Navigating the EU rail-market liberalization

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The large-scale liberalization of the European Union’s commercial long-distance passenger-rail market is now in progress. What are the implications for incumbents, new entrants, and the market as a whole? Which routes should new entrants prioritize? Can a compelling entry strategy be defined? What can incumbents do to mitigate their risk?

To answer these and other questions, we drew on the latest McKinsey research on this imminent liberalization, as well as the impact of other market-liberalization efforts in the transportation arena. (For more on how we arrived at our insights, see the sidebar, “Our approach.”)

The new liberalization effort, approved in December 2016 by the European Parliament and the European Commission and by the member states, will have substantial implications for European rail. This fourth railway package of EU legislation is intended to remove all remaining barriers to a single European rail area, reducing competitive imbalances and harmonizing regulations among the national passenger-rail systems. The effort aims to give all players equal access to national markets; to encourage competition and innovation; and to boost safety, interoperability, and reliability across the region.

Those are the intentions, but what are the realities on the ground?

The background of rail-market liberalization in Europe

Over the past ten to 20 years, liberalization plans and initiatives have periodically emerged in the European Union’s long-distance passenger-rail market. These efforts first gained momentum in the 1990s. Such countries as Germany and the United Kingdom acted as pioneers, soon followed by others, including Austria and Italy. Each liberalized market has different competitive dynamics today (Exhibit 1).

In Europe, incumbents dominate domestic commercial long-distance rail markets, with the exception of Austria and Italy.

In this context, we have three main observations:

  • Since we find no clear correlation between the years of market liberalization and the level of competition, liberalization is not enough to ensure a competitive market.
  • A real push from local authorities and attractive routes for a point-to-point entry strategy can facilitate competition, as in Austria and Italy.
  • Despite past liberalization efforts, incumbents still dominate the European Union’s domestic long-distance rail markets, except in Austria and Italy, although the primary EU incumbents operate in cross-border routes through joint ventures.

The new legislation will change the status quo across the European Union, making competition more dynamic throughout the region and changing the market, with major strategic implications for most players and stakeholders. But the future is far from predictable. These new regulations may well generate advances—improved passenger service, market growth, strong investor returns, and a modal shift that benefits the environment—across the entire rail landscape. The changes should be greatest for countries, such as France and Spain, that have not yet liberalized their long-distance routes. But the regulations should stimulate competition in already-liberalized markets as well.

The European Commission has stated its intention to reduce competitive asymmetries among national rail systems (the legislation’s market pillar) and to guarantee the same level of national-market access to all by harmonizing technical regulations (the technical pillar). Exhibit 2 summarizes these two pillars of the legislation.

The European Commission has stated its intention to reduce competitive asymmetries among national rail systems.

Illuminating elements

Three things offer insights into the realities of a liberalization effort in railways: the effects of liberalization in the airline industry, the impact of liberalization in selected long-distance railway markets, and the interest of rail operators in entering new markets today.

1. Liberalization’s effects in the airline industry

Market liberalization has significantly shaped the competitive dynamics of the European airline industry: increased competition from low-cost carriers (LCCs) sharply reduced the incumbents’ market share and yields. In some core European markets, for example, LCCs reached a seat share as high as 50 percent in just ten years. Meanwhile, the yields of existing carriers fell by 20 to 30 percent, on average, and by up to 60 percent in specific routes (Exhibit 3).

In the airline industry, increased competition from low-cost carriers has drastically reduced the incumbents’ market share.

Relevant challenges to airline incumbents included the following:

  • the commoditization of short-haul flights, with price as the leading incentive for customers
  • disruptive pricing from LCCs, which have much lower cost structures than the incumbents do
  • the need—made difficult by complex operating processes and legacy commitments—to close the cost gap by moving quickly
  • the need to choose between market share and yield
  • the need to operate money-losing routes to support hub-and-spoke networks for long-haul passengers

Low-cost entrants were ultimately successful because they responded to the new competitive context flexibly and strategically. That gave them leadership positions in the most attractive markets and routes; created strong consumer brand recognition through a distinctive value proposition; held down costs; created a balanced portfolio of revenues, beyond airline tickets; delivered exceptional customer service; and gave the LCCs a sound financial foundation.

Given the global interoperability of airplanes, the airline industry isn’t fully comparable to the rail industry. But there are two strong similarities. As in the rail industry today, traditional airline players with legacy costs dominated domestic and cross-border markets before liberalization. Also, both industries have significant fixed costs, which can push operators to reduce prices in hopes of filling spare capacity.

2. Liberalization effects in rail markets with relatively competitive dynamics

In rail markets, such as Austria and Italy, with true competition, incumbents have lost 20 to 40 percent of their market share in core routes. In Italy, for example, competition has had multiple effects on many stakeholders in recent years:

  • Passengers have simultaneously seen service levels improve, travel times decrease, train frequency increase, and prices fall. All this has increased demand for rail services and brought about a modal shift in favor of trains.
  • Thanks to this additional demand, the rail operators’ revenue pool has risen by 47 percent in Italy. This increase has more than counterbalanced the downward pressure on pricing—a 20 to 30 percent decline in the most competitive routes (Exhibit 4).
  • Rail OEMs have gained about €3 billion in new investments because rail operators are enhancing their national rail fleets—for example, the deployment of about 100 new trains in the network.
Liberalization of the commercial long-distance (high-speed) rail market in Italy has put pressure on pricing while increasing the overall revenue pool.

