South Africa’s current freight rail regulatory regime does not possess most of the features of economies that perform well on the basis of volume growth, volume density, train performance and staff productivity. The freight rail regulatory regime lacks a settlement process; rules on pricing, investment and access; and an independent regulator with legislated investigative, enforcement and decision‐making powers. The same applies to the terminal operations at South Africa’s ports – TPT manages 16 cargo terminal facilities across the South African ports. Although many private companies are involved in the port terminal operations, they mostly operate in individual markets and do not compete with TPT, or with each other.<sup>20</sup> Department of Transport plans to improve the regulation of the sector by establishing the STER. At this stage the STER is proposed to cover road, rail, aviation and maritime transport. It is intended that the STER will be self‐funded through a surcharge levied on the regulated entities, based on the cost of regulating a particular sector. If this is insufficient, the STER can be funded through the money appropriated by Parliament.

# <u>Failure to force transparency in cross‐subsidization</u>

Transnet’s centralized structure (where a single CEO and board approve decisions for all of its operating divisions) allows the company to move funds between operating divisions. As a condition of the petroleum levy and the National Ports Act, Transnet is required to corporatize its Pipelines and National Ports Authority operating divisions. Transnet has indicated that the corporatization of these two operating divisions is likely to have a material financial impact – it raises capital using its complete balance sheet – and could constitute a default of its funding agreements (Transnet, 2014b).

There are two types of cross‐subsidization that takes place within Transnet: (i) cross‐subsidy within an unregulated sector between consumers of the same output (within a vertically integrated entity – e.g. TFR); and (ii) cross‐subsidy between regulated and unregulated sectors which have economically distinct outputs (within a horizontally integrated entity – Transnet) (Heald, 1997). The first type occurs within TFR between the heavy haul and the general freight businesses. In this case, a certain degree of cross‐subsidization is unavoidable: there are costs that are common to both business units. Even strict accounting rules for the separation of are unlikely to prevent this. The second type of cross‐ subsidy occurs, for example, from the profitable Pipelines and National Ports Authority divisions to the rest of Transnet. The National Ports Authority, which generated 22 percent of its EBITDA and 13 percent of its revenue, received only 9 percent of its capital investment. This is not a once‐off anomaly, using historic financial data it is clear that it reflects a trend: despite TNPA being one of Transnet’s most profitable divisions, its share of total investment has declined in recent years.

Profits from Transnet’s more profitable divisions are being diverted to the freight rail division to correct for historical underinvestment.<sup>21</sup> This diversion of profits may have the unintended consequence of undercapitalizing key components of the freight logistics network, such as the port system, in order to compensate for years of underinvestment in freight rail. Also, it is possible that cross‐subsidization delays Transnet’s response to the competitive pressure from road haulage: profits generated in the export commodity lines and other businesses to some extent permit continued underperformance of the general freight business. Cross‐subsidies continue to distort the incentives for efficient cost recovery which prevents a business from improving capacity allocation, responding to user needs and maximizing cost‐recovery for use of infrastructure.

> 20 Examples include the RBCT operated by coal producers, the SA Sugar Terminal operated by the South African Sugar Industry Association and handling of the bulk petroleum cargo.

> 21 This is based on an analysis of data from 2010 to 2015. The unavailability of earlier data prevents an understanding of historical trends in cross‐subsidisation. For example, it may be that historical underinvestment in rail is partly due to the fact that the port system previously received the bulk of investment based on a more attractive return on investment (ROI). One could argue that the ROI for investment in freight rail versus port infrastructure was skewed by an unlevel playing field between road and rail as well as port tariffs that are very high by international standards.

_17_