ATR: Policy Briefs: The Folly of Rail Re-Regulation

The Folly of Rail Re-Regulation

By: Peter Ferrara

In this Policy Brief:

Twenty years ago, the nation's railroads were headed for extinction. Some Northeastern freight railroads had already collapsed and were in government hands. Over one-fifth of the railroad track nationwide was held by railroads in bankruptcy. The rest of the industry was not earning enough to maintain its track and facilities or to replace them as they wore out.

This dismal state was due to 90 years of tight Federal regulation of railroad rates and practices that prevented railroads from efficiently serving their customers and responding to the intense competition they faced. In response, some advocated that the government take over and run the railroads, which would have made things much worse, and cost taxpayers billions of dollars. Thankfully, Congress took the opposite course in 1980, by partially deregulating the railroads.

This action was a huge success, more so than even its advocates imagined. Today, nearly 20 years later, railroads have achieved enormous economic efficiencies, doubling and tripling productivity. Expenditures on equipment and rights of way by railroads are up sharply. Railroad profitability levels are on their way back to long-term viability. Most remarkably, railroads have done all this while reducing rail rates by more than 50% after inflation.

But this is not good enough for some. A minority of railroad shipping customers are demanding various forms of reregulation. These customers think railroad rates should have fallen even more, or are upset that rates have fallen more for others than for them.

These shippers and their advocates do not say that they favor reregulation. But what they are advocating would eventually reverse the tremendously successful deregulation of 1980, which would ultimately produce the same pre-1980 results. Perversely, the regulatory mandates they seek would eventually increase rather than reduce the rates they pay. Ultimately, railroads would not have the profitability to attract the capital investment to maintain and replace their track and facilities, and would eventually collapse. These same shippers would then be back asking for Federal taxpayer bailouts.

More than 100 years ago, railroads were the dominant means of commercial transportation. Trucking and the national highway system had not been developed yet. Neither had air transportation. Barges and other water transportation were the main long distance competition, but they could not compete everywhere, particularly in the plains or far western United States.

At that time railroads were highly profitable. But a public outcry developed against what many saw as high and discriminatory rates. This eventually led to the creation of the Federal Interstate Commerce Commission (ICC) in 1887, which was given authority to regulate rail rates and much more.

But the ICC soon found that apart from free market competition, there was no objective principle that they could use to set rail rates. As Phillip Longman explains,

The problem essentially was not that the commissioners were intent on appeasing political pressures, but that they lacked any objective basis for valuing railroad services in the absence of a free market. The commission was then left to wallow in shifting subjective standards of what were "fair" and "equitable" rates ‑ standards that it could neither consistently apply nor defend in the face of intense popular pressure for low tariffs.(1)

As a result, the ICC gave in to political pressures and squeezed rail rates lower and lower in real terms.

After 20 years of ICC regulation, it was clear that inflation was causing railroad costs to surge well ahead of their rates. As a result, the industry could no longer raise the capital to maintain and replace its track or equipment. But, responding to strong political pressures, the ICC would not ease up on rail rates. By 1917, with the start of World War I, the nation's railroads could not handle the increased volume of freight, and leading railroads were ready to file for bankruptcy.

As a war time act, the government took over the major railroads and operated them to support the war effort. Interestingly, during that time the government increased rail rates by almost 70%. Though the government restored the railroads to private ownership after the war, under continued heavy regulation they just continued their long-term decline.

Over time, the ICC became one of the most powerful government agencies, with control over every facet of rail operations. Rate regulation expanded into regulation of routes, equipment acquisition and utilization, labor practices, service offerings, consumer relations, and just about every other aspect of railroad operations. With railroad operations and pricing predominantly managed on the basis of political, rather than economic, considerations, serious inefficiency arose in the railroad industry.

For example, in the early 1960s, Southern Railway developed 100-ton jumbo hopper cars that it could use to reduce rates for grain shippers by up to 60%. But the ICC was convinced that this was just a mechanism to give some shippers discriminatory rate reductions. So the ICC prohibited the railroads from using the cars for years, until Southern Railway won a Supreme Court decision.(2)

In the late 1960s, Illinois Central Railroad developed a new service called Rent-A-Train, which would lease entire trains to individual shippers. But the ICC disallowed key provisions in the plan that guaranteed train schedules on the grounds that partial refunds for breaking the guarantees amounted to prohibited shipper rebates.

In the late 1970s, the ICC broke up unit trains that operated at lower costs by carrying the same commodity in all cars of a dedicated train. The ICC did this to ensure that a shortage of grain cars at the time be spread among other shippers. But this disruption actually made the shortage worse by reducing rail car utilization.

