WCTL Seeks Revenue Adequacy Remedy (Updated May 23 with AAR Rebuttal)Written by William C. Vantuono, Editor-in-Chief
The Western Coal Traffic League (WCTL) has filed for a writ of mandamus with the D.C. Circuit Court for the Surface Transportation Board to take administrative action in Docket No. EP 722, Railroad Revenue Adequacy (called “Revenue Adequacy 2014” in the petition). The Association of American Railroads has filed a rebuttal with the STB.
A writ of mandamus is described as “a remedy that can be used to compel a lower court to perform an act that is ministerial in nature and that the court has a clear duty to do under law.” When filing a petition for a writ of mandamus, a petitioner must show that there is no other remedy available. A writ of mandamus is different from an appeal. It asks the higher court to order the lower court to rule on an issue, but does not tell the judge how to rule.
“The STB initiated EP 722 in 2014, but has not taken any actual action, despite holding hearings and even addressing the issue at some length in the Railroad Regulatory Form Task Force Report of April 25, 2019,” notes attorney Robert D. Rosenberg of Slover & Loftus LLP, counsel for the WCTL. “Railroad Revenue Adequacy is one of the four prongs of constrained market pricing in the Coal Rate Guidelines (Interstate Commerce Commission, 1985), but has never been applied in a railroad rate case. The revenue adequacy constraint could be of immense value to captive shippers, where stand-alone cost does not provide an effective remedy, which applies to most captive shippers.”
“Congress has directed the STB to promulgate standards to determine on an annual basis whether large rail carriers are earning adequate revenues,” WCTL writes in its petition (download below). “Congress has also directed the STB to determine the maximum reasonableness of rail rates, and the STB has adopted rules that place a constraint on maximum rail rates charged by revenue-adequate rail carriers.
“In 2014, the STB published a Notice instituting a proceeding asking for public comments addressing two issues: whether its current standards for measuring railroad revenue adequacy should be modified, and how it should apply its revenue adequacy constraint (STB Docket No. EP 722, Railroad Revenue Adequacy 2014). In response to the STB’s Notice, the Western Coal Traffic League, an organization comprised of rail shippers of coal mined in the western U.S., filed extensive comments demonstrating that the STB’s current revenue adequacy standards were substantially overstating revenues carriers needed to be deemed revenue-adequate; setting forth proposed approaches to accurately determine carrier revenue adequacy; and requesting the Board adopt a WCTL-developed methodology to quantify maximum relief under the revenue adequacy constraint. Many other rail users presented similar comments and proposals.
“The record in Revenue Adequacy 2014 initially closed in August 2015—nearly eight years ago. Since that time, the STB has not addressed the merits of the WCTL’s comments and proposals (or those submitted by other shippers). The shipping public deserves better than this lack of action from the agency Congress has entrusted to protect them from unlawfully high rail rates.
“There comes a time when ‘a court must let the agency know, in no uncertain terms, that enough is enough’ (International Chemical Workers Union, D.C. Circuit, 1992). Eight years of delay is enough. The WCTL respectfully requests the Court issue a writ of mandamus directing the STB to take action to address the merits of the issues it raised in Revenue Adequacy 2014.”
FROM RAILROADS & ECONOMIC REGULATION
The following excerpt from Railway Age Capitol Hill Contributing Editor Frank N. Wilner’s forthcoming book, Railroads & Economic Regulation, covers revenue adequacy and what led to how it is currently calculated:
The 1980 Staggers Rail Act contained a directive that the Interstate Commerce Commission (now Surface Transportation Board) establish standards and procedures for “maintaining reasonable rates where there is an absence of effective competition and where rail rates provide revenues that exceed the amount necessary to maintain the rail system and to attract capital.” It was a balancing act, as the ability of railroads to engage in demand-based differential pricing—to achieve revenue adequacy—required equal protection.
Revenue adequacy means 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.
