Report No. 58836-RU Russia Public Expenditure Review June 8, 2011 Poverty Reduction and Economic Management Unit (ECSPE) Europe and Central Asia Region Document of the World Bank RUSSIAN FEDERATION - GOVERNMENT FISCAL YEAR January 1 – December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of June 8, 2011) Currency Unit Ruble USD1.00 29.71 Weights and Measures Metric System ABBREVIATIONS AND ACRONYMS CIS Commonwealth of Independent States DFID Department for International Development EU European Union EU-10 European Union 10 new member states EU-15 European Union 15 member states before 2004 expansion FDI Foreign Direct Investment FTP Federal Targeted Program FTS Federal Tariff Service G-20 Group of 20 GCI Global Competitiveness Index GDP gross domestic product IBRD International Bank for Reconstruction and Development IFC International Finance Corporation IFI international financial institution IMF International Monetary Fund MOF Ministry of Finance NLTF National Land Transport Fund NPS New pay system NZTA New Zealand Transport Agency OECD Organisation for Economic Co-operation and Development PBC performance-based contract PEM Public Expenditure Management PER Public Expenditure Review PFM Public Financial Management PPP private-public partnership PRP performance-related pay RZD Russian Railways SOE state-owned enterprise VAT value added tax VEB Vnesheconombank (Bank for Development and Foreign Economic Affairs) Vice President: Philippe Le Houerou Country Director: Pedro Alba Sector Director: Yvonne Tsikata Sector Manager: Benu Bidani Task Team Leader: Karlis Smits CONTENTS PREFACE ............................................................................................................................................... 1 EXECUTIVE SUMMARY ............................................................................................................................ i 1. INTRODUCTION............................................................................................................................. 1 2. AGGREGATE FISCAL DISCIPLINE AND OVERALL PUBLIC EXPENDITURE MANAGEMENT .............................................................................................................................. 2 A. RECENT MACROFISCAL DEVELOPMENTS AND SOURCES OF TENSION ............................ 2 B. FUNDING NEEDS AND PRESSURES ARISING FROM THE GOVERNMENT’S POSTCRISIS POLICY AGENDA ...................................................................................................... 5 C. ENSURING EXPENDITURE SAVINGS BY IMPROVING PUBLIC EXPENDITURE MANAGEMENT PRACTICES ............................................................................ 11 D. FINDING EXPENDITURE SAVINGS BY IMPROVING ALLOCATIONS .................................. 14 E. SUMMARY OF RECOMMENDATIONS ....................................................................................... 23 3. STRENGTHENING CAPITAL BUDGETING IN ROAD AND RAIL SECTORS................. 26 A. INFRASTRUCTURE, GROWTH, AND PUBLIC EXPENDITURE ............................................... 26 B. THE ROAD SYSTEM: CURRENT ISSUES AND CHALLENGES ............................................... 27 C. THE ROAD SYSTEM: KEY RECOMMENDATIONS ................................................................... 52 D. THE RAIL SECTOR: CURRENT ISSUES AND CHALLENGES .................................................. 55 E. THE RAIL SECTOR: KEY RECOMMENDATIONS ...................................................................... 67 4. STRENGTHENING PUBLIC EMPLOYMENT ......................................................................... 70 A. AGGREGATE PUBLIC EMPLOYMENT ....................................................................................... 70 B. ABILITY TO ATTRACT AND RETAIN QUALIFIED STAFF ...................................................... 74 C. TRANSITION TOWARD PERFORMANCE-FOCUSED PERSONNEL MANAGEMENT ............................................................................................................................... 81 D. MAINTAINING A FISCALLY SUSTAINABLE WAGE BILL ...................................................... 84 E. SUMMARY OF RECOMENDATIONS ........................................................................................... 92 APPENDICES ............................................................................................................................................. 95 BIBLIOGRAPHY ...................................................................................................................................... 107 LIST OF TABLES Table 2.1: Key Fiscal Parameters, 2005–13 ................................................................................................. 3 Table 2.2: Shortfall in Fiscal Revenues Because of Changes in Tax Legislation ......................................... 4 Table 2.3: Preliminary Estimates of Additional Funding Needs in 2011–13, Changes Relative to the Previous Year ........................................................................................................................ 6 Table 2.4: Preliminary Estimates of Additional Funding Needs in 2011–13 ............................................... 8 Table 2.5: Plan A: Creating Fiscal Space for Expenditure Priorities 2011-13, Changes Relative to the Previous Year ........................................................................................................................ 9 Table 2.6: Plan B: Creating Fiscal Space for Expenditure Priorities in 2011–13, Changes Relative to the Previous Year ...................................................................................................................... 10 Table 2.7: Aggregate Fiscal Allocations by Budget Types......................................................................... 11 Table 2.8: Changes in Aggregate Allocation of Consolidated Budget for Various Priorities .................... 15 Table 2.9: Budget Expenditures by Programs ............................................................................................ 15 Table 2.10: Government’s Estimates of Inefficient Budget Expenditures at the Regional Level, 2007–0916 Table 2.11: Evolution of General Government Expenditures by Economic Classification ........................ 17 Table 2.12: Evolution of General Government Expenditures by Function................................................. 19 Table 2.13: Social Protection Expenditures by Program Type ................................................................... 20 Table 2.14: General Government Education Expenditures by Function .................................................... 22 Table 2.15: Summary of Recommendations: Aggregate Macrofiscal Framework ..................................... 23 Table 3.1: The Road Network ..................................................................................................................... 28 Table 3.2: Length and Percentage of the Federal Road Network not Meeting Standards, 2009 ................ 30 Table 3.3: Federal and Regional Expenditures on the Road Sector ............................................................ 31 Table 3.4: Avtodor Program, 2010–15 ....................................................................................................... 33 Table 3.5: Required Road Maintenance and Rehabilitation Expenditures According to the Transport Strategy ................................................................................................................................ 34 Table 3.6: Financing Gap for Maintenance, Rehabilitation, and Reconstruction ....................................... 34 Table 3.7: Length of Road Network According to the Transport Strategy ................................................. 35 Table 3.8: Funding gap in road transport sector ......................................................................................... 37 Table 3.9: Diesel and Other Fuel Prices ..................................................................................................... 37 Table 3.10: Road Expenditures According to the Transport Strategy, 2010–30 ........................................ 40 Table 3.11: Length of Toll Network in Selected Countries, 2008 .............................................................. 41 Table 3.12: Estimated Capital Costs of PPP Projects ................................................................................. 43 Table 3.13: Official Unit Cost Norms for Maintenance, Repair, and Major Repairs in Russia, 2007 ....... 49 Table 3.14: Quartiles and average of costs per km of an inter-urban road, by type of work in World Bank financed road projects in Eastern Europe and Central Asia ................................................ 49 Table 3.15: A Summary of Recommendations: Road Sector ..................................................................... 53 Table 3.16: Wagon Fleet in Russia, 2004–08 ............................................................................................. 58 Table 3.17: International Indicators of Rail Productivity, 2008 ................................................................. 59 Table 3.18: Federal Government’s Support to the Railway Sector ............................................................ 61 Table 3.19: Railway Density by District, 2006 ........................................................................................... 63 Table 3.20: Transport Strategy of the Russian Federation: Rail Capital Investments ................................ 64 Table 3.21: A Summary of Recommendations: Rail Sector ....................................................................... 67 Table 4.1: General Government Education Employment, 2008 ................................................................. 72 Table 4.2: General Government Health Employment, 2008....................................................................... 73 Table 4.3: Civil Service Employment by Levels and Branches of Government, 2009 .............................. 74 Table 4.4: A Percentage Difference between Sector and Overall Average Wages by Economic Sectors, 2008 ..................................................................................................................................... 77 Table 4.5: A Matrix of Monetary, In-kind, and Intangible Rewards for Public Sector Employees ........... 78 Table 4.6: Average Monthly Employment Turnover Rates by Sector in Russia ........................................ 79 Table 4.7: Russia: A Comparison of Key Components of the Old and New Wage System ....................... 83 Table 4.8: Average Budget Expenditures on Compensation of Employees in Russia, 2006–09................ 85 Table 4.9: Compression Ratios for Select Sectors, 2005–09 ...................................................................... 86 Table 4.10: Changes in Public Employment Levels: Public Administration, Education, and Health Care, 2005 versus 2008 ................................................................................................................. 87 Table 4.11: Share of Expenditures Funded by Own Revenues by Level of Government, 2009 ................ 89 Table 4.12: Share of Expenditures Funded by Own Revenues by Level of Government, 2009 ................ 92 Table 4.13: A Summary of Recommendations: Strengthening Public Employment .................................. 92 LIST OF FIGURES Figure 2.1: Expenditure Impulse and Changes in the Output Gap 2002–10................................................. 4 Figure 2.2: Medium-term Funding Needs and Sources under Two Adjustment Scenarios, end of 2013 ..... 9 Figure 2.3: Russia’s Nonoil Fiscal Deficit under Two Adjustment Scenarios, 2007–20 ............................. 9 Figure 2.4: Size of General Government in Russia and Select Countries................................................... 12 Figure 2.5: Changes in General Government’s expenditures by Category ................................................. 16 Figure 2.6: General Government Expenditures as a Share of GDP in the Russian Federation and G-20 Countries, by Economic Classification, 2008 ..................................................................... 18 Figure 2.7: General Government Expenditures as a Share of GDP in the Russian Federation and Select Country Groups, by Functional Classification .................................................................... 19 Figure 2.8: Federal Budget Transfers to the Pension Fund as a Share of GDP and Average Replacement Rate...................................................................................................................................... 20 Figure 3.1: Public Road Spatial Density: Russian Federation and select countries (left) and Russian Federation and selected federal districts (right) .................................................................. 28 Figure 3.2: Road Fatalities per 10,000 Passenger Cars............................................................................... 31 Figure 3.3: Rail Network Length, 2008 ...................................................................................................... 57 Figure 3.4: Network Length (kilometer), Passenger Traffic (billion passenger-kilometers), and Freight Traffic (billion traffic-kilometers), 2008 ............................................................................. 59 Figure 3.5: Capital Investments by RZD .................................................................................................... 65 Figure 3.6: Average Indexation of Freight Tariffs ...................................................................................... 67 Figure 4.1: Number of People Employed in General Government and Public Corporations ..................... 71 Figure 4.2: Distribution of Employees according to Salary Brackets Based on the Minimum Subsistence Level, 2009 .......................................................................................................................... 76 Figure 4.3: Wage Structure in Budget ........................................................................................................ 76 Figure 4.4: Relationship between Regional GDP per Capita and Aggregate Public-Private Wage Gaps by Level of Government and Regions and by Population Size of Regions, 2009 .................... 76 Figure 4.5: Ratio of Teacher’s Salaries and GDP per Capita in Russia and OECD Countries ................... 77 Figure 4.6: Tenure Distribution in Public Administration, 2009 ................................................................ 80 Figure 4.7: Age Profile of Civil Service: Federal-Level Civil Service, 2009 ............................................. 80 Figure 4.8: Shares of Female Employment by Different Categories of Civil Service Posts, 2009 ............ 81 Figure 4.9: Shares of Female Employment in Health and Education Sectors, 2008) ................................. 81 Figure 4.10: Contribution of Employment and Wage Increase to the Aggregate Wage Bill Increase in 2008 Relative to 2007, by Levels of Government ............................................................... 85 Figure 4.11: Real Wage Increases in Russia by Sectors ............................................................................. 86 Figure 4.12: Wage Bill as a Share of Total Outlays and as a Share of GDP .............................................. 87 Figure 4.13: A Relationship between Average Wages and Vacancy Rates in Federal-Level Executive Agencies, First Half of 2010 ............................................................................................... 88 LIST OF BOXES Box 2.1: A Permanent Income Fiscal Rule: The Case of Russia ................................................................. 7 Box 2.2: Types of Federal Transfers to Regions in Russia ........................................................................ 12 Box 2.3: Key messages of World Bank’s Social Expenditure Review ...................................................... 22 Box 3.1: Infrastructure, Competiveness, and Constraints to Russia’s Business ........................................ 27 Box 3.2: Institutions in the Russian Road Sector....................................................................................... 29 Box 3.3: International Practice: Overloading Enforcement in North America and the EU ....................... 36 Box 3.4: International Practice: The U.S. Interstate Highway System and Fuel Taxes ............................. 38 Box 3.5: International Practice: Experience with Second-Generation Road Funds .................................. 39 Box 3.6: International Practice: European Experience with the Vignette.................................................. 42 Box 3.7: International Practice: The Chilean Experience with Infrastructure Bonds ................................ 44 Box 3.8: Reverse Auction Procurement in Russia and its Problems ......................................................... 45 Box 3.9: Fiscal Savings and Procurement Efficiency ................................................................................ 47 Box 3.10: International Practice: Experience with PPPs in Central and Southeastern Europe.................. 51 Box 4.1: Employment in Russia’s State-Owned Enterprises ..................................................................... 71 Box 4.2: Pay Setting in Russia’s Civil Service .......................................................................................... 75 Box 4.3: Housing Subsidies for the Federal Civil Service......................................................................... 79 Box 4.4: International Practice: Performance-Related Pay in OECD Countries ....................................... 82 Box 4.5: International Experience: Options for Restraining the Wage Bill............................................... 91 APPENDICES APPENDIX A: Functional Classification of General Government Expenditure ...................................... 95 APPENDIX B: Economic Classification of General Government Expenditure in Advanced G-20 Countries, 2008–09 ...................................................................................................... 96 APPENDIX C: Main Social Protection Programs in the Russian Federation, 2010 ................................. 97 APPENDIX D: Distribution of Functional and Institutional Classification of Federal Budget Expenditures, 2010 ...................................................................................................... 98 APPENDIX E: International Experience: Performance-Based Maintenance Contracting in Estonia and Argentina ..................................................................................................................... 99 APPENDIX F: Comparative Unit Costs in Road Works ........................................................................ 102 APPENDIX G: Russian Railways Network, 2010 ................................................................................. 104 APPENDIX H: Russian Railways High-Speed Passenger Transport System Planned for Completion by 2030 ........................................................................................................................... 105 APPENDIX I: Railway Expansion Plans in the Russian Federation, through and beyond 2030 ............ 106 PREFACE Over the past decade, the Ministry of Finance (MOF) of the Russian Federation has introduced a number of reforms to tighten fiscal discipline, improve effectiveness of budget expenditures, and strengthen expenditure controls. The long-standing World Bank dialogue with the MOF budget policy department has supported these reform efforts through analytical and technical assistance on a range of fiscal issues. This assistance includes assessing fiscal risks and ensuring long-term fiscal sustainability (Long-Term Fiscal Sustainability Study), conducting regular macroeconomic and fiscal analyses in Russian Economic Reports, and providing advice on strengthening public financial management practices and implementing performance budgeting. With the onset of the global crisis and tighter budget constraints, the dialogue has shifted to approaches and measures aimed at improving the efficiency of public expenditures. In this context, the World Bank recently undertook a Social Expenditure Review (SER) focused on the efficiency of subnational public expenditures in health, education, and social assistance. This Public Expenditure Review (PER) complements and extends these activities by focusing on two areas that are of particular importance for Russia’s growth and fiscal future––transport infrastructure and public sector employment––and that account for a large share of Russia’s budget. The primary objective of the PER is to assist the MOF in identifying opportunities for savings and efficiency gains in these large categories of government expenditure. The report was prepared by a Bank team led by Karlis Smits. The team included Zeljko Bogetic (Lead Economist and Country Sector Coordinator for the Poverty Reduction and Economic Management Network for the Russian Federation who supported the policy dialogue, provided strategic advice in all stages of the study, and helped edit the final report); Carolina Monsalve (Transport Economist, ECSS5, who authored the chapter on transport); Stepan Titov (Senior Economist, ECSP3, who provided the material on public financial management); Maya Gusarova (who contributed the chapter on public employment); and Francesco Scaduto-Mendola (consultant who assisted the task team leader in drafting parts of the report). Olga Emelyanova provided valuable research assistance. Judy Wiltshire provided exemplary team assistance. Two analytical background reports were prepared and integrated into this final report. One, titled ―Elaboration of Proposals for Enhancing the Efficiency of Budget Expenditures in the Transport Sector,‖ was prepared by a PACC Consulting team comprising Leonid Azimov (team leader), Andrei Orlov, and Dmitry Bachilo. The other, titled ―Elaboration of Proposals for Enhancing the Efficiency of Budget Expenditures in the Field of Remuneration and Employment in the Public Sector,‖ was prepared by Alexander Horoshilov (Team Leader), Alexander Razumov, Robert Yakovlev, and Marina Kolosnicina. The PER team benefited from the guidance and advice of Pedro Alba (Country Director), Yvonne M. Tsikata (Sector Director, ECSPE), Luca Barbone (former Sector Director, ECSPE) and Benu Bidani (Sector Manager, ECSP3) and from discussions on public sector reform with William Dorotinsky (Sector Manager, ECSP4). Comments from Henri Kerali (Sector Manager, ECSS5); Daria Zakharova (Deputy Division Chief, International Monetary Fund); Gary Reid (former Lead Public Sector Specialist); Richard Martin Humphreys (Senior Transport Economist); Martha B. Lawrence (Senior Transport Specialist); Vickram Cuttaree (Senior Infrastructure Economist, ECSS5); Andreas Schliessler (Lead Transport Specialist, ECSS5); Clelia Rontoyanni (Public Sector Specialist); Victor Sulla (Economist, ECSP3); Sergei Ulatov (Economist, ECSP3); and Vladislav V. Onishchenko (Noncommercial Foundation for Enterprise Restructuring and Financial Institutions Development) are also gratefully acknowledged. The peer reviewers were Marijn Verhoeven (Lead Economist, PRMPS) and Andreas Dietrich Kopp (Lead Transport Economist, TWITR). Comments and discussions with Evsey Gurvich, Head of the Ministry of Finance Economic Expert Group, are gratefully acknowledged. The team also extends its gratitude to the Ministry of Transport (especially Dmitry Tvardovskiy, Adviser to the Minister of Transport) and to the Russian Railways (especially Alexey Tokar, Head of Debt and Trade Finance in the Corporate Finance Department), whose representatives cooperated closely with the team and provided comments on earlier versions of this report. EXECUTIVE SUMMARY 1. The primary objective of the Public Expenditure Review (PER) is to assist the Ministry of Finance (MOF) in identifying opportunities for efficiency gains in some key categories of government expenditure. In this context, policy makers face two related fiscal dilemmas. First, how can expenditure efficiency be increased to provide public services with fewer resources? Second, how can the fiscal space for key infrastructure investments be increased to ensure an enabling environment for long-term growth and diversification? To answer these questions, this PER analyzes three closely interrelated topics: (a) aggregate fiscal discipline and overall public expenditure management, (b) public expenditures in transport with specific focus on roads and railways, and (c) public employment and the wage bill of budget organizations. The focus on these large expenditure segments of the Russian Federation’s budget was mandated by the MOF’s operational needs to identify efficiency gains in these sectors and then―Key “Key questions: First, how can expenditure to use the findings to extend such exercises to other efficiency be increased to provide public sectors. It is envisaged that future PERs, in a services with fewer resources? Second, how programmatic fashion, could provide in-depth can the fiscal space for key infrastructure investments be increased to ensure an analyses of other major categories of expenditures, enabling environment for long-term growth feeding into the MOF policy analysis and budget and diversification?” planning cycle. Aggregate Fiscal Discipline and Overall Public Expenditure Management 2. The impact of the global economic crisis (documented in recent Russian Economic Reports) was swift and deep, requiring the implementation of massive countercyclical fiscal policy measures totaling 6.7 percent of gross domestic product (GDP) in 2008 and 2009. The countercyclical fiscal policy steps clearly helped contain the impact of the crisis. But in the postcrisis period, Russia faces a balancing act of controlling public finances and supporting the recovery under more difficult conditions. Although remaining fiscal reserves do allow a margin of maneuver to balance these risks, in a likely scenario of a sluggish global recovery and modest growth, Russia will face a tightening budget constraint in the medium term. 3. This report argues that though the budget contains important initiatives in the right direction, supporting accelerated modernization and upgrading infrastructure will require both deeper reforms and additional resources. In particular, the budget is likely to require (a) a permanent increase of budget expenditures equivalent to another half percentage point of GDP by 2013 (including quasi-fiscal activities of state-owned enterprises) to support economic modernization initiatives such as energy efficiency, (b) 1.1 percent of GDP to close the road maintenance gap, and (c) 1.0 percent of GDP for capital expenditures to address the maintenance backlog and basic road network expansion. On the revenue side, additional fiscal pressures arise from the expected decline in (and risks to) oil and gas and nontax revenues. i 4. To deal with these pressures, the government’s federal budget law for 2011–13 “[T]he government expects in the (denoted as Plan A for the purpose of this report) medium term (under Plan A) to aims to gradually broaden the nonoil revenue base gradually reduce the fiscal deficit from and reduce expenditures. Under this scenario, 4.1 percent of GDP in 2010 to 2.9 revenue and expenditure measures will result in percent in 2013.” additional fiscal space totaling 5.1 percentage points of GDP over the next three years. As a result of these measures, the government expects in the medium term (under Plan A) to gradually reduce the fiscal deficit from the 4.1 percent of GDP in 2010 to 2.9 percent in 2013. The federal budget deficit will be financed mainly from domestic financing sources (particularly domestic borrowing), supplemented by modest external borrowing. 5. But this gradual approach to fiscal adjustment carries nonmarginal risks. First, excessive reliance on domestic borrowing implies a risk of increasing interest rates. Second, the adjustment could be slower than envisaged because of the expenditure pressures of the 2011–12 election cycle. Third, a negative oil price shock could result in the widening of the deficit. And fourth, under “Fiscal adjustment in 2011–13 needs to all realistic medium-term scenarios, Russia will not be more ambitious given the highly uncertain international environment.” have the cushion of fiscal reserves that it had enjoyed before the crisis, thus making its budget and the economy more vulnerable to new shocks. Under these circumstances, fiscal adjustment in 2011– 13 might need to be more ambitious given the highly uncertain international environment and prospects for oil prices. 6. An alternative fiscal consolidation scenario (Plan B) incorporates more ambitious measures to reduce nonpriority expenditures and broaden the non-oil tax revenue base; these proposed measures are additional to the fiscal measures in federal budget law. This alternative plan envisions additional increases in excise taxes on tobacco, alcohol, and gasoline to “Additional expenditure savings from bring them to the average levels of Group of 20 strengthened public expenditure management and better expenditure countries (G-20). There is also scope to increase allocations are expected to yield further value added tax (VAT) revenues by improving tax savings of over 2 percentage points of administration and minimizing VAT exemptions. GDP.” Additional expenditure savings from strengthened public expenditure management and better expenditure allocations are expected to yield further savings of over 2 percentage points of GDP. Specific proposed measures include the following: a. Strengthening results monitoring systems to monitor target indicators of public programs. The government is initiating the legal reclassification of tens of thousands of public entities, which are now included in the budget, into ―autonomous entities‖ that would effectively be turned into arm’s-length public entities or nonprofit organizations providing public services (such as education, science, health, and culture). But fiscal savings from these reforms will occur only over the medium term and will require effective results monitoring systems. b. Reducing crisis-related subsidies supporting select sectors of the economy. With the easing of the global crisis, these subsidies to public and private enterprises should be gradually phased out. ii c. Increasing the targeting of social assistance programs. In terms of noncontributory spending levels, Russia ranks among the generous spenders. But only a small fraction of these resources is targeted to the poor, and the few income-tested programs explicitly designed to serve poor or vulnerable populations have mediocre targeting properties. d. Taking steps to ensure the long-term sustainability of the pension system. Worsening demographic conditions indicate that the sustainability of the pension system will be one of the main fiscal challenges. One of the steps taken by the government has been to introduce “Worsening demographic conditions higher contribution rates to improve the indicate that the sustainability of the sustainability of the pension system, but pension system will be one of the main fiscal challenges.” further steps might be necessary. e. Supporting structural reforms in the education and health sectors. Although average public expenditures on education have increased in recent years, structural reforms aimed at increasing expenditure efficiency are progressing slowly. The present system of allocation, regulation, and incentives leaves little room for increasing allocations for capital investments while a large number of schools are in dire need of renovation. 7. Under this supplemental Plan B, the cumulative increase in fiscal space over three years will equal more than 9 percentage points of GDP compared with 5.1 percentage points in the budget. The implementation of this more ambitious consolidation plan would not only create fiscal space for additional spending needs to support diversification and modernization, but also ensure a fiscally sustainable nonoil deficit level by 2015. Strengthening Capital Budgeting in the Road Sector 8. With chronic underfunding, the road infrastructure has deteriorated significantly over the past decade. Out of the 49,995 kilometers of federal roads, only slightly more than one-third meet the standard requirements and can be considered to be in good or fair condition. The remaining roads are in poor condition. Over 50 percent of the federal network fails to meet the smoothness and strength requirements. A number of factors have played a role: a. Years of inadequate funding for maintenance and rehabilitation. As a percentage of GDP, federal and regional expenditures on roads have declined from 2.8 percent of GDP in 2000 to only 1.5 percent in 2009. In comparison, China has spent about 3.5 percent of GDP annually since the 1990s and has significantly improved the quality and expanded the size of its network, thereby supporting its subsequent economic boom. b. Compared to Finland, a country with comparable weather conditions, actual road maintenance costs per km appear similar in Russia, although road condition outcomes are very different. For Russia the official unit cost norms per kilometer of maintenance costs of federal roads vary between US$27,000 and US$55,000 depending on the category of road. However, estimates provided by Rosavtodor suggest that actual unit costs—as opposed to official unit cost norms —for federal and regional roads are equal to €8,034 per road kilometer (US$ 11,520) in 2010. This figure is much lower than the official unit cost norms, as only a fraction of roads are maintained to standard. In the case of Finland, the cost was €7,274 per road kilometer (US$ 10,430) in 2008 for all road iii types, which is similar to the levels in Russia1. While Finland spends comparable levels to Russia on an unadjusted per kilometer basis, the quality of its roads according to the World Economic Forum is ranked 13th out of 139 countries, whereas Russia’s ranks 125th. This highlights the importance of getting better information and looking at actual expenditures on maintenance and outcomes, as well as the need to better explain these costs over time. c. Inadequate planning of regular maintenance. Depending on traffic, adequate and regular maintenance can sustain road pavements for a period far beyond the original design life, thus reducing the need for reconstruction. A failure to maintain a paved road has also been estimated to increase user costs by a factor of three in terms of additional time, fuel, and vehicular wear and tear, with a direct impact on the price of goods and the expenses that individuals pay for goods and services. d. High traffic intensity on some routes because of structural deficiencies. The radial structure of the network makes it highly dependent on the Moscow hub, with regions deprived of more direct transportation links. It is estimated that given the traffic intensity and usage in Russia, more than a third of the federal road network needs to be reconstructed to a higher technical category, with reinforced surfaces, to allow normal traffic for heavy vehicles. e. Operation of roads above designed loading capacity. The majority of Russia’s present design standards for public roads are still based on the maximum axle loads of less than 10 tons, whereas the European designs of many trucks operating in Russia have axle loads of 11 to 16 tons on double axles. Many of these roads now sustain traffic from a high number of much larger trucks with European dimensions. f. Rampant overloading. Overloading is a key factor shortening the life span of the pavement surface. International research has shown that pavement damage from loading is proportional to the axle load raised to the fourth power. Hence, heavier vehicles cause greatly increased rates of pavement damage. 9. Current expenditures on road maintenance and rehabilitation at the federal and regional levels are significantly below required levels, but there is a significant scope to increase financing using fuel taxes and “This report estimates a sizable financing gap vehicle license fees. This report’s calculations for maintenance and reconstruction for federal suggest a sizable financing gap for maintenance and regional roads of about 1.1 percent of and rehabilitation for federal and regional roads GDP, with the largest gap in the regional road of about 1.1 percent of GDP, with the largest network.” gap in the regional road network. Taking into account a modest expansion of network, the total needs for road sector are around 3.5 percent of GDP per year, a level of expenditure observed in other upper middle income countries. Given insufficient spending on road maintenance, additional financing could include the following: a. Fuel taxes––the primary transport pricing policy instrument worldwide––could be used more in Russia to finance the maintenance of roads and highways. Fuel taxes remain relatively low in Russia with important scope for increases, resulting, among 1 However, it is difficult to draw any conclusions from this case, because Russian unit costs include repair and major repairs, while Finnish costs include only maintenance expenses. In addition, not only are maintenance interventions defined differently in both countries, but the road design standards also differ considerable, making unadjusted comparisons fraught with difficulties. iv other things, in higher revenues and progressive distributional impact on the households. A well-designed fuel surcharge could generate revenue sufficient to finance the maintenance of the network but not its expansion, which would have to be funded from other sources. b. Vehicle license fees are generally low but could raise substantial additional financing for the road sector. In 2008, Rub 53.1 billion (US$1.7 billion) was collected from a vehicle fleet of 38 million, but as with fuel taxes such fees are general revenues and no portion is earmarked for the road sector. The total funds collected are quite small, reflecting generally low vehicle registration rates. c. Russia could use the fuel tax and vehicle license fees to ensure a fully funded road maintenance program. Several countries use a second-generation road fund to ensure the affordability of a fully funded road maintenance program. These funds aim to link revenues such as the fuel tax and vehicle license fees and expenditures, with charges “Given chronic under funding the key focus paid into the road fund that are typically should be on creating an affordable and managed by boards representing the fully funded road maintenance program.” interests of road users. As of January 1, 2011, a Federal Motorway Fund is established for financing road construction, rehabilitation and maintenance projects. However, this fund appears to be a traditional road fund and not a second-generation road fund. Requirements for a successful road fund typically include (a) independence from the general government budget; (b) management by a strong and independent board; (c) user charges consisting of license fees, fuel tax and international transit fees; (d) direct deposit of user charges into the road fund; (e) formal mechanism for varying road user charges (which should be indexed); (f) consistent and simple procedure for allocating funds between different road agencies; and (g) independent financial and technical audits to avoid leakages and to ensure that funds are spent according to a work program and specification. d. International financial institutions (IFIs) remain an important potential source of funding for road projects. IFIs could provide not only finance with long maturity, but also international and best-practice experience as well as expertise in project preparation, monitoring, and supervision. This form of financing would be particularly valuable for roads that are not on strategic corridors and do not have the potential to be concessioned to private operators but are still economically viable. e. Innovative local credit enhancement entities and techniques (credit guarantees) can be used to help mobilize domestic commercial debt resources for subsovereign infrastructure finance. These resources could be a potential avenue for increasing investments in the road sector at the regional and local levels. Credit enhancements are meant to mitigate risks in debt transactions that creditors cannot or are not willing to take. By doing so, such enhancements increase the overall creditworthiness of a borrower or a specific debt transaction, are cost-effective, and support capital market development while promoting a ―hard-credit‖ financial culture. f. The Russian Federation has almost no “Russia has only one toll section in its entire toll roads, but the potential for their federal road network––a 20-kilometer detour development is considerable. Unlike around the village of Khlevnoe in the Lipetsk region––but the potential is considerable.” v other developed countries (as well as many developing countries), where networks of toll roads and high-speed motor roads have long been successfully operated and have generated substantial revenues, Russia has only one toll section in its entire federal road network––a 20-kilometer detour around the village of Khlevnoe in the Lipetsk region. At another extreme is China, which has created major enhancements to its national road asset base in a very short period of time. China added about 41,000 kilometers of high- grade tolled expressways between 1990 and 2005 and has since kept growing the tolled expressway network by about 8,000 kilometers per year. g. Infrastructure bonds are another mechanism for tapping into long-term domestic financing of road projects. These bonds are meant to be issued by a special-purpose project entity to raise funds to finance infrastructure construction or reconstruction. 10. The federal budget suggests a considerable increase in financing to the road sector during the “Increasing competition for the 2011–13 period. According to this report’s estimates, procurement of road works is such funding levels for the road sector by 2013 will imperative.” narrow––but not eliminate––the funding gap for maintenance of the federal highway system. But to improve the performance and outcomes in the road sector, it will be important not only to raise expenditures, but also to adopt measures to ensure that funds are spent efficiently, thereby providing value for money for scarce public funds: a. The Transport Strategy sets out a series of ambitious targets for regional road network expansion, but a valid question remains regarding whether such an expansion in peripheral regions is necessary or feasible. The econometric analysis and international experience suggest that the productivity-enhancing effect of improved infrastructure would be the strongest in Russia’s capital region. Thus, infrastructure investment by itself is unlikely to help growth in lagging regions. b. A road classification exercise would need to be undertaken with a view to the governments’ financial capacity—at the federal, regional, and local road levels— and users’ willingness to pay for existing and planned roads. Functional classification is an indispensable tool for rational assessment and assignment of responsibilities in the road sector. A road network that is very large and poorly maintained and has technical standards that are too high will deteriorate; indeed, this is what is happening in Russia. c. There is an urgent need to reconsider current procurement rules, which require procurement of civil works through reverse auction, a practice unique to the Russian Federation. A reverse auction is a type of auction in which sellers compete to obtain business on the basis of the lowest price quoted. The World Bank does not consider auctions an appropriate method of procurement, particularly for civil works, given the considerable risks to quality, among other issues. Instead of reliance on the market, an initial price or ceiling is introduced to determine the contract price, but in many instances the starting price of the procured works is based on the available funds rather than an accurate estimation of costs. As a result, the final contract cost is in most cases far from the realistic market price that would result from open and fair competition. Indeed, the evidence of negative effects of procurement through auctions in Russia is significant. vi d. Introducing performance-based maintenance contracts could lead to significant cost savings. The traditional way of contracting out road maintenance defines specific works to be done, and payments are based on the completed work. By contrast, performance- based contracts define minimum conditions of road, bridge, and other traffic assets that have to be met by the contractor, as well as other services. e. Increasing competition for the procurement of road works is imperative. Few contractors have the capability to deliver large roads projects, particularly at the regional level. This lack of contractor capability reflects, in part, the large and expensive equipment required to undertake road construction projects, but it also results from the Soviet legacy of organizing the industry around large regional monopolies. Possible remedies might include requiring procurement competitions to include bidders from as many regions as possible and outlawing subcontracting between bidders once the contract has been awarded. f. Introducing an improved asset management system for the road network should assist in making spending decisions. Sound decisions need reliable, relevant, and accessible information, such as data on budget, traffic counts, road accidents, and pavement design. Asset management is a process of maintaining, upgrading, and operating physical assets cost-effectively, which should lead to improvements in financial efficiency through (a) improved decision making based on costs and benefits of alternatives, (b) justification of work programs and funding requirements, (c) recognition of costs of operating road assets over the life cycle of the assets, and (d) increased cost- effectiveness of maintenance through proper planning of works. Strengthening Capital Budgeting in the Rail Sector 11. The Russian railway sector is dominated by Russian Rail (RZD), one of the largest railway companies in the world. The strength of RZD is underpinned by its monopoly status as both national railway infrastructure owner and locomotive provider, the competitiveness of freight railway in Russia, and RZD’s “The strength of Russia’s railway sector vis-à-vis dominance of the national freight rail other large railway systems reflects its high market market. The strength of Russia’s railway share in the freight sector, high overall traffic sector vis-à-vis other large railway systems volumes, and the positive outcomes of recent reflects its high market share in the freight reforms, but there remains large scope for sector, high overall traffic volumes, and improvements.” the positive outcomes of recent reforms. 