Modernizing Freight Rail Regulation (2015)

4

REVIEW OF OTHER REGULATORY PROVISIONS

The preceding chapter focused on the rate reasonableness provisions of the railroad regulatory program. Those provisions deal directly with balancing the interest of railroads in earning adequate revenues against that of shippers in obtaining reasonable rates and service levels. However, they are not the only regulatory requirements or practices that can affect railroad rates, service levels, and revenue adequacy. Because of the impracticality of critiquing all relevant elements of the regulatory program, the committee concentrated its assessment on four provisions that have remained controversial or unsettled in their implementation and that are candidates for change.

The four provisions examined are (a) the common carrier obligation and its implications for service quality in a partially deregulated railroad industry, (b) the requirement that regulators annually determine the revenue adequacy of Class I railroads and whether this requirement retains a useful purpose, (c) the exemption of railroad mergers from standard antitrust reviews focused only on competition and whether a rationale remains for reviews conducted by regulators according to a broader “public interest” appraisal, and (d) the authority of regulators to use reciprocal switching orders to forestall or remedy unreasonable rates. The requirements associated with each provision and the history of its implementation are discussed. The committee’s assessment of its continued relevance and of the need for changes follows.

COMMON CARRIER SERVICE OBLIGATION

Requirements and History

The obligation of railroads to provide service under terms of common carriage can be traced to English common law and requirements

in charters granted by states that gave railroads land rights through eminent domain (Keeler 1983, 19–22). As discussed in Chapter 1, railroads providing common carriage were expected to serve all shippers equally, without “discrimination,” and at just and reasonable prices. Later codified in the Interstate Commerce Act, the common carrier obligation, and its emphasis on nondiscrimination as interpreted by courts, was the foundation for many regulatory requirements such as prohibitions on private contracting and the discounting of rates.

Before the commencement of regulatory reforms during the 1970s, all railroad traffic was moved in common carriage. Thus, rates and other terms of service were publicly posted and fairly uniform across shippers. The Staggers Rail Act retained the common carrier duty but transformed both its applicability and its enforceability in a number of ways. First, by requiring regulatory exemptions for all truck-competitive traffic and by legalizing the use of confidential contracts, the law ended the general applicability of common carriage; railroads would become common and contract carriers, held to both regulatory and contractual obligations. Second, by reducing the standardization of rates, the law increased the likelihood of a less homogeneous rail service generally, since service attributes could be expected to vary along with rates. Third, even as regulators were required to establish rules governing the mechanics of a common carrier service offering, such as tariff disclosure and dissemination practices, they were not given well-defined authorities to prescribe and enforce the substance of these offerings, such as minimally acceptable levels of service speed and reliability.

More than 30 years after the Staggers Rail Act, the common carrier service obligation remains poorly defined. In 2008, the Surface Transportation Board (STB) held a hearing to obtain public input on the extent of the common carrier obligation and to whom it applies.¹ The law simply states that a railroad must “provide the transportation or service on reasonable request.”² STB’s hearing revealed how railroads and shippers differ in their interpretation of the demands and expectations embodied in this requirement. As described in Chapter 2, shippers

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¹ STB Ex Parte No. 677, Common Carrier Obligation of Railroads.

² In its section governing common carrier transportation (49 USC §11101).

have expressed concern that railroad service for common carriage is substandard—unpredictable in its quality and unreliable in its provision. Absent clear service standards, shippers contend that a railroad has no reason to maintain a consistent common carrier service and that consequently it will unilaterally revise service terms and conditions.³

Railroads maintain that the common carrier service obligation is not absolute. Requests for service can be unreasonable if they do not take into account capacity shortages resulting from exogenous factors such as severe weather and surges in a commodity’s demand. This viewpoint was discussed in Chapter 2.⁴ The railroads also contend that shipper demands for rail transportation service are not reasonable when such service imposes large uncompensated costs and risks. In particular, railroads have raised concern about potentially ruinous liability from transporting tank car loads of chemicals that present a toxic inhalation hazard (TIH), such as anhydrous ammonia and chlorine (AAR 2011).⁵ Although railroads have substantial freedom to set the rates for this common carrier service, STB establishes the rules governing tariff terms such as the allowance of indemnity clauses that can shift liability risks.⁶ In situations in which TIH shipments are moved in markets lacking effective competition, railroads complain that the threat of rate regulation restricts their ability to raise rates to compensatory levels. They contend that STB’s regulatory costing methodology [the Uniform Railroad Costing System (URCS)] omits many of the risk-related costs associated with a TIH shipment and thus exposes the railroad to the law’s maximum rate provisions if prices are set in a manner that reflects directly attributable costs.

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³ Shipper concerns can be found in the large number of comments submitted to STB Ex Parte No. 677. The examples given here are drawn from statements by the National Grain and Feed Association (NGFA), April 27, 2008, and the Western Coal Traffic League, April 17, 2008.

⁴ See comments of the Association of American Railroads (AAR) to STB Ex Parte Nos. 677 (March 2008) and 677-1 (July 2, 2008).

⁵ For more detailed discussions of the common carrier obligation and hazardous materials service, see Branscomb et al. 2010 and Abel 2011.

⁶ In 2011, Union Pacific Railroad Company (UP) filed a petition requesting that STB allow general tariff provisions that would require TIH shippers to indemnify UP against all liabilities except those caused solely by the railroad. STB denied the petition. It argued that the impact of allowing such a generalized provision would be overly broad and cited agency precedent avoiding broad allowances and relying instead on narrow adjudications of specific tariffs (STB Docket No. FD 35504, April 30, 2013).

Shippers maintain that rail transportation is generally safer than truck transportation and that any changes in practice will risk creating a less safe system for transporting many shipments.⁷ In their view, the traditional arrangements for allocating liability to the railroad and shipper based on fault have not resulted in ruinous liabilities for railroads, and railroads exaggerate their concerns to increase contract bargaining power. They favor interpreting the law’s reference to shippers making “reasonable” requests for service as meaning that the request must be “specific as to the volume, commodity, and time of shipment.”⁸

Assessment

The common carrier service obligation rests on a long history of legal and regulatory interpretations. Its relevance has been complicated by the industry’s partial deregulation and the advent of modern logistics systems. Developments such as just-in-time inventorying, computerized tracking of shipments, and an increasingly globalized and multimodal supply chain have diversified service capabilities and expectations (Lasserre 2004; Hale 1999). The willingness of shippers to pay for service attributes such as speed and reliability is likely higher and more varied today than it once was, and perhaps much higher than during the 1970s, when all traffic was moved in a more homogeneous manner under regulated common carriage.

Historically, regulators focused more on controlling rates than on ensuring service quality. Rates were more quantifiable and possibly more pertinent to shippers when service was supplied according to more uniform tariff terms. As common carrier rates were deregulated, so too was service quality, since a product’s price and quality will be interlinked. The common carrier obligation was thus retained without a regulatory framework that could be used to ensure a minimal service response by railroads. Such a framework may have been impractical in any case, in view of the growing variability in shipper service expectations and demands.

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⁷ See shipper comments to STB Ex Parte No. 677, Common Carrier Obligation of Railroads: Hazardous Materials.

⁸ STB Ex Parte No. 346-25b, July 27, 2005.

