Transportation Systems Casebook/Revenue Adequacy

Summary

As it did with most industries the heavily regulated environment era left railroad companies in a detrimental financial state. In times pre the Staggers Act of 1980, in the early 1970’s, the rail industry experienced financials hardships due to regulation. Rail companies were unable to adjust rates, merge or abandon obsolete services. Efficiency and reliability were among the major problems and some railroad companies began to go bankrupt. The first concern of “Revenue Adequacy” was first rooted in the 1976 Railroad Revitalization and Regulatory Reform Acts. The section of this act dealt with tasking the Interstate Commerce Commission (ICC) with developing “standards and procedures for the establishment of revenue levels adequate to cover total operating expenses including depreciation and obsolescence, plus a fair and economic profit or return (or both) on capital employed businesses.” The Interstate Commerce Commission in 1979 defined revenue adequacy as a rate-of-return on investment between seven and ten percent. Yet at that time only 13 of the 36 Class 1 railroads had reached those levels. The declining state of freight railroad bred concern for changes to occur. This in turn led to the passage of the Stagger Act of 1980 which was to “provide for the restoration, maintenance, and improvement of the physical facilities and financial stability of the rail system of the United States.” This case study will give a comprehensive overview of concept of revenue adequacy, the cost and benefits to obtaining revenue adequacy and its impacts on the rail industry.

List of Actors

US Government

Surface Transportation Board- An independent adjudicatory and economic-regulatory agency charged by Congress with resolving railroad rate and service disputes and reviewing proposed railroad mergers. The agency has jurisdiction over railroad rate and service issues and rail restructuring transactions (mergers, line sales, line construction, and line abandonments); certain trucking company, moving van, and non-contiguous ocean shipping company rate matters; certain intercity passenger bus company structure, financial, and operational matters; and rates and services of certain pipelines not regulated by the Federal Energy Regulatory Commission. The agency has authority to investigate rail service matters of regional and national significance. STB was created on January 1, 1996 by the ICC Termination Act of 1995, the Board is the successor to the former Interstate Commerce Commission (1887-1995) and was administratively aligned with the U.S. Department of Transportation from 1996 to mid-December 2015. The STB Reauthorization Act of 2015 established the STB as a wholly independent federal agency on December 18, 2015.

Major Class 1 Railroad Companies

BNSF Railway - One of the largest freight rail lines which is a product of about 390 different railroad lines acquired over a span of 160 years; with the first line, Aurora Branch Line, starting in 1849. BNSF received their new name and a look in 2005. Their staff consist of over 40,000 employees, they operate over 32,000 route miles in 28 states and 3 Canadian provinces and they serve two-thirds of the US, portions of Canada and key Mexican gateways.. In 2015 they had a total operating revenue of about 21.4 billion dollars.

Canadian National Railway Company - Canadian National Railways - incorporated June of 1919, is the longest railway system in North America. It has approximately 19,000 route-miles in North America. Now known as Canadian National (CN), the former Crown Corporation expanded its holdings to include marine operations, hotels, telecommunications and resource industries. However, the core of CN was still its railway system, which had its origins in the amalgamation of five financially troubled railways during the years 1917–23: the Grand Trunk and its subsidiary, the Grand Trunk Pacific; the Intercolonial; the Canadian Northern; and the National Transcontinental. In 1995, CN was sold to private investors and it serves the cities and ports of Vancouver, Prince Rupert, B.C., Montreal, Halifax, New Orleans, and Mobile, Ala., and the metropolitan areas of Toronto, Edmonton, Winnipeg, Calgary, Chicago, Memphis, Detroit, Duluth, Minn./Superior, Wis., and Jackson, Miss., with connections to all points in North America. In 2015 CN employed over 23,172 workers in Canada and the US and earned 12.6 billion in revenue. CN has one of the lowest operating ratio among Class 1 railroads based on 2015 year-end results.

Canadian Pacific - was founded in 1881 to physically unite Canada and Canadians from coast to coast. By 1889 that mission had been fulfilled and the railway extended from coast to coast and the enterprise had expanded to include a wide range of related and unrelated businesses. Its 14,000 mile network extends from the Port of Vancouver in the Canada's West to The Port of Montreal in Canada's East, and to the U.S. industrial centers of Chicago, Newark, Philadelphia, Washington, New York City and Buffalo.

