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November 2003

Wrong side of the tracks?

Railroads have made impressive strides over the past two decades, but challenges lie ahead for railroad firms and the communities they serve

David Page
Contributing Writer and
Ronald A. Wirtz
Editor

When Craig Rockey gets stuck in traffic, he worries about railroads. As vice president of policy and economics with the Association of American Railroads (AAR), Rockey understands how congestion on the country's highways could adversely affect the way railroads operate.

By the year 2020, the U.S. Department of Transportation is expecting the amount of freight being hauled within the United States to almost double. If that comes to pass, according to Rockey, “it will put tremendous pressure on state legislatures to allow longer and heavier trucks on roadways and to push for more passenger rail service,” which in turn will affect freight service.

But that's just one problem in a hopper-full of challenges facing railroads today, and after two-plus decades of improvement, the industry faces a crossroad in some ways reminiscent of the one it faced in the late 1970s. At the time, the nation's heavily regulated rail industry was on the verge of collapsing under the weight of outdated regulations, as more than 20 percent of the country's rail mileage was held by railroads in bankruptcy. With the passage of the Staggers Act in 1980, Congress eliminated many of the most burdensome regulations, thereby giving railroad management enough flexibility to run operations more efficiently.

While Staggers did not totally do away with oversight of rail rates by the Interstate Commerce Commission (succeeded by the Surface Transportation Board in 1996), it did allow railroads to price competing routes and services differently and to enter into confidential rate and service contracts. The legislation also streamlined procedures for the abandonment and sale of rail lines and abolished collective rate making, except among railroads participating in a joint-line movement.

This deregulation has been good for the rail industry. According to AAR statistics, rail freight has been on the upswing for the past couple of decades, and that pattern mostly continued in 2003. Through mid-August, the cumulative volume of 15 major carriers, representing 95 percent of U.S. rail freight, showed that carloads were flat at about 13 million. But trailers and containers rose 6 percent to almost 7.8 million to support a growing trend in intermodal freight. (See Minnesota story.)

Recent freight data are not available for district states, but they have been experiencing solid growth as well. The number of carloads rose from approximately 10.2 million in 1995 to 12.4 million in 2001, according to AAR data. Because railroads provide 42 percent of the nation's intercity freight ton-miles—more than any other mode—rail traffic figures are also regarded as an economic indicator for the country as a whole.

While most shipping trends are encouraging for the industry, the problem, according to Rockey, is that “all the low-hanging fruit” of productivity gains made possible by the Staggers Act has been plucked. At the same time, many would like to impose new demands on railroad firms. Some want more rail passenger traffic, while grain farmers in North Dakota, Montana and elsewhere have long complained of price abuse from railroads. These and other parties are urging Congress to re-regulate the industry.

Stagger(ing) out of a slump

Thanks mostly to the Staggers Act, railroads have managed to reverse course over the last two decades. Nowhere is this more evident than in productivity. From 1980 to 2001, labor productivity rose by 360 percent, while locomotive and track productivity both increased by better than 130 percent, according to the AAR.

That's helped railroads improve their financial performance, rising from an anemic annual average of 2 percent rate of return in the 1970s, to 4.4 percent in the 1980s, to 6.9 percent in the 1990s. In 2002, the big rail carriers—called Class I—topped an 8 percent rate of return. Even so, railroads remain consistently in the bottom quartile of profitability among all industries.

The industry has also underwent considerable consolidation. Since the Staggers Act, the number of Class I railroads has gone from 30 independent systems (operating some 76 subsidiary lines large enough to be called Class I lines themselves) to just six firms last year (and a total of seven Class I lines).

Consolidation figures can be somewhat misleading. For one, the revenue bar for a Class I line has been lifted steadily higher and is currently at $250 million. As a result, nine former Class I railroads are still around but classified as a regional or short-line carrier. Staggers also allowed railroads to shed unprofitable lines, and in their place is a growing number of regional and local lines. According to the Federal Railroad Administration, the number of regional and local railroads grew by 36 firms, or about 7 percent, from 1990 to 2000.