Retention of the common carrier service requirement implies that regulators must have a way to monitor the service response by railroads. Like the Interstate Commerce Commission (ICC) before it, STB lacks such a monitoring capability. Thus, it has functioned instead much like a sounding board for shippers to express their service grievances.⁹ For the most part, the complaints are conveyed to STB by shippers who depend on common carriage. This does not mean that exempt or contract shippers lack similar concerns; however, contractual remedies are available to them and are enforced through the courts. The complaint record must be considered with caution, because service complaints associated with common carriage dominate STB hearings and there will always be common carrier shippers with service complaints.

Some aggregate statistics on railroad service performance are available, such as railroad train speeds and dwell times as discussed in Chapter 2, but they are not specific to common carriage service. In its review of railroad service performance, Laurits R. Christensen Associates (2009, ES-43) observed that “to evaluate many of the shippers’ service quality concerns at more than aggregate or anecdotal levels, data that capture service performance metrics at a disaggregate level are necessary.” Since that observation was made, STB has taken steps to increase service-related data, as noted in Chapter 2. However, these efforts do not extend to collecting data on service performance at the shipment-specific level, which would permit direct comparisons of the service provided in common and contract carriage both regularly and when capacity is tight.

A central concern of railroads is their obligation to transport TIH shipments without assurances of adequate rate compensation and protections from risk. In the previous chapter, STB’s URCS was reviewed. The question of whether railroads are being allowed to charge compensatory rates for TIH shipments is interconnected with the use of URCS because URCS determines whether a TIH tariff rate is too high and eligible for rate relief. As documented in Chapter 3, the cost allocations made by URCS are essentially arbitrary but produce nonrandom biases, such as uniformly high

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⁹ See STB Ex Parte No. 677 for an example of a service-related hearing.

revenue-to-variable-cost (R/VC) percentages for some shipments, including hazardous materials.

The shortcomings of the current rate relief implementation as they pertain to TIH shipments in particular appear in Table 4-1, which examines two commonly transported TIH materials, anhydrous ammonia and chlorine. More than three-quarters of chlorine and anhydrous ammonia shipments in 2012, both tariff and contract, had rate levels that would have qualified for rate challenges according to the law’s 180 percent R/VC ratio. In view of these uniformly high ratios, a reason for railroads seeking to modify the common carrier obligation for TIH traffic may be to counter biases in URCS. Regulators face many complexities in resolving the scope of the common carrier obligation; however, this aspect of the problem, an artifact of a flawed regulatory process, should not be difficult to fix.

TABLE 4-1 Average Revenue per Ton-Mile, Anhydrous Ammonia and Chlorine, 2012

NOTE: STCC = Standard Transportation Commodity Code.

SOURCE: 2012 Carload Waybill Sample.

ANNUAL REVENUE ADEQUACY DETERMINATION

Requirements and History

Revenue adequacy as an explicit goal of railroad regulatory policy dates to the Railroad Revitalization and Regulatory Reform (4-R) Act of 1976.¹⁰ The act directed ICC “to make an adequate and continuing effort to assist [railroads] in attaining such revenue levels” as needed to “provide a flow of net income plus depreciation adequate to support prudent capital outlays, assure the repayment of a reasonable level of debt, permit the raising of needed equity capital, and cover the effects of inflation.”¹¹ Four years later, the Staggers Rail Act added the requirement that regulators “maintain and revise as necessary standards and procedures for establishing revenue levels for all carriers … that are adequate, under honest, economical, and efficient management, to cover total operating expenses, including depreciation and obsolescence, plus a reasonable and economic profit or return (or both) on capital employed in the business. …”¹² Regulators are directed to use these standards and procedures to “annually determine which rail carriers are earning adequate revenues” and to make “an adequate and continuing effort to assist those carriers in attaining [adequate] revenue levels.”¹³

In response to the provisions in these two laws, ICC developed procedures for making the annual determinations, which STB inherited and has periodically modified in rulemakings over the past two decades.¹⁴ STB describes the assessment process as “essentially mechanical.”¹⁵ Each year, it calculates an average return on investment (ROI) for all Class I railroads and then compares each railroad’s ROI with an estimate of the industrywide cost of capital.¹⁶ The ROIs are

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¹⁰ Public Law 94-210.

¹¹ 49 USC §15(a)(4).

¹² 49 USC §10704.

¹³ 49 USC §10704.

¹⁴ ICC defined adequate revenues as those achieving the level necessary for a railroad to compete equally with other firms for available financing to maintain, replace, modernize, and, when appropriate, expand its facilities and services. ICC Ex Parte No. 393, Standards for Railroad Revenue Adequacy.

¹⁵ STB Ex Parte No. 552-18, Railroad Revenue Adequacy 2013, September 2, 2014.

¹⁶ See STB Ex Parte No. 552-18 and all previous years.

computed from annual financial information reported to STB by comparing tax-adjusted income with investments made in assets normally used for rail transportation services. To calculate the industrywide cost of capital, STB determines the interest paid by railroads on borrowed funds and estimates the returns that shareholders demand as compensation for their investment risk. Because these latter returns to equity cannot be observed directly, they are estimated by using financial models that involve the discounting of estimated future cash flows. STB then weights the two components of the cost of attracting capital to compute an industrywide cost of capital figure. If a railroad’s calculated ROI equals or exceeds the industrywide cost of capital, the railroad is declared to be revenue adequate.

Any choice of models and methods for computing the industrywide cost of capital is bound to be controversial because STB uses the results in a number of regulatory proceedings. The cost of capital estimate, for example, is used in determining the capital costs associated with building a stand-alone railroad in a stand-alone cost proceeding, in determining the compensation to be awarded to shippers when a rate is found to be unreasonable, and in reviewing line abandonment applications.¹⁷ However, the annual revenue adequacy determination itself, which uses the cost of capital figure as its denominator, does not play a meaningful role in any regulatory decisions.¹⁸

Whether STB intends to use the results of its annual determinations for more substantive regulatory purposes remains unclear. As discussed in Chapter 3, the Coal Rate Guidelines imply that a railroad’s revenue adequacy status “over time”¹⁹ may be used in making

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¹⁷ The cost of capital methodology has been modified periodically in response to complaints from shippers and railroads. Last modified in 2009, the model is the subject of an ongoing STB proceeding in response to shipper complaints that the railroad capital costs calculated are too high and vary inexplicably. See STB Ex Parte No. 664-2: Petition of the Western Coal Traffic League to Institute a Rulemaking Proceeding to Abolish the Use of the Multi-Stage Discounted Cash Flow Model of the Railroad Industry’s Cost of Equity Capital, December 23, 2013.

¹⁸ The revenue adequacy results have been used at times for more general purposes, such as justification for regulatory priorities. For example, in announcing new merger review procedures in 2001, STB noted that the changes were being made to improve protection of competition but expressed concern that “rail carriers continue to generate very modest returns that are typically below those of the industries they serve.” STB Ex Parte No. 582-1, June 11, 2001.

