Modernizing Freight Rail Regulation (2015) / Chapter Skim
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3 REVIEW OF THE RATE RELIEF PROCESS
3 REVIEW OF THE RATE RELIEF PROCESS
Pages 101-144
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From page 101... ...
.4 If a disputed rate exceeds this percentage and is found to be in a market lacking effective competition, STB can rule on whether the rate is reasonable.5 If STB finds the rate to be unreasonable, it must order the railroad to compensate the shipper for overpayments, and it may prescribe the maximum rate the railroad can charge for future movements.6 In ruling on the reasonableness of a rate, STB is directed to be respectful of the law's overarching policies (see Box 1-2) ,7 including the policy that railroads must be able to earn "adequate revenues." Adequate revenues are defined as those "sufficient -- under 1 49 USC §10101(4)
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From page 102... ...
Estimate the variable cost of a priced unit of traffic to determine whether its rate exceeds the 180 percent statutory threshold.
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From page 103... ...
e rate dispute resolution process used in Canada is examined, and an alternative method for identifying unusually high rates is described. HISTORICAL CONTEXT AND LINKS TO REVENUE ADEQUACY Rate Reasonableness: Efficiency, Fairness, and Revenue Adequacy As discussed in Chapter 1, the policy interest in "reasonable" rates dates back to the ICA of 1887 and even further to the common law principles that shaped the legal doctrine of common carriage.
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From page 104... ...
is is a clear directive to ensure financially sound railroads, and the Commission is not to misuse the term "reasonable" to circumvent this directive.11 Before the Staggers Rail Act, rail rates had been kept too high in many markets in which shippers had nonrail competitive options; this caused potentially profitable traffic to be priced out of the rail market. By allowing railroads to adjust rates according to demand, the act ended this inefficiency of the previous regulatory system.12 In making an exception to these pricing freedoms, the act's maximum rate provisions required regulators to determine what constitutes an "unreasonable" rate in markets in which a railroad lacked effective competition and could exercise significant market power.
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From page 105... ...
us, in introducing its first set of guidelines for ruling on rate reasonableness, the 1985 Coal Rate Guidelines,15 ICC set a precedent whereby all evidentiary standards for judging the fairness of a rate would need to be linked, at least ostensibly, to the statutory goal of ensuring revenue adequacy. is link was stated explicitly in the 13 As noted in Chapter 1, Grimm and Winston (2000)
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From page 106... ...
Because of the congressional directive that regulators not grant rate relief so permissively that it threatens railroad revenue adequacy, the confidence that regulators have in this statutory formula as a screen for limiting rate relief cases is critical. In the absence of such confidence, the introduction of exacting and imposing standards for assessing market dominance and rate reasonableness might be expected.
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From page 107... ...
VARIABLE COST FORMULA When the Staggers Rail Act introduced the R/VC formula for screening rates for relief eligibility, ICC had long been using accounting-based cost allocation systems for costing railroad services and activities.16 e law directed the agency to develop an updated method to determine "economically accurate railroad costs directly and indirectly associated with particular movements of goods, including the variable costs associated with particular movements."17 To comply, ICC developed the Uniform Railroad Costing System (URCS) , which shares a methodological approach with earlier cost accounting schemes and remains in use today.18 For reasons explained next, estimation of variable cost with the URCS or any other cost allocation scheme is inherently problematic.
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From page 108... ...
Furthermore, whether the term "variable cost" was meant to be the incremental cost of a priced shipment (e.g., the added fuel use or wear and tear that one additional shipment creates) or something else is not clear.
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From page 109... ...
Because the time period is likely to be based solely on when expense data are collected, there will be an inherent arbitrariness in the distinction between fixed and variable costs. e cost allocator thus has to establish rules for dividing the subset of a railroad's reported expenses characterized as "variable" for an arbitrarily determined time period.
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From page 110... ...
