STB’s Cost of Capital Dilemma

NEWS ITEM: The Surface Transportation Board (STB) proposes to change the formula for computing the cost of the equity component of the railroad industry’s cost of capital. This is of consequence to railroads, shippers and investors because cost of capital is a determinant of railroad revenue adequacy and a threshold for a host of other regulatory limitations on rail ratemaking.

Background is in order.

First, railroad economic regulation was only partially relaxed in 1980 by the Staggers Rail Act. While most rail freight rates are now the product of market forces and insulated from regulator interference, captive shippers—those able to demonstrate a lack of effective transportation alternatives to rail—may still challenge before the STB the reasonableness of their common carrier (not confidential contract) freight rates in hopes of having any intended rate hike cancelled or modified.

Second, how the STB rules on those rate challenges is influenced by whether the railroads’ rate of return on net investment (ROI, which is what railroads earn providing transportation) equals or exceeds the industry’s cost of capital (the interest railroads pay lenders, as well as expected returns to equity investors). When ROI equals or exceeds the cost of capital, railroads are considered revenue adequate.

Of the cost of capital test, STB predecessor Interstate Commerce Commission (ICC) said in 1981, when adopting the test, that “such a standard is widely agreed to be the minimum necessary to attract and maintain capital in the railroad, or any other industry. If a firm is unable to earn the cost of capital, [lenders and investors] will be unwilling to supply capital to it. The cost of capital is, by definition, the rate at which the market values investment funds.”

As railroad revenue adequacy has been more a quest than a result—at least according to pronouncements of regulators—the ICC and STB have been more tolerant of rail rate increases imposed on captive shippers. The reason is that the 1980 Staggers Rail Act instructed them to assist railroads in achieving revenue adequacy.

Although railroads correctly say that captive shippers have prevailed in roughly half of rate complaint cases before the STB, shippers say, also correctly, that most of the victories resulted in lower rate rollbacks than sought—so much so that shippers ceased filing rate complaints as the costs of pursuing them too often exceeded the relief granted.

Third, differences of a few percentage points in the calculated cost of capital were relatively insignificant for revenue adequacy purposes until relatively recently, as railroads had been clawing their way back from decades of regulatory micro-management that had enrolled them in a foot race toward the nearest bankruptcy court.

In 1981, for example, the ICC determined that railroads were paying more than 12% for investment capital when that investment was returning an ROI of less than 5%—a topsy-turvy situation discouraging further capital investment in assets such as track, crossties, motive power, rolling stock, signals, structures and computers.

Fourth, circumstances change. In recent years, all major railroads have achieved, or are near to achieving, an ROI at or above their cost of capital, which has placed greater consequence on how the STB calculates the cost of capital. In September 2019, for example, the STB determined that Class I railroads CSX, Soo Line (Canadian Pacific) and Union Pacific (UP) achieved in 2018 an ROI equal to or greater than the rail industry’s average cost of capital, while BNSF and Norfolk Southern were less than a percentage point shy.

Captive shippers are of the opinion that all Class I railroads are revenue adequate, and have been so for many years, and are further skeptical of the STB’s 2018 cost of capital determination, as its 12.2% calculation was more than 2 percentage points higher than in 2017 and more than 3 percentage points higher than in 2016. Conspicuously, the higher the cost of capital, the higher the bar for achieving revenue adequacy.

While shippers contend there is no indication of greater financial risk that may have increased the railroads’ cost of capital for 2018, railroads consider the collapse of coal traffic a significant addition to financial risk. The STB did not mention the coal traffic collapse in expressing some surprise over its 2018 cost of capital calculation.

Perhaps of more concern to the STB is that Wall Street analysts, with reputations on the line, consider the industry’s cost of capital to be but 7%—a figure even embraced by now-retired BNSF Executive Chairman Matt Rose. Thus was advanced by the STB its Oct. 11 decision—subject to revision based on invited stakeholder comment—to adjust the formula for calculating cost of capital. There is yet to be a suggestion that the STB scrap its own models and adopt those utilized by Wall Street firms.

In questioning its 12.2% cost of capital calculation, and proposing through its Oct. 11 decision a formula revision, the STB, while ignoring the demise of coal traffic, did cite implementation by railroads of cost-saving Precision Scheduled Railroading. “Significant operating changes that occur over a relatively short period of time,” said the STB, “can have a unique effect on the Board’s annual cost of capital determination, particularly if they are neither one-time events nor expected to cause permanent changes in the industry’s growth rates.”

