Congress called on the U.S. Department of Transportation (USDOT) to sponsor this study of the U.S. freight railroad industry’s economic regulation, including its purpose and performance in ensuring that railroads can earn enough revenue to continue to operate and invest and that rail shippers can obtain adequate service at reasonable rates.1 The study charge specifically calls for recommendations on the future role of the Surface Transportation Board (STB) in overseeing and regulating the service levels and rate offerings of railroads, particularly as they become revenue adequate.
STB was established in 1995 to succeed the Interstate Commerce Commission (ICC), which had been responsible for administering the federal railroad regulatory program when the Staggers Rail Act of 1980 substantially eased or eliminated many long-standing regulations on railroad pricing and operations. To the detriment of freight shippers, these regulations hindered the ability of the private railroads to earn enough revenues to invest, innovate, and become efficient. Implementation of the act’s reforms was quickly followed by the restructuring and revitalization of the freight railroads, which shed large amounts of excess, uneconomic capacity; substantially increased their productivity; and introduced innovations that conferred large benefits on shippers in the form of improved service offerings and lower rates. By the late 1990s, the Staggers Rail Act had succeeded in spurring the development of a modern and more efficient railroad industry that was better able to compete with trucks, maintain and expand capacity, and respond flexibly to shippers’ needs with less regulatory oversight and control.
1 The study does not address the federal role in overseeing and regulating the safety of railroads and railroad shipments, which are the primary responsibilities of the Federal Railroad Administration and the Pipeline and Hazardous Materials Safety Administration.
Examinations of rate and service levels in the post-Staggers railroad industry since 2000 find that rates have been rising in real terms and that service disturbances have been episodic and occasionally widespread, particularly after abrupt increases in freight demand and bouts of severe weather. Rising rates have coincided with a slowdown in productivity gains—since many of the largest opportunities for improvements after deregulation had been exploited—and by volatility in input prices, particularly for fuel. Complaints about service offerings, including assertions of chronic unreliability, have been voiced by some shippers, particularly those using common carrier service, which remains subject to regulatory oversight. However, trends and patterns in common carrier service cannot be readily discerned because of a lack of sufficiently detailed data on most aspects of service quality.
The Staggers Rail Act prompted the modernization of the freight railroads to the benefit of shippers generally, but questions have been raised about the continued applicability of some of its provisions to the financially stronger railroad industry that has emerged. When the act was passed, there was much uncertainty about how successful the reforms would be in rescuing a distressed industry that had been receiving growing government subsidies but whose services remained critical to many shippers. Shippers of bulk commodities such as grain, coal, and chemicals remained especially dependent on rail. Thus, in addition to easing or ending many regulations to give the railroads more pricing and operating freedom, the act preserved some old regulatory provisions and added new ones. Some of these provisions were intended to enhance the ability of the railroads to earn the revenues needed to pay for their capital-intensive systems. Others were aimed at protecting shippers who depend on rail transportation from the loss of vital service and from railroads’ taking advantage of less competition in certain markets to charge unreasonably high rates.
Five of these regulatory provisions are examined closely in this study because, 35 years after the Staggers Rail Act, they remain the subject of controversy as the railroad industry’s competitive structure has changed, shipper expectations for service have evolved, and the
- Maximum rate protections afforded shippers who use common carrier service in markets that lack effective competition. These protections allow shippers to dispute a common carrier rate if it exceeds a statutory threshold of 180 percent of the shipment’s “variable cost,” as determined by STB through assignment of portions of a railroad’s total expenses to individual shipments. Shippers that meet the threshold must then prove the railroad lacks effective competition and that revenues earned from the disputed rate are unreasonable because they exceed the amount required by the railroad to keep providing the service.
- Common carrier obligation of railroads to provide service to shippers on reasonable request, and STB’s authority to regulate and supervise the posting of common carrier rates and the setting and fulfillment of other service terms.
- Annual determinations of the revenue adequacy of each major railroad, which STB is required by law to issue and are implemented by comparing a railroad’s annual rate of return on investment with an estimate of the industrywide cost of capital.
- Railroad merger and acquisition approvals that are to be conducted by STB according to a broad public interest standard that emphasizes the preservation of competitive rail service in freight markets but gives weight to other interests deemed by regulators to be publicly beneficial, including the transaction’s potential to affect the financial condition of other railroads.
