Freight Railroads
Preliminary Observations on Rates, Competition, and Capacity Issues Gao ID: GAO-06-898T June 21, 2006The Staggers Rail Act of 1980 largely deregulated the freight railroad industry, giving the railroads freedom to price their services according to market conditions and encouraging greater reliance on competition to set rates. The act recognized the need for railroads to use demand-based differential pricing in the deregulated environment and to recover costs by setting higher rates for shippers with fewer transportation alternatives. The act also recognized that some shippers might not have access to competitive alternatives and might be subject to unreasonably high rates. It established a threshold for rate relief and granted the Interstate Commerce Commission and the Surface Transportation Board (STB) the authority to develop a rate relief process for those "captive" shippers. This testimony provides preliminary results on GAO's ongoing work and addresses (1) the changes that have occurred in the freight railroad industry since the enactment of the Staggers Rail Act, including changes in rail rates and competition in the industry, (2) the alternative approaches that have been proposed and could be considered to address remaining competition and captivity concerns, and (3) the projections for freight traffic demand over the next 15 to 25 years, the freight railroad industry's projected ability to meet that demand, and potential federal policy responses. To fulfill these objectives, GAO examined STB data, interviewed affected parties, and held an expert panel.
The changes that have occurred in the railroad industry since the enactment of the Staggers Rail Act are widely viewed as positive. Railroad industry financial health improved substantially and rates generally declined between 1985 and 2000, but increased slightly from 2001 through 2004. Concerns about competition and captivity remain because traffic is concentrated in fewer railroads and some shippers are paying significantly higher rates than others. It is difficult to precisely determine the number of shippers that are "captive" because proxy measures can overstate or understate captivity. However, GAO's preliminary analysis indicates that while captivity may be dropping, the share of potentially captive shippers that are paying the highest rates--those substantially above the threshold for rate relief--has increased. A number of alternative approaches have been suggested by shipper groups and others to address remaining concerns about competition and captivity; however, any alternative approaches should be carefully considered. Two areas are particularly integral to further improvement. First, while STB has broad authority to investigate industry practices and has assessed competition--generally in railroad merger cases--there has been little assessment by any federal agency of the state of competition and of where specific areas of inadequate competition and the inappropriate exercise of market power might exist. Such an assessment would allow decisionmakers to identify areas where competition is lacking and to assess the need for and merits of targeted approaches to address this situation. These approaches include requiring reciprocal switching arrangements, which allow one railroad to switch railcars of another railroad, and/or terminal access agreements, which permit one railroad to use another's terminals. Second, a number of different approaches have been suggested that could make the rate relief process less expensive and more expeditious, and thus potentially more accessible, such as arbitration and increased use of simplified guidelines. Each of the proposed approaches has both advantages and drawbacks. Any alternative approach to address competition and captivity should be carefully considered to ensure that the approach will achieve the important balance set out in the Staggers Rail Act of allowing the railroads to earn adequate revenues while assuring protection for captive shippers from unreasonable rates. Significant increases in freight traffic over the next 15 to 25 years are forecasted, and the railroad industry's ability to meet future demand is largely uncertain. Investments in rail projects can produce benefits for the public--for example, shifting truck freight traffic to railroads can reduce highway congestion. As a result, the federal and state governments have been increasingly participating in freight rail improvement projects--for example, Congress provided $100 million to the CREATE project in 2005 to improve the rail network in Chicago. Congress is likely to face additional decisions in the years ahead regarding federal policy toward the nation's freight railroad system. GAO would note, based on past work, that federal involvement should occur only where demonstrable public benefits exist, and where a mechanism is in place to appropriately allocate the cost of financing these benefits between the private and public sectors, and between national, state, and local interests.
GAO-06-898T, Freight Railroads: Preliminary Observations on Rates, Competition, and Capacity Issues
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Testimony:
Before the Subcommittee on Surface Transportation and Merchant Marine,
Senate Committee on Commerce, Science, and Transportation, U.S. Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery Expected at 10:00 a.m. EDT:
Wednesday, June 21, 2006:
Freight Railroads:
Preliminary Observations on Rates, Competition, and Capacity Issues:
Statement of JayEtta Z. Hecker, Director,
Physical Infrastructure Issues:
GAO-06-898T:
GAO Highlights:
Highlights of GAO-06-898T, a testimony before the Subcommittee on
Surface Transportation and Merchant Marine, Committee on Commerce,
Science, and Transportation, U.S. Senate.
Why GAO Did This Study:
The Staggers Rail Act of 1980 largely deregulated the freight railroad
industry, giving the railroads freedom to price their services
according to market conditions and encouraging greater reliance on
competition to set rates. The act recognized the need for railroads to
use demand-based differential pricing in the deregulated environment
and to recover costs by setting higher rates for shippers with fewer
transportation alternatives. The act also recognized that some shippers
might not have access to competitive alternatives and might be subject
to unreasonably high rates. It established a threshold for rate relief
and granted the Interstate Commerce Commission and the Surface
Transportation Board (STB) the authority to develop a rate relief
process for those ’captive“ shippers.
This testimony provides preliminary results on GAO‘s ongoing work and
addresses (1) the changes that have occurred in the freight railroad
industry since the enactment of the Staggers Rail Act, including
changes in rail rates and competition in the industry, (2) the
alternative approaches that have been proposed and could be considered
to address remaining competition and captivity concerns, and (3) the
projections for freight traffic demand over the next 15 to 25 years,
the freight railroad industry‘s projected ability to meet that demand,
and potential federal policy responses. To fulfill these objectives,
GAO examined STB data, interviewed affected parties, and held an expert
panel.
What GAO Found:
The changes that have occurred in the railroad industry since the
enactment of the Staggers Rail Act are widely viewed as positive.
Railroad industry financial health improved substantially and rates
generally declined between 1985 and 2000, but increased slightly from
2001 through 2004. Concerns about competition and captivity remain
because traffic is concentrated in fewer railroads and some shippers
are paying significantly higher rates than others. It is difficult to
precisely determine the number of shippers that are ’captive“ because
proxy measures can overstate or understate captivity. However, GAO‘s
preliminary analysis indicates that while captivity may be dropping,
the share of potentially captive shippers that are paying the highest
rates”those substantially above the threshold for rate relief”has
increased.
