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129

June 5, 1987

THE CONSUMER RAIL EQUITY ACT: RETURNING TO THE DARK DAYS OF REGULATION

I am convinced that we would have had no Conrail to sell today without the Staggers Rail Act of 198a..the nation's rail system remains a private-sector industry only because of [Staggers]-L Stanley Crane Chairman, Consolidated Rail Corporation (Conrail)

INTRODUCTION

In the United States' largest-ever stock offering, the federal government this March sold its 85 percent interest in the Consolidated Rail Corporation, popularly known as Conrail, for approximately $1.6 billion. This put the freight railroad back into private hands after ten years under A ashington's control. Yet only a few years ago, it was assumed widely that Conrail would be a permanent ward of Congress. Not only was Conrail losing hundreds of millions of dollars each year, but most of the nation's other railroads also teetered on collapse. Rather than discussin the privatization of Conrail, most lawmakers were tig speaking of the prospect of na onalizing the rest of the railroad system. This dismal situation b!pgan to change in 1980 with the Staggers Rail Act, which partially deregulated the railroads." The Act, among other things, allowed the railroads greater rate flexibility and eliminated regulation altogether for most traffic. In the seven years under Staggers, the railway industry and its customers have seen a remarkable improvement. Rates to railroad customers have dropped, and service has improved tremendoysly with total savings to consumers estimated at as much as $20 billion dollars annually. And the railroads have returned to financial health, although their earnings are still relatively low. Threatening the Gains of Consumers. Not all shippers, admittedly, are happy with this transformation. Many of those who are dependent upon rail transportation to get their goods to market--primarily shippers of coal and other bulk commodides--complain that they have not shared fully in the benefits of deregulation because of a perceived lack of competition. Ostensibly to remedy this, several bills have been introduced in Congress to roll back the Staggers Act. Chief among these is the so-called "Consumer Rail.]@quity Act" (S. 676 and H.R. 1393) introduced by Senator Jay Rockefeller, the West Virginia Democrat, and Representative Frank Boucher, the Virginia Democrat. Reregulation, however, would do more h:trm than good. There is substantial evidence that the needs of all shippers can be met by the market in the current partially deregulated environment. Subjecting the railroad industry to increased control by the federal bureaucracy, meanwhile, would threaten seriously the gains made by raff customers and consumers in the past seven years. It would increase costs and reduce service for the majority of U.S. consumers, while possibly driving railroads back to the edge of bankruptcy.

RAIL REGULATION IN THE U.S.

Federal regulation of the railroad industry began exactly a century ago, with the creation of the Interstate Commerce Commission (ICC) in 1887. At that time, almost all long distance passenger and freight travel was by rail, and it was generally believed that railroads possessed uncontrolled monoRoly power. This understandably prompted wide support for federal control of railroads. For the following 93 years, almost every aspect of the U.S. railroad industry was regulated by the ICC. The Commission approved maximum and minimum prices for each commodity and each route served by the railroads, prevented @pecial discounts to customers, and required extensive public hearings before service on any line could be discontinued. Mergers between railroads and other transportation companies were banned.