¹⁹ Italics are in the quoted text.

rate reasonableness determinations (ICC 1985, 11). The guidelines declare that the “first logical constraint on a carrier’s pricing is that its rates not be designed to earn greater revenues than needed to achieve and maintain this revenue adequacy level,” that “rate increases would generally only be permitted to the extent needed for the carrier to reach and maintain revenue adequacy,” and that a shipper should “not be required to continue to pay differentially higher rates than other shippers when some or all of that differential is no longer necessary to ensure a financially sound carrier capable of meeting its current and future service needs” (ICC 1985, 11). This language implies that firmwide revenue adequacy, as indicated by each railroad’s annual determinations, could at some point be used much like a profitability test for deciding on maximum rate levels. Indeed, the guidelines state that the “revenue adequacy standard represents a reasonable level of profitability for a healthy carrier. … Carriers do not need any greater revenues than this standard permits, and we believe that, in a regulated setting, they are not entitled to any higher revenues” (ICC 1985, 11).

The provision calling for the development of revenue adequacy standards resides in the section of the Staggers Rail Act that prescribes the adjudication of rate disputes.²⁰ This positioning may explain ICC’s original interest in linking the results of the annual determination to its decisions about reasonable rates. That linkage has never been used to adjudicate a railroad rate challenge.²¹ Nevertheless, STB’s annual release of its revenue adequacy findings attracts attention. For most of the agency’s first 20 years, the findings have shown railroads falling short of revenue adequacy. This supports railroad claims that revenue adequacy should remain a policy priority and tempers demands for changes in regulatory policy, such as expansion of access to rate relief. Shippers have claimed that the results provide an overly conservative depiction of railroad financial performance inconsistent with other evidence of financial health, such as positive balance sheets and rising

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²⁰ 49 USC §10704.

²¹ STB regulates interstate pipelines that carry products other than petroleum, natural gas, and water. In 2000, shippers of anhydrous ammonia successfully challenged the rates charged by a pipeline operator by using the revenue adequacy standard from the Coal Rate Guidelines. See STB Docket No. 41685, CF Industries, Inc., v. Koch Pipeline Company, LP, May 3, 2000.

stock values.²² As more railroads have been judged revenue adequate in recent years, railroads have expressed more skepticism about the process. They indicate shortcomings in the methods used to value assets.²³ Conversely, some shippers have begun to argue more forcefully that STB should clarify how it intends to use the results in making regulatory decisions, including decisions about reasonable rate levels.²⁴

Assessment

While the law does not define how the results from revenue adequacy determinations should be used, several possible purposes can be surmised. First, Congress likely intended that the annual determinations inform affirmative steps to help railroads regain financial viability. That purpose is consistent with the requirement for revenue adequacy standards that first appeared in the 4-R Act, when rescuing the industry from its financial distress was a priority.²⁵ A related possibility is that the annual determination was meant to gauge the reformed regulatory program’s impact on the ability of railroads to keep investing and perhaps to monitor the industry for sustained supracompetitive rates of return that might indicate an excess of market power. A third possibility, in light of the position of the requirement in the law’s section on rate relief procedures, is that the annual determinations would be used in a more direct manner as a profitability test for making rate reasonableness assessments that are more favorable to shippers.

With regard to the first purpose, Congress would have wanted frequent monitoring of each railroad’s financial condition in light of the large amount of railroad service being supplied with the assistance of government subsidies during the 1970s. The ability of distressed and

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²² See, for example, Appendix A in Comments of Arkansas Electric Cooperative Corporation, STB Ex Parte No. 722, September 5, 2014.

²³ See Opening Comments of the Association of American Railroads (AAR), STB Ex Parte No. 722, September 5, 2014. AAR identifies various problems with ROI measurements, including the use of historical asset values rather than replacement costs.

²⁴ See comments to STB Ex Parte No. 722 by Arkansas Electric Cooperative Corporation, Western Coal Traffic League, Consumers United for Rail Equity, the Olin Corporation, and other shippers and shipper groups.

²⁵ This argument is made by Macher et al. (2014). The authors elaborate on the various interpretations of Congress’s intentions in requiring annual revenue adequacy determinations.

failing railroads to earn adequate revenues was a pressing concern. Thus, there is little doubt that the annual revenue adequacy determination was intended to support measures to rescue the railroad industry when it was introduced. That purpose can no longer be considered relevant. Railroads long ago attained financial viability and independence from government subsidies.

The second possible purpose—to monitor the effects of the regulatory program on the ability of railroads to keep investing and for signs of railroads exploiting market power—remains a policy interest. Some level of tracking of railroad industry profitability and financial performance may be important in ensuring that regulations and other government policies not reduce railroads’ incentives or capabilities with regard to investment over time. Similarly, monitoring the industry for signs of monopoly behavior, such as by periodic assessment of competition, general levels of profitability, and rate and service trends, is consistent with the policy objective of curbing anticonsumer behavior. In essence, policy makers need to know whether a railroad’s profits are consistently outside a reasonable band of profitability that characterizes many other industries over a business cycle. However, such information is not provided by a regulatory agency annually making what are largely perfunctory comparisons of each railroad’s rate of return with an estimate of the industrywide cost of capital.

Continuation of the determinations of revenue adequacy might be considered innocuous if they did not prolong the misguided view that a single annual pass/fail measure of railroad profitability can be used to regulate rates. Such an application could result in the evolution of STB’s industrywide cost of capital figure into something resembling public utility rate-of-return regulation in which the firm is constrained to pricing levels yielding a return on capital that is no higher than a prescribed level. Rate-of-return regulation has had a mixed record in the industries in which it is used because it can incentivize excessive capital-to-labor ratios and lessen the motivation for asset replacement and the pursuit of innovation.²⁶ Rate-of-return regulation connotes an

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²⁶ The classic discussion of the effect of rate-of-return regulation on labor–capital ratios that are not cost minimizing is given by Averch and Johnson (1962). A review of the economics literature on adverse effects of rate-of-return regulation, including effects on asset replacement and innovation, is provided by Biglaiser and Riordan (2000).

interest in restricting railroad profitability that would be at odds with the deregulatory thrust of the Staggers Rail Act reforms.

MERGER REVIEW ACCORDING TO A PUBLIC INTEREST STANDARD

A railroad or other party controlling one or more railroads must obtain approval from STB to merge with or purchase another railroad. STB inherited this review authority from ICC, which under the Staggers Rail Act retained its exclusive power to approve all railroad mergers and acquisitions.²⁷ The railroad industry therefore remains exempt from Section 7 of the Clayton Act, which requires economically significant mergers in most industries to be reviewed by the Antitrust Division of the U.S. Department of Justice (USDOJ) or the Federal Trade Commission (FTC) before they are consummated.²⁸ The antitrust reviews consider only whether the transaction will “substantially lessen competition.” In contrast, STB is required to consider many other potential merger-related effects that are characterized in the law as being in the public interest. Among them are impacts on rail workers, safety, community development, and the ability of the merging railroads and other competing railroads to earn adequate revenues. The specific wording of the law with regard to matters that must be considered is given in the following subsection.

When Congress created STB in 1995, USDOJ recommended ending the railroad industry’s exemption from the exclusively competition-based appraisal standard used for airlines, which were deregulated at about the same time as railroads.²⁹ The reasoning was that eliminating the broader public interest standard and transferring merger reviews to USDOJ’s Antitrust Division would clarify and expedite the review

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²⁷ 49 USC §11321 and §11326.

²⁸ The Clayton Act (15 USC §18) was amended substantially in 1976 by the Hart–Scott–Rodino Antitrust Improvements Act (Public Law 94-435), which established the federal premerger notification program that provides USDOJ and FTC with information about large mergers and acquisitions before they occur.

