Railing at "Open Access"
PROPOSALS IN THE RAIL INDUSTRY

by Paul A. Cunningham & Robert M. Jenkins III

Paul A. Cunningham and Robert M. Jenkins are partners in the law firm of Harkins Cunningham, in Washington, D.C.

 

Proponents of "open access" in the freight rail industry frequently draw analogies to the ongoing access debates in the electric utility and telecommunications industries. But the debate in the rail industry is more narrowly focused. Railroads have long been required to interchange traffic with each other. In any case, railroads must cooperate in order to offer nationwide service to their customers. Rail shippers can transport their goods physically from any rail-served origin to any rail-served destination in the country. The access issue in this industry usually is not about whether railroads should be made to cooperate in providing service to shippers but, rather, how much shippers should pay for the service they receive.

On 31 December 1995, the Surface Transportation Board became the successor to the Interstate Commerce Commission (ICC) as the federal regulator of rail rates and practices. Since Congress passed the Staggers Rail Act of 1980, the ICC and the Board have generally avoided interfering with the operations of the rail industry. The Board for the most part now leaves to individual railroads the job of negotiating the terms on which they interchange traffic with each other, haul or switch traffic for each other, or operate on each other’s lines. The Board will intervene to resolve complaints that the rates a rail customer pays for service from origin to destination are too high in the aggregate. But, absent a claim of anticompetitive foreclosure, the Board will usually not intervene in a dispute about the prices for portions of movements or the terms of railroads’ dealings with each other.

That narrow approach to access regulation, limited to circumstances where there is demonstrated market abuse, has worked well for railroads and shippers alike. It precludes anticompetitive behavior and monopoly pricing, yet it requires a minimum of regulatory oversight.

Some shippers have recently been pressuring the Board to adopt universal "access" measures that they believe will result in lower prices. But rate management by government would endanger the very existence of the railroads and retard economic progress. To maximize efficiency, the pricing and bundling of services should be left to suppliers and customers, not to regulators, whenever possible.

 

Rail Interchange System

Most shippers’ facilities in the United States are served by only one railroad. Even if more than one railroad reaches a geographic region or urban area, usually only one rail line runs into an individual customer’s facility. Often the railroad serving the origin is different from the railroad serving the destination.

Where railroads provide "interline" service involving more than one railroad, they typically set one rate to the shipper for service from the origin to the destination and negotiate with one another their respective shares of the shipper’s payments. Loaded and empty cars are usually transferred from one railroad to the other at the interchange point between the railroads. However, there are many negotiated variations on this type of interchange. They might include the following:

  • • The right to "run-through trains." In specific cases, one railroad has the right to run an entire train, including its engines, and sometimes its crew, over the entire length of a multi-railroad movement.

    • "Trackage rights." One railroad has the general right to operate any of its trains on another railroad’s lines.

    • "Haulage rights." One railroad has the right to market the services of another as its own.

    • "Reciprocal switching rights." One railroad has the right to market the terminal services of another as its own.

  • Most of those arrangements are worked out voluntarily between railroads, with no regulatory involvement. The proponents of open access seek to supplant that privately negotiated system with regulated access systems for one reason only: to suppress the differential prices the railroads charge for their services.

     

    Railroad Economics

    To judge whether a regulatory arrangement makes freight shipments by rail more competitive or not, it is necessary to understand something about the economics of rail service. First, railroads have very high fixed costs, for example, for roadbed and tracks, that do not vary with the amount of service provided. Whether a railroad runs few trains or many, it must meet those costs. Second, shippers’ demand for rail services, that is, their "elasticity" of demand, varies considerably. Some shippers have few transportation, production, or purchase options. Higher prices are unlikely to drive them away from rail transport. Others are much more sensitive to price changes. Refrigerators, for example, might be shipped by rail or by truck. Those two factors—high fixed costs and widely varying elasticity of shipper demand—have important implications for the economies of rail service.

    Assume, for example, that a railroad has $1,000 in fixed costs per month, regardless of the number of shipments it makes. Also assume that the added variable cost for each shipment will be on average $5. In a particular month, a high-demand customer plans to make forty shipments, a medium-demand customer plans to make thirty-five shipments and a low-demand customer plans to make twenty-five shipments. This means one hundred shipments for that month. If each shipper is charged an equal percentage of the fixed costs, the result is seen in Table 1.