A number of alternative approaches have been suggested by shipper
groups and others to address remaining concerns about competition and
captivity; however, any alternative approaches should be carefully
considered. Two areas are particularly integral to further improvement.
First, while STB has broad authority to investigate industry practices
and has assessed competition”generally in railroad merger cases”there
has been little assessment by any federal agency of the state of
competition and of where specific areas of inadequate competition and
the inappropriate exercise of market power might exist. Such an
assessment would allow decisionmakers to identify areas where
competition is lacking and to assess the need for and merits of
targeted approaches to address this situation. These approaches include
requiring reciprocal switching arrangements, which allow one railroad
to switch railcars of another railroad, and/or terminal access
agreements, which permit one railroad to use another‘s terminals.
Second, a number of different approaches have been suggested that could
make the rate relief process less expensive and more expeditious, and
thus potentially more accessible, such as arbitration and increased use
of simplified guidelines. Each of the proposed approaches has both
advantages and drawbacks. Any alternative approach to address
competition and captivity should be carefully considered to ensure that
the approach will achieve the important balance set out in the Staggers
Rail Act of allowing the railroads to earn adequate revenues while
assuring protection for captive shippers from unreasonable rates.
Significant increases in freight traffic over the next 15 to 25 years
are forecasted, and the railroad industry‘s ability to meet future
demand is largely uncertain. Investments in rail projects can produce
benefits for the public--for example, shifting truck freight traffic to
railroads can reduce highway congestion. As a result, the federal and
state governments have been increasingly participating in freight rail
improvement projects”for example, Congress provided $100 million to the
CREATE project in 2005 to improve the rail network in Chicago. Congress
is likely to face additional decisions in the years ahead regarding
federal policy toward the nation‘s freight railroad system. GAO would
note, based on past work, that federal involvement should occur only
where demonstrable public benefits exist, and where a mechanism is in
place to appropriately allocate the cost of financing these benefits
between the private and public sectors, and between national, state,
and local interests.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-898T].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact JayEtta Z. Hecker at
(202) 512-2834 or heckerj@gao.gov.
[End of Section]
Mr. Chairman and Members of the Committee:
We appreciate the opportunity to testify on our preliminary
observations on the impact of deregulation of the freight railroad
industry. As you know, over 25 years ago, Congress, with the leadership
of this committee, transformed federal transportation policy. After
almost 100 years of economic regulation, the railroad industry was in
serious economic trouble in the 1970s, with rising costs, losses, and
bankruptcies. In response, Congress passed the Railroad Revitalization
and Regulatory Reform Act in 1976 and the Staggers Rail Act in 1980
that substantially deregulated the railroad industry. The 1980 act
encouraged greater reliance on competition to set rates and gave
railroads increased freedom to price their services according to market
conditions, including using differential pricing--that is, recovering a
greater proportion of their costs from rates charged to shippers with a
greater dependency on rail transportation. Furthermore, the act
anticipated that some shippers might not have competitive alternatives,
and gave the Interstate Commerce Commission (ICC), and later the
Surface Transportation Board (STB), the authority to establish a rate
relief process so that shippers could obtain relief from unreasonably
high rates.
At the request of several members of this committee, we have ongoing
work providing a retrospective on the performance of the rail industry
since the Staggers Rail Act. My comments today focus on (1) the changes
that have occurred in the freight railroad industry since the enactment
of the Staggers Rail Act, including changes in rail rates and
competition in the industry, (2) what alternative approaches have been
proposed and could be considered to address remaining competition and
captivity concerns, and (3) the projections for freight traffic demand
over the next 15 to 25 years, the freight railroad industry's projected
ability to meet that demand, and potential federal policy responses.
To fulfill our objectives, we examined STB's Carload Waybill Sample
from 1985-2004 (the latest data available at the time of our review).
This document includes data on rail rates, tonnage, federal regulation,
and other statistics but disguises some revenues to avoid disclosing
confidential business information to the public. We obtained a version
of the Carload Waybill Sample that did not disguise revenues. We also
interviewed, and reviewed information from representatives of each
Class I railroad in North America,[Footnote 1] shipper groups,
economists, and experts in the rail industry, and held an expert panel
consisting of individuals with expertise in the freight railroad
industry and the economics of transportation deregulation, interviewed
shipper groups, railroads, and economists, and reviewed pending
legislation and literature. We also reviewed forecasts of future
freight rail demand and capacity, including synthesizing forecasting,
and transportation planning literature, and interviewed federal and
state transportation officials, financial market analysts, national
association representatives, and transportation experts. While we are
aware that service issues such as on time performance and the supply of
railcars by the railroads are of concern to many people here today,
service issues are not included in the preliminary observations I will
present today. Instead, we will leave comments about service to other
individuals testifying. My comments today are based on our past body of
work on the freight rail industry as well as our ongoing work, which we
are conducting in accordance with generally accepted government
auditing standards (see app. I for a list of our past reports on the
freight railroad industry).
In summary:
² The changes that have occurred in the railroad industry since the
enactment of the Staggers Rail Act are widely viewed as positive, as
the financial health of the industry has improved and most rates have
declined since 1985, although concerns about competition and captivity
in the industry remain. The freight railroad industry's financial
health improved substantially as railroads cut costs through
productivity improvements, streamlined and "right-sized" their rail
networks, implemented new technologies, and expanded business into new
markets such as the intermodal market, which consists of containers and
trailers that can be carried on ships, trucks, or rail. Between 1985
and 2000, rates generally declined, but have increased slightly from
2001 through 2004.[Footnote 2] Several factors could have contributed
to recent rate increases, including continuing consolidation in the
industry and broad changes in the domestic and world economy and
emergence of a capacity constrained environment, where demand exceeds
supply. Concerns about competition and captivity in the industry remain
because traffic is concentrated in fewer railroads and, although rates
have declined for most shippers since the enactment of the Staggers
Rail Act, rates have not declined uniformly and some shippers are
paying significantly higher rates than others. It is difficult to
precisely determine the number of shippers who are "captive" to one
railroad because proxy measures that provide the best indication can
overstate or understate captivity. However, our preliminary analysis
indicates that while the extent of potential captivity may be dropping,
the share of potentially captive shippers who are paying the highest
rates--those substantially above the threshold for rate relief--has
increased. Whether this increase reflects an exercise or possible abuse
of market power or is simply a reflection of rational economic
practices by the railroads in an environment of excess demand remains
uncertain.