²⁹ USDOJ, rather than FTC, reviews most transportation industry mergers. See testimony of Steven C. Sunshine, Deputy Assistant Attorney General, Antitrust Division, Statement before the U.S. House of Representatives Committee on Transportation and Infrastructure, January 26, 1995 (http://www.justice.gov/atr/public/testimony/0056.htm).

process, which was ill defined and slowed by special interests (including competing railroads) seeking concessions. Congress retained the standard but added certain features associated with conventional antitrust reviews, including use of divestiture as a remedial condition to counter potentially adverse competitive effects. In addition, STB was required to give substantial weight to any competition-related recommendations by USDOJ.³⁰

Public Interest Standard in Historical Context

Public interest standards giving regulators independent responsibility to review mergers are used in some regulated industries that are otherwise exempt from merger review by the antitrust enforcement agencies. Regulatory commissions for specific industries such as the Federal Energy Regulatory Commission and the Federal Communications Commission (FCC) are charged not only with evaluating the competitive implications of a transaction but also with ensuring that legislatively articulated policy goals are maintained or furthered. For example, FCC must review mergers to ensure that they do not reduce universal service, harm broadband deployment, or exceed foreign ownership restrictions (Koutsky and Spiwak 2010).

The law states that STB must review and approve planned mergers involving at least two Class I railroads. The review must consider “at least (1) the effect of the proposed transaction on the adequacy of transportation to the public; (2) the effect on the public interest of including, or failing to include, other rail carriers in the area involved in the proposed transaction; (3) the total fixed charges that result from the proposed transaction; (4) the interest of rail carrier employees affected by the proposed transaction; and (5) whether the proposed transaction would have an adverse effect on competition among rail carriers in the affected region or in the national rail system.”³¹

The Staggers Rail Act added the competition criterion for merger reviews, but the remaining public interest criteria originated in the Transportation Act of 1940 (Phillips 1962, 9). Few railroad mergers

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³⁰ 49 USC §11324(d).

³¹ 49 USC §11324.

occurred between World Wars I and II, but the public interest standard was applied by ICC during the 1950s and 1960s in a number of cases (Gallamore and Meyer 2014, 132–133). According to Gallamore and Meyer (2014, 132–133), many of the merger review decisions during the period focused on enhancing or protecting railroad finances rather than protecting competition. First, mergers of regionally competing railroads were approved so that traffic could be concentrated by reducing parallel capacity. Second, end-to-end mergers whose consummation risked extending financially stronger railroads with single-line service into new territories and upsetting existing railroad divisions of traffic and revenues were denied.³² Traffic protection conditions were often required when mergers were approved both to lessen anticompetitive effects and to minimize adverse effects on other railroads (Crum and Allen 1986, 47). The era’s mergers of rival railroads were deemed necessary to promote financial stability, which was viewed as a more pressing goal than achieving the single-line efficiencies from end-to-end mergers.

With this perspective and the worsening financial condition of the railroads during the 1970s in mind, the retention of the public interest standard by the Staggers Rail Act is understandable, despite its deregulatory tenor. Coupled with the act’s imposition of decision deadlines, the public interest standard was viewed as more flexible in allowing the railroad industry to shed uneconomic capacity and achieve financial stability.

A wave of mergers followed soon after passage of the Staggers Rail Act. In late 1980, the Chessie System and the Family Lines System combined to form CSX Corporation. Two years later, the Norfolk and Western Railroad and the Southern Railway merged to form Norfolk Southern Corporation (NSF). At about the same time, the Frisco Railroad merged with Burlington Northern (BN), and Union Pacific (UP) Railroad acquired the Missouri Pacific and Western Pacific Railroads. During the 1990s, the four largest Class I railroads took their current shape. CSX and NSF split Conrail’s assets, BN merged with the Santa Fe Railroad, and UP merged with the Southern Pacific Railroad (SP).

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³² Gallamore and Meyer (2014, 137) note that from the mid-1950s through the 1960s, ICC approved 16 major mergers, only two or three of which had mostly end-to-end characteristics. They report that ICC turned down only four major mergers during the 1950s and 1960s, and two were end to end.

Through mergers, reclassifications, and bankruptcies, the number of Class I railroads was reduced from 40 in 1980 to seven, its current level, by the end of the decade.³³

Most of these mergers took place before STB’s creation, but the Conrail acquisitions and the UP-SP merger were approved by STB. The latter transaction was particularly controversial and revealed the difference between the approval standards and practices used by rail regulators and antitrust enforcers. In opposing the 1996 merger, USDOJ argued that a reduction in rail competitors in the West from three to two could cause “overwhelming competitive harm” in a large number of markets as the unified railroad exercised market power unilaterally and through coordinated behavior with the single remaining competitor (BN).³⁴ In granting approval, STB placed greater emphasis on the financial benefits of the merger. The financially weak SP would become part of a stronger system that would be in a better position to compete aggressively with the newly merged and more efficient BN, to the benefit of shippers in western markets (Kwoka and White 2004; Nottingham 2007; Conant 2004).

STB accepted UP’s proposals to counter competition losses by extending trackage rights agreements with BN.³⁵ USDOJ raised concern about the long-term viability and enforceability of such agreements. In addition, USDOJ was less inclined to accept the public interest benefits claimed by the railroads. It viewed them as overstated, not recognizable as public benefits, or achievable through other means (Kwoka and White 2004; Nottingham 2007; Massa 1997). In general, USDOJ’s concerns were similar to past criticisms of ICC as being too accepting of industry estimates of efficiencies, cost savings, and other claimed benefits from proposed mergers (Massa 1997).

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³³ AAR (2014) recommends caution in comparing the number of Class I railroads in 1980 with the number in 2014. For example, of the 40 railroads that were classified as Class I in 1980, 14 would not have qualified according to today’s Class I revenue requirements, even after adjustment for inflation. AAR also points out that one of the other 26 Class I railroads in 1980 provided mostly passenger service, two were bankrupt before deregulation, and five were legally distinct entities but had unified operations, marketing, and administration even before 1980. A more reasonable estimate, according to AAR, is that 18 Class I rail systems existed in 1980 and ultimately merged to form the seven that remain. Even AAR’s numbers indicate substantial consolidation activity.

³⁴ STB NOR No. 32760, August 6, 1996, p. 89.

³⁵ STB granted BN and other railroads trackage rights over about 4,000 miles of track, mainly between California and Colorado and in Texas and other areas on the Gulf Coast.

The economic effects of the mergers approved by ICC and STB during the first two decades after the Staggers Rail Act’s passage have been extensively studied (e.g., Wilson 1997; Berndt et al. 1993; Pittman 1990; Chapin and Schmidt 1999; Winston et al. 2011; Wilson and Bitzan 2003; Grimm and Plaistow 1999). The studies generally found that consolidation activity contributed significantly to the industry’s shedding of uneconomic legacy capacity and resultant cost savings. The extent varied from merger to merger, depending on the degree to which a merger had vertical (involving end-to-end connections) and horizontal (involving parallel capacity) features. Efficiency gains were largely passed on to shippers through lower rates and enhanced service. The magnitude of the benefits was small compared with those ensuing from other developments after deregulation, such as the move to larger cars and longer and more frequent trains.