The railroad industry continued to dominate U.S. transportation through the first third of this century when it began losing business to the trucking industry. Shippers took full advantage of their newfound alternative to railways. ne railroads had accounted for 74.9 percent of the intercity freight traffic in 1929, but this share fell to 44.1 percent in 1960. By 1975, it was down to 36.7 percent. Net operating income also took a nose@ive, falling from over $5.7 billion in 1929 (in constant 1977 dollars) to $343 million in 1977. Edging on Collapse. By the 1970s, U.S. railroads were in abysmal shape. The return on net investment never exceeded.3 percent betwee@ 1970 and 1979, at a time when even a simple savings account was paying,5 1/2 percent. Indeed, the entire industry edged on Collapse. Between 1967 and 1973, the Penn Central railroad and seven other eastern railroads, representing the bulk of the northeastern railroad system, went into bankruptcy. To preserve freight service in the region, these firms were purchased by the federal government and reorganized into Conrail, at a cost to taxpa rs of about $7.7 billion ov' the next decade." Nevertheless, failures continued. By the ate 1970s, railroads representing 21 peicent of U.S. railroad mileage were operating under the control of bankruptcy courts. Shippers and consumers were hit badly by the decline of the industry. Strapped for cash, the surviving railroads no longer could maintain their systems adequately, and they began to deteriorate. By 1975, railtoadsyre forced to reduce speed limits on 15 percent of their tracks because of track conditions. On many mainline stretches where freight trains at one time generally had run at 60 mph or more, the railroads were forced to impose limits of 10 miles per hour or less. Standing Derailment. Worse still, the rails, became dangerous: the numbe5 of train accidents caused by track defects almost quadrupled between 1967 and 1971.1 The situation became so bad that the term "standing derailmenf'was coined by railroad analysts to describe the 'increasingly frequent phenomenon of freight cars slipping off deteriorating track while stationary. Prices paid by shippers for this deteriorating service, meanwhile, iqyreased about 10 ercent faster than the c nsumer price index between 1967 and 1971." Not surprisingly, a p 0 1975 Department of Transportation survey found that 34 percent of the nation's shippers did not feel they were gettinq?dequate service, while over 97 percent of shippers found truck service to be adequate.

DEREGULATION OF THE RAILROADS

Policymakers tried for several years to deal with the troubled state of the industry through more government controis and involvement. Billions of dollars were spent on aranteed loans and direct federal aid to the industry. But by the mid-1970s, policymakers came to realize that the solution lay in less, not more, federal involvement. Lawmakers began to appreciate that the ability of railroads to compete effectively with other forms of transportation was being hampered by the pervasive controls and the red tape imposed by the ICC.

The first step toward loosening restrictions was the 1976 Railroad Revitalization and Regulatory Reform Act, known as the '*R" Act. This Act was the first legislation that recognized that railroads were no longer the monopolists of a century earlier and that in most of their business they now competed fiercely with trucks and other forms of transport. The '*R" Act freed railroad rates from ICC review, other than in cases where a railroad was found to be "market dominant," that is, where there was no adequate competition. Ship ers facing such a lack of adequate competition are known as "captive shippers." The trougle was that the ICC predictably- was reluctant to yield power and thus interpreted the Act narrowly, concluding that over three-quarters of railroad traffic was "captive" and therefore subject to regulation. Staggers Rail Act. Sweeping changes in rail regulation came four years later with the Staggers Rail Act of 1980. Among the most important provisions of the legislation: 1) A railroad could not be declared "market dominant" if its fates were below a cert in 4 ercentage of the "variable," or incremental, cost ce. 4Ms freed approxi @5 percent of all rail traffic from rate regulation. Lpf the servi mately 2) Where a railroad was market dominant, the ICC would still consider whether it was making adequate revenues overall in determining whether a particular rate was unreasonably high. 3) All rates could be raised to cover inflation, plus 6 percent, each year for four years, without ICC approval. After that, rates could be raised 4 percent each year if the railroad was not revenue adequate. 4) Shippers and railroads were permitted to bypass the entire regulatory system, if they wished, and negotiate their own rates for rail service. Since 1980, deregulation has been augmented by an ICC, led by Reagan-appointed commissioners, which generally has favored deregulation. They have interpreted the Staggers Act broadly and have helped the industry lower costs by approving necessary mergers and divestitures of track, among other actions. Since deregulation, the fortunes of the railroads and their customers have improved dramatically. Rate structures, which had pleased regulators but bore no relation to the actual cost of service, have been rewritten. Innovative services have grown rapidly. Example: "piggyback" service, which allows a truck-trailer to be carried directly on a railroad car, enabling railroads to compete more aggressively with trucks. While this service was available before 1980, deregulation is credited with spurring the aggressive market techniques that have made it a commonplace. Costs have been cut by railroads shedding excess trackage. Railroads have caught up with long-deferred maintenance and repair, restoring track and equipment to sound condition. And labor productivity was improved, as railroads chip away at antiquated work rules, while raising average.wages. In all, railway pperating, expenses fell in 1985 from $34.2 billion in 1919 to $25.2 billion in constant dollars, while traffic volume remained almost unchanged.