Actually, the ICC and STB—with no shortage of suggestions by railroad and shipper stakeholders—have for decades been grappling with how best to measure railroad cost of capital. Although the cost of debt is readily determined by observing interest rates railroads pay lenders, measuring the cost of equity capital is far more art than science, as it involves predicting future stock prices, cash flow and other variables.

In 1985, the ICC said the formula “does not appear to produce a realistic picture of the state of the rail industry.” No matter, as future revenue adequacy determinations remained the same, with most railroads remaining shy of being revenue adequate, according to STB calculations.

This was notwithstanding that Burlington Northern acquired Atchison, Topeka & Santa Fe for $4.1 billion to become BNSF; UP purchased Southern Pacific for $4 billion; and CSX and NS jointly acquired Conrail for $10 billion. And in its 1994 annual report, CSX—found that year by the STB as revenue inadequate—said, “For the past two years, CSX earned in excess of its cost of capital.”

In 1996, ICC successor STB found that for 1995, just three of the then 11 Class I railroads were revenue adequate, prompting then-Vice Chairman Gus A. Owen to say that while he voted to approve that determination, “I believe the time is ripe to investigate the appropriateness of these methods.” In February 1997, economist Alfred E. Kahn, previously chairman of New York’s Public Service Commission, and an architect of commercial airline economic deregulation, called the ICC/STB revenue adequacy test “totally discredited, [producing] nonsensical results.”

In 2008 and 2009, following complaints that the STB’s formula rested on the false premise that high growth rates could continue in perpetuity, regulators adjusted the formula for computing the equity portion of the cost of capital, adopting what it yet again now proposes to adjust.

Actually, following the 2008 and 2009 revisions, different results emerged than previously. The STB has found UP revenue adequate since 2010; BNSF for eight consecutive years until 2018; and CSX almost consistently within a single percentage point of revenue adequacy. Indeed, UP completed a $10 billion stock buyback in 2018, CSX has been buying back $5 billion of its stock, NS repurchased $12 billion of its stock since 2006, and BNSF has been providing substantial dividends to its Berkshire-Hathaway parent.

So, why another formula revision? As mentioned, the 12.2% cost of capital computed by the STB for 2018 exceeds by more than five percentage points what is used by Wall Street analysts. Additionally, shippers assert that the existing models, using historical growth rates dating to 1926, create distortions, and that the models artificially overstate firm growth by failing to adjust for stock buybacks.

Rather than scrap its existing formula for calculating the cost of equity, the STB’s proposes to adjust how it estimates future rail stock performance. It will utilize—in terms more familiar to economists and financial analysts—a capital asset pricing model, a multi-stage discounted cash flow model (MSDCF), and a “step MSDCF” that gradually adjusts for expected future growth.

Together, these statistical and econometric models look backward and forward, and include future estimates of growth in the U.S. economy. “By using multiple models that are based on different perspectives and rely on different inputs,” the Board said it expects these changes to provide greater accuracy.

This is hardly the whole enchilada. In August, the STB requested proposals for a study of potential changes to its 30-year-old Uniform Rail Costing System (URCS), which is used for, among other tasks, a gatekeeping function to determine which shippers are eligible to challenge rail rates. Also unresolved is the STB’s preferred length of the business cycle for assessing whether long-term revenue adequacy has been achieved.

With a current three-member STB that recently terminated a rulemaking intended to define standards by which railroads may impose fuel surcharges—saying the three members were unable to agree—it is a fool’s errand to predict the outcome of any pending STB business, especially with two vacant seats on the five-person Board likely to remain unfilled into 2020.

To be watched in 2020 are how the Board finalizes this cost of capital rulemaking; whether it revises URCS; whether it revisits the fuel surcharge standards; whether it defines the length of a business cycle; and whether it takes further action on long-dormant rulemakings as whether to allowing a second railroad competitive access to sole-served shipper facilities; and whether to follow through on a 1985 rulemaking that promised rate caps on revenue adequate railroads.

Frank N. Wilner is author of six books, including Amtrak: Past, Present, Future; Understanding the Railway Labor Act; and Railroad Mergers: History, Analysis, Insight, all published by Simmons-Boardman Books. Wilner earned undergraduate and graduate degrees in economics and labor relations from Virginia Tech. He has been assistant vice president, policy, for the Association of American Railroads; a White House appointed chief of staff at the Surface Transportation Board; and director of public relations for the United Transportation Union. He is a past president of the Association of Transportation Law Professionals. Wilner drafted the railroad section of the Heritage Foundation’s Mandate for Leadership (Volumes I and II), which were policy blueprints for the two Reagan Administrations; and was a guest columnist for the Cato Institute’s Regulation magazine.