Fundamental Flaws of URCS ICC introduced URCS with the idea of defining a railroad's fixed and variable costs more precisely by dividing expenses into more discrete categories and defining units of traffic more narrowly, such as by car type, shipment size, and length of haul.21 Regressions were run to determine whether certain cost items were more or less fixed with respect to traffic volume changes (e.g., by showing that annual fuel used to run locomotives was 96 percent variable with traffic)
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From page 111... ...
It is a cost allocation scheme that has no economic foundation, as amply illustrated by the "make-whole" contrivance to redistribute unallocated costs. Its refinements relative to earlier cost allocation schemes have done nothing to make the results any more reliable or less arbitrary because the large majority of cost items characterized by URCS as "variable" are clearly not variable (e.g., road property)
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From page 112... ...
. Yet in conceding these deficiencies, STB overlooks their significance by acknowledging that "the role of URCS is to estimate that portion of the variable costs of providing rail service that can be attributed to any given [emphasis added]
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From page 113... ...
However, estimates of variable cost that are derived in a highly arbitrary manner -- in ways described above -- cannot be expected to have a tenable or stable relationship to these incremental costs, and thus they can offer no meaningful insight into market power when they are compared with a shipment's rate. Box 3-1 indicates how a number of cost allocation rules that might be viewed as reasonable can yield substantially different R/VC percentages, which would cause shipments to fall below or exceed the 180 percent threshold.
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From page 114... ...
= $466, the difference between its total revenue and total variable costs. ere is no unambiguous way to allocate the common variable costs of $500 to the individual products to obtain product-specific variable costs.
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From page 115... ...
Both Product 1 and Product 3 violate the 180 percent threshold. e fourth cost allocation rule simply assigns one-third of the $500 of common variable costs to each product.
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From page 116... ...
Examples of Alternative Rules for Computing a Rate's Fully Allocated Cost Threshold: 180 Percent R/VC Value Method Used to Compute Fully Allocated Cost Product � Product � Product � Quantity-based cost allocation ���.�� ���.�� ���.�� Revenue-based cost allocation ���.�� ���.�� ��.�� Variable cost–based cost allocation ���.�� ���.�� ��.�� Equal cost allocation by product ���.�� ���.�� ���.�� Actual rates for shipments ���.�� ���.�� ���.�� Box 3-1 (continued) EXAMPLE OF THE ARBITRARINESS OF COST ALLOCATION RULES Christensen Associates concluded that URCS was flawed by failing to take into account "latent cost-causing factors or other shipment features."24 STB has defended URCS from such findings by stating that ratios below 100 percent are possible for some traffic 24 Laurits R
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From page 117... ...
Eakin, Christensen Associates, presentation to the committee, January 10, 2014 (http://www.trb.org/ PolicyStudies/RailTransReg.aspx)
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From page 118... ...
For example, analyses of R/VCs for nonexempt (tariff and contract) traffic grouped by market distance show that shorter-haul shipments have much higher shares of ton-miles exceeding the 180 percent threshold than do longer-haul shipments (Figure 3-1)
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From page 119... ...
Replacing or reforming URCS with more "refined" methods of cost allocation would be substituting one contrivance for another. e more appropriate solution is to replace reliance on URCS in rate regulation with a system for identifying unusually high rates that is economically sound and that does not apply arbitrary cost allocation rules.
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From page 120... ...
.28 However, since 1998 STB has prohibited such showings on the basis that they "significantly impede the efficient processing" of the proceedings and present "undue burdens and obstacles" for shippers challenging rates.29 is decision was in direct response to the demand by Congress for the timely handling of rate challenges, "avoiding delay in the discovery and evidentiary phases" of proceedings.30 STB reported that rate cases proceeded more quickly after the exclusion of geographic and product competition from market dominance inquiries. However, a number of cases in the past several years have caused STB to express concern that assessments of market dominance will once again slow down and potentially deter rate challenges.
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From page 121... ...