12. Overall, federal budget funds allocated to the rail sector rose significantly during 2007–10. The share of federal government transport expenditures allocated to the railway sector has risen from 17.6 percent in 2008 to 25.7 percent in 2009 and is estimated to rise to 29.3 percent in 2010. Responding to the impact of the crisis on RZD, the government introduced in 2009 freight operating subsidies or freight tariff ―compensation.‖ Although introduced as temporary, these subsidies have been continued in the 2010 federal budget. Because of prior commitments to increase the compensation for loss-making passenger services, government support in passenger operating subsidies has been rising, while the railway infrastructure requirements of the Sochi Olympics have led to equity injections. 13. Financing for RZD will continue to be determined mainly by the tariff structure, annual tariff indexation, and additional financial support from the government. Thus, vii changes to the regulatory framework governing the rail sector are critical, because they will determine RZD’s cash flow and its overall financial performance. In particular, the following changes could improve the overall performance: a. Reforms to the regulated freight tariff structure should be based on transparency, market responsiveness, and full cost recovery. For the infrastructure and locomotive components, every tariff category should cover at least its long-run marginal cost, and fixed costs should be recovered through the commodity markups for higher-value goods. b. The manner in which the annual average indexation of freight tariffs is determined needs to be made predictable and transparent and should ensure that there is no need for compensatory payments. It appears critical that the annual average indexation of freight tariffs be done in a predictable and transparent fashion and that it take into account the price pressures faced by RZD, for example, by taking into account changes in the producer price index. 14. The Transport Strategy provides for the following two phases of rail sector development: modernization of the rail transport (through 2015) and expansion of the network (2016–30). The first phase focuses mainly on the replacement of the rolling stock “As of end 2008, about 18,380 kilometers, and rehabilitation of infrastructure, with some consisting of 14.8 percent of total operating 5,193 kilometers of new track to be track length, needed a rail track overhaul.” commissioned. The main target in the second phase is to build between 16,000 and 20,700 kilometers in railway lines (depending on the scenario) by 2030. Key questions that policy makers need to address include the following: a. Will significant rail infrastructure investment in all regions of Russia produce the highest economic benefits nationally, or are there are trade-offs between peripheral and national growth? It is critical to ensure that the investments are based on detailed assessments showing positive economic returns. b. What are the efficient distances for various modes of transport, and what should be the required speed for the new tracks to be built? In the high-investment scenario, out of 21,000 kilometers of new track, the Transport Strategy envisages 10,000 kilometers of fast lines (140–160 kilometers per hour) and 1,500 kilometers of high-speed lines (200– 250 kilometers per hour). For routes under 300 kilometers, high-speed rail tends to substitute for air transport and can be important for relieving airport congestion. For distances exceeding 1,000 kilometers, air transport becomes more attractive. Fast and high-speed rail should reflect the nature of potential traffic along those lines, the composition of traffic, and cost-recovery considerations. c. Will the large network expansion result in underfunding of much-needed maintenance and rehabilitation? As of end 2008, about 18,380 kilometers, consisting of 14.8 percent of total operating track length, needed a rail track overhaul. This figure has been increasing since 2004, because of cutbacks in funding of track work. It is, therefore, necessary to support continued rehabilitation of the existing track and to secure funding before embarking on an extensive network expansion. viii Strengthening Public Employment 15. At present, the government’s wage bill—comprising more than one-fourth of all government expenditure—faces conflicting pressures. In the current environment, one of the most important challenges is to ensure the medium-term fiscal sustainability of overall expenditures, including the aggregate wage bill. But as long as public wages—especially in education and health—remain low compared to those in the private sector, pressures on the aggregate public wage bill will persist. At the same time, improving remuneration is fundamental to improving the incentives and performance of public administration, as well as the quality of service delivery. Poor incentives for performance, especially for excellence, are likely to further jeopardize both the quality of and the access to public services. 16. Although Russia made much progress in introducing various elements of performance management, reform of individual performance has been slow. The Russian civil service law defines personal performance evaluation tools, but most are highly formal and disconnected from institutional “In the short term, efficiency gains in the federal-level civil performance management. A lack service employment could be achieved by a combination of of methodological guidance on measures that include elimination of vacant positions and developing individual performance voluntary retirement.” contracts, as well as individual performance indicators, prompted ministries and agencies to choose the traditional remuneration practice, consisting of a base salary and additional payments (mainly compensations related to rank and position). Furthermore, the personnel units continue to play mainly administrative roles of keeping personnel records and administering recruitment processes while the personnel actions are often at the discretion of the head of the agency. Oversight of personnel management is often weak to nonexistent. 17. Despite weak performance appraisal systems, the implementation of a performance- related pay (PRP) system in public budget organizations (non–civil servants) is advancing rapidly. The new system has multiple objectives, including (a) differentiating remuneration on the basis of performance and outcome, (b) increasing attractiveness to hire qualified staff, (c) increasing productivity and optimizing the employment size in public budget organizations, (d) increasing transparency of the pay system, (e) introducing incentive measures that result in the use of more applied knowledge, (f) increasing the overall wage levels, and (g) increasing the independence of managers of public budget organizations. In 2010, more than 40 percent of regular employees funded by the federal budget have been converted to the PRP. At the regional level, 40 regions have already introduced the PRP, and the remaining 43 will make a transition in 2011. 18. There is a temptation (and danger) to develop PRP to boost public sector performance or potentially reduce base salaries. The lessons from member countries of the Organisation for Economic Co-operation and Development (OECD) indicate that the success of implementing PRP depends more on the quality of the performance appraisal process rather than on pay and that monitoring and measuring performance in the public sector remain a challenge. Unlike the private sector, where the results are easily measured in financial terms, the public sector deals with policies, regulation, and public services, which are difficult to turn into quantifiable performance indicators within individual control. In Russia, although individual results monitoring remains a challenge, the introduction of performance pay has been supported by parallel policy initiatives on implementing service agreements between budget holders and ix service delivery organizations, which specify the volume and quality of public services to be delivered. 19. It is also clear that without structural changes in the education and health sectors, closing the large wage gaps will come at a significant fiscal cost. The largest gaps are in municipal education and health. For example, wages in preschool, primary, and secondary education institutions at the municipal level are more than 50 percent below the average wage level. The estimated cost of closing these gaps without reducing employment in education is estimated at about 0.82 percent of GDP per year and in the health sector at about 0.53 percent of GDP per year. The largest burden would fall on the budgets of subnational entities, whose wage bills would increase by almost a third. Already in the past years, measures to close the wage gap resulted in a sharp increase in the wage bill. Between 2006 and 2009, the subnational wage bill increased by more than 20 percent per year in real terms. 20. To contain the wage bill, the government will need to reassess “In the medium- to long-term, these and additional reductions in employment will require the consolidation priorities within the public sector and of administrative functions through automation and to right-size the staffing levels. This modernization. But the biggest challenge will be to effort is a medium-term challenge. In the implement similar measures at the subnational level.” education and health sectors, the government’s effort to transform public budget organizations into autonomous agencies will greatly enhance managers’ incentive to right-size employment. The existing education system, in particular, has significant scope for optimizing inputs without jeopardizing education outcomes. 21. In the medium term, the government plans boldly to right-size the civil service by reducing the federal-level civil service positions by 20 percent over the next three years. The experience in other countries indicates, however, that significant employment and wage reductions alone are rarely accomplished quickly. Instead, they are typically accompanied by privatization and a mix of enterprise and wage bill control systems, coupled with incremental reductions in employment through hiring freezes, attrition, and elimination of vacant posts. By 2013, according to the budget law, a combination of short-term and medium-term measures is expected to result in a decrease in the aggregate federal-level wage bill by 0.9 percentage points of GDP. In the short term, a reduction of 5 percent in federal-level civil service employment could be achieved by a combination of measures that include elimination of vacant positions and voluntary retirement. In the medium to long term, these and additional reductions in employment will require the consolidation of administrative functions through automation and modernization. But the biggest challenge will be to implement similar measures at the subnational level. x 1. INTRODUCTION 1.1. After a decade of high growth followed by a severe recession in 2009, the Russian Federation is experiencing significantly slower postcrisis growth and the need for fiscal adjustment. Compared with the 7 percent average annual growth in the precrisis period, Russia is likely to grow at a much more moderate pace––3.5 to 4.0 percent per year––in the postcrisis years. More moderate oil prices, higher cost of capital, and lower and volatile capital flows are likely to characterize Russia’s ―new normal,‖ external environment. Under these circumstances of tighter budget constraints at all levels, two major public expenditure policy questions arise. First, how can expenditure efficiency be increased to provide public services with reduced fiscal resources? And second, how can the fiscal space for key infrastructure investments be increased to ensure an enabling environment for long-term growth and economic diversification? These questions are analyzed in this report. 1.2. The primary objective of the Public Expenditure Review (PER) is to assist the Ministry of Finance (MOF) in identifying opportunities for efficiency gains in a few key categories of government expenditure. This PER consists of three closely interlinked parts focusing on (a) aggregate fiscal discipline and overall public expenditure management, (b) public expenditures in the transport sector with a specific focus on roads, and (c) public employment and the wage bill of budget organizations. The focus is mandated by the MOF’s gradual fiscal adjustment and reform plans, and the PER aims to inform the MOF’s regular budget policy cycle. It is also envisaged that the review could become a regular practice in the future, focusing on other major categories of expenditures. 1 2. AGGREGATE FISCAL DISCIPLINE AND OVERALL PUBLIC EXPENDITURE MANAGEMENT A. RECENT MACROFISCAL DEVELOPMENTS AND SOURCES OF TENSION 2.1. The purpose of this chapter is to analyze the aggregate fiscal discipline in the context of recent macrofiscal developments and government’s postcrisis reform agenda. Hence, this part aims to contribute to the government’s thinking about its medium-term fiscal challenges and appropriate policy responses. The crucial point of departure is that the global crisis has fundamentally altered the medium-term growth (and fiscal) path of the Russian Federation’s economy from the one anticipated before the crisis. This report ponders the implications of this situation for public expenditures at a time when Russia faces a balancing act of controlling public finances while supporting economic recovery under much more difficult conditions. A number of challenges are ahead. First, what reform and funding needs in expenditure policy arise from the government’s postcrisis reform agenda? Second, how can fiscal space be created to fund these measures without undermining long-term fiscal sustainability and economic growth? Recent Economic Developments 2.2. In the period between 1998 and 2008, Russia’s economy grew briskly at about 7 percent annually, yet the economy remained vulnerable to both external and fiscal risks, and in late 2007, it began to overheat just at the time when global demand began to falter. Overall macroeconomic stability was strengthened by (a) healthy fiscal surpluses against pressures for larger spending and lower tax rates; (b) monetary policy that helped reduce high inflation to about 12 percent by the end of 2007; and (c) the creation of an oil reserve fund2 to help limit the Dutch disease that plagued many oil-rich countries. However, domestic demand was the primary engine of economic growth before the crisis. Oil and gas fiscal revenues increased from 6 percent of gross domestic product (GDP) in 2001 to more than 10 percent in 2008, thereby allowing additional spending room, but also led to increased dependence on a highly volatile source of income. And just prior to the crisis, Russia’s decade-long economic expansion accelerated above the long-term trend, with clear signs of overheating, raising macro- vulnerabilities. 2.3. As a result of these vulnerabilities, the impact of the global economic crisis was swift and deep, and the economy is now recovering at a moderate pace. A decline in the global demand, collapse of oil prices, reversal of capital flows, and tightening of credit triggered a sharp slowdown and then deep recession in 2009. Although Russia entered the global crisis with a strong fiscal position, low public debt, and large fiscal and monetary reserves, GDP still contracted by 7.9 percent in 2009. Since the second half of 2009, however, the economy has been on a path of gradual recovery driven increasingly by domestic demand but with relatively high unemployment and very limited credit activity. Russia’s real GDP will likely return to the precrisis level only in late 2012. Growth in the medium term is expected to be much more moderate than before the crisis. Sustained, nonseasonal improvements in the labor market will be slow. 2 This fund was introduced in 2004 and was split into two funds (Reserve Fund and Future Generation Fund) in 2008. 2 Recent Fiscal Developments 2.4. During the past decade, Russia created a modern tax system, designed two oil funds to manage fiscal reserves, and reduced its public debt to below 10 percent of GDP. These reforms helped limit the Dutch disease syndrome despite the run up in oil prices and large capital inflows. Prudent budget management, using good practice lessons from Organisation for Economic Co-operation and Development (OECD) and oil-rich countries, enabled Russia to run consistent fiscal surpluses until the full effects of the crisis were felt in 2009 (see table 2.1). Table 2.1: Key Fiscal Parameters, 2005–13 percentage of GDP 2005 2006 2007 2008 2009 2010 2011* 2012* 2013* Revenues (consolidated) 39.7 39.5 40.2 38.5 34.4 35.3 34.8 34.0 33.2 Federal budget 23.7 23.4 23.6 22.3 18.8 18.7 17.6 17.0 16.8 Oil revenues (Federal Budget) 9.9 11.0 8.8 10.6 7.7 8.6 8.1 7.9 7.5 Nonoil revenues (Federal 13.8 12.4 14.8 11.7 11.1 10.1 9.5 9.1 9.3 budget) Expenditures (consolidated) 31.6 31.2 34.1 33.7 40.6 38.9 38.9 37.6 36.3 Federal budget 16.3 15.9 18.1 18.2 24.7 22.7 21.2 20.1 19.7 Federal budget nonoil deficit -2.5 -3.5 -3.3 -6.5 -13.5 -12.7 -11.6 -10.5 -9.8 Federal budget balance 7.4 7.5 5.5 4.1 -5.9 -4.1 -3.6 -3.1 -2.9 Consolidated budget balance 8.1 8.3 6.1 4.8 -6.2 -3.6 -4.2 -3.6 -3.1 Fiscal reserves 5.7 8.7 11.6 16.0 11.8 7.7 6.3*** 5.9*** 5.3*** Reserve Fund** n.a. n.a. n.a. 9.8 4.7 1.7 Future Generation Fund** n.a. n.a. n.a. 6.3 7.1 6.0 Source: Ministry of Finance; Economic Expert Group, * World Bank staff estimates based on the Federal Budget Law. Note: n.a. = not applicable. * estimates based on the 2011 federal budget law; it does not reflect subsequent federal budget amendments. ** This fund was introduced in 2008. 2.5. Despite these reforms, the nonoil tax base did not expand and public expenditures remained volatile and pro-cyclical in recent years. The government reduced the Unified Social Tax to 26 percent in 2005 and the value added tax (VAT) rate from 20 percent to 18 percent in 2004. These and other tax reductions resulted in the loss of tax revenues of about 4 percent of GDP (table 2.2). Wide proliferation of tax exemptions and holidays has further narrowed the nonoil revenue base, and the oil funds did not entirely insulate the economy from oil and capital inflows. Analytically, an increase in oil revenues can be used (a) to increase expenditures, (b) to reduce taxes, for example by reducing the nonoil revenue base, and (c) to increase savings.3 The creation of the funds allowed for channeling part of the oil windfall revenues into savings, reducing the fluctuations in expenditure levels or nonoil revenues. A pro- cyclical policy stance since 2006, however, contributed to a widening of the output gap, thereby exacerbating inflationary pressures and increasing macro-vulnerabilities (figure 2.1). Such spending increases also may have stretched the government’s planning and management capacity. 3 The equations are (a) Δ(Budget balance) = Δ(oil revenues) + Δ(nonoil revenues) − Δ(expenditure) or (b) Δ(oil revenues) = −Δ(nonoil revenues) + Δ(expenditure) + Δ(budget balance). 3 Table 2.2: Shortfall in Fiscal Revenues Because of Changes in Tax Legislation Date of Permanent fiscal impact introduction as percentage of GDP Total 4.32 Reduction in VAT from 20 percent to 18 percent Jan. 1, 2004 0.55 Abolishing of sales tax Jan. 1, 2004 0.35 Decrease in Unified Social Tax from 35.6 percent to 26 percent Jan. 1, 2005 1.40 Introduction of amortization premium of 10 percent Jan. 1, 2006 0.11 Reduction in oil extraction tax Jan. 1, 2007 0.10 Reduction in corporate income tax from 24 to 20 percent Jan. 1, 2009 0.60 Change in nontaxable threshold level of oil price used to calculate Jan. 1, 2009 0.20 mineral extraction tax Introduction of tax breaks for oil extraction in East Siberian oil fields Jan. 1, 2010 0.29 Reduction of export duties to natural gas exported to Ukraine Apr. 1, 2010 0.13 Source: Ministry of Finance, World Bank staff estimates. Figure 2.1: Expenditure Impulse and Changes in the Output Gap 2002–10 percentage of GDP Source: World Bank staff estimates based on budget execution reports. Note: Other = discretionary measures. The methodology for calculating expenditure impulses is based on (Fedelino, Ivanova, & Hordon, 2009). 2.6. In response to the crisis, Russia implemented a massive countercyclical policy package––totaling 6.7 percent of GDP in 2008 and 2009––but it now faces the challenge of sustained adjustment. Large fiscal reserves before the crisis (about 16 percent of GDP at the end of 2008) allowed the government to introduce an anticrisis package, cushioning the crisis impact. The measures were aimed at (a) strengthening the financial sector, (b) providing emergency fiscal support for enterprises and regions, and (c) minimizing the social impact4 (for more detail on fiscal policy responses during the crisis, see Russian Economic Reports, World Bank 2009-10). But now Russia faces a balancing act of controlling public finances, withdrawing the stimulus, and supporting recovery. After the deficit of more than 6 percent of GDP in 2009, the government is planning a gradual fiscal adjustment to eliminate the deficit by 2015. The budget law for 2011–13 aims to gradually reduce the federal budget deficit from 4.1 percent of GDP in 2010 to 2.9 percent in 2013. 4 Although the indexation of pensions (on average, by 35 percent in 2009), a sizable increase in the public sector wage bill (by 30 percent for employees of federal-level public budget organizations in December 2008), and an increase in the minimum wage level (from Rub 2,300 per month to Rub 4,330 per month, an increase of 88 percent, in January 2009) were planned before the crisis, the measures have mitigated the social impact. 4 B. FUNDING NEEDS AND PRESSURES ARISING FROM THE GOVERNMENT’S POSTCRISIS POLICY AGENDA Fiscal Implication of Russia’s Postcrisis Policy Agenda 2.7. In the short-term, the government’s 2011–13 budget emphasizes six key economic policy goals. These goals include (a) using the budget as a key policy instrument to maintain macroeconomic stability; (b) improving public expenditure efficiency; (c) ensuring a results- oriented performance of public sector institutions; (d) developing instruments that support innovations; (e) improving the quality of human capital; and (f) ensuring long-term sustainability of the pension system. 2.8. The implementation of these goals requires not only advancement of structural reforms, but also significant fiscal resources. According to the federal budget for 2011–13, these additional expenditures amount to almost 1 percent of GDP. But they are unlikely to be sufficient to address the infrastructure constraints and support Russia’s vast modernization agenda. A significant part of the expenditure allocations supporting economic modernization and innovations (such as the support for higher education, research and development, Skolkovo Innovation City, and energy efficiency) introduced in 2011 are to be gradually scaled back over 2012 and 2013 (in real terms, as a percentage of GDP). 2.9. This report argues that, in addition to accelerated reforms, supporting modernization could require additional fiscal resources. The report estimates additional funding needs for supporting economic modernization and innovations (0.5 percent of GDP by 2013), road maintenance (1.1 percent of GDP), and capital expenditures to address the maintenance backlog and network expansion (1.0 percent of GDP) (see chapter 3 on road expenditures) (table 2.3). These previously mentioned goals are also consistent with the long- and medium-term policy planning documents (outlined in the Economic Development Strategy 2020, the president’s medium-term budget framework). Furthermore, Russia’s well-documented demographic trends—declining population, aging population, increasing demand for pension and health services, and changing structure of demand for education––will result in an increase in social expenditures by an additional 3.5 percent of GDP in 2016–20 (Bogetic et al. 2010). These are daunting expenditure pressures that can be accommodated only by sustained and significant fiscal adjustment, which is more ambitious than the adjustment in the 2011–13 budget. To implement it, the authorities will need to compensate for downward pressures on revenues and to avoid the temptation to use extra-budgetary financing for public services. More important, the authorities will need to strengthen the institutional framework, especially in capital budgeting practices, to minimize the risk that additional funding is misused. 5 Table 2.3: Preliminary Estimates of Additional Funding Needs in 2011–13, Changes Relative to the Previous Year Percentage points of GDP Federal budget law Total needs Funding need Total (2013 relative (2013 relative 2011 2012 2013 to 2010) to 2010) 1. Additional Expenditure Pressures 0.5 0.0 0.4 0.9 3.3 Modernization of road infrastructure 0.1 0.1 0.1 0.3 2.2 Modernization of military 0.2 -0.1 0.4 0.6 0.6 Support of economic modernization and innovations 0.2 -0.1 -0.2 0.0 0.5 2. Gradual decrease in oil and gas revenues 0.5 0.3 0.3 1.1 2.5** 3. Decrease in non-oil revenues 1.2 0.3 0.1 1.6 1.6 4. Debt financing 0.2 0.1 0.0 0.3 0.3 Total (1 + 2 + 3 + 4) 2.4 0.7 0.8 3.9 7.7 Source: World Bank staff estimates based on Federal budget law. ** Oil prices fall to USD60 per barrel relative to baseline assumptions of the budget. 2.10. Both oil and nonoil revenues face significant downside risks. For example, the federal budget is based on a favorable oil forecast. Oil prices are expected to remain high over the medium term; the price of Urals is estimated to be US$75 per barrel in 2011, US$78 in 2012, and US$79 in 2013. But oil and gas revenues are expected to decrease by about 1.1 percent of GDP in the medium term because of relatively stable oil and gas extraction and export volumes5 that are not offset by high prices of minerals or movements in the exchange rate. Although this oil price forecast is broadly consistent with current market expectations, it reflects the vulnerability of Russia’s budget to a sudden drop in oil prices. Indeed, if oil prices fall to US$60 per barrel, the cumulative, the adverse fiscal impact will exceed 2.5 percent of GDP in 2013. Furthermore, nontax revenues are expected to weaken because of lower interest income from reduced balances of the Reserve and National Welfare funds. In 2009, the interest revenues from these funds transferred to the budget amounted to Rub 297.6 billion (US$9.9 billion), while in 2013 these transfers will be only Rub 29.2 billion (slightly less than US$1 billion) (table 2.3). Funding New Policy Initiatives within a Sound Macrofiscal Framework 2.11. Fiscal resources and plans to use them must ―add up‖—the new policy initiatives can be financed by increasing revenues, by decreasing existing expenditures, or by borrowing. In simple terms, if the new expenditures cannot be financed by reprioritizing existing expenditures, by increasing expenditure efficiency, or by increasing the revenue base, they must be financed through debt issuance. Russia’s current external debt levels are low, providing a degree of maneuver, but as debt levels rise, debt service in future years could represent a drag on the budget and the economy. 2.12. For oil-rich countries that are dependent on highly volatile oil revenues, fiscal sustainability is especially important, requiring an explicit use of long-term fiscal rules. This report argues that for Russia’s existing oil resource allocation rule to be effective in the long run, it could be complemented by a rule of nonoil primary fiscal deficit (Bogetic et al. 2010). 5 According to projections of the Ministry of Economic Development, the taxable volume exports of oil will range from 226.1 million tons of oil in 2011 to 221.9 million tons in 2013. Taxable extraction level of oil will range from 441.3 million tons in 2011 to 423.7 million tons in 2013. Exports of natural gas are expected to range from 132.4 billion cubic meters in 2011 to 157.1 billion cubic meters in 2013. Taxable volume of extracted natural gas is expected to range from 596.6 billion cubic meters to 631.6 billion cubic meters in 2013. 6 Under such a rule, Russia would spend in the long run only as much as it has earned, that is, as much as the permanent income from oil assets would allow, leaving the stock of assets intact for future generations (box 2.1). This more conservative fiscal rule would automatically ensure fiscal sustainability, stabilize public expenditures, and establish greater fairness between current and future generations. However, the use of fiscal rules should not be detached from a prudent use of fiscal policy to address growth constraints. Box 2.1: A Permanent Income Fiscal Rule: The Case of Russia Fiscal policy design in resource-rich countries must address three basic issues. First, oil income stems from exhausting a fixed supply; this gives rise to an intergenerational equity issue because the current generation may wish to share the oil wealth with generations born after the exhaustion date. Second, resource income is typically highly volatile. Finally, long periods of resource revenues will put upward pressure on the real exchange rate, leading to a decline in the traded goods sector (the so-called Dutch disease). The permanent income approach to fiscal policy restricts spending of the oil wealth to a level that can be maintained forever, and it provides a rules-based solution to all three issues. Restricting spending out of oil revenues to a level that can be maintained indefinitely is, by definition, a sustainable policy. This approach is possible through saving in good years and running deficits in bad years in such a way that accumulated income and investment proceeds provide enough resources to maintain spending levels in low (or zero, postexhaustion) income years. This approach to designing long-term fiscal policy involves two key steps: (a) computing the discounted value of projected revenues and (b) calculating the income level exactly equal to the same discounted value. Restricting spending to that hypothetical income level is, by definition, sustainable indefinitely. For example, if a safe real rate of interest is about 3.0 percent (equal to the U.S. long-term historical real rate plus a hundred basis points for Russian risk) and a long-term U.S. inflation rate is 2.4 percent, a safe nominal rate of return would be 5.4 percent. But the income stream being discounted is not a safe stream because it is shrouded in substantial uncertainty. To account for riskiness, a 3 percent risk premium is added to the basic safe real rate. Obviously, this puts a limit on the ―measured uncertainty‖ called risk, but it appears to be a reasonableassumption that would cover the possible level of risk under most conditions in Russia based on past experience. Under the baseline Russian scenario, this calculation shows Russia’s oil and gas wealth at a total of about US$3 trillion, or 215 percent of 2009 GDP. The permanent income equivalent of this amount is the constant real annual amount that has the same discounted value, this time using the safe real rate for discounting because it is by assumption a safe stream. This permanent income equivalent is about 60.1 billion in constant 2009 U.S. dollars, or 4.3 percent of GDP in 2009. This 4.3 percent of GDP is the sustainable nonoil deficit that can be safely consumed each year out of oil revenues without running into sustainability problems while sharing the oil wealth fairly over all current and future generations. Source: Based on the findings of the Long-term fiscal study, World Bank, 2010. 2.13. The federal budget deficit will be financed mainly from domestic financing sources—domestic borrowing supplemented by modest external borrowing. In 2011, a part of the deficit will be financed also by a drawdown of the reserve fund, but in 2012–13, the deficit will be financed mainly using domestic sources (table 2.4). The domestic financing sources include the privatization revenues from the sale of state assets, approximately 0.5 percent of GDP per year, and the issuance of domestic bonds. Although adequate liquidity exists in the domestic market to finance the relatively small deficit (Consolidated Financial sector assets were 75.4 percent of GDP in 2009), there is a risk that in the long term doing so could cause an increase in interest rates and crowd out bond issues by state-owned enterprises (SOEs) or large enterprises. There is also a risk that the pace of fiscal adjustment on the expenditure side will become slower because of the election cycle, resulting in higher deficit, the financing of which might become more challenging in the medium term. 7 Table 2.4: Preliminary Estimates of Additional Funding Needs in 2011–13 percentage of GDP 2008 2009 2010 Federal budget law 2011–13 2011 2012 2013 Total deficit -4.1 5.9 4.1 3.6 3.1 2.9 Drawdown from the reserve and -4.8 5.2 3.7 0.5 0.0 0.0 stabilization funds Net external financing -0.3 -0.3 0.3 0.1 0.1 0.1 Net domestic financing 1.0 1.1 0.1 3.0 2.9 2.7 Source: World Bank staff estimates based on federal budget. 2.14. We analyze two postcrisis fiscal programs: the first based on the government’s fiscal consolidation scenario outlined in the federal budget law for 2011–13 and the second based on a more ambitious adjustment. For consistency purposes, both scenarios include identical macrofiscal assumptions based on the medium-term outlook underpinning the federal budget for 2011–13. These scenarios should be viewed as a distribution (or a range) of possible outcomes and integrate the strategic policy choice of partly or fully meeting the postcrisis reform agenda. 2.15. The government’s consolidation scenario (Plan A) is based on a modest increase in the nonoil revenue base and the phasing out of most of the anticrisis measures not related to social protection. The parameters of this scenario are based on the 2011–13 budget law that introduces changes in the tax code aimed at increasing excise taxes on gasoline and tobacco. As of 2011, excise tax revenues on gasoline will be earmarked specifically for the road sector; hence, the tax increase will fund additional expenditures in the road sector at federal and regional levels. Additionally, efforts to strengthen the VAT administration will result in higher tax revenues over the medium term. On the expenditure side, the largest savings will result from the introduction of a higher social insurance contribution rate, effective January 1, 2011, that will reduce the pension fund deficit (effectively requiring smaller transfers from the federal budget to cover this deficit, a reduction by 0.9 percent of GDP relative to 2010). Similarly, a gradual phaseout of large social programs related to a provision of new housing for veterans of the World War II will result in additional social expenditure savings. In addition, transfers to regions are expected to decrease from as high as 3.8 percent of GDP in 2009 to only 1.6 percent in 2013 as a result of the gradual phaseout of anticrisis measures at the regional level and the consolidation of fiscal subsidies to the regions under a unified transfer window. Under this scenario, revenue and expenditure measures will result in cumulative fiscal space totaling 5.1 percent of GDP over the next three years (table 2.5) and a reduction in fiscal deficit from 4.1 percent of GDP in 2010 to 2.9 percent in 2013. 2.16. However, the government’s fiscal consolidation plan might not be sufficient to improve the overall fiscal position and to reduce the nonoil deficit to fiscally sustainable levels. First, the pace of fiscal adjustment in the 2011–13 budget is slower than initially envisaged, pushing the hard decisions on expenditure adjustments into the future. A more rapid adjustment is needed to bring the nonoil fiscal deficit down to the long-term, sustainable level of about 4.3 percent of GDP. Second, with the price of oil used in the budget close to the current forecast, Russia’s budget has become more vulnerable to a sudden drop in oil prices. A negative oil price shock (for example, oil prices falling to US$60 per barrel) could reduce the actual net fiscal adjustment by 33 percent. Third, expenditure pressures may increase in the election cycle for 2011–12, thereby leading to a further weakening of fiscal adjustment. Moreover, if one takes into account additional expenditure pressures related to the modernization of infrastructure, the 8 government’s fiscal consolidation plan might not be sufficient to improve the overall fiscal position. There is also a risk that an increase in inflation in the medium term will require additional indexation of social benefits that would result in further deterioration of the fiscal balance (figures 2.2 and 2.3). Therefore, a more ambitious consolidation plan is needed to support the economic diversification and modernization agenda and to achieve a fiscally sustainable nonoil deficit level by 2015. Table 2.5: Plan A: Creating Fiscal Space for Expenditure Priorities 2011-13, Changes Relative to the Previous Year Percentage points of GDP Total (2013 relative to 2011 2012 2013 2010) 1. Net Revenue measures (nonoil revenues) 0.7 0.0 0.2 0.9 Excise tax on tobacco (1,000 cigarettes with filters: 284 RUR in 2011, 360 RUR in 2012, 460 RUR in 2013; 1,000 cigarettes without filters: 360 RUR; 1,000 papyrus cigarettes: RUR 460) 0.04 0.03 0.02 0.1 Excise tax on gasoline (increase by 1 RUR per liter in 2011, by an additional 1 RUR in 2013) 0.16 0.01 0.08 0.3 Additional dividends from SOEs (federal-level ownership) and Unitary Enterprises 0.1 0.0 0.0 0.1 Improvement of VAT administration 0.5 0.0 0.1 0.5 2. Net expenditure measures 2.2 1.2 0.8 4.2 Wage bill savings 0.2 0.3 0.4 0.9 Streamlining of transfers (regional level) 0.1 0.3 0.1 0.6 Optimizing of social expenditures 1.5 0.1 0.1 1.8 Other expenditure cuts 0.3 0.4 0.2 1.0 3. Total revenue and expenditure measures (1 + 2) 2.9 1.2 1.0 5.1 4. Net fiscal adjustment taking into account new cost pressures and shortfall in nonoil and nontax revenues 0.5 0.5 0.2 1.2 Source: World Bank staff estimates based on federal budget. Figure 2.2: Medium-term Funding Needs and Sources Figure 2.3: Russia’s Nonoil Fiscal Deficit under Two Adjustment Scenarios, end of 2013 under Two Adjustment Scenarios, 2007–20 relative to 2010 Source: World Bank staff estimates. 2.17. A more ambitious consolidation scenario (Plan B) that could be considered by the government incorporates more measures to reduce nonpriority expenditures, to broaden non-oil tax revenue base, and to ensure a faster convergence to a sustainable fiscal position. 9 These measures are additional to the government plan (Plan A) presented previously. In particular, this plan envisions additional increases in excise taxes on tobacco, alcohol, and gasoline to bring them to the average levels of Group of 20 (G-20) countries. Furthermore, there is still scope to increase VAT revenues by improving tax administration and minimizing VAT exemptions and reduced rates.6 Additional expenditure savings through improvement of public expenditure management practices and improvement of expenditure allocation (a reduction in subsidies to support select sectors of the economy introduced during the crisis year), phasing out of poorly targeted social assistance programs, and expenditure cuts in subsidies to support public or private enterprises are expected to yield savings over 2 percent of GDP (see the following two sections for a more detailed discussion). Under this scenario, the cumulative increase in fiscal space will equal more than 9 percent of GDP over the next three years compared with 5.1 percent under the budget scenario (table 2.6). In addition, there is a need to strengthen taxation of nonoil mineral extraction industries. Table 2.6: Plan B: Creating Fiscal Space for Expenditure Priorities in 2011–13, Changes Relative to the Previous Year percentage points of GDP 2011 2012 2013 Total (2013 relative to 2010) 1. Net revenue measures 1.0 0.5 1.0 2.6 Government’s scenario to increase nonoil revenues (Plan A) 0.7 0.0 0.2 0.9 Additional increases in excise tax on gasoline 0.1 0.2 0.3 0.5 Additional taxes on tobacco and alcohol 0.0 0.1 0.1 0.2 Additional VAT revenues from improved compliance and minimizing exemptions 0.2 0.3 0.5 1.0 2. Net expenditure measures 2.2 2.2 2.2 6.5 Government’s scenario to cut existing expenditures (Plan A) 2.2 1.2 0.8 4.2 Improvement of capital budgeting practices by introduction of performance-based contracting in road maintenance 0.1 0.1 0.2 Improvement of capital budgeting practices by increasing competition in road maintenance contracts 0.12 0.12 0.24 Elimination of federal budget compensation payments for freight cargo tariffs 0.1 0.1 Gradually phasing out of poorly targeted social assistance programs 0.4 0.6 1.0 Cuts in subsidies to support public or private enterprises 0.28 0.58 0.86 3. Total revenue and expenditure measures (1 + 2) 3.2 2.7 3.2 9.1 4. Net fiscal adjustment taking into account new cost pressures and shortfall in nonoil and nontax revenues 0.8 2.0 2.4 5.2 Source: World Bank staff estimates based on federal budget. 6 Possible savings for additional VAT revenues in Russia are based on International Monetary Fund estimates (IMF 2010). Reduction of compliance gap by 15 percent is estimated to increase VAT revenues by 0.4 percent of GDP. Reduction of VAT exemptions by 15 percent is estimated to increase VAT revenues by 0.54 percent of GDP. 10 C. ENSURING EXPENDITURE SAVINGS BY IMPROVING PUBLIC EXPENDITURE MANAGEMENT PRACTICES Budgeting System 2.18. Russia is a federal state with a three-tier budget system and three major social funds. At the regional level, there are six types of governments: republic, krai, oblast, autonomous oblast, autonomous okrug, and two federal cities. At the local level, the government structure is complex because of the variety of bodies that include upper-level municipalities (mostly municipal districts) and lower-level municipalities (urban and rural settlements). In recent years, subnational budget expenditures grew from 13.6 percent of GDP in 2006 to 16.0 percent in 2009, in part because of the crisis-related transfers to the regions. But in 2010, subnational budget expenditures were expected to decline by more than 1 percent of GDP (table 2.7). There are three federal-level social security extrabudgetary funds in Russia: the State Pension Fund, the Social Insurance Fund, and the Federal Mandatory Health Insurance Fund. Federal extrabudgetary expenditures increased very significantly from 6.9 percent of GDP in 2006 to 10.1 percent in 2010. At the regional level, there are the Territorial Mandatory Health Insurance Funds. Federal and regional extrabudgetary funds receive a significant share of their revenues from federal and regional transfers, respectively. Table 2.7: Aggregate Fiscal Allocations by Budget Types percentage of GDP 2006 2007 2008 2009 2010 Federal budget expenditures 15.9 18.1 18.2 24.7 22.7 Federal-level extrabudgetary funds 6.9 6.4 6.6 8.7 10.1 Subnational budget expenditures 13.6 14.5 15.0 16.0 14.8 Subnational-level extrabudgetary funds 1.3 1.3 1.3 1.4 1.3 Federal budget transfers to regions 2.2 2.6 2.6 3.8 3.1 Federal budget transfers to special funds 3.4 3.2 3.8 5.4 6.1 Total outlays 31.7 34.4 34.3 40.6 38.9 Source: World Bank staff estimates based on budget execution reports. 2.19. The size of government, measured in terms of aggregate budget expenditure as a share of GDP, is comparable to that of other countries with the same level of income (figure 2.4). Despite increases in expenditures in recent years, Russia’s expenditure levels are similar to those of European Union (EU) new member countries and advanced industrial countries. At the same time, the aggregate expenditure level in Russia is below that of Nordic countries and EU old member countries, but higher than that of Commonwealth of Independent States (CIS) countries. 11 Figure 2.4: Size of General Government in Russia and Select Countries Source: World Bank staff estimates based on International Monetary Fund Government Finance Statistics dataset. Note: PPP = purchase power parity. 2.20. In the medium term, federal budget transfers to regions and extrabudgetary funds are expected to decrease, resulting in federal budget savings of about 2.5 percent of GDP cumulative over the next three years. In general, the transfers from the federal budget can be classified into two broad groups: transfers to regions (with the aim to equalize regional differences) and transfers to special funds, including compensating the shortfall in the pension fund. In practice, there are multiple types of federal transfers to regions. Transfers to extrabudgetary funds are expected to decrease as a result of an increase in social security contributions paid by employers. On January 1, 2010, the Unified Social Tax was replaced with insurance contributions payable to four separate extrabudgetary funds. Furthermore, after a transition period as of January 1, 2011, a general rate of these contributions will also increase from 26 percent under the Unified Social Tax to 34 percent. Similarly, transfers to regions are expected to decrease from as high as 3.8 percent of GDP in 2009 to only 1.6 percent in 2013. Box 2.2: Types of Federal Transfers to Regions in Russia In Russia, there are five types of federal transfers to regions: Equalization grants: These are general purpose grants allocated through a formula. Gap-filling subsidies: First introduced in 2004, these subsidies compensate regions for losses of tax revenues or increased expenditure burdens that result from federal policies. Compensation for federal mandates: The federal government compensates subnational governments for 100 percent of their expenditures on federal government responsibilities (for example, cost of running civil registration offices). This type of transfer is not financial aid but rather a special mechanism that allows the federal government to perform its own functions at the subnational level. Capital transfers: These amounts include capital transfers under federally targeted programs. Capital investments not related to such programs are further subdivided into regional development programs—federal programs whose beneficiaries are individual regions or groups of regions and nationwide programs such as education or the expansion of information technology. Operating transfers to special territories, restricted-access cities: These transfers are direct, general-purpose subsidies to centers of defense industry and research and development. Source: (De Silva et al. 2009). 