- Seldom-exercised authority to order a railroad to allow competitors access to its sole-served traffic, particularly through the use of reciprocal switching arrangements whereby the railroad is required for a regulated fee to transport the traffic to and from nearby interchanges for line-haul service by another railroad.
The study committee, which was asked to advise on the future role of STB, was struck by the extent to which these regulatory provisions serve purposes that are now expired or are being implemented in ways that no
longer serve their goals. The committee’s findings of unsound and outdated regulations and regulatory practices, all introduced decades ago when the railroads and associated policy concerns were much different from those of today, are summarized next along with recommendations for replacing them with practices better suited to the modern freight railroad industry that the Staggers Rail Act helped bring about.
MAXIMUM RATE PROTECTIONS
The committee finds that more appropriate, reliable, and usable procedures for resolving rate disputes are needed to fulfill the regulatory interest in protecting shippers in markets that lack effective competition from unreasonably high rates. The methods used by STB to assign variable costs to shipments by allocating portions of a railroad’s total expenses are economically invalid and produce unreliable results because most railroad costs are shared by traffic and cannot be unambiguously divided and allocated to individual units of traffic. The allocations, made by STB through use of its Uniform Railroad Costing System (URCS), are inevitably arbitrary and therefore cannot have a stable or meaningful connection to a shipment’s rate or to the level of market power possessed by the railroad. The fundamental problem lies with the law’s requirement that variable costs be allocated to shipments when most railroad costs are shared and not traceable to individual shipments. This study documents how the URCS-derived variable costs used to implement the law’s 180 percent revenue-to-variable-cost formula have led to systematic biases in the traffic qualifying for rate relief and to nonsensical outcomes such as a quarter of traffic being priced below its URCS-derived variable cost.
When the Staggers Rail Act was passed, all railroad pricing had been regulated, and hence there were no competitively determined rates that could serve as benchmarks for assessing the reasonableness of rates in markets with no effective competition. Accordingly, regulators preserved the long-standing and dubious practice of pretending to establish the variable cost of transporting individual shipments by apportioning indivisible common costs. Three decades later, ample data on market-based rates are available. They offer the potential for using statistical methods to predict what a shipment’s tariff rate would
be in a market having effective competition. The idea is that such predicted competitive rates can be used as benchmarks for determining whether a disputed rate is unusually high and deserves further scrutiny as potentially unreasonable. The demonstration of a benchmarking methodology in this report suggests that screening rates for relief eligibility on the basis of rates paid for comparable shipments in effectively competitive markets holds sufficient promise to warrant a concerted effort to develop, test, and refine candidate methodologies for implementation.
Successful development of a competitive rate benchmarking methodology would end the need to screen rates for relief eligibility by using a formula that applies an arbitrary 180 percent standard to an arbitrary and unreliable cost allocation, and accordingly the committee offers the following advice to Congress:
Recommendation: Prepare to repeal the 180 percent revenue-to-variable-cost formula by directing USDOT to develop, test, and refine competitive rate benchmarking methods that can replace URCS in screening rates for eligibility to be challenged.
USDOT is recommended to lead the effort to develop a competitive rate benchmarking tool because it is not committed to the conceptually flawed URCS, which STB uses for multiple regulatory purposes. Replacing the URCS-based revenue-to-variable-cost formula with a more reliable and economically valid means of screening rates for eligibility to be challenged would allow regulators to dispense with the controversial follow-on procedures that are used in ruling on the reasonableness of challenged rates. The committee finds that these procedures lack a sound economic rationale and are unusable by most shippers, and thus they deserve to be replaced.
Perhaps because of the unreliability of the URCS-based screening process, STB has instituted exacting and burdensome standards for judging the reasonableness of challenged rates. The standards are intended to respect the law’s interest in ensuring that railroads are not denied the opportunity to earn adequate revenues. STB’s stand-alone cost test and other URCS-based procedures for judging rates are supposed to provide insight into the revenue needed by the railroad to
keep supplying the service at issue. However, the use of these methods offers little insight into actual revenue needs, is inappropriate to the circumstances of many shippers, and entails such high litigation costs that many shippers have not been able to avail themselves of the rate relief process. The result has been large and prolonged inequalities in shipper access to the law’s maximum rate protections. Thus, the goal of reform should be to introduce a more rational and reliable rate screening process that will allow for less burdensome follow-on methods for ruling on the reasonableness of rates and for creation of an overall system for affording rate relief that is accessible to more shippers.