² A number of alternative approaches have been suggested by shipper
groups, economists, and other experts in the rail industry to address
remaining concerns about competition and captivity--however, any
alternative approaches should be carefully considered. While a number
of approaches have been suggested, I would, based on our preliminary
work, like to focus on two areas that are particularly integral to
further improvement. First, while STB has broad legislative authority
to investigate industry practices and has assessed competition
practices--generally in reviewing railroad merger cases--there has been
little assessment of competition nationally by any federal agency of
the state of competition nationally and where specific areas of
inadequate competition and the inappropriate exercise of market power
might exist. Given widespread disagreement about the adequacy of
competition in the industry and the fact that proxy measures can
understate or overstate captivity, such an assessment would allow
decisionmakers to identify areas where competition is lacking and to
assess the need for and merits of targeted approaches to address it.
These approaches include requiring reciprocal switching arrangements,
which allow one railroad to switch railcars of another railroad, and/or
terminal access agreements, which permits one railroad to use another's
terminals. Second, although the Staggers Rail Act recognized that some
shippers might not have access to competitive alternatives and might be
subject to unreasonably high rates, there is widespread agreement that
the rate relief process does not provide expeditious handling and
resolution of complaints, is expensive, time-consuming, and complex,
and that, as a result, it is largely inaccessible to most shippers. A
number of different approaches have been suggested by shipper
organizations and others that could make the process less expensive and
more expeditious, and thus more accessible, such as arbitration and
increased use of simplified guidelines. Each of the proposed approaches
has both advantages and drawbacks. Any alternative approaches to
address competition and captivity should be carefully considered to
ensure that the approach will achieve the important balance set out in
the Staggers Rail Act of allowing the railroads to earn adequate
revenues and invest in its infrastructure while assuring protection for
captive shippers from unreasonable rates.
² Significant increases in freight traffic over the next 15 to 25 years
are forecasted, although many factors can affect the accuracy of these
forecasts, and the railroad industry's ability to meet future demand is
largely uncertain. Although railroads have reported significant
increased investment and have told us that they plan to continue making
infrastructure investments, they also expressed uncertainty as to their
ability to keep pace with some of the higher projections of future
freight rail demand. Besides securing benefits for private rail
networks, investments in rail projects can produce benefits for the
public--for example, shifting truck freight traffic to railroads can
reduce highway congestion. As a result, the federal and state
governments have been increasingly participating in freight rail
improvement projects--for example, a number of states are involved in
joint projects with the railroads and, in 1997, the U.S. Department of
Transportation provided a $400 million loan to the Alameda Corridor
Transportation Authority for the Alameda Corridor project to
consolidate rail and other freight traveling to and from the ports of
Los Angeles and Long Beach. In addition, in 2005, Congress authorized
$100 million for the Chicago CREATE project to improve the rail network
in Chicago. Congress is likely to face additional decisions in the
years ahead regarding federal policy toward the nation's freight
railroad system. While our work continues, we would note, based on our
past work, that federal involvement should only occur where
demonstrable public benefits exist, and a where a mechanism is in place
to appropriately allocate the cost of financing these benefits between
the public and private sectors, and between national, state, and local
interests.
Background:
Freight rail is an important component of our nation's economy.
Approximately 42 percent of all inter-city freight in the United
States, measured in ton miles, moves on rail lines. Freight rail is
particularly important to producers and users of certain commodities.
For example, about 70 percent of automobiles manufactured domestically,
about 70 percent of coal delivered to power plants, and about 32
percent of grain moves on freight rail.
Beginning in 1887, the Interstate Commerce Commission (ICC) regulated
almost all of the rates that railroads charged shippers. Congress
passed the Railroad Revitalization and Regulatory Reform Act in 1976
and the Staggers Rail Act in 1980, and these acts greatly increased the
reliance on competition in the railroad industry. Specifically, these
acts allowed railroads and shippers to enter into confidential
contracts which set rates and prohibited the ICC from regulating rates
where railroads had effective competition or if the rates had been
negotiated between the railroad and the shipper. The ICC Termination
Act of 1995 abolished the ICC and transferred its regulatory functions
to STB. Taken together, these acts anchor the federal government's role
in the freight rail industry and have established numerous goals for
regulating the industry, including the following:
² to allow, to the maximum extent possible, competition and demand for
services to establish reasonable rates for transportation by rail.
² to minimize the need for federal regulatory control over the rail
transportation system and to require fair and expeditious regulatory
decisions when regulation is required.
² to promote a safe and efficient rail transportation system by
allowing rail carriers to earn adequate revenues, as determined by STB.
² to ensure effective competition among rail carriers and with other
modes to meet the needs of the public.
² to maintain reasonable rates where there is an absence of effective
competition and where rail rates provide revenues which exceed the
amount necessary to maintain the rail system and to attract capital.
² to prohibit predatory pricing and practices, to avoid undue
concentrations of market power; and:
² to provide for the expeditious handling and resolution of all
proceedings.
Two important components of the current regulatory structure are the
concepts of revenue adequacy and demand-based differential pricing.
Congress established the concept of revenue adequacy as an indicator of
the financial health of the industry. STB determines the revenue
adequacy of a railroad by comparing the railroad's return on investment
with the industrywide cost of capital. If a railroad's return on
investment is greater than the industry-wide cost of capital, STB
determines that railroad to be revenue adequate. Historically, the ICC
and STB have rarely found railroads to be revenue adequate, which many
observers relate to characteristics of the industry's cost structure.
Railroads incur large fixed costs to build and operate networks that
jointly serve many different shippers. While some fixed costs can be
attributed to serving particular shippers, and some costs vary with
particular movements, other costs are not attributable to particular
shippers or movements. Nonetheless, a railroad must recover these costs
if the railroad is to continue to provide service over the long run,
and, to the extent that railroads have not been revenue adequate, this
may indicate that they are not fully recovering these costs.