Railroad revenue adequacy is of consequence to captive shippers because the ICC’s 1985 Coal Rate Guidelines decision—one of the ICC’s responses to its Staggers Rail Act directives—provided that upon railroads becoming revenue adequate, a railroad must demonstrate, “with particularity,” its need for higher revenue, describe the harm it would suffer if it could not collect higher revenue, and explain why a captive shipper should pay higher rates. “Our concept is simply that a railroad not use [demand-based] differential pricing to consistently earn, over time,a return on investment above the cost of capital,” said the ICC. (See Conrail v. ICC, 812 F.2d 1444 [3d Cir. 1987]).
Neither the ICC nor its STB) successor has ever applied a revenue adequacy constraint to railroads as provided in the 1985 Coal Rate Guidelines.
Revenue Adequacy Dispute
The 1976 Railroad Revitalization and Regulatory Reform (4-R) Act instructed the ICC to “develop and promulgate reasonable standards and procedures” so that railroads might achieve revenue adequacy.
In 1981, the ICC adopted a single test—compare a railroad’s return on investment (ROI) with the rail industry’s after-tax cost of capital, which is the weighted average of the current cost of debt (interest paid on borrowed funds) and current cost of equity (returns demanded by shareholders for bearing their investment risk) If ROI at least equals the industry’s cost of capital, the railroad is deemed revenue-adequate for that year. (See Ex Parte No. 393, Standards for Railroad Revenue Adequacy, 364 ICC 803 , aff’d sub nom. Bessemer & Lake Erie Railroad v. U.S., 691 F.2d 1104 [3d Cir. 1982], cert denied 462 U.S. 1110 , modified, Ex Parte No. 393 [Sub-No. 1], Standards for Railroad Revenue Adequacy, 3 ICC2d 261 , aff’d sub nom. Conrail v. U.S., 855 F.2d 78 [3d Cir. 1988]. The cost of capital also is used in determining rate reasonableness, and in rulings on applications for Terminal Trackage Rights, Reciprocal Switching, line-abandonment, and merger.)
The cost of capital has two components: debt and equity. While the cost of outstanding debt is observable as the market interest rate, the cost of equity must be estimated. The ICC chose a predictive model—a “single-stage discounted cash flow” (DCF) that considers dividends paid shareholders and security analyst forecasts of future growth. (See Railroad Cost of Capital – 1982, 367 ICC 662 ). Shippers said it did not yield “a realistic picture of the state of the rail industry.” (See Ex Parte No. 463, Railroad Revenue Adequacy – 1984 Determination, 1 ICC2d 615 ). Ignored, for example, was a $2.5 billion cash windfall railroads received from an accelerated depreciation provision contained in the 1981 Economic Recovery Tax Act (Economic Recovery Tax Act, 95 Stat. 172 ).
In 1995, after ICC successor STB found just 3 of the then 11 Class I railroads, STB Vice Chairperson Gus A. Owen wrote in Ex Parte No. 552, Railroad Revenue Adequacy – 1995 Determination, 1 STB 167 (1996):
“Class I freight railroads exceeded earnings per share estimates of independent financial analysts in 1995, they have posted sustained ton-mile growth over the past decade, and they have made remarkable and sustained productivity gains through rationalization of the workforce, fixed-plant, and equipment. The president of the Association of American Railroads [Edwin L. Harper], which represents each of the Class I railroads party to this proceeding, repeatedly has spoken in public of ‘a new Golden Age’ for railroads. Such an incongruity begs for further study of the methods we utilize to determine revenue adequacy.”
Economist Alfred E. Kahn, previously chairperson of New York’s Public Service Commission and an architect of commercial airline economic deregulation, termed the ICC’s revenue adequacy determination “totally discredited … [producing] nonsensical results.” Its flaws, Kahn said, “are irremediable [and] should be abandoned.” (Testimony of Alfred E. Kahn before the House Railroad Subcommittee, Hearings, Reauthorization of the Surface Transportation Board, 105th Cong., 2d Sess. , p. 391.)
Shippers cited evidence of a flawed regulatory process:
- The 1983 purchase by BNSF predecessor Burlington Northern (BN) of El Paso Natural Gas for $600 million. (Prepared Statement of Detroit Edison CEO Walter J. McCarthy before the House Transportation Subcommittee, Staggers Rail Act Oversight, 98th Cong., 1st Sess. [July 27, 1983], p. 521.)