Replacing the law’s revenue-to-variable-cost formula with a more reliable competitive rate benchmarking screen should not threaten revenue adequacy because regulators would be able to set the strictness of the screen—that is, the amount by which a rate can exceed its predicted competitive level before being subject to challenge. There is a trade-off regulators would need to consider in making such a decision: a stricter screen will provide less risk to railroad revenue adequacy but afford fewer shippers with legitimate rate grievances eligibility for relief. Making the screen less strict will offer greater opportunity for aggrieved shippers to challenge their rates but pose a greater risk to railroad revenue adequacy. Although decisions about the appropriate screening threshold could be controversial, they would be transparent, which is preferable to the current dependence on arbitrary and unreliable cost allocation rules used in implementing an arbitrary revenue-to-variable-cost formula instituted more than a generation ago.
With the ability to exercise more direct control over the rate screening process, regulators could discard the burdensome and inappropriate rate reasonableness standards that are in use today, and Congress could more confidently take the following action:
Recommendation: Replace STB rate reasonableness hearings with arbitration procedures that compel faster resolutions of disputes involving rates deemed eligible for challenge because they substantially exceed their competitive rate benchmarks.
The standards and procedures used by ICC and STB for ruling on the reasonableness of challenged rates have proved to be slow, costly, and
inappropriate for many shippers’ circumstances over three decades. Thus, they prevent shippers from having equal and effective access to the law’s maximum rate protections. Efforts to streamline and expedite the process through the use of simplified procedures have not overcome these deficiencies and in some respects have made matters worse. The simplified procedures make STB more dependent on the unreliable and arbitrary cost allocations of URCS. They replace the ill-suited and cumbersome stand-alone cost test with procedures that offer even less predictable decision criteria and lack even that test’s weak conceptual basis.
STB’s direct role in maximum rate rulings should be ended and replaced by an independent arbitration process similar to the one long used for resolving rate disputes in Canada. Unless both parties to a rate challenge agree to another format, the arbitration should be performed under a strict time limit and a final-offer rule whereby each side offers its evidence, arguments, and possibly a changed rate or other remedy in a complete and unmodifiable form after a brief hearing. The arbitrator should be instructed to keep the offers private and choose only one side’s full offer without compromise. A competitive rate benchmarking method cannot control for all factors that may legitimately affect rate levels. Therefore, market dominance may not always be the cause of a challenged rate appearing high in comparison with its competitive benchmark rate. Accordingly, the arbitrator should consider evidence of market dominance, and if dominance is not found, the arbitrator should be instructed either to dismiss the challenge or to choose the railroad’s final offer. Serious consideration should be given to restricting opportunities for appealing such rulings to ensure that the arbitration process remains timely and economical.
Finally, the allowable remedies in arbitration offers should not be limited to alternative rates. The Staggers Rail Act gives regulators authority to order reciprocal switching when “necessary to provide competitive rail service.” Reciprocal switching has never been prescribed by STB when a rate is found to be unreasonable, partly out of concern that such an intervention would cause rates to fall below the statutory 180 percent revenue-to-variable-cost threshold. The repeal of this arbitrary formula should make this concern moot. In addition, any
reciprocal switching arrangement proposed in a final offer arbitration is likely to be reasonable in scope and severity if the party proposing it intends to prevail. Accordingly, there should be no need for regulators to set switching fee schedules or to establish applicable distance limits, since such terms should be part of any offer put before the arbitrator that included reciprocal switching. Congress could therefore take the following recommended step:
Recommendation: Allow reciprocal switching as a remedy for unreasonable rates.
Permit parties in rate arbitrations to propose reciprocal switching arrangements in their offers to resolve the dispute if they so desire and allow the arbitrator to order that such arrangements be made.