2.21. A number of structural reforms following the 1998 crisis have significantly strengthened Russia’s fiscal framework and public financial management. In 2007, the government lengthened its fiscal planning horizon and improved predictability of public 12 spending by introducing a three-year budget framework.7 This approach allowed line ministries to better plan for the medium term, obliging budgetary authorities to consider the multiannual consequences of their spending initiatives. The budget was consistently based on conservative oil price assumptions, providing a reserve cushion in case of unpleasant oil price surprises. The budget was also separated into baseline budget and new budget initiatives―a major achievement, providing more transparency, stability, and predictability to the budget within a medium-term framework. Recent Public Sector Institutional Reforms 2.22. The government is beginning an overhaul of the public sector―aiming to reduce its size and reliance on the budget, to cut waste, and to improve efficiency and service delivery. The first phase of that reform––currently under preparation by the Ministry of Finance––involves reforming the institutional structure of budget agencies to reduce complexity and waste and to improve efficiency. The reform calls for the legal reclassification of tens of thousands of public entities, now included in the budget, into ―autonomous entities‖ that would effectively be turned into ―arms-length bodies‖ or nonprofit organizations (as in education, science, health, and culture).8 The majority of these autonomous entities would be financed in large part from the sale of their own services, although some budget financing could continue. To receive the government subsidy, the autonomous agencies would need to sign service agreements with the government, including a clear mission statement, a list of services and goods being produced, and a record of the quantity and quality level of the outputs. Thus, the reform program represents a clear shift to a performance-oriented public sector, emphasizing efficiency, effectiveness, and managerial accountability—reforms that OECD countries have been implementing to various degrees over the past 20 years. Although any such reform clearly has risks, the government views it pragmatically as a medium-term task and intends to embark on its implementation gradually. It is important to stress that fiscal savings from these reforms will occur over the medium term and will require an effective results-monitoring system to be in place. Thus, a significant emphasis and focus should be on developing such results-monitoring systems―including enlisting private companies, academic institutions, and nongovernmental organizations to monitor target indicators of public programs. The role of external audit (performance audit) will also become very important in ascertaining that service delivery units comply with their contractual obligations, on the basis of which they receive budget financing. 2.23. The government has also prepared a strategy and an action plan to improve the effectiveness of public expenditures. This approach reflects a policy commitment to ensure that public spending is used more effectively in the environment of lower government revenues and tight budget constraints. The program introduces ambitious steps to overhaul the budget process. The budget will be transformed into a program budget consisting of specific programs grouped into key areas linked to Russia’s development objectives and concrete monitoring frameworks. Such a reform will eventually make it possible to link allocated funds to target indicators. At the same time, the government continues efforts to increase transparency in the preparation, allocation, and execution of public budgets at all levels. The budget decentralization efforts and 7 The framework was suspended in 2009 as a result of the crisis, but was reintroduced in 2010. 8 Only about 20 percent of the entities representing core functions of the state (police, government apparatus, and defense) would be redefined as ―Treasury-financed organizations,‖ which would entitle them to be fully funded from the budget. The majority of organizations will be turned into autonomous entities and will receive government funding for providing an agreed-upon volume of public services. 13 decentralization of the decision-making process will lead to better-informed decisions on the use of financial resources. D. FINDING EXPENDITURE SAVINGS BY IMPROVING ALLOCATIONS Aligning Aggregate Expenditure Allocations to Government Objectives 2.24. The government’s long-term economic development strategy (Economic Development Strategy 2020) adopted in 2008 highlights seven priority areas to promote an innovative, socially oriented economic development. The strategy was drafted just before the crisis, in the period between 2006 and 2008. As a result, the underlying growth scenarios are effectively outdated in the postcrisis environment (the strategy envisioned an annual growth of at least 6 percent per year over the next decade). Nevertheless, priorities identified in this strategy remain an integral part of the government’s long-term policy framework. Key priorities of this strategy include the following:  Developing Russia’s human potential through major improvements in education, housing, and pensions  Promoting environmental protection and mitigating the impact of climate change  Creating a competitive institutional environment that stimulates entrepreneurial activity and attracts capital  Diversifying the economy through innovative technological change  Strengthening Russia’s global competitiveness in traditional economic sectors (energy, transport, and agriculture) and reducing the depletion of raw materials  Promoting spatial development to decrease regional inequalities in living standards  Strengthening Russia’s external economic status as a main financial center and a contributor to global public goods. 2.25. However, budget allocations to fund these priorities were made largely by increasing aggregate expenditures rather than by a strategic reprioritization of expenditures. Expenditure priorities for human potential and competitiveness were all additional expenditures, requiring almost no strategic reprioritization of existing expenditures (table 2.8). Favorable oil and gas prices in 2007 and 2008 allowed for an increase in the aggregate expenditure levels without a need to increase borrowing. Similarly, during the crisis in 2009, large fiscal reserves allowed the government to increase expenditures for priority areas without undertaking any expenditure reprioritization. As a result, the aggregate expenditure level has increased by more than 6 percent of GDP between 2006 and 2010. 2.26. Adequacy of funding among priorities varied widely, partly in response to the crisis. Before the crisis, additional resources were allocated to strengthen Russia’s competiveness in the energy, transport, and agriculture sectors while other priority areas such as education received only moderate expenditure increases in real terms. During the crisis, the most significant increases in allocation were related to social protection (an increase in pensions). It is also clear that expenditure allocations in 2009 and 2010 were primarily focused on minimizing the impact of the unprecedented economic crisis. 14 Table 2.8: Changes in Aggregate Allocation of Consolidated Budget for Various Priorities Percentage points of GDP 2008/2006 2010/2008 1. Development of human potential 0.8 3.1 Education 0.1 0.0 Housing 0.4 -1.1 Social protection 0.3 4.2 2. Promotion of environmental protection 0.0 0.0 3. Strengthening of global competitiveness in traditional 1.9 -0.5 economic sectors (energy, agriculture, and transport) 4. Additional spending related to priority areas (1 + 2 + 3) 2.7 2.6 5. Additional spending not directly linked to priority areas 0.1 1.7 Source: World Bank staff estimates based on budget execution reports. 2.27. Going forward, the government plans to restructure the budget by introducing 39 budget programs grouped in five separate policy areas that would establish a clear link between strategic policy priorities and budget expenditures. Budget programs related to improving the quality of life will have the largest share of budget allocations (table 2.9). Currently, the strategic reprioritization of expenditures is undermined by the fact that multiple institutions are responsible for delivering public services in overlapping areas. In 2010, the Ministry of Education accounted for only a half of all federal-level education expenditures (excluding transfers to subnationals), while in addition to the Ministry of Health and Social Services, almost a third of health care expenditures were executed by other line ministries. Such fragmentation is likely to hinder a transition to true program-based budgeting. Table 2.9: Budget Expenditures by Programs percentage of total program expenditures 2011 2012 2013 Quality of life 51.7 52.8 54.1 Innovations and modernization of economy 17.8 17.1 16.7 National security 9.3 9.2 9.1 Regional development 3.8 3.1 1.6 Public administration 17.4 17.9 18.4 Source: World Bank staff estimates based on the Ministry of Finance. Defining Productive and Unproductive Expenditures 2.28. Public spending affects economic growth depending on the way it is allocated, the way these allocations are efficiently and effectively spent, and the quality of general governance. Broad allocations of spending among government functions may affect growth because some categories of activities appear to spur growth more than others: expenditure multipliers vary across expenditure categories. And within each category of spending, it is possible to allocate resources more or less efficiently and effectively. Therefore, high levels of spending in unproductive areas (most notably, redistributive spending on public consumption and social transfers) can have a negative impact on growth, while spending in productive areas (capital investment, education, and health) can promote growth (World Bank 2007; see figure 2.5). Furthermore, countries with better governance are generally able to collect taxes and spend public funds more efficiently and effectively. 2.29. In 2010, in Russia the fiscal consolidation was mainly done at the expense of productive expenditures. In 2010, social transfers were maintained while investment spending 15 was cut. Cuts in productive expenditures are likely to fall on much-needed infrastructure maintenance. In 2010, public expenditures on transport were estimated to fall by 0.6 percent of GDP from the (already) low level of 2.5 percent in 2009. This decrease is insufficient in the short term and problematic in the long term insofar as public infrastructure represents a primary channel for the government to promote competitiveness, international and interregional interconnectivity, and productivity growth. Figure 2.5: Changes in General Government’s expenditures by Category Source: World Bank staff estimates based on budget execution reports. Note: Productive expenditures include education, health, and infrastructure expenditures. Unproductive expenditures include the following functional classifications: social protection, culture, and environment. 2.30. But this broad characterization of productive and unproductive spending is clearly rough, and actual spending in each area must be scrutinized in practice. Spending in productive categories such as education can still be wasteful, while well-targeted spending in less-productive categories can be beneficial. According to the methodology of the Ministry of Regional Development, the share of inefficient expenditures (defined as those exceeding normalized unit cost standards set at the national level) at the subnational level totals slightly more than 1 percent of GDP per year (table 2.10). But it is estimated that about 18 percent of expenditures on secondary education were inefficient in 2009. Although Russia should try to shift spending toward productive areas to the extent possible, it is even more important that the efficiency of spending be increased in each area. The next two subsections will analyze sectoral expenditure patterns in more detail. Table 2.10: Government’s Estimates of Inefficient Budget Expenditures at the Regional Level, 2007–09 percentage of GDP 2007 2008 2009 Public administration 0.3 0.2 0.2 Health 0.2 0.2 0.2 Secondary education 0.4 0.3 0.4 Housing and communal services 0.3 0.2 0.3 Total 1.1 1.0 1.1 Source: Ministry of Regional Development. Economic Classification of Budget Expenditures 2.31. Social benefits account for almost half of aggregate expenditure increases in 2009 (table 2.11). As with other countries in Central and Eastern Europe, pensions in Russia pose 16 some of the most difficult and intractable issues in public finance policy, exacerbated by the legacy of socialism and demographic trends. Legacy issues of very high rates of employment and generous pension coverage—with relatively low retirement ages and broad coverage for disability—result in high pension spending relative to other fast-growing countries at similar income levels in other regions (World Bank 2007). Table 2.11: Evolution of General Government Expenditures by Economic Classification percentage of GDP 2006 2007 2008 2009 2010* Expense 27.3 33.2 33.4 39.3 38.0 Compensation of employees 7.8 7.4 8.8 10.2 9.5 Wages and salaries 6.6 6.1 7.6 8.7 8.1 Social contributions 1.1 1.3 1.3 1.5 1.4 Use of goods and services 6.5 6.9 5.3 6.3 6.1 Consumption of fixed capital n.a. 3.2 3.7 4.1 3.9 Interest 0.8 0.5 0.6 0.5 0.6 Subsidies 1.7 4.7 4.1 5.4 4.0 Grants 0.1 0.1 0.1 0.2 0.1 Social benefits 9.3 9.6 9.7 12.4 12.7 Social security benefits 6.3 6.3 6.7 8.7 8.9 Other expense 1.0 1.9 0.9 0.3 1.1 Total outlays 31.7 34.4 34.3 40.6 38.9 Source: World Bank staff estimates based on budget execution reports. * Estimate. Note: n.a. = not available. 2.32. The wage bill registered a record high in 2009, reaching 10.2 percent of GDP. Prior to 2008, the aggregate wage bill was consistently below 8 percent of GDP, slightly lower than the average for European Union 10 (EU-10) countries (the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Romania, Bulgaria, Poland, the Slovak Republic, and Slovenia). As a share of GDP, the wage bill remained fairly constant between 2002 and 2008, and sizable nominal increases in the wage bill were offset by equally high growth in GDP. An increase in the wage bill in 2009 was triggered in part by a sharply higher minimum wage (from Rub 2,300 per month to Rub 4,330 per month, an increase by 88 percent, in January 2009). But the share of wages and salaries in total outlays remained stable at around 22 percent in 2009 (see chapter 4 for an in- depth discussion on the wage bill issues). 2.33. Over the past decade, subsidies (defined as unrequited payment to support public or private enterprises) have declined, but they increased again in 2009, reaching 5.4 percent of GDP. In the period between 2002 and 2006, the subsidy level fell from 5 percent of GDP to about 1.5 percent. But in 2007, subsidies surged again, exceeding 5 percent of GDP in 2009 because of anticrisis measures. As a result, in 2009 alone, subsidies increased by 1.3 percent of GDP. Compared to EU-10 countries with overall subsidy levels slightly more than 1 percent of GDP on average, subsidies in Russia remain high. 2.34. At first blush, relative to other countries, capital expenditures in Russia as a share of GDP seem high. In 2008, capital expenditures accounted for about 6 percent of GDP, slightly higher than in other emerging G-20 countries, and higher than 3.2 percent in the EU new member countries and in advanced G-20 countries (figure 2.6). In 2008, about 20 percent of investment in Russia was financed through public budgets (6.5 percent from the federal budget, 12.2 from subnational budgets, and 1.6 percent from extrabudgetary funds). For comparison, in 2004 the public budget covered only 17.4 percent of all investment expenditures. 17 Figure 2.6: General Government Expenditures as a Share of GDP in the Russian Federation and G- 20 Countries, by Economic Classification, 2008 Source: IMF 2010. 2.35. But on closer inspection, parts of capital expenditures are, in fact, recurrent subsidies (capital transfers), and public capital expenditures remain largely inadequate and fragmented among various programs. Capital transfers were approximately 0.45 percent of GDP per year in 2008 and 2009, slightly less than 10 percent of all capital expenditures. There are four federal target programs for capital expenditures, the largest of which is the Federal Targeted Program (FTP). The multiplicity of the investment programs has made capital investment planning cumbersome, with inadequate provisions for operating expenses. One third of expenditures from the FTP are allocated to the transport sector. The second-highest allocation is for regional development (about 13 percent). The project selection process is not formalized and projects are selected on the basis of expert assessment in the process of FTP approval. The launching of the Investment Fund in 2006 created an additional fragmentation of investment planning. Importantly, the projects in the Investment Fund are not linked to current expenditures required for project implementation, thereby leading to systemic underfunding of maintenance (Kraan et al 2008). Functional Classification of Budget Expenditures 2.36. Approximately half of budget outlays represent social expenditures––publicly financed programs in education, health, culture, mass media, sports, and social protection (table 2.12). The second-largest expenditure component is infrastructure expenditures that include energy, transport, communications, and housing and communal services, which account for about one-fifth of total outlays. 18 Table 2.12: Evolution of General Government Expenditures by Function percentage of GDP 2006 2007 2008 2009 2010 Total expenditures 31.7 34.4 34.3 40.6 38.9 Public administration 3.1 3.5 3.1 3.3 3.2 National defense 2.5 2.5 2.5 3.1 2.8 Public order 2.7 2.6 2.6 3.2 3.0 National economy 3.5 4.7 5.4 7.1 5.2 Energy 0.1 0.1 0.1 0.2 0.1 Transport 1.5 1.8 2.2 2.5 2.5 Communications 0.1 0.1 0.1 0.1 0.2 Housing and communal services 2.3 3.3 2.8 2.6 2.4 Environmental 0.1 0.1 0.1 0.1 0.1 Education 3.9 4.1 4.0 4.6 4.2 Culture 0.7 0.7 0.7 0.8 0.8 Health 3.6 4.2 3.7 4.2 3.8 Social protection 8.8 8.6 9.0 11.7 13.0 Source: World Bank staff estimates based on budget execution reports. Figure 2.7: General Government Expenditures as a Share of GDP in the Russian Federation and Select Country Groups, by Functional Classification Source: International Monetary Fund, Government finance Statistics dataset; Ministry of Finance (data for the Russian Federation). 2.37. Social protection9 is the largest budget item within the consolidated government’s spending, accounting for 25 percent of expenditures and one-half of social expenditures. The largest share of social protection expenditures (about 80 percent) finances social insurance programs such as pensions and other programs providing benefits for contributors in case of sickness, maternity, or unemployment (see appendix C for a list of social insurance and noncontributory social assistance programs). Noncontributory social assistance programs and subsidies10 channel the remaining 20 percent of social protection expenditures. In recent years, both social insurance and noncontributory program expenditures have increased significantly 9 Russia’s extensive social protection system includes contributory programs such as pensions and unemployment benefits and noncontributory programs such as privileges and income-tested social assistance. 10 Noncontributory subsidies and programs include, for example, subsidies for privileged citizens or income-tested social assistance programs. 19 (table 2.13). Almost all social protection benefits, with the exception of child allowances, have increased in real terms. Between 2004 and 2009, the minimum unemployment benefit level increased more than five times in real terms, and average pensions increased by 40 percent in real terms during the same period. In 2006, the relative level of social protection expenditures as a share of GDP was significantly lower than in other countries, but in 2010, social protection expenditures in Russia are almost as high as in advanced countries (figure 2.7). Table 2.13: Social Protection Expenditures by Program Type percentage of GDP 2006 2007 2008 2009 2010 Social protection 8.8 8.6 9.0 11.7 13.0 Pensions 6.2 5.9 6.2 8.3 9.9 Other social insurance 0.7 0.7 0.6 0.6 0.7 Noncontributory programs 1.8 2.0 2.2 2.5 2.4 Source: World Bank staff estimates based on budget execution reports. 2.38. Pension increases had the most significant impact on social protection expenditures. Pension expenditures increased from 6.2 percent of GDP in 2006 to almost 10 percent in 2010. Nominal base pension increased by 30 percent in 2009 followed by a scheduled increase of 46 percent in 2010. But this was not offset by an increase in pension contribution rates, resulting in the escalating pension fund deficit. Although the average replacement rate (ratio of average pension and wage) increased from about 25 percent in 2007 to more than 35 percent in 2010, federal transfers to cover the pension fund doubled (figure 2.8). Regarding the declining working-age population, sustainability is the key issue of the pension system. The introduction of higher contribution rates effective January 1, 2011, is one of the steps taken by the government to improve sustainability. Figure 2.8: Federal Budget Transfers to the Pension Fund as a Share of GDP and Average Replacement Rate Source: World Bank staff estimates based on budget execution reports, Rosstat. 2.39. Although resources channeled through noncontributory programs are substantial, the impact on poverty is small. Estimates suggest that total noncontributory spending accounted for at least 2.8 percent of GDP in 2010 (in 2002, the total was about 6 percent of GDP). In terms of noncontributory spending, Russia ranks among the generous spenders. But according to a recent World Bank report assessing Russia’s living standards,11 only a small 11 World Bank report, Russian Federation: Addressing the Challenge of Chronic Poverty and Vulnerability, analyzing poverty incidence during 2002–06 (2009). 20 fraction of these resources is targeted to the poor12 and the few income-tested programs explicitly designed to serve poor or vulnerable populations have mediocre targeting.13 The majority of these programs are administrated by subnational governments; the federal budget accounts for only 10 percent of all noncontributory expenditures. 2.40. Public expenditures on health have increased steadily but remain comparatively low and inefficient. Since 2001, public sector expenditures on health have fluctuated between 2.7 percent of GDP and 4.2 percent, significantly less than in industrialized countries. In real terms, health care spending rose above pretransition levels only in 2006 with the injection of resources from the National Priority Health Program. Russia’s total health expenditures (public and private) are 5.3 percent of GDP, significantly below the levels observed in countries with similar per capita income level (see appendix A). There remain serious structural problems in Russia’s health sector that undermine the efficiency of health expenditures. Despite the fact that subnational government expenditure on health varies substantially relative to gross regional product (GRP)—mostly between 2 and 4 percent of GRP, but up to 15 percent—health outcomes across regions do not significantly vary, suggesting important inefficiencies (Box 2.3). 2.41. Although spending on education rose in recent years, efficiency-enhancing reforms progressed slowly. Before the crisis, consolidated budget expenditures on education increased from approximately 3.7 percent of GDP in 2005 to slightly more than 4 percent in 2008. However, relative to other countries, public expenditure on education as a share of GDP significantly lags (figure 2.7). According to the OECD, the average secondary education expenditures per student in Russia are about two times lower than in EU new member countries (four times lower than in EU old member countries). Reforms aimed at increasing efficiency, such as the introduction of a per capita secondary education financing model (primary and secondary education account for almost half of all education expenditures; see table 2.14), remain in the pilot stage. Furthermore, the present system of allocation, regulations, and incentives leaves little room for improving the allocation of resources for capital investments and development with a significant number of schools in need of renovations. Thus, in the current environment of limited fiscal resources, it is especially important to improve efficiency and broaden institutional reforms (Froumin and Shmis 2008). (World Bank [2010d] and Hauner [2007] provide more in-depth analysis of education expenditure.) 12 According to the HBS survey (2006), only a third of the beneficiaries of income-tested programs in Russia are indeed poor. Of the four best programs from countries in transition, the average is two thirds. 13 About one-half of social assistance spending in Russia finances privileges and regressive subsidies for housing, utilities, and energy that largely benefit middle class and richer households in a system designed for different categories of citizens. Only a small part of the subsidies goes to the poorest 20 percent of the population. 21 Box 2.3: Key messages of World Bank’s Social Expenditure Review Additional social sector financing per se would not enable Russia to improve quality and performance. The fundamental structural distortions in the health and education systems need to be resolved in order to fundamentally improve efficiency. In specific terms, the analysis undertaken under the framework of the Social Expenditure Review leads to the following key messages:  Russia has significant scope for spending its existing fiscal resources allocated to social services (health, education, and social protection) more efficiently. The efficiency reforms could improve human development outcomes and at the same time protect the current fiscal envelope on social services from expanding. The findings indicate that better education and health outcomes could be achieved with the current input of physical resources into the education and health systems. Sector reforms and inter-budgetary transfers are important elements in optimizing service networks and in keeping under control physical (and fiscal) inputs in the provision of social services.  The regional analysis of social sector spending and of the related human development outcomes suggests that some regions have made significant efficiency advances in the health and education sectors while at the same time protecting or improving human development outcomes. More-reform-oriented regions are also found to be generally more efficient at a given point in time. This evidence is encouraging and provides empirical support for further advancing the efficiency reform agenda.  A quest for the quality of inputs in the provision of social services is of paramount importance in reducing the quantity of inputs while at the same time improving human development outcomes. For example, the analysis of the education sector shows that quantitative inputs such as the student-teacher ratio and the average school size are significantly correlated with the costs per student, but not with educational outcomes. At the same time, educational outcomes are found to be highly correlated with the factors capturing the quality of inputs in the education system. It is estimated that efficiency improvements across all the regions may free up about 25-30 billion Rubles in the general education sector, and up to 180-200 billion Rubles in the health sector. Any potential fiscal savings made from reducing the quantity of physical inputs in health and education could be used to enhance the quality of inputs.  The current system of inter-budgetary transfers provides several options for changes that would position it better for the delivery of social services and the provision of budget efficiency incentives. The system in its current form already plays a crucial role in helping the regional/local governments in providing and financing social services such as health and education, not least through smoothing the regional differences in social spending per capita. However, several potential changes to the system of inter-budgetary transfers have the potential to make it even better positioned for the delivery of social services and the improvement of budget efficiency incentives. Source: Social Expenditure Review, World Bank (2011). Table 2.14: General Government Education Expenditures by Function percentage of GDP 2006 2007 2008 2009 2010 Total 3.9 4.1 4.0 4.6 4.2 Preschool 0.5 0.6 0.6 0.7 0.7 Primary and secondary 1.8 1.8 1.8 2.0 1.8 Vocational 0.4 0.4 0.4 0.5 0.4 Higher 0.6 0.7 0.7 0.9 0.8 Other 0.5 0.5 0.5 0.4 0.4 Source: World Bank staff estimates based on budget execution reports. 2.42. Between 2004 and 2008, public expenditures on transport averaged about 1.5 percent of GDP per year, yet different transport subsectors vary enormously in the extent to which they rely on public funding. Given the limited short-term scope for full cost recovery in the public transport sector, much of the transport infrastructure (capital expenditures) is directly financed by subsidies or capital transfers. Whereas operating costs of infrastructure are largely financed by user charges, roads and waterways depend almost exclusively on public finance. Only about 10 percent of the costs of rail, sea, and air transport come from the public budget, while more than 90 percent of the costs of roads and inland waterways are covered by the public funds. 22 E. SUMMARY OF RECOMMENDATIONS 2.43. The crisis has provided an opportunity and impetus to rethink and accelerate public sector reforms, especially in improving public expenditure management; it is important that these lessons are not lost in the return to business as usual after the crisis. Aggregate analysis of expenditures indicates that there is much scope for increasing efficiency by identifying functional categories of unproductive spending to target for cuts in the medium term and by creating room for priority expenditures (table 2.15). This approach would require a systematic, annual review of public spending categories, in the context of the annual budget reviews, to identify the scope for cuts without affecting the desired service delivery and to advance all-important institutional reforms. The government has a strong record of strengthening budget management for many years, and its three-year budget for 2011–13 aims to implement a gradual fiscal adjustment plan containing many important initiatives. Notwithstanding important measures in this budget, a more ambitious adjustment is recommended to bring Russia’s finances to a long-term sustainable path more rapidly, to better prepare Russia’s budget for future external shocks, and to engender efficiency gains across key spending categories. Table 2.15: Summary of Recommendations: Aggregate Macrofiscal Framework Responsible Options for reform and Suggested Expected impact agency recommendations sequencing Strengthening aggregate macrofiscal framework to support the long-term growth Maintaining MOF Conservative oil price Continuous Avoiding of excessive, budget planning assumptions underpinning unanticipated expenditure with a medium-term fiscal plans cuts in cases of negative oil conservative (three-year federal budget) price shocks macroeconomic Minimizing of mid-year budget forecast, including revisions conservative oil price Reintroducing MOF Nonoil and gas fiscal deficit Sequentially Balanced and sustainable fiscal rules target for the federal budget over the medium budget system in the long kept below 4.5 percent of GDP term term Reduced risk from oil price volatility Greater fairness between current and future generations Enhancing MOF Increase in the size of Medium-term More automatic flexibility to automatic unemployment benefits and respond to new economic stabilizers means-tested social assistance shocks. programs Strengthening MOF Consistent fiscal risk analysis Ongoing Reduced medium- and long- long-term fiscal and assessment, including risks government term fiscal risks risk analysis and arising from medium- and long- effort assessment term demographic trends, changes in global economic conditions, and contingent liabilities Improving public expenditure management practices Increasing MOF Developing of municipal Ongoing Increased budget transparency in budget monitoring systems government accountability that results in preparation, Enlisting of external bodies effort increased quality of public 23 Responsible Options for reform and Suggested Expected impact agency recommendations sequencing allocation, and (private companies) to monitor service delivery execution of target indicators of public public budgets at programs all levels Refocusing budget MOF, MOE, Strengthening of the role of Ongoing Improved government expenditure line financial directorates in line government performance, increased control from ministries ministries to play a key role in effort quality of publics services inputs to results budget formulation, improving (outputs and the efficiency and effectiveness outcomes) of the spending Introduction of methods and techniques to assess the efficiency of federal government operations by designing specific performance indicators to measure the efficiency of spending and to assess achievements against the planned parameters Strengthening MOF, MOE, Planning of capital Short-term Increased effectiveness of capital budgeting MRD expenditures to be linked with capital expenditure programs practices provision for operating expenditures Increase in transparency in project selection in public investment programs Introducing MOF, MOE Gradual introduction of Medium-term Increased expenditure program-based program-based budgeting (ongoing efficiency budgeting government Improved public sector effort) productivity Broadening tax base Increasing MOF Increase of excise taxes on Short- to Increased fiscal revenues by revenues from alcohol and tobacco to average medium-term 0.23 percent of GDP tobacco and levels of G-20 countries (0.58 Improvement of health alcohol excise percent of GDP) outcomes taxes Increasing MOF Increase of excise taxes on fuel Short- to Increased fiscal revenues by revenues from fuel medium-term 0.5 percent of GDP taxes Improving the MOF Improvement of compliance by Short- to Reduction of compliance gap revenue strengthening the tax medium-term by 15 percent is estimated to performance of administration increase VAT revenues by VAT Minimizing of exemptions and 0.4 percent of GDP VAT reduced rates Reduction of VAT exemptions by 15 percent is estimated to increase VAT revenues by 0.54 percent of GDP Improving expenditure allocations Ensuring adequate MOF, MOT, Limiting of expenditure cuts in Short- to Protection of human capital resources for MOE productive sectors medium-term and key infrastructure, which social sectors are key ingredients to future 24 Responsible Options for reform and Suggested Expected impact agency recommendations sequencing (education and economic growth health) and infrastructure maintenance Overseeing MOF Consolidating of fiscal Medium-term, Increased expenditure intergovernmental subsidies to the regions in the ongoing efficiency fiscal relations key policy areas under a unified government Reduction in federal budget transfer window effort transfers by 1.1 percent of Introduction of efficiency GDP cumulative in 2011–13 criteria for granting subsidies to regions Overseeing social MOF, Gradual phasing out of poorly Gradually over Increased efficiency and protection and MOHSS targeted social assistance the medium term better targeting of the social social assistance programs for a gradual protection system substitution of privileges with targeted programs Enhancing MOF, all Continuing of reforms to Medium-term, Increased accessibility and efficiency of ministries introduce ―autonomous‖ ongoing quality of government government and agencies agencies as a new form of government (municipal) services in service delivery delivery and financing of effort education, health care, government services culture, social security, and Enhancing of transparency of other socially sensitive areas institutions delivering public services Eliminating of overlapping and redundant functions and mandates among the government levels and among government agencies Phasing out MOF Reduction of the aggregate Gradually over Reduced quasi-fiscal anticrisis expenditure on subsidies to the the medium term activities measures precrisis levels by gradually Fiscal savings up to 1.3 phasing out subsidies to percent of GDP enterprises and capital transfers to enterprises. Note: MOE = Ministry of Education, MOF = Ministry of Finance, MOHSS = Ministry of Health and Social Services, MOT = Ministry of Transportation, MRD = Ministry of Regional Development. 25 3. STRENGTHENING CAPITAL BUDGETING IN ROAD AND RAIL SECTORS 3.1. This chapter analyzes the Russian Federation’s capital budgeting practices by focusing on the transport sector––specifically roads and rail––the single largest item of capital expenditures. Russia faces a number of significant, and often conflicting, challenges in the transport sector. First, the condition of the transport network has been declining over the past decades because of insufficient spending on maintenance and rehabilitation, raising costs to the economy and reducing the competitiveness of the country. Second, there is also a need to continue the necessary reform to strengthen the institutional framework and to improve allocation efficiency in the sector and the sustainability of expenditures. Finally, and most important, there is a need to adopt a more professional approach to the management of transport infrastructure, mainly road assets, to enhance efficient use of the resources for the maintenance of assets and, thus, support the sustainability of all expenditures. A. INFRASTRUCTURE, GROWTH, AND PUBLIC EXPENDITURE 3.2. Public infrastructure has long been recognized as a key factor of development and a tool by which governments can promote competitiveness and regional and productivity growth. A recent Organisation for Economic Co-operation and Development (OECD) report suggests that investment in infrastructure has an effect on the pattern of economic growth and that the effect depends on the stage of economic development (Hulten 2007). In countries like the United States which has a large road network, the main effect of reduced transport costs stemming from road infrastructure investments is the relocation of economic activities to lower- cost regions, with significantly changing productivity or output. However, the addition of capacity to capacity-constrained networks will tend to cause an improvement in productivity and lead to an expansion of economic growth. Cross-country studies have shown that the rates of return to paved roads in certain middle-income countries are exceptionally high, suggesting significant macroeconomic externalities associated with infrastructure (Canning and Bennathan 2007). Although these studies have not looked at the Russian economy, they do suggest that for a number of middle-income countries, there can be significant, positive contributions to economic growth, unlike the case for more mature economies. 3.3. In Russia, the condition of transport infrastructure is generally poor and has been declining because of underinvestment in maintenance and rehabilitation. Public expenditure on transport amounted to 1.5 percent of gross domestic product (GDP) per year in recent years, which, as this report argues, is below the international norms and Russia’s own requirements for maintenance and basic expansion of the network. Poor quality of infrastructure is also increasingly viewed as a key constraint to Russia’s competitiveness and business (box 3.1). The deterioration in road asset quality is a proxy for insufficient expenditure on maintenance and rehabilitation in Russia, leading to a mounting maintenance backlog problem. 26 Box 3.1: Infrastructure, Competiveness, and Constraints to Russia’s Business The quality of infrastructure is perceived to be an important component of competiveness and overall business environment. According to recent cross-country rankings, the quality of Russia’s infrastructure appears to be significantly lagging that of comparators. Business surveys show that firms and enterprises indicate the quality of infrastructure to be either inadequate or becoming a constraint. For the past three decades, the World Economic Forum’s annual competitiveness reports have examined many factors enabling national economies to achieve sustained economic growth and long-term prosperity. Since 2005, the World Economic Forum has based its competitiveness analysis on the Global Competitiveness Index (GCI), a highly comprehensive index that captures 12 pillars of competitiveness, including infrastructure. The World Economic Forum Global Competitiveness Report 2009–2010 ranks Russia 63rd out of 133 countries, just above Romania and below Montenegro. Compared to the 2008 ranking, Russia slipped by 12 places mainly because of a notable deterioration in financial market efficiency. Russia’s rank in infrastructure, 71st, is lower than its overall rank (63rd), just above Georgia and below Morocco. There are some infrastructure areas in which Russia is more competitive: available seat kilometers (13th); quality of railroad infrastructure (33rd), and number of telephone lines (40th). But Russia is significantly less competitive in other infrastructure areas: quality of electricity supply (73rd); quality of port infrastructure (87th); quality of air transport infrastructure (92nd); and quality of roads (118th). The quality of roads in Russia is ranked below Kazakhstan, but above Ukraine. Furthermore, newly released results of the European Bank for Reconstruction and Development–World Bank Business Environment and Enterprise Survey covering a broad range of issues about the business environment in Russia and other countries of Central and Eastern Europe, indicated that Russian enterprises were experiencing a significant worsening in the infrastructure constraints since the previous survey was carried out in 2005. Transport is becoming a major constraint, with 64 percent of firms indicating it was a problem in 2008, significantly higher than the 28 percent reported in 2005. Sources: EBRD and World Bank 2010, World Economic Forum 2009. 3.4. But the provision of public infrastructure depends critically not only on financing, but also on management and institutions. Public investment in infrastructure should reflect both cost-benefit and macroeconomic considerations that take into account financing and capacity constraints. An important survey of economic issues of infrastructure (Estache 2007) shows that investment planning and policy coordination are essential to avoid bottlenecks that slow national and regional growth or distort urban-rural resource allocations. Thus, despite evidence indicating that insufficient infrastructure is becoming a constraint to economic growth in Russia (especially in select regions), the economic impact of public investment will also depend on institutional issues related to planning and implementation of large-scale infrastructure initiatives. B. THE ROAD SYSTEM: CURRENT ISSUES AND CHALLENGES The Road Network 3.5. Russia, with a land area of 17.1 million square kilometers, is the largest country in the world, with 963,000 kilometers of roads of which 629,000 kilometers are public roads and 754,000 kilometers are hard-paved surface roads as of 2008. Of the public road network, more than three quarters are regional and intermunicipal roads (table 3.1). The federal highway system and its management cover less than 5 percent of total road network, but about 60 percent of motorways, and account for 40 percent of road freight traffic volume, including nearly all international freight traffic. 3.6. The policy makers aiming to improve the Russian road network face a number of pressing issues requiring a multipronged policy approach: (a) scarcity and structural design of the network, (b) poor road conditions, (c) outdated design standards, (d) overloading, and (e) road safety. 27 Table 3.1: The Road Network kilometers, thousands 2000 2007 2008 Supply side (kilometers, thousands) Hard surface roads 754 771 754 Public roads 532 624 629 Federal roads 46 49 50 Motorways 29 30 30 Regional and intermunicipal roads 486 469 456 Local roads n/a 107 124 Departmental roads 221 147 125 Demand Side Total number of vehicles (thousands) 24,993 35,455 38,264 Light vehicles 20,247 29,405 32,021 Buses 624 882 894 Heavy trucks 4,122 5,168 5,349 Cargo volumes (tons, millions) 5,878 6,861 6,893 Cargo turnover (billion ton kilometers) 153 206 216 Source: Rosstat, http://www.infostat.ru/catalog.html. 3.7. The Russian road network is sparse. This sparsity reflects, in part, the traditional reliance on the railway system, the large size of country and the spatial concentration of economic activities. Public road spatial density, at 37 kilometers per 1,000 square kilometers, is very low compared to that in Canada, a large country with similar climate (110 kilometers per 1,000 square kilometers), but it rises to 110 kilometers per 1,000 square kilometers in the European part of Russia. Conversely, it falls as low as 6 kilometers per 1,000 square kilometers in the Far East Federal District (figure 3.1). On a second measure, public road density is also low in Russia, at 4.4 kilometers per 1,000 inhabitants, compared to 32.4 in Canada and 7.8 in Germany, although it is higher than China, which has only 2.64 kilometers per 1,000 inhabitants, because of the large population base. Figure 3.1: Public Road Spatial Density: Russian Federation and select countries (left) and Russian Federation and selected federal districts (right) km per 1000 square kilometers Russian Federation Canada Finland China USA Sweden UK Germany 0 500 1000 1500 2000 Sources: PACC consulting ; Rosstat, http://www.infostat.ru/catalog.html; World Bank estimates. 