Estonia: The Privatisation of Estonian Railway System Constitutes a Precedent in Europe

Estonia has risen to share (with Ireland, the Netherlands and the USA) fourth place in the Index of Economic Freedom made up by the Heritage Foundation together with The Wall Street Journal for year 2001.

Therefore it cannot be surprising that Estonia has managed to successfully use the model of free economy also in its privatisation policy. The privatisation of state enterprises in Estonia, which in the first years of re-institution of independence was first and foremost envisaged to create a functioning market economy, has advanced even farther than can be noticed in the privatisation practice of several states with "deep-rooted" market economy.

The privatisation of the railway system in Estonia was actually the first grant of the use of a railway system entirely to the private sector in continental Europe.

Railways have been privatised also in Great Britain. However, the privatisation model applied in Great Britain and the conditions for the functioning of railway undertakings in Great Britain are substantially different from those in Estonia. Therefore, it would not be appropriate to transfer the problems that arose in the privatisation of British railways into the context of Estonia.

Instead, the privatisation of the railway system in Estonia can to a certain extent be compared with the USA where larger railway enterprises are completely in private ownership and where is no such an extensively authorised possessor and regulator of infrastructure like Railtrack in Great Britain.

The privatisation of the gigantic monopoly Estonian Railways that originated from the times of Soviet occupation was a complicated and responsibility-involving task from both legal and economic aspect.

In the privatisation of Estonian Railways, first the state enterprise was transformed into several smaller companies. The transformation was based on the functions that the new companies founded on the basis of state enterprise Estonian Railways were to fulfil.

The two key companies founded on the basis of state enterprise Estonian Railways were AS Eesti Raudtee (Estonian Railways Ltd) engaged mostly in freight traffic, and AS Edelaraudtee (South-eastern Railways Ltd) engaged in passenger traffic within the territory of Estonia.

After the transformation of the "old" Estonian Railways, the state decided to sell, by way of international competition, the shares of the public limited companies established as a result of the transformation. The privatisation of the shares of Estonian Railways Ltd and South-eastern Railways Ltd was carried out by Estonian Privatisation Agency by way of international competition.

100% of shares in South-eastern Railways (the public limited company engaged in passenger traffic) and 66% of shares in Estonian Railways (the public limited company engaged in freight traffic) were put to sale.

For the sake of clarity it needs to be mentioned that, differently from the railways of many other European countries, the Estonian railways engaged in freight traffic are capable of earning profit first of all through the large transit flows between Russia and the West, while the railways engaged in passenger traffic need state subsidies for operating due to the small and dispersedly dwelling population of Estonia.

The significant difference between the sales price of shares received by the state out of the privatisation of the shares of Estonian Railways Ltd and South-eastern Railways Ltd is due to this very circumstance: while out of the sale of 100% of shares in South-eastern Railways Ltd approximately a 0,56 million US dollars (10 million Estonian kroons) were received, out of the sale of 66% shares in Estonian Railways Ltd approximately 56 million US dollars (1 billion Estonian kroons) were earned as the sales price.

Of course, the earning of revenue through the sale of shares in railway undertakings was not the only aim of the privatisation of the Estonian railway system.

According to the privatisation program adopted by the Government of Estonia, the objectives of the privatisation included, among other things, the involvement of a strategic investor and the ensuring of the long-term development of railways, the ensuring of placing investments in railway infrastructure and in railway undertakings in general, the increasing of the capacity of railway infrastructure, the ensuring of free access of various operators to railway infrastructure, and the increase of the competitive ability of Estonian railways in the rivalry for transit flows with the railways and ports of neighbouring states.

A differentia of the privatisation of Estonian railway companies consisted in the circumstance that Estonian Railways and South-eastern Railways were simultaneously both owners of railway infrastructure and providers of rail transport services. Thus, it had to be ensured that the said companies do not abuse their relatively strong market positions.

The essential rules for the protection of market had been laid down already in the Railways Act, which was adopted on 23 February 1999 and which, in its turn, was based on the directives of the European Union concerning railways.

