Reciprocal Switch Peril Grows

Written by Frank N. Wilner, Capitol Hill Contributing Editor
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No two words torment railroad executives and their investors more than “reciprocal switching”—a potential Surface Transportation Board (STB) decree that a railroad with sole physical access to a shipper facility transfer (switch) a shipper’s cars to a junction point with a second (competing) railroad. The second railroad pays a compensatory per-car switching fee whose reasonableness is determined by the STB.

To obtain reciprocal switching—known as “interswitching” in Canada, where it is in use for more than a century—the shipper must prove to the STB that the reciprocal switch is feasible and necessary to enhance competition.

Statutory authority to impose reciprocal switching dates to 1980, when Congress, in partially deregulating railroads, created safeguards against rail market power abuse where shippers are captive to a single railroad at an origin or destination terminal.

This shipper safeguard was a trade-off for less onerous regulatory oversight. Partial economic deregulation allowed railroads greater pricing freedom and permitted scrapping of inefficient routes, the ability to concentrate traffic on fewer miles of track, cancellation of joint rates where the division of revenue is below variable costs, and reduced hurdles in abandoning light-density lines.

Also discarded was a bizarre regulatory mandate that rates be uniform over all route possibilities regardless of efficiency or differing route costs affected by density, weather and geography. Shippers previously could choose, for example, any of almost 5 million route permutations between Little Rock, Ark., and Detroit, Mich., as calculated by Quaker Oats transportation executive Sam Hall Flint.

STB Chairman Marty Oberman

Until Democrat Martin J. Oberman succeeded Republican Ann D. Begeman as STB Chairperson in early 2021, railroads were confident they had obstructed a 10-year shipper effort—led by the National Industrial Transportation League (NITL)—to obtain the reciprocal switching remedy. In a November announcement, which a Wall Street analyst said is “freaking out investors,” Oberman scheduled a March 2022 public hearing to consider a decade-old and languishing Notice of Proposed Rulemaking (NPRM) — Docket No. Ex Parte 711 (Sub-No. 1), Reciprocal Switching.

As partial justification, Oberman cited a July 2021 President Biden Executive Order encouraging the STB to consider reciprocal switching as a means of promoting competition. Although the STB is an independent (from the Executive Branch) agency, Oberman said, “I welcome the nationwide policy contained in this new Executive Order.” He expressed “concerns with the sufficiency of competition in the rail industry and my interest in exploring ways the Board can improve the rail industry’s competitive landscape in order to ensure fairer pricing.”

Oberman also cited “significant changes in and affecting the rail industry” since the long languishing NPRM was issued at the NITL’s urging in 2011. Notably, not a single reciprocal switching remedy has been imposed by the STB or its Interstate Commerce Commission (ICC) predecessor since the mid-1980s.

The impediment has been a 1985 ICC precedent—in a case known as Midtec—that reciprocal switching be imposed only following a showing by shippers of railroad anti-competitive conduct.

Unable to prevail under that precedent—calling it an “insurmountable evidentiary hurdle”—shippers in 1998 urged the Senate Commerce Committee to direct the STB to develop a record on competition issues such as reciprocal switching. Then-STB Chairperson Linda J. Morgan responded that the matter be “more appropriately resolved by Congress,” which took no action in the face of intense railroad lobbying.

In 2011, then-STB Chairperson Daniel R. Elliott III, a Democrat, instituted the NPRM to consider a NITL petition that the Midtec market-power abuse threshold be scrapped in favor of a finding that:
• The shipper is served by a single Class I railroad.
• There is no effective barge, truck or rail competition.
• The freight rate exceeds 240% of variable costs or the sole-serving railroad has handled 75% or more of the traffic over the past year.
• Within 30 miles of the sole-served facility, there is, or can be, a working interchange (junction point) with a competing railroad.
• The switching is safe, feasible and would not unduly hamper the railroad’s ability to serve existing customers.