28 Box 3.2: Institutions in the Russian Road Sector The Ministry of Transport is responsible for transport policy development and transport sector regulation, including roads. It is mandated to develop and approve transport sector regulation, negotiate and sign international transport agreements and to act as a designated authority implementing international transport agreements in Russia. It is also responsible for procuring transport-related design, survey, and research works for public needs, as well as coordinating and supervising the operation of the subordinate subsector-specific federal agencies. Two key federal institutions in the road sector are Rosavtodor and Avtodor. Rosavtodor, the Federal Highway Agency, is the federal executive authority responsible for public service delivery and public property management in the road transport and road subsectors. It is mandated to coordinate new road construction and ensure that federal highway conditions meet the existing rules, standards, technical regulations, and other regulatory documents and to act as a public client and procure works and services relating to federal highway civil works. Rosavtodor manages the federal highways both directly and through a system of state-owned institutions responsible for day-to-day operation of the federal highways. The system includes 10 federal highway administrations, 22 highway offices, and 4 road construction directorates. In addition, Rosavtodor manages federal state-owned unitary enterprises engaged in federal highway maintenance, rehabilitation, reconstruction, and construction. It also supervises 195 federal unitary enterprises responsible for repair and maintenance of federal roads. Rosavtodor is responsible for the Federal Targeted Program of the Modernization of the Russian Highway System 2002–2010 and the surface roads subprogram of the Development of Russia’s Transportation System 2010–2015. Avtodor, the Russian Motor Roads Public Company, is a new public company created in the second half of 2009. Among its objectives are (a) establishment of a backbone network of high-speed roads of federal importance; (b) creation of a more market-oriented system of road management to attract private investors and to allow the use of additional financial tools to mobilize investment resources; (c) improvement of the efficiency of road asset management and upgrade of road enterprises; and (d) movement to a phase of dynamic road network development. Avtodor creates a mechanism for attracting private sector participation in road investments, something that was quite difficult for a federal executive body such as the Federal Highway Agency or budget institutions subordinate to it. 3.8. The radial structure of the federal road network and rising car ownership contributes to congestion. The network is excessively dependent on the Moscow hub, while regions are deprived of more direct transportation links. As a result, traffic intensity in some of the radial routes exiting Moscow exceeds 100,000 to 150,000 annual average daily traffic, higher than the maximum road capacity, with sections of federal highways going into large cities typically paralyzed for several kilometers. At the same time, the number of registered vehicles rose by more than 50 percent over 2000–07, to 38 million by 2008, straining the road infrastructure. Given current traffic intensity and actual usage levels, more than a third of the federal road network needs to be reconstructed to a higher technical category, with reinforced surfaces to allow for heavy vehicles. 3.9. The condition of the federal, regional, and local road network is less than satisfactory. Of the 49,995 kilometers of federal roads, only slightly more than a third meet the standard requirements and can be considered to be in good and fair condition (table 3.2). Technical inadequacies and high loads result in very slow traffic through major roads (40–60 kilometers per hour in roads designed for traffic of 80–100 kilometers per hour). The poor state of the federal network reflects: (a) years of inadequate maintenance and rehabilitation; (b) poor quality of road construction; (c) high traffic intensity; (d) operation of roads above designed loading capacity; and (e) inadequate planning and management of regular maintenance. About 76 percent of regional roads do not meet the regulatory standards for transport operating conditions, leading to higher cost of road transportation. More than half of the local road network does not have hard surfacing. There are almost two million people living in areas without access 29 to public-use roads, while about 40,000 communities lack year-round connectivity to the public- use road network. Table 3.2: Length and Percentage of the Federal Road Network not Meeting Standards, 2009 Length (kilometers) Percentage Failing to meet minimum riding quality requirements 28,500 57.1 Failing to meet minimum grip requirements 12,200 24.4 Failing to meet minimum strength requirements 24,900 49.9 Failing to meet minimum defects requirements 35,100 70.3 Source: Avtodor, Long-Term Program of the Russian Motor Roads Public Company (2010–2015), Dec 31, 2009. 3.10. However, the road design standards are inadequate and out of date. Most of the roads that were built in the pretransition period have a width of up to 10 meters, with a tight radius that avoided high construction costs, and were suitable for maximum axle loads of six or eight tons per axle. Many of these roads now carry a much higher volume of traffic and much larger trucks with European dimensions (the majority of Russia’s present design standards for public roads are still based on the maximum axle loads of less than 10 tons, but the European designs of many trucks operating in Russia have axle loads of 11 tons to 16 tons on double axles). As a result, the outdated design standards constrain the network capacity. In addition, pavement standards in Russia are not based on an equivalent standard axle, which requires factoring in forecast traffic demand over the design life to determine pavement strength. 3.11. Truck overloading is rampant because of poor enforcement of regulations, thereby worsening road conditions. International research has shown that pavement damage because of loading is proportional to the axle load, raised to the fourth power. This means that heavier vehicles cause greatly increased rates of pavement damage. As a result, road safety remains a serious issue in Russia, with significant economic and social impact. The number of fatalities has remained largely unchanged over the period 2000–08—from 29,600 to 29,900 per year over the period—while the number of injuries has more than doubled, reaching 270,900 in 2008. The fatalities per 10,000 passenger cars have declined from 14.6 in 2000 to 9.3 in 2008. But, fatalities in Russia remain exceptionally high––six times higher than the European Union (EU) average, and much higher than the worst-performing country in the EU, Romania (figure 3.2). Economic costs of the fatalities alone could be as high as 1.7 percent of GDP per year, which exceeds the estimated social costs for both fatalities and injuries from road traffic crashes in middle-income countries (World Bank 2009). Road accidents are among the main causes contributing to premature mortality and disability among working-age males. A report prepared in 2006 by the European Conference of Ministers of Transport, the World Bank, and the World Health Organization found that a combination of weak performance goals, an intrinsically unsafe road system, and fragmented institutional processes result in road accidents in Russia (World Bank 2009). 30 Figure 3.2: Road Fatalities per 10,000 Passenger Cars EU-15 EU-27 Bulgaria Romania Russia (2008) 0.0 2.0 4.0 6.0 8.0 10.0 Sources: EU; Rosstat, http://www.infostat.ru/catalog.html; World Bank estimates. Expenditures in the Road Sector14 3.12. Russia’s public expenditures on the road sector are low and declining. Federal and regional expenditures on roads have declined from 2.8 percent of GDP in 2000 to 1.5 percent in 2009 and are projected to decline to 1.1 percent in 2010. This compares with about 3.5 percent of GDP spent annually since the 1990s by China, a country that has significantly improved the quality and length of its road network (World Bank 2007). The decline in public funds during the 2000–04 period (table 3.3) reflects fiscal reforms undertaken from 1999 to 2001 that phased out the road fund and its main source of revenue. The Russian road funds at the time were not functioning very effectively, and the so-called road user tax based on business turnover was distortionary and unrelated to road network usage. Russian road funds also did not have an accountable relationship between quasi-user charges paid by road users and expenditures on road maintenance, a key feature of ―good practice‖ funds. Although federal expenditures had been rising over the period 2003–09, this was reversed during the financial crisis. Regional expenditures have been cut in half over the period 2008–10. Private sector investments in the road sector have been minimal to date, unable to pick up the slack left by the public sector. But the private sector could be an important source of financing going forward, through private investment via the Investment Fund, the issuance of infrastructure bonds, and private public partnership (PPP) arrangements for toll roads, as discussed later. Table 3.3: Federal and Regional Expenditures on the Road Sector Rub, billions 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Nominal prices Total budget expenditures 203 196 217 222 206 294 402 480 640 602 475 Federal budget, excluding transfers 39 35 39 40 50 72 120 134 199 239 237 Federal transfers 10 25 30 41 37 46 46 85 83 89 37 Regional budget 154 136 149 141 119 175 237 261 358 274 201 Total (percentage of GDP) 2.8 2.2 2.0 1.7 1.2 1.4 1.5 1.5 1.6 1.5 1.1 Real prices (2009 = 100) Total budget expenditures 621 493 473 424 356 450 561 615 719 602 432 Federal budget, excluding transfers 119 87 84 77 86 111 167 172 223 239 215 Federal transfers 30 64 65 78 64 70 64 108 93 89 34 Regional budget 472 342 324 269 206 269 330 335 402 274 183 Sources: Ministry of Finance; International Monetary Fund; World Bank estimates. Note: All data are real except for 2010, which are based on the 2010 budget. Real price adjustments are done using the annual consumer price index. 14 This section excludes spending by municipalities on local roads, because this information is not readily available and focuses mostly on federal expenditures. 31 3.13. Although federal funding for rehabilitation and maintenance had been broadly on the rise during 2003–08, it is clearly inadequate. After a decade of neglect, funds allocated more recently for maintenance in the federal network have declined further, from Rub 66.7 billion in 2009 (US$2.2 billion) to a projected Rub 61.7 billion in 2010 (US$2 billion)—a trend that is unlikely to support any improvements in road quality. Inadequate maintenance hastens the deterioration of any road at an increasing rate until reconstruction is necessary, at considerably greater expense than any short-term saving in maintenance expenditure. The result is the accumulation of a maintenance backlog, a form of a contingent liability of future expenditure needs. 3.14. Regional expenditures have declined particularly sharply during the 2000–10 period. The road network under the administration of regions has, in fact, declined from 486,000 kilometers in 2000 to 456,000 kilometers in 2010, a reduction of 6.2 percent. In contrast, real expenditures in the road sector over the same period have declined by more than 60 percent. This decline reflects the impact of the financial crisis on regional budgets. This decline also leads to postponed maintenance and rehabilitation with deleterious effects on road condition and to the need for more expensive rehabilitation and reconstruction in the future. 3.15. In 2010, federal funds for the federal road network were spent by both Rosavtodor and Avtodor, the new agency, to target key transport bottlenecks. In 2009 1,966 kilometers of federal roads were transferred to Avtodor, and by 2015, Avtodor is expected to control about 2,860 kilometers of roads—less than 6 percent of the federal road network. Most of the funds in 2010–15 will be used for construction (table 3.4). The program will be financing expenditures on key federal highways, including the M1 to Belarus, the M4 to Don, the M3 to Ukraine, the Central Moscow ring road, the highway from Saint Petersburg to Kazakhstan, the Moscow–Saint Petersburg highway, and the Primrosk ring road. So for the first five years of operations, Avtodor commendably has been mandated to build key highways in areas experiencing bottlenecks. Sources of funds for maintenance, rehabilitation, and reconstruction are expected to come exclusively from federal budget subsidies in 2010 with tolls becoming a source of financing in the future. Toll revenues could rise to Rub 18 billion (US$600 million) by 2015. For road construction, the government is expected to finance Rub 972 billion (US$32 billion) over 2010– 15, with significant funds—Rub 515 billion (US$17 billion) from concessions. The creation of a new agency reflects the view that Rosavtodor was not well equipped to deal with the reconstruction and rehabilitation of roads to be financed under PPP arrangements. 32 Table 3.4: Avtodor Program, 2010–15 Rub, billions 2010 2011 2012 2013 2014 2015 2010–15 Use of funds 83.0 120.3 210.4 290.6 381.8 477.3 1,563.4 Maintenance 1.9 3.5 3.6 4.2 4.6 5.3 23.2 Rehabilitation 3.2 1.6 2.3 2.3 3.3 4.7 17.3 Reconstruction 0.8 2.1 3.0 4.6 8.2 13.0 31.7 Construction 77.1 113.0 201.0 278.4 364.6 453.3 1,487.4 Other 0.0 0.2 0.5 1.1 1.0 1.1 3.9 Sources of funds 83.0 120.3 210.4 290.6 381.8 477.3 1,563.4 Revenues for maintenance, 5.9 7.3 9.5 12.2 17.2 24.0 76.0 rehabilitation, and reconstruction Federal budget subsidies 5.8 6.5 6.8 6.5 6.0 5.9 37.4 Toll revenues 0.1 0.8 2.7 5.7 11.1 18.1 38.4 Fines from overloaded trucks 0.0 0.0 0.0 0.0 0.0 0.0 0.2 Revenues for construction 77.1 113.0 201.0 278.4 364.6 453.3 1,487.4 Subsidies from the Federal budget 39.8 72.9 140.8 208.4 214.6 253.3 929.8 Investment Fund (federal funds) 19.2 19.7 3.5 n/a n/a n/a 42.5 Off-budget funding (private investors) 18.0 20.4 56.6 70.0 150.0 200.0 515.1 Source: Avtodor. 3.16. Current expenditures on road maintenance and rehabilitation at the federal and regional levels are significantly below required levels. To calculate the annual amount of funds that should be spent on maintenance, rehabilitation, and reconstruction, the World Bank used (a) the official unit costs per kilometer for maintenance, repair, and major repairs; (b) a breakdown of unit cost-coefficient adjustment factors by category of road; (c) the intervention intervals for repairs and major repairs; and (d) the size of the federal and regional road network by road category. As table 3.5 reveals, the necessary financing for Avtodor over the period 2010–15 for maintenance and reconstruction is in line with its investment program. But these calculations suggest that expenditures on the federal network should total an estimated Rub 181 billion (US$6.04 billion) and Rub 646 billion (US$21.5 billion) annually for the regional network. When these numbers are compared to actual expenditures, there is a sizeable gap for maintenance and reconstruction for federal and regional roads estimated at about 1.1 percent of GDP, with the largest gap in the regional road network (table 3.6). Table 3.5 also shows what the federal and regional governments would be spending on the upgrade and construction of roads according to the Transport Strategy. If one adds the estimated financing to maintain, repair, and reconstruct federal roads and annual capital expenditures according to the Transport Strategy, total expenditures on federal roads would rise from 0.29 percent of GDP according to the 2010 budget to 1.95 percent of GDP. 3.17. The federal budget for 2011 allocates a considerable increase in financing to the road sector during 2011–13, reversing developments during 2009–10. The federal budget foresees funding to the road sector to be Rub 82.9 billion higher (US$2.8 billion) in 2011, rising in 2012 to Rub 176.9 billion (US$5.9 billion) more than in 2010, and in 2013 to Rub 279.4 billion (US$9.3 billion) more than in 2010. This will narrow the funding gap by 2013. However, as argued elsewhere in this chapter, for improvement of outcomes in the road sector, it will be important not only to raise expenditures, but also to adopt measures to ensure that funds are spent efficiently. 33 Table 3.5: Required Road Maintenance and Rehabilitation Expenditures According to the Transport Strategy Rub, billions 2010 2011 2012 2013 2014 2015 Total Federal roads 181 195 208 222 236 251 1,293 Rosavtodor 170 182 194 207 220 233 1,206 Maintenance 41 44 47 50 54 57 293 Rehabilitation 50 54 58 61 65 69 357 Reconstruction 78 84 89 95 101 107 554 Avtodor 12 13 14 15 16 17 87 Maintenance 3 4 4 4 5 5 25 Rehabilitation 4 4 4 4 5 5 25 Reconstruction 5 5 6 6 7 7 37 Regional roads 646 693 741 790 839 890 4,599 Maintenance 169 182 194 207 220 233 1,205 Rehabilitation 179 192 205 219 232 246 1,273 Reconstruction 298 319 342 364 387 410 2,120 Memorandum item Federal expenditure (including transfers) 588 588 588 588 588 588 3,527 on construction as per Transport Strategy Regional expenditure on construction as 316 316 316 316 316 316 1,895 per Transport Strategy Source: World Bank estimates based on Transport Strategy. Table 3.6: Financing Gap for Maintenance, Rehabilitation, and Reconstruction Required annual Average annual expenditure expenditure (2008–10) according to norms Gap RUB RUB RUB (billions) % of GDP (billions) % of GDP (billions) % of GDP Total expenditure 387.8 1.0 828.0 2.1 440.2 1.1 Federal 65.3 0.2 181.6 0.5 116.3 0.3 Regional 322.5 0.8 646.4 1.6 323.9 0.8 Source: World Bank estimates. Notes: Required annual expenditure is the amount needed to meet regular maintenance requirements established by unit cost norms set in the Russian Federation. The Planned Road Network Expansion 3.18. The Transport Strategy sets out ambitious targets for the road sector, including a massive regional road network expansion. The first phase (2010–15) envisages construction and upgrading of nearly 8,000 kilometers of federal public roads and 1,900 kilometers of toll highways and motorways, including the Moscow–Saint Petersburg motorway, Central Ring Road in Moscow, and the M4 Don road. The toll highways’ objectives are largely aligned with the proposed plan for the recently established Avtodor. Among the objectives of the second phase (2016–30) is a highly ambitious road construction program, which would see the network of public motor roads increase from 724,500 kilometers in 2007 to 1,059,600 kilometers in 2015 and 1,350,000 kilometers by 2030. (By contrast, as discussed later, China’s much-heralded, road- building spree during 1990–2005 increased the length of the network by 41,000 kilometers). The Transport Strategy also calls for a major improvement in the quality of the federal road network and an increase in the share of motorways in compliance with regulatory requirements. In 34 addition, it calls for an extensive development of the local hard-surface road network to link communities that would be prioritized in the Central and Black Earth Belt; the Northern Caucasus; the Volga region; and south regions of the Urals, Siberia, and the Far East. 3.19. During 2010–15, a public roads network extension in excess of 300,000 kilometers appears unrealizable and also raises questions about necessity and prioritization.15 A further network expansion of nearly 300,000 kilometers during 2016–30 foresees a continued increase in local roads, and a reduction in regional and municipal roads because some of these assets are transferred to local roads (table 3.7). A recent paper (Brown et al. 2008) reviewed firm-level industrial data for 1989–2004 to assess the implications of transport investment. The econometric analysis and simulations suggest that the productivity-enhancing effect of improved infrastructure would be the strongest in Russia’s capital region, reflecting strong agglomeration effects. Two regions show particularly low economic gains to improved transport connectivity: the Northeast and East Siberia. The analysis suggests that infrastructure investment alone is unlikely to help growth in lagging regions and that expenditures favoring spatial equality at the expense of funding high-return regions such as the Central Federal District are likely to impose severe trade-offs with respect to boosting national economic performance. By contrast, spending on improving the quality of life and social services in the isolated regions appears important from the viewpoint of equity of social services provision. (World Bank 2009e;) Therefore, it is important that realistic traffic demand forecasts are used for each potential project and that a proper economic evaluation is made—particularly for local roads. Table 3.7: Length of Road Network According to the Transport Strategy kilometers 2007 2010 2015 2020 2030 Length of public motor roads 725 854 1,060 1,169 1,350 Federal roads 47 54 56 79 95 Regional and municipal roads 527 510 482 460 410 Local roads 150 290 522 630 845 Length of nonpublic roads 175 195 230 270 350 Source: Ministry of Transport, Russian Federation. 3.20. A road classification is required at the federal, regional, and local roads level with the view toward government’s financial capacity and users’ willingness to pay. Although an administrative classification such as the one in Russia assigns road ownership, a functional classification––an indispensable tool in the sector––determines technical requirements and maintenance practices and influences administrative classification and financing. The purposes of functional classification include (a) delineation of public responsibilities in the provision and standard of public roads; (b) assignment of a road’s ownership and responsibility for its management and financing; (c) assignment of minimum standards, including permissible vehicle axle loads, weights, and dimensions; and (d) determination of the size of the public road network 15 For a proper assessment of the proposed road network expansion plan, it would be necessary to develop a travel demand model, such as a four-stage demand model. Such a model has four submodels: trip generation, trip distribution, modal split, and trip assignment. The model would initially define the area covered and divide it into a number of zones and would consider the entire transport network in the system. The data required would include base-year population levels and economic activity per zone. The model can be viewed as an attempt to answer a series of decisions concerning the number of trips generated, the destination, the mode of travel, and the route adopted. Once the travel demand model is completed, it is loaded to the supply model and will produce a given performance level. Ideally, such a model should have been developed prior to the development of the Transport Strategy, and it is by modeling transport demand that one can assess whether the specific proposals for network expansion make sense, given current and forecast population and economic activity. 35 and its quality commensurate with what the country can afford at the time and reflecting actual demand. Although there have been some reclassification of roads among different administrative categories in recent years, a broader exercise reviewing the entire road classification is warranted. 3.21. Before a major network expansion, the government conducts a full review of vehicle and road design standards in Russia, taking into account the types of vehicles that are expected to be in operation over the next decade. On that basis, the government introduces new standards for maximum vehicle weights and road design to ensure compatibility with current and future traffic. There is a need to strengthen overloading enforcement as a result of rampant overloading (box 3.3). As of January 1, 2011, new charges will apply for heavy trucks with axle loads exceeding 12 tons, and the key issues will be enforcement and the adequacy of charges. Box 3.3: International Practice: Overloading Enforcement in North America and the EU In North America (United States and Canada), transport load enforcement is governed by regulations including load limit, driving time, distance controls, and type of materials a vehicle is allowed to carry. Such regulations are implemented by police or a specific government unit. Medium- and heavy-freight vehicles (usually above five tons of gross weight) are tested randomly on the network through various types of weight stations or mobile control units. Larger expressways usually have permanent weight stations and weigh-in-motion (WIM) installations. Vehicles are also required to undergo recurrent state or provincial inspections for safety and emissions. In some areas, weight limits take into account the strength of the pavement structure during specific seasons. For example, in Canada, load limits are tightened—that is, lowered—during the spring thaw to minimize damage to the pavement structure. Today, most North American pavements also experience higher freight volumes, higher tire pressures, and different axle load configurations than those for which they were initially designed. This has led to the preparation of new pavement design guides. Most European Union countries adopted similar regulations before joining the EU. The new European Transport Policy for 2010 establishes goals to improve traffic safety and efficiency that would require extended safety control measures for heavy-goods transport on roads. To achieve these objectives, a significant increase in police personnel will be needed, which is not practical. The EU is experimenting with fully automatic, integrated road controls that would include automated overload control of wheels, axles, trucks, and trailers. Some countries (for example, the United Kingdom) are testing WIM systems linked to automatic vehicle detection. These systems would automatically analyze the license numbers of overloaded vehicles and, using the vehicle registration database, automatically issue violation citations to the owners. Source: World Bank 2007. Additional Funding Sources 3.22. How can the road expansion program be financed at the same time that funding for maintenance is increased? This is a key financing dilemma in Russia’s road sector. The key to resolving this dilemma is the policy resolve that public funding of the road network expansion should not come at the expense of maintenance. Although private investors can invest through PPP for toll roads, this would not be the case for roads that are not tolled, for which most of the funding for expansion would come through federal and regional budgets. Federal and regional expenditures on the road sector are forecast to reach 1.1 percent of GDP in 2010. However, this is clearly inadequate to cover necessary costs for regular maintenance, rehabilitation and reconstruction needs. Taking into account a modest expansion of road network, the total needs for road sector are around to 3.5 percent of GDP per year, a level of expenditure observed in other upper middle income countries. 36 Table 3.8: Funding gap in road transport sector As a share of GDP Average annual Desired annual Gap expenditure (2008–10) expenditure level Regular Maintenance 1.0 2.1 1.1 Maintenance backlog 0.7 0.7 New construction 0.4 0.7 0.3 Total 1.4 3.5 2.1 Source: World Bank estimates. 3.23. Additional potential funding sources for maintenance could come from fuel taxes. Fuel taxes are a primary pricing and revenue tool in the road sector worldwide. In 2009, revenues from fuel taxes reached Rub 147 billion (US$4.9 billion) in Russia (table 3.8) but could be considerably higher. According to a recent report by GTZ (Deutsche Gesellschaft für Technische Zusammenarbeit, or German Agency for Technical Cooperation), some 80 to 90 percent of transport revenues worldwide are raised from fuel taxes (GTZ 2009). In the United States, modest fuel taxes of about US$0.10 per liter of diesel and gasoline are levied to cover all direct expenditure for roads and highways—maintenance, refurbishment, new construction, and capital recovery for the roads and highways departments. For comparison, in November 2008, U.S. prices (including taxes) for diesel were US$0.78 per liter and for super gasoline US$0.56 per liter. Although fuel prices are higher in Russia, they are not high compared to other countries with similar per capita income, suggesting there is scope for increases (table 3.9). In the United States, the fuel tax also funds the Federal Highway Trust Fund, and the state highway funds help finance surface transportation programs (box 3.4). Table 3.8: Revenue Collected from Fuel Taxes Rub billions, nominal prices 2005 2006 2007 2008 2009 Fuel excise tax 123.3 109.7 165.7 139.7 147.2 Federal 54.8 36.3 87.5 56.6 1.7 Regional 68.5 73.4 78.2 83.1 145.6 Source: Ministry of Finance. 3.24. In Russia, a surcharge equivalent to US$0.10 per liter (Rub 3) could raise in excess of US$2.2 billion per year. In addition to a significant revenue effect, these charges are also distributionally progressive. As with many other countries, a fuel surcharge of this level may generate revenue sufficient to finance maintenance of the network, but not its expansion, which will have to be funded from other sources. Indeed, as of January 1, 2011, excises on gasoline and fuel will be raised, and the funds collected will be split between regional and federal road funds, but the basis and the impact of these changes are not clear at this time. Table 3.9: Diesel and Other Fuel Prices US$ per liter (Nov. 2008) Diesel Super gasoline Brazil 1.03 1.26 Chile 0. 95 0.95 Latvia 1.23 1.12 Russian Federation 0.86 0.89 Turkey 1.63 1.87 Uruguay 1.23 1.12 Source: GTZ 2009; International Monetary Fund, World Economic Outlook, April, 2010 (database), http://www.imf.org/external/pubs/ft/weo/2010/01/weodata/index.aspx. 37 Box 3.4: International Practice: The U.S. Interstate Highway System and Fuel Taxes July 29, 2006, was the 50th anniversary of the day that the U.S. Congress passed and President Eisenhower signed into law the Federal-Aid Highway Act that allocated US$25 billion to pay for 90 percent of the 66,000-kilometer U.S. Interstate Highway System, then known as the ―National System of Interstate and Defense Highways.‖ Congress levied a 3 percent federal tax on gasoline and diesel fuel consumption and subsequently expanded the fuel tax–funded network to include other routes and new states (Hawaii and Alaska). Recent reports on this milestone have highlighted the importance of the interstate highways for the U.S. transportation system. One benefit stands out: greater mobility and flexibility of goods and people in the U.S. distribution system. This flexibility has benefited manufacturers, especially in the lagging regions of the South, resulting in a thriving, Southern-based automobile industry (BMW in South Carolina; Mercedes in Alabama; Honda in North and South Carolina, Georgia, and Alabama; and Toyota in Tennessee, Alabama, and Kentucky), as well as the location decisions of today’s big-box retailers—Wal-Mart (Arkansas) and Home Depot (Georgia)—and distribution firms—FedEx (Tennessee). Source: World Bank 2007. 3.25. Vehicle license fees are low but could raise substantial additional financing. In 2008, Rub 53.1 billion (US$1.7 billion) was collected from a vehicle fleet of 38 million (an average of US$45 per vehicle per year), but, as with fuel taxes, these are general revenues and no portion is earmarked for the road sector. The total funds collected are quite small, reflecting generally low vehicle registration rates. The rates in Chile––a spatially large country with similarly low population density and a per capita income comparable to Russia––are significantly higher and depend on the model of the vehicle, its axle load, and its age. For a typical passenger car, the annual vehicle registration fee in Chile is equal to US$114 (more than twice that of Russia). If such fees were applied to the Russian passenger car fleet, they would generate US$3.7 billion while the truck fleet could yield US$2.7 billion if a fee of US$500 were collected. If one assumes a rate of US$200 for buses, the total annual income generated by vehicle registration would reach US$6.5 billion. The distribution of the fee per vehicle category class should reflect the costs imposed on the road network and the benefits that operators derive, which would suggest that the fee for large trucks should be about four or five times higher than that for passenger cars. 3.26. Several countries use the fuel tax and vehicle license fees to establish a second- generation road fund. Second-generation road funds link revenues and expenditures, with charges paid into the road fund being related to road use, easily recognizable, and simple to administer. With this type of fund, users pay a road access charge and then pay according to how they use the road, normally through a fuel levy. However, because the fuel levy does not capture the greater damage caused by heavy vehicles, one option is to adopt weight-distance charging as in New Zealand (box 3.5) or a weight-related annual charge related to the pavement damage caused by different vehicle classes, through an annual vehicle registration fee. The fuel levy on gasoline and diesel can be over and above excise and other taxes. The second-generation road funds are typically managed by boards representing the interests of road users. 3.27. A key feature of second-generation road funds is that they aim for affordability of a fully funded road maintenance program. This implies the need to define a core network of users that are willing and able to finance. Requirements for a successful road fund include (a) independence from the general government budget; (b) management by a strong and independent board; (c) user charges consisting of license fees, fuel tax, bridge tolls, and international transit fees; (d) direct deposit of user charges into the road fund; (e) formal mechanism for varying road user charges (which should be indexed); (f) consistent and simple procedure for allocating funds between different road agencies; and (g) independent financial and technical audits to avoid 38 leakages and to ensure that funds are spent according to a work program and specification (Robinson 2008). In January 1, 2011, a regional fund and a Federal Motorway Fund was established in Russia for the financing of construction and rehabilitation projects. But it seems that these funds would be traditional road funds and not second-generation road funds. Box 3.5: International Practice: Experience with Second-Generation Road Funds An example of the successful introduction of a second-generation road fund is the case of New Zealand. New Zealand’s road users primarily fund the country’s land transport system through fuel excise duty (gasoline tax), charges on diesel and heavy vehicles (road user charges), and vehicle registration and licensing fees. All fuel excise duty and road user charges that flow into the National Land Transport Fund (NLTF) are fully hypothecated. These funds are paid into the NLTF for investment in maintaining and improving land transport networks and services. Other funding comes directly from the Crown (central government), local authorities, and, in some cases, other sources such as developers’ contributions. The New Zealand Transport Agency (NZTA) makes allocations from the NLTF to fund (a) local transport networks and services delivered and cofunded by local government; (b) the management and delivery of the state highway network and transport services; (c) the road policing program; and (d) sector training and research. NZTA also receives funds directly through the Ministry of Transport that are managed on behalf of the Ministry of Transport and allocated to fast-track, high-priority state highway activities, among others. Although these funds are not part of the NLTF, they are managed in much the same way— applying criteria and prioritizing, programming, and reviewing them—to ensure a simple and transparent funding process. The 2009/10 NLTF investment plan was the first year of the three-year National Land Transport Programme administered by NZTA, allowing for a longer-term view of investments. Each year an annual report is published by NZTA for accounting purposes and is presented to the parliament. A key to the New Zealand experience is the level of transparency, accountability, and autonomy, without political interference in the use of the funds. Source: New Zealand Transport Agency, National Land Transport Fund. 3.28. International financial institutions (IFIs) remain an important, potential source of funding for road projects. IFIs can provide not only finance with long maturity, but also international expertise and the know-how of best practice experiences applicable to Russia. Importantly, IFI’s significant potential funding at the federal and subnational levels has largely not been used to date. This form of financing would be particularly valuable for economically viable roads in less-strategic corridors with limited potential for concessions and private sector financing. Such IFI financing could allow regional and local borrowers to apply efficient procurement and financial management practices and to incorporate best international management practices and standards. Technical assistance, which typically accompanies such projects, can serve as an important source of know-how and showcase for best practice and institutional reform that can benefit the wider sector. Finally, IFIs can provide maturities of 20 years, well in excess of those provided by private commercial banks or domestic bond markets. 3.29. Innovative local credit enhancement entities and techniques can also be used to help mobilize domestic commercial debt resources for subsovereign infrastructure finance. Credit enhancements are meant to mitigate risks in debt transactions that creditors cannot or are not willing to take. By doing so, these enhancements increase the overall creditworthiness of a borrower or a specific debt transaction, are cost effective, and support capital market development, while promoting a hard-credit culture (Kehew, Matsukawa, and Petersen 2005). One example of such a technique is a partial credit guarantee, an instrument that allows the guarantor to share the risk of debt service default with the lenders on a predetermined basis. In other cases, the institutions providing credit enhancements have been government entities or government-owned financial institutions. IFIs can provide support to such schemes in a variety of ways, including by providing seed capital reserves to help the guarantor achieve creditworthiness or by extending standby loan agreements with the guarantor, so that the guarantor can withdraw funds when required. In August 2010, Avtodor announced that it planned to offer bonds of Rub 7.5 billion (US$243 million) in 2011 and Rub 12 billion (US$389 million) in 2012. 39 3.30. The Transport Strategy envisages a vast pipeline of projects in the road sector to be financed by the private sector, but to date, few concession agreements have been signed (table 3.10). In the federal government’s Transport Strategy, private sector funds are projected to equal Rub 16.7 trillion (US$555 billion) during 2010–30, with Rub 729 billion (US$24 billion) in 2010–15. In the more recent long-term program for Avtodor, private sector funds are expected to finance Rub 515 billion (US$17.2 billion) of road construction during 2010–15. The sources of financing for PPPs include private investors, infrastructure bonds, Vnesheconombank (VEB; the Russian development bank), and IFIs. But to date, expenditure in the road sector by the private sector has been minimal, reflecting the time taken to develop the legislative and institutional framework to support private-public infrastructure development. Recent developments include the establishment of the Expert Council on PPP acting under the auspices of the Duma, the Investment Fund created in 2006 to provide state cofinancing, the establishment of VEB with a leading role in promoting and financing PPP projects, and, most recently, the establishment of Avtodor. Table 3.10: Road Expenditures According to the Transport Strategy, 2010–30 2010–15 2016–20 2021–30 Total Rub, billions Federal budget 3,527 5,112 19,277 27,916 Regions 1,895 2,711 10,822 15,428 Extrabudgetary 729 1,816 14,107 16,652 Total 6,151 9,639 44,206 59,996 US$, billions Federal budget 118 170 643 931 Regions 63 90 361 515 Extrabudgetary 24 61 470 555 Total 205 321 1,474 2,001 Source: Russian Federation Transport Strategy. 3.31. Although the potential of tolls is significant and is reflected in the Transport Strategy, there are currently almost no toll roads in Russia. Unlike other countries where toll networks and high-speed motor roads have long been successfully operated, generating substantial revenues, there is only one toll section in the entire federal road network––a 20- kilometer detour around the village of Khlevnoe in Lipetsk Region. At another extreme is China, which has expanded its national road asset base in a very short period of time—by about 41,000 kilometers of high-grade tolled expressways between 1990 and 2005. Since then, China has further expanded its tolled expressway network each year by about 8,000 kilometers. But although the creation of a tolled highway network is one of the priorities identified in Russia’s Transport Strategy, only a small percentage of the Russian road network has traffic volumes high enough to support toll road concessions based on full cost recovery (table 3.11). Given limitations in willingness to pay about US$0.05 per kilometer for a car and about US$0.20 per kilometer for a truck, and investment costs of US$2 million–US$3 million per kilometer, toll road concessions in Russia become viable at traffic levels of about 15,000 to 20,000 vehicles per day. This limits the applicability of the tolled expressways to an estimated 10,000 kilometers or about 20 percent of the federal road network (Eijbergen et al. 2004). Although the traffic levels have increased in recent years, the conclusion of relatively limited applicability of tolls in Russia compared to many densely populated states remains. 40 Table 3.11: Length of Toll Network in Selected Countries, 2008 Toll network length Total network length Length of high-speed % of toll roads in (kilometers, (kilometers, motorways (kilometers, network thousands) thousands) thousands) France 8.4 1,003 12.0 0.8 Germany 12.5 644 12.5 1.9 Japan 7.4 1,193 7.4 0.6 United States 7.9 6,491 75.0 0.1 Mexico 6.2 342 10.4 1.8 China 133.0 3,584 55.0 3.7 Source: Avtodor. 3.32. The introduction of a vignette system on selected federal roads, alongside tolls, is one option when traffic levels are insufficient so that a charge per kilometer cannot cover full costs. A vignette is a toll sticker used in several European countries that is affixed to a motor vehicle passing through expressways and motorways. Vignettes, often valid for a week, month, or year, are a form of tax on vehicles and are usually designed in a way that detaching or reattaching is impossible. Compliance is ensured through police enforcement, with large fines for motor vehicles that are caught without the vignette. Unlike a toll, a vignette is independent of the distance travelled—whether one uses a motorway five times a week or once a week, the cost of the vignette is the same. Unlike fuel taxes and tolls, the vignette separates road user costs from actual road usage, which is a reason many countries have been moving toward a distance-based tolling system (box 3.6). In the EU, a Euro vignette system charges heavy-goods vehicles for the use of roads that are part of the trans-European network. This allows EU member states to levy charges on vehicles weighing more than 3.5 tons. The charges could be levied according to a time-based system—per day, per week, or per month as with a vignette—or a distance-based system. 