It has reasoned that its use is valid because "Congress regarded R/VC ratios as an appropriate measure for allocating joint and common costs among rail shippers, as reflected in the 180 percent R/VC jurisdictional floor for rate relief."32 A case in 2012, for example, was brought by a producer of plastic pellets contending that the defendant railroads had market dominance affecting rates in 42 markets.33 e central issue was whether trucks, which are sometimes used to transport the pellets, function as a practical constraint on railroad pricing. To assess this potential, STB has resorted to using URCS and its R/VC values to estimate the highest price that the railroad could charge the pellet shipper without causing substantial traffic to be diverted to trucks.34 In 2013, the Association of American Railroads petitioned STB to restore product and geographic competition.
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From page 122... ...
eir introduction is considered later in this report. RATE REASONABLENESS STANDARDS If a shipper is charged a tariff rate that exceeds 180 percent of variable cost and can prove it ships in a dominated market, it is eligible to challenge the rate by using one of three main methods for judging rate reasonableness.
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From page 123... ...
Absent further guidance on the application of a firmwide revenue adequacy constraint -- or any near-term prospects for its use given the still tenuous financial condition of railroads in 1985 -- the Coal Rate Guidelines' two other constraints for judging rate reasonableness took precedence. First, the shipper would not be required to bear the cost 38 49 USC §10704(d)
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From page 124... ...
Of course, this cost cannot be directly observed. Hence, ICC introduced the SAC test, the stated purpose of which was to estimate a competitive rate level "to determine the least cost at which an efficient competitor could provide the [stand-alone]
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From page 125... ...
Of course, any concern over inefficient entry is inapplicable to railroads, inasmuch as the prospect of high rates inviting railroad entry, with its large fixed and sunk costs, is negligible.42 As noted above, the Coal Rate Guidelines are explicit in referring to the subsidy-free goal as a rationale for the SAC test, which implies an interest in the fairness aspect of cross-subsidization -- that is, to ensure that shippers are not forced to pay higher rates that benefit other shippers. However, as Pittman (2010)
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From page 126... ...
While the Coal Rate Guidelines make clear that part of SAC's purpose is to identify such management inefficiencies,43 that purpose appears highly questionable today in light of the railroads' own profit incentives, which should motivate management efficiency. us, as Pittman explains in his critique, the decision by regulators to apply the SAC test must hinge on purposes other than those arising from cross-subsidies or an intention to protect efficiency.
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From page 127... ...
e annual revenues required to recover the SARR's capital costs (and taxes) are combined with the annual operating costs to calculate the SARR's total annual revenue requirements.
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From page 128... ...
URCS is used to calculate the variable costs to allocate revenues from shared, or crossover, traffic. Because the analysis period covers multiple years, a present value analysis is used that takes into account the time value of money; the annual over- and underrecovery are netted as of a single point in time.
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From page 129... ...
ey contain details and determinations with regard to matters whose relevance cannot in practice be evaluated by outsiders and presumably can be evaluated by STB only with much dedicated expertise and effort.44 Whether the complex hypothetical scenarios that emerge have any connection to the genuine revenue needs of the defendant railroad, which operates a broader network shared by many shippers with many fixed and sunk costs, cannot be readily discerned. e SAC evidentiary rules were originally intended for use by coal shippers, who ship large volumes on a regular basis over fixed traffic corridors.
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From page 130... ...
. Coal shippers maintain that the SAC process is burdensome and leads to rates being judged reasonable at conservatively high levels out of deference to revenue adequacy, when the true revenue needs of the railroad are lower because of network economies.
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From page 131... ...
Within a short period after adopting the Coal Rate Guidelines, ICC recognized that shippers of lower volumes over more varied routes would not be strong candidates for disputing a rate with the SAC test. However, ICC took many years to develop a set of alternative procedures.
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From page 132... ...
347-2, Rate Guidelines -- Non-Coal Proceedings, December 27, 1996. 48 STB Ex Parte No.