Other regulatory requirements forced railroad companies to continue service on money-losing lines, to employ far more workers then needed, to continue providing money-losing passenger service, and to buy unnecessary box cars and run them empty. The railroads also lost a billion dollars a year in the 1970s waiting for rate increase approvals to compensate for soaring inflation.

By the end of the 1970s, the railroad industry was fading into complete disarray. While railroad rates ended up climbing 2 percentage points faster than inflation each year over the previous decade, the industry's annual return on investment had fallen to less than 2%. The government had taken over most of the major Northeastern railroads, which had collapsed into bankruptcy. Nationally, railroads accounting for over 20% of the nation's track were bankrupt.

Because railroads were no longer able to finance capital investment, their track and equipment deteriorated. By the mid-1970s, deferred maintenance and delayed capital expenditures amounted to billions of dollars. The rate of accidents due to track or structure defects quadrupled from 1966 to 1976. Because of such safety problems, almost 50,000 miles of track, about 15% of all track nationally, could be operated only at reduced speeds, as slow as 10 miles per hour. The new phenomenon of "standing derailments" arose, which meant that some tracks were so deteriorated that train cars derailed while standing perfectly still.

Taxpayers were already paying $250 million per year in subsidies to keep some railroads running. Policymakers in Washington began talking about nationalizing the railroads, a move that would have cost taxpayers at least $100 billion to purchase all the facilities and equipment, and billions more in annual operating subsidies.

Under the Staggers Rail Act of 1980, Congress took a radically different approach. It repealed much of the ICC's regulatory authority, but did leave authority to control rates in abusive circumstances. The Act allowed railroads and shippers, for the first time, to enter into long-term confidential contracts, allowing them to provide service and pricing terms acceptable to both sides. These contracts are exempt from regulation. As a result, railroads under Staggers were allowed to price their services at rates set by the market, not by bureaucrats in Washington.

But the Staggers Act did not eliminate all railroad regulation. The Surface Transportation Board (STB), which has now replaced the ICC,(3) regulates rates today only where it finds a railroad is "market dominant" (i.e., it has little or no effective competitive constraints on its rates). The Board presumes rates are reasonable, and therefore permissible, if they are below a certain threshold, which is set at 180% of the costs of serving the particular shipper. For rates above this threshold, the Board will decide whether the rate is reasonable based on a number of criteria, including whether the rate charged the customer is more than it would cost an efficient railroad (or other mode of transportation) to serve that customer. If the STB finds the rate unreasonable, it can order the railroad to reduce the rate and pay reparations to the shipper.

Railroads were also set free to determine their own routes, and to more easily abandon uneconomic routes, although much of this track was bought by the hundreds of new "short-line" and regional railroads that have been created since 1980. But railroads are still required to cooperate with each other in carrying freight on the most efficient route available to each customer. Railroads must also accept freight from other rail carriers for delivery to destination points on their routes.

This deregulatory reform succeeded beyond all expectations. The railroads used their new freedom to implement sweeping new efficiencies and cost saving measures. As a result, since 1980, rail labor productivity has tripled, and capital productivity has doubled.

With the freedom to earn market returns, railroads have invested huge sums of new capital to maintain and upgrade track and equipment. During the 1990s alone, railroads have devoted more than $120 billion to such investment. In 1997 alone, the major railroads spent $15 billion on investment in roadway and equipment such as new locomotives and rail cars. This total investment equaled 45% of operating revenues for the year. All these investments have further improved productivity.

Moreover, as a result of the new efficiencies and capital investment, rail service has improved sharply, notwithstanding isolated, temporary service problems. Indeed, the Federal Trade Commission estimates that shippers save $5-to-$10 billion annually because of faster and more reliable service. In addition, over 99% of rail shipments are delivered without a freight claim for damages.

Most remarkably, shippers receive this improved service at sharply reduced rates. Since deregulation, rail rates overall have fallen by 55% after inflation. Rates have fallen for all major commodity groups and in all regions of the country, including for shippers who are calling most loudly for reregulation. For example, since 1981 rail rates have fallen by 52% for farm products, 56% for coal, 47% for chemicals, 56% for lumber and wood products, and 51% for pulp and paper products.

