National Academy of Sciences Study on Freight Rail

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National Academy of Sciences Study on Freight Rail Regulation NGFA Convention San Diego, CA

National Academy of Sciences Study on Freight Rail Regulation NGFA Convention San Diego, CA March 13, 2016 Tom Menzies

National Academy of Sciences NAS is a private, non-profit organization Created during Civil War

National Academy of Sciences NAS is a private, non-profit organization Created during Civil War to provide independent advice to government Studies are performed by expert committees whose members are free of financial conflicts Reports are peer reviewed, not subject to change by sponsor

Congress called on NAS to Review: • • • Freight rail rates & service:

Congress called on NAS to Review: • • • Freight rail rates & service: What have the trends been since 1980 Staggers Act & more recently STB regulatory policy: Has the policy achieved Staggers’ goals of: • Railroads being revenue adequate? • Shippers getting reasonable rates & service? STB’s Future: How should STB regulate rates & service going forward? Large/Complex Report: Focus of this presentation is on how STB should regulate rates going forward

Committee for a Study of Freight Rail Regulation • • Richard Schmalensee, MIT, Chair

Committee for a Study of Freight Rail Regulation • • Richard Schmalensee, MIT, Chair Ken Boyer, Michigan State University Jerry Ellig, George Mason University Tony Gómez-Ibáñez, Harvard University Anne Goodchild, University of Washington Wes Wilson, University of Oregon, Eugene Frank Wolak, Stanford University

Historical Background • By the 1970 s—RRs were in a crisis • Suffering from

Historical Background • By the 1970 s—RRs were in a crisis • Suffering from decades of overregulation, truck competition • Stream of bankruptcies • revenue April 1972: Lehigh and Hudson River Railway June 1972: Erie Lackawanna Railway July 1973: Beech Creek Railroad; Cleveland, Cincinnati, Chicago and St. Louis Railway; Cleveland Pittsburgh Railroad; Delaware Railroad; Erie and Pittsburgh Railroad; Michigan Central Railroad; Northern Central Railway; Penndel Company; Philadelphia and Trenton Railroad; Philadelphia, Baltimore and Washington Railroad; Pittsburgh, Fort Wayne and Chicago Railway; Pittsburgh, Youngstown and Ashtabula Railway; Union Railroad of Baltimore (Penn Central subsidiaries) October 1973: Ann Arbor Railroad • Congress paying $ billions for bailouts

Dramatic Changes in Economic Landscape RRs Suffered Serious Harm from Competing Modes Led to

Dramatic Changes in Economic Landscape RRs Suffered Serious Harm from Competing Modes Led to loss of nearly all highvalue, nonbulk traffic. Truck was service faster and more secure Led to sharp drop in passenger demand • Cars had become ubiquitous • Jet planes made air travel faster 6

Dire Consequences Ensued Rail System Had Become Too Large and Misaligned with Demand Overbuilt

Dire Consequences Ensued Rail System Had Become Too Large and Misaligned with Demand Overbuilt Networks Were Developed Mostly Between 1850 and 1920 Rail revenues were too low to maintain this vast, underused network 7

Problems Made Worse by Overregulation RRs had been regulated since 1880 s Regulation’s original

Problems Made Worse by Overregulation RRs had been regulated since 1880 s Regulation’s original purpose was to stabilize RR industry 1880 s—RRs faced little competition, except with one another • RR would gain local monopoly rates up • Higher rates attract entry rates fall • Rate wars rates fell below total cost • Bankruptcies • Single RR remains rates up • Cycle repeats Shippers would benefit at first, but instability hurt all

ICC’s 19 th Century Solution to Instability Limit RR entry, abandonment & mergers Allow

ICC’s 19 th Century Solution to Instability Limit RR entry, abandonment & mergers Allow RRs to create cartels, or rate bureaus, to divide traffic and coordinate rates To satisfy shippers, rate bureaus charged: • Higher rates for high-value goods (manufactured goods) • Lower rates for low-value bulk goods (coal, grain, etc) High-value shippers benefited from transport stability Low-value (bulk) shippers benefited from lower rates A system of cross subsidies--RRs able to earn enough total revenue to coverhead. Continued for decades……