41 Box 3.6: International Practice: European Experience with the Vignette A number of European countries currently have a national vignette system for access to motorways and expressways. They tend to offer options to purchase for a year, a month, and a week or ten days, with the cost of the annual rate varying significantly across countries. Vignette (US$) Country Annually Monthly Weekly Austria 76.5 23 7.90* Czech Republic 47 14 10* Hungary 139 16 10 Slovenia 95 30 15 Switzerland 34** n.a. n.a. Source: Authors. Note: n.a. = not applicable. * 10-day vignette. ** 14 month vignette. In the case of Austria, vignettes are required for all motorways and expressways under federal administration. Compliance is controlled by the police and the employees of the federal motorway administration. When a driver is caught without a vignette, a substitute toll of €110 must be paid, and €220 must be paid when a vignette sticker has been altered. If the substitute toll is not paid, then the driver can face a penalty of between €400 and €4,000. In recent years, a number of countries have replaced the vignette with a distance-based tolling system. Germany abolished the vignette system in August 2003, replacing it with a distance-based payment system for trucks exceeding 12 tons that was established January 1, 2005, and is administered by Toll Collect, while the motorway remains free for passenger vehicles. Likewise, vignettes were abolished for heavier vehicles and replaced with distance-based tolling in 2010. Although Switzerland has a vignette system for passenger cars, heavier vehicles are subject to a distance-based tax for all types of roads. In Hungary, physical stickers were replaced with an electronic vignette system, with motorway usage verified by roadside cameras on the basis of on license plates. This brief review suggests a number of alternatives, in terms of (a) types of roads covered, (b) types of vehicles covered by the vignette, and (c) physical or manual vignette. The move toward a distance-based system allows payment by the road user to be more closely aligned with actual road usage, which is not the case with a vignette. A vignette allows a motorist to enter a motorway or expressway system, but penalizes those who barely use the motorway vis-à-vis someone whose usage is much more frequent. A distance-based system also captures the externalities, such as congestion and air pollution, in a manner that the vignette does not. Source: World Bank. 3.33. In addition, Russia’s very limited experience with tolls and concessions has been adversely affected by the financial crisis as well as delays, perhaps resulting from the size and complexity of projects. In 2009, two road concession agreements were signed (first section of the tolled Moscow–Saint Petersburg Speedway and the M1 Belarus Federal Highway) with financial closure (a final stage in a financial agreement where conditions have been satisfied or waived, documents have been executed, and drawdowns become permissible) in 2010. Capital costs are very high on a per-kilometer basis. This may reflect the government shifting significant risk to bidders, which translates into large premiums on the part of investors (table 3.12). In both cases, it took nearly two years from the announcement of the tender to the signing of a concession agreement, and in both cases, the concessions are for 30 years, with operation expected to start 36 months after financial close. Also, not all PPP projects have proceeded as smoothly—the Western High Speed Diameter Motorway is a case in point. A preferred bidder was selected in June 2008, but because of difficulties in raising finance and agreeing on commercial terms, the federal government, through the Investment Fund, and the Saint Petersburg region are financing the last section through a traditional construction project and not 42 as a PPP project. A tender for the concession to develop a one-kilometer toll tunnel under the Neva River linking the left and right banks of Saint Petersburg has been delayed from the time bids were submitted in February 2009 to 2011. These delays may also reflect the large size and complexity of the projects, with a larger number of banks involved. Smaller projects of about US$500 million may be easier to finance. Table 3.12: Estimated Capital Costs of PPP Projects Rub US$ Length US$ per (millions) (millions) (kilometers) kilometer Moscow –Saint Petersburg Speedway 59,594 1,987 43.1 46,112,770 M1 Belarus Federal Highway 21,489 717 18.5 38,665,138 Orlovsky Toll Transit Tunnel 26,400 51 1.0 51,262,136 Sources: Ministry of Transport; EPEC and DLA Piper 2009. 3.34. Infrastructure bonds are another mechanism for tapping into long-term domestic financing of road projects. The federal government prepared a draft law for the introduction of project-specific, ruble-denominated bonds, or so-called infrastructure bonds, in 2009. These bonds are meant to be issued by a special-purpose project entity to raise funds to finance infrastructure construction or reconstruction. The aim is to develop a long-term debt instrument that would be attractive to the Pension Fund, which, at the same time, would provide a long- length maturity that is currently unavailable in the market. One of the vulnerabilities of this approach is that VEB is administering part of these second-tier pension funds but is also actively involved in financing infrastructure projects through PPPs, representing a potential conflict of interest. The draft law is too prescriptive, specifying the nature of documentation, procurement, and disclosures, issues that should be a reflection of a specific project requirement and negotiations. This has also been a problem with the Federal Concessions Law. Although it refers to competitive bidding, the draft law does not impose financial viability criteria, which is troubling because pension funds should be buying the bonds. From a fiscal perspective, it appears that the infrastructure bonds will require guarantees from the federal government or VEB, with the consequent contingent liabilities. This approach has been successfully applied in Chile, but the guarantees in the Chilean case did not come from the state, and more important, the bonds are issued in the market and bought by private pension administrators (box 3.7).16 16 An example in the region is the €100 million issued in 2005 by the water company owned by the city of Bydgoszcz, Poland. The European Bank for Reconstruction and Development purchased 40 percent, with the remaining 60 percent purchased by local pension funds and other institutional investors. There are no state or city guarantees, but there are assurances that the issuer can obtain sufficient revenues to ensure timely debt service and an agreement not to issue new individual permits for construction. 43 Box 3.7: International Practice: The Chilean Experience with Infrastructure Bonds In the 1990s, Chile implemented build-operate-transfer (BOT) contracts for public works to tackle a perceived deficit in terms of the stock and quality of infrastructure. Chile did not have a developed, long-term domestic debt market at that time. The infrastructure bond is a debt issued by companies awarded BOT contracts. In general, such bonds are 100 percent guaranteed by insurance policies issued by international insurance companies, providing external credit backing, enabling them to achieve better ratings by replacing the issuer’s risk with the insurance company’s risk. Two types of infrastructure bonds have been developed: (i) Preoperational bond: This bond is used once construction has begun and before it is finished. This is project finance funding, because the funding structure includes funds for investment before works begin and the funding of future payments required for the project to go ahead. The future funds required to amortize the bond depend on the project’s ultimate completion and success. (ii) Operational bond: This bond is issued once the public work is at an operational stage, with the company fully entitled to operate the project. This is a revenue bond, because the debt instrument is issued to fund a finished project, and debt repayment is backed by future revenue streams. For institutional investors and, in particular, the pension fund, the main benefit of infrastructure bonds as an asset category is that it creates a new class of long-term securities with higher returns than a government bond. Investment by domestic institutional investors for project-funding purposes provided two main benefits: (a) investments that are long-term in nature to match maturities, and (b) the removal of all foreign exchange risk. In addition, with the involvement of pension funds, political and regulatory risk could be reduced, because it would be expected that the government would show greater discipline in adhering to contracts as resources coming from the funded project that would be funding workers’ pensions. The key stumbling block was how to solve the project risk issue. Once Chile obtained a solid, investment-grade sovereign rating, monoline insurance companies became available to enhance the issuance of local securities providing their guarantee.a This means that no project risk is passed on to institutional investors. In 1996, the legal and regulatory issues were resolved. In November 1998, the first infrastructure bond of Latin America was issued for US$150 million, followed by US$208 million issued in 1999 and US$210 million in 2001, with more than US$3.76 billion in issuance by 2009. In the case of Chile, success factors included the capacity to attract monoline insurers or international financial institutions to take on the project risk and to provide guarantees on the timely payment of debt. It was also dependent on the investment-grade sovereign rating of Chile and the local investment grade for the project. Other factors have been those critical for any PPP, including the appropriate legal and regulatory framework, open and transparent bidding process for concession award, and legal protection of private property. Source: Hormazábal 2010. a. Monoline insurers guarantee the timely repayment of bond principal and interest when an issuer defaults. Institutional Arrangements for Improved Resource Use 3.35. Although closing the financing gap will require additional public funds allocated to the road sector, significant efficiency gains can be realized in current expenditures. A number of measures are relevant in this regard: (a) reviewing the procurement methods for civil works; (b) introducing performance-based management contracts in the road sector; (c) introducing improved asset-management techniques and ensuring that the programming of road works incorporates economic principles; (d) creating a more commercially oriented Rosavtodor; and (e) improving strategic planning in the road sector. 3.36. There is an urgent need to reconsider current procurement rules, which currently require procurement of civil works through reverse auctions, a practice unique to Russia. The World Bank, by contrast, does not consider reverse auctions—a type of auction in which sellers compete to obtain business based on the lowest price quoted—an appropriate method of procurement, and particularly for civil works, given the considerable risks to quality, among other issues (box 3.8). No other country uses reverse auctions for civil works; this relatively new procurement method is used for the purchase of goods, such as pharmaceuticals or information technology services. In reverse auctions, instead of relying on the market, an initial price or 44 ceiling is introduced to determine the contract price, but in many instances, the starting price of the procured works is not based on an accurate estimation, but on available funds. As a result, the final contract cost in most cases is far from the realistic market price reflecting open and fair competition. The use of reverse auctions essentially removes the qualification-based selection from the procurement process, although basing construction services only on the lowest bid may lead to an increase in overall project costs because of the necessity of variation orders or through reduced quality. Indeed, there is evidence in Russia of the negative effects of procurement through auction. The introduction of new online reverse auctions as of January 1, 2011, will do little to change the underlying problems associated with auctions for civil works. The reintroduction of civil works procurement with prequalification—either through traditional tendering based on bills of quantities or through performance-based contracts with tendering based on specified outcomes as opposed to inputs—would bring Russia in line with international best practice. Box 3.8: Reverse Auction Procurement in Russia and its Problems The Russian procurement system is based on the public procurement law, ―On Placement of Orders for Supplying Goods, Executing Works, and Providing Services for State and Municipal Needs‖ (No. 94-FL), which was enacted July 21, 2005, and became effective January 1, 2006. This new public procurement law (PPL), and subsequent amendments, leaves little space for interpretation and judgment, establishing an overly prescriptive, detailed framework that is almost impossible to amend through secondary regulations. Pursuant to one of the amendments of the PPL, reverse auction is made the only method for procurement of most construction services. Under open bidding, a bidder does not know who will submit the bid, the way many bidders will participate, or the exact competitors’ prices. In these circumstances, a decent bidder will need to quote realistic prices that take into consideration market situation and possible risks and that include normal profits. During the auction, participants struggling for a contract may dump prices that may later put a contractor in a difficult situation, participants may collude before the beginning of the auction, or a participant who came alone may win the contract at an initial price that may be overestimated. As a result, it becomes difficult to ensure procurement efficiency. Reverse auctions as implemented in Russia largely exclude prequalification, which is usually necessary for large or complex works or in any circumstances in which the high costs of preparing a detailed bid could discourage competition. This also ensures that invitations to bid are extended only to those who have adequate capabilities and resources. Prequalification normally takes into account experience and past performance on similar contracts; capacities with respect to personnel, equipment, and construction; and financial position. In addition, most of the obligatory norms and rules in the construction industry were cancelled or made into recommendations. This creates the risk that procurement through auctions, with competition based solely on price, could lead unqualified and inexperienced firms with insufficient financial resources into winning a contract, with considerable risks of poor quality of construction works. Although the procurement law establishes the Ministry of Economic Development and Trade as the authority responsible for procurement methodology and the Federal Antimonopoly Service as the entity responsible for procurement control, the creation of an independent public procurement office and independent procurement review body, recommended by the World Bank, has not been considered. Source: World Bank 2006b. 3.37. Increasing competition for the procurement of road works is imperative. Inadequate competitive pressures in the road construction sector tend to lead to high investment costs and inefficient use of public funds. The lack of competition is fundamentally attributable to the market structure of the road construction sector, but is exacerbated by deficiencies in the principles and practice of public sector procurement for roads projects.17 Consequently, the unit 17 A World Bank review of 60 auctions conducted by the federal state unitary enterprise MariyskAvtodor in 2008 found that in 36 cases, only one bid was submitted; in such a case, the client must declare such an auction abortive and conclude a contract with the only bidder for the initial price. In 40 cases, contracts were signed with state unitary entities and in only four cases with private firms, raising serious concerns about competition in the construction industry. Other problems include the conduct of procurement with significant violations of existing procurement rules and increased number of bidder complaints. Attempts to 45 costs of road construction are artificially inflated. There are few contractors available with the capability to deliver large roads projects, particularly at the regional level. This reflects, in part, the large and expensive equipment required to undertake road construction projects, generating scale economies that favor larger suppliers. It also reflects the Soviet legacy of organizing the industry in the form of large, regional monopolies. The limited mobility of the heavy construction machinery further strengthens market power at the local level. As a result, there are few bidders for road construction projects, and collusion is believed to be commonplace. For these reasons, there are typically no more than two bidders on regional road construction projects, with significant scope for collusion. Possible remedies might include requiring competitions to include bidders from as many regions as possible and outlawing subcontracting between bidders once the contract has been awarded. Evidence from other countries shows that an increase in competition results in sizable fiscal savings that could reduce total investment needs in the road sector by as much as 6 percent as a result of a decrease in average equilibrium bid prices for road works (box 3.9). An introduction of such efficiency gains in Russia would result in a reduction of the financing gap for road maintenance by about 0.12 percent of GDP. Devising tenders in such a way as to attract foreign contractors is one mechanism that could spur competition. combat corruption through the procurement law have not been effective and have failed to make the Russian procurement system transparent, effective, fair, and responsible. These procurement issues can lead to escalating road construction, rehabilitation, and maintenance costs, as well as poor quality, which can make the life of roads shorter and, thus, increase overall costs. 46 Box 3.9: Fiscal Savings and Procurement Efficiency Improvement of efficiency in public procurement is often the key to eliminating waste and improving technical efficiency in public expenditure. But even where public procurement systems are particularly fragile, improvements in efficiency can be made. Improvement of competition for contracts is one way of strengthening public procurement. The problem is that the authorities typically do not know the true project costs of private contractors. This is a fundamental asymmetric information problem that auctioneers must overcome in contracting out a public service. The authorities may know their own costs, which presumably are too high compared with private costs. They may also be able to observe some pieces of market-based engineering costs. But they never know—nor do they observe––the minimum possible project cost in the market. If they knew, they could negotiate and contract directly with the most efficient firm. Auction theory shows that under standard circumstances, intensifying competition at an auction would induce bidding firms to reveal their true preferences—that is, costs in market context—resulting in more efficient auction outcomes. The impact of competition on efficiency in procurement can be significant. An analysis of 211 procurement auctions for infrastructure development projects in 29 countries from 1997 to 2007 finds that the projected competition effect in the roads sector is, indeed, very significant and can result in a fiscal savings equivalent to 6 percent of total road infrastructure financing needs in Europe and Central Asia Region. The sample includes 394 winning and losing bids in the road sector, with the average bid amount of US$29 million. On the basis of these estimated bid functions evaluated at the mean values, the average equilibrium bid is calculated. This is the predicted cost of a notional average infrastructure contract. The contract theoretically involves 49 kilometers of roads with 2.9 lanes, of which 35 percent are new construction work and 30 percent are rehabilitation. As shown in the following figure, the road unit cost is projected to be US$0.7 million per kilometer when auction competition is minimal, but can be reduced to less than US$0.5 million per kilometer if more than six firms compete with one another for the contract. Box Figure 1 Predicted Bid Amount per Unit: Box Figure 2 Predicted Road Unit Bid by Lot Roads Length Source: Estache and Iimi 2008. In addition, the predicted unit cost is significantly affected by contract design, especially the size of the contract. When the estimated equilibrium bid function for road projects is evaluated with different lengths of roads, it is evident that a road of less than 10 kilometers would be extremely expensive. Hence, how to design lot packages is an important issue. As expected, large electricity projects have a lower unit cost because of economies of scale. Source: Authors based on Estache and Iimi 2008. 3.38. International comparisons of road maintenance costs are an important tool for benchmarking performance vis-à-vis other road agencies, but must be treated with caution. If one looks at the cost of maintenance per km, then there are number of factors to keep in mind. Firstly, the design standards of roads differ, and it is important to ensure that the lane and shoulder widths, as well as the number of lanes—among other factors—are similar to the benchmarking countries or transformed with conversion factors to ensure that like and like are being compared. Secondly, maintenance standards are defined differently in different countries, with some countries including more costly repairs in the definition. Thirdly, an aggregate 47 maintenance unit cost definition can be misleading when it comes to actual costs and efficiency. If maintenance costs per km is simply total maintenance expenditure divided by total network length, then the unit costs will go down, ceteris paribus, by simply reducing expenditures on maintenance, by making a decision to not maintain a part of the network or reducing the nature of the interventions and thus worsening road condition. This will not present an efficiency gain, but could lead to the need for more costly rehabilitation works in the future. An alternative manner of assessing road work costs would be to look at actual maintenance contracts, or a sample of them, and comparing their evolution over time and across regions within a country, and also comparing across countries, including conversion factors where necessary to account for different road design and maintenance standards. Appendix F provides further international unit cost data for rehabilitation, reconstruction, and construction of interurban and regional roads, which can be useful for comparative purposes, based on actual contract values, rather than taking an aggregate approach. 3.39. Compared to Finland, a country with comparable weather conditions, actual road maintenance costs per km appear similar in Russia, although road condition outcomes are very different. For Russia the official unit costs per kilometer of maintenance, repair, and major repairs are presented in table 3.13, by category of road. Maintenance per kilometer costs between US$27,148 and US$55,111 depending on the category of road. In addition, there are coefficients applied to these costs to factor in differences in cost by region. However, estimates provided by Rosavtodor suggest that actual unit costs for federal and regional roads are equal to €8,034 per road kilometer (US$ 11,520) in 2010. This figure is much lower than the official unit costs, as only a fraction of roads are maintained to standard—an estimated 38.63 percent of federal roads meet these standards. In the case of Finland, which has a climate similar to that of Russia, the cost was €7,274 per road kilometer (US$ 10,430) in 2008 for all road types, which is similar to the levels in Russia. However, it is difficult to draw any conclusions from this case, because Russian unit costs include repair and major repairs, while Finnish costs include only maintenance expenses—in addition, not only are maintenance interventions defined differently in both countries, but the design standards also differ considerable, making unadjusted comparisons fraught with difficulties. For benchmarking Russia’s expenditures on road maintenance, it would be useful if maintenance unit costs, exclusive of repairs and rehabilitation, were collected. But more importantly, there is a need to develop a database of contract based unit costs for maintenance to assess actual costs of specific interventions in order to ascertain prices across regions in Russia, comparisons across countries and over time. While Finland spends comparable levels to Russia on a per kilometer basis the quality of its roads according to the World Economic Forum is ranked 13th out of 139 countries, whereas Russia’s ranks 125th.18 This highlights the importance of looking at actual expenditures on maintenance and outcomes, as well as drilling down to provide explanations for costs and tracking and monitoring costs over time.19 18 This is likely to reflect insufficient maintenance and rehabilitation in the past, leading to a significant cumulative maintenance and rehabilitation backlog, as well as the impact of overloading on the condition of roads, among other factors. World Economic Forum (2010), Global Competitiveness Report 2010-2011, edited by Professor Klaus Schwab. Geneva, Switzerland. 19 A comprehensive assessment of maintenance unit costs—but also those for construction and rehabilitation—should be looking at a sample of individual contract values on a per km basis, and then drilling down to individual items on bills of quantities, benchmarking across regions in Russia and over time, and against international comparators. Alongside total maintenance expenditures, and unit costs, should be an assessment of how the additional expenditure translates into improvements in road condition, as measured by the international roughness index (IRI) for example. 48 3.40. The average unit cost of rehabilitation and reconstruction of an inter-urban road (2-lane, 7m-wide equivalent, category II road according to Russian standards) excluding the costs of structures in World Bank financed projects is showed in table 3.1420. This comparison shows that the average unit costs of road works vary substantially across the countries, yet road maintenance unit cost norms in Russia are on the high side relative to similar category roads in World Bank financed projects in other countries in the region. For making of a benchmark of Russia’s expenditure’s on road maintenance, it would be useful if maintenance unit costs, exclusive of repairs and rehabilitation, were collected. Table 3.13: Official Unit Cost Norms for Maintenance, Repair, and Major Repairs in Russia, 2007 US$ per kilometer Category of roads I II III IV V Maintenance 55,111 34,750 30,949 28,506 27,148 Repair 308,619 161,203 154,840 145,295 106,055 Major repair 1,230,023 609,984 556,359 489,328 335,156 Sources: Federal Government Decision No. 539, August 23, 2007; World Bank estimates. Table 3.14: Quartiles and average of costs per km of an inter-urban road, by type of work in World Bank financed road projects in Eastern Europe and Central Asia US$ per kilometer in 2009 prices First Quartile Mean Third Quartile New construction 1,111,211 1,482,157 1,888,305 Rehabilitation/Reconstruction 192,239 446,750 687,276 Rehabilitation/Reconstruction (Secondary roads) 126,606 172,712 203,555 Asphalt pavement overlays 115,626 130,026 134,107 Single surface treatment 73,850 91,682 103,694 Periodic Maintenance 24,732 30,512 36,202 Source: Alexeeva, Queiroz, and Ishihara (2011). 3.41. Introducing performance-based maintenance contracts could potentially lead to significant cost savings. The traditional way of contracting out road maintenance is based on work measured and paid for at agreed rates. By contrast, performance-based contracts (PBCs) define minimum conditions of road, bridge, and traffic assets that must be met by the contractor, as well as other services. Payments are based on how well the contractor complies with performance standards defined in the contract, and not on works and services executed. Road agencies in a number of countries have moved to PBCs because of several advantages over traditional approaches, including (a) cost savings in managing and maintaining road assets, (b) greater expenditure certainty for road agencies, (c) ability to manage the road network with fewer agency staff members, and (d) stable multiyear financing of maintenance. The contractor is generally paid in monthly installments through the contract period, with the risk of cost overruns transferred to the contractor (Stankevich, Qusreshi, and Queiroz 2005). If legislation permits a maximum three-year contract, as is the case in Russia, then the agency can begin with a three-year contract, and once the required changes permitting long-term contracts are approved by legislation, longer duration contracts can be signed. It makes sense to start with simpler, short-term PBCs on a pilot basis to choose contracts in line with the capacities of the contracting industry. In the case of Argentina, which has had a successful experience with performance- 20 The averages and quartiles of cost per km of similar works are calculated based on the reviewed sample of road works contracts signed between 2000 and 2010 in each country. 49 based contracting, the first contracts were limited to four-year periods of routine maintenance, and based on this success, new contracts were designed that included both rehabilitation and maintenance (see appendix E). The cost savings of using PBCs over conventional contracts have been documented to range from 7 percent to as high as 35 percent.21 For perspective, if PBCs are implemented in 20 percent of Russia’s highway system and average cost savings over conventional contracts reach 25 percent, the financing gap for maintenance needs is reduced by an additional 0.1 percent of GDP. 3.42. Although legal and institutional framework has been established for PPPs, to date there has been limited private sector investment in the road sector. For 2008 and 2009, there was no private cofinancing for federal projects included in the Investment Fund, although for 2010, Avtodor’s program envisaged Rub 18 billion (US$600 million) of off-budget financing.22 This reflects in part the impact of the financial crisis, which has delayed concession agreements and financial close where there are such agreements. It also means that although important in the medium term, the amounts envisaged in the Transport Strategy—Rub 729 billion (US$24 billion) in 2010–15—may not be met. The costs to the federal and regional governments are also likely to be higher, in terms of guarantees and conditions to successfully conclude the first projects. 3.43. Going forward, it will be important to ensure that the motivation for developing PPP projects is value for money, and not only the need for investment funds. The concept of value for money is defined as the optimum combination of whole-life costs and quality or fitness for purpose of the goods and services to be procured by the public sector. In theory, the public sector rule for prioritizing PPPs should be value for money: If a project can be procured and implemented more efficiently under a PPP than under traditional public investment, then it should be taken forward. Value for money in this context is generated by several factors, including (a) optimal risk transfer to the private sector, (b) careful assessment of the services to be provided achieving whole life asset management and holistic risk management (not normally associated with public procurement), (c) flexibility provided to the private sector for innovation and efficiency, (d) competitive and transparent procurement, and (e) the availability of appropriate capacity in the public and private sector. Unfortunately, in practice, the focus in many countries in Eastern Europe has been too often on maximizing private investment, while value-for-money calculations generally have been overlooked or clearly were secondary. Interestingly, value for money does not imply the lowest-cost option.23 There are also important lessons to learn from the experience in Central and Southeastern Europe (box 3.10). 21 According to the World Bank’s PBC resource guide (http://www-esd.worldbank.org/pbc_resource_guide ), average cost savings in select countries that have introduced PBC are as follows: Argentina, 16–20 percent; Australia, 30 percent; British Columbia (Canada), 10 percent; Alberta (Canada), 25–35 percent; Finland, 7–10 percent; New Zealand, 30 percent; Virginia (United States), 17 percent; and Florida (United States), 15 percent. 22 Two subregional projects will benefit from private investors, the Orlovsky Tunnel and the Western High Speed Diameter motorway. 23 Russia’s procurement law has a very specific requirement to engage the lowest-cost offer. This fact became a major challenge in the development of a series of PPP projects that the city of Saint Petersburg was implementing between 2008 and 2010. 50 Box 3.10: International Practice: Experience with PPPs in Central and Southeastern Europe The first attempts to implement PPP projects in the transport sector in Central and Southeastern Europe faced obstacles that led in many instances to delays, protracted negotiations, renegotiations, and cancellations. Among privately managed road projects, several factors contributed to these problems: Lack of robust feasibility studies. Most of the unsuccessful projects lacked a solid feasibility study carried out before procurement. The negotiations failed to reach financial closure. Optimistic traffic forecasts. In the early years, optimistic traffic forecasts hurt several concessionaires because they bore the demand risk. In the absence of minimum traffic or revenue guarantees, lenders sometimes requested an independent traffic review, delaying and potentially preventing financial closure. There are examples of many projects in other countries that failed or never materialized because of lower-than-expected traffic (for example, Czech Republic D5 motorway in 1993 or M1/M15 toll road in Hungary). Public resistance to tolls. With a PPP scheme, users must pay a larger share of the cost in a region where road use had been largely free. This led some users to switch to parallel roads, contributing to traffic and revenue shortfalls. In the case of the M1/M15 highway in Hungary and the Trakia motorway in Bulgaria, increases in toll rates, even justified by inflation and traffic, led to legal action or public resistance. Changing of financial support mechanisms. In response to public resistance to tolls, some governments introduced a vignette system, whereby the toll is collected by selling motorway stickers (vignettes). In Hungary, for example, direct tolls in the M5 Toll Motorway Project were replaced by a general motorway vignette and the payment of availability fees to the concessionaire. These shifts transferred a significant traffic risk burden to the public sector. But the rates were deliberately low to make them acceptable and, as a result, could not compensate for the heavy capital investments. In Poland, where the vignette system was introduced for the national road system in 2006, the state has been unable to settle a dispute with the concessionaire for the A4 Toll Motorway Project on compensation for lost revenue. Noncompetitive procurement. Many countries started their road concession program with limited competition and sometimes, with change of governments, had to cancel negotiations or renegotiate. Without competitive procurement, negotiations typically take longer and can result in lower value for money. Subsequent revision of legal and regulatory framework. Projects were often implemented in isolation from sector policy so that specific laws or regulations were considered late in the process. In the A1 Toll Motorway Project in Poland, for example, the decision to amend the Toll Motorway Act was made only at the procurement stage. As a result, it took nearly seven years to advance from selection of the concessionaire to signature. Source: Cuttaree et al. 2009. 3.44. Improved road asset management system for the road network should help inform spending decisions. Sound decisions need reliable, relevant, and accessible information, such as data on budgets, traffic counts, road accidents, and pavement design. Asset management is a process of maintaining, upgrading, and operating physical assets cost-effectively, which should lead to improvements in financial efficiency through (a) improved decision making based on costs and benefits of alternatives, (b) justification for work programs and funding requirements, (c) recognition of costs of operating road assets over the life cycle of the assets, and (d) increased cost effectiveness of maintenance through proper planning of works. Essential data such as traffic counts should be collected continuously. Economic decision models such as the Highway Design and Management model are instrumental in assisting effective prioritization processes. In contrast, there is no formalized mechanism in the present system for linking expenditures to operate a road with traffic intensity, which leads to inadequate allocation of budget funds for operation of roads among the regions. In addition, reconstruction projects financed by the Federal Targeted Program (FTP) or Investment Fund are determined on the basis of economic criteria on a case-by-case basis, and not from a road network prioritization basis. 3.45. Managing roads like a business—commercializing road management—leads to a number of changes in the way the roads are managed and requires more autonomy for the road agency. These changes include (a) establishing a more autonomous road agency that 51 operates at arm’s length from the government, (b) replacing the previous model of accountability with better oversight arrangements that strengthen accountability and pay more attention to the needs of road users, and (c) streamlining the structure of the road agency and improving terms and conditions of employment for road agency staff members. A number of road agencies that have been restructured or made into public companies have been set up under new legislation, and there are clear guidelines on how such legislation should be prepared. 3.46. It is possible that in future Avtodor could function as a second-generation road fund to ensure a fully funded road maintenance program. Instead of creating a new second- generation road fund, Avtodor could be strengthened to perform functions of a second generation road fund. Its existing institutional framework could be easily adopted to meet the requirements of a successful road fund: independence from the general government budget, management by a strong and independent board. 3.47. Improving the strategy in the road sector appears important in light of ambitious expansion plans. The Transport Strategy for 2010–30 was approved by the federal government in November 2008. However, a number of new initiatives in the road sector were not included in the strategy, thereby limiting its value. For example, three recent high-profile government policy initiatives—the creation of Avtodor, the legislation aimed at introducing infrastructure bonds, and the creation of a road fund—were not mentioned in the 2008 Transport Strategy. A national transport strategy can be useful in helping people understand the reasoning behind the government’s decisions and actions in the sector by (a) explaining the government’s goals and the principles that guide it, (b) helping to identify shortcomings in existing policies and strategies, and (c) helping to ensure consistency in the application of policy priorities.24 But these benefits are entirely lost if key policies are developed on an ad hoc basis and without consideration for what is deemed to be the key strategic document in the sector. C. THE ROAD SYSTEM: KEY RECOMMENDATIONS 3.48. The overall condition of road infrastructure has deteriorated over the past decade, reflecting low and declining public expenditure in the sector. The financial crisis had a significantly negative impact on road allocations in 2009 and 2010, which can be expected to lead to further increases in the maintenance and rehabilitation backlog. At the same time, the federal government has recognized the condition of the road sector as a constraint on economic growth and has plans to launch an ambitious network expansion over the medium to long term, requiring additional resources. This chapter argues––on the basis of the analysis of Russian and international experience–that despite good policy initiatives in the current budget, there is much more that can be done on policy, institutional, and funding fronts to meet the ambitious targets of maintaining, rehabilitating, and expanding Russia’s road network. The key policy recommendations are summarized in table 3.14. 24 See, for example, Lee and Hine 2008. 52 Table 3.15: A Summary of Recommendations: Road Sector Responsible Options for reform and Suggested Expected impact Objective agency recommendations sequencing 1. Ensuring adequate provision of funding Increase road user MOF, MOT Increase road user fees (excise Short-term Reduced depreciation of charges to provide tax on fuel) to gradually road assets adequate funds for increase annual expenditures on Fiscal savings over the long road maintenance, road maintenance, run (maintenance is cost rehabilitation, and rehabilitation, and effective and markedly reconstruction. reconstruction by 1.1 percent cheaper than addressing a of GDP relative to 2010 levels. mounting maintenance But to improve the performance backlog problem) and outcomes in the road sector, it will be important not only to raise expenditures, but also to adopt measures to ensure that funds are spent efficiently, Increase funds for MOI Increase expenditures on Short-term Increased road safety improving road campaigns, driver education, Reduction of mortality rate safety. better enforcement, and and health costs and research and data collection. property damage related to road accidents Introduce fully MOF, MOT Consider strengthening the Medium-term Increased expenditure funded road institutional framework to efficiency and accountability maintenance include best international of resource of use program practices of second generation road funds. Consider IFI MOT, MOF Consider projects with IFIs Short-term Higher long-term finance at financing and TA national and subnational for road levels, as well as improvement international expertise and projects. best practice experience Establish a multi- MOT, MOE, Introduce a coherent multi- Medium-term Increased expenditure year financing MOF annual expenditure framework efficiency and accountability framework for the for the road sector, which could of resource use transport sector, be updated on an annual basis. including roads, for a three- to five- year period. 2. Strengthening management and planning practices of road network Review the MOT Review the first phase of the Short-term Improved strategic planning objectives and strategy implementation to in transport sector (targets of time frame for the ensure that the objectives are the Transport Strategy for the first phase of attainable given federal and road sector appear Transport regional budgets, as well as overambitious and difficult to Strategy. private sector investments and attain) implementation capacity. Carry out MOT While an administrative Short-term Improved resource planning functional road classification such as the one in by ensuring that the classification Russia assigns road ownership, government’s stated road exercise to assess a functional classification expansion program is governments’ determines technical realizable financial requirements and maintenance 53 Responsible Options for reform and Suggested Expected impact Objective agency recommendations sequencing capacity—at the practices, and influences federal, regional, administrative classification and and local roads financing. levels—and users’ willingness to pay for existing and planned roads. Conduct a full MOT On the basis of that review, Medium-term Improved expenditure review of vehicle introduce the new standards for efficiency, up-to-date design and road design maximum vehicle weights and standards that will facilitate standards. road design to ensure that they optimizing road network are compatible with existing and future traffic. Introduce MOT Start with three-year contracts Medium-term Improved expenditure performance- on a pilot basis to choose efficiency based contracts in line with the If PBCs are implemented on maintenance capacities of the contracting 20 percent of Russia’s contracts. industry. highway system and average cost savings over conventional contracts reach 25 percent, the financing gap for maintenance needs is reduced by additional 0.1 percent of GDP. Introduce an MOT Compile reliable, relevant, and Medium-term Improved expenditure improved road accessible information, such as efficiency stemming from asset management data on budget, traffic counts, improved management and system for the road accidents, and pavement spending decisions road network design. Strengthen the MOI Strengthen penalties and ensure Medium-term Reduction in widespread enforcement of that enforcement has a random violation of existing truck overload nature so that truck operators overloading regulations controls and cannot plan to avoid them. prolonging the life of regulations pavements Consider a consistent nationwide policy toward the enforcement of axle load limits, on all road classes, with sufficient financing for enforcement. 3. Strengthening the institutional framework Review the MOE Review the Public Procurement Medium-term Improved expenditure procurement Law with the aim of limiting efficiency by improving procedure. the role of reverse auctions for procurement procedures. The procurement of civil works. World Bank does not consider reverse auctions—a type of auction in which sellers compete to obtain business based on the lowest price quoted—as an appropriate method of procurement, and particularly for civil works, given the 54 Responsible Options for reform and Suggested Expected impact Objective agency recommendations sequencing considerable risks to quality. Increase MOE Possible remedies might Medium-term Improved expenditure competition for include requiring competitions efficiency as competition in the procurement to include bidders from as the road works sector limits of road works. many regions as possible and the scope for collusion. outlawing subcontracting An increasing competition between bidders once the for road works that results in contract has been awarded. a decrease in average bidding price by 10 percent can reduce the financing gap for road maintenance by about 0.12 percent of GDP. Strengthen the MOE Revise the Federal Russian Medium-term Reduced burden on public legal and Law on Concession budget resources by institutional Agreements to meet increasing the share of framework for international standards, for private sector road financing PPPs. example, the standard form contract is rigid and all assets and tender procedures are restrictive with regard to selection criteria and timing. Increasing MOT Managing roads like a Medium-term Improved road management autonomy for the business—commercializing practices road agency. road management—requires more autonomy for the road agency Note: EBRD = European Bank for Reconstruction and Development, IBRD = International Bank for Reconstruction and Development, MOE = Ministry of Education, MOF = Ministry of Finance, MOI = Ministry of Interior, MOT = Ministry of Transportation D. THE RAIL SECTOR: CURRENT ISSUES AND CHALLENGES 3.49. The Russian railway sector is dominated by Russian Railways (RZD), one of the largest railway companies in the world.25 As the owner of the national railway infrastructure and the locomotive provider, RZD is a monopoly. It also has a strong, competitive position in freight railway and dominates the national rail freight market. RZD has consistently received investment grade ratings by the international credit rating agencies (foreign currency BBB rating by Standard & Poor’s). In terms of productivity, the railway sector, including RZD, is quite efficient and largely self-financing, although the government’s support has increased lately during the global crisis. 