Ukrainian Railway Reform and Investment Options

The Ukrainian railway industry is characterized by a dominant player, the Joint Stock Company Ukrzaliznytsia (UZ), a unitary enterprise with regional branches. UZ operates the country’s public rail infrastructure, a natural monopoly, and provides passenger and freight transportation and services in adjacent markets. The post-soviet model of regional governance, as well as financial challenges of the last decade, have created an ongoing crisis for UZ. This is a classic example of deteriorating quality of services of a natural monopoly while costs continue to rise. To address the problems the government aims to change the rules in the rail transport sector through deregulation and private investment. It must be said that this strategy is at the initial phase and investors are not lining up to enter the market. However, sooner or later, reforms will be launched, and those armed with essential information will get an advantage.

What are UZ’s Assets?

UZ controls two types of property: the first one includes assets dedicated to social and non-core activities, i.e. production of various goods and services consumed by the core business — operation, maintenance and development of the public rail infrastructure, as well as freight and passenger transportation services. The company also owns rolling stock (locomotives, wagons and other machinery). It is important to note that the main buildings of all passenger stations in Ukraine are owned by UZ. This is actually an exception from the second type of property: publicly-owned rail infrastructure of general use operated by UZ. Existing legislation prohibits the privatization of infrastructure, or any contracts for its O&M, lease or PPP/concessions.

Theoretically, the public company’s assets can be an object of purchase and sale, lease and concession agreements. However, as a public company fully controlled by the government, UZ acts cautiously according to its Strategy. Approval of the document is a kind of prelude to coming reform in the railway transport sector. So far we have seen progress in several directions.

Concessions for Passenger Stations

The process has been launched thanks to the Global Infrastructure Facilities and International Finance Corporation (World Bank Group), which secured funding for a pre-feasibility study of concession projects. The first group of stations includes Kyiv Central, Kharkiv, Dnipro, Khmelnytsky, Vinnytsia, Mykolaiv and Chop. Concessions for the operation and development of these objects may turn out to be sustainable investment projects. But today it’s hard to predict when the next steps will be taken.

IPO

At the end of November 2019, the EBRD, Ministry of Infrastructure of Ukraine and UZ signed a Memorandum of Understanding on UZ’s IPO. The document is not publicly available, though numerous statements by the company’s management have revealed that money, and UZ expects to raise USD 3 billion, will be directed towards renewal of rolling stock. The ministry considers that the IPO could potentially be best placed in the US and UK markets. Logically, in the context of UZ’s restructuring strategy, the IPO could be organized after UZ’s reorganization and establishment of a new cargo company, which will own the rolling stock.

Divestiture of Non-core Assets

Another opportunity for investment is acquisition of UZ’s non-core assets which, according to the company’s statements, are valued at UAH 7-10 billion. The list of those assets is still being compiled, though we can say that these property facilities are used for various economic activities, such as production of construction materials, animal farming and even medical services. The selling procedure has not been defined yet.

Another investment opportunity may be to establish joint ventures in which the company will retain joint control over new business entities, even though this type of investment has not been registered in Ukraine since the mid-90s.

Access of Private Locomotives to Public Rail Infrastructure

The permanent shortage of locomotives is one of the reasons for liberalization of the freight rail transport segment. The only available option for investors today is a lease. Nevertheless, the private sector does not seem to find the lease contract a sustainable solution.

Since opening the freight market is a long-term process, the Draft Law On Railway Transport sets a 2-year transition period. But the government decided to start an advance pilot project allowing private locomotives to use public rail facilities on a limited number of routes. This is the first case when private companies were allowed to operate on the public rail infrastructure and it’s a real incentive for freight owners to invest in additional rolling stock.

Coming Reform and Investment Opportunities

It is difficult to say when the first draft of the Law On Railway Transport was developed. Nobody knows how many drafts have been elaborated since then. The Transport Committee of the Ukrainian Parliament is currently discussing the latest version. The draft is one of consensus between the public authorities and major market players, primarily large freight owners and port operators. Understandably, the draft is not perfect, but everyone agrees it should outline the future structure of the market. Here are the key features of the law and how its implementation is likely to affect investment in the sector.

The core of the proposed reform is establishment of a vertically-integrated management system consisting of six companies engaged in specific operations. On the top of the pyramid there will be a company with a corporate management function. Another company will operate the public rail infrastructure and provide access to the facilities; as a natural monopoly it will be subject to regulation by the state. The users of this company’s services will be two separate freight and passenger carriers which in the future will compete with other private companies on the market. The other two subsidiary companies will supply products and services for the needs of the infrastructure operator and utilize non-core assets for social and other purposes.

The draft law introduces a new definition of “strategic assets” which include the main railways in general use, technological facilities and transmission devices being directly used by transport operators. The strategic assets are not transferred into the authorized capital of UZ, and they will remain in public ownership and be operated by the company operating the infrastructure. They can’t be privatized, leased or transferred into concession. It is worth noting that all buildings of the railway stations will become the property of the infrastructure company.

The remainder of UZ’s property, such as railway rolling stock, industrial factories, maintenance and repair depots, as well as non-core assets, will be transferred into the ownership of other companies in accordance with their relevant functional use.

No need to dig deeper into other important developments such as tariff regulation, transport regulator, safety standards and cargo security. It is sufficient to focus on the above issues in order to understand future investment opportunities. Analysis of the draft law shows that it will diversify objects for investment but it does not create any special mechanisms or instruments to attract investment into the rail sector. The existing legal status of UZ’s assets will remain the same after the bill has been adopted. The only difference will be operation as a group of six companies instead of one.

The operator of the public rail infrastructure will primarily manage so-called “strategic” facilities. The draft law does not explicitly prohibit lease or PPP/concessions of such facilities. However, the design, construction, reconstruction and modernization of strategic infrastructure objects can be performed only by the infrastructure operator. It means that those facilities cannot be an object for any investment projects with the participation of private capital. The only exception is concessions for railway passenger stations.

The start of reform will signal the launch of preparations for the IPO of the cargo company. This is the most lucrative business, which requires infusion of capital. The UZ Strategy does not envisage that the assets of the cargo and passenger transport companies can be privatized, leased or transferred into PPP/concession.

Those companies supplying goods and services for the core rail transport business are likely to create wider opportunities for investors and strategic partnerships with international players. However, the Strategy does not specify the legal forms of such potential collaboration.

The organizational structure of companies managing social and non-core assets will be set up with regard to activities not directly related to the transportation business. Before launching the divestiture UZ must prepare a plan for the optimization of non-core assets with the criteria for identifying assets and activities as non-core, their importance for the main business and methods to decide on their future use: lease, sale, etc.

As we can see, all investment opportunities will appear after the restructuring of UZ is completed or, at least, during this process. According to the timeline set out in the Strategy, the process will take two years from the time that the Law of Ukraine On Railway Transport comes into effect.