20 th Century: Trucks Upset Cartels Nonbulk Shippers (e. g. , manufactured goods) •

20 th Century: Trucks Upset Cartels Nonbulk Shippers (e. g. , manufactured goods) • They were being charged high regulated rates they wouldn’t pay • They didn’t care if rail service went away • Simply switch to ubiquitous truck Bulk Shippers: • They were paying regulated rates that were too low for RRs to maintain and improve the service • But these shippers needed the service • RRs failures would be disastrous 10

Major Government Responses Letting RRs fail was not an option 1971: Congress ended required

Major Government Responses Letting RRs fail was not an option 1971: Congress ended required passenger service • Created AMTRAK 1976: Congress bailed out bankrupt railroads • Created CONRAIL 11

But More Dramatic Change Was Needed Nationalizing RRs was not an option Congress forced

But More Dramatic Change Was Needed Nationalizing RRs was not an option Congress forced to accept that ICC regulatory regime was outdated and harmful 1980: Congress Passed Staggers Rail Act Key Provisions • Deregulated most rates—outlawed rate bureaus • Allowed RRs to shed excess capacity • Allowed RRs to obtain and exploit more market power

Rate Deregulation Railroads were free to charge according to each shipper’s “willingness to pay”

Rate Deregulation Railroads were free to charge according to each shipper’s “willingness to pay” for rail service • RRs could charge what the market would bear for rail traffic that can move by truck • RRs and shippers were allowed to negotiate private contracts What did these reforms do? • RRs could negotiate rates according to each shipper’s “willingness to pay” • Shippers with more transport options pay less • Shippers with fewer options pay more

Is “Willingness to Pay” Fair? Key Goal of Staggers was to Stop Bailouts This

Is “Willingness to Pay” Fair? Key Goal of Staggers was to Stop Bailouts This meant RRs would need to become revenue adequate, earning enough to pay for their overhead (e. g. , tracks etc) Fair or not, trying to get shippers with good truck and water service to pay rail rates high enough to coverhead was a losing proposition Meanwhile, shippers without good options would suffer the most if their rail service went away for lack of revenues Congress had no choice--RRs would have to be allowed to price according to willingness to pay

 Many Staggers Provisions Strengthened “Willingness to Pay” Allowed Capacity Cutbacks: • Liberalized abandonments

Many Staggers Provisions Strengthened “Willingness to Pay” Allowed Capacity Cutbacks: • Liberalized abandonments and mergers • RRs could therefore shed duplicative, uneconomic capacity (including capacity from rivals) • RRs could consolidate market power in some locations Gave RR’s Operating Freedom: • Allowed cancellation of old interchange agreements • RRs could therefore “capture” some shippers • “Captive” shippers would have few options, and thus a higher willingness to pay

But Staggers also offered protections for shippers with few transport options Recognized that giving

But Staggers also offered protections for shippers with few transport options Recognized that giving RRs more market power could lead to monopoly exploitation --RRs might charge excessive rates, higher than needed for revenue adequacy Staggers mandated that RRs charge “reasonable” rates? --But “reasonable“ was not defined, except that a rate must bear some relation to the RRs need to earn adequate revenue

Staggers Solution to Protect Shippers from Unreasonable Rates If tariff exceeds 180% of the

Staggers Solution to Protect Shippers from Unreasonable Rates If tariff exceeds 180% of the “variable cost” of the service, shipper could protest But no guarantee of relief. The 180% R/VC is an initial screen, allowing progress to the next stages of protest. Protesting shipper must then: --show it has no competitive options (e. g. , subject to market dominance) --prove the rate is “unreasonable” –-that is, out of line with the RR’s revenue adequacy needs

Implementation of Rate Relief was Left to STB Major Challenges for STB: What exactly

Implementation of Rate Relief was Left to STB Major Challenges for STB: What exactly is the “Variable Cost” of a shipment? What constitutes “Market Dominance”? What constitutes an “Unreasonable” rate out of line with revenue adequacy needs?