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From page 133... ...
Finally, STB compares the disputed rate's R/VC with calculations of the average markup that the railroad is presumed to need on all of its potentially captive traffic to make the railroad revenue adequate. e purpose of the three benchmarks is "to ensure that the complaining shipper's traffic is not bearing a disproportionate share of the carrier's revenue requirements vis-à-vis other relatively demand-inelastic traffic without good cause."53 STB applies the three benchmarks to a formula for ascertaining when a disputed rate is reasonable.54 50 STB Ex Parte No.
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From page 134... ...
In stipulating that the variable cost of a priced unit of traffic be calculated as a means of screening it for eligibility for rate relief, the Staggers Rail Act created an insoluble problem for regulators. Most 55 STB Ex Parte No.
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From page 135... ...
Among them are the pricing of about 25 percent of all railroad shipments below their presumed variable cost and most short-haul and hazardous materials traffic exceeding the 180 percent R/VC threshold. Perhaps to compensate for an unreliable URCS-based rate screening process, STB has instituted exacting and complex procedures for assessing market dominance and rate reasonableness.
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From page 136... ...
e arbitrator reviews the evidence, listens to the parties, and then makes a decision. STB now uses arbitration to resolve certain nonrate disputes between shippers and railroads, and a voluntary arbitration and mediation program is used by BNSF Railway and grain shippers to settle rate and service disputes in Montana.58 e National Grain and Feed Association has operated an arbitration system for railroad–shipper disputes since the early 20th century, which it expanded in 1998 to include involvement by major railroads.59 In conducting hearings during 2001 on the potential to use arbitration for small rate cases, STB also examined the potential for using the binding, final-offer form that is practiced in Canada.60 e agency 57 A recent legislative proposal for rate arbitration was introduced on September 8, 2014, in S
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From page 137... ...
As in the United States, the Canadian freight railroad industry has been substantially deregulated for about 30 years, and the easing of regulation has been accompanied by improved productivity and lower freight rates.62 Canada requires railroads to offer common carrier service and exempts traffic moved under confidential contract from regulations governing rate and service offerings, as does the United States. e two major Canadian railroads are closely integrated with the U.S.
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From page 138... ...
Canada does not mandate that arbitrators have any special knowledge or training in the railroad industry, and arbitration decisions are confidential and do not create precedent. For these reasons, the process can be even more unpredictable and compel compromise, and only on rare occasions do parties avail themselves of the process in successive years (Cairns 2014)
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From page 139... ...
Review of the Rate Relief Process 139 Box 3-3 FINAL-OFFER RATE ARBITRATION IN CANADA Arbitration is intended to be a faster, more flexible, and more economical means of dispute resolution than litigation. In conventional arbitration, the arbitrator is free to impose any award that he or she believes is appropriate.
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From page 140... ...
e panel concluded that as a consequence of this requirement, a shipper in a competitive market would be unlikely to endure the complexity and expense of a case in view of the low likelihood of prevailing once its competitive status was exposed (Minister of Public Works and Government Services Canada 2001, 71)
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From page 141... ...
e challenge for regulators is to replace an unreliable and arbitrary cost allocation scheme with an economically sound approach for identifying rates that may be unreasonable. Such an approach will, in turn, allow for the development of procedures for assessing the reasonableness of rates that are not so burdensome and costly that they effectively deny eligibility for relief to shippers for reasons unrelated to the legitimacy of their claims.
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From page 142... ...
e demonstration in Appendix B suggests that such models would be no more complicated to construct and run, and would probably be less so, than the annual derivation of variable costs from URCS. e complexity of the latter (and the potential to upset existing patterns of results)
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From page 143... ...
Although decisions about the appropriate threshold could be controversial, they would be transparent. at is preferable to the current system, which relies on arbitrary cost allocation rules that are used in implementing an arbitrary R/VC threshold.
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From page 144... ...
1985. Coal Rate Guidelines, Nationwide.
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