ANNUAL REVENUE ADEQUACY DETERMINATIONS
The Staggers Rail Act requires STB to maintain standards and procedures to be used annually for determining which Class I railroads are earning revenues sufficient to attract capital. This annual pass/fail appraisal of revenue adequacy has become ritualistic while offering little substantive information for regulators and policy makers in monitoring the industry’s economic and competitive conditions. The decades-old requirement, adopted when railroads were failing and the subject of government rescue efforts, suggests a long-term interest in regulating the profitability of individual railroads, which appears neither practical nor consistent with the deregulatory thrust of the Staggers Rail Act reforms. By sponsoring periodic assessments of economic and competitive conditions in the industry as a whole that used more varied data and analytic techniques, Congress and STB would obtain a richer set of information to support regulatory decisions and policies. The committee therefore recommends that Congress take the following step:
Recommendation: End annual revenue adequacy determinations and require periodic assessments of industrywide economic and competitive conditions.
Decades ago when the railroads were heavily regulated, they were exempted from customary antitrust reviews of mergers and subjected instead to a broader public interest review by ICC. Even after economic regulation in the industry was eased, the public interest standard was retained, in part to allow the more financially viable railroads to reduce perceived duplicative capacity by acquiring struggling competitors and thereby concentrating traffic and revenues to regain profitability. Any such rationale for keeping the public interest standard no longer exists, since STB itself has stated that excess and duplicative capacity are no longer problems and that preserving competition among the remaining railroads will be the priority for future reviews. In view of the diminished reasons for the public interest standard, its preservation can only detract from the appropriate focus on competition. STB is not as qualified to assess competitive effects as the Antitrust Division of the U.S. Department of Justice, which because of its specialized expertise on these matters is already required to advise STB on a merger’s potential competitive effects. Accordingly, the committee recommends that Congress take the following step:
Recommendation: Transfer merger review authority to the antitrust agencies and apply customary antitrust principles rather than a public interest standard.
STRATEGIC REVIEW OF STB DATA PROGRAMS
Recommendation: Congress should give STB the direction and resources to undertake a strategic review of all of its data programs to simplify or discontinue the reporting of little-used data as a general matter and to support the recommended changes in its regulatory practices and approaches.
In particular, STB should be directed to review and introduce means to improve the accuracy, utility, timeliness, and availability of the Carload Waybill Sample. Its improvement will be needed to support
The strategic review should also give priority to the data needed by STB to fulfill its role in assessing the railroad response to the common carrier obligation. STB should seek to obtain shipment-level data on service quality. Options should be explored for collecting such data, including additions and enhancements to the Carload Waybill Sample itself, because shipment-level tracking is essential for understanding trends in service levels and patterns as they shift and vary across time, regions, and traffic segments.
Finally, STB should reassess its collection of detailed railroad accounting, financial, and operations data with an eye to reducing railroad reporting burdens as appropriate given the changes in practice and responsibilities advised in this report. In particular, consideration should be given to the kinds of data that will be needed in conducting the recommended periodic economic and competitive studies of the industry.
There are opportunities for STB to take early steps to advance the recommendations of this report, such as by supporting USDOT in exploring competitive rate benchmarking methods and by commencing the planning of a modernized data program. Such efforts could help inform the legislative actions that are likely to be required to further the recommendations—actions that the committee believes are overdue. The last major revision to the Staggers Rail Act terminated ICC and created STB 20 years ago. The Staggers Rail Act itself was passed 35 years ago. Since then, the railroad industry has been transformed, essentially modernized in step with the other transportation industries that were deregulated at about the same time. The railroad industry was in a fundamentally different position at the time of its deregulation. It was on the edge of bankruptcy despite its considerable potential market power and needed specialized regulatory reforms that took its financial distress into account. The industry continues to have characteristics differing from those of the other transportation modes,
such as its vertical integration and the ability to obtain and exercise local market power, that demand ongoing regulatory oversight. Thus, railroad deregulation should not be complete. However, the economic regulations that remain should be suited to the financially sound, modern railroad industry of today and not to the foundering one that required rescue 35 years ago. The actions recommended in this report recognize the continued significance of the railroad regulatory program and are intended to resynchronize key elements of it that have become outdated.
The modernization proposed in this report would reduce the anachronistic regulatory burdens railroads still bear while giving more shippers real protection against unreasonable rates. It would thus continue the process begun by the Staggers Rail Act—a process that is aimed at producing a modern, efficient, and competitive railroad industry able to attract capital, maintain and expand its capacity, and serve its customers with the minimum necessary regulatory oversight.