RESULTS OF DEREGULATION

Lower Prices

Railroad rates have dropped substantially since Staggers was enacted in 1980. But this decline in railroad rates generally is not reflected in the standard rate indices. According to the indemublished by the Bureau of Labor Statistics (BLS), for example, rates have just about staye even with inflation since 1981. Yet, had this actually been the case, rail revenug would have been about $34 billion in 1985. In fact, they were less than $27 billion.

Such indices mainly reflect the "official" rates filed with the ICC. But very little traffic actually moves at those rates, as shippers routinely negotiate more favorable private contracts with railroads--a practice that was illegal before Staggers. In 1985, for instance, 63 percepl, of all coal, and 57.percent of all grain shipments were made under such contracts. 9 This percentage is believed to be even higher today. Because of these problems with rate indices, the best measure of rail rates is the amount of money railroads actually receive for moving each ton of traffic. These numbers show rail costs are down. Railroad revenues per ton of freight hauled dropped over 15 percent from 19811o 1985, adjusted for inflation, although revenues previously had been increasing each year. Effective rates have fallen even lower for certain types of commodities. In 1985, farme,Ts paid about one-third less per ton to get their products to market than they did in 198 L" Costs r mile have decreased even further with a 19.1 Bercent decrease in revenues overall per Ui eeper ton of freight hauled, adjusted for inflation.

Better Service

Railroad customers have enjoyed significantly improved service since deregulation. Stagers and subsequent ICC decisions allowing railroads to cut costs and eliminate waste yielded savings to pay for long-deferred maintenance. Railroads upgraded their equipment, ending the long period of deterioration. The result: trains once again are running at full speed and on time. The average train speed, for Scample, has increased 27.3 percent from' 1979 to 1985, and 20.3 percent trom 1980 to 1985. Further, the new power to negotiate contracts has provided new incentives for service iTprovement. Before deregulation, railroads were required by law to treat all customers alike, regardless of differing- circumstances. Provisionlof special services or discounts to articular customers was; prohibited. Indeed, railroads could be prosecuted by the ICC if \u222\'5fd extra services for a customer, as this could be deemed an illegal discount. R today routinely negotiate with their customers to provide services geared to meet Particular needs of each shipment. Incentives for guaranteed damage-free service, on-time delivery, and door-to-door service are common. Shippers recognize these improvements. According to a recent poll commissioned by the Association of American Railroads, 72 percent of rail shippers feel that since deregul@tion the railroads have become more dependable in keeping schedulesinore responsive to customer needs, and more reliable in performance since Staggers.M stonier satisfaction in turn has h I the railroads by halting their decades-long slide in business. The share of intercity frei t auled by railroads stpped sliding in 1982 when it hit 35.8 percent and since has cl* e to about 37 percent.

Improved Safety Railroads had to upgrade the quality of their track and equipment to win customers in the more competitive business environment. Tlis has improved safety notably. From 1980 to 1985 the number of train accidents has been cut by 67.3 percent, decreasing from 8,451 accidents in 1980 to 2,760 in 1986. Pose caused by track defects are down 70.9 percent, from 3,492 in 1980 to 1,016 in 1986. A deregulated rail system has proved to be a safer one.

Improved Finances The railroad industry is no longer on the endangered species list. Since the first tentative deregulatory steps were taken in the late 1970s, railroad return on net investment has risen substantially. While returns were about 2 percent during most of the 7 2-7 12 Os, dropping as low as 1.2 percent in 1975, by 1980 they had reached 4.2 percent. Returns have continued in the 4 percent range in the years since Staggers was enacted, with a drop to 2.1 percent in the 1982 recession year and reaching 4.7 percent in 1984. Relative to inflation, the financial condition of the railroads improved steadily after Staggers was enacted: return on net investment was 8.2 percent less than inflation in 1980, @nd 1.6 percent less in 1982. In 1984 it was 0.5 percent mQj:e than inflation. These improvements were crucial during the 1982-1983 recession."" Traditionally, the railroad industry has been particularly susceptible to recessions. This time, however, the industry managed to survive the recession, without any major bankruptcies, an Wmost unprecedented situation.

