Reassessing Rail Reregulation

Tags: Legislation, Public Policy, and Regulations, Intermodal, Rail

Will rail reregulation untie captive shippers but tie up rail productivity?

In the 30 years since the Staggers Act deregulated the American railroad industry, rail rates have dropped 55 percent, volumes have nearly doubled, and railroads have invested more than $460 billion in their systems, "according to the Association of American Railroads (AAR). But some shippers still perceive that they are captive to the railroads and subject to — or victims of — their market power.

That sentiment is echoed strongly by West Virginia Senator John D. Rockefeller IV, chairman of the Senate Committee on Commerce, Science, and Transportation. “The railroads are earning 12- and 13-percent profit margins, which puts them at the top of the Fortune 500,” Rockefeller said in a recently issued staff report. “And they’re just getting more profitable because they’re raising their shipping prices by an average of five percent each year.”

While railroads tell regulators they are barely earning sufficient revenues, they boast of profits when talking to Wall Street analysts, Rockefeller says. “Whether we do it this year or next year, railroad reform is going to happen,” he notes. “Either Congress will do it, or it will need to be done through regulation.”

Another call for stricter regulation comes from Senator Herb Kohl, chairman of the Judiciary Committee’s Subcommittee on Antitrust, Competition Policy and Consumer Rights.

“It is crucial that antitrust law enforcement be a part of our nation’s rail policy,” Kohl told Sen. Rockefeller’s committee. “For decades, freight railroads have been insulated from the normal rules of competition followed by almost all other parts of our economy by an outmoded and unwarranted antitrust exemption.”

In response, the AAR vehemently disagrees that there is a need “to roll back the successes achieved since the 1980 Staggers Act. Imposing new Washington regulations will undermine the railroads’ ability to sustain private investments in the nation’s rail network that provide hundreds of thousands of American jobs, and the foundation for both freight and passenger rail.”

The railroads spent $21.8 billion of their own private capital in 2008, and $20.2 billion in 2009, to build, maintain, and modernize the nation’s 140,000-mile rail network that serves both passengers and freight, according to the AAR.

“There’s nothing wrong with success,” insists the AAR. “We’ve run smart, successful businesses, improving efficiency and service for our customers while keeping prices below what they were 30 years ago. Now is not the time to inject greater regulatory involvement from Washington, but instead to keep letting the current balanced system work.”

The deregulation of the railroad industry “ushered in increased market flexibility, competitive and differential rates for rail service, and a climate open to innovation,” notes consulting firm Laurits R. Christensen Associates Inc. in a report to the Surface Transportation Board (STB), the regulatory body overseeing the railroads.

“In the years following the passage of The Staggers Act, the railroad industry experienced dramatic reductions in costs and increased productivity, which yielded higher returns for carriers and lower inflation-adjusted rates for shippers,” the report states. “Thus both railroads and their customers benefited from regulatory reform.”

For the first time since it was created in 1996, the STB is facing reauthorization by Congress. Among the changes proposed in the reauthorization bill — S. 2889, sponsored by Sen. Rockefeller — the STB would be moved out of the Department of Transportation and become an independent agency. Board membership would increase from three to five members. The bill also takes aim at class exemptions, the Uniform Railroad Costing System, and rail interchange agreements.

STB Chairman Daniel R. Elliott III offers his support, at least for part of this proposal: “I plan to examine the rules the agency has in place regarding rail-to-rail competition,” he says. “It is time to explore the commodity exemption system.

“The STB is extensively reviewing its Uniform Railroad Costing System — the agency’s general purpose costing model — which estimates the variable cost of transporting goods by rail,” he says.

Let’s Be Reasonable

Elliott addresses some concerns raised about captive shippers. “Only common carrier rates (as opposed to rates contained in a contract) for non-exempt commodities by market dominant carriers are subject to rate review,” he notes. “It is in those instances where it is most important that the agency be able to step in: rates for captive shippers that have no competitive alternatives. The statute mandates that such rail rates be ‘reasonable.’”

Illustrating the difficulty of striking a balance between protecting shippers and preserving the railroads’ ability to attract capital investment, Elliott cites a Russian ban on wheat exports, which, he suggests, would increase demand for U.S. wheat.

“The railroads’ role in the supply chain will be even more vital than usual,” Elliott says. “And, with the railroads significantly reducing their number of employees and equipment in use in 2009 due to the poor economy, some parts of the shipping community are concerned about whether the rails will be able to provide adequate service as traffic levels continue to increase.”

Deputy Secretary of Transportation John D. Porcari voices a similar concern. “Freight railroads will need to be profitable to attract the level of private capital investment necessary to assure that the rest of their systems are built and maintained to meet our future freight mobility needs.”

Porcari appears to hedge on the proposed legislation, however. “Finding the correct balance will be difficult. History would indicate that we will be very fortunate indeed if we find this balance the first time.

“The Staggers Rail Act of 1980 was the fourth piece of legislation enacted within a decade to address the rail financial crisis,” he adds. “So any policy changes need to include provisions for quick correction if they are found to be detrimental to transportation investment.”

Congestion issues will still need to be addressed, as they have been with the development of the Alameda Corridor and Chicago’s CREATE projects. Porcari adds the need for commitments from state and local partners. “They, too, need to put into place the appropriate policies, program structures, and investments — both public and private — to achieve this enhanced opportunity for rail,” he says.

A more immediate snapshot of shipper experience and expectations comes from Morgan Stanley’s newly released Freight Pulse Survey. The 19th semi-annual survey of shippers indicates volume growth estimates are “robust but decelerating.” Rates, however, are on the rise.

On the general economic front, shippers report that orders are rising faster than inventories, indicating the volume increases are less about restocking and more about market growth.