Despite these steep rate declines, the financial health of railroads has improved markedly, and the industry is heading steadily towards long-term financial viability. The industry-wide return on investment has climbed to 7% in the 1990s compared to 2% in the 1970s before deregulation. But this return is still less than 80% of the industry's cost of capital, which it will have to earn eventually to be able to maintain and finance replacements for its track and other capital equipment. Moreover, railroad profitability is still significantly below average for all U.S. industries by a range of measures. Railroad returns remain well below the average for other Fortune 500 companies, with many companies and industries earning 50% to 100% more than railroads. Industries shipping on railroads are also substantially more profitable. In short, railroads are on the way back ‑ but they're not yet all the way back.

The benefits of rail deregulation were summed up by two economists in 1990 as follows,

A rough calculation of annual total welfare gains in the United States from rail deregulation resulting from the Staggers Act would include something on the order of $5.3 billion to $7.2 billion in lower rates to shippers, $5 billion to $10 billion in reduced inventory-related logistics costs, slightly less than $500 million in higher profits to railroads, and slightly over $700 million in savings to taxpayers.(4)

ICC Termination Act. That Act left most of the features of the Staggers Act in place, abolished the ICC, and replaced it with the vastly slimmed down Surface Transportation Board. Net Federal spending for that Board is only about $10 million per year.

So what's the problem? Why are some shippers complaining and demanding new regulation? The problem arises because a minority of shippers refuses to accept the demand-based, or differential, pricing that is a cornerstone of the Staggers Act and is now used throughout the railroad industry. Under demand-based pricing, different shippers pay different rates based upon their level of demand for rail service.

Demand-based pricing is common throughout private markets. It means simply that sellers will charge more where demand is higher. Airlines, for example, charge more for traveling during busier times, such as the business week. Luxury cars have higher profit margins than subcompacts. Movie tickets are more expensive during peak evening hours than during afternoon matinees. Electricity and telephone calls are cheaper in off-peak hours.

Demand-based pricing is critical for railroads because of two basic features of railroad economics. First, railroads have high fixed costs, primarily for track and roadbed. These costs do not vary with the amount of services provided, e.g., the cost of building the track and roadbed is the same regardless of how many trains run over it.

Secondly, the "elasticity" of demand among shipper customers varies widely. Some shippers have high elasticity ‑ i.e., they have a broad range of options. They may be able to use other railroads, water transportation, or trucks. If rail rates rise too much for them, they will shift to their other options. Other shippers have fewer options. Water transportation may not be available to them, and trucks may be highly expensive for transporting their products.

Under demand-based pricing, the shippers with higher elasticity and many alternatives are charged the most they can be before they would leave the railroad for alternative transportation. The shippers with low elasticity and few or no alternatives are charged higher rates to cover remaining railroad costs. The result is an economically efficient pricing system.

The problem is that some of the low-elasticity shippers object to paying more than others, even though the rates they pay have dropped sharply under deregulation as well. These shippers see themselves as exploited by a monopolist who is their only available source of transportation. Consequently, they have been fighting deregulation for years, demanding one form of new regulation or another that they believe would eliminate demand-based or differential pricing.

These pro-regulation shippers fail to see that demand-based, or differential, pricing benefits all shippers. If rates were equalized across all shippers, then those shippers with higher elasticity and readily available alternatives would leave the railroads altogether. If they go, so do the contributions they make (however small) to the railroads' high fixed costs. All of these fixed costs would then have to be paid by a smaller number of remaining shippers. Their rates would then be higher than they are today under demand-based pricing. Indeed, it is conceivable that the customer base reductions could result in rates that would be too high even for the shippers with no feasible alternatives. Then, not only would the railroad go out of business, but these remaining shippers would as well.

These "captive" shippers with few or no transportation alternatives produce much rhetoric about monopolist railroads exploiting them for excessive monopoly profits. But the data do not support them. As discussed above, railroad profits are still well below industry averages in the U.S., and well below the return needed to cover their cost of capital, a prerequisite to long-term economic viability. And, as noted earlier, rail rates have plummeted and service quality has risen since deregulation ‑ actions not usually associated with monopolists.

In addition, these "captive" shippers are still protected by rate reasonableness regulation. They can still bring claims of excessive rates before the STB, as shippers with no real competitive alternatives. The STB then can and does strike excessive rates down. Shippers do win such cases before the STB when railroads seek to impose excessive rates. Indeed, 74% of all cases result in some rate relief for shippers. The problem for the reregulation forces is that they can't get the STB to scrap demand-based or differential pricing and impose the same pricing on all shippers, as the STB recognizes and accepts the arguments for demand based pricing discussed above.