Norfolk Southern - The history of Norfolk Southern spans to nearly two centuries of American railroading and its earliest predecessor was Charters South Carolina Canal and Rail Road which dates back to 1827. They were the first company to computerized operations. Norfolk Southern is and has been one of the nation’s premier transportation companies. Norfolk Southern Railway operates approximately 20,000 route miles in 22 states and the District of Columbia. They serves every major container port in the eastern United States and provides connections to other rail carriers. Norfolk Southern operates the most extensive intermodal network in the East and is a major transporter of coal, automotive, and industrial products.

Union Pacific - the first transcontinental railroad dating back to 1862 and is compromised from a series of mergers throughout the years. They are: Chicago & North Western Railroad, Missouri-Kansas-Texas Railroad, Missouri Pacific Railroad, Denver & Rio Grande Western Railroad, Southern Pacific Railroad and Western Pacific Railroad. The Union Pacific Railroad now connects 23 states in the western two-thirds of the country. They service includes Agricultural Products, Automotive, Chemicals, Coal, Industrial Products and Intermodal. Union Pacific serves many of the fastest-growing U.S. population centers, operates from all major West Coast and Gulf Coast ports to eastern gateways, connects with Canada's rail systems and is the only railroad serving all six major Mexico gateways. They service over 10,000 customers, operating over 32,000 route miles and with over 40,000 employees.

Time Line

1887

Interstate Commerce Act of 1887 was enacted by major political parties and with the assistance of pressure groups. The act had the following 6 points. 1. Mandating of "just and reasonable" rate changes. (This was the traditional language of the Anglo-American common law). 2. Prohibition of discrimination in the form of either special rates or rebates for individual shippers. 3. Prohibition of discrimination or unjustified "preference" in rates for any particular localities or shippers or products. 4.Forbidding of long-haul / short-haul discrimination. Unless an exception was allowed by the Interstate Commerce Commission, no company might charge more for a shorter than for a longer distance on the same route (and in the same direction). 5.Prohibition of pooling of traffic or markets. 6. Establishment of a five-member Interstate Commerce Commission.

1974

Congress passed the Regional Rail Reorganization Act of 1974 known as the 3R Act. This legislation provided interim funding and created a rail operator known as Conrail as a government funded private company. Under the 3 R Act an organization known as the United States Railway Association (USRA) prepared a final system plan which identified all lines from the bankrupt carriers that would be transferred to a new corporation known as The Consolidated Rail Corporation (CONRAIL).

1976

Congress approved Conrail’s Final System Plan as part of the Railroad Regulatory Reform Act of 1976. This law, known as the 4R Act was signed into law on February 5, 1976. Incidentally, the 4R Act turned over the ownership of most of the North East Corridor to Amtrak. Freight operating rights over this trackage was guaranteed to Conrail however.

April 1, 1976

Conrail began operations. Its mandate was to revitalize rail service in the Northeast and Midwest and operate as a for-profit-company. However, it must be noted that Conrail as a carrier did not begin a turn around until 1980 when the Staggers was passed.

October 14, 1980

In 1980 Congress passed the Staggers Act and President Jimmy Carter signed this piece of landmark legislation in October of that year. The Staggers Act named for Representative Harley O. Staggers of West Virginia deregulated the railroad industry and created competition among railroads and allowed railroads to compete with trucking companies. The Staggers Act granted greater pricing freedom, streamlined merger timetables between parallel or formerly competing carriers, expedited the line abandonment process, allowed multi-modal ownership and permitted confidential contracts with shippers. The passage of the Staggers Act allowed the railroads to divest themselves of their unprofitable passenger business and concentrate on their core activity, which is the movement of freight. At the time of the passage of the Staggers Act only 3 American railroads still operated their own passenger service. They were the Southern, Denver Rio Grande and Western and the Rock Island. By 1983 all 3 of those freight carriers opted to turn over their private service to Amtrak or in the case of the Rock Island, to commuter authorities.