3.50. Federal government expenditures to support RZD have expanded sharply in recent years. Regional and local government support to the railway sector in Russia is small, between Rub 2 billion and Rub 3 billion per year in recent years; hence, the focus of this chapter on federal rail expenditures. The railway’s share of federal transport expenditures has risen from 17.6 percent in 2008 to 25.7 percent in 2009 and is projected to rise to 29.3 percent in 2010. Responding to the impact of the crisis on RZD, in 2009 the government introduced temporary 25 RZD is a holding company with more than 63 subsidies as of the end of 2009. In 2008, the company employed 1.26 million staff members and its total revenue was equal to 2.65 percent of GDP, making it one of the largest companies in Russia by revenue. 55 freight operating subsidies (freight tariff ―compensation‖), but these subsidies have been extended into 2010. Subsidies for the passenger operating segment have been rising. The railway infrastructure requirements of the Sochi Olympics have also led to large equity injections. Institutional and Regulatory Framework 3.51. In 2001, Russia embarked on a comprehensive, three-phase railway structural reform program. The reform program set out strategic priorities for the rail industry up to 2010 and beyond with the aim of improving the efficiency and profitability of rail services in Russia and encouraging investment for modernization. This led to the foundation of RZD as a state- owned company to manage the assets formerly belonging to the Ministry of Railways—the Ministry of Railways was renamed the Federal Railway Transport Agency. One of the main objectives of the reform was to separate the natural monopoly activity of the company from the fields of activity where competition would be possible and to attract private investment and private initiatives to the competitive segments. 3.52. The reform so far has been largely successful, but there have been delays in completing the second and third phases of reform. The reform has reduced cross-subsidies, improved transparency, raised investment opportunities, and increased flexibility in operating tariffs. Next on the reform agenda are the sale of shares of the ancillary companies created during the reform—there has been some progress to date with sales of shares of Transcontainer (a leading rail container operator and a subsidiary of RZD); and the development and finalization of the public service obligation (PSO) arrangements for passenger services. The final phases of reform have been delayed but are likely to happen in the coming years. These phases include the establishment of the Freight One Company and, in April 2010, the Federal Passenger Company, as well as reforms in the commuter passenger transport segment with the view to eliminate cross- subsidies in passenger transport and increase transparency and efficiency. Although these long- term efforts are moving in the right direction, the definition and introduction of a PSO and federal government PSO funding remain a priority, as well as defining adequate sources of local finance to the suburban and regional joint stock companies. 3.53. One of the outstanding issues is the ultimate competitive structure of the railway sector. The focus of reforms to date has been on promoting competition at the operator level and not at the carrier level. In the Russian context, a carrier has the responsibility to offer service to anyone on the entire system in accordance with the published tariffs of the carrier; the only carrier is RZD. An operator provides its own wagons or locomotives but uses RZD as the carrier for moving traffic. RZD has fostered the growth of new operators, but the full development of competing carriers awaits the adoption of a legal system. A key issue that arises relates to whether an independent operator could have nondiscriminatory access if the freight carrier and infrastructure are owned by the same holding company (RZD). The EU and the United States would not consider competition limited to the supply of wagons or locomotives to be sufficient for limiting market power. The railway reform strategy envisages in its third phase that competition will be developed in the rail freight transport sector through the licensing of railway carriers, but this will not develop without the withdrawal of the requirement to provide services across the entire network. 3.54. The Transport Strategy envisages carrier competition, but this could require a review of the freight tariff regime in place. The Russian approach sets freight tariffs to recover full costs for RZD as a whole, and then offers discounts for a shipper or operator who provides 56 private wagons and locomotives. This approach results in significant noninfrastructure costs in the access charge. In the top-down approach, freight tariffs are determined by starting with total costs and then subtracting the costs of wagons and locomotives, whereas the bottom-up approach includes costs only directly attributable to infrastructure. It would be necessary to assess whether there is a need to review the existing freight tariff regime methodology to ensure its appropriateness if the intention is to create a space for new carriers. Also, the legal definition of a carrier—one offering services to all shippers over the entire rail system—effectively limits the emergence of competition at the carrier level. Removing this impediment could help open up the market for competition in the supply of locomotives. Railway Assets and Traffic 3.55. The rail network in Russia is one of the largest in the world, and the intensity of its use is high. Total route length of 85,000 kilometers makes it one of the largest in the world after the United States (figure 3.3). With only 5 kilometers of track per 1,000 square kilometers of land, however, Russia’s track density is low. This reflects the large size of the country and the concentration of its economic activities in a few regions. Since 2003, investments have been made to develop and enhance infrastructure along the major railway routes—Kuzbass–North West, Kuzbass–Far Eastern Transport Hub, Kuzbass–Azov–Black Sea Transport Hub—that are used for transporting most of the bulk freight destined for the sea port of Murmansk, the Baltic Sea, the Far East, the Black Sea, and the Azov sea (see map in appendix I). But investments in infrastructure during 2003–08 have been used to construct 860 kilometers of new and second tracks, to construct 800 kilometers of station tracks, and to electrify more than 670 kilometers of tracks, an increase in the operational network of less than 1 percent. As of the end of 2008, the electrified track mileage reached 43,086 kilometers or 51 percent of the length in use. The Transport Strategy envisages an expansion of the total network of between 19 percent and 24 percent during 2016–30, with an increase of between 16,000 and 20,000 kilometers depending on the scenario. Figure 3.3: Rail Network Length, 2008 Kilometers (thousands) Canada 57 China 61 India 63 Russian Federation 85 European Union 211 USA 227 0 50 100 150 200 250 Source: RZD. 3.56. The track length with an overdue overhaul has increased during 2004–08. There have been recent improvements to the load-bearing capacity of the track structure and a reduction in the light rail network. Overall traffic and average freight traffic density increased significantly during 2004–08, thanks to the improved technical condition of tracks. But cutbacks in funding have led to a reduction in rail track overhaul. As a result, the length of track due for overhaul has increased from 14,050 kilometers in 2004 (11.4 percent of the total) to 18,380 57 kilometers in 2008 (14.8 percent of the total). This situation is recognized by the Transport Strategy, which highlights that reduced rehabilitation and reconstruction of infrastructure. 3.57. The growing Russian rail freight is transported by a fleet of approximately one million freight wagons. Freight One Company manages more than 200,000 wagons (table 3.15) and nearly 40 percent of the fleet is still operated by RZD, Freight One Company’s parent. RZD has a universal service obligation, which means that it must supply wagons to all customers on an equal basis. As a consequence, for wagon types in short supply, customers may face long delays in receiving wagons to load. RZD must charge all clients the regulated tariff, which is the benchmark in the market. Table 3.16: Wagon Fleet in Russia, 2004–08 2004 2005 2006 2007 2008 Total 835 886 927 955 1,003 RZD 624 631 591 568 405 RZD subsidiaries 0 0 27 55 212 Private fleet 211 255 309 332 386 Source: RZD. 3.58. The locomotive fleet consists of a rising number of obsolete units, while the average age of RZD’s wagon fleet is relatively old. The percentage of locomotives with expired life service has risen during 2004–08, from 11.4 percent of the fleet to 18.0 percent, suggesting that not enough locomotives have been renewed and purchased. The average life hides considerable variation by type of locomotive, with freight locomotives much newer than passenger locomotives. With limited funds for purchases and modernization, RZD, through its subsidiaries, is focusing more resources on freight wagons, which generate the bulk of its revenues. In contrast, the average age of RZD’s freight wagon fleet is relatively high at 21.7 years. However, the freight wagon fleet owned by private operators is much newer, suggesting that the average age of the freight wagon fleet for the country as a whole is much lower. 3.59. But despite deficiencies, the quality of Russia’s rail infrastructure is higher than for other transport modes. According to Rosstat, railway asset deterioration has been on the rise in the past three years, although the deterioration is much less so than in other transport modes.26 Russia’s indicators of rail productivity are high, reflecting overall efficiency. Given the high volume of traffic carried by Russia’s rail, it is not surprising that its rail productivity—measured in terms of staff productivity, track productivity intensity, wagon productivity, coach productivity, and locomotive productivity—is higher than the EU average (table 3.16). Staff productivity is more than three times higher than the EU average, freight fleet productivity is more than five times higher, and passenger fleet productivity is 1.7 times higher. Freight wagon productivity is also higher than in Canada and India, close to the levels of China, although lower than in the United States. The strength of Russia’s railway sector vis-à-vis other large railway systems reflects its high market share in the freight sector, high overall traffic volumes, and positive impact of recent reforms. 26 In 2008, asset deterioration in air transport was 48 percent, inland waterways 67 percent, rail 24 percent, roads 48 percent, and maritime ports 48 percent. 58 Table 3.17: International Indicators of Rail Productivity, 2008 Staff Track Freight track Wagon Coach Locomotive productivity productivity productivity productivity productivity productivity (ton- (ton- (ton- (ton- (passenger- (ton- kilometers kilometers kilometers kilometers kilometers kilometers and and per km of per cargo per and passenger passenger truck) wagon) passenger passenger kilometers kilometers wagon) kilometers per per km of per employee) truck) locomotive) Canada 10,578,912 6,286,406 6,259,683 3,996,229 2,506,557 122,341,156 China 1,582,958 54,015,656 41,306,451 4,398,355 18,196,746 190,723,377 European Union 650,741 3,551,917 1,695,565 756,100 2,960,549 27,723,778 Russian Federation 2,350,208 30,516,234 28,452,708 3,928,547 4,997,726 129,970,504 United States n/a 12,323,569 12,279,814 6,191,980 8,535,223 115,278,911 India 918,440 20,391,413 8,232,997 2,639,412 16,978,082 159,226,510 Sources: International Union of Railways, RZD. 3.60. Freight traffic, at 2,424 billion ton kilometers in 2008, is one the highest in the world, dwarfing the entire traffic of the EU, Canada, and India combined. Such high freight traffic volume is the result of vast distances and of rail as the preferred means of transport for all major cargo (except oil and gas), which in turn reflects the structure of the Russian economy, with long distances and heavy concentration of commodities (figure 3.4). Russia is a world leader in the intensity of freight traffic and ranks second to China at 28.5 million ton-kilometers per kilometer of track. By contrast, passenger traffic is below the levels of Japan, the EU, India, and China, reflecting in part a much smaller population than the EU, India, and China, and fewer trips taken than in Japan. In the passenger segment, rail is second to travel by car, although it remains the dominant mode of travel for medium- and long-distance passenger travel; air travel is also important for passengers on long-distance routes outside central Russia. Figure 3.4: Network Length (kilometer), Passenger Traffic (billion passenger-kilometers), and Freight Traffic (billion traffic-kilometers), 2008 Canada 57 Russia 176 Canada 358 China 61 EU 359 Japan 256 India 63 India 521 Source: UIC, RZD. EU 393 Russia 85 Russia 2,424 India 770 EU 211 China 2,512 USA 227 China 773 USA 2,788 0 50 100 150 200 250 0 200 400 600 800 1000 0 1,000 2,000 3,000 Sources: RZD; European Commission 2009. 3.61. The volume of cargo carried by private or leased railway wagons has been rising in the past five years, and it consists mainly of high-profit cargo. Freight cargo carried by private or leased wagons has risen from 31.5 percent in 2003 to 41 percent in 2008, with the remaining share held by RZD—the subsidiaries and affiliates carry 9.3 percent of the traffic and RZD (excluding subsidiaries and affiliates) carries the remaining 49.7 percent. This proportion reflects railway tariff policy, which has served as a powerful tool for the expansion of 59 competition because the track access charge regime in place offers discounts for shippers or operators who own private freight wagons. The tariff discount policy takes into account competition and implies some level of cross-subsidies. Meanwhile, the cargo structure of RZD differs from that of the traffic in railway wagons owned by independent private entities: high- profit cargo represents 18.7 percent of cargo traffic for RZD, with the remaining 71.2 percent consisting of low-profit cargo, while high-profit cargo represents 44.2 percent of privately owned railway wagons. 3.62. Freight traffic in the first half of 2010 has bounced back from the lows of 2009, but passenger traffic continues to decline. Freight traffic in the first six months rose by 12.2 percent compared to the same period in 2009, with significant rises for certain categories of commodities (coke, crap ferrous metals). Traffic reached 1,209 billion tons per kilometer, a rise of 14.5 percent compared to the same period in 2009. By contrast, passenger services declined by 20.3 percent in the same period with long-distance services down by 1.6 percent and commuter services down by 21.6 percent. With the real economic activity still below the precrisis level, RZD expects that volumes of freight and passenger services traffic will recover very slowly, reaching precrisis level only after 2013. Financial Performance of RZD 3.63. Despite the difficult context and declining traffic volumes, RZD’s overall financial results were positive for 2009 and financial recovery continues in 2010. Although the first half of 2009 saw a net loss of Rub 13.7 billion (US$457 million), there was a turnaround in the second half and the year ended with a profit of Rub 14.4 billion (US$480 million). This reflects anticrisis measures to reduce operating costs. In addition, RZD also received Rub 40.6 billion (US$1.4 billion) compensation in the third quarter to cover losses resulting from an 8 percent rise in freight tariffs, instead of the planned 14 percent increase. In addition, RZD reduced its investment program for 2009 by 30 percent. These anticrisis measures, reduced investments, and increased government support led to a turnaround in the financial results for the second half of 2009. In 2010, financial position continued to strengthen even after accounting for subsidies. RZD posted a profit of Rub 58.5 billion (US$1.9 billion) in the first half of the year, compared to a loss of Rub 13.7 billion (US$445 million) over the same period in 2009. Government subsidies in this period were equal to Rub 11.8 billion (US$384 million). Freight volumes rose by 12.2 percent. This good performance is driven by a recovery in demand (traffic) and measures aimed at reducing costs. 3.64. There are two key drivers of RZD’s financial performance that are highly dependent on government policy—tariff policy and subsidies (that is, ―compensation‖ payments). The federal government compensates RZD for loss-making services resulting from the low, regulated prices. The framework for tariff regulation is generally favorable to RZD, but it is not transparent and is subject to political interference. Regulation is based on a combination of ―cost-plus-profit‖ mechanism and a rolling, three-year price cap annually revised by the Federal Tariff Service. Regulated profit does not incorporate any guaranteed minimum return on capital but should cover debt service, dividend payments, and the investment program as approved by the regulator. The current cap for 2008–10 stipulates tariff adjustments above the projected inflation rate, but in 2009 and 2010, the agreed tariff rise was lower than provided by the framework, which led to the approval of an additional ―freight subsidy‖ to compensate for the revenue. 60 Budget Expenditures in the Railway Sector 3.65. Overall, federal funds allocated to the rail sector rose significantly over the 2007–10 period. This support takes a variety of forms: (a) operating subsidies or compensations to offset regulated freight tariffs, (b) operating subsidies to offset losses in passenger transportation, (c) equity injections or recapitalizations for cofinancing major investment projects, and (d) funds from the FTP and Investment Fund for capital investments. Public sector support for the railway sector reached Rub 74 billion (US$2.5 billion) in 2008 (table 3.17) with a 27 percent rise in funds for investments. Subsidies for providing loss-making passenger services also rose in 2008, given the federal government’s commitment to increasingly compensate rail operators for those services. 3.66. The 2010 federal budget envisages support to the railway sector of Rub 155 billion (US$5.2 billion), maintaining the freight operating subsidy introduced in 2009. Subsidies, at Rub 80.2 billion (US$2.7 billion), are largely unchanged from 2009 and exceed funds allocated for investment. However, the 2010 budget also provides an equity injection of Rub 60 billion (US$ 2 billion) to RZD, more than doubling the amount in 2008. As in 2008, the bulk of these funds are intended to finance the rail infrastructure associated with the Sochi Olympics. Although anticrisis measures might be reversed once the Russian economy recovers, spending to finance the Olympics can keep federal expenditures on rail over the period 2010–13 higher than those before 2008. The continuation of the freight operating subsidy beyond 2010 seems difficult to justify because freight is a profitable market segment if tariffs are set appropriately. Table 3.18: Federal Government’s Support to the Railway Sector Rub, millions, nominal prices (except as noted) 2007 2008 2009 2010 Administration 5,138 6,929 7,158 6,535 Investment 10,376 47,358 60,261 66,573 Federal Targeted Program 2,576 1,122 6,511 6,573 Investment Fund 0 11,024 20,549 0 Capital transfers to sub-nationals 7,800 8,800 4,823 0 Recapitalization of RZD 0 24,575 28,243 60,000 Other 0 1,838 133 0 Subsidies 10,934 19,537 76,894 80,210 Passengera 10,900 19,400 36,076 28,957 Freight 0 0 40,688 50,000 Other 34 137 130 1,253 Total 26,657 73,987 145,846 154,606 Total (percentage of GDP) 0.08 0.18 0.37 0.34 Sources: Ministry of Finance; World Bank estimates. a. In 2010, passenger subsidies include compensation for shortfalls of revenue as a result of 2010 regulations of regional governments on reduced tariffs for socially vulnerable groups. The Transport Strategy and Network Expansion 3.67. The Transport Strategy aims to modernize (through 2015) and expand (2016 through 2030) the rail network. The first phase focuses mainly on the replacement of rolling stock, the rehabilitation of infrastructure, and the commissioning of 5,193 kilometers of new, priority track. The second phase aims to build new railway lines, between 16,000 kilometers and 20,700 kilometers by 2030 (appendix I provides a map of the planned rail network development). The strategy proposes a significant expansion of the network from an essentially stagnant 61 network (about 85,000 kilometers) over the past 20 years. The objective is to eliminate key bottlenecks and open new territories, raising density by up to 24 percent. The strategy calls for new, heavy-haul rail tracks of more than 13,800 kilometers interconnecting the ports of the Far East, North-West, and South of Russia and land border crossing points along the western frontier. The Baikal-Amur Mainline will be an essential component of this railway network allowing the Trans-Siberian Railway to be used for passenger and transit container traffic. The strategy also includes qualitative indicators of freight and passenger services (for example, delivery time and transit), which are also expected to improve. 3.68. Such a large expansion of the track network is in response to the need to address the inevitable ―territorial unevenness‖ of transport infrastructure in a vast country. From this perspective, the underdeveloped transport sector is often viewed as an impediment to development of new areas and mineral deposits, primarily in Siberia and the Far East, and passengers are not served adequately in the Far North and Far East regions. As table 3.18 reveals, although rail density—measured in length of track per 1,000 square kilometers—is 5.0 for Russia, this number hides considerable regional variation, from a density of 1.0 in the Far Eastern Federal District to a density of 17.7 in the Central Federal District. Although the overall network density is low compared to EU countries or the United States, it is not that much lower than in China or Canada. In the case of Canada, a harsh climate means that the bulk of economic activity is concentrated in the southern parts of the country, and in that sense, the network is spread unevenly, as is the case for Russia. So, low rail density in a large country does not necessarily reflect a suboptimal network size—the size of the network can simply be reflecting population and economic activity concentration and the associated passenger and freight demand. This underscores the need to carefully conduct an economic evaluation of the merits of network expansion on a line-by-line basis. 3.69. There are three strategic issues in the sector. First, does major rail infrastructure investment in all regions of Russia produce the highest economic benefits nationally? Or is there a trade-off between the growth of periphery and the national economy? If new mineral deposits are, indeed, located in Siberia and the Far East, as suggested by the Transport Strategy, then an economic evaluation should reveal whether investment in railway track is most appropriate. If these deposits consist of oil in Eastern Siberia and gas in the Arctic shelf, however, the relevant question is intermodal: whether one or another mode of transport (track development or pipelines or shipping) is the most appropriate to transport these commodities. Most important is to ensure that the investments made are based on detailed assessments and positive economic returns. 62 Table 3.19: Railway Density by District, 2006 Track length Surface area Railway density (kilometers, (square kilometers, (kilometers per 1,000 thousands) thousands) square kilometers) Russian Federation 85.2 17,075 5.0 Central Federal District 11.5 651 17.7 South Federal District 5.5 592 9.3 North-Western Federal District 15.0 1,678 8.9 Far Eastern Federal District 6.0 6,216 1.0 Siberian Federal District 16.8 5,115 3.3 Urals Federal District 12.3 1,789 6.9 Volga Federal District 18.1 1,038 17.4 Memorandum items United States 227.0 9,519 23.8 Canada 57.5 9,985 5.8 China 63.4 9,597 6.6 Sources: Rosstat, http://www.infostat.ru/catalog.html; PACC. 3.70. The second related issue is the appropriateness of different modes of transport for various distances and, relatedly, the required speed of the new tracks to be built. In the high-investment scenario, out of 21,000 kilometers of new track, the Transport Strategy envisages 10,000 kilometers of fast lines (140 to 160 kilometers per hour) and 1,500 kilometers of high-speed lines (200 to 250 kilometers per hour). Undoubtedly, some of the identified priority directions for fast and high-speed lines, such as passenger trains on the Central Federal District traveling south, appear sensible and the Moscow–Saint Petersburg train service— operational since December 17, 200927—has been successful (appendix H) with an average occupancy rate of 86 percent. More recently, in July 2010 Sapsan trains began running on the Moscow–Nizhny Novgorod lines. High-speed rail lines increase capacity—due to higher frequency resulting from higher speed and up-to-date signaling systems—because they usually supplement existing routes while freeing capacity on the conventional network for freight and passenger services. High-speed rail also reduces travel time and competes with air transport. For routes under 300 kilometers, high-speed rail tends to substitute for air transport and can be important for relieving airport congestion. As with other expansion plans, fast and high-speed rail should reflect proper feasibility studies and the nature of potential traffic along those lines, composition of traffic, and cost recovery considerations. 3.71. And the third issue is the trade-off between the expansion of tracks and their maintenance and rehabilitation. As of the end of 2008, 18,380 kilometers of track, consisting of 14.8 percent of total operating track length, needed a rail track overhaul. The need for track maintenance and rehabilitation has been increasing since 2004. The Transport Strategy acknowledges the importance of reconstructing rail lines and sections; careful consideration must be given as to how additional funds for infrastructure maintenance will be financed at the same time that significant line expansion is expected to occur. Future Financing Needs 3.72. The rail strategy would require substantial increase in federal funding, particularly after 2015. For the period 2010–15, the Transport Strategy would require federal funding at 27 The Sapsan high-speed train services operating between Moscow and Saint Petersburg have faced high demand, with RZD increasing train services in 2010. 63 about 72 percent more than in 2008 (table 3.19). Thus, for 2010–15, out of total estimated costs of Rub 7.7 trillion (US$257 billion), 90 percent would be financed through extrabudgetary funds. For the second phase, total costs rise very sharply, to Rub 50.4 trillion (US$1.7 trillion)— exceeding Russia’s nominal GDP in 2009—reflecting the fact that one of the main objectives in this period is the building of 20,700 kilometers of new railway lines. Once again, in this second phase the bulk of the funds would be coming from extrabudgetary sources. A key issue is the lack of clarity as to where these extrabudgetary funds will be coming from, because the funds required exceed RZD’s financing capacity. Table 3.20: Transport Strategy of the Russian Federation: Rail Capital Investments Rub, billions 2010–15 2016–30 Total Annual Total Annual Federal budget 485 81 2,805 187 Russian Federation budget entities 254 42 3,100 207 Extrabudgetary funds 6,926 1,154 44,510 2,967 Total 7,665 1,278 50,415 3,361 Source: Transport Strategy of the Russian Federation up to 2030. 3.73. External investor funding for railway projects under the Investment Funds in 2007– 09 has been more than 10 times lower than the levels envisaged in the Transport Strategy. The first phase of the Transport Strategy envisages annual expenditures by external investors of more than Rub 1,154 billion (US$38 billion) annually, although actual annual expenditures during 2007–09 have varied between Rub 14 billion (US$562 million) in 2008 to Rub 26 billion (US$867 million) in 2009. Because 90 percent of the rail developments are supposed to be financed by an external investor, it is doubtful that RZD and private freight operators could raise their financing capacity tenfold in the next five years. This investment plan exceeds the financing capacity of the state, RZD cash flow, and RZD borrowing capacity. 3.74. Compared to the targets of the first phase of the Transport Strategy, an investment shortfall during 2010–15 appears likely. Projected railway capital investments during 2010–12 are significantly below those envisaged in the first phase of the Transport Strategy. The first phase of the Transport Strategy (2010–15) assumes total capital investments of Rub 7,665 billion (US$255 billion), which translates into Rub 1,278 billion (US$43 billion) annually. However, in recent years RZD has spent considerably less than this amount (figure 3.5). The Investment Program for 2010, agreed to with the federal government in December 2009, foresees investments of Rub 270.5 billion in 2010, and for 2011 and 2012 the levels are likely to be Rub 285.0 billion and Rub 299.9 billion, respectively. This is a view echoed by RZD, which has estimated that the shortfall could equal Rub 1.9 trillion, given current levels of government support.28 With current trends of support, the percentage of rail due for maintenance could total 20 percent, and the number of overhead power lines in operation longer than their service life could rise to 50 percent. It is, therefore, important to ensure that the railway Transport Strategy objectives are in line with the cash flow and financing capacity of RZD, which depend in part on federal support. It is also critical that an expansion of track is not carried out at the expense of deteriorating track and rolling stock, with a negative effect on passenger and freight services quality. Another important concern is to ensure that the investment plans are in line with RZD’s 28 The levels are those reported by Interfax on October 23, 2009. 64 implementation capacity. In sum, the investment targets set forth in the Transport Strategy do not appear to be realistic and might need to be revised. Figure 3.5: Capital Investments by RZD Rub, billions 450 400 381.7 350 299.9 300 285 262.8 270.5 255.5 250 200 172.4 151.1 150 127.6 100 50 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 Sources: RZD; Investment Program 2010–12. Note: Data from 2004 to 2009 are actual expenditures, while data for 2010 to 2012 are projections based on the investment program agreed with by the government. Financing Sources 3.75. RZD’s investment program has far been financed to date by a combination of internal cash flow, direct state support (subsidies, equity injections, and investment from the Investment Fund and FTP), and debt. Raising outside capital is done in accordance with the company’s borrowing program, including syndicated and bilateral loans, ruble bonds, Eurobonds, and leasing. On December 8, 2004, the first of a series of RZD bonds were successfully placed on the market. From Rub 12 billion (US$424 million) in 2005, the ruble bond issuance rose to Rub 50 billion (US$2 billion) in 2008 and Rub 130 billion (US$4.3 billion) in 2009. In addition to the rising amount and number of issues, the maturity period has been extended—one bond issue in 2009 has a redemption date of 2024, whereas the three bond issues of 2004 had one-year, two-year, and five-year redemption periods, up to 15 years. The main goal of RZD remains to secure long-term ruble-denominated debt; in November 2009 RZD’s board approved plans to issue Rub 200 billion (US$6.67 billion) in 2010. Although ruble bond issuance is rising, it is unlikely to ensure financing to significantly boost investments to the levels foreseen in the Transport Strategy. 3.76. International bond issues remain an alternative financing option. On March 26, 2010, RZD placed a seven-year, US$1.5 billion Eurobond, its first international bond issue. The spread on the bonds is the lowest of any corporation in Russia, and there was considerable interest in the bonds, which were oversubscribed. The rating agency Fitch assigned a BBB rating to the bonds—aligning it with Russia’s debt—reflecting its 100-percent state ownership, the company’s strategic importance, and the government’s extensive role in the company pricing and various forms of financial support. As a result, RZD is able to tap a broader investor base and potentially improve its financing terms. 3.77. Another source of financing is a series of initial public offerings of some of RZD’s subsidiaries. RZD stated at the end of March 2010 that it was preparing to float Freight One Company before June 2011—Freight One has been valued at about US$5.1 billion. RZD has also 65 stated its plan to float a stake of about 35 percent of Transcontainer. In the medium term, RZD has stated its desire to sell a stake of Freight Two Company. This would provide additional funds to upgrade the rolling stock. In total, about 30 noncore subsidiaries, including equipment manufacturers and repair plants, could be sold in near future. RZD has stated that it could raise as much as Rub 100 billion (US$3.3 billion) over the next three years with the sale of subsidiaries. 3.78. However, to a large extent, the financing for RZD will continue to be determined by the tariff structure and its indexation, as well as by financial support from the government. This means that changes to the regulatory framework governing the rail sector are critical, because they will determine RZD’s cash flow and overall financial performance. In addition, the ultimate structure of the rail sector will determine the long-term financial health of RZD. In this regard, the Transport Strategy states that one of the major principles for developing the railway transport market involves two or more railway infrastructure managers and carriers. 3.79. The RZD’s regulated freight structure offers cross-subsidies for different categories of freight cargo. The current pricing policy is based on two underlying principles: (a) keeping low the indexation of cargo freight tariffs to support industry and (b) using differentiation mechanisms for various types of freight cargo. The freight tariff structure (PC 10-01) takes all of the freight commodities handled by rail and reduces them to four overall tariff grades, with additional subgrades. The structure is rigid because it does not permit contract tariffs based on demand determinants and because it creates cross-subsidies, which force certain tariffs to be higher than necessary and weaken rail’s competitiveness for those commodities. The important issue is that the freight tariff should be cost based, transparent, and predictable and be based on economically justified expenses and an adequate margin for a return on investments. With increased rail freight competition, there is also a risk that new competitors will focus on the high- profit segments, leaving RZD with the low-profit, high-volume segment. This has started to happen, because RZD must provide services across the entire network, whereas other operators can be selective and focus on transporting those freight commodities that have higher profit margins. 3.80. Reforming the regulated freight tariff structure should be based on the principles of transparency and market responsiveness while fully covering costs. For the infrastructure and locomotive components, every tariff category should cover at least its long-run marginal cost, and fixed costs should be recovered through the commodity markups for higher-valued goods. This approach would eliminate the likely cross-subsidy for coal. Provision of wagons is taking place in a competitive marketplace and is not subject to state regulations, and thus, this component should reflect the cost of the wagon regardless of the commodity, or private operators will not invest in them. 3.81. The mechanism of indexation of freight tariffs must be made predictable and transparent, ensuring no need for compensatory payments. Indexation parameters are determined by the Federal Tariff Service (FTS), to take account of inflation, among other factors. As figure 3.6 reveals, indexation in 2008 was significantly above inflation, but this was reversed following the financial crisis in 2009–10. The annual average indexation of freight tariffs should be done in a predictable and transparent fashion, taking into account the price pressures faced by RZD (for example, increases in producer prices). Federal government funds should compensate 66 for loss-making passenger services through the PSO, and should ensure adequate cash flow to increase RZD’s expenditures on investment.29 Figure 3.6: Average Indexation of Freight Tariffs 25 20 15 10 5 0 2003 2004 2005 2006 2007 2008 2009 2010 Average freight tariff increase (%) Consumer price index (%) Sources: RZD, World Bank. E. THE RAIL SECTOR: KEY RECOMMENDATIONS 3.82. The overall condition of railway infrastructure, although better than for other modes of transport, has also been deteriorating, requiring more concerted policy measures, many of which are forthcoming. The condition of rolling stock has been improving, given the effect of investments by new private operators. In terms of performance, the financial crisis has had a significantly negative effect on railway traffic volumes, which has led the federal government to increase its support to the sector. But the question remains as to what extent the sector will be able to keep up with rising demand in the postcrisis period without additional measures aimed at improving efficiency, improving operations and maintenance, and financing a realistic expansion program. To this end, the key recommendations are summarized in table 3.20. Table 3.21: A Summary of Recommendations: Rail Sector Responsible Options for reform and Suggested Expected impact agency recommendations sequencing 1. Budget expenditures Priority should be MOT, RZD It is critical that an expansion Short-term Maintenance of the quality given to of track is not carried out at the of existing rail infrastructure maintenance and expense of deteriorating track, rehabilitation. overhead power lines, and other infrastructure, with a negative impact on passenger and freight services quality. Adjust freight MOT Review the freight tariff Short-term, Reduced suboptimal tariffs to ensure regime. medium-term allocation of federal funds by cost-recovery, Freight operating subsidies aligning the tariff structure thereby ensuring should be removed in 2011. with sound economic that (a) the The average annual freight principles and the infrastructure and indexation should be set so as competitive market locomotives tariff, to require no freight operating Fiscal savings in amount of in each instance, subsidies, 0.1 percent of GDP by 29 Taking 2005 as the base year (2005=100), average passenger tariffs stood at 99 in 2008, according to Rosstat data, with both average long-distance and commuter tariffs lower than in 2005. 67 Responsible Options for reform and Suggested Expected impact agency recommendations sequencing fully covers the Temporary targeted subsidies to eliminating federal budget long-run marginal particularly hard-hit economic compensation payments for cost of providing sectors would be more efficient freight cargo tariffs the associated than providing lower freight infrastructure or tariffs for all sectors. locomotive A reduction in cross-subsidies service, and (b) would require raising tariffs for the wagontariff basic commodities (Grade 1); reflects the cost of this has happened to some providing the extent already, and it would be wagon[[car?]], important to review the regardless of structure to ensure that it more commodity closely reflects costs. Review the It appears critical that the Medium-term Reduced suboptimal indexation of annual average indexation of allocation of federal funds freight tariffs freight tariffs be done in a by aligning the tariff process. predictable and transparent structure with sound fashion and that it avoids the economic principles and the need for compensatory freight competitive market subsidies. Federal government funds should be directed at compensating for loss-making passenger services and should not be providing freight subsidies. 2. Strengthening management and planning practices Review the MOT Revise the first phase to ensure Short-term Improved strategic planning objectives and that the investment objectives in transport sector (targets of time frame of the are attainable given the the Transport Strategy for the first phase of the financial capacity of RZD and railway sector appear Transport federal support, as well as overambitious and difficult to Strategy. implementation capacity. attain, especially because funding has been lowered more than envisaged prior to the financial crisis) Ensure that rail MOT, RZD A careful economic evaluation Medium-term Higher economic impact infrastructure should reveal whether from rail investments investment in investment in railway track in (infrastructure investment peripheral regions remote regions is most itself is unlikely to help is justified from a appropriate and whether other growth in lagging regions, financial and policy measures are more and expenditures favoring economic point of appropriate. spatial equality at the view. expense of funding high- return regions such as the Central Federal District, are likely to impose severe trade- off with respect to boosting national economic performance) Review the need MOT, RZD It is important for each high- Medium-term Increased cost effectiveness for 10,000 speed rail project that there is of rail transport service. Fast kilometers of an assessment of the need for and high speed rail should 68 Responsible Options for reform and Suggested Expected impact agency recommendations sequencing high-speed rail. high speed-rail, the benefits and reflect the nature of potential costs of rail services of 140– traffic along those lines, 160 kilometers per hour versus composition of traffic, and 200–250 kilometers per hour cost recovery considerations. and 300–350 kilometers per hour. 3. Strengthening the institutional framework Introduce public With the creation of the Federal Short-term Increased accessibility of service obligation Passenger Company, the transport services (PSO) funding. definition and introduction of a public service obligation and federal government PSO funding remains a priority, as well as defining adequate sources of local finance to the suburban and regional joint stock companies. Review the legal Review the legal requirement Medium-term Increased competition by requirement that a that a carrier must provide changing the legal carrier must service across the entire requirement that prevents the provide service network. establishment of a new across the entire railway carrier (as envisaged network. in the third phase of the railway reform) Note: MOT = Ministry of Transportation. 69 4. STRENGTHENING PUBLIC EMPLOYMENT 4.1. The primary focus of this chapter is to analyze public sector employment by focusing on three core government objectives in human resource management: (a) strengthening the public sector’s ability to attract and retain human capital, (b) introducing performance-focused human resource management practices, and (c) maintaining a fiscally sustainable wage bill. Currently, the wage bill—comprising more than one-fourth of all government expenditure—faces conflicting pressures. It is clear that improving the remuneration system, including increasing wage levels in education and health sectors, is an essential task to improve the effectiveness and quality of public administration and service delivery. Yet given the budget constraints, one of the most important challenges is to ensure the medium-term fiscal sustainability of overall expenditures, including the aggregate wage bill. A. AGGREGATE PUBLIC EMPLOYMENT 4.2. Over the past two decades, the Russia Federation’s labor market has undergone significant transformation that has also altered the size and composition of public employment. Between 1992 and 2009, total public employment fell dramatically––from about 50 million to 23 million. The most significant decline occurred in the early part of the 1990s, mainly as a result of a decline in public enterprise employment. After 1995, the reduction in employment was accomplished through continuous, modest annual reductions rather than through dramatic, one–off retrenchment. 4.3. In 2009, aggregate public sector employment30 totaled more than 23 million, approximately 16 percent of total population and 33 percent of total employment. Approximately two-thirds of aggregate public employment (14.6 million) belongs to the general government.31 About 30 percent of general government employment was at the federal level and the remaining 70 percent was at the subnational level. Public enterprise (unitary, joint stock, and state corporations) employment32 totaled more than 9 million (see box 4.1). Compared with the Organisation for Economic Co-operation and Development (OECD) countries, Russia’s relative public employment (as a percentage of population), averaging about 16 percent, is high; in most OECD countries, it has not exceeded 12 percent (see figure 4.1). 30 Aggregate public sector employment is defined as the employment in state-owned enterprises, armed forces, and the civilian government sector. 31 Aggregate public employment is defined as employment in all government department offices, organizations, and other bodies that are agencies or instruments of the central or local authorities, whether accounted for or financed in ordinary or extraordinary budgets or extrabudgetary funds. There are six mutually exclusive categories of employment within the general government: (a) armed forces, (b) civilian central government (excluding education, health, and police), (c) subnational government (excluding education, health, and police), (d) health employees, (e) education employees, and (f) police. 32 Public unitary employment includes people working in unitary enterprises, joint stock companies, and state corporations. 