Owing to other pending cases and limited staff, no progress on the 2011 NPRM occurred until 2016, when the Elliott-chaired STB revisited it, proposing a case-by-case approach along the lines of the NITL’s recommendations. Shippers were to bear the evidentiary burden as to practicality, but were not required to demonstrate railroad anti-competitive conduct. In 2017, the NPRM went back into hibernation when Begeman was elevated by President Trump to Chairperson.

Ann D. Begeman, STB member

This was predictable, as before becoming Chairperson, which immediately allowed her to control the STB docket, Begeman opposed the NPRM. She wrote in a dissent when Elliott was chairperson, “How can the Board provide fair and consistent switching judgments on a case-by-case basis without creating complexity and cost impacts on the one hand, and not introducing more unpredictability to the rail network on the other?”

Begeman, who remained an STB member after President Biden elevated Oberman to Chairperson in 2021, departs the STB at month’s end and will not participate when the NPRM is reopened in March. Her presumed successor, Democrat Karen J. Hedlund, whose position is unknown, awaits Senate confirmation. In addition to Democrat Oberman, the fate of the NPRM will rest with Democrat Robert E. Primus and Republicans Patrick J. Fuchs and Michelle A. Schultz. None has expressed a public opinion on the NPRM.

In opposing the NPRM, the Association of American Railroads (AAR) says reciprocal switching could “force” railroads to route traffic less than optimally. Shipper outside legal counsel Sandra L. Brown, of the firm Thompson Hine, says, “Optimality is in the eye of the beholder. It would always be optimal for a monopolist to keep its monopoly hold and not have to compete against another railroad for traffic.”

In meetings with individual STB members—summaries of which must, by statute, be made public—Union Pacific Railroad (UP) said reciprocal switching could increase transit time, contribute to network congestion and be detrimental to network fluidity. Another shipper attorney, asking not to be identified, said UP’s argument is counterintuitive, as no shipper would choose a remedy causing service quality to deteriorate.

Mike Haverty, Railway Age’s 2001 Railroader of the Year when CEO of Kansas City Southern. Today, among other endeavors, he’s part owner of the Kansas City Royals.

Joining the AAR, UP and other railroads in opposition to reciprocal switching is Mike Haverty, former CEO of Kansas City Southern (KCS) and earlier president of Atchison, Topeka & Santa Fe (now part of BNSF). Considered one of the 20th century’s leading visionaries—having acquired for KCS rail concessions in Mexico and Panama and having collaborated with trucker J.B. Hunt to launch the rail industry’s first dedicated premium-service, premium-priced intermodal service named Quantum—Haverty speaks with authority. In conversations with this columnist, Haverty said:

“I know that Hunter Harrison promoted [Canadian style interswitching], but he did so as part of an architectural plan he had in his head to create a two-railroad duopoly in all of North America. We are not there yet and may never be. To promote a form of reregulation at this point is dangerous for the rail industry. Reciprocal switching, or [physical access] by which another railroad operates with their own locomotives and crews over a competitor’s track, could have potentially been devastating to the railroad and would have never allowed KCS to develop as an international rail network.

“Let me give you an example. KCS exclusively served multiple coal-fired utility plants on its line between Shreveport, LA, and Wiley (East Dallas), Texas, with Powder River Basin coal interchanged to us at Kansas City by BNSF and UP. With reciprocal switching, KCS could have been short-hauled, as UP had junction points fewer than two miles from a utility plant at Welch and four miles from another at Monticello.

“KCS would then have only been able to quote a reciprocal short-haul rate to deliver the coal trains to the plants. KCS could never quote a reciprocal short-haul rate to equal its 800-mile plus long-haul rate from Kansas City. KCS would have lost millions of dollars in revenue and may have even gone out of business as coal revenues at the time were a large percentage of total KCS revenues.

“By handling the traffic directly the 800 miles between Kansas City and the coal-fired plants, KCS was able to invest hundreds of millions of dollars in infrastructure on its primary main line to Shreveport and its secondary main line to Wiley that would never have happened had there been [reciprocal switching or physical access].”