Compared with Europe’s liberalized routes, a majority of the rest still have high untapped market-growth potential in modal share vis-à-vis other transportation modes and offering levels. This indicates that market liberalization may have an impact on several core routes in the European Union, as it did in Italy (Exhibit 5).

Compared with liberalized routes, most European main routes still have high untapped market-growth potential.

3. The rail operators’ interest in new markets

Several rail operators have declared their intention to enter newly liberalized EU markets. They include the German operator FlixBus, which is deploying FlixTrains on French tracks; the French operator SNCF, operating its low-cost Ouigo trains on long-distance routes in other countries; Italo, which is participating in tenders for rail transport throughout the United Kingdom; and Trenitalia’s Thello, which is entering France’s high-speed long-distance market.

Given these intentions, several potential competitive scenarios seem likely along two key dimensions: a new entrant’s cost structure and service level, and its target footprint. A new entrant pursuing a low-cost local footprint with a limited number of trains, for example, might have an aggressive price strategy promising safe on-time travel. A player looking for a low-cost extensive footprint might operate a limited number of trains on multiple routes, matching the scheduling of regional and urban services to increase the customer base. And a new entrant (perhaps an incumbent from another region) that wants to offer full service in a local footprint might pursue a customer-relationship model as a differentiating factor, along with an initially aggressive price strategy that gradually shifts toward the incumbent’s level.

Key success factors for new rail-market entrants

Entering a new market presents uncertainties and risks, from the choice of operating model to capital-expenditure and regulatory risk. To face these challenges and develop a compelling strategy, new entrants must begin by answering three essential questions: what is the core value proposition, the institutional setup, and the optimal operating model?

New entrants should develop their entry strategies with these questions in mind. There is no predefined winning strategy for entering a new rail market, especially given the peculiarities of different markets and competitive settings. Nonetheless, we can propose several building blocks for a successful entry into long-distance rail markets. Each strategy is based on lessons learned from previously liberalized markets.

  • Market and route selection. Assess and prioritize the most attractive corridors—and their most relevant routes—starting with a point-to-point strategy and potentially expanding the footprint in a second stage. Bear in mind the incumbent’s potential countermoves, such as price reductions.
  • Commercial excellence. Develop a relationship model to attract and retain loyal customers through, for example, a strong brand with a distinctive value proposition. Use digital channels to reach both new and existing customers at lower cost.
  • Cost leadership and savings. Start with an asset-light operating model to reduce financial and operating risks and maintenance costs. Take advantage of the smaller nonincumbent cost base in the new region to support margins during the initial growth phase.
  • Station and track access. Enter major railway stations to ensure a presence in growing hubs. Push for reduced track and station fees.
  • Rolling-stock availability. Confirm that rolling stock is available in time to enter the market with an adequate offering—ideally, stock approved by the authorities in multiple countries to promote flexible fleet management.
  • A sound financial foundation and market agility. Ensure access to financial capital for at least three years—estimated as the minimum time to breakeven—and develop an agile business unit that can respond quickly to market dynamics during ramp-up.
How OEMs can succeed in digitized rail infrastructure

How OEMs can succeed in digitized rail infrastructure

Strategic options for incumbents

Liberalization may have not only risks but also benefits for incumbents. To take full advantage of the liberalization opportunity while safeguarding their current business, they can pursue five specific measures:

  • Boost capacity. Improve the current offering—greater frequency, more seats, and more direct connections—on the most attractive routes.
  • Personalize services. To differentiate the service vis-à-vis new entrants, develop an offering based on the needs and habits of passengers. Provide ancillary services on board and in rail stations to improve the customer experience and brand loyalty. And fully utilize the customer-relationship-management system already in place.
  • Reduce prices selectively. Cut prices on trains with a low load factor and on routes where or when competitors operate. Avoid across-the-board price reductions.
  • Optimize costs. Implement a zero-based-budgeting approach, renegotiate contracts with lead suppliers, and revamp the current operating model to include digital and advanced analytics for predictive maintenance and workforce planning.
  • Be the new entrant. Evaluate the likelihood of success for a new entity with a low-cost rail offering in the domestic market, and use this to defend against further competition from new entrants. At the same time, recognize the high risk of cannibalization.

The impact of the European Union’s fourth railway package will clearly be sizable, potentially benefiting the entire rail industry. In Italy, for example, the rail-market revenue pool increased by approximately 50 percent in just seven years. In addition, liberalization can give passengers new offerings and better services, boost investments for rail OEMs, improve financial returns for investors, and spark a modal shift that benefits the environment.

To take full advantage, both incumbents and new entrants will require strong support from their top-management teams, a close watch on the domestic market’s competitive dynamics, and an ongoing search for emerging opportunities in other EU rail markets.

Download The liberalization of the EU passenger rail market, the full report on which this article is based (PDF–5.7 MB).

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