What shippers want—what railroads demand

Pricing concessions vs. pricing freedom: A battle is won, but the threat lingers.

The swing of the political pendulum last fall was a severe reverse for the forces of railroad re-regulation, but it fell short of a knockout blow, in the view of strategists on both sides. New battle lines are likely to be drawn when the Surface Transportation Board opens a long-awaited hearing June 23 on “Competition in the Railroad Industry.”

Contentious shipper demands will be dragged out of storage and re-argued at next month’s hearing—for example, bottleneck rates and reciprocal switching, which some powerful railroad customers view as shortcuts to lower rates.

One way or another, attention will be directed to the question of how the railroads could be “revenue inadequate” while posting strong earnings, maintaining positions on the Stock Exchange at or near record levels, and pulling together enough cash and credit for a record investment of $12 billion in capital improvements this year. This means that return on investment (ROI) will also come under scrutiny.

ROI plays an important role in rate cases and line abandonment proceedings. Under the Staggers Rail Act of 1980, the railroads are not “revenue adequate” until their return on investment equals or surpasses their cost of capital. In its most recent annual determination, announced last fall, STB found the railroad cost of capital to be 10.43% for 2009. The return on investment for railroads as a group, for the 12 months ended June 30, 2010, was close to that—9.60%. Among Class I’s, only Soo Line (Canadian Pacific’s U.S. operation) earned more than the cost of capital, with an ROI of 15.3%. BNSF had an ROI of 10.25%, UP 10.02%, Norfolk Southern 9.44%, and CSX 8.64%.

The railroad industry won some breathing space when last year’s GOP juggernaut flattened a strong initiative in Congress to limit railroad pricing freedom through antitrust action. But railroaders like Norfolk Southern CEO Wick Moorman are not letting their guard down.

As he accepted Railway Age’s 2011 Railroader of the Year Award in March, Moorman warned: “Washington, with the threat of adverse legislative or regulatory action, is fully capable of knocking this industry back into the shape it was in 30 years ago—a weak, ineffective, unsafe rail network.”

“While the threat seems to be slightly diminished for now,” said Moorman in his annual letter to shareholders, “we will remain fully engaged with policymakers everywhere to aggressively make the case that a healthy, vibrant rail system is good not only for all those we serve, but even more important, for our country as a whole.”

“As we work through 2011,” said Moorman, “we continue to be concerned about the possibility of regulations and legislation that could diminish our ability to earn the adequate—but by no means excessive—returns that enable us to improve our infrastructure, hire employees, and do our part to improve the American economy.”

“It astonishes me,” he continued, “that today, 30 years after the Staggers Act successfully freed railroads to compete, there remain those who would return us to the dark old days of unreasonable regulation.”

Union Pacific is also closely monitoring the situation and says that any loss of regulatory freedom could force it to reconsider the industry’s biggest single capital improvement program, pegged this year at more than $3 billion.

If there is eventually a clear-cut winner in this long running struggle to transfer billions of dollars from one big industry to other big industries, logic as well as the law says it will be the railroads.

The Staggers Rail Act of 1980, which is now under attack, not only averted the clear and present danger of railroad nationalization, but it has come close to achieving its core goal. That goal was not, for the record, ensuring competitive choices for the railroads’ customers, but ensuring that there would continue to be private railroads with sufficient earning power to renew and improve their properties and provide not just desirable but essential transportation. A cascade of railroad bankruptcies, including the giant Penn Central failure, had put this in reasonable doubt. A Railway Age poll of railroad shippers in the 1970s found that around 70% of them expected the railroads to be nationalized.

While Staggers effectively addressed this situation, a side effect of the “railroad renaissance” was to make a number of shippers—of coal, wheat, and other commodities that that are not easily moved by truck—captive to a single carrier. These shippers now claim that safeguards written into the law to prevent abuse of pricing power have not worked.

The result has been continuing rate challenges. The Surface Transportation Board—which the shipper lobby Consumers United for Rail Equity (CURE) has claimed “is broke” and needs fixing—recently made it far cheaper than it used to be for shippers to mount a rate challenge. The board has also successfully encouraged mediation for settling rate challenges without further fuss or expense.

Railway Age Columnist Lawrence H Kaufman points out (p. 48) that about half of all challenges have been settled between the two parties. It’s the other half that keeps things interesting.

Independent studies have examined the issues from the point of view of all parties. Perhaps the most important was that which the STB commissioned from the Madison, Wis., firm of Christensen Associates. STB asked the consultant to assess the state of railroad competition in the U.S. As summarized by the STB, the study “painted the portrait of a healthy rail industry that, since 2009, has remained revenue sufficient, meaning railroads are able to cover their operating costs and earn a rate of return that enables them attract investment capital to pay for more locomotives, railcars, and make other improvements. The study also found that the large productivity gains in the 1980s and 1990s—when the railroads shed excess rail lines, reduced crew sizes, and streamlined operations—are no longer strong enough to offset rising operating costs. The study found that escalating rates during the five-year period 2004-2008 were driven by fluctuating fuel prices and other costs and did not appear to reflect a greater exercise of railroad market power over captive shippers. Since 2002, the study determined, “increases in the rate of input price growth combined with slower productivity growth have resulted in unit cost increases.” The study also found that “economies of density appear to have been exhausted in recent years.”

The STB’s Christensen study, while warning of the consequences to railroads of certain shipper demands, did not find shipper positions entirely without merit, and suggested further inquiry into such issues as the heavy investment by electric utilities in their own fleets of unit coal trains. But the overriding conclusion was this: “Providing significant rate relief for some shippers will likely result in price increases for other shippers or threaten railroad financial viability.”

Both sides have powerful political and economic constituencies, and there is growing feeling that there will likely be mutual concessions ending in what the AAR is calling “balanced regulation.” That of course brings up the question of who does the balancing.

The Democrat-controlled Senate continues to be a candidate for the job. Glenn English, chairman of Consumers United for Rail Equity, notes that on March 3, the Senate Judiciary Committee approved the Railroad Antitrust Enforcement Act, to “remove the antitrust exemptions currently exploited by the freight railroad industry.”

Republican Congressman Bill Shuster, chairman of the House Transportation and Infrastructure Subcommittee on Railroads, Pipelines & Hazardous Materials, is uncompromising on the issue: “The United States has the best freight rail network in the world. In fact, 43% of the freight carried each year in the U.S. goes by train, and demand is projected to grow by 88% in the next 25 years. To meet this demand, rail capacity must grow. The Committee will oppose re-regulation of the industry that would stifle its continued growth and success.”

CURE, which has said that 44% of all tonnage is served by only one rail carrier, and therefore captive, says its position is that “rail customers are not seeking to change the fundamental principles of the current regulatory system. Rather, they would like to see several significant fixes to balance out the positions between railroads and rail customers.”

One seasoned transportation lobbyist told Railway Age that in his view, what shipper strategists really expect is none of the above.

“I have always believed that the captive shippers are funding their legislative effort less to gain the legislation and more to keep pressure on railroads for lower rates,” says this lobbyist.

“I think both sides have legitimate arguments, but the fact is that most of the captive shipper problems involve coal and electric utility shippers who have sufficient market power to negotiate in the marketplace.

“The only winners over the past 30 years,” he concludes, “have been the lawyers and lobbyists.”

If true, this could be a story with no end in sight.