Shippers say Haverty’s example is outdated. A shipper attorney asking not to be identified, said, “While reimbursement for reciprocal switching may not have been high enough at one time to keep KCS in business, the coal business no longer is nearly as significant today. Meanwhile, mergers—including the pending KCS-Canadian Pacific merger that likely will be approved by the STB—have created systems large enough to withstand the revenue impact.”

Sandra L. Brown, Thompson Hine

Thompson Hine’s Brown agrees, saying, “No longer is there concern that reciprocal switching could harm a smaller railroad such as KCS and drive it out of business. Mostly likely, the movement will shift to a different interchange point only if it is more efficient and the new combined rate is more competitive. But if the original interchange point is more efficient, the railroad should be able to retain its longer haul at its original interchange point. Reciprocal switching will favor the more efficient route, which is what competition is all about.” 

Shippers especially emphasize the “then versus now.” During the time of Haverty’s example, railroads were struggling to achieve revenue adequacy—earning enough to cover total operating costs, including depreciation and obsolescence, plus a competitive return on invested capital sufficient over the long term to attract capital to maintain a railroad’s large and costly infrastructure, including locomotives and rolling stock.

Where only three of 11 Class I railroads were revenue adequate in 1995, the STB reports that for 2020, major Class I railroads BNSF, CSX, KCS and UP were revenue adequate; and Norfolk Southern (NS) missed the mark by less than four-tenths of a single percentage point.

Additionally, the rail industry’s operating ratio—a commonly used performance metric—which during the 1990s was typically above 85%, declined to under 65% for 2020, reported the AAR. Operating ratio is operating expenses divided by operating revenue. The smaller the ratio the better, as it signifies improved operational efficiency.   

Economist Harvey A. Levine, the AAR’s Vice President of Economics and Finance during the 1980s and 1990s, and now retired, says, “The benefit of reciprocal switching is that when a railroad is more than revenue adequate, it introduces competition into the marketplace that is far more effective than the alternative of a costly, problematic and Byzantine rate-challenge proceeding.”

“The purpose of a financially healthy railroad system is to serve the shippers, for it is the competitive shipment of their goods that grows the U.S. economy.” —Debra L. Miller, former STB member (2014-18)

Retired STB Chief Economist William F. Huneke told this columnist, “STB has to decide how much effort it wants to put into this. It already has two mergers in house and several other open rulemakings. Is this the priority? If not, it will languish as it has for more than a decade.”

For railroads, the reality is that not since 2009—when bills to place railroads more fully under the antitrust laws were successfully voted out of the respective House and Senate Judiciary Committee—have railroads faced such a strong shipper threat. Those bills failed to reach the House and Senate floors for a final vote, allowing railroads to remain largely exempt from Justice Department oversight where STB regulation exists.

Debra L. Miller, former STB member (2014-18)

The looming reciprocal switching threat explains why the AAR is spending significant sums on lobbying such as television advertising in the Washington, D.C., viewing market, as well as contributing to public policy advocacy firms that regularly shop AAR-influenced opinion articles among newspapers and periodicals.

William H. Dempsey, retired AAR President

Former STB member Debra L. Miller (2014-18), a Democrat, told this columnist, “If the Board can find the sweet spot between the onerousness of the process to prove the need for the reciprocal switch and the railroads’ sense of fair play, they will have done a service to the concept of competition. The purpose of a financially healthy railroad system is to serve the shippers, for it is the competitive shipment of their goods that grows the U.S. economy. That simple fact gets lost in this discussion, but it shouldn’t.”

The revisiting by the STB in March of this decade-old NPRM promises to be for railroads their most significant public policy challenge of 2022. To borrow a phrase once used by retired AAR President William H. Dempsey, “It is a rat hole worth watching.”

Frank N. Wilner 

Railway Age Capitol Hill Contributing Editor Frank N. Wilner is a former Assistant Vice President for Policy at the AAR, a former STB chief of staff, and former president of the STB bar association. Publication of his latest book, Railroads & Economic Regulation, is pending.

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