The railroads' returns on investment, however, remain very low. In 1986, the return was 4 percent. JU By co3T ,son, the average return on invested capital in U.S. industry last year was 10.7 percent. Wtus, while its financial condition has improved since the 1970s, the railroad industy is still struggling.

THE THREAT OF REREGULATION

Not all railroad shippers are satisfied with deregulation. Some feel that the Stapers Act does notprotect them from high railroad rates. For the most part, these dissatisfied customers ship coal and other commodities not easily transported by truck. Competition thus is less intense. These critics argue that they are "captive shippers," in that they have no choice but to use railroads and consequently have to pay high rates for railroad service.

Several bills have been introduced in Con to address these com -laints. The proposal is the "Consumer leading Equi@. IS. 676, H.R. 1393 , also known as the "CURE-bilr'because it is support y a coa i i of shippers known as "Consumers United for Rail Equity." Among other t i , is biI I :

1) Shift the burden of proof to a railroad to demonstrate that its rates are reasonable, in contrast to the current rules that require the shipper to show that the rates are unreasonable before the ICC can intervene.

2) Force railroads to make available certain of their facilities and equipment to a competing railroad at "competitive" rates.

3) Forbid the ICC from considering competition from different regions and different products (known as "geographic" and "product" competition) in determining whether a railroad is "market dominant."

Proponents of this legislation argue that these changes would not undo deregulation, only fine-tune it to make it more "fair." The truth is that these changes could jeopardize seriously the gains made by shippers and railroads over the last seven years. More important, such changes are not needed to protect shippers.

Changing the burden of proof in rate cases, for instance, may seem to be. a minor ppint of legal procedure. But as every lawyer knows, the issue of who h t rove his case is often the most important factor in determining the outcome of a caseo. Znder current law, a complaining shipper has to prove to the ICC that a railroad's rate is unreasonable. Ilus the railroads are presumed innocent until proved guilty. Presumed Guilty. The CURE bill, however, would presume the railroads guilty until proved innocent. The railroad's rates would be viewed as unreasonable until proved otherwise. Thus simply by filing' a complaint with the ICC; a shipper could force a railroad into a long and complex proceeding *in which it would have to prove its rates were reasonable, a difficult task. Even if the shipper eventually lost, the delays imposed could be very costly to a railroad. Ile inevitable result would be rates determined more by lawyers and bureaucrats than by the marketplace. Tle proposal to require railroads to offer their services to other railroads is also flawed. The bill would limit "joint rates"--rates at which one railroad carries another railroad's traffic to its final destination--to "competitive" levels. The rate is deemed competitive if it does not exceed the vAriable cost of the service by a higher percentage than does the regular railroad rate. This violates basic principles of justice. Just as it would not be iust to force a grocery store to open its property to its competitors at particular rates, it is not just to force railroads to do so. The rates deemed to be "reasonable," moreover, are set at arbitrary levels. More is involved in rate setting than calculating variable costs. As important, for example, is the demand for the service. The CURE proposal would impose by legislative flat an arbitrary formula for the division of freight revenues among railroads. 33 This should be decided by the railroads involved, based on the circumstances in each case. Competition in Many Forms. In any case, the ICC recently ap roved a procedure by which shippers who feel they have been harmed by unreasonably gigh joint rates, or the lack of joint rates, can seek relief. Under this procedure, the Commission will not permit changes in existing joint rates if it finds them contrary to the competition policy of the Staggers Act or otherwise anticompetitive. Thus, even under current law, shippers are not without recourse. Lastly, the provision prohibiting the ICC from considering Seographic and product competition when determining whether a railroad is "market dommant" and a shipper "captive" would create an unrealistically narrow definition of competition. The fact is, competition comes in many forms. T'here is direct competition between two railroads in a market and competition between a railroad, trucks, ships, and other modes of transportion. There also is indirect competition, which can be as potent as the direct variety. Example: a coalproducer may have access only to a single railroad to ship to market, yet the coal purchaser can buy from a number of sources, all relatively the same distance away. Ilis competition from a different geographic area effectively limits the amount a railroad may charge. If its rates are unreasonably high, less coal will be sold from that area and the railroad will make less money. Similarly, product competition limits railroad rates, as users of coal, for instance, are able to switch to other fuels if railroad rates rise too much. While not as easily quantified as other forms of competition, geographic and product competition restrain the market power of railroads.