Revised Merger Policy and Recent Issues

In 1999, BN and the Canadian National (CN) applied to merge, 3 years after the UP-SP merger and shortly after CSX and NSF had divided Conrail to create two major railroads in the East. By this time, STB had come to believe that the industry’s excess capacity had been largely eliminated through line abandonments and the earlier mergers; hence, the potential for additional efficiencies from further consolidations had been exhausted for the most part.³⁶ The agency raised concern that another merger would prompt a final round of mergers involving the few Class I railroads that remained.³⁷ Furthermore, the BN-CN merger was proposed in the wake of prolonged service disturbances after UP’s integration of SP. STB declared a 15-month moratorium on further reviews until a reassessment of its merger evaluation criteria was complete.³⁸

During the moratorium, BN and CN withdrew their application to merge. In June 2001 STB introduced its Major Rail Consolidation

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³⁶ STB Ex Parte No. 582, April 7, 2000.

³⁷ STB Ex Parte No. 582, April 7, 2000.

³⁸ STB Ex Parte No. 582, April 7, 2000.

Procedures.³⁹ In that document, it reaffirmed its obligation to use a public interest standard but declared that applicants would face a higher burden of proof to demonstrate that anticipated public benefits would be “substantial and demonstrable” and thus outweigh any anticompetitive effects. The agency explained:

STB also indicated that it would no longer review the effects of each merger in isolation. Instead, it would consider the cumulative effects of consolidation activity on the level of competitiveness in the railroad industry as a whole. It stated that

After the new merger procedures were announced, some railroads expressed concern that STB’s emphasis on “enhanced” competition imposed a more restrictive standard than the traditional antitrust policy of preventing the substantial lessening of competition.⁴²

Because no Class I railroads have applied to merge since 1999, there is no precedent to show how STB would apply its new burden-of-proof standards. During the past decade, nearly all STB actions pertaining to its merger and acquisition authorities have involved regional and short-line railroads leasing or buying branch lines from

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³⁹ STB Ex Parte No. 582-1, June 7, 2001.

⁴⁰ STB Ex Parte No. 582-1, June 7, 2001.

⁴¹ STB Ex Parte No. 582-1, June 7, 2001.

⁴² Comments of BN to STB Ex Parte No. 582-1, May 16, 2001, pp. 11–12.

larger carriers. These transactions are normally viewed as minor and as qualifying for exemption from full-scale merger and acquisition reviews. The Staggers Rail Act requires that STB promptly approve proposed transactions not involving two or more Class I railroads unless it finds a likelihood of lessened competition or the creation of a monopoly and it determines that the anticompetitive effects from these outcomes outweigh the public interest in meeting transportation needs.⁴³ Nevertheless, STB has faced criticism over certain approved transactions, particularly those involving interchange commitments that limit the ability of the regional or short-line railroad to interchange traffic with major railroads other than the seller or lessor.⁴⁴ Such interchange commitments can be viewed as anticompetitive because they prevent the short-line railroad from offering shippers more competitive routing alternatives.⁴⁵

Shippers have referred to interchange commitments as “paper barriers” to competition and have petitioned STB to prohibit commitments lasting longer than 5 years.⁴⁶ In response, STB has mentioned the important role that these contractual commitments can play in preserving rail service on low-volume lines. They enable smaller railroads to finance the lines by guaranteeing traffic to the major railroad that sells or leases them.⁴⁷ However, in acknowledging that such commitments can lead to abuse, STB concluded that decisions about their propriety should be made on a case-by-case basis. Rather than issuing general prohibitions, STB has required that a purchaser or lessee disclose more information on the duration and other terms of the commitments.⁴⁸

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⁴³ Contractual terms between Class I and short-line railroads that are part of a sale or lease of trackage or a transfer of operating rights that involve interchange commitments are subject to STB approval under its authority to approve mergers and acquisitions.

⁴⁴ A typical interchange commitment, for example, is a lease credit for rail cars interchanged with the seller or lessor carrier.

⁴⁵ For example, see Review of Rail Access and Competition Issues—Renewed Petition of the Western Coal Traffic League, STB Ex Parte No. 575-1, October 30, 2007.

⁴⁶ Review of Rail Access and Competition Issues—Renewed Petition of the Western Coal Traffic League, STB Ex Parte No. 575-1, October 30, 2007.

⁴⁷ STB Ex Parte No. 714, Information Required in Notices and Petitions Containing Interchange Commitments, October 29, 2012.

⁴⁸ STB Ex Parte No. 575-1, May 29, 2008.

Overview of STB’s Merger Review Procedures for Major Railroads

Comparison of STB’s railroad merger review process with that of USDOJ in applying the competition appraisal standard for mergers in most other industries is helpful. Briefly, the latter process begins with the merger parties notifying USDOJ of their plan. USDOJ may request more information. If the plan raises no competition-related concerns, USDOJ may allow the transaction to proceed after 30 days have elapsed (or sooner with USDOJ approval). If it has concerns, USDOJ may request additional information from the merger parties; from other interested parties (e.g., customers); and from relevant federal agencies, such as the U.S. Department of Transportation in the case of the airline industry. If USDOJ concludes that the transaction could lessen competition in violation of the Clayton Act, it will seek to stop the transaction by filing a complaint in federal court. This step is often unnecessary, since the threat of action alone often persuades the parties to address the concerns or abandon the merger.⁴⁹

The Horizontal Merger Guidelines, which USDOJ develops jointly with FTC, are central to its review process. That document describes the main analytical techniques and types of evidence used by the two antitrust agencies in assessing whether a merger could substantially lessen competition. For example, the guidelines outline the methods to be used for defining markets and measuring market concentration; they explain how competitive behavior is examined, including both unilateral and coordinated behavior; and they give hypothetical examples to make the economic concepts more understandable. They were introduced in their modern form in 1982 and are updated every 5 to 10 years on the basis of new economic learning and case law. In addition to informing USDOJ’s review procedures, the guidelines are intended to provide potential merger parties, courts, and others with an understanding of the rationale and analytical processes underlying enforcement and thus to deter mergers that would likely be challenged.

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⁴⁹ See testimony of Steven C. Sunshine, Deputy Assistant Attorney General, Antitrust Division, Statement Before the U.S. House of Representatives Committee on Transportation and Infrastructure, January 26, 1995 (http://www.justice.gov/atr/public/testimony/0056.htm).

STB’s Major Rail Consolidation Procedures differ from the Horizontal Merger Guidelines in a number of ways. Rather than providing an analytical framework for predicting competitive effects, the procedures delineate a series of principles in statements explaining STB’s views on the ways in which a railroad merger can serve the public interest. STB does not bear the burden of proof to deny a merger; railroad applicants bear the burden of making a convincing case for why the merger should be approved in light of STB’s stated principles about what constitutes the public interest. Applicants are thus required to explain “the purpose sought to be accomplished by the proposed transaction, such as improving service, enhancing competition, strengthening the nation’s transportation infrastructure, creating operating economies, and ensuring financial viability.”⁵⁰

The procedures emphasize that other claimed benefits of a merger should not be pursued at the expense of competition. The merger applicants—not STB—are responsible for demonstrating that such a trade-off will not occur. The applicants must propose competition “enhancements” if they cannot avoid competition losses in certain markets. Examples are the establishment of shared terminal areas, the granting of trackage rights, and the termination of existing interchange commitments with short-line railroads. In addition, the procedures require applicants to propose backup remedies if their competition enhancements are not effective.