- The 1983 purchase by CSX of Texas Gas Resources for more than $1 billion as reported by the Aug. 8, 1983,Washington Post.
- The 1994 BN acquisition of Atchison, Topeka & Santa Fe (Santa Fe) for $4.1 billion, creating BNSF.
- The 1994 CSX annual report saying, “For the past 2 years, CSX earned in excess of its cost of capital,” even though the STB that year found CSX not to be revenue adequate.
- The 1995 UP acquisition of Southern Pacific (SP) for $4 billion plus debt, as reported by the Aug. 4, 1995 Chicago Tribune.
- The 1998 acquisition of Conrail by CSX and NS for between $11.6 billion and $13.9 billion, as estimated by the National Industrial Transportation League and The Fertilizer Institute. (See Erie-Niagara Steering Committee v. STB, 247 F.3d 437 [2d Cir. 2001].)
- In 7 of 8 years between 2001 and 2008, the rail industry ranked among the top 10 in Fortune magazine’s profitability list.
Beginning in 2008, after the STB revised its methods for calculating revenue adequacy, different results emerged. (In 2008, the STB replaced its DCF model for calculating the cost of equity with a capital asset pricing model [CAPM] that estimates investor expectation by comparing railroad stock prices to the overall market. Ex Parte No. 664, Methodology to be Employed in Determining the Railroad Industry’s Cost of Capital [served Jan. 17, 2008]. Where the DCF method produced a cost of capital of 15.2%, the CAPM model produced an 8.4% cost of capital.) UP was found revenue-adequate in all 10 years between 2010 and 2019, NS in 7 of those 10 years, BNSF in 5 of those 10 years, and CSX in 2 of those years and within a single percentage point of revenue adequacy in 6 other years.
In 2009, the STB adopted an average of the CAPM and a multistage DCF (MSDCF)—the CAPM looking backward and the MSDCF looking forward by using Wall Street analyst forecasts. See Ex Parte No. 664 (Sub-No. 1), Methodology to Be Employed in Determining the Railroad Industry’s Cost of Capital (served Jan. 28, 2009). The MSDCF includes a short-term 5-year growth period, an intermediate period over the following 5 years, and an open-ended long-term growth period. See Ex Parte No. 664 (Sub-No. 4), Revisions for the Board’s Methodology for Determining the Railroad Industry’s Cost of Capital (served Sept. 30, 2019).
A still untried means of determining the cost of equity capital would be to adopt an average of Wall Street analyst estimates—an acknowledgment that Wall Street firms are staffed with the best and brightest of equity analysts, are in stiff competition with each other for investor confidence, and are more removed from political influence than are STB members, who are dependent on White House nomination, Senate confirmation, and congressional approval of the agency’s budgets.
Additionally, Congress has been urged to scrap the annual revenue adequacy determination. The previously mentioned TRB report (Modernizing Freight Railroad Regulation) concluded that the annual determination “serves no constructive purpose,” and “its persistence prolongs the misguided view that a single yes/no indicator of railroad profitability should be used to regulate rates.” The TRB suggested a periodic assessment of industry-wide economic and competitive conditions.
In December 2020, the STB opened a rulemaking to consider a petition by several Class I railroads to change the Board’s procedures for annually determining whether Class I rail carriers are revenue-adequate: Ex Parte No. 766, Joint Petition for Rulemaking – Revenue Adequacy Determinations (served Dec. 30, 2020). The STB has yet to issue a final decision.
The AAR, on behalf of its member railroads, filed a rebuttal with the STB (download below). “The AAR reiterates that it followed the Board’s instructions to use the methodology in Railroad Cost of Capital – 2021, and WCTL does not dispute that. Indeed, WCTL admits that it ‘does not dispute the accuracy of the AAR’s mathematical calculations in implementing its interpretation of the Board’s methodology.’ There being no errors in AAR’s calculations, nor any claims that the AAR failed to follow the cost-of-capital calculation methodology set forth in Railroad Cost of Capital – 2021, the Board should determine that the railroads’ cost of capital for 2022 is 10.58% … and deny WCTL’s backdoor petition for rulemaking.”