The complaint against deregulation and the demand for new regulation consequently arises because some shippers who have enjoyed sharp reductions in rail rates since deregulation insist their rates should have dropped more, and are covetous of the lower rates of others. These shippers, however, are lucky that railroads are fighting so hard for a system that has kept their rates so low, and that may ultimately keep these shippers, as well as the railroads, in business.

Disgruntled shippers have lobbied hard for legislation to overturn demand based pricing and reregulate the railroads. In the last Congress, Senator Jay Rockefeller (D-WV) led the sponsorship of such a bill, the misnamed Railroad Shipper Protection Act of 1997. This bill has been reintroduced in the current Congress (S.621).

The bill is another shortsighted attempt to overturn demand-based pricing. Of course, as discussed above, without demand-based pricing, prices for the most price-sensitive shippers with other options will rise, and these shippers will then leave the railroads. The railroads' high fixed costs for track and roadbed will then have to be paid completely by the remaining "captive" shippers. Their rates will consequently rise, contrary to their original goal, unless the railroads just disinvest and phase out service. Without such rate increases, railroads would be forced back to the pre-deregulation days of inadequate returns to finance track maintenance and replacement, declining and inadequate service, railroad bankruptcies, and ultimate railroad extinction. Those shippers seeking reregulation because of localized service problems should beware. For such reregulation would ultimately worsen service, as the railroad industry eventually returns to the deterioration and disrepair of the 1970s.

The Rockefeller bill attempts to eliminate demand-based pricing through a provision that greatly expands the scope of the definition of market dominance. Since the Board has authority to regulate rail rates only where such dominance is found, this provision would greatly expand the scope of rate regulation as well.

Under the new definition, market dominance would be presumed whenever a shipper faces the choice of only one railroad at any point from origin to destination. Other forms of competition, e.g., alternative forms of transportation, such as trucks or barges, or any other competitive factor, could not be considered. Likewise, where the shipper has the choice of two or more rail carriers, then the Board may consider only alternative forms of transportation and not any further factors (such as product and geographic competition).

Obviously, under the new definition, consideration of market dominance will not involve a full analysis of market competition. Instead, that analysis will be arbitrarily truncated in order to greatly expand the government's regulation of rail rates. Advocates of the bill state that this change will "eliminate the regulatory burden confronting captive rail shippers," by making a showing of market dominance much simpler. But the regulation at issue applies to railroads and the rates they may charge, not shippers. And instead of reducing regulation, this change would greatly expand the scope of rail rates that will be subject to Federal regulation.

Once rail rates come under regulatory scrutiny, the Rockefeller bill incredibly provides that rates are to be judged without consideration of revenue adequacy for railroads. The current requirement that regulators consider railroad revenue sufficiency in determining the reasonableness of rates, a centerpiece of the 1980 Staggers Act reforms, would be abolished. Instead, in determining rate reasonableness, primary consideration is to be given to the reasonableness of rates for the shippers.

This is infantilism parading as public policy. Obviously, railroads cannot stay in business to provide any service to shippers at all unless their revenues are adequate. In the real world, rates cannot be set at whatever seems reasonable to the shipper, a totally subjective standard, without full consideration of railroad costs. This change in regulatory standards is just a prescription for driving railroads out of the market altogether, which will also destroy any so-called "captive shippers" with no economically feasible alternative means of transportation for their product.

Finally, the bill would reestablish Federal regulation over routes offered by the railroads. It would overturn decades of precedent by requiring railroads to offer a route between any two points on its line where freight can be originated, terminated or interchanged, regardless of the efficiency of the routing. The railroad would have to offer a separate rate for each portion of that route, and each rate would be subject to Federal regulation. Consequently, Federal rate regulation would be extended again to these newly required routes, with demand pricing on these routes likely displaced again, as described above.

Such regulation is unnecessary as railroads must already offer shippers the most efficient and direct route between origin and destination. The shippers simply want to cherry pick those segments of a railroad's lines where they may have no alternatives, and utilize them at below cost rates. The idea that under such regulation rail lines would continue to be available for such cherry picking over the long run is folly. Under this scenario, railroads would not have sufficient revenues to obtain the capital investment to maintain and replace track, and it would just deteriorate over time, as in the pre-regulation period.

The STB considered and rejected reforms identical to those in the Rockefeller bill in the so-called "bottleneck" proceedings in 1996. Opposition to the proposal was wide-spread, with many shippers opposed because they recognized it was unworkable and would severely harm the railroads. Several major ports that rely on rail connections, including Long Beach, Seattle, Oakland, Portland, Houston, and Baltimore, also opposed the proposal. So did a dozen top economists, including Nobel Laureate Kenneth Arrow, who filed statements in opposition to the proposals. Joining the opposition as well were top investment bankers, who told the STB the proposals would "reverse the railroad's progress toward financial health and would severely hamper their ability to make investment to maintain and improve their facilities and equipment." The United Transportation Union opposed the proposal (on the grounds that it would cause the loss of rail industry jobs), as did the U.S. Department of Transportation.