Nonetheless, various government and industry sources note that the top five railroads control about 90 percent of the country's rail traffic, and that has a lot of shippers claiming they are the victim of market power wielded by railroads that are often the only transport option for commodities.

Sticker shock, the good kind

The fear after Staggers was that freight lines, free to charge what they wanted, would send rates skyward. In fact, the opposite happened. The AAR estimates that inflation-adjusted freight prices have dropped 60 percent over the last two decades. Research by the Surface Transportation Board (STB) has found that railroad rates have fallen by more than half since passage of the Staggers Act, and even faster for railroads serving the western half of the United States. But as one transportation official points out, “That doesn't mean there isn't differential pricing in North Dakota.”

Differential pricing is a practice whereby a firm charges different rates to different customers based on demand, competition and other factors—something railroads were not allowed to do before Staggers. While there are no official statistics on the matter, it is believed that low-density rural routes in North Dakota and elsewhere are charged anywhere from 15 percent to 60 percent more than heavy-traffic routes.

A 2002 General Accounting Office report found that railroad shipping rates for wheat originating in three district regions (Great Falls, Mont.; Grand Forks, N.D.; and Duluth, Minn.) all saw costs decrease from 1997 to 2000. However, the average rate paid to ship wheat from Great Falls to Portland, Ore. (better than 3 cents per ton-mile), was about twice the rate of Duluth to Chicago. There are many factors to consider—mountainous topography between Great Falls and Portland likely incurs higher maintenance and other costs—but the GAO points out that “rail rates were generally higher in areas considered to have less railroad-to-railroad competition.” There is virtually no competition on the Great Falls line, while shippers can send wheat out of Duluth by boat via the Great Lakes.

As one might expect, railroad competition is a hot topic in North Dakota, where “shippers in almost all of western North Dakota are captive to BNSF [Burlington Northern Santa Fe Railway],” according to Tony Clark, a commissioner from the state Public Service Commission, in testimony last year to a U.S. Senate committee. “Unlike so many other regions of the country, we simply have no alternatives”—or at least viable ones, given there is no direct water access and trucking is “inadequate when it comes to moving bulk commodities distances of 300 to 1,000 miles.”

There are rules also in place to protect small and medium-sized shippers from being captive price takers—being at the mercy of carriers, regardless of price. The STB is in charge of determining the reasonableness of rail rates and, by statute, uses a formula that divides freight revenue against variable (or nonfixed) costs to guide its fairness decisions. If the R/VC is greater than 180 and the railroad is deemed to have no competition from other railroads or modes of transportation, the STB can then consider whether the rate is reasonable.

Nationwide, as much as 30 percent of railroad revenue came from shipments transported at rates that exceeded the government threshold for warranting possible government review. Still, the STB has had very few complaints from shippers, particularly small ones seen as the most vulnerable.

However, the complaint process is widely ridiculed as a bureaucratic nightmare. One Montana rate case dragged on for 17 years. Gathering the necessary information to determine reasonableness can take years and cost a shipper several million dollars. The railroad can spend $5 million or more defending itself. Although the process for small shippers is supposed to be less costly (a $6,000 filing fee as opposed to a $61,400 filing fee for “large” cases), the last small rate case was brought in 1991. In May testimony, STB chair Roger Nober notes, “It is well settled that the [complaint] method is too lengthy, expensive and difficult to use for a small rate case.”

At the same time, the price-gouging case against large haulers has some holes as well. The STB, for example has found “no firm evidence that the rate gap ... has widened appreciably” between exclusively served and other rail shippers since 1984.

The R/VC formula is also a crude measuring stick for determining market power, particularly given productivity improvements among railroads. For example, if revenue (from a commodity shipment) is $1.50, and the variable cost is $1, the R/VC is 150 percent. But if productivity enhancements are able to shave 50 cents off the carrier's variable cost, and that savings is passed on to shippers—and price trends suggest that has been happening for the last two decades—the R/VC ratio nonetheless goes over the threshold at 200 percent.