The Railways Act stipulates that railway undertakings that provide public rail transport services or manage railways designated for public use are required to keep separate accounting of the revenue and expenditure relating to the areas of transport services and the management of railway infrastructure; state aid granted for the management of infrastructure and compensation paid by the state for the provision of public utility transport services may not be transferred from one area of activity to another. However, the legislation of Estonia does not require that the management of railway infrastructure and the provision of rail transport services be split up into different companies.

At the same time the Railways Act of the Republic of Estonia obliges owners of railway infrastructure to ensure free access to the infrastructure in their possession for the purpose of providing rail transport services. Railway infrastructure owners are required to distribute the free infrastructure capacity of railways (i.e. not the entire capacity) on the basis of a public competition. The Railway Administration performs supervision over the exercise of the lawful rights and obligations of railway undertakings.

In the course of the privatisation of the Estonian railway system, additional legislation was adopted which was necessary for ensuring the access of other undertakings to railway infrastructure and the distribution, to a certain extent, of the infrastructure capacity of railways on the basis of public competition.

The reason why the entire railway infrastructure capacity is not subject to distribution on the basis of public competition in Estonia consists in the circumstance that Estonian Railways and South-eastern Railways are concurrently both owners of railway infrastructure and providers of rail transport services. The accompanying market positions bestow the necessary competitive ability upon these companies. While the EU directives concerning railways are mostly based on the presumption that passenger traffic, and not freight traffic, is the field that produces profit in railway business and that different railways within a country compete, the situation is diametrically different in Estonia.

Due to the relatively small size of the Estonian market and the large volume of transit trade, the competitors of e.g. Estonian Railways are not Estonian companies, but rather the railways and ports of neighbouring states. Therefore, in case of Estonia, it would be shortsighted to create a forced internal competition by legislation.

Considering the state of Estonia as a whole, it is more beneficial to have an internationally competitive railway in an important geographical region, instead of several scattered small undertakings that are incapable of competing for transit flows in the region of the Baltic Sea.

Another distinctive feature of the privatisation of Estonian railway undertakings consisted in the circumstance that the entire land, on which the infrastructure of privatised Estonian Railways and South-eastern Railways is located, was retained in state ownership.

Privatised Estonian Railways and South-eastern Railways will use the land under their infrastructure in compliance with the building lease agreements to be signed with the state. The building lease instrument grants to the state more definite and extensive legal possibilities of protecting its rights and ensuring that the terms and conditions agreed in privatisation agreements are complied with while letting the private proprietor have the legal security necessary for exercising the right of ownership in the railway infrastructure.

The agreement for the privatisation of 100% of shares in South-eastern Railways Ltd (passenger traffic) was signed on 29 November 2000 with GB Railways Eesti AS, a subsidiary of the British railway undertaking GB Railways Plc, under which, in addition to the payment of the purchase price and the performance of other obligations arising from the privatisation agreement, the privatiser made a contribution to the share capital of South-eastern Railways Ltd to the approximate amount of five and a half million US dollars (100 million Estonian kroons).

As a result of the privatisation of South-eastern Railways and through the improvement of efficiency, the state subsidies relating to the provision of rail transport services for passengers in Estonia decrease substantially year-by-year under the agreed schedule when compared to the time that South-eastern Railways Ltd was still in state ownership.

The privatisation of Estonian Railways Ltd (freight traffic) was internationally announced on 17 April 2000.

As a result of strong political pressure and the activity of various groups of interest, the privatisation process turned out to be rather complex. However, the objectives established in the course of preparations for the privatisation were attained eventually.

The agreement for the privatisation of 66% of shares in Estonian Railways Ltd (freight traffic) was signed on 30 April 2001, under which Baltic Rail Services OÜ, an American-British-Estonian joint consortium, became the owner of the 66% of shares in Estonian Railways Ltd.

The majority voting interest (56% of votes) in Baltic Rail Services OÜ that privatised Estonian Railways belongs to Jarvis Plc, a British railway infrastructure undertaking, and to US-based railway undertakings Rail World Inc and Railroad Development Corporation.