The procedures were issued 5 years after the UP-SP merger and reflect a concern about the potential for mergers to cause large transitory service disruptions. Applicants are required to provide a detailed service assurance plan and to explain how they would cooperate with other railroads in overcoming service disruptions. The procedures also reflect a concern that a merger would prompt a round of industry consolidation. Accordingly, applicants are required to speculate on the “cumulative impacts” of their merger and how it could affect the competitive structure of the industry in the years ahead. They must explain how any competitive changes would affect the claimed benefits of their merger and how any conditions attached to the merger (e.g., trackage rights, terminal access agreements) would need to be amended as a result.

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⁵⁰ STB Ex Parte No. 582-1, June 7, 2001.

Assessment

Because no Class I railroads have applied to merge since STB introduced its new merger review procedures in 2001, there is no precedent for how the decision-making process would unfold. Nevertheless, merger review guidelines that have well-defined purposes, evidentiary requirements, and evaluation rules and criteria should make the process comprehensible and transparent. Firms considering a merger should have a clear understanding of expectations and be able to structure the transaction accordingly or be dissuaded from pursuing it in the first place. A main purpose of the Horizontal Merger Guidelines is to offer guidance that the business community can use in assessing the antitrust enforcement risks of a proposed transaction.⁵¹ Similar transparency of purpose and articulation of procedure are not offered in STB’s Major Rail Consolidation Procedures. Apparently, STB’s statutory obligation to balance the law’s public interest considerations complicates the development of a straightforward review framework comparable with that of the antitrust standard.

The procedures do not offer a methodology for reviewing merger plans. As noted, the procedures make merger applicants responsible for the analysis of their merger plans, but the procedures themselves lack clear guidance on the evidence and analytical methods that are to be used for such analyses. The procedures offer little guidance on how regulators would evaluate the results of the analysis or how they would assess the various actions to be proposed by applicants to protect or further the public interest. Indeed, the merger outcomes that would be construed as desirable and that merger applicants should be expected to prove cannot be known in advance on the basis of the guidance offered in the procedures.

STB’s own statements about the importance of preserving competition suggests that this clouded approval process is not a consequence of regulators having other priorities in mind. Instead, it is a legacy obligation to scrutinize mergers in the context of a broader public interest standard. STB itself has stated that the significance of perceived public interests that guided its merger reviews in the past,

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⁵¹ See “Commentary on Horizontal Merger Guidelines,” USDOJ and FTC, March 2006, p. v.

particularly the interest in helping the industry shed uneconomic and duplicative capacity, has been greatly diminished. In its overview of the procedures, STB explains that the revised merger review rules were necessitated in light of the “declining number of number of Class I railroads, the elimination of the industry’s excess capacity, and the serious transitional problems that have accompanied recent major rail consolidations.”⁵² It states that “our shift in policy places greater emphasis in the public interest assessment on enhancing competition while ensuring a stable and balanced rail transportation system.”⁵³

STB itself believes that the preservation of competition should be central to merger reviews and that other public interest concerns have expired or been diminished. Thus, questioning the purpose of STB continuing to be responsible for merger reviews is reasonable. If preservation of competition is the primary concern, USDOJ’s Antitrust Division is far more qualified to lead the reviews, in view of its staff of competition analysts and the well-established evidentiary and evaluation framework in the Horizontal Merger Guidelines. The law already requires USDOJ to advise STB on the competition impacts of major railroad mergers. The continued subordination of USDOJ’s role is now justified, as a practical matter, mainly on the grounds that STB is better positioned to redress service disruptions that can arise during the integration of merged railroads. However, STB can invoke other authorities to minimize such effects from mergers that pass the competition scrutiny of USDOJ.⁵⁴

AUTHORITY TO ORDER RECIPROCAL SWITCHING

Before the Staggers Rail Act, when regulated rates were largely equalized, shippers had limited incentive to seek alternative railroad routings

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⁵²Major Rail Consolidation Procedures, p. 8.

⁵³Major Rail Consolidation Procedures, p. 8.

⁵⁴ For example, in response to service problems following the UP-SP merger, STB adopted rules to address localized service inadequacies by establishing expedited procedures for shippers to obtain temporary alternative rail service from another carrier when the incumbent carrier cannot properly serve shippers. These rules were promulgated in accordance with the agency’s authority to order alternative through routes in the public interest [(49 USC §10705(a)] and to direct the handling of traffic and the use of rail facilities for a limited time when there is an emergency situation (49 USC §11123). See Expedited Relief for Service Inadequacies, STB Ex Parte No. 628, December 21, 1998.

for the purpose of obtaining a more competitive rate. However, once rates were allowed to vary, that incentive would change, especially on routes that involved a “bottleneck” segment whereby only one railroad could serve the route fully.

A bottleneck segment is illustrated in Figure 4-1. In the example, the rail segment between Points A and B is the bottleneck, since it can be served only by Railroad 1. If Railroad 1 does not quote a rate to the interchange of Railroad 2, Railroad 1 has effective control over the service supplied to all shippers on its larger network who originate or terminate shipments on the bottleneck segment (on the assumption that there are no nonrail transportation alternatives). Provisions in the Staggers Rail Act had the practical effect of allowing a railroad to cancel many interline and terminal access agreements for traffic that it could serve on its own, which reinforced the ability of railroads to control bottleneck traffic (GAO 1987).

However, the Staggers Rail Act left several authorities with regulators that they could use to order a railroad to allow competitor access

FIGURE 4-1 Rail bottleneck scenario.

to bottleneck traffic if such an order was deemed “practicable and in the public interest.”⁵⁵ First, regulators could simply mandate that the railroads interchange traffic, and if necessary they could regulate the division of revenues, including the switching fee (i.e., mandate that railroads establish “through routes”).⁵⁶ Second, regulators could require that a railroad allow other railroads (again for a regulated fee) to operate on the tracks within terminal areas that were bottlenecks. In essence, this allows other railroads to market the host railroad’s terminal as if it were their own.⁵⁷ Third, regulators could order a railroad to accept shipper requests to haul traffic short distances over the bottleneck segment to and from a nearby interchange with a second railroad that would perform the line-haul move. As explained in Figure 4-1, this practice is referred to as mandated “reciprocal switching.”

A key distinction between reciprocal switching and the other access authorities is the stipulation in the Staggers Rail Act that regulators can order such arrangements not only if practical and in the public interest but also if deemed “necessary to provide competitive rail service.”⁵⁸ The specific reference to competition in the act represents a new regulatory power (rather than a holdover authority as applicable to the designation of through routes and terminal access). It has led to debate about STB’s ability to use reciprocal switching as a means of curbing railroad market power by stimulating or introducing the threat of competition for bottleneck traffic.

Limited Practical Use of Reciprocal Switching Orders

In implementing the Staggers Rail Act, ICC took the view that its authorities to order competitive access to bottleneck traffic were not meant to

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⁵⁵ “Practicable and in the public interest” was historically interpreted by ICC as requiring the demonstration of “some actual necessity or compelling reason” why such an arrangement should be ordered. Such a showing would need to entail “more than a mere desire on the part of shippers or other interested parties for something that would be convenient or desirable to them” [Jamestown Chamber of Commerce v. Jamestown, W. & N.R. Co., 195 ICC 289, 291 (1933)].