The STB's 2000 report states that “while there are clearly instances where railroads retain a certain degree of pricing power, nearly all of the productivity gains have been passed to rail customers ... evidence that, on the whole, the railroad industry clearly operates in a competitive environment.”

But officials and grain farmers from Montana and North Dakota appear willing to challenge that conclusion because of a differential (and inverse) pricing scheme by BNSF. That plan lowered grain rates only in the eastern part of North Dakota and into Minnesota—despite the fact that these shipments were sent west—through territory that did not receive the discount. Elevators not offered the reduced rates were paying R/VC ratios of 300 or more, according to testimony by North Dakota's Clark.

This inverse pricing was needed to make efficient use of lines and rail cars, according to Steve Forsberg, general director of public affairs for BNSF. “Like any pricing incentive,” Forsberg says, inverse pricing was “meant to address slack demand.”

After meeting in September 2002 with North Dakota Gov. John Hoeven and state regulators, BNSF management decided to end its inverse pricing structure by eliminating lower prices for the selected grain elevators as of August of this year. Hoeven responded by getting $250,000 from the state Legislature to begin the process of filing a complaint with the STB, a process that could take at least two years and cost $1 million or more.

Wal-Mart-icized

Much of the hand-wringing might best be explained by what one source called the “Wal-Mart argument.” When a Wal-Mart comes to town, smaller retailers are often forced out because they can't offer comparable selection or low prices. Trends in railroad freight are moving to the same big-box or hub model for efficiency purposes. Rather than run around to many small elevators to load cars, railroads are pushing the grain industry to aggregate harvests in fewer—and much bigger—elevators that can load 110-car shuttle trains, which are fast becoming the long-haul standard.

This model does create certain hardships—some farmers might have to truck crops longer distances to elevators, and some elevators will go out of business. But the data also show that the efficiencies gained by this hub model are passed along to shippers and ultimately to consumers in the form of lower prices.

Forsberg says that “shuttle trains are the grain industry equivalent of shopping at Sam's [Club]. We get twice the velocity with shuttle trains, meaning that we can turn cars around twice as fast.” Forsberg, who grew up on a farm in North Dakota, understands what it means to a community to have a grain elevator shut down, but indicates that railroads are still reacting to the fact that lines were overbuilt in the 19th century. “We can't operate as many branch lines as we used to and stay in business,” he says.

The STB has examined whether, in certain instances, it would be economically wise for a firm to lay new track. There are cases where new investment appears to make sense—Dakota Minnesota & Eastern Railroad Corp.'s proposed coal line through much of the district is a good example.

But in a case involving a challenge to the reasonableness of certain rail rates charged to Montana grain shippers, the STB looked at the North Dakota and Montana region served by BNSF. Based on evidence submitted by the parties to the rate dispute, the STB determined that even if many of the normal expenses of building a new line (like environmental permitting and litigation) were eliminated down to just the capital costs of putting in track and the costs of operating the railroad, it still wouldn't make economic sense for a private firm to do so.

The good old (regulated) days

Other challenges loom for both smaller railroads and shippers along low-traffic lines, according to testimony and reports from the Rail-Shipper Transportation Advisory Council, a congressional creation born when the Interstate Commerce Commission was eliminated in 1995.

RSTAC notes that efficiency improvements like unit trains and computerized switching have “potentially condemned a significant portion of the short line capacity to obsolescence.” Class I carriers are moving to a heavier-car standard for larger payloads, which requires infrastructure improvements in all low-density Class I lines, as well as regional or local carriers wanting a piece of their connecting action, and “without this investment, the lower-density feeder network will effectively be cut off from the larger railway system” because it can't handle such cars, according to an August statement by RSTAC.

But the industry faces a critical lack of infrastructure investment in these very rail lines, according to RSTAC. Among the evidence, it cites a 1999 survey of short-line and regional carriers by the American Association of State Highway and Transportation Officials that estimated unmet capital needs of these carriers in the range of $8 billion to $12 billion.