Consequently, the Staggers Rail Act recognized the need for railroads
to use demand-based differential pricing in the deregulated
environment. Demand-based differential pricing in theory permits a
railroad to recover their joint and common costs across its entire
traffic base by setting higher rates for traffic with fewer
transportation alternatives than for traffic with more alternatives.
This means that a railroad might incur similar incremental costs in
providing service to two different shippers that ship similar tonnages
in similar car types traveling over similar distances, but that the
railroad may charge quite different rates. In this way, the railroad
recovers a greater portion of its joint and common costs from the
shipper that is more dependent on railroad transportation, but, to the
extent that the railroad is able to offer lower rates to the shipper
with more transportation alternatives, the other shipper makes a
contribution toward those costs.
The Staggers Rail Act further required that the railroads' need to
differentially price its services be balanced with the rights of
shippers to be free from, and to seek redress from unreasonable rates.
Railroads incur variable costs--that is the costs of moving particular
shipments--in providing service. The Staggers Rail Act stated that any
rate that was found to be above 180 percent of a railroad's variable
cost for a particular shipment was potentially an unreasonable rate and
granted the ICC, and later the STB, the authority to establish a rate
relief process. In response, the ICC established two criteria for
allowing a rail rate case. First, as stated in law, the rate had to be
above 180 percent of the revenue-to-variable-cost (R/VC) ratio. Second,
the shipper had to demonstrate that it had no other reasonable
transportation alternative. Such a shipper is referred to as a "captive
shipper."
Railroad Industry Increasingly Healthy and Rates Down Since Enactment
of the Staggers Rail Act, but Competition and Captivity Concerns
Remain:
The changes that have occurred in the railroad industry since the
enactment of the Staggers Rail Act are widely viewed as positive. The
railroad industry's financial health improved substantially as it cut
costs, boosted productivity, and "right-sized" its networks. Rates
generally declined between 1985 and 2000 but increased slightly from
2001 through 2004. Concerns about competition and captivity in the
industry remain because traffic is concentrated in fewer railroads and,
although rates have declined for most shippers, some shippers are
paying significantly higher rates than others. While it is difficult to
precisely determine the number of shippers who are "captive" to one
railroad, our preliminary analysis indicates that while the extent of
potential captivity may be dropping, the share of potentially captive
shippers who are paying the highest rates--those substantially above
the threshold for rate relief--has increased.
Railroad Industry Financial Health Improved Substantially:
There is widespread consensus that the freight rail industry has
benefited from the Staggers Rail Act. Specifically, various measures
indicate an increasingly strong freight railroad industry. Freight
railroads' improved financial health is illustrated by increases in
productivity, volume of shipments, and stock prices. Freight railroads
have also cut costs by streamlining their workforce and "right-sizing"
their rail network, through which the railroads have reduced track,
equipment, and facilities to more closely match demand. These measures
are shown in figure 1.
Figure 1: Railroads' Financial Performance: 1964-2004:
[See PDF for image]
[End of figure]
Freight railroads have also expanded their business into new markets -
such as the intermodal market - and implemented new technologies,
including larger cars, and are currently developing new scheduling and
train control systems. Some observers believe that the competition
faced by railroads from other modes of transportation has created
incentives for innovative practices, and that the ability to enter into
confidential contracts with shippers has permitted railroads to make
specific investments and to develop service arrangements tailored to
the requirements of different shippers.
Rates Declined From 1985 through 2000 and Rose Slightly from 2001
through 2004:
Rail rates across the industry have generally declined since enactment
of the Staggers Rail Act. Because changes in traffic patterns over time
(for example, hauls over longer distance) can result in increases in
lower priced traffic and a decrease in average revenue per ton mile, it
can present misleading rate trends. Therefore, we developed a rail rate
index[Footnote 3] to examine trends in rail rates over the 1985-2004
period. These indexes account for changes in traffic patterns over time
which could affect revenue statistics but do not account for inflation.
As a result, we have also included the price index for the gross
domestic product.
Although there has been a slight upturn in rates from 2001 through
2004, the industry continues to experience rates that are generally
lower than they were in 1985. During this time some costs have also
been passed on to shippers, such as having shippers provide equipment.
There was a steep decline in rates from 1985 to 1987 when rates dropped
by 10 percent. Rates continued to decline, although not as steeply,
through 1998. Rates increased in 1999, then dropped again in 2000. In
2001 and 2002 rates rose again. Rates were nearly flat in 2003 and
2004, finishing approximately 3 percent above rates in 2000, but 20
percent below 1985 rates. This is shown in figure 2.
Figure 2: Industry Rail Rates 1985-2004:
[See PDF for image]
[End of figure]
These data include rates through 2004. According to freight railroad
officials, shippers, and financial analysts, since 2004 rates have
continued to increase as the demand for freight rail service has
increased, rail capacity has become more limited, and as a result,
freight railroad companies have gained increased pricing power.
A number of factors may have contributed to recent rate increases.
Ongoing industry and economic changes have influenced how railroads
have set their rates. Since the Staggers Rail Act was enacted, the
railroad industry and the economic environment in which it operates
have changed considerably. Not only has the rail industry continued to
consolidate, potentially increasing market power by the largest
railroads, but after years of reducing the number of its employees and
shedding track capacity, the industry is increasingly operating in a
capacity-constrained environment where demand for their services
exceeds their capacity. In addition, the industry has more recently
increased employment and invested in increased capacity in key traffic
corridors. Additionally, changes in broader domestic and world economic
conditions have led to changes in the mix and profitability of traffic
carried by railroads.
Competition and Captivity Concerns Remain:
Concerns about competition and captivity in the railroad industry
remain because traffic is concentrated in fewer railroads and even
though rates have declined for most shippers since the enactment of the
Staggers Rail Act, some shippers are paying significantly higher rates
than other shippers--a reflection of differential pricing. There is
significant disagreement on the state of competition in the rail
industry. In 1976, there were 63 Class I railroads operating in the
United States compared with 7 Class I railroads in 2004.[Footnote 4] As
figure 3 shows, 4 of these Class I railroads accounted for over 89
percent of the industry's revenues in 2004. While some experts view
this concentration as a sign that the industry has become less
competitive over time, others believe that the railroad mergers and
acquisitions actually increased competition in the rail industry
because STB placed conditions on the mergers intended to maintain
competition. These experts also point to the hundreds of short line
railroads[Footnote 5] that have come into being since the enactment of
the Staggers Rail Act, as well as other increased competitive options
for shippers from other modes such as trucks and barges.