In addition, shippers report ample capacity, although they express some near-term concern about tighter truckload and intermodal capacity. So, mode shifting is more a function of trying to improve on pricing than it is a search for capacity.

The picture on volumes is turning positive. The Freight Pulse Survey, released in September 2010, covers current conditions and six-month projections. Shipper respondents to the September survey say they expect a two-percent increase in rail volumes. This was lower than the 2.6-percent increase indicated in the April 2010 survey, but those two surveys follow three successive surveys indicating volume declines. In the October 2008 report, shippers indicated a slight drop in rail volumes, followed in April 2009 by a two-percent decline, and in October 2009 by another 1.5-percent drop.

The 2010 surveys are the first time since September 2006 that shippers have forecast an increase of more than one percent in expected rail volumes.

Half of shippers say they expect rail spending to increase by one percent to five percent. That number jumps to 72 percent of shippers when the range is extended to include a six- to 10-percent increase. The expected rate increase change is back up to 3.1 percent, the highest it has been since the 3.5 percent reported in September 2007.

Leveraging other modes is the top negotiating tool shippers report using against rate increases. That said, six percent of shippers say they are shifting significant volumes from motor carriage to rail, and 50 percent say they are shifting some volumes to rail. Tighter capacity and rate pressure in the truckload sector have made rail competitive on price, but lead times are the biggest obstacle for those shifting from truckload to intermodal.

Service is also a concern for bulk shippers who perceive railroads are giving preference to higher-value, time-sensitive intermodal traffic. And organizations representing large-volume shippers and rail users — such as agriculture, chemical, and power generation — add examples of substantial rate increases to their argument.

Pricing issues may derive in part from one of The Staggers Act’s key provisions — the ability of railroads to negotiate confidential contracts with shippers. One of the first following the enactment of The Staggers Act in 1980 was a 30-year contract for moving coal.

Though that’s an exception more than a rule, analyst firms have long reported the effect on rates and railroad earnings when long-term contracts come up for renegotiation. While legacy rates and terms may have weighed on rail earnings, the new rates also can skew the picture of overall rate increases.

The Christensen report to the STB examines rates and rate structures, as well as “captive shipper” concerns, and advises that railroad ratemaking is a complex and specialized process.

“For most years in the 1987 to 2006 period of our study, the Class I railroad industry does not appear to be earning above normal profit,” says the report. “The increase in railroad rates experienced in recent years is the result of declining productivity growth and increased costs rather than the increased exercise of market power.”

What Price Rate Relief?

While industry groups representing bulk shippers argue for rate relief and closer regulation, the Christensen report says that providing significant rate relief to certain groups of shippers will likely result in rate increases for other shippers or threaten railroad financial viability.

Rail ton/miles have increased steadily while track owned or operated has declined, leading to more intense use of existing networks. “This increasingly intensive use of rail networks results in lower per-unit costs — a reflection of economies of density,” says the report.

In keeping with Government Accountability Office findings, the Christensen study shows that the number of shipments moving at more than 300 percent of revenue/variable cost (R/VC) increased; so had the number of shipments moving at less than 100 percent R/VC.

“Correctly assessing the presence of market-dominant behavior requires direct assessment of relevant market structure factors,” notes the report. “Thus, regulatory reforms that would establish R/VC tests as the sole quantitative indicator of a railroad’s market dominance are not appropriate.”

Incremental policies such as reciprocal switching and terminal agreements have a greater likelihood of resolving shipper concerns via competitive response, and have a lower risk of leading to adverse changes in industry structure, costs, and operations.

Railroad unit costs have risen while productivity gains have slowed. “One effect of this slowing productivity growth is the diminished ability of railroads to absorb increases in their input prices in recent years,” says the report.

Differential Pricing

“Economies of density arise when the average cost of serving customers decreases as the volume of business increases over a network,” says Christensen. When economies of density are present, marginal cost pricing does not produce enough revenue to cover a firm’s total cost, and it must find alternative pricing or funding.

Differential pricing (i.e., charging different price markups over marginal costs to different customers or customer classes) is recognized in economic literature as a way to achieve sufficient revenue in the presence of economies of density, notes Christensen. This is the case with other network industries as well as the railroad industry, with different customer groups facing different levels of price markups over marginal costs.

Since the passage of the Staggers Act, freight rail transportation rates have been largely deregulated, with the Surface Transportation Board providing a regulatory backstop for captive shippers. Differential pricing is acknowledged by policy as a method by which railroads achieve revenue adequacy, with the STB determining whether the degree of differential pricing is reasonable if a rate is challenged, explains Christensen.

STB Chairman Elliott seems to support this view for moderation in the STB’s approach. “As economic conditions continue to improve, the Surface Transportation Board will need to monitor how and to what degree it should reexamine and tailor its regulatory policies to meet new conditions,” he says.

“Although the railroad industry’s earnings have increased in recent years, they do not appear to be excessive from a financial market perspective,” notes the Christensen report. “Among the financial metrics we examined, one commonly cited financial measure is earnings per share. We found that from 1997 to 2006 there were many similarities among the financial performances of the rail industry, the electric utilities industry, and the S&P 500 composite.

“Overall, the railroad industry is pricing at levels generating earnings that maintain or slightly exceed those necessary to ensure financial viability,” notes Christensen in its assessment to the STB. This implies there is little room to provide significant “rate relief” to certain groups of shippers without requiring increases in rates for other shippers or threatening the railroads’ financial viability.

In the end, the Christensen report places the responsibility for the next step with the regulators: “While economic analysis may be able to quantify benefits and costs to specific stakeholders given more precise policy proposals, the cost/benefit balance will ultimately be struck by policymakers.”