While railroad infrastructure is generally considered overbuilt today—the legacy of a system developed to move goods before the advent of the interstate highway system—RSTAC points out that the system today has many bottlenecks. These in turn have led to capacity constraints and “a general disintegration of service”—a point widely repeated by shippers. For example, BNSF has regularly been at the bottom of rail satisfaction surveys of grain elevator managers conducted by the North Dakota Public Service Commission.

But the biggest—or seemingly loudest—complaint about railroads has to do with differential pricing, as many believe it is patently unfair to charge different shippers different prices for the same commodity. Steve Strege, executive vice president of the North Dakota Grain Dealers Association, testified at a Senate hearing last year that “BNSF must create a level playing field, with reasonable rates for all producers, to ensure that farmers get a fair market price for their commodities.” A letter last year to BNSF from the governors of five states, including Montana and North and South Dakota, ended by asking that BNSF “administer its pricing methods in a way that is fair to all of our railroad customers and grain elevators.”

The farm sector is not alone in its frustration over railroad rates. In a 2002 BusinessNorth article, an official of National Steel Pellet Co. in Keewatin, Minn., said it was “held hostage” by BNSF because the railroad “owns the track and no one else can go on it.” The steel firm pays 1.6 cents per ton-mile to ship pellets down to St. Louis, but 5 cents per ton-mile to ship pellets just 70 miles east to Duluth.

That sentiment is the foundation of the current push to re-regulate railroads. Current proposals in both houses of Congress—one reintroduced by Minnesota Rep. James Oberstar after being scuttled in 2001—seek to simplify the process of determining market dominance and establish greater pricing control in geographic areas believed to be getting gouged. In many ways, such proposals represent a railroad version of the universal service philosophy for telephones, where providers use profitable high-volume lines to subsidize lower-volume lines.

One transportation source, who wished to remain nameless for political reasons, warned that re-regulation could have some unintended consequences. While forcing railroads to lower rates on low-density lines could help shippers in the short term, in the long run it would be a disincentive for firms to invest new capital on such lines, which ultimately would “exacerbate deferred maintenance ... and eventually lead to possible abandonment,” which is made easier by Staggers.

The effort to re-regulate also goes beyond rate setting. Oberstar's bill provides mandatory terminal access and reciprocal switching rights under certain circumstances, something the AAR's Rockey says was “like allowing Ford to use a GM plant during its off hours.”

As truck freight increases as expected, so too will pressure to create commuter railroads to ease congestion on highways, and Oberstar's bill gives commuter rail authorities guaranteed access to freight railroads' rights of way, something that likely will require investment and investigation in numerous areas. “In order to allow passenger trains to use freight lines, the issue of liability, among other things, needs to be addressed,” says Rockey. “Passengers are different from a load of plywood.”

Forsberg, from BNSF, says the railroad does not have a problem working side by side with passenger service, as long as commuter rail authorities make the kind of investments in track and signal systems needed for freight and passenger service to coexist. California has made substantial investments in commuter rail, for example, as have cities like Dallas, Los Angeles and Seattle.

“We're not looking for direct subsidies,” Forsberg says, stressing that public-private partnerships can help to help improve traffic flow. In Missouri, for example, the state sold revenue bonds that the railroads are paying off in order to improve the flow of trains through Kansas City. “There is no risk on the state's part,” Forsberg notes, “and the railroads get a rate on the bonds they could not have otherwise gotten.”

A commuter rail line between St. Cloud and the Twin Cities has been in the making for several years, but Forsberg doesn't think the proposed investments are enough. “The numbers being offered are far below what we estimate will be needed,” he says.

Still, Forsberg is positive, if a bit nervous, about the future for railroads. “Economically things are looking upbeat; we've made a lot of progress since Staggers,” Forsberg says. “But the political situation is such that the legacy of some bills has me very concerned.”

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