Figure 3: Railroad Market Concentration, 1985-2004:
[See PDF for image]
[End of figure]
According to our preliminary analysis, some commodities and shippers
are paying significantly higher rates than other shippers. This can be
seen in rates charged to commodities and at specific routes. Figure 4
compares commodity rates for coal and grain prices from 1985 through
2004 using our rail rate index. As figure 4 shows, all rate changes
were below the rate of inflation and thus all rates declined in real
terms. However during that period, coal rates dropped even more sharply
than industrywide rates, declining 35 percent. Grain rates initially
declined from 1985 to 1987, but then diverged from industry trends and
increased, resulting in a net 9 percent nominal increase by 2004.
Figure 4: Industry, Coal, and Grain Rate Changes, 1985-2004:
[See PDF for image]
[End of figure]
It is difficult to precisely determine the number of shippers who are
"captive" to one railroad because proxy measures that provide the best
indication can overstate or understate captivity. One way of
determining potential captivity in our preliminary analysis was to
identify which Bureau of Economic Analysis (BEA) economic areas were
served by only one Class I railroad. [Footnote 6] In 2004, 27 of the
177 BEA economic areas were served by only one Class I railroad. As
shown in figure 5, these areas include parts of Montana, North Dakota,
New Mexico, Maine, and other states. We also examined specific origin
and destination pairs and found that in 2004, origin and destination
routes with access to only one Class I railroad carried 12 percent of
industry revenue. This represents a decline from 1994, when 22 percent
of industry revenue moved on routes served by one Class I railroad.
This decline suggests that more railroad traffic is traveling on routes
with access to more than one Class I railroad.
Figure 5: Number of Class I Railroads Serving Economic Areas:
[See PDF for image]
[End of figure]
While examining BEA areas provides a proxy measure for captivity, a
number of factors may understate or overstate whether shippers are
actually captive. The first two of these factors may work to understate
the extent of captivity among shippers. First, routes originating
within economic areas served by multiple Class I railroads may still be
captive if only one Class I railroad serves their destination, meaning
the shipper can use only that one railroad for that particular route.
Second, some BEA areas are quite large, so a shipper within the area
may have access to only one railroad even though there are two or more
railroads within the broader area. Two additional limitations may work
to overstate the number of locations captive to one railroad. First,
this analysis accounts for Class I railroads only and does not account
for competitive rail options that might be offered by Class II or III
railroads such as the Guilford Rail System, which operates in northern
New England. Second, this analysis considers only competition among
rail carriers and does not examine competition between rail and other
transportation modes such as trucks and barges.
To determine potential captivity during our preliminary analysis, we
applied another proxy measure--the definition of potentially captive
traffic used in the Staggers Rail Act. The act defines potentially
captive traffic as any that pays over 180 percent of the revenue-to-
variable cost (R/VC) ratio. As a percentage of all rail traffic, the
amount of potentially captive traffic traveling over 180 percent R/VC
and the revenue generated from that traffic have both declined since
1985.
However, our preliminary analysis indicates the share of potentially
captive shippers who are paying the highest rates--those substantially
above the threshold for rate relief--has increased. While total tons
have increased significantly (from about 1.37 billion in 1985 to about
2.14 billion in 2004), figure 6 shows that tons traveling between 180
and 300 percent R/VC but have remained fairly constant--an increase
from about 497 million tons in 1985 to about 527 million tons in 2004.
However tons traveling above 300 percent R/VC have more than doubled--
from about 53 million tons in 1985 to over 130 million tons in 2004.
Figure 6: Tons Traveling Over 180 Percent R/VC: 1985-2004:
[See PDF for image]
[End of figure]
This pattern can also be seen in the share of traffic traveling above
and below 180 percent R/VC between 1985 and 2004. As figure 7
illustrates, the percent of all traffic traveling between 180 and 300
percent R/VC decreased from 36 percent in 1985 to 25 percent in 2004.
In contrast, the percent of all traffic traveling above 300 percent R/
VC increased from 4 percent in 1985 to 6 percent in 2004.
Figure 7: Percent of Traffic by R/VC, 1985 and 2004:
[See PDF for image]
[End of figure]
Our preliminary analysis indicates that this overall change in traffic
traveling over 300 percent R/VC can be seen in certain states and
commodities. For example, 39 percent of grain originating in Montana
and 20 percent of coal in West Virginia traveled over 300 percent R/VC
in 2004. As shown in figure 8, this represents a significant increase
from 1985, when 14 percent of grain in Montana and 4 percent of coal in
West Virginia traveled over 300 percent R/VC.
Figure 8: Percent of Tonnage Traveling Over 300 Percent R/VC, 1985-
2004:
[See PDF for image]
[End of figure]
As with BEA areas, examining R/VC levels as a proxy measure for
captivity can also understate or overstate captivity. For example, it
is possible for the R/VC ratio to increase while the rate paid by a
shipper is declining. Assume that in Year 1, a shipper is paying a rate
of $20 and the railroad's variable cost is $12. The R/VC ratio--a
division of the rate and the variable cost--would be 167 percent. If in
Year 2 the variable costs decline by $2.00 from $12 to $10, and the
railroad passes this cost savings directly on the shipper in the form
of a reduced rate, the shipper would pay $18 instead of $20. However,
as shown in table 1, because both revenue and variable cost decline,
the R/VC ratio increases to 180 percent.
Table 1: Possible Changes in R/VC Ratios:
Year: Year 1;
Revenue collected: $20.00;
Variable costs: $12.00;
R/VC: 167%.
Year: Year 2;
Revenue collected: $18.00;
Variable costs: $10.00;
R/VC: 180%.
Source: GAO.
[End of table]
Although proxy measures have inherent limitations, they can serve as
useful indicators of trends in railroad pricing, how the railroads may
be exercising their market power to set rates, and where competition
and captivity concerns remain. Whether these trends reflect an exercise
or possible abuse of market power or is simply a reflection of rational
economic practices by the railroads in an environment of excess demand
remains uncertain.