70 Figure 4.1: Number of People Employed in General Government and Public Corporations Sources: International Labour Organization Statistical Database for government employment; World Bank, World Development Indicators. Note: General government and public corporations data for 2006 are for the Czech Republic, France, New Zealand, Spain, and the United Kingdom. Box 4.1: Employment in Russia’s State-Owned Enterprises Despite a large-scale privatization in the 1990s, state ownership is still important in Russia. In 2006, fully state-owned and mixed-domestic public companies accounted for almost one-fifth of all manufacturing industry output. In the banking industry, it is estimated that more than 45 percent of total assets are held by state-controlled banks (Sprenger 2008). Furthermore, estimates by troika dialog indicate that in 2007 the federal and regional governments accounted for about 40 percent of the stock market capitalization in Russia. In the oil and gas sector, capitalization was 47 percent, while in the banking sector it was 64 percent. There are three main forms of state-owned enterprises (SOEs) in Russia: (a) joint stock companies (for example, Gazprom, Sberbank, Russian Railways, and Transneft), (b) unitary enterprises at the federal, regional, or municipal level (for example, Rosoboronexport, Post of Russia, and Rosspirtprom), and (c) state corporations (for example Vnesheconombank, Rosnanotekh, Rostekhnologii, and Rosatom). New SOEs include the United Shipbuilding Corporation, United Aircraft Corporation, and Rostekhnologii. In 2009, about 9.4 million people were employed by SOEs. Forty-four percent of those were at SOEs at the federal level, 12 percent were at a regional level, 28 percent were at a municipal level, and the remaining were employed by mixed- ownership companies (box table 2.1). At the federal level, transport and communication sector employs accounted for more than one-third of all employees of SOEs. Russian Railways is the largest employer with more than 1.1 million employees, which constitutes about 12 percent of all employees of SOEs. Other large SOEs include Post of Russia (415,000 employees) and Sberbank (265,000 employees). At a regional level, the transport and communication sector takes the largest share of employment among SOEs, employing one-fifth of employees of SOEs. At a municipal level, the major employment category is production and distribution of gas and electricity, which accounts for slightly less than one-third of all employees of SOEs. Between 2005 and 2009, employment in public enterprises fell by more than 14 percent. In 2009, employment in SOEs continued to decrease. For example, the employment levels in Russian Railways were cut by 7.7 percent. But Russia continues to have a slightly larger share of employment in public enterprises, at about 6.6 percent of total population in 2008, compared with 4 percent in the European Union new member states and below 2 percent in the OECD countries (Reid and Orac 2007). Box Table 1 SOE Employment by Sector and Ownership, 2009 thousands Federal Regional Municipal Mixed Total Transport and communication 1,391 286 217 250 2,143 Manufacturing 833 107 37 885 1,863 Real estate 939 186 373 194 1,693 Production and distribution of gas 84 149 442 298 973 and electricity Financial services 111 7 2 427 548 Communal and social services 56 56 231 38 381 Mining 8 9 >1 298 315 Agriculture 107 97 39 46 289 Construction 99 62 32 92 286 Other sectors 497 129 144 1,518 921 Total 4,127 1,087 1,518 2,679 9,411 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. 71 4.4. Public budgetary organizations account for two-thirds of total public employment.33 The sectoral composition of public employment of budgetary organizations varies significantly among levels of government. At the federal level, the majority is employed in public administration. At the regional level, most of this employment is in education, and at the municipal level, most of this employment is in health. In 2008, approximately 435,000 were employed in sectors traditionally not related to core functions of public-service delivery (for example, agriculture, manufacturing, retail trade, and similar sectors). At the federal and regional levels, these sectors accounted for about 5 percent of total public employment funded by the budget. 4.5. Education employment accounts for more than a third of total public employment (table 4.1). During the past 15 years, Russia carried out policy measures aimed at decentralizing the national education system. As a result, about 80 percent of education employment is currently under the subnational jurisdiction. The composition of employment reflects the division of responsibilities in delivery of public services and intergovernmental expenditure assignments. At the municipal level, secondary education is the single largest employment category and accounts for half of education employment. At the federal level, higher education institutions account for 72 percent of employment, and at the regional level, vocational education accounts for 40 percent of employment. Table 4.1: General Government Education Employment, 2008 Millions of people Percentage of total Total Federal Regional Municipal Total Federal Regional Municipal Total 5.56 1.06 0.84 3.65 100.0 100.0 100.0 100.0 Preschool education 1.34 0.02 0.14 1.18 24.2 2.1 16.1 32.4 Primary education 0.36 > 0.01 0.06 0.30 6.5 0.2 7.3 8.2 Secondary education 2.02 0.01 0.23 1.78 36.4 0.8 27.5 48.8 Vocational 0.56 0.20 0.34 0.01 10.0 19.1 40.5 0.4 education (secondary) Higher education 0.85 0.82 0.03 0.00 15.3 77.2 3.1 0.1 Other 0.42 0.01 0.05 0.37 7.0 0.6 5.6 10.1 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. 4.6. In general, the traditional process of budget allocations based on input norms has resulted in inflexible and inefficient use of resources, especially in secondary education. Russia’s education system remains quite resource intensive: the average student-teacher ratio is 1 to 9.9 for primary and secondary education compared with 1 to 12.6 and 1 to 11.7 in European Union (EU) old and new member countries, respectively (World Bank 2010d). The average class size at the primary and secondary levels of education is 16.9 (and declining) compared with about 21 in the EU. A transition to per capita financing (a principle of money follows the student) will enable regional authorities to make resource-based decisions, including decisions related to the rationalizing of the school network.34 Yet, full-scale implementation of per capita financing remains a challenge for municipalities because schools have limited spending autonomy35 34 Since 2008, general education has been financed on a per capita (student) basis in all regions. 35 Formally, municipalities are free to set any policy for allocating the local budget (including funds received from the region) through the per capita allocation across schools. However, the budget legislation severely constrains such autonomy. 72 (World Bank 2010d). The current system of budget financing, through a detailed itemized allocation, is both rigid and inefficient. 4.7. Health employment accounted for about 27 percent of total public employment. The delivery of health care services in Russia is a regional and municipal responsibility; hence, 86 percent of employment is at the subnational level (see table 4.2). Hospital staff is the single largest employment category at every level of the government. On the whole, this reflects the health system’s reliance on specialist treatment and hospitalization. Table 4.2: General Government Health Employment, 2008 Millions of people Percentage of total Total Federal Regional Municipal Total Federal Regional Municipal Total 3.4 0.5 0.9 2.0 100.0 100.0 100.0 100.0 % Hospitals 2.6 0.3 0.7 1.6 77.3 62.5 77.6 80.7 Sanatoriums 0.1 0.1 0.1 0.0 3.4 12.5 5.3 0.4 Doctor’s practice 0.4 0.0 0.1 0.2 10.7 8.3 11.0 11.0 Sanitary and 0.1 0.1 0.0 0.0 2.1 14.9 0.1 0.0 epidemiology Ambulance 0.1 0.0 0.0 0.1 2.6 0.1 1.1 3.9 Dentistry 0.1 0.0 0.0 0.1 2.1 0.9 1.5 2.7 Other 0.1 0.0 0.0 0.0 1.8 0.8 3.4 1.3 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. 4.8. Reflecting the system’s orientation toward inpatient care, health care in Russia uses far more physical resources per patient than in other countries (World Bank 2010d). Public employment levels in health and social protection, at around 2.9 percent of total population, are similar to those in the comparator countries—about 2.9 percent in the European Union 15 (EU- 15) and about 3.3 percent in the non-EU OECD countries (Reid and Orac 2007). However, the number of hospital beds and medical staff members per patient far exceeds the levels observed in EU countries—97 hospital bends per 10,000 people in Russia compared with only 54 in the EU- 15 and 34 in countries with similar gross domestic product (GDP) per capita. The number of physicians per 10,000 people in Russia is almost 50, although the average in OECD countries is 30. 4.9. In 2009, federal and subnational civil service employment stood at 870,000 (or roughly 0.6 percent of total population) with about 73 percent employed by the federal authorities. Employment at the executive-level authorities (including at the local self- governments with executive functions) accounts for more than 82 percent of core government administration employment (table 4.3). Relative to other countries, the core government (civil service and non–civil service public administration) employment level in Russia is moderate. The core government employment as a share of total population in Russia was only 2.4 percent, slightly higher than in Poland (1 percent) and Ukraine (1.5 percent), but lower than in Denmark (15.3 percent), France (6.9 percent), Italy (5.9 percent), and Germany (4.5 percent). 73 Table 4.3: Civil Service Employment by Levels and Branches of Government, 2009 Total Legislative Executive Judiciary Other Thousands Total 868.2 13.1 710.9 132.0 9.9 Federal institutions 634.8 3.9 515.8 111.2 1.6 Federal level 39.0 3.9 29.4 2.5 1.6 Regional level 595.8 0.0 486.4 108.7 0.0 Subnational institutions 233.3 9.2 195.1 20.7 8.3 Percentage of total Total 100 1.5 81.9 15.2 1.1 Federal institutions 100 0.6 81.3 17.5 0.3 Federal level 100 9.9 75.4 6.4 4.1 Regional level 100 0.0 81.6 18.3 0.0 Subnational institutions 100 4.0 83.6 8.9 3.6 Sources: Rosstat, World Bank staff estimates. B. ABILITY TO ATTRACT AND RETAIN QUALIFIED STAFF Remuneration Policies and Practices in Public Budgetary Organizations 4.10. Until 2005, the public budgetary organizations had a centralized wage-setting framework regulated by the federal executive bodies. The wage system was based on two components: (a) a basic, minimum component (defined by the federal authorities), and (b) a discretionary component—the variable part—consisting of two subcomponents, allowances (related to the work environment, nature of work, and duties of a post), and bonuses. The basic wage in sectors funded by the budget was largely based on the Salary Grid (Unified Tariff Scale) and was linked to the nature or duties of a post. In total, the Salary Grid consisted of 18 separate grades and the minimum grade was linked to the minimum wage level set uniformly across all regions. The aim of the variable part was to account for regional differences in labor markets. Regional authorities were able to supplement the Salary Grid with additional payments or coefficients. However, the size of the variable wage part (premium) was constrained by fiscal resources (including extrabudgetary revenues) of regional authorities. In practice, the public wage system resembled the revenue-sharing mechanism (the variable part of wage increases when the fiscal position improves and decreases when the fiscal position worsens) that appears to be a systemic feature of the Russian economy where extraordinary wage flexibility is paired with the stability of employment (Gimpelson and Lukiyanova 2009). At the regional level, such pro- cyclical wage-setting policies contributed to an increase in the regional differentiation and risks to regional budgets (Kwon and Spilimbergo 2004). 74 Box 4.2: Pay Setting in Russia’s Civil Service A civil service is a subset of public administration officials that includes mainly professional staff members of the executive branch of the government and excludes auxiliary staff members (for example, drivers and security guards). A framework Federal Law on State Service System of the Russian Federation of 2003 established a two-tier system: federal public service and civilian public service of ―subjects of the federation.‖ The federal public service is subdivided into civilian, military, and law enforcement service. The Federal Law On State Civil Service of the Russian Federation of 2004 defines: (a) rights and obligations of civil servants; (b) limitations and prohibitions of the state service requirement to the conduct of the civil servants; (c) regulation of the conflict of interests; and (d) obligations to annually submit information on income, property, and related obligations. The remuneration of federal public-service officials is set according to the presidential decree on remuneration of civil servants (Decree No. 763 dated July 25, 2006). Within each category, the wage may consist of three parts: base salary; allowances, and bonus payments. The base wages of civil servants are set according to a scale consisting of 12 steps. The base wage band is narrow but allowances vary significantly (box figure 1). Allowances for seniority and work environment constitute a significant share of the remuneration. The lack of a clear structure for these compensations allows managers very wide discretion in establishing pay levels within their organizations as long as they remain within the available wage bill envelope. According to Rosstat, in the first half of 2010 the average salary of federal-level executive institutions was Rub 47,400 per month (US$1,580 per month) which is on average 2.5 times more than the national average monthly wage. Box Figure 1 Compensation Amount by Select Civil Service Positions: Norms Source: World Bank staff estimates. 4.11. Since 2005, a separation of responsibilities among levels of government enabled subnational authorities to introduce their own normative regulations regarding remuneration, but did not fundamentally change the centralized wage-setting mechanism. For the federal-level budget institutions, the wage system continued to be based on the Salary Grid set by the federal government (box 4.2). For the budgetary organizations under the subnational jurisdiction, the unified system of wage setting was replaced by region-specific wage systems. However, in practice, the majority of regions continued to apply the Salary Grid scales for setting the base wage level. A few regions applied an alternative approach based on setting individual regional salary grids set by the regional budget laws. The underlying nature of the centralized wage-setting mechanism did not change. The ability to increase the base wages or pay supplemental bonuses continued to be constrained by extrabudgetary revenues or savings in the wage bill of budgetary organizations, resulting in large differences among sectors and regions. In 2009, the average wage in the public sector ranged from Rub 12,000 (US$400) per month in Ingushetia to Rub 48,000 (US$1,567) in Chukotka autonomous region. Regions that faced the fiscal constraints are forced to keep the base salaries below or close to subsistence levels (especially for low-skilled workers). In 2009, approximately 20 percent of all public employees received wages below subsistence levels, a substantial decrease from 25 percent in 75 2005 (see figures 4.2 and 4.3). In education, approximately every fifth employee received wages below subsistence. Furthermore, salary structures are flat and differentiated modestly, according to the length of experience, status, and workload. Figure 4.2: Distribution of Employees according to Figure 4.3: Wage Structure in Budget Salary Brackets Based on the Minimum Subsistence Institutions by Type of Activity, 2009 Level, 2009 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. staff estimates. 4.12. More important, the decentralized wage setting did not eliminate public-private wage gaps. Although the wage gaps (a difference with the average wage level in all sectors of the economy) persisted at both the federal- and the subnational-level budgetary organizations, two different forces were at play (figure 4.4). At the federal level (federal-level employees at the regional level), the wage gap tends to be higher in rich regions, reflecting the inability of the centralized wage scale to keep up with large wage increases in the private sector. However, at the subnational level (regional- or municipal-level employees), large wage gaps exist in poorer regions that are fiscally constrained. Figure 4.4: Relationship between Regional GDP per Capita and Aggregate Public-Private Wage Gaps by Level of Government and Regions and by Population Size of Regions, 2009 a. Federal level b. Regional level c. Municipal level Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. Note: In each panel, the vertical axis is the ratio between public sector wage and average private wage level and the horizontal axis is a log of per capita regional income levels. The bubbles represent the size of the population of regions. 4.13. The largest wage gaps are in municipal-level education and health sectors. Average wages in preschool, primary, and secondary education institutions at the municipal level are generally more than 50 percent below the average wage level (table 4.4). In the health sector, wages for doctors and mid-level medical personnel in municipal institutions are significantly below the average wage levels. Although the ratio of civil service pay to private sector pay at the regional level, and to some extent at the federal level, was largely in line with the ratio observed 76 in the EU and OECD countries, average wages at the municipal level are 23 percent below the national average wage. Similarly, the ratio of average teacher salary to GDP per capita in Russia is significantly lower than the average in the OECD countries. Table 4.4: A Percentage Difference between Sector and Overall Average Wages by Economic Sectors, 2008 percent Education Health and social services and primary establishme Vocational Secondary Mid-level Preschool education education education education personnel Public practices Doctor’s services medical Higher profile Large- Social health Levels administration nts Federal -34.6 -22.5 -32.9 -4.0 13.7 -21.3 -5.3 -28.4 +5.9 Regional -9.1 0.5 -26.6 14.2 -11.4 -28.6 +2.9 -44.2 +28.3 Municipal -54.7 -43.7 -39.0 -27.9 -32.1 -55.0 -35.8 -53.6 -23.2 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. Note: A negative number indicates the wage level below the national average, and a positive number indicates the wage level above the national average. Figure 4.5: Ratio of Teacher’s Salaries and GDP per Capita in Russia and OECD Countries Source: OECD Education indicators 2010. Note: The OECD average includes both OECD countries and partner countries. Data for OECD countries are relative to minimum statutory salary levels in those countries. 4.14. As in many countries, public sector compensation in Russia includes various nonwage and nonmonetary benefits. There are 10 possible elements of a total rewards package for public sector employees (table 4.5). According to the budget execution reports, the nonwage monetary compensation, which includes such categories as reallocation benefits and per diems, constituted about 2 percent of total compensation expenditures. At the federal level, the nonwage compensation was approximately two times larger than at the subnational level when measured as a share of GDP or total compensation. A provision of housing is one of the most lucrative, contractually provided in-kind benefits. The criteria for the housing assistance vary among institutions, but typically include the length of service, duty station, and living conditions (see box 4.3 on housing subsidies at the Federal Civil Service). Excessive nonmonetary benefits can distort incentives and undermine the transparency and budgeting of the wage bill. 77 Table 4.5: A Matrix of Monetary, In-kind, and Intangible Rewards for Public Sector Employees Contractually provided Noncontractual Monetary in-kind intangible Monetary Current Base 1. Base wage and salary 2. Health insurance, using 3. Job security, rewards rewards departmental medical prestige, social establishments, extensive privileges summer holidays [education sector] Allowances 4. Transportation, housing, 5. Transportation, housing, 6. Trips abroad, 7. Gifts, meals, telephone, travel, meals, travel, training contributions cost-of-living, payment for from parents health treatment, access to (education) credit resources, education and patients grants (health care) Future expectations 8. Pension 9. Housing 10. reputation, re- employment after retirement Source: World Bank, Poverty Reduction and Economic Management anchor, HRM team. 4.15. A recent survey of employees at regional-level federal and subnational budgetary organizations indicates that nonmonetary benefits in the private sector are on average more than two times greater than in the public service, contributing to the public-private remuneration gap (World Bank 2009). The difference in social benefits varies with positions, with lower-ranked public officials having access to more benefits than their colleagues in the private sector, and higher-ranked public officials enjoying up to four times fewer benefits (as estimated in monetary terms) compared to their private sector managers. The most common privileges for civil servants include the use of service transport, departmental medical establishments, and sanatorium treatments. 4.16. As in other countries of Central and Eastern Europe, informal payments in health care and education are common. Lingering from the past, these informal institutions (understood as informal norms of behavior) depend on a number of ―soft‖ factors (such as attitudes and values) that remain relatively unchanged despite changes in ―hard‖ factors (such as legislation, and financial and administration structure). Various studies document that the frequencies of these payments in the health sector remain high but vary from region to region, with about 19 percent of surveyed patients in Lipetsk oblast indicating that they have paid informally in the past three years (Aarva et al. 2009). In the education sector, according to a survey by Higher School of Economics (2009), in the 2006/2007 academic year, more than 70 percent of families with school children contributed money for school donations, a part of which is a contribution to teachers. The average size of these donations was Rub 2,600 per academic year in Moscow (about US$80) and Rub 900 per academic year outside Moscow (about US$30). The same survey indicates that bribes, although less frequent in secondary-education establishments, averaged about Rub 4,200 in Moscow (about US$140) and Rub 2,100 outside Moscow (about US$70). The largest amount of unofficial payments was in preschool education establishments; bribes for preschool acceptance were on average Rub 14,100 per year in Moscow (about US$470) and Rub 6,200 per year outside Moscow (about US$200). 4.17. Furthermore, more than two-thirds of teaching staff members at the higher- education institutions and more than one-third of teachers at secondary-education institutions report supplemental sources of income. According to the survey (Higher School of Economics 2009), the most common forms of additional income are additional work in other educational institutions and tutoring. Moonlighting is a coping mechanism for income-poor 78 households that lingers from Soviet times. Financially, the most rewarding supplementary activity is research activity. Box 4.3: Housing Subsidies for the Federal Civil Service The federal targeted investment program for housing for 2002–10 includes a special subprogram aimed to provide housing support for federal-level civil service officials. In total, about Rub 10 billion (US$333 million) were allocated for this activity (see box table 1). The implementation of this program accelerated in 2009 to provide stimulus to the housing market. Box Table 1 Aggregate Outlays for Housing Subsidy Rub, billions Total (2006–10) 2006 2007 2008 2009 2010 Federal civil service 10.17 1.16 1.62 0.26 4.31 2.82 Young scientists 4.72 0.70 0.70 0.68 1.84 0.80 Prosecutor’s office 3.52 0.55 0.94 0.67 0.64 0.72 Source: Ministry of Finance. The provision of housing subsidies in the federal civil service is regulated by norms set by the government of Russia. The nominal price per square meter is set by the Ministry of Regional Development, but the Ministry of Health and Social Services calculates regional coefficients. The criteria for the provision of housing benefits include length of service and current living conditions, but the following categories, managers, and senior advisers that do not meet these criteria can also be eligible for a one-off housing subsidy. In 2009, the normative price per square meter ranged from Rub 13,900 in Karachaevo-Cherkasskaya Republic to Rub 73,800 in Moscow. Ability to Retain Qualified Staff 4.18. Employment turnover rates are not excessive but, predictably, low-wage sectors (for example, vocational education and social services) tend to have higher turnover rates (table 4.6). In public administration, low wage levels may also have contributed to relatively high vacancy rates in select cadre categories of the civil service (especially in Moscow and Saint Petersburg). For comparison, in the EU countries, the turnover rates in public administration range from 0.9–1.2 percent in the United Kingdom (management-level staff members) to 10 percent in Sweden. Table 4.6: Average Monthly Employment Turnover Rates by Sector in Russia percent 2005 2006 2007 2008 Education 1.52 1.46 1.48 1.54 ..of which (o/w) preschool and primary 1.67 1.58 1.63 1.62 education ..o/w secondary education 1.23 1.18 1.19 1.29 ..o/w vocational education 1.91 1.77 1.84 1.96 ..o/w higher education 1.71 1.68 1.71 1.73 Health and social services 1.81 1.64 1.68 1.68 ..o/w doctor’s practices 1.56 1.48 1.47 1.53 ..o/w mid-level medical personnel 1.52 1.19 1.66 .. ..o/w large profile health establishments 1.54 1.47 1.44 .. ..o/w social services 2.17 2.00 2.18 2.15 Public administration 1.73 1.53 1.30 1.12 Aggregate of all sectors of economy 2.61 2.58 2.61 2.72 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. Note: Turnover rate is calculated as ratio of total number of employees leaving over total employment in each sector in a given year. .. = not available. 4.19. Low overall turnover rates and pay structure that rewards tenure result in high employment durations. More than 44 percent of public administration employees have worked 79 for more than a decade at their representative institutions. At the top management level, more than 90 percent of employees have career tenure exceeding five years. (figure 4.6). According to the Bureau of Labor Statistics in 2010, the median tenure was 7.2 years in the United States’ public sector (7.9 years for the federal government), indicating a similar long tenure profile. However, in Russia, the age distribution of federal-level civil servants shows an uneven distribution. Two large groups dominate—people younger than age 30 and people between age 50 and 59 (figure 4.7). The age profile is fairly consistent, and there are no large differences among those employed by ministries, federal agencies, or federal services. A sharp increase in those who are younger than age 30 is explained by the fact that an increase in civil service occurring over the past decade was predominately at specialist and support-specialist levels that typically fall in that age category. Figure 4.6: Tenure Distribution in Public Figure 4.7: Age Profile of Civil Service: Administration, 2009 Federal-Level Civil Service, 2009 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Sources: Rosstat, http://www.infostat.ru/catalog.html; Bank staff estimates. World Bank staff estimates. 4.20. The gender structure of public employment shows significant underrepresentation of women in top positions and an overrepresentation in support-level positions. In 2009, only 20 percent of top-level managers, top advisers, or top specialists in federal-level civil service posts were women, although women accounted for more than 83 percent of all junior support specialist positions (figures 4.8 and 4.9). 80 Figure 4.8: Shares of Female Employment by Figure 4.9: Shares of Female Employment in Different Categories of Civil Service Posts, 2009 Health and Education Sectors, 2008) Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. C. TRANSITION TOWARD PERFORMANCE-FOCUSED PERSONNEL MANAGEMENT Linking Performance and Pay 4.21. In recent decades, many countries have introduced performance-based budgeting, management, and reporting systems to improve public-service delivery. The focus on performance has led to more flexible approaches to pay setting in the public sector. This involves an adaptation not only to pay levels and structures to account for differences in labor market characteristics, but also to wages based on individual performance, competences, and qualifications. There are wide variations in the degree to which performance-related pay (PRP) is actually applied throughout an entire civil service, and very few OECD country civil service systems can be considered to have extensive, formalized PRP systems (box 4.4) (OECD 2005). In general, the PRP systems are based on the following assumptions: (a) organizations can accurately measure individual, team or unit, or organization outputs; (b) individual and team or unit outputs contribute to organizational performance; and (c) pay can be administered in a way that capitalizes on its expected incentive value for potential recipients. 4.22. Over the past decade Russia has made considerable progress in introducing various elements of performance-management systems, but the implementation of individual performance-appraisal mechanisms is progressing slowly. Remarkably, Russia made considerable progress with the most difficult elements of performance-management systems, including the introduction of a strategic-planning system and performance-measurement mechanism at the federal-level institutions. Yet, the biggest problem is in the less-complex aspects of a performance-management system—individual performance evaluation systems (Verheijen and Dobrolyubova 2007). Formally, the Russian civil service law defines personal performance–evaluation tools, but most of these tools are highly formal and remain disconnected from institutional performance management. Furthermore, a lack of coordination between civil service and budget reforms results in a rigid wage bill funding, linked to the staff schedule under the budget rule. Last but not least, as confirmed by sociological surveys, the implementation of results-oriented, performance-evaluation systems in Russia have not been supported by civil service culture. All of these factors and a lack of methodological guidance on developing individual performance agreements, as well as individual performance indicators, prompted 81 ministries and agencies to choose the traditional remuneration practice consisting of a base salary and additional payments (mainly allowances related to rank and position). The personnel units continue to play administrative roles of keeping personnel records and administering recruitment processes, although the personnel actions are often at the discretion of the head of the agency. Oversight of personnel management is often weak to nonexistent. Career advancement, especially in civil service, is more a matter of length of service (World Bank 2006). Box 4.4: International Practice: Performance-Related Pay in OECD Countries Significant numbers of civil servants were covered by PRP schemes of one kind or another in most OECD member countries, particularly senior managers, but increasingly also nonmanagerial employees. The introduction of performance-pay policies occurred in the context of the economic and budgetary difficulties faced by OECD member countries in the mid-1970s. Reasons for introducing PRP are multiple, but they focus essentially on improving the individual motivation and accountability of civil servants as a way to improve performance. There is no single model of PRP across OECD member countries. Models are diverse and vary according to the nature of the civil service system, the pay determination system, and the degree of centralization or delegation in financial and human resources management. However, common trends are clearly emerging across groups of countries and across the OECD as a whole:  PRP policies have spread from management level to cover many different staff categories in the past 10 years.  Among PRP policies, there has been some increase in the use of collective performance schemes with reference to the achievement of organizational targets, at the team or unit level or the organizational level.  Long-running, standardized PRP schemes have evolved into more decentralized systems, which facilitate delegation of managerial functions.  There is an increased diversity of the criteria against which performance is assessed. Both career-based and position-based civil service systems tend to converge not only in the attention given to outputs, but also in competencies and general social skills.  Performance-rating systems are less standardized, less formalized, and less detailed than they were 10 years ago. On the one hand, performance appraisals rely more on the assessment of preidentified objectives and on dialogue with line management than on strictly quantifiable indicators. On the other hand, systems of rating performance that impose quotas on the number of people who can succeed under them are more widespread across OECD member countries.  The size of performance payments is generally a fairly modest percentage of the base salary, especially among nonmanagerial employees. Merit increments tend to be smaller than one-off bonuses; they are often below a maximum of 5 percent of the base salary. PRP bonuses, which tend to supplement or replace merit increments, are in general higher, but overall, maximum awards usually represent less than 10 percent of the base salary for civil servants. At the management level, performance payments are generally higher, about 20 percent of the base salary. Source: OECD 2005. 4.23. Despite weak performance-appraisal systems, the implementation of a PRP system in public budgetary organizations (non–civil servants) is advancing very rapidly. The legal framework for the new pay system (NPS) was introduced in 2007, and as of December 1, 2008, all federal-level public budgetary organizations are required to use the new system. The new system pursued multiple objectives, including (a) differentiation of remuneration based on performance and outcome; (b) increasing attractiveness to hire qualified staff members; (c) increasing productivity and optimizing the employment size in public budgetary organizations; (d) increasing transparency of pay system; (e) introducing stimulating measures that result in application of knowledge; (f) increasing overall wage levels; and (g) increasing independence of managers of public budgetary organizations. Regional-level public organizations are also introducing the NPS as a basis for remuneration in the public budgetary organizations. As of 2010, 41 percent of regular employees funded by the federal budget have been converted to the NPS. At the regional level, 40 regions have already introduced the NPS and the remaining 43 will make a transition in 2011. 4.24. Although there are many common elements between the new and centralized systems of wage setting, there are important differences in setting the base salary and supplemental benefits (table 4.7). One of the major features of the NPS is the decentralized 82 approach to the base salary setting. The minimum base salary for professional groups is recommended by the federal ministry or agency—the budget holder. The professional qualification groups are approved by the Ministry of Health and Social Services—the regulator in the area of labor issues and employment in the public sector. The variable part consists of allowances, set by the Labor Code and federal legislation, and a discretionary part, the bigger share of which is defined by the organization’s manager. Beginning in January 2010, not less than 30 percent of the federal budget resources, allocated to the remuneration, are required to fund the discretionary part to stimulate performance. However, in practice this share was much higher; in the first half of 2010, bonuses accounted for 44 percent of the wage bill of federal budgetary organizations that introduced the new wage system. The base salary accounted for only 42 percent, and allowances accounted for 14 percent. For public budgetary organizations under the supervision of the Ministry of Economic Development and Trade, the share of bonuses was 52 percent. Table 4.7: Russia: A Comparison of Key Components of the Old and New Wage System Old system New system Base salary Base salary Base salary is based on the Salary Grid set by The head of budget organization sets the base salary according to the government of the Russian Federation. the nature of the work and qualification. The minimum level of base salary for a particular set of qualifications cannot be lower than recommended by the respective federal agency that is overseeing the public budget organization. Allowances Allowances Allowances are set according to norms Allowances are set according to norms specified in the labor code, specified in the labor code, respective federal respective federal laws, and resolutions of the government of the laws, and resolutions of the government of the Russian Federation. Russian Federation. Bonus payments Bonus payments The head of the budget organization can The head of the budget organization is responsible for introducing introduce additional bonus payments using the a system of bonus payments. As of January 1, 2010, the heads of resources from own revenues (non–budget the budget organization are instructed to allocate at least 30 revenues) or optimization of the wage bill. percent of the aggregate wage bill (allocated by the budget) to bonus payments. Wage-setting mechanism for the head of Wage-setting mechanism for the head of the agency the agency No special procedure is used. The base salary for the head of the public budget organization is set by the contract. The base salary cannot exceed five times the average wage level at the public budget organization under his or her supervision. The base salary for deputy heads and chief accountants is set at 10–30 percent less than the base salary of the head of the public budget organization. The bonus payments for the head of the public budget organization is determined on the basis of the performance (results) of public budget organization set by the methodology to evaluate the performance of federal budgetary organizations. Budgeting of the aggregate wage bill is Budgeting of the aggregate wage bill detached from the directly linked with the staffing levels staffing levels Source: World Bank staff. 4.25. The new wage-setting system also introduces strict regulation of wage setting for senior management of public budgetary organizations. The base salaries for heads of organizations are set proportionally to the average salary of key senior staff members. The base salaries for deputy heads and chief accountants are fixed at levels ranging from 10 to 30 percent 83 below the head’s base salary. Determination of the size of discretionary compensation for the senior management is a responsibility of executive agencies—budget holders that are funding public services provided by the organization. The budget holders set performance indicators and can use up to 5 percent of the remuneration fund, aimed to cover salaries of subordinate organizations, for performance bonuses of the heads of organizations. 4.26. Early evidence indicates that the introduction of the NPS resulted in an increase in average wages in federal budgetary organizations. At the end of 2009, the average wage in federal-level budgetary organizations increased by 16.8 percent relative to October 2008. The budget resources allocated to wages increased by 40.4 percent while the own-revenue funds allocated to the wage bill increased by 7 percent. A large increase in the wage bill is explained by the fact that according to regulations, no employee should experience a salary decrease as a result of the conversion to the new system. Therefore, additional fiscal resources were needed to fund performance bonuses. The increase in wages varied widely across institutions, from 13 to 112 percent in education and 15 to 100 percent in science. It remains too early to make conclusions on the effect of the reform on public sector performance. 4.27. There is a temptation (and a danger) for transition countries to develop performance pay as a way to boost public sector performance rapidly or to potentially reduce the size of base salaries when the issue is to improve the appraisal process. Some countries have instituted PRP as a large proportion (50–60 percent) of the base salary. Such policies are counterproductive if implemented within an inadequate management framework with weak monitoring and evaluation because PRP may increase mistrust, corruption, and patronage. It may also lead to a drop in the staff morale, discouraging skilled professionals from entering the public sector. The lessons from OECD countries indicate that success of PRP implementation depends more on the quality of the performance-appraisal process and less on pay alone. The international experience of incentive-pay schemes in the United Kingdom service delivery agencies, such as National Health Service, reveals that these schemes are neither individual nor organizational, but team-based. Thus, the credibility of managerial judgment is important in the performance-appraisal process, and successful implementation is possible in mature and well-established civil service environments (OECD 2005). Although individual results monitoring remains a challenge in Russia, the introduction of performance pay has been supported by parallel policy initiatives on implementing service agreements36 between budget holders and service delivery organizations, which specify volume and quality of public services to be delivered. D. MAINTAINING A FISCALLY SUSTAINABLE WAGE BILL Aggregate Spending Efficiency 4.28. Between 2006 and 2009, the aggregate wage bill increased by about 2.5 percent of GDP to reach 10.9 percent of GDP, an increase of 66 percent in real terms! 37 (table 4.8). During the crisis year 2009, the wage bill measured in real terms (in constant rubles) increased by 2.4 percent at the subnational level and by 13 percent at the federal level as part of the 36 Service agreements were adopted by Government Statutory Act N1065 from December 29, 2008, ―On Procedures of Development and Funding Service Agreements by Federal Executive Authorities and Public Budget Organizations,‖ enforced on January 1, 2009. 37 The amount is an inflation-adjusted expenditure level in rubles. 84 anticrisis response. The wage bill as a share of total expenditures varies from region to region— from as high as 44 percent in Tuva Republic to only 8 percent in oil-rich Tyumen oblast—but the average for Russia is 25 percent. Table 4.8: Average Budget Expenditures on Compensation of Employees in Russia, 2006–09 2006 2007 2008 2009 Percentage of GDP Total 8.5 8.6 8.8 10.9 Federal Budget 3.7 3.8 3.8 4.9 Subnational consolidated budget 4.7 4.8 4.9 5.8 Federal and subnational extra budgetary funds 0.1 0.1 0.1 0.2 Percentage of current expenditures Total 23.9 23.9 26.5 25.2 Federal Budget 19.1 19.0 21.7 19.0 Subnational consolidated budget 31.8 31.9 32.8 33.8 Rub, billions (2009) Total 2,561.4 3,233.1 3,968.5 4,249.6 Federal budget 1,124.0 1,404.3 1,699.5 1,920.1 Subnational consolidated budget 1,400.4 1,784.6 2,213.9 2,268.1 Federal and subnational extrabudgetary funds 36.9 44.1 55.1 61.4 Sources: Ministry of Finance, World Bank staff estimates. 4.29. Increases in the wage bill were driven mainly by increases in wages rather than employment. The largest increases in personnel expenditures were at the subnational level where the average wage bill went up by more than 20 percent per year in real terms (figure 4.10). In 2009, the wage bill jumped in about half of the regions in real terms. An increase in the minimum wage in early 2009 put more pressures on poor regions because they had a higher share of public sector employees with binding minimum wages. The wage bill increased by 27 percent in Ingushetia, one of the poorest regions in Russia. However, the city of Moscow, one of the richest regions, also experienced a sizable increase in the wage bill—an increase of 23 percent. Figure 4.10: Contribution of Employment and Wage Increase to the Aggregate Wage Bill Increase in 2008 Relative to 2007, by Levels of Government Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. 4.30. In recent years before the crisis, public sector wages significantly exceeded growth in real GDP per capita (figure 4.11). By mid-2005, there were early signs that the aggregate demand was outpacing Russia’s long-term productive capacity, resulting in rising inflationary pressures. The real wage growth significantly outpaced productivity growth, exceeding 10 85 percent growth per year in real terms in the period between 2005 and 2008. Average real wages for public sector employees were also growing rapidly, especially in 2005 and 2006. Wages in the public sector continued to increase even in the crisis of 2009, notably in education. Figure 4.11: Real Wage Increases in Russia by Sectors Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. 4.31. Public wage increases, especially in 2009, benefited mostly low-wage earners (table 4.9). In the period between 2005 and 2009, the compression ratio (the ratio of highest and lowest deciles’ average nominal wages) fell in the education, health, and public administration sectors. The wage compression also increased in other sectors, as a result of the minimum wage hike. For example, in the education sector the lowest deciles had an increase in nominal wage by about 50 percent relative to 2007. Table 4.9: Compression Ratios for Select Sectors, 2005–09 2005 2006 2007 2009 All sectors 24.9 25.3 22.1 14.7 Education 15.6 16.5 15.3 10.3 Health 12.6 14.9 13.8 10.1 Public administration 14.7 14.7 13.8 9.8 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. 