Settlement about 42,000 km of optic fiber cable running Corporation and then sold through public along the railway right-of-way. RailTel uses this auctions and other transactions to reduce the capacity to sell telecommunications services to amount of debt accumulated during the network telecommunications companies in Indian and to expansion. large commercial clients. Similarly, in the US, the Southern Pacific Railroad pioneered selling Financing Railway Companies shared use of its telecommunications network to Private investors are also willing to buy bonds or commercial buyers. It is now part of the third equity shares in railways, when the underlying largest wireless network operator in the US. railway business is profitable. Examples include vertically integrated railways in China, Japan and Real Estate. In Hong Kong, the metro company, North America and train operators in Europe and MTR Corporation, leases retail and advertising Australia. space within its stations and has the right to develop residential and commercial projects China. The Guangshen Railway Company Limited both within and above existing stations and provides passenger and freight rail services along new line extensions. It carries out the real between Guanzhou and Hong Kong. Shares in estate projects through joint ventures with the company were first listed on the New York private, commercial real estate developers. As of and Hong Kong stock exchange in 1996, yielding 2013, MTR had completed developments at 33 RMB 4.2 billion net (US$ 526 million). The stations, generating some 94,000 housing units company is profitable and trades at a P/E ratio of and more than 2 million square meters of 12.5.5 commercial space. In 2013, the station commercial business, property development and North America. The freight railways in North rental activities in Hong Kong generated an America are privately owned. The equity of the operating profit of US$1.1 billion to support the large railways has a market value greater than railway activity. In addition, the property 4 development near the station supports the See “Financing Transit with Land Values”, World metro by generating metro trips. This financing Bank 2014. 5 model is being explored for metros in China. P/E ratio is the stock price/earnings of the previous fiscal year. Thus, a P/E ratio of 12.5 would equate to 8% current earnings rate on an investment, as a In Japan, agencies have long applied land value percentage of its current market price (E/P). capture mechanisms to finance their railway development in conjunction with other funding China Transport Topics No. 10 5 World Bank US$ 250 billion6 and trades at an average P/E that the investment cannot be liquidated when ratio of 22.9. While some of the railway were needed). always private companies, two were government owned and were sold to private Railway investors typically consider risks related investors. In 1995, the Canadian government to: traffic, tariff, competition, dominant industry floated shares government-owned railway, players like CRC, regulation, labor, technology, Canadian National for US$ 1.65 billion. In 1987, environmental liabilities, transport of hazardous the US Government sold 85 percent of materials, operational safety, weather, and government-owned Conrail to private investors energy costs. Depending on the country, for US$ 1.6 billion. After twelve years under investors may also consider risks related to private management, Conrail was bought by CSX corporate governance, fair treatment of minority and Norfolk Southern for US$ 10.3 billion. shareholders, expropriation, currency risk, war, and civil conflict. For example, a recent stock Japan. In 1987, Japan reformed its heavily loss analyst’s report highlights the “legal and making Japanese National Railway, by dividing it regulatory risks associated with Chinese into regional railways, creating a commercial operations, our corporate governance concerns environment in which they would operate, and resulting from related-party transactions, transferring accumulated debt to a settlement dependence on operations of the national company. At first the stock was held by the freight rail network, exposure to economic public sector, but after they began showing cycles, and exchange rate volatility.7” positive financial results, shares were progressively sold to private investors and Railways typically finance their operations with a proceeds used to pay off the settlement combination of debt and equity. The debt may company debt. The privatization was completed take the form of borrowings from financial in 2002 for JR East, 2004 for JR West and 2006 institutions or of bonds sold to the general for JR Central. Today, the three companies have public. Debt obligations are paid as a contractual raised equity of US$ 45 billion and bonds of US$ obligation (and may be secured by rolling stock 31 billion from private investors and financial or other assets), so are less risky than stock, institutions. which receives a return only after the obligations to debt holders are satisfied. As a result the ATTRACTING SUPPORT OF PRIVATE INVESTORS return required by investors on debt is normally lower than the return on equity. Private sector investors seek to earn a return on their investment that is commensurate with the A railway’s overall Weighted Average Cost of risk associated with it. Investors require a lower Capital (WACC) is the return on all debt and rate of return for an investment considered very equity weighted by their respective shares in the safe and a higher rate of return for more risky capital structure: investments. In weighing the risks, investors consider both the risk of receiving less than the WACC = (% share of capital that is debt) X expected return (in interest or dividends) and (expected return on debt) + risk to the value of the investment principal (that (% share of capital that is equity) X the value of their investment may decline, or (expected return on equity) 6 Market Capitalization of Canadian National, Canadian Pacific, CSX, Genesee & Wyoming, Kansas For large US railways in 2012, the cost of long City Southern, Norfolk Southern, and Union Pacific. term debt was determined to be 3.3 percent, This does not include the value of Burlington 7 Northern Santa Fe, which was purchased by Berkshire S&P Capital IQ, Stock Report: Guangshen Railway Co Hathaway in 2010 (estimated value of US$ 40 billion). Ltd. June 21, 2014. China Transport Topics No. 10 6 World Bank while the cost of common equity was 13.4 have to be able to understand the risks and percent and the overall WACC was 11.12%. 8 believe that risks can and will be managed. Note that the return to shareholders as priced in Higher risks require higher return. Investors will the market is comprised of both (i) a current typically pay a premium to obtain management earnings rate (about 4.4% for large US railways) control of an enterprise, because that assures plus (ii) the expectation of increases in earnings them that they have the right to manage the per share into the future. risks to their investment. Investors seek companies that will earn enough PPPs Should Create Value for All Participants. profits to pay for both debt and returns on When the public sector and the private sector equity investment. Therefore, they invest in work together in a PPP, the PPP must generate companies whose rate of expected return on value for both parties to be sustainable. The assets is greater than the company’s expected public sector may benefit from the private WACC. sector’s market responsiveness, cost efficiency, technological knowhow or financial capacity. The CHARACTERISTICS OF SUCCESSFUL EXPERIENCE private sector may benefit from the public sector’s existing assets, exclusive right to Experience shows that railways can attract operate services, knowledgeable staff, access to substantial private sector investment and that resources or ability to manage certain risks. The there are some common elements of successful deal has to work for both parties—lopsided PPPs experiences. usually end up in bankruptcy or with one party abandoning the PPP. The Activity Must Be Profitable. Private sector investors want to make money. Therefore, they Risks in PPPs Should Be Taken by the Party Best will only be attracted to activities that are Able to Manage Them. In structuring a PPP, the profitable. If the activity is inherently public sector is best able to manage certain risks profitable—wagon operations in Russia, station (e.g., land acquisition or risks associated with development in Hong Kong, or freight transport government actions) while the private sector in the USA—private investors will naturally be may excel at managing other risks (e.g., attracted to it on a significant scale. If the attracting customers). Successful PPPs share the activity is not inherently profitable, then the risks in a way that the party best able to manage private sector can be attracted to invest in it, but them has the responsibility and incentive to do only if government supports the activity so. financially and with sufficient certainty to make long term investment profitable and acceptably RELEVANCE FOR CHINA risky to the private partner. This can be achieved through a proper combination of dividend and A range of creative approaches are available potential capital appreciation, for example within the framework discussed above to attract related to land use rights located near stations. more private sector investment to the railway sector by “packaging” railway investments to The Risks Must Be Manageable. Private sector provide a return and mitigate risks so they are investors are willing to take risks. However they attractive to private investors. 8 United States Surface Transportation Board, Identify and Create Profitable Railway Activities. Railroad Cost of Capital – 2012 (decided: August 30, The most fundamental step is to create railway 2013) found that the weighted average cost of capital markets (e.g., equipment leasing) and entities for US railways in 2012 was (22.56% debt capital X (e.g., service companies, leasing companies, real 3.29% return on debt) + (77.44% equity capital x estate companies, railway infrastructure 13.40 return on equity) = 11.12%. China Transport Topics No. 10 7 World Bank companies) that are profitable and financially Investors are wary of investing in the equity of a sustainable. This would build on the model, company that is controlled by government, for already partly in place, with joint ventures in fear that their concerns as minority shareholders charge of line construction and operation, and will be ignored. This can be addressed by making outsourcing of track maintenance and train a significant share of the entity’s stock available operations to railway administrations. This to investors and broadening the shareholder model, adjusted with transparent rules on access base. This issue is less of a concern for debt and pricing could allow for private participation. financing, as debt is a contractual obligation and Where China wants to attract private sector government control of equity often creates an investment to inherently unprofitable activities, implied guarantee