Thus here we are in the 21st Century and the gold standard for freight carriers is revenue adequacy. This is not to say that controversy within the industry and between carriers and shippers does not exist.

October 23, 2008

In a decision released by the Surface Transportation Board (STB) the STB denied a petition filed by the Association of American Railroads (AAR) to institute a rulemaking proceeding to consider the use of replacement cost methodology in the Board’s annual railroad revenue adequacy determination.

September 8, 2015

The STB finds that the following Class I rail carriers were revenue adequate in 2014. BNSF, Grand Trunk Corporation, Norfolk Southern Combined Railroad Subsidiaries and the Union Pacific Railroad Company.

September 8, 2016

The STB found that based on a determination of a 9.61% cost of capital, the Board found that BNSF Railway Company., Grand Trunk Corp. (CN), Soo Line Corp. (CP), and the Union Pacific Railroad Co. were revenue adequate for 2015. CSX, Kansas City Southern and Norfolk Southern did not make the list. According to the STB news release “A railroad is considered to be revenue –adequate to at least the current cost of capital for the railroad industry, which for 2015 the board determined to be 9.61%. Congress directed the Board to conduct such revenue adequacy determinations on an annual basis.

Maps

BNSF Service Map

Canadian National Service Map

Canadian Pacific Service Map

Norfolk Southern Service Map

Union Pacific System Map

CSX System Map

Policy Issues

Measurability of Revenue Adequacy Part of the conundrum of both measuring revenue adequacy and defining which railroads meet that test, is that no economist can 100% accurately predict what the cost of capital will be next year, in two years, etc., Interest rates for commercial borrowing are subject to many outside variables. There is no clear way to continually measure revenue adequacy. The percentage railroad companies need in order to be deemed revenue adequate varies from year to year. In 2014 Norfolk Southern was considered a revenue adequate company and in 2015 they were not. Therefore with no clear continual way to measure, freight companies go into their calendar year not having a target percentage to reach for. All that is available to them is an algorithm. The concept that was developed was initially done at a time when the financial wellbeing of the freight industry was in peril.

Economic Regulation STB is currently planning to enact a revenue cap on freight railroads. This can potentially place the railroads in a state pre-Staggers state. A balanced regulatory structure is what has proven to work on both sides of the spectrum, protecting rail customer against unreasonable rates but still allowing freight railroads the freedom to make adjustments as the economy change.

Regulatory Oversight Railroad profitability may be used as a trigger for determining reasonableness of rates on particular rail shipments. Constraints had relatively little practical effect when it was introduced because there was a widespread of revenue inadequacies but since then railroads are being deemed more adequate. Profits used to determine rates opposed to economy will work in favor of the customer but it can potentially harm the fright railroad companies over time.

Narrative

Class l:

Over time, the definition of Class l railroads has changed. As of 2014, the Association of American Railroads (AAR) has defined Class l railroads as, “having operating revenues at, or exceeding, S475.75 million annually. Currently there are only seven railroads that are considered to be Class l, which makes up an astonishing 93 percent of the industry’s revenue. With leaving only seven percent of revenue to Class ll, known as regionals, and Class ll, known as short lines. Although Class ll and Class lll, only produce seven percent of the total railroad industry’s revenue, both classes have a total combined number of over 500 railroads.

Staggers Rail Act of 1980:

“Revenue adequacy” is a term defined by Congress as the ability of privately owned freight railroads to achieve revenue levels that are adequate to cover total operating expenses, including depreciation and obsolescence, plus a reasonable return on capital employed in the business so as to attract and retain capital in amounts adequate to provide a sound transportation system.

With the railroad industry struggling to survive; the current U.S. President, Jimmy Carter, along with Congress, were able to establish the Staggers Rail Act of 1980. This was enforced after multiple attempts to revive the railroad industry’s financial burden. During the signing of the approved legislation, President Jimmy Carter stated, ““In recent decades the problems of the railroad industry have become severe. Its 1979 rate of return on net investment was 2.7 percent, as compared to over ten percent for comparable industries. We have seen a number of major railroad bankruptcies and the continuing expenditure of billions of Federal dollars to keep railroads running. Service and equipment have deteriorated. A key reason for this state of affairs has been overregulation by the Federal Government. At the heart of this legislation is freeing the railroad industry and its customers from such excessive control.”