Proposed Alternative Approaches To Address Remaining Competition and
Captivity Concerns Should Be Carefully Considered:
A number of alternative approaches have been suggested by shipper
groups, economists, and other experts in the rail industry to address
remaining concerns about competition and captivity--however, any
alternative approaches should be carefully considered. Two areas--an
assessment of competition and addressing problems with the rate relief
process--are particularly integral to further improvement. Any
alternative approaches to address competition and captivity should be
carefully considered to ensure that the approach achieves the important
balance set out in the Staggers Act of allowing the railroads to earn
adequate revenues and invest in its infrastructure while assuring
protection for captive shippers from unreasonable rates.
Assessment of Competition Has Been Limited:
Our preliminary work shows there has been little assessment by the
federal government of where areas of inadequate competition might exist
or how changes in industry concentration might be resulting in the
inappropriate exercise of market power. Although the STB has broad
legislative authority to investigate industry practices, it has
generally limited its reviews of competition to merger cases. STB is
responsible for reviewing railroad merger proposals, approving those
that it finds consistent with the public interest, and ensuring that
any potential merger-related harm to competition is mitigated. STB's
mitigation efforts have focused on preserving competition, such as
granting the authority for one railroad to operate over the tracks of
another railroad (called trackage rights). As we reported in 2001, STB
found little competition-related harm during its oversight of recent
mergers. However, rail mergers can have different effects on rail
rates. For example, using an econometric approach that isolated the
specific effects of the Union Pacific/Southern Pacific merger on rail
rates for certain commodities in two geographic areas--Reno, Nevada,
and Salt Lake City, Utah--we found that the merger reduced rates for
four of six commodities, placed upward pressure on rates for one
commodity, and left rates relatively unchanged for one commodity. In
analyzing rail rates as part of merger oversight, STB examines the
merger oversight record, which generally focuses on the overall
direction and magnitude of rate changes, rather than specific
commodities or geographic areas. According to STB officials, in
general, the records have not permitted STB to reliably and precisely
isolate the effects of mergers on rates from the effects of other
factors (such as the price of diesel fuel).
STB is not unaware of concerns about competition. In addition to
reviewing competition in terms of mergers, STB has also instituted
proceedings to review rail access and competition issues. For example,
in April 1998, STB commenced a review at the request of Congress to
review access and competition issues in the rail industry. In an April
1998 decision on these issues, STB agreed to consider revising its
competitive access rules. However, in its December 1998 report to
Congress, STB declined to take further action on this issue because it
had adopted new rules allowing shippers temporary access to alternative
routing options during periods of poor service. In addition, STB
observed that the competitive access issue raises basic policy
questions that are more appropriately resolved by Congress.
Furthermore, in a December 1998 ruling on a Houston/Gulf Coast
oversight proceeding, STB recognized the possibility that opening up
access could fundamentally change the nation's rail system, possibly
benefiting some shippers with high-volume traffic while reducing
investment elsewhere in the system and ultimately reducing or
eliminating service for small, lower-volume shippers in rural areas.
Finally, STB adopted new regulations for rail mergers in 2001. These
new regulations require the applicant to demonstrate that the merger
would enhance, not just preserve, competition.
Given the disagreement about the adequacy of competition in the
industry and the fact that proxy measures can understate or overstate
captivity, an assessment of competition and how changes in industry
concentration might be resulting in the inappropriate exercise of
market power would allow decisionmakers to identify areas where
competition is lacking and to assess the need for and merits of
targeted approaches to address it. The targeted approaches most
frequently proposed by shipper groups and others include reciprocal
switching arrangements, which allow one railroad to switch railcars of
another railroad, and terminal access agreements, which permits one
railroad to use another's terminals. We will discuss the potential
costs and benefits of these approaches further in our final report. Use
of these approaches should be carefully considered to ensure that the
approach achieves the important goals set out in the Staggers Rail Act.
For example, if these approaches expand competitive options and
decrease the number of captive shippers, which could decrease the need
for federal regulation and the need for a rate relief process. On the
other hand these approaches could also reduce rail rates and thus
railroad revenues and affect the ability of the railroads to earn
adequate revenues and invest in its infrastructure.
Rate Relief Process Is Largely Inaccessible, but Different Approaches
Should Be Carefully Considered:
The principal vehicle through which shippers seek relief from
unreasonable rates is the rate relief process. The Staggers Rail Act
recognized that some shippers may not have access to competitive
alternatives and may therefore be subject to unreasonably high rates.
For these shippers, the act gave ICC, and later STB, the authority to
establish a rate relief process so that shippers could obtain relief
from unreasonably high rates, as well as more general powers to monitor
the railroad industry. Under the standard rate relief process, the
Board requires a shipper to demonstrate how much an optimally efficient
railroad would need to charge that shipper. Therefore, the shipper must
construct a hypothetical, perfectly efficient railroad that would
replace its current carrier.
There is widespread agreement the rate relief process is inaccessible
to most shippers and does not provide expeditious handling and
resolution of complaints. The process is expensive, time consuming and
complex, and, as a result, several shipper's organizations told us that
it is unlikely they would ever file a rate case. Since 2001, only 10
cases have been filed, and these cases took between 2.6 and 3.6 years-
-an average of 3.3 years per case--to complete. In addition, while STB
does not keep records of the cost of a rate case, shippers we
interviewed agreed that the process can cost approximately $3 million
per litigant. As a result, shippers told us that, for them to bring a
case, the case would need to involve several million dollars so that it
was worthwhile to spend $3 million on a case that they could possibly
lose. The process is complex because the legal procedures requires that
(1) the shipper construct a model of a hypothetical, perfectly
efficient railroad and (2) the railroad and shipper have opportunities
to present their facts and viewpoints as well to present new evidence.
Congress and STB have recognized the problems with the rate relief
process and taken actions to address them. First, Congress required STB
to develop simplified guidelines. STB developed guidelines to
streamline the process when the value of traffic at stake did not make
it feasible to incur the costs of conducting a full rate case. Under
these simplified guidelines, shippers do not have to construct a
hypothetical railroad and can instead rely on industry averages to try
to prove that their rate is unreasonable. Although these simplified
guidelines have been in place since 1997, the process set out by the
guidelines has not been used. Second, STB worked to improve the
standard rate relief process. Specifically, STB now holds oral
arguments to begin cases and, according to STB officials, these oral
arguments help to clarify disagreements without adding any time to the
process. In addition, STB has added staff to process cases.