Finally, the premise behind the Rockefeller bill that the rail industry lacks adequate competition and exercises monopoly power to exploit shippers is simply wrong.

As previously discussed, railroad profits are well below U.S. industrial averages and below the cost of capital they will need to achieve to attain long-term financial viability. Moreover, instead of cutting back service and raising rates as monopolists do, railroads are broadly expanding service and cutting rates. Rail revenues account for less than 8% of total freight transportation expenditures, as railroads face broad competition from trucks and barges. In addition, since deregulation almost 350 new railroads have entered the industry nationwide. Also, rail rates are constrained by the product and geographic competition faced by their customers. If railroad rates are too high, their customers will lose business to others not dependent on rail transportation, cutting back on the railroad market as well.

Another scheme to overturn demand-based pricing that has been widely discussed but not included in the legislation analyzed above is euphemistically called "competitive access." Under this proposal, a railroad would have to let other railroads run their trains over the first railroad's track if the customer preferred the second railroad to carry the customer's freight. The first railroad would be paid a fee for the use of its track by the second railroad. The premise is that the resulting competition between railroads would bid down rail rates, especially for so-called captive shippers served by only one railroad. The shippers currently paying relatively more of a railroad's fixed costs under demand-based pricing argue that they would then have broad transportation alternatives of their own, and could avoid the relatively higher charges.

Of course, under this scheme, the government would have to regulate what a railroad could charge for use of its track. Otherwise, the railroad could evade the track usage requirement by charging a prohibitive fee. Indeed, enforcing this requirement would draw the government into another morass regulating the details of railroad operations. The government would have to resolve incredibly complex issues regarding conflicts over usage of the same track at the same time by different claimants. It would have to decide how to handle a railroad that was already using its track to capacity for its own customers. Would the railroad be required to invest to expand capacity? Indeed, the government would have to regulate track maintenance and investment by railroads who simply felt they weren't being compensated sufficiently for use of their track by others. Scheduling, routes, maintenance, investment, pricing and a host of other issues would become the province of Federal regulation.

This new regulation cannot be justified on grounds of access, because current law already requires full access for shippers. Every railroad is already required to accept freight from other railroads to be delivered to destinations on its line. Moreover, railroads must cooperate in accepting freight from each other to provide shippers the most efficient and direct routes for their freight.

Rather, the whole point of "competitive access" is to reduce rates for a small group of shippers by overturning demand-based pricing. But, as explained earlier, demand-based pricing is essential for railroads to efficiently raise the funds necessary to maintain and improve rail infrastructure. If railroads are prevented by rate regulation from charging the full amount of track costs, which is what advocates of this reform have openly called for , then railroads will not maintain and replace their track. As Greg Swienton, senior vice president for BNSF Railroad has stated, "How many railroad owners do you think are going to continue to pour billions of dollars into capital improvements in their franchises so that a competitor can come in and take the best traffic?"

Such new regulation, more aptly called forced access rather than competitive access, would also trample the property rights of railroads in their own tracks. The vast majority of railroad right-of-way in the United States is privately owned. A decent respect for the economic freedom of U.S. citizens demands that the government uphold such property rights, not ignore them. Indeed, if railroads are not fully compensated for use of their track, then these forced access proposals would amount to an unconstitutional taking of private property without just compensation.

Advocates of such access argue that it is similar to the developing requirements in the electric utility and telecommunications industries, where producers are required to let others use their transmission lines to transmit their product or service. But railroads already have that kind of required access. Again, they must accept freight from others for delivery on their lines, or to complete the most efficient route for such freight. What the advocates of forced access are asking for is the equivalent of letting competing utilities into a company's power plants so the competitors can use those plants to generate electricity for the company's current customers. No U.S. industry has that kind of unworkable and unfair forced access.

Deregulation of railroads has succeeded beyond all expectations. Shippers today pay far lower rates for far better service, and railroads are on their way to attaining long-term financial viability. To the extent that problems arise, the current regulatory system is capable of addressing them. There is no justification for turning away from such success and adopting reregulation. The reregulation promoted by a small minority of shortsighted shippers would in fact end up counterproductively creating far higher prices for them, deteriorated service, and ultimately far less rail service.