⁵⁶ 49 USC §10705(a)(1).

⁵⁷ 49 USC §111103(c)(1).

⁵⁸ 49 USC §111103(c). Specifically, the law states that STB “may require rail carriers to enter into reciprocal switching agreements, where it finds such agreements to be practicable and in the public interest, or where such agreements are necessary to provide competitive rail service.”

be used freely to inject more competition into rail markets but instead to address specific anticompetitive behaviors. In its Intramodal Competition Rules,⁵⁹ the agency declared that through-route, terminal access, and reciprocal switching arrangements affecting bottleneck traffic may be prescribed only if “necessary to remedy or prevent an act that is contrary to the competition policies” of the law.⁶⁰ The rules went on to define anticompetitive behavior as a railroad using its market power to extract unreasonable terms or to disregard the needs of a shipper by rendering inadequate service. A complainant would need to demonstrate, for example, that the single-line service offered by the bottleneck railroad, in lieu of an interline service, is inadequate because the routing is so circuitous, slow, and inefficient that it essentially disregards a shipper’s needs for rail transportation.

In promulgating the Intramodal Competition Rules, which were challenged by shippers but subsequently upheld in court,⁶¹ ICC reasoned that the law merely authorizes, but does not require, it to order bottleneck access arrangements. It maintained that a narrow interpretation of the authorities focused on anticompetitive conduct that leads to unreasonable service offerings (as opposed to unreasonable rates) was consistent with the law’s policy. The agency contended that actions to “initiate an open-ended restructuring of service to and within terminal areas solely to introduce additional carrier service” would run counter to the law’s directive to minimize regulatory control.⁶²

ICC further maintained that any interventions for the express purpose of enhancing competition in sole-served markets must respect the law’s rate reasonableness criteria. The Staggers Rail Act, for example, is explicit in stating that railroads have a safe harbor in pricing traffic up to 180 percent of its “variable cost.” If a rate in a market lacking effective competition exceeds this threshold, aggrieved shippers are eligible to file a rate case. If the shippers prevail, regulators can prescribe a rate that is

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⁵⁹ ICC Ex Parte 445, Intramodal Rail Competition, codified at 49 CFR 1144.

⁶⁰ 49 CFR 1144.2(a)(1).

⁶¹ See Baltimore Gas and Elec. v. United States, 817 F.2d 108 (D.C. Cir. 1987) and Midtec Paper Corp. v. U.S., U.S. Court of Appeals, District of Columbia, September 16, 1988.

⁶² ICC reasoned that “rail carriers have been given a great deal of flexibility to adjust their rates under the Staggers Act. We are convinced that Congress’s aim in creating section 11103(c) was to provide a competitive counterbalance to this broadened rate freedom.” See Delaware & H. Ry. Co. v. Consolidated R. Co., 367 I.C.C. 718, 720-21 (1983).

closer to the 180 percent threshold, but they cannot prescribe one that is lower. Inasmuch as mandated reciprocal switching (in lieu of a rate prescription) could cause the shipper’s rate to fall below the 180 percent level, regulators concluded that such an intervention would violate the law’s safe harbor provision.⁶³

The counterargument put forth by shippers was that Congress had given ICC a new regulatory power to order reciprocal switching when necessary to provide competitive rail service. In doing so, Congress meant to increase the options available to STB in addressing the concerns of aggrieved shippers and in providing a mechanism for controlling railroad market power through competitive access rather than only by prescribing maximum rates after disputes. According to this view, reciprocal switching orders should not be treated as subordinate to the law’s rate relief provisions, and STB has the authority to order their use as it sees fit to provide for competitive service.⁶⁴

Reciprocal Switching in Canada and Proposals for the United States

Canadian Interswitching

Canada has long allowed a shipper to demand that a railroad offer reciprocal switching (referred to as “interswitching”) over its bottleneck segments. By law, a shipper with access to only one railroad at the origin or destination of a haul can have the shipment transferred to another railroad according to a government-prescribed switching rate if the origin or destination is within a radius of 30 kilometers (about 19 miles) of an interchange point. The Canadian Transportation Agency establishes the switching fees according to a distance-based table applicable to all regions of the country. The fees are charged per car and vary in amount according to the bottleneck distance (grouped in four zones) and the total number of cars involved. The cars are supplied by the line-haul carrier. The current fees (in Canadian dollars) average about $250 per car and $3.38 per kilometer when fewer than 60 cars are interswitched and about $65 per car and $1.20 per kilometer when shipments exceed

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⁶³ Midtec Paper Corp. v. U.S., U.S. Court of Appeals, District of Columbia, September 16, 1988.

⁶⁴ The argument is recounted in Midtec Paper Corp. v. U.S., U.S. Court of Appeals, District of Columbia, September 16, 1988.

59 cars.⁶⁵ All shippers can take advantage of the regulated switching rates regardless of their competitive options (i.e., there is no market dominance test).⁶⁶

According to a 2001 Canadian government review panel, the interswitching requirements that are now used to provide competitive access were instituted early in the 20th century to prevent overbuilding of multiple rail terminals in urban areas and to ensure that a joint switching rate could be calculated quickly (Minister of Public Works and Government Services Canada 2001, 63). The review panel recommended keeping the requirement to serve its current purpose of providing competitive access but recommended against proposals to expand the distance beyond 30 kilometers, expressing satisfaction with the status quo (Minister of Public Works and Government Services Canada 2001, 63). That status quo, according to Cairns (2014), leads to 3 to 5 percent of the total traffic carried by the CN and Canadian Pacific (CP) railroads being interswitched at the regulated switching rates. Cairns observed that further use of the interswitching provision may be limited, as a practical matter, because CN-CP network layouts do not offer many alternative routings that would make interswitched traffic competitive (i.e., the interswitched traffic would move over uneconomical, circuitous routes).

Proposals for Mandated Reciprocal Switching in the United States

Since the Intramodal Competition Rules were adopted by ICC in 1986, shipper groups have periodically petitioned or pursued legislation to have them changed to allow for more expansive use of the regulatory authority to order reciprocal switching.⁶⁷ During the course of

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⁶⁵https://www.otc-cta.gc.ca/eng/interswitchingrates.

⁶⁶ Under certain circumstances, when a shipper contends that it is subject to “substantial commercial harm,” the law permits interswitching at distances greater than 30 kilometers. According to Cairns (2013), the requirement to prove commercial harm has limited shipper use of this provision.

⁶⁷ One recent example of a legislative proposal to mandate reciprocal switching to enhance competition is the Railroad Competition and Service Improvement Act of 2007 (S. 953 and H.R. 2125). The bill would have defined “areas of inadequate competition” if shippers pay rates above 180 percent of R/VC and are served by a single railroad. In such defined areas, the bill would authorize STB to order reciprocal switching and terminal trackage rights.

this study, STB was considering a petition by the National Industrial Transportation League (NITL), an organization of rail shippers, to repeal the Intramodal Competition Rules and to reinterpret the law so that a railroad would be required to engage in reciprocal switching under certain defined conditions.⁶⁸ In its petition, NITL asserts that the current authority has been rendered meaningless: no shipper has attempted to obtain a reciprocal switching order for more than 15 years because of the burden of proving abusive service under the rules.

