Wall Street Darlings or Revenue Inadequate?

RAILWAY AGE, WATCHING WASHINGTON, SEPTEMBER 2019 – Although a purchase is said to be worth precisely what a buyer agrees to pay, not all buyers possess equivalent market power as sellers. United Parcel Service (UPS), for example, may choose between truck and rail. But where freight cannot efficiently move by truck, shippers wishing to remain in business typically pay higher freight rates than if they had effective alternatives to rail.

Thus, when Congress partially scrapped railroad economic regulation—beginning with the 1976 4-R Act and culminating with the 1980 Staggers Rail Act—in recognition of ubiquitous truck competition, regulatory oversight was retained for where railroads possess superior market power. Notably, Congress also instructed regulators to assist railroads in improving their earnings so as to attract needed capital.

This focus on revenue adequacy assures investor confidence by allowing railroads to attract capital to maintain, replace and modernize their track networks. That outcome similarly benefits shippers who depend on reliable rail transportation.

To measure railroad revenue adequacy, regulators compare a railroad’s return on net investment with the industry’s current cost of debt and equity capital—a process as much art as science in that it assesses investor expectations amidst such vagaries as predicting interest rates, stock prices, dividends and inflation. A railroad is deemed revenue adequate if it achieves—over a yet-to-be regulator-defined business cycle—a rate of return on net investment at least equal to its current cost of capital.

While Surface Transportation Board (STB) predecessor Interstate Commerce Commission (ICC) promised in 1985 it would limit future rate increases by revenue adequate railroads, the agency has yet to declare when and how that will occur, even though major railroads have equaled or exceeded the revenue adequacy threshold. BNSF and Norfolk Southern have surpassed the threshold for most of the past 10 years, with CSX and Union Pacific exceeding the threshold for 2018—and no Class I railroad has said in annual reports to investors that it is not revenue adequate.

Railroads consider revenue adequacy an “aspirational goal” and not an event to establish new “wide-ranging price controls.” They suggest many shippers troublingly remain addicted to the narcotic of pervasive government intervention that, before partial economic deregulation, sent the entire rail industry hurtling toward financial insolvency.

Shippers, however, are frustrated with the STB’s failure to deliver on a five-year-old promise to re-evaluate how revenue adequacy is measured (Ex Parte No. 722) and to apply the rate limitation as promised 34 years ago. One skeptic asked rhetorically of the delay, “Is there a predisposed mindset that the agency simply does not believe captive shippers need protection from the rates railroads are now charging?”

Shipper cynicism intensified in August when the STB calculated for 2018 a new railroad cost of capital of 12.22%—more than 2 percentage points higher than in 2017 and more than 3 percentage points higher than in 2016. Significantly, it exceeds by more than 5 percentage points the 7% cost of capital used by Wall Street analysts in their models, which have been referenced by now-retired BNSF Executive Chairman Matt Rose. Of the STB-calculated leap in the cost of capital, the Western Coal Traffic League said, “There is no reason to think that railroading has become riskier.”

Even the STB expressed surprise over its own calculations, acknowledging that “major ongoing changes within the rail industry—financial and operational—underscore the importance of exploring whether the methodology can still yet better capture information.” Shippers are looking to the STB’s internal Rate Reform Task Force to provide answers.

Perennial sparring between railroads and their customers over regulatory concepts such as revenue adequacy imply each is engaged in rent seeking—the economic term for manipulating public power to enhance one’s parochial interests.

The reality is that Congress, in its wisdom, sometimes cuffs the free-market invisible hand memorialized by 18th century political philosopher Adam Smith, thus preventing railroads from universally practicing a preferred market-based management.

Shippers, meanwhile, reject old notions that railroads are an endangered species, viewing them as Wall Street darlings demonstrably revenue adequate and no longer entitled to regulatory favoritism.

In the middle are rail regulators empowered by Congress to choose winners and losers, but who have dithered for five years and counting on just how to measure and decide.

(Editor’s note: The STB on Sept. 12 announced it would hold a public hearing on revenue adequacy issues to consider stakeholder comment on recommendations previously made by an STB internal review task force. The task force suggested the establishment of a definition of long-term revenue adequacy and consideration of providing different remedies for rate cases involving carriers are long-term revenue adequate.

AAR President and CEO Ian Jefferies issued the following statement regarding the STB’s proposed new rules regarding that December public hearing:

“We continue to urge caution with respect to changes that violate the fundamental legal and economic principles that must bind the Board and warn against unintended consequences. The current regulatory balance has allowed railroads to invest in their networks in order to improve safety and meet the current and future needs of customers. During the December hearing, railroads will reiterate that revenue adequacy reflects the industry’s financial soundness and stability under the current regulatory scheme and must not be a trigger for new government intervention and rate regulation.”)

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.