of the debt. it will need to create a system for providing subsidies to those activities. The State Council Any actions government takes to enhance the Opinion of August 2013 takes a step in this overall investment climate, such as enhancing direction, referring to “establishing a reasonable protection of rights of minority shareholders subsidy mechanism for welfare transportation.” (shareholders who do not have a significant direct ability to influence management control Create Policy and Legal Environment that over risks), would also reduce the perception of protects the interests of different types of risk.9 investors in the railway sector. Investors perceive a number of risks to the railway sector because Promote Asset Sharing Opportunities. The the legal/regulatory framework, corporate potential for development of land around governance and management control of railways, railway lines in China, although constrained by strongly focus on State-owned railways and regulation, is high. The State Council Opinion of China Railway Corporation. This environment August 2013 affirmed the importance of provides limited protection and creates encouraging “comprehensive land development uncertainties for private investors. Investors and use” and “comprehensive development of considering development of branch lines or railway stations land and the land along the resource-based lines, would be particularly railway lines.” This Opinion was clarified as part concerned about traffic routing and the interface of a new State Council Directive [2014] (37) with the rest of the network. Government can issued in July 2014 on “Land Comprehensive mitigate these risks by creating a legal Development in Supporting Railway framework for railways that is clear, objective, Construction”. reliable, compensatory and neutral between public and private suppliers of similar goods or The new Directive establishes the principles of services. This would be an efficient way to comprehensive land development around rail reduce private investors risk level and their cost stations. It emphasizes the need for three- of capital. dimensional development (ground level, above ground and underground), good interface across Manage the Perception of Risk. The government transport modes, functional integration of the and CRC currently control many of the “levers” stations and economic and intensive and of profitability of railway entities in China. For economic use of the stations and adjacent areas. example, control of tariffs gives the government It emphasizes the need for close planning by substantial control over the revenue component local governments, and the effective use of land of the profitability equation, affecting both around new and old stations by railway current earnings and the potential for growth in transport companies. It also encourages earnings over time. Establishing clear, objective, 9 reliable, and compensatory tariff regulation See World Bank, “Railway Price Regulation In China: could mitigate investor’s perception of this risk. Time for a Rethink?” (2011). China Transport Topics No. 10 8 World Bank investors in new rail projects to implement Paul Amos, Consultant, John Winner and Andrei comprehensive development of land around Evdokimov, Harral Winner Thompson Sharp stations and adjacent areas to secure financing Klein. and revenues. This note is part of the China Transport Note This new Directive provides a valuable Series to share experience about the opportunity to broaden the source of financing transformation of the Chinese transport sector. for rail development and to increase the For comments, please contact Martha Lawrence economic viability of new lines. Until recently, (mlawrence@worldbank.org) from the land value increases accrued to the local Washington World Bank Office or Gerald Ollivier government and developers, only. The new (gollivier@worldbank.org) from the Beijing Directive offers a possibility for an investor to World Bank Office. combine land development rights with the development of a new railway projects. The Any findings, interpretations, and conclusions application of the new Directive will require a expressed herein are those of the authors and do number of pilots to turn those principles into not necessarily reflect the views of the World reality, through clear mechanisms for integrating Bank. Neither the World Bank nor the authors urban planning, land use and rail development in guarantee the accuracy of any data or other areas around stations. The definition of a priority information contained in this document and development area around stations, as provided accept no responsibility whatsoever for any by the new Directive, could facilitate such consequence of their use. process. Expand PPPs for Services. Passenger and logistics service are fields where scope for development in China exists and private sector companies are active throughout the world. Private sector companies have strong technical and management knowledge, while Chinese railways have local knowledge, transport capacity, land and facilities. The potential for development of PPPs for rail-linked logistics services in China appears high and worth expanding. ********** Martha Lawrence is a Senior Railway Specialist in the Transport and ICT Global Practice in the Washington Office of the World Bank. Gerald Ollivier is a Senior Infrastructure Specialist in the Transport and ICT Global Practice in the Beijing Office of the World Bank. Other contributors include: Emre Eser, Infrastructure Specialist, Transport and ICT Global, World Bank, Richard Bullock, Consultant,