In short, NITL has proposed that if a shipper’s facility is served by only one Class I railroad or if the shipper is paying a tariff rate that exceeds 240 percent of R/VC, the railroad serving the shipper would be required to switch traffic, according to a regulated fee schedule, with any competing railroad that wants to do so and that operates from an interchange within a reasonable distance of the shipper’s facility. NITL proposes, as one criterion, that the relevant distance be set at 30 miles.⁶⁹ The organization proposes that STB promulgate rules requiring a railroad to accept a request for reciprocal switching if these criteria are met.⁷⁰

Assessment

The desirability and legality of NITL’s proposal could not be assessed by the committee. Any proposal that relies on an R/VC formula to determine shipper eligibility, as the NITL proposal does, is problematic because of the unreliability of variable cost estimates derived by STB, as discussed in Chapter 3. Nevertheless, a few generic issues pertaining to reciprocal switching orders deserve attention, all of them empirical in nature.

First, in proposing reciprocal switching in addition to (rather than as a replacement for) the current rate relief process, NITL recognizes that an access mileage limit (i.e., 30 miles) would have differing effects on shippers simply by virtue of where they are located

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⁶⁸ STB Ex Parte No. 711, NITL, March 30, 2013.

⁶⁹ The proposal contains other eligibility criteria that are not explained here but that can be found in the NITL petition.

⁷⁰ B. J. Carlton, NITL Presentation to Study Committee on Railroad Transportation and Regulation, March 14, 2014. http://www.trb.org/PolicyStudies/RailTransReg.aspx.

on a railroad’s network and where that network has interchanges with competing railroads. Whether some types of shippers are more likely than others to be located near eligible interchanges can be determined by examining the layout of railroads and the distribution of shippers, as well as the mileage limits delineated in the reciprocal switching proposal. In particular, any reciprocal switching proposal with a short mileage limit would lead to variability in shipper access to relief by commodity type, since some commodities may be produced at locations farther from interchange points than others (e.g., wheat versus chemicals).⁷¹

Other empirical questions concern the practical effect that a reciprocal switching order would have on competition and thus on the rate and service levels in individual markets. Whether shippers would benefit from vigorous competition would depend on various factors such as the traffic density economies and routing circuities of each railroad and the willingness of railroads to bid for one another’s sole-served traffic.⁷² The Canadian experience with setting switching fees on the basis of an uncomplicated but variable schedule suggests that setting such fees would be administratively feasible, but the size and structure of the fees would affect the amount of competitive activity at the margin.

Any assessment of a reciprocal switching measure will depend on its specific design features and on assumptions about the circumstances in which it would be applied. Thus, the committee cannot offer conclusions about the effect of proposals like the one made by NITL without a thorough empirical analysis. Findings concerning the desirability of a targeted or broad (i.e., Canadian-style) application of reciprocal switching would be based on the outcome of such empirical assessments. A possible starting point for STB in assessing the impact of reciprocal switching is to allow its use in a more limited setting. For example, it could be used as an optional remedy for rates that have

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⁷¹ NGFA expressed concern to the study committee that most grain shippers would not qualify for mandated switching because of their generally longer distances from interchanges [R. Gordon, NGFA, NGFA statement to the study committee, March 14, 2014 (http://www.trb.org/PolicyStudies/RailTransReg.aspx)].

⁷² A primary concern expressed by railroads is that mandated switching could cause serious service inefficiencies by intruding on the ability of carriers to structure their networks, control their operations, and plan capacity utilization (see AAR comments to STB Ex Parte 711).

already been ruled unreasonable and thereby offer an alternative to a prescribed rate. This would be consistent with STB’s policy of exercising its authority to order reciprocal switching only when it determines that an anticompetitive abuse has occurred.

CHAPTER SUMMARY

Common Carrier Service Obligation

Until passage of the Staggers Rail Act, all railroad traffic was moved in common carriage, and thus all rates were publicly posted, with service terms and conditions that were to a large extent homogeneous. By allowing common carrier rates to vary widely, the law increased the likelihood that service attributes would also become more heterogeneous. Thirty-five years after the act’s passage, not only have the railroads been transformed but so too has the broader logistics system in which they and their shipper customers operate. Consequently, a common carriage framework that omits service quality no longer appears tenable. Yet a fixed or well-defined service standard appears impractical in view of the wide diversity of shipper demands and expectations. Nevertheless, regulators must be able to monitor the response of railroads to the common carrier obligation. They need regularly collected data on service quality to evaluate service performance, particularly shipment-specific data to ascertain whether the service provided in common carriage is substantially different from that provided in contract carriage and whether differentials change markedly when capacity is tight.

Annual Revenue Adequacy Determination

Every year, STB must compare each Class I railroad’s ROI with an estimate of the industrywide cost of capital. Railroads with an ROI that exceeds the cost of capital are declared revenue adequate. The requirement was first instituted when many railroads were on the edge of bankruptcy and some were receiving substantial government subsidies—a state of affairs that no longer exists.

Nevertheless, there is a continuing public interest in ensuring the ability of railroads to keep producing and reinvesting. This must be

balanced with the interest in preventing them from exercising market power to an excessive degree. In essence, policy makers need to be able to determine whether a railroad’s profits consistently fall outside a reasonable band of profitability for a prolonged period. This need is not met by a regulatory agency issuing an annual pass-or-fail assessment of each railroad’s earnings performance.

Merger Review

Two Class I railroads seeking to merge must apply and obtain approval from STB, which inherited this review authority from ICC. By law, STB must consider a range of potential effects from a merger, including impacts on the competitive structure of markets, rail workers, the environment, safety, and the ability of the merger applicants and other railroads to earn adequate revenues. In contrast, merger reviews conducted by the antitrust agencies focus exclusively on whether the transaction is likely to “substantially lessen competition.” The railroad merger review process lacks the same transparency and clarity of purpose because of the statutory requirement for a public interest appraisal. The practical purpose of the appraisal after deregulation was to reduce the uneconomic capacity of struggling railroads and concentrate traffic and revenues for the healthier railroads that remained. Financial stability in the industry has been achieved, and any further merger reviews are likely to hinge on efficiency and competition issues that USDOJ is most qualified to assess. Thus, the rationale for retaining STB’s role in reviewing mergers according to a public interest standard is not compelling.

Authority to Order Reciprocal Switching

The Staggers Rail Act gave regulators authority to order reciprocal switching arrangements when “necessary to provide competitive rail service.” Reciprocal switching has been ordered on rare occasion in the United States to address competitive abuses that led to inadequate service. ICC’s rationale for making minimal use of the authority, to which STB adheres, is that the law’s maximum rate provision is available to captive shippers to obtain reasonable rates. Furthermore, reciprocal switching has not been imposed as a remedy for rates found

to be unreasonable because the law expressly allows railroads to price up to 180 percent of variable cost, and a reciprocal switching remedy could depress rates below that level. The experience in Canada, where reciprocal switching is required regardless of rate levels, provides an opportunity for assessing its effects, particularly if the interest is in broader application. One possible starting point for assessing reciprocal switching on a more limited basis is to allow its use as an optional remedy for rates that have been ruled unreasonable and thus perhaps as an alternative to a prescribed rate.

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