DO RAIL DEPENDENT SHIPPERS NEED RATE RELIEF?

Much support for reregulation comes from a perception that certain shippers dependent on railroads are forced to pay unjustifiably high rates. This is a nuisperception. Almost all es of shippers have seen their rates re luced since deregulation--including coal shippers, %PC most vocal reregulation supporters. The rates for coal shipments have fallp from an average $1230 per ton in 1980 to $12.15 per ton today, adjusted for inflation.' Recognizing this, many dissatisfied shippers argue that, while rates have dropped, they have not dropped enough. To evaluate this argument, it is necessary to remember that railroads, as other industries, face two types of-costs: "fixed"'and "variable." Fixed costs are those incurred by the railroad regardless of the amount of business it does, such as the cost of track and equipment. Variable costs are the additional costs arising from a particular shipment for such things as labor and fuel. High Fixed Costs. Obviously, a railroad cannot simply charge customers for the variable costs of each shipment, since this would leave nothing for the fixed costs. In railroads, in contrast to many other industries, these fixed costs constitute a very high proportion of total costs, given the need for substantial investment in track and equipment. Coal shippers argue that they are forced to pay far more than their "fair share" of fixed costs Th . t out that shippers of coal and other commodities, for which railroads are @ ml the @nlj reeYagi oly available form of transportation, often are charged rates that are 200 percent or more than the variable costs incurred. On the other hand, they claim, commodities for which there are non-rail alternatives are charged rates that are a much smaller percent of their variable cost. The Biggest Losers. Such differences, however, are not unfair. There are only two ways that the rates for the rail-dependent shippers can be reduced: by cutting total rail revenues, or by increasing rates for other shippers. Re cing total revenues would drain needed funds from railroads, which are o . n profitable as it is. Raising rates for other shippers is no more practical. As the railro s know too well, these shippers would ship their goods by truck if rail prices were raised. Thus, to pay for their high fixed costs, railroads are forced to charge more to customers who are dependent on their services than those who have alternatives. Without such "differential pricing," railroads would lose needed business and funds, resulting in poorer service and higher prices for all their customers. In fact, the biggest losers would be the rail-dependent shippers, including the coal shippers themselves. If the rail system once again were to deteriorate, most shippers would turn to truckers, and rail dependent shippers would face reduced service at prices even higher than they now pay, as fixed costs were spread over a narrower base of customers.

CONCLUSION

Ile railroad industry, once in a steep decline and facing nationalization or extinction, has enjoyed a remarkable turnaround in the years since it was partially deregulated. Costs have been reduced, service and safety improved, and rates lowered, resulting in a savings of billions of dollars for the U.S. economy.

The railroads have been brought back from the brink of bankruptcy, but they are not yet in the clear. The return on investment still is only These gains notwithstanding, some lawmakers are threatening to stiffen regulati indus in the name of "fairer" rates for certain shippers. Such regulation would only und =e railroads, to the detriment of all shippers. Railroad regulation was devised for the railroads of 1887. It is a disaster for the railroads and shippers of 1987.

James L Gattuso McKenna Senior Policy Analyst in Regulatory Affairs