4.32. Although there were no significant changes in public employment in education and health, civil service employment continued to increase. Between 2005 and 2008, employment in health and social services increased by 2 percent while in education it fell by 2.4 percent (table 4.10). At the municipal level, employment decreased, mainly in education and health. But in the period between 1999 and 2009, aggregate civil service employment increased by 382,000 or 79 percent. Despite both a functional audit of the federal government that identified 1,468 redundant functions and a subsequent reform of the structure of federal executive authorities (a reduction in types of government bodies from six to three),38 the employment level at the federal-level executive bodies also increased. In relative terms, the largest increase was at subnational institutions—an increase by 124 percent. This was also the period of economic boom and high oil prices when the economy registered an average annual growth rate of almost 7 percent. 38 The presidential decree of March 2004 on the system and structure of federal executive authorities was reduced to (a) ministries that are responsible for exercising the functions related to the elaboration of state policy and legal regulation (setting rules function); (b) services that are responsible for exercising the functions related to control and supervision (enforcing rules function); and (c) agencies that are responsible for exercising the functions related to the provision of public service, the management of state property, and so on (implementing rules function). 86 Table 4.10: Changes in Public Employment Levels: Public Administration, Education, and Health Care, 2005 versus 2008 Millions of people Percentage of increase Total Federal Regional Municipal Total Federal Regional Municipal Public administration 0.33 0.23 0.07 0.03 10.1 9.5 19.7 6.3 and defense Education -0.14 -0.01 -0.01 -0.12 -2.4 -0.6 -1.6 -3.1 Health care 0.08 0.01 0.17 -0.10 2.0 2.8 12.4 -4.5 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. 4.33. Despite recent increases, Russia’s wage bill remains comparatively modest, reflecting low wages in education and health. As a share of total expenditure, the wage bill ranged from about 15 percent (Germany) to 33 percent (Denmark) in OECD member countries (figure 4.12). In 2009, as a result of significant growth declines, the aggregate wage bill as a share of GDP increased in almost all OECD countries with the exception of Hungary. But the increase was among the highest in Russia, followed by Denmark, Finland, and Spain. As a share of total outlays, the picture is mixed: In a majority of countries, including Russia, which introduced sizable fiscal stimulus measures, the share of the wage bill in total outlays decreased. But in Russia, relatively high public employment levels and a modest wage bill relative to other countries is a result of relatively low wage levels in the education and health sectors. As a result, without adjustments in employment, pressures to eliminate wage gaps in these two sectors could easily push Russia’s wage bill above 12 percent of GDP. Figure 4.12: Wage Bill as a Share of Total Outlays and as a Share of GDP Sources: International Monetary Fund, Government Finance Statistics dataset, World Bank staff estimates. Wage Bill Control Policies and Practices 4.34. The fiscal decentralization during the past decade resulted in a transfer of decision- making authority related to employment and expenditure to subnational governments. As a result, regions and municipalities were able to set their own standards for service provision within a federal framework and also set their own wage policies for public employees. So fiscal decentralization resulted in the transition from a unilateral pay setting based on centralized norms toward a decentralized system of wage bargaining. But the fiscal autonomy on the revenue side was progressing only slowly, resulting in a discrepancy between the revenue autonomy and spending mandates. Although federal grants and transfers were used to partly narrow the gap, subnational fiscal constraints translated into low education and health sector wages. 87 4.35. At the same time, various fiscal rules and regulations were set to regulate the overall fiscal balances and aggregate wage limits of subnational entities. Strict deficit ceilings for ―subjects of the federation‖ (that is, subnational governments) were introduced in the budget code: The budget deficit of a unit of the federation may not exceed 5 percent of revenues. The public sector wage limits were also set for regions and municipalities that are recipients of federal grant transfers. According to article 85 of the budget code, in regions that are recipients of federal grant transfers, the average wages for regional-level public sector employees cannot exceed the average wage levels of federal-level public sector employees of the same category. Similarly, in municipalities that are recipients of regional transfers, public sector wages cannot exceed levels set by regional authorities. According to the Ministry of Finance, the compliance rate for this rule has increased from 21 percent in 2005, when 54 regions were not in compliance, to more than 80 percent in 2009, with only 8 regions not in compliance. 4.36. There is, appropriately, no automatic indexation of the wage bill so that each indexation and its levels are set according to the annual budget law. The federal budget law specifies the indexation level for key categories of public employment—civil service, military, and judiciary. In 2011, the federal budget law envisions an indexation of wages for military personnel, public administration personnel, judges, and prosecution office personnel by 6.5 percent. 4.37. In general, the appropriation of the wage bill, especially in civil service, continues to be based on the head-count levels set by the normative list of employees multiplied by the wage level. One of the key drawbacks of the centralized wage-setting system was the fact that the budget appropriations and pay bargaining remained linked. This practice for wage bill appropriation encourages budget organizations to leave vacancies unfilled and to use the funds to increase existing employees’ salaries through discretionary benefits and bonuses (or possibly to reallocate the funds to different economic categories). Rosstat data for the first quarter of 2010 indicates that the federal-level executive budget institutions that had higher vacancy rates also tended to have slightly higher average wages (Figure 4.13). Figure 4.13: A Relationship between Average Wages and Vacancy Rates in Federal-Level Executive Agencies, First Half of 2010 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. 4.38. The headcount rule for the wage bill (the wage bill is based on a budgetary organization’s headcount) had simplified control, but also created incentive for the heads of public budgetary organizations to maintain high official headcount. Basing the wage bill 88 on official headcount limits the ability of an agency to align resources toward budget goals. Moreover, with decentralized pay arrangements, it is essential that wage bargaining is separated from budgeting, with those responsible for pay-setting having clear budget parameters established before they agree to pay settlements. The NPS introduces a mechanism designed to delink the wage bill from the staff schedule. Under the NPS, the remuneration fund is linked to organizations’ objectives, functions, and public services offered. Hence, staff decreases do not result in budget reductions, although the budget increases or decreases when the functions change. 4.39. Public budgetary organizations are allowed to supplement wage bill allocations from the budget with their own revenues. On average, 14 percent of compensation of employees is funded by the budget institutions’ own revenues (table 4.11). As a result, at the regional level implicit revenue-sharing arrangements were more significant. Because the revenue-generation abilities differ from agency to agency, this practice contributes to an increase in wage inequality. Table 4.11: Share of Expenditures Funded by Own Revenues by Level of Government, 2009 percent All expenditures Compensation of employees Total 6.7 14.0 Federal 4.6 10.9 Subnational 10.0 17.0 Sources: Ministry of Finance, World Bank staff estimates. 4.40. The introduction of the NPS will also shift the responsibility of individual wage control to heads of public budgetary organizations. The public employment is very fragmented with more than 200,000 separate budgetary organizations that, on average, employ slightly more than 70 employees each (table 4.12). The majority of those budget institutions are at the municipal level, although approximately 36,000 budgetary organizations exist at the federal level. The average size of these federal-level budget institutions is about two times larger than that of the municipal-level budgetary institutions. Table 4.12: Average Employment Level of Each Budget Institution, 2009 number of people Total Federal Regional Municipal Total 73 121 84 56 Education 95 291 106 78 Health 171 143 131 228 Public administration and defense 48 98 43 15 Other 38 109 50 23 Sources: Rosstat, http://www.infostat.ru/catalog.html; World Bank staff estimates. Government’s Efforts to Contain the Wage Bill 4.41. Currently, the wage bill—comprising more than one-fourth of all government expenditure—faces conflicting pressures. Given the budget constraint, one of the most important challenges is to ensure medium-term fiscal sustainability of overall expenditures, including the aggregate wage bill. But as long as public wage levels, especially in education and health, remain low relative to private sector wage levels, pressures on the aggregate wage bill will continue. It is also clear that without structural changes in the education and health sectors, closing this wage gap will come at a significant fiscal cost. The estimated costs of closing the 89 wage gap without adjustment in the number of employment levels in education is estimated to be about 0.82 percent of GDP per year and in the health sector about 0.53 percent of GDP per year. The largest burden would fall on the budgets of subnational entities, where the wage bill would increase by almost a third. 4.42. To contain the cost while increasing individual pay, the government will need to carefully assess priorities and right-size the staffing levels. In education and health, the government’s reform plans to transform public budgetary organizations into autonomous agencies will greatly increase the incentives of managers of these organizations to optimize employment levels. The education system, for example, has significant scope for optimizing inputs without jeopardizing education outcomes. A recent social sector expenditure review (World Bank 2010d) indicates that quantitative inputs such as student-teacher ratio, average school size, and number of schools are significantly correlated with the cost per student, but are not significantly related to educational outcomes. 4.43. In the short term, the government plans to reduce the wage bill of any federal-level budget institution in which the average annual wage exceeds Rub 415,000 per employee. According to Rosstat data, in the first half of 2010, only 12 out of 74 federal-level executive bodies (ministries, agencies, and services) were below this level. Therefore, this rule, if implemented, will be binding to a significant number of federal-level budget institutions. At the same time, there is a risk that this policy measure could undermine the ability of institutions working on more advanced issues requiring specific skills to attract qualified staff members. 4.44. In the medium term, the government plans to reduce the federal-level civil service positions by 20 percent over the next three years. The government has an ambitious plan to reduce staff positions by 5 percent at federal-level executive branches by April 1, 2011, by an additional 5 percent by April 1, 2012, and by an additional 10 percent by April 1, 2013. In addition, a freeze on creating new staff positions at federal-level executive branches is effective until January 1, 2014. The regional governments are also encouraged to introduce similar measures. Experience in other countries indicates that significant and sustained employment and wage reductions were rarely accomplished quickly. They were often accomplished through privatization of select public services and a gradual process of reductions using a mixture of improvements in the establishment and wage bill control systems, coupled with relatively painless devices for incremental reductions in employment such as hiring freezes, attrition, and elimination of vacant posts (box 4.5). By 2013, according to the draft budget law, a combination of short-term and medium-term measures is expected to result in a decrease in the aggregate federal-level wage bill by 0.9 percent of GDP. 90 Box 4.5: International Experience: Options for Restraining the Wage Bill Over the past decades, a number of countries have introduced measures to restrain the wage bill. The following is a summary of key measures (not mutually exclusive) for restraining the wage bill. Retaining savings from vacant positions. Some countries allocate to line ministries at the beginning of the year the full budget amount for approved staff positions. If the average vacancy rate in ministries is 10 percent over the course of a fiscal year, then potential savings worth 10 percent of the ministry wage bill are possible without any reduction in staffing. In some countries, ministries retain the salaries for vacant positions and reallocate these funds as salary top-ups or bonuses for on-board staff members. Furloughs. Instead of formal layoffs (permanent reduction in force), some countries have used forced leave without pay for a few days or weeks to reduce wage expenditure in the current year. This is a one-off measure but may need to be repeated in future years if spending pressures remain a problem. (for example,. Maryland, United States, in 2008–09) Contracting out or outsourcing. It may be possible to contract out some basic service-delivery functions that still remain in the public sector, thereby reducing the wage bill. Examples include many local or municipal functions (garbage collection, snow removal, and health services). Careful cost-benefit analysis is required, because outsourcing may reduce total costs for service delivery and improve service delivery in the process, but such results are not always achieved. Some countries have moved away from filling government positions through the civil service, preferring short- or long-term contract employees. Contract employees can be let go more easily and at lower cost, but this approach can lead to dual personnel systems, with special management challenges (for example, Peru). Wage reduction of current employees. Reducing the wages and benefits of current public sector employees is always difficult, and in some countries may be prohibited by the constitution. But in some cases, countries or even ministries have reduced public sector pay rates to maintain employment and reduce the wage bill (for example, Ukraine in 2008). Downsizing and voluntary retirement. In any discussion around these thorny topics, it is always worth keeping in mind that major downsizing exercises have a pretty poor track record (because of the design complexities and the obvious anguish that they create). Many countries have statutory provisions for separation benefits (severance payments, retraining, and so on), and it is important to note that formal downsizing can actually increase personnel-related expenditures in the year of the downsizing itself. It may take up to two years or more before the net savings of formal downsizing exceed the immediate costs (even if one assumes that the government refrains from hiring or rehiring employees in the interim—as short-term consultants or otherwise) Administrative function consolidation. Identify common administrative tasks across agencies or ministries, and try to consolidate the functions in central services units, downsizing in the process. In 2008, Finland started to implement such measures, creating central, government wide service units for human resource management, procurement, and so on. Taking advantage of gains from automation and modernization. As countries have modernized their public sector—particularly public financial management—the roles and responsibilities of some entities have changed, but the staffing has not been reduced commensurately. Similar approaches can be followed for other sectoral ministries, as well, though the necessary analysis, business processes reengineering, and restaffing would likely require some investment up front, and significant lead time would be needed to implement the reform. Recruitment freeze. Freezes have received bad press and also raise the obvious problem of uneven vacancies; but attrition (retirement, resignation, and death) is generally about 3–5 percent per year, which represents a significant savings and attracts less public attention than formal retrenchment strategies. A partial freeze might also be possible, allowing limited refilling of vacant positions (for example essential services). For example, in the United States during the 1990s, a partial freeze was put in place for the federal government, allowing re-filling of two out of every five vacant posts. Retirement of overage staff members (working pensioners). This may have some impact on service delivery, but is likely to be minimal. Review and rationalization of allowances. It is here where many of the de facto and potentially unwarranted salary increases will be found. Source: Dorotinsky, Manning, and Rinne 2009. 4.45. In the short term, the first reduction of 5 percent in federal-level civil service employment could be achieved by a combination of measures that include the elimination of vacant positions and voluntary retirement of working-age pensioners. At the end of 2009, according to Rosstat the vacancy rate varied from 2 percent at the Ministry of Foreign Affairs to 37 percent at the Ministry of Defense. For the federal-level agencies at the central level, the average vacancy rate reached almost 20 percent, although for those at the regional level it reached almost 8 percent (table 4.13). If the majority of these vacancies are eliminated (setting the vacancy rate no larger than 5 percent in each budget institution), in aggregate terms about 19,000 staff positions equivalent to 3.7 percent of the federal civil service at the executive branch 91 could be eliminated without any actual job losses. Similarly, a voluntary early retirement program targeted to one-fifth of working pensioners could result in an additional elimination of staff positions by slightly more than 8,000, equivalent to 1.6 percent of federal civil service staff members. Table 4.12: Share of Expenditures Funded by Own Revenues by Level of Government, 2009 Baseline, 2009 (%) Changes (number of Changes (%) people) Vacancy Working Vacancy Voluntary Voluntary rate pensioners elimination retirement Vacancies retirement Total 8.1 6.7 19,112 8,320 3.7 1.6 Federal ministries 13.4 14.5 1,648 458 10.8 3.0 Federal agencies at 18.5 12.7 2,156 347 17.4 2.8 central level Federal agencies at 7.6 6.3 15,308 7,516 3.2 1.6 regional level Source: World Bank staff estimates based on Rosstat data. 4.46. In the medium to long term, additional reductions in employment will require the consolidation of administrative functions and gains from automation and modernization. In the past decade, the government has undertaken a broad set of reforms to raise the efficiency and effectiveness of resource use in the public sector and to create more room for private sector growth. However, these reforms have so far not resulted in a leaner and smaller public sector. In the postcrisis environment of much tighter budget constraints, new reforms have potentially far- reaching effects on public sector performance as a whole: overhauling the organization of the public sector, improving energy efficiency, and modernizing infrastructure, especially in the railway and information and communication technology sectors. E. SUMMARY OF RECOMENDATIONS 4.47. The coexistence of high public employment and low funding currently poses a risk to the implementation of effective public sector employment and pay reform. Improving remuneration is fundamental to improving the performance of core public administration functions and incentives, as well as improving the quality of public-service delivery. In addition, the lack of recognition of excellence and poor incentives for performance are likely to further jeopardize both the quality and the access to public services. The skill mix and distribution of human resources for public-service delivery in education and health are not in line with current and future needs. To address these complex issues, this report proposes a number of specific measures to complement the government’s own efforts to help achieve the government’s objectives of reform (table 4.13). Table 4.13: A Summary of Recommendations: Strengthening Public Employment Responsible Options for reform and Suggested agency recommendations sequencing Expected impact 1. Maintaining a sustainable wage bill Reducing wage MOF Decrease aggregate wage bill in Short-term, Increased consistency in bill in public any institution where the ongoing wage levels among budget institutions average annual wage per government government institutions with excessive employee exceeds Rub effort Fiscal sustainability of the wage levels 415,000. aggregate wage bill 92 Responsible Options for reform and Suggested agency recommendations sequencing Expected impact Limiting the MOF Maintain aggregate public wage Medium-term, Fiscal sustainability of the growth of bill below 10 percent. ongoing aggregate wage bill aggregate wage Decrease aggregate civil government Improved public sector bill service size by 20 percent over effort productivity the next three years. Developing a All line Develop a comprehensive Medium-term Mapping of existing gaps comprehensive ministries human resource strategy that and resource needs and human resource includes needs assessment in identification of the optimal strategy terms of required qualifications mix of human resources in key sectors: education and needed in education and health. health sectors, limiting possible shortages in qualifications Improved public sector productivity Advancing MOEd, MOH In health, a gradual shift from Medium-term Increased expenditure structural reforms impatient care toward efficiency in health and preventive care provides a education sectors substantial scope for improving the allocation and use of available resources by restructuring the organization of heath facilities network. In education, there is a need to introduce a more flexible mechanism of teacher remuneration that would be tied to teacher performance and will depend on concrete outcomes of teacher activities in the classroom. Streamlining All line Divest government functions Short-term, Improved expenditure government ministries other than core functions to ongoing efficiency (municipal) specialized entities established government administration specifically for servicing effort several government authorities or contracting out services (outsourcing). Enhance incentives for the heads of federal authorities to right-size the number of staff of their central headquarters and territorial branches, and cut budget expenditures to support their operations. Right-size the number of federal government civil servants in relation to other staff members in federal government authorities, Streamline the network of government (municipal)- owned unitary enterprises. 93 Responsible Options for reform and Suggested agency recommendations sequencing Expected impact 2. Improving pay structure: Linking performance and pay Improving the All ministries Minimize nonperformance- Short-term, Improved motivation and structure of wages related benefits and medium-term increased staff retention in the public allowances. The use of Strengthening of incentives sector collective performance for employee performance schemes can be also considered. (The team is more important for the attainment of the organization’s goal than is its individual members.) Limit the share of total remuneration based on seniority. Introducing an All ministries Develop performance appraisal Medium-term Support of a successful efficient, procedures. implementation of transparent, and performance pay accountable A precondition for implementation of successful implementation performance of Performance Related Pay appraisal systems procedures A regular MOH Administer a regular Medium-term Help in identifying monitoring and monitoring and evaluation of methodological and capacity evaluation of performance pay practice, gaps and in addressing them performance pay accompanied by the on a timely basis practices are dissemination of best practice. Addressing possible needed. Monitoring and evaluation is accountability and also curtailed to ensure that the implementation risks reform achieved its objectives. Strengthening All ministries Strengthen human resource Medium-term Support of a successful human resource management capacity in public implementation of management sector organizations. performance pay capacity in public sector organizations Note: MOEd = Ministry of Education; MOF = Ministry of Finance, MOH = Ministry of Health and Social Services. 94 APPENDICES APPENDIX A: Functional Classification of General Government Expenditure percentage of GDP Environmental General public Total outlays Housing and Public order culture, and Recreation, community protection Education protection and safety Economic amenities Defense services religion Health affairs Social Advanced countries Austria 2007 6.96 0.86 1.44 4.63 0.46 0.62 7.60 1.09 5.19 19.97 48.82 France 2008 7.12 1.76 1.24 2.80 0.86 1.88 7.84 1.53 5.85 21.80 52.67 Germany 2008 5.98 1.07 1.54 3.39 0.48 0.78 6.24 0.61 4.00 19.75 43.84 Luxembourg 2008 0.32 0.28 1.01 4.75 1.14 0.92 4.80 2.04 5.23 25.64 40.48 Netherlands 2008 7.30 1.33 1.83 4.93 0.84 1.06 5.97 1.35 5.25 16.06 45.91 Australia 2008 3.32 1.47 1.59 3.74 0.46 0.86 5.90 0.75 4.44 8.69 32.44 Denmark 2008 6.74 1.53 1.04 2.87 0.50 0.47 7.79 1.59 7.01 22.40 51.94 Iceland 2008 6.50 0.06 1.52 19.51 0.66 0.51 7.94 3.79 8.37 8.93 57.82 Israel 2008 5.63 7.44 1.72 2.64 0.65 0.50 5.22 1.46 7.20 11.38 43.85 Japan 2006 4.66 0.94 1.41 3.81 1.29 0.66 7.12 0.13 3.87 12.29 36.17 New 2007 4.62 1.09 1.71 3.52 0.43 0.71 5.62 1.59 5.65 11.77 36.72 Zealand Norway 2008 4.34 1.56 0.89 3.60 0.58 0.61 6.73 1.08 5.19 15.31 39.90 Singapore 2008 2.06 4.29 0.91 2.16 1.27 1.07 0.25 3.24 2.13 17.38 Sweden 2008 7.55 1.49 1.38 4.97 0.36 0.74 7.00 1.05 6.94 21.51 53.09 Switzerland 2007 4.94 0.88 1.67 3.81 0.56 0.38 4.09 0.88 5.74 14.00 33.50 United 2008 4.93 4.57 2.22 4.01 0.00 0.70 7.91 0.32 6.41 7.49 38.56 States Central and Eastern Europe Albania 2006 6.32 1.30 1.84 4.47 1.66 2.42 0.37 3.16 7.80 29.32 Bulgaria 2008 4.28 1.99 2.86 4.36 1.13 1.13 4.24 0.90 4.14 11.80 36.84 Croatia 2008 4.71 1.55 2.35 4.92 0.27 1.92 5.71 1.31 4.15 13.77 40.66 Czech 2008 4.61 1.18 2.11 7.52 1.05 1.35 5.92 1.07 3.86 12.46 40.71 Republic Hungary 2007 9.36 1.26 1.98 6.56 0.71 1.00 4.87 1.46 5.30 17.35 49.79 Latvia 2008 4.16 1.50 2.19 7.27 1.03 1.23 3.56 1.73 6.46 9.31 38.45 Lithuania 2008 3.12 1.34 1.92 4.46 0.96 0.53 5.72 1.35 5.89 12.29 37.58 Poland 2008 5.49 1.62 2.03 4.94 0.62 0.81 4.74 1.23 5.28 16.27 43.03 Slovak 2008 5.64 1.35 1.93 4.95 0.79 0.74 6.52 1.01 3.24 10.18 35.73 Republic CIS and Mongolia Belarus 2008 6.53 1.09 1.91 12.84 0.41 2.41 4.15 1.23 5.67 12.46 48.71 Georgia 2007 0.27 8.82 4.27 2.08 0.45 2.94 1.54 1.04 2.70 4.85 28.95 Kazakhstan 2007 1.99 1.32 1.91 3.48 0.12 1.59 2.37 0.97 3.61 3.99 20.56 Russian 2010 Federation 4.10 2.90 3.00 4.90 0.10 1.70 3.60 0.70 4.00 13.20 39.20 Ukraine 2008 3.21 1.19 2.57 5.72 0.25 0.96 3.73 0.86 6.33 20.58 45.40 Source: International Monetary Fund Government Finance Statistics dataset. Note: CIS = Commonwealth of Independent States. 95 APPENDIX B: Economic Classification of General Government Expenditure in Advanced G-20 Countries, 2008–09 percentage of GDP Country Russian Australia Canada France Germany Italy United United Federation Kingdom States 2008 2009 2008 2009 2008 2008 2009 2008 2009 2008 2009 2008 2009 2008 2009 Total 33.4 39.9 31.40 34.72 38.5 52.0 54.4 43.9 47.7 48.5 51.4 46.0 50.1 22.7 25.8 Compensation of 8.8 10.2 8.76 9.30 11.6 12.7 13.2 6.9 7.4 10.8 11.3 11.0 12.0 2.8 3.1 employees Use of goods and 5.3 6.3 6.16 6.58 9.5 5.0 5.3 4.3 4.7 5.5 6.1 12.3 13.4 3.0 3.1 services Consumption of fixed 3.7 4.1 1.26 1.36 2.0 2.6 2.7 1.6 1.7 1.8 2.0 0.9 1.0 0.8 0.8 capital Interest 0.6 0.5 1.28 1.40 3.8 2.8 2.4 2.7 2.6 5.1 4.6 2.3 1.9 2.0 1.9 Subsidies 4.1 5.4 1.32 1.41 1.1 1.4 1.5 1.1 1.4 1.0 1.0 0.6 0.7 0.4 0.4 Grants 0.1 0.2 0.16 0.23 2.7 3.4 4.1 Social benefits 9.7 12.4 9.45 11.64 7.5 23.3 24.7 24.4 26.6 20.4 22.1 13.1 15.1 9.7 11.3 Other expense 0.9 0.3 3.02 2.80 0.4 4.2 4.5 2.9 3.3 3.8 4.4 5.8 6.0 0.6 1.1 Sources: International Monetary Fund Government Finance Statistics dataset; Ministry of Finance (Russian data). Note: G-20 = Group of Twenty. 96 APPENDIX C: Main Social Protection Programs in the Russian Federation, 2010 Programs Eligibility Benefit Financing and Administration Pension (labor) Women age 55+, men Monthly cash benefit Contributory; Three pillars (PAYG, age 60+, disabled and funded, and voluntary); financed by the survivors social tax paid to the Social Insurance Fund; administered by the Pension Fund Unemployment Officially registered Monthly cash benefit for a maximum Noncontributory; general revenue benefit unemployed duration of 12 months; 75 percent of the financing; administered by the previous wage for the first three months Employment Services of unemployment, 60 percent for the next four months, and 45 percent for the next five months; minimum (20 percent minimum standard of living) and maximum thresholds Sick-leave Employed, temporarily Monthly cash benefit for limited period Contributory; funded by a tax paid to compensation unable to work the Social Insurance Fund; administered by enterprises Maternity Employed mothers Monthly cash payment Contributory; financed by a tax paid to leave before delivery (70 the Social Insurance Fund; days) and after (70 administered by enterprises days; 110 days for more than one child) Social pension Women age 60+, men Monthly cash benefit Noncontributory; general revenue age 65+, and people financing by the federal budget; with disabilities administered by the pension fund (including those disabled since childhood) ineligible for labor pension and with no other source of income Housing Income tested; based on Monthly housing subsidy Noncontributory; funded and allowance share of family budget administered by local governments spent on Housing and Utility Services norms Social Income based One-time or monthly benefit in cash or Noncontributory; funded and assistance in kind administered by local governments benefits Child Children from families Monthly cash benefit until the child Noncontributory; funded and allowance with per capita income reaches age 16 (age 18 if in school) administered by local governments below regional subsistence minimum Privileges and Various categories of Discounted or free goods and services Noncontributory; funded by federal and subsidies individuals and (food, transportation, housing and regional budgets; administered by families; merit or needs utilities, recreation and rehabilitation, regional governments. based health services, preschool, training) Social work Vulnerable children and Counseling services, rehabilitation, day Noncontributory; funded by regional and care youth and their families; care, temporary shelters, psychosocial and local governments; administered by services adults and elderly support local governments Residential Children deprived of Long-term placement in residential care Noncontributory; funded by regional care in parental care, poor and local governments; administered by institutions children, children and local governments adults with disabilities, and frail elderly Source: Authors based on World Bank Living Standards Survey 2009. Note: PAYG = pay as you go. 97 APPENDIX D: Distribution of Functional and Institutional Classification of Federal Budget Expenditures, 2010 percent National economy National defense Public order and Budget transfers Healthcare and Environmental Housing and communal protection Education services security sports Ministry of Regional Development 21.4 2.4 3.3 6.6 Ministry of Health; Ministry of Sports, 71.0 6.9 0.5 6.8 Tourism, and Youth Policy Ministry of Finance 2.4 0.3 84.5 0.7 2.2 18.0 0.5 Ministry of Interior, Ministry of Emergency 19.0 11.2 0.2 91.7 0.0 1.0 8.7 Situations, Ministry of Justice Ministry of Defense 50.9 10.4 0.1 92.5 0.0 13.1 Ministry of Industry, Ministry of Energy, Ministry of Economic Development, 3.3 0.8 4.8 4.5 56.3 8.8 1.2 Ministry of Agriculture, Ministry of Transport Ministry of Education and Science 1.2 0.7 0.7 49.3 Ministry of Natural Resources and Ecology 0.2 2.9 98.8 Other ministries 1.8 6.4 0.3 7.5 0.8 17.3 6.3 Total 100 100 100 100 100 100 100 100 Source: World Bank staff estimates based on budget execution reports. 98 APPENDIX E: International Experience: Performance-Based Maintenance Contracting in Estonia and Argentina The Case of Estonia From 1995 through 2000, the Estonian National Road Administration (ENRA) tested several one-year and two-year performance-based contracts (PBCs). Satisfied with the results of these experiments, the ENRA moved in 2000 to using longer-term performance-based contracts on a regular basis. By 2005, 63 percent of the national road network, specifically 10,288 kilometers of paved and gravel roads, was covered under five-year PBCs, which were fully funded from the central government budget. PBCs are awarded for those road corridors where only maintenance is warranted, not rehabilitation. These contracts typically cover routine maintenance and winter maintenance (snow removal, snow blowing, and ice cleaning). As of February 2005, 5 private contractors were commissioned to execute 12 PBCs. These contracts may not be renewed. At the end of the fifth year, the contractors that have completed their obligations, and are interested in continuing for another 5-year term, must participate in an open, competitive bidding process again. The legislative framework actually permits extension of contracts for up to an additional two years, but contractors in Estonia are interested in longer terms and prefer going through a competition again. In 1995, a consulting company was hired to supervise one-year and two-year pilot PBCs. After analyzing this experience, the ENRA and its regional offices concluded that the supervision of PBCs required fewer personnel and fewer resources than with the traditional method of procurement and could be done by in-house staff. At present, the supervision of contractors executing PBCs is arranged through periodic informal and regular monthly inspections. Typically, periodic inspections are done by a single supervisor from the road agency. Other agency staff members can be engaged if their assistance is needed to resolve emerging problems. Regular monthly inspections are conducted by an official commission, appointed by decree by the head of the respective road region. The commission usually consists of three supervisors, one traffic person, and two representatives from the ENRA. Contractors are not official members of the commission, but the decree indicates that it is the contractor’s responsibility to assign the appropriate people to represent their interests during the commission’s inspections. Though the contractors are not obliged to attend monthly inspections, they receive invitations from the ENRA (or its regional offices) to participate, and they always do. The ENRA is interested in the physical presence of the contractor, because the contractor helps discuss identified defects and resolve possible disputes on the site. To avoid corruption among the parties concerned and achieve better contractor accountability, one of the regions (Kagu) has rotates its three commissions from county to county when they are to conduct monthly site inspections. Road users are also encouraged to participate in monitoring and evaluation of the contractors’ work. Billboards with contact information are established along the contracted road corridors to report any deficiencies. Since the deployment of a PBC approach, the ENRA has noticed a decrease in the number of complaints from road users regarding road conditions. In 2003, the number of personnel at the ENRA and regional offices was reduced by 283 people (29 percent) as a result of the road management organization reform. One of the reasons was the outsourcing of routine maintenance works under PBCs, which results in the need for fewer workers to continue executing other kinds of road works and fewer administration staff to administer and supervise PBCs. 99 The ENRA and its state agencies have established strong partnership relations with their contractors. The administration arranges biannual workshops to bring together representatives of the contractors and road agencies involved in PBCs. The main objective of such events is to share experiences of different counties, collaboratively discuss lessons learned, and find innovative solutions for future implementation of PBCs. The Case of Argentina The first step for the introduction of maintenance contracts was a nationwide road survey to estimate traffic, determine the minimum road standards, define the rehabilitation and maintenance required, and identify the size and shape of the road network for contracting out. Roads with traffic in the range of 300 to 3,000 annual average daily traffic (AADT) were deemed eligible for output-based contracting, while those with traffic in excess were deemed concessionable. Using survey information, the government set uniform national output indicators for the contracts. Introduced in August 1995, the first output-based contracts were kilometer-per-month contracts spanning four years and covering about 3,600 kilometers. The 11 contracts covered roads that were in good and fair conditions and expected to require only routine maintenance. Contractors were paid equal monthly installments for specified services, as long as the quality of outputs complied with the technical specifications. Given the satisfactory outcome, these contracts were renewed for a further four years. Given this positive experience, a contract was then designed that combined rehabilitation and maintenance of paved roads—contrato de recuperación y mantenimiento (CREMA), requiring the contractor to rehabilitate and then maintain a network of roads for five years for a lump-sum amount. Each contract covers road sections varying in length from 100 to 300 kilometers. The contract specifies the sections that need rehabilitation and the minimum solution required to ensure a positive net present value. Bidding is done through international competitive bidding. Only after the contract is awarded does the contractor prepare a detailed engineering design, proposing any rehabilitation solution above the minimum threshold defined in the contract, which requires making a judgment about how much up-front rehabilitation is required to raise the roads to a level at which they can be cost-effectively maintained. The payment schedule is designed to provide incentives for the contractor to maintain the network for the full length of the contract. Up to 60 percent is paid by the end of the first year, when rehabilitation works are completed, with the remaining payments in 48 equal monthly amounts. In addition, the contract requires a performance guarantee of 20 percent. Throughout the contract period, performance is assessed during monthly on-site inspections by the government engineer and the contractor to verify compliance with minimum standards—meet or exceed the minimum thickness of overlays and not exceed the maximum level of roughness, rut depth, or cracking or raveling. Regular visual inspections verify the existence of potholes, cracking and rutting, condition of shoulders, culverts and rails, as well as guardrails and vertical and horizontal signs. The CREMA program was designed to be implemented in two phases. The first phase involved a network of 11,700 kilometers, 55 percent of the nonconcessioned national paved network. In 1997, 60 contracts were signed, averaging about 180 kilometers in length. The contracts were awarded mainly to local construction companies—with high private sector participation—with 100 each contract attracting between 5 and 20 proposals. The second phase involved 4,000 kilometers and 20 contracts and was initiated in August 2000. By making long-term payment obligations legally binding on the government, the CREMA contracts have prevented the Treasury from failing to provide funding for road maintenance. The program has substantially improved the condition of the network, reducing the share of roads in poor condition from 25 percent to less than 5 percent by the end of 1999. Damage to roads caused by vehicle overloading is being address by asking contractors to provide and operate devices for measuring axle-loads and to report overloading to the relevant authorities. By holding contractors accountable for the future quality of roads, PBCs have built-in incentives to keep the contractors focused on road condition during the execution of works. Sources: Liautaud 2001; World Bank 2006b. 101 APPENDIX F: Comparative Unit Costs in Road Works A recent report produced by the World Bank has reviewed road sector contracts under World Bank–funded projects in 14 countries in Europe and Central Asia—Albania, Armenia, Azerbaijan, Bosnia and Herzegovina, Bulgaria, Croatia, Estonia, Georgia, Kazakhstan, the former Yugoslav Republic of Macedonia, Poland, Romania, Serbia, and Ukraine (Alexeeva, Queiroz, and Ishihara forthcoming). The data cover 200 completed and ongoing road works contracts signed between 2000 and 2010. This provides useful comparative information on unit costs for different road works interventions. Higher unit costs for rehabilitation, reconstruction, and construction works can reflect, in part, higher design standards, such as geometric horizontal design with a long radius of curvature and thicker pavement layers, terrain type, and the existence of well-developed road construction industry, among others. With these caveats in mind, table F.1 presents rehabilitation, reconstruction, and construction costs for interurban and regional roads. For rehabilitation and reconstruction, unit costs are on the high side for Ukraine and Kazakhstan when compared to another former Soviet Union republic, Estonia. Table F.1 Rehabilitation, Reconstruction, and Construction Costs for Interurban and Regional Roads 2009 US$ per kilometer Rehabilitation and reconstruction New construction costs costs Country Albania n.a. 822,746 Armenia 186,876 n.a. Azerbaijan 413,945 1,656,151 Bosnia and Herzegovina n.a. n.a. Bulgaria 417,284 173 Estonia 182,283 n/a Georgia 220,797 1,546,638 Kazakhstan 878,703 n.a. Macedonia, FYR n.a. n.a. Poland 479,540 1,596,966 Romania n.a. 1,668,658 Serbia 235,099 n.a. Ukraine 828,523 n.a. Source: Alexeeva, Queiroz, and Ishihara forthcoming . Note: n.a. = not available. To compare like with like, the report provides not only unit cost data per kilometer of road works, but also average unit rates of asphalt concrete, Portland cement, and Portland cement concrete pavement and of milling of asphalt layers. Table F.2 reproduces the average unit rates of road works, and once again, asphalt concrete unit costs are much higher for Ukraine and Kazakhstan than for Estonia. 102 Table F.2 Average Unit Rates of Road Works 2009 US$ per cubic meter Asphalt concrete Portland cement concrete Asphalt mix/bituminous Country Albania 167 107 152 Armenia 222 n.a. n.a. Azerbaijan 75 353 77 Bosnia and 153 n/a n.a. Herzegovina Bulgaria 189 173 139 Estonia 86 n/a n.a. Georgia 145 128 n.a. Kazakhstan 135 n.a. n.a. Macedonia, FYR 140 n.a. 111 Poland 129 116 98 Romania 145 80 108 Serbia 176 n.a. 113 Ukraine 153 160 106 Source: Alexeeva, Queiroz, and Ishihara forthcoming . Note: n.a. = not available. The report highlights red flags or alert indicators of potential entry points for corrupt activities at various stages of project cycle, including the following:  Period between bid opening and contract-signing dates is more than 7 months.  Cost increases by more than 20 percent during implantation.  Time overrun is more than 30 percent of the originally contracted period.  Contract value is more than 20 percent above the engineer’s estimate.  Half or more of firms buy bidding documents but do not bid.  Twenty percent or more of prequalified firms do not bid.  The difference between a winning bid and next lowest bid is less than 2 percent.  The difference between contract price and read-out bidding price is more than 10 percent.  The winning bid is not the lowest bid accepted for detailed examination.  Only one or two entities supply bids. 103 APPENDIX G: Russian Railways Network, 2010 Source: Russian Railways. 104 APPENDIX H: Russian Railways High-Speed Passenger Transport System Planned for Completion by 2030 Source: Russian Railways. 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Geneva: World Economic Forum. 110 This map was produced by the Map Design Unit of The World Bank. 70°N 80°N 80°N UNITED STATES OF AMERICA The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank A RCT IC O CEA N Group, any judgment on the legal status of any territory, or any Bering St endorsement or acceptance of such boundaries. ra Nor wegian Sea it 60°N NETH. NORWAY ng e Ra DENMARK r y B a r e n t s Franz Josef da SWEDEN East Siberian An GERMANY S e a Land Sea Anadyr Severnaya New Siberia Zemlya Islands Murmansk Novaya RUSSIAN FINLAND FED. Zemlya Kaliningrad Kola Laptev ESTONIA Pen. Kara Sea Sea LATVIA POLAND LITH. Karelia la insu In St. Petersburg Pen di Kolyma Pskov m yr ange Tay g irka Petrozavodsk Arkhangel'sk Novgorod Che rskiy BELARUS Nar'yan Mar Ran Kolmya R Yamal ga ge a wland n Smolensk Tver Pen. at Lo Vologda Gyda Kh Siberian MOSCOWYaroslavl Kotlas Vorkuta Pen. Bryansk Kaluga UKRAINE s. 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