The chairman of the management board of Baltic Rail Services OÜ that privatised Estonian Railways is E. A. Burkhardt, the former president of the US-based railway undertaking Wisconsin Central and the "Railroader of the Year" as elected by the influential magazine Railway Age in 1999.

In relation to the involvement of American railway undertakings, it should be brought up that American railway undertakings engaged in freight traffic are quite unanimously considered to be the best in the world and an example for other railway undertakings.

Under the privatisation agreement, Baltic Rail Services assumed the obligation to invest at least 265 million US dollars (4,7 billion Estonian kroons) in Estonian Railways Ltd within 10 years, incl. at least 144 million US dollars (2,56 billion Estonian kroons) within the first five years of operation.

Baltic Rail Services also committed itself to the management of the company in compliance with its business plan and technical and financial plan, assuming also the obligation to continue activities in managing the railway infrastructure at least during the effective term of the building lease i.e. at least within 50 years.

During the first five years of operation, the placing of investments in Estonian Railways and the adherence to the business plan are secured by bank guarantees, as well.

For the time being, 34% of shares in Estonian Railways are retained in the ownership of the state of Estonia, enabling the state to exercise its statutory rights as a shareholder in relation to material decisions concerning the company. Namely, the legislation of the Republic of Estonia stipulates that e.g. resolutions on increase or reduction of the share capital of a company, on amendment of the articles of association of a company, and on dissolution, merger, division or transformation of a company may be adopted if at least two-thirds of the shareholders of the company are in favour.

The state has also other rights deriving from the privatisation agreement, which are necessary for ensuring the efficient functioning of railways, incl. the right to inspect the compliance with the business plan and the investing obligation, the right to exercise its right of veto in material issues, the right to restrict the re-sale of shares during the term of the business plan, etc.

But why was the privatisation of the Estonian railway system necessary in the first place?

As was mentioned above, the state yielded an excellent price for 66% of shares in Estonian Railways Ltd, considering the financial position of the company, which will be included in reserves and be used to support various projects essential for the state.

It was of even greater relevance that the financial position, the profit indicators and the condition of infrastructure of both Estonian Railways and South-eastern Railways indicated that the state was not capable of being a sufficiently good proprietor of the railway system. The management of the railway system in state ownership was over-politicised and subject to excessive and unreasonable pressure of various groups of interest. This was evidenced by e.g. the circumstance that year-by-year ports, forwarding agencies and transit undertakings in private ownership continued to make agreements with state-owned Estonian Railways on the basis of unreasonably low tariffs, wherefore the profit of Estonian Railways remained marginal.

The inefficient management and the poor revenue values of the state-owned railway system rendered it impossible to place necessary investments and ensure the competitive ability and development of the railway system in long-term perspective.

The Government of Estonia is of the opinion that the state must not necessarily participate in business, when a private proprietor can do it better. Instead, the state must concentrate on the tasks that are essential for fulfilling the functions of the state and for ensuring the welfare of people.

As a result of the privatisation of railways, all the responsibility and obligations relating to the future functioning of the Estonian railway system lie with private proprietors who, as a rule, operate more efficiently than the state and are more capable of developing and competing in business terms. By privatising Estonian Railways, the state was relieved of the undertaking connected with eastern trading involving high risks, as well as of the duty to place taxpayers’ money in it in the future.

Supervision over the functioning of the railway system will be exercised by the state first of all via market regulators, the Railway Administration being the most important of those.

The most remarkable outcome of the privatisation, indeed, consists in the circumstance that, unlike the state, the new owners of railways have the necessary resources, know-how, will and security to justify their large-scale investments, as well as the purchase price paid.

Thus, all the prerequisites for both Estonian Railways (freight traffic) and South-eastern Railways (passenger traffic) to become state-of-the-art undertakings with enhanced competitive ability and to contribute to the improvement of the business climate of Estonia as a whole have been created.