According to shippers and railroad officials we spoke with, the
simplified guidelines are confusing regarding who is eligible to use
the process and how it would work. In addition, several shippers'
organizations told us that shippers are concerned about using the
simplified guidelines because since they have never been used, they
believe it will be challenged in court and result in lengthy
litigation. STB officials told us that they - not the shippers - would
be responsible for defending the guidelines in court. STB officials
also said that, if a shipper won a small rate case, STB could order
reparations to the shipper before the case was appealed to the courts.
During our preliminary work we identified a number of different
approaches that have been suggested by shipper organizations and others
that could make the rate relief process less expensive and more
expeditious, and therefore potentially more accessible. Each of the
proposed approaches has both advantages and drawbacks. These approaches
included the following:
² Increased use of arbitration: Under arbitration, the two parties
would present their case before an arbitrator, who would then determine
the rate. This approach would replace the shipper's requirement to
create a hypothetical railroad. Proponents of this system argue that it
provides both the railroads and the shippers with an incentive to
suggest a reasonable rate (because otherwise the arbitrator could
select the other's offer) and that the threat of arbitration can induce
the parties to resolve their own problems and limit the need for
federal regulation. However, critics of this approach suggest that
arbitration decisions may not be based on economic principles such as
the revenue and cost structure of the railroad and that arbitrators may
not be knowledgeable about the railroad industry.
² Increased use of simplified guidelines: The simplified guidelines use
standard industry average figures for revenue data instead of requiring
the shipper to create a hypothetical railroad. This approach would
reduce the time and complexity of the process; however, it may not
provide as accurate and precise a measure as the current process.
However, as noted above, the use of STB's simplified guidelines has not
been fully reviewed by the courts, and many railroad industry experts
believe the first use of the guidelines will result in lengthy
litigation.
² Increased use of alternative cost approaches: For example, STB could
use the long-run incremental cost approach to evaluate and decide rate
cases. This process, which is used for regulating pipelines, bases
rates on the actual incremental cost of moving a particular shipment,
plus a reasonable rate of return. This approach allows for a quick,
standard method for setting prices, but does not take into account the
need for differential pricing or the railroad's need to charge higher
rates in order to become revenue adequate. Structuring rate regulation
around actual costs can also create potential disincentives for the
regulated entity to control its costs.
Again, these alternative approaches should be carefully considered to
ensure that the approach achieves the important balance set out in the
Staggers Act. A significant factor in evaluating each of these
alternatives is the revenue adequacy of the railroads. The Staggers
Rail Act established revenue adequacy as a goal for the industry and
allowed the railroads to use differential pricing to increase their
revenues. The act further gave the ICC (and later STB) the authority to
determine the revenue adequacy of the railroads each year. While the
specific method for determining revenue adequacy has been
controversial, the overall trend in revenue adequacy may be more
important. In its last report in 2004, STB determined that one railroad
is revenue adequate and that others are approaching revenue adequacy.
While it is too early to determine that the industry as a whole is
achieving revenue adequacy, this is a significant shift in the rail
industry because for decades after enactment of the Staggers Rail Act,
the railroads were all considered revenue inadequate.
Different approaches to addressing remaining competition and captivity
concerns will likely recognize to some degree the railroads' continued
need to more consistently recover their cost of capital and become
revenue adequate. The railroads need additional revenue for
infrastructure investment to keep pace with increased demand. On the
other hand, different approaches also raise the question as to what
degree the railroads should continue to rely on obtaining significantly
higher prices from those with greater reliance on rail transportation
in a revenue adequate environment where total railroad revenues are
increasingly sufficient to meet the railroad's investment needs.
Significant Growth in Freight Rail Traffic Demand Is Forecast But
Continued Capacity Building Is Uncertain:
The demand for freight and freight rail is forecast to increase
significantly in the future, although many factors can affect the
accuracy of these forecasts. Freight markets are volatile and
unpredictable and thus freight demand forecasts may prove to be off the
mark. For example, much freight demand is determined by trade that
originates outside the United States. Many of the data used to develop
these freight demand forecasts are proprietary and a result, we could
not assess the validity or reasonableness of the assumptions used to
develop the predictions. However, forecasts of freight and freight rail
demand are useful as one possible scenario of the future. As the
Congressional Budget Office (CBO) observed in a January 2006 report,
forecasts of future demand can be viewed as more illustrative than
quantitatively accurate.[Footnote 7]
Major freight railroads have reported that they expect to invest about
$8 billion in infrastructure during 2006--a 21 percent increase over
2005--and have told us that they plan to continue making infrastructure
investments.[Footnote 8] Although railroads are sufficiently profitable
to be investing at record levels today, it is not certain whether in
the future investments will keep pace with the projected demand.
Railroads secure private benefits by investing in their infrastructure
and have many considerations in making new infrastructure investments
such as the need to obtain the highest return on their investment,
optimize the performance of their network, and respond to other
significant capital needs of rail operations. The railroads we
interviewed were generally unwilling to discuss their future investment
plans with us as this is business proprietary information. We are
therefore unable to comment on how companies are likely to choose among
their competing investment priorities for the future.
In addition to securing private benefits for railroad networks,
investments in rail projects can produce benefits for the public--some
of these public benefits are, as CBO's report pointed out, large in
comparison to anticipated private railroad benefits. For example,
shifting truck freight traffic to railroads can reduce highway
congestion and reduce or avoid public expenditures that otherwise would
be needed to build additional highway capacity or provide additional
maintenance to accommodate growth in truck traffic. These and other
public benefits can be realized at the national, state, and local
levels. For example, rail investment may generate benefits to the
national economy by lowering the costs of producing and distributing
goods. Since rail uses less fuel than trucks, energy use and emissions
may be reduced. In contrast, a rail project that eliminates or improves
a highway-rail crossing could deliver primarily local public safety
benefits by reducing accidents, time lost waiting for trains to pass,
and pollution and noise from idling trains and lessening the risk of
delays for emergency vehicles at crossings.