    Table 1
    Equal Distribution of Fixed Costs
    $10 per Shipment*

      Shipments Fix cost/
    shipment
    Total fixed costs Variable cost/
    shipment
    Total variable costs Total costs
    High 40 $10 $400 $5 $200 $600
    Medium 35 $10 $350 $5 $175 $525
    Low 25 $10 $250 $5 $125 $375
              Total Costs = $1,500

    But the low-demand customer, with a high degree of price elasticity, might find the $15 cost per shipment too high and simply use trucks or other means of transportation. In that case the $1,000 in fixed costs will be divided among seventy-five shipments rather than one hundred. The equally-divided fixed cost per shipment thus will be $13.33. In that case the costs to the remaining two shippers are seen in Table 2. Here the high- and medium-demand shippers each pay more of the fixed costs and the railroad provides less rail service and receives less revenue. But the higher $18.33 total cost per shipment might cause the medium-demand shipper to take some or all of its business elsewhere. In a worst-case scenario the high-demand shipper would have to pay the entire $1,000 in fixed costs, as shown in Table 3. If the remaining shipper cannot afford the $30 cost per shipment, the railroad in the long run will go out of business.

    Table 2
    Equal Distribution of Fixed Costs
    $13.33 per Shipment*

      Shipments Fix cost/
    shipment
    Total fixed costs Variable cost/
    shipment
    Total variable costs Total costs
    High 40 $13.33 $533.33 $5 $200 $733.33
    Medium 35 $13.33 $466.67 $5 $175 $641.67
              Total = $1,375.00

    * Numbers Rounded

    To avoid such situations, railroads tend to price in accordance with demand ("differential pricing") rather than cost formulas. Thus, in the example above, if the low-demand shipper cannot or will not pay more than $10 per shipment (thereby covering $5 in fixed costs and $5 in variable costs), that is what the railroad charges. The railroad might make up the resulting $125 revenue shortfall (25 shipments x $5) by charging higher prices to the other customers. The railroad, for example, might seek to have the high-demand shipper contribute an additional $90. This would work out to $12.25 in fixed costs for each shipment ($490/40). And the railroad might assign to the medium-demand shipper an additional $35 to the railroad’s fixed costs, which works out to $11 per shipment ($385/35). Assuming they could bear these costs, the result would be as shown in Table 4. In this case, the low-demand shipper stays with the railroad. The high- and medium-demand shippers might resent the "unequal" pricing. But the high-demand shipper’s total cost of $690 is still less that the $733.33 cost (or, in the worst case, $1200) that would result if the low-demand shipper took its transportation business elsewhere. And the medium-demand shipper’s total $560 cost is less than the $641.55 cost without the low-demand shipper, a cost that would drive the medium-demand shipper away.

    Table 3
    Equal Distribution of Fixed Costs
    $25 per Shipment

      Shipments Fix cost/
    shipment
    Total fixed costs Variable cost/
    shipment
    Total variable costs Total costs
    High 40 $25 $1,000 $5 $200 $1,200
              Total costs = $1,200

    Table 4
    Demand Based Distribution
    of Fixed Costs

      Shipments Fix cost/
    shipment
    Total fixed costs Variable cost/
    shipment
    Total variable costs Total costs
    High 40 $12.25 $490 $5 $200 $690
    Medium 35 $11.00 $385 $5 $175 $560
    Low 25 $5.00 $125 $5 $125 $250
              Total costs = $1,500

    It might seem obvious that demand-based differential pricing makes good economic sense, whether for interline movements involving two or more railroads or for single-line movements involving one railroad. The promotion of such market pricing is the foundation of much of the Surface Transportation Board’s modern approach to rail rate regulation. However, demand-based differential pricing has not always been so favored and the proponents of access regulation seem bent on using their proposals to turn back the clock to an era of formula-based pricing.

    The Staggers Rail Act of 1980

    In the 1970’s the American rail industry was on its knees, largely because regulation had crippled its ability to respond to competitive forces and cover the costs of their services. Eight large railroads went bankrupt and many others struggled to survive. Policymakers gave serious consideration to nationalizing the rail freight system.