The Stagger Rail Act lead to the demise of the Interstate Commerce Commission. After 16 years of the act’s life, the ICC was removed and its authority was split between the Department of Transportation and the Surface Transportation Board. The Staggers Rail Act deregulated the federal government and limited their involvement which in turn substantially improved the industry’s financial situation. It limited ICC’s authority, which is now STB, “to regulate rates only for traffic where competition is not effective to protect shippers.” Another key point is the Staggers Act allowed railroad-shipper contracts. These contracts consist of predetermined, individualized, fixed rates for specific shippers that have been negotiated by the shipper and railroad without any interference. Today it is estimated that one-third of all railroad traffic is under a railroad-shipper contract.

Coal Companies:

Both coal producers and coal-fired utilities have an invested interest in the railroad revenue adequacy. This is mainly because the outcome of the railroad revenue adequacy has a direct effect on the rates that railroads charge. However, the outcome effects the coal producers and coal-fired utility companies in different ways. Producers are worried because the higher the railroad rates, the less competitive their coal prices will be. On the other hand, coal-fired utility companies worry because the higher the railroad rates are the less money they can make from the sale of electric energy.

Problems with Attracting Investors:

Corporate investors must consider multiple factors before choosing any company to invest money into. The two major factors for investors are predicted rate of return and the risk of their principal. With that being stated, investors are more likely invest in company who have a track record of having a low risk of negative return and has a strong possibility of a high rate of return. However, the railroad industry is notoriously known for not being revenue adequate. Which means the railroad companies are not able to cover the cost of expenses, cost of operating efficiently, and the cost of giving investors a competitive return. The U.S. Surface Transportation Board (STB) now proactively determines the rate of return for investors to be competitive. But despite how proactive the STB is, it won’t go far unless the railroads can consistently be revenue adequate.

Railroad Revenue Adequacy for 2015:

Just last month, September 8th, 2016, the STB announced the railroad companies that were deemed revenue adequate for the previous year (2015). The companies listed below were able to attain the rate of return on net investment which was a minimum of 9.61% for 2015 and cover all cost of their capitol. Revenue Adequacy for 2015: 1. BNSF Railway Co. 2. Grand Truck Corp. 3. Soo Line Corp. 4. Union Pacific Railroad

To view all decisions of revenue adequacy for railroads, click here:

Price Regulation and Revenue Adequacy

In 1996, the STB created the RSAM Benchmark, which now limits railroads to a price that a railroad can charge for a shipment. Since then, every year the STB meets and determines these prices for every railroad. The RSAM Benchmark is determined by using three statistical data. 1. (REV>180): Total revenue with a revenue-to-variable-cost greater than 180. 2. (VC>180): Total variable cost with a revenue-to-variable-cost greater than 180. 3. (REV shortage/overage): Amount short of revenue adequacy/Amount over revenue adequacy The Board then adds REV>180 with REV shortage or overage, and divides it by VC>180; which will be the RSAM Benchmark. The STB then determines if the calculated RSAM is sufficient enough to allow the railroad to have competitive prices.

Discussion Questions

Is freight rail industry deregulation, i.e. the reforms of the Staggers Act of 1980 actually working for the freight railroad industry as of the 21st Century?

Does passing policy law changes, as in the case of the Staggers Act but not supervising execution actually insure that private freight carriers remain revenue adequate?

If the evaluation tool of revenue adequacy is creating a cap on rates what are the pros and cons of this policy?

If making the cost of capital, to include maintaining a state of good repair and the ability to modernize, is the test of revenue adequacy doing its job?

Additional Readings

https://www.ams.usda.gov/sites/default/files/media/Constrained%20Market%20Pricing%20and%20Revenue%20Adequacy%20Summary.pdf

https://ssrn.com/abstract=2461424

https://www.stb.gov/Decisions/readingroom.nsf/(search-129.174.182.68-10602)?OpenView&Count=5000