In pursuit of these public gains, the federal and state governments
have been increasingly participating in freight rail improvement
projects. For example, the State of Delaware spent about $14 million to
rehabilitate a bridge in exchange for receiving a fee for each railroad
car that crosses the bridge. The federal government has also become
more involved in freight rail partnerships. Specifically, in 1997 the
U.S. Department of Transportation provided a $400 million loan to the
Alameda Corridor Transportation Authority for the Alameda Corridor
project, which included a number of rail and road improvements to
consolidate freight traveling to and from the ports of Los Angeles and
Long Beach. These ports are a significant gateway for freight that is
imported from Asia and distributed throughout the U.S. In addition, in
2005, Congress provided $100 million to the Chicago CREATE project to
improve the rail infrastructure and ease congestion in and around
Chicago--the busiest freight rail center in the U.S.
In the years ahead Congress is likely to face additional decisions
regarding potential federal policy responses and the federal role in
the nation's freight railroad infrastructure. Based on our ongoing and
past work, I would like to make three observations. First, any
potential federal policy response should recognize that subsidies can
potentially distort the performance of markets and that the federal
fiscal environment is highly constrained. Second, any such response
should occur in the context of a comprehensive National Freight Policy
that reflects system performance based goals and a framework for
intergovernmental and public-private cooperation. DOT initiated this
effort by publishing a draft Framework for a National Freight Policy
this year for comment. Third, federal involvement should only occur
where demonstrable wide-ranging public benefits and a mechanism to
appropriately allocate the cost of financing these benefits between the
public and private sectors exists and, to the extent possible, focuses
on benefits that are more national than local in scope. Although new
freight rail investment tax credits have been suggested, our past work
has pointed out that it is difficult to target this approach to desired
activities and outcomes and ensure that it generates the desired new
investments as opposed to subsidizing investment that would have been
undertaken at some point anyway. This approach can also have
problematic fiscal impacts because it either lowers tax revenues or
leads to higher overall tax rates to offset revenue losses. We will be
discussing these areas in greater detail when we issue our report.
Mr. Chairman, this concludes my prepared statement. I would be happy to
respond to any questions you or other Members of the Committee may have
at this time.
Contact and Acknowledgments:
For questions regarding this testimony, please contact JayEtta Z.
Hecker on (202) 512-2834 or heckerj@gao.gov. Individuals making key
contributions to this testimony include Ashley Alley, Steve Brown,
Matthew T. Cail, Sheranda S. Campbell, Steve Cohen, Elizabeth
Eisenstadt, Libby Halperin, Richard Jorgenson, Tom McCool, John Mingus,
Josh H. Ormond, and John W. Shumann.
[End of section]
Appendix I: Appendix I Related GAO Products:
Regulation: Changes in Freight Railroad Rates from 1997 through 2000.
GAO-02-524. Washington, D.C.: June 7, 2002.
Freight Railroad Regulation: Surface Transportation Board's Oversight
Could Benefit From Evidence Better Identifying How Mergers Affect
Rates. GAO-01-689. Washington, D.C.: July 5, 2001.
Railroad Regulation: Current Issues Associated With the Rate Relief
Process. GAO/RCED-99-46. Washington, D.C.: April 29, 1999.
Railroad Regulation: Changes in Railroad Rates and Service Quality
Since 1990. GAO/RCED-99-93. Washington, D.C.: April 6, 1999.
Railroad Competitiveness: Federal Laws and Policies Affect Railroad
Competitiveness. GAO/RCED-92-16. Washington, D.C.: November 5, 1991.
Railroad Regulation: Economic and Financial Impacts of the Staggers
Rail Act of 1980. GAO/RCED-90-80. Washington, D.C.: May 16, 1990.
Railroad Regulation: Shipper Experiences and Current Issues in ICC
Regulation of Rail Rates. GAO/RCED-87-119. Washington, D.C.: September
9, 1987.
Railroad Regulation: Competitive Access and Its Effects on Selected
Railroads and Shippers. GAO/RCED-87-109. Washington, D.C.: June 18,
1987.
Railroad Revenues: Analysis of Alternative Methods To Measure Revenue
Adequacy. GAO/RCED-87-15BR. Washington, D.C.: October 2, 1986.
Shipper Rail Rates: Interstate Commerce Commission's Handling of
Complaints. GAO/RCED-86-54FS. Washington, D.C.: January 30, 1986.
[End of section]
(544126):
FOOTNOTES
[1] As of 2004, a Class I railroad is any railroad with an operating
revenue above $277.7 million.
[2] While rate data are not available for 2005 and 2006, shippers,
railroads, and financial analysts we spoke with told us that rates have
generally increased during those years.
[3] We constructed rate indexes to examine trends in rail rates over
the 1985 to 2004 period. These indexes define traffic patterns for a
given commodity in terms of census region to census region flows of
that commodity, and we calculate the average revenue per ton mile for
each of these traffic flows. The index is calculated as the weighted
average of these traffic flows in each year, expressed as a percentage
of the value for 1985, where the weights reflect the traffic patterns
in 2004. By fixing the weights as of one period of time, we attempt to
measure pure price changes rather than calculating the average revenue
per ton mile in each year. Over time, changes in traffic patterns could
result in a substitution of lower priced traffic for higher priced
traffic, or vice versa, so that a decrease in average revenue per ton
mile might partly reflect this change in traffic patterns. The rate
index for the overall industry was defined similarly, except that the
traffic pattern bundle was defined in terms broad commodity, census
region of origin, and mileage block categories. For comparison
purposes, we also present the price index for gross domestic product
over this period.
[4] In addition to consolidation, which is the main reason for the
reduction in the number of Class I railroads, other reasons were
carrier bankruptcies and a 1992 ICC change in the threshold for
qualifying as a Class I railroad (from $5 million in annual revenue in
1976 to $250 million in 1992).
[5] A short line railroad is an independent railroad company that
operates over a short distance.
[6] Economic areas are those areas defined by the Bureau of Economic
Analysis which define the relevant regional economic markets in the
U.S.
[7] Congressional Budget Office Freight Rail Transportation: Long Term
Issues January 2006.
[8] According to STB, some portion of this $8 billion investment is
focused on maintenance as opposed to capacity expansion.
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