    Congress chose instead to pass the Staggers Rail Act of 1980, which mandated an end to many of the rigid regulations that had stifled the railroads, allowing markets to the maximum extent possible to set rates and the terms of joint rail operations. The Board in the 1980’s implemented the Staggers Act by adopting rules permitting regulatory intervention only where necessary (1) to remedy monopoly pricing for service from the origin to the destination ("rate reasonableness") or (2) to remedy or prevent anticompetitive conduct regarding joint services ("competitive access").

    Rate Reasonableness. The premise of the Board’s rate reasonableness rules is that competition in most transportation markets is fierce. In addition to intermodal competition among railroads and intramodal competition from trucks, barges, and pipelines, product and geographic competition substantially constrain rail rates on most movements. Yet, as has been seen, the fixed and common costs of rail service are quite high. Thus, to require railroads to charge prices to their customers based upon an accounting proration of those costs would be self-defeating, driving away some shippers and ultimately raising prices for remaining shippers.

    The Board has permitted—indeed, encouraged—railroads to set demand-based prices that maximize the contribution that each service could make to the fixed and common costs of the rail system. The Board will only intervene to lower prices for a particular service or set of services if the revenues exceed the total economic costs of providing that service or set of services.

    As a result of this pricing freedom, railroads’ rates are lower in real terms in every commodity group than they were when the Staggers Act went into effect—over 50 percent lower per ton-mile on average. At the same time, the railroads’ service and efficiency have improved enormously. They have made the kinds of capital improvements required to provide even more efficient service in the future. Annual capital investment in the rail industry has doubled since 1980. Yet none of the major railroads has been able to consistently earn a cost of capital return on its overall investment.

    Relatively few rate reasonableness cases have been brought against the railroads under the Board’s rules, and most of those cases have resulted in a determination that the challenged rates did not exceed the cost of the services in question.

    Competitive Access. The Board’s competitive access rules are meant to remedy or prevent anticompetitive conduct regarding joint services between railroads. The premise of those rules is that railroads know their business better than the government. So long as they are permitted to set demand-based differential prices for their individual services, railroads have strong incentives to cooperate with one another to move traffic as efficiently as possible between an origin and a destination. That means negotiating both mutually beneficial revenue shares and efficient interconnections. Higher efficiency of freight movement means more competitiveness with other modes of transportation and more revenues to cover fixed and common costs.

    The Board’s competitive access rules were designed to remedy the unusual situation in which a railroad might consciously foreclose more efficient joint service. If rail traffic is moving efficiently, and the rate the shipper pays for service from origin to destination is reasonable, the Board will investigate no further. The Board’s competitive access rules are not designed, and cannot properly be used, to force down reasonable, market-based rates.

    Although a few shippers have invoked the Board’s competitive access rules since the Staggers Act was passed, none has been able to show that a railroad has engaged in the kind of anticompetitive conduct those rules are designed to prevent.

     

    "Open Access" Proposals

    Unhappy with the Board’s approach to rate reasonableness and competitive access, some shippers have sought to circumvent the Board’s rules by demanding what they call "open access". Open access proponents are not always clear what they mean by that term, but more regulation is always involved. They do not seek a requirement that railroads freely interchange traffic with each other; mandatory interchange of traffic has long been required in the rail industry. Instead, they want to dictate the terms on which railroads deal with each other—without having to demonstrate that there is any competitive need for this interference in the railroads’ business dealings.

    Reciprocal Switching. This is not the first time that proposals have been put forward to micro-manage the railroads’ joint operations. Even as the Staggers Act was being considered by Congress, a legislative proposal was made to require railroads to offer a particular form of access—reciprocal switching—at every terminal area in the country. Under the proposal, a customer in a terminal area might require the railroad serving its facility to switch its freight to another carrier at below-market prices. Proponents argued that this mandate would promote rail-to-rail competition. Congress rejected that proposal, but it did give the Board the authority to impose reciprocal switching regulation on a case-by-case basis, if it found that the regulation was in the public interest.

    At first the Board was inclined to apply its new authority liberally, but it soon recognized that it would be embroiled in endless regulatory disputes about the appropriate price and other terms for terminal services in