Defining “Variable Cost” is Problematic In fact, it is futile A Quick Example Demonstrates

Defining “Variable Cost” is Problematic In fact, it is futile A Quick Example Demonstrates Why

A A A Fixed/Sunk Cost of Existing Track But what is “Variable Cost” of

A A A Fixed/Sunk Cost of Existing Track But what is “Variable Cost” of Serving A? + + ?

B B AA What is “Variable Cost” of serving B? Extra ?

B B AA What is “Variable Cost” of serving B? Extra ?

Or are these the “Variable Costs” of Serving A & B? A A B

Or are these the “Variable Costs” of Serving A & B? A A B B + VC of A = + VC of B = + +

But this makes no sense! B B A A If RR stopped serving B,

But this makes no sense! B B A A If RR stopped serving B, it would not save half the cost of the engine

Then what is the “Variable Cost”? There is no “right” way to estimate VC

Then what is the “Variable Cost”? There is no “right” way to estimate VC All methods of dividing common costs such as labor and locomotives are arbitrary Alfred Kahn: its like “looking for a black cat in a dark room …when there is no cat”

Why care that VC estimates are arbitrary? Garbage in/garbage out…. . leads to illogical

Why care that VC estimates are arbitrary? Garbage in/garbage out…. . leads to illogical outcomes Each year STB estimates 25% of shipments are earning less than their variable cost This implies RRs are losing money on 25% of traffic! More likely reason for this outcome is that STB’s VC estimates are unreliable

If VCs are inherently unreliable, then how can they be used to screen eligibility

If VCs are inherently unreliable, then how can they be used to screen eligibility for rate protests? To be eligible to protest, a shipper must first show that its rate is >180% of VC STB has a legitimate concern that an unreliable screen could lead to a flood of rate relief protests A flood would tax STB’s adjudication abilities It would also risk RR revenue adequacy if there were too many rate cases

How to compensate for an unreliable eligibility screen? Create a demanding rate relief procedure

How to compensate for an unreliable eligibility screen? Create a demanding rate relief procedure at the back end of the adjudication process. A procedure that is so costly and intimidating that few shippers will protest a rate even if they meet the 180% R/VC threshold The Stand Alone Cost (SAC) Test meets these criteria

If one wanted to design an intimidating process, SAC would be the ideal SAC

If one wanted to design an intimidating process, SAC would be the ideal SAC requires developing an elaborate, hypothetical railroad that “shows” the revenues a RR would need in order to serve only the traffic of the protesting shipper SAC cases are very complicated and costly to develop, >$5 million Sure to dissuade all “frivolous” claims, protecting STB from flood of cases and railroads from risks to revenue adequacy

But are “frivolous” claims the only ones being turned away by the imposing SAC

But are “frivolous” claims the only ones being turned away by the imposing SAC process? SAC was designed for shippers with large claims, moving large quantities on fixed traffic lanes (e. g. , coal shippers in 1985) But did Staggers intend for rate relief to apply only to shippers moving large volumes on fixed lanes? SAC’s litigation cost means that shippers of smaller volumes are reluctant to bring a case. The litigation costs exceed their claims

The evidence bears this out: Rate Disputes Adjudicated Using SAC, 1996 -2014 Disposition Coal

The evidence bears this out: Rate Disputes Adjudicated Using SAC, 1996 -2014 Disposition Coal Grain Minerals Chemicals Rate Reasonable 7 1 0 2 Rate Unreasonable 7 0 1 0 Settlement 21 0 0 3 Withdrawn 2 0 0 0 Total 37 1 1 5

Why not scrap SAC and replace it with something faster and less expensive such

Why not scrap SAC and replace it with something faster and less expensive such as arbitration? Arbitration would mean that shippers with small claims would not be denied access to rate relief because of high litigation costs But can arbitration work when protest eligibility is based on an unreliable 180% R/VC screen? A problem is that a very large share of traffic exceeds the 180% figure.

Large Share of Traffic <180% R/VC

Large Share of Traffic <180% R/VC

It would be unwise to reform only the “back end” of the rate relief

It would be unwise to reform only the “back end” of the rate relief process First thing needed is a more reliable “screen” to replace R/VC Fixing this problem would allow for a faster, more economical “backend” of the rate adjudication process End Goal: A rate relief process that is not inherently biased against certain kinds of shippers

Why is Eliminating this Bias Critical? Share of Total Common Carriage Ton-miles Year 2000

Why is Eliminating this Bias Critical? Share of Total Common Carriage Ton-miles Year 2000 to 2012 Grain/Food up from 21% to 50% Coal drops from 48% to 11% Year 2012 34

Committee Recommends STB should stop trying to estimate the variable cost of shipments It

Committee Recommends STB should stop trying to estimate the variable cost of shipments It should replace the R/VC screen with “Competitive Rate Benchmarking” as a screen A more reliable screen will allow for the termination of SAC and the use of a faster arbitration process to award rate relief

What is Competitive Rate Benchmarking? When Staggers was passed in 1980, all rates were

What is Competitive Rate Benchmarking? When Staggers was passed in 1980, all rates were regulated Not possible to compare rates in competitive markets with rates in noncompetitive markets Congress called for VC estimation as a proxy. But now we know this does not work. But today, many rates are in competitive markets— where there are two or more railroads or rail and water competition These competitive rates can serve as “benchmarks” for assessing the reasonability of rates in noncompetitive markets

How would it work? Statistical models can compare the rates of similar shipments, controlling

How would it work? Statistical models can compare the rates of similar shipments, controlling for distance, car type, train size, and other cost factors Models can “predict” what the rate should be for a given commodity according to distance traveled, car type, railroad, and train size when there is competition 10 cents/ton-mile 0 2 4 6 8 10 12 14 16 18

Curve shows the probability of competitive rates 10 cents/ton-mile 0 2 4 6 8

Curve shows the probability of competitive rates 10 cents/ton-mile 0 2 4 6 8 10 12 14 16 18 20 But no model can control for everything. There is a chance that the competitive rate is 12 cents cts But the chance of it being 12 cents is smaller And even smaller for 16 cents etc

10 cents/ton-mile 0 2 4 6 8 10 12 14 16 18 20 One

10 cents/ton-mile 0 2 4 6 8 10 12 14 16 18 20 One might ask: Why is that rate so out of line? Is it “unreasonable”? Should the shipper be eligible to protest?

Committee recommends that STB establish these probability distributions for major commodities (grain, coal, chemicals,

Committee recommends that STB establish these probability distributions for major commodities (grain, coal, chemicals, etc) using its Carload Waybill data STB would then need to set the threshold above the competitive rate benchmark that would qualify a shipper to protest For example, if a rate is 60 percent higher than the benchmark, then a shipper could protest In our example, • Competitive benchmark is 10 cents • Threshold for protest would be 16 cents • Any shipper could protest if rate is >=16 cents

Having a much more reliable and controllable screen, STB could do away with the

Having a much more reliable and controllable screen, STB could do away with the imposing SAC test Committee recommends Final Offer Arbitration to replace all STB rate adjudications • Arbitration is relatively informal, so it can be fast, economical, & will not deter cases. • Canada has shown its effectiveness when accompanied by time limits. Used here in grain industry • Final-offer rule will prompt compromise and settlement Goal is for a process that does not threaten RR revenue adequacy while also not shutting out shippers from rate relief access

Summary Committee was asked to examine the current regulatory regime Found that it worked

Summary Committee was asked to examine the current regulatory regime Found that it worked to revive a failing railroad industry RR industry is much more efficient and innovative to the benefit of shippers But the industry has changed, and some Staggers Era regulations are no longer appropriate Rate relief process has run its course, no longer achieving goals of the Staggers Act An alternative process is over due

Other Areas in Need of “Modernization” Annual RR Revenue Adequacy Determination— No longer serving

Other Areas in Need of “Modernization” Annual RR Revenue Adequacy Determination— No longer serving a purpose, should be ended STB merger review authorities—Not a regulatory function warranted, should be transferred to USDOJ STB needs to collect more shipment-level data to monitor common carrier service. Current oversight is too dependent on anecdotal information

Thank you Questions? tmenzies@nas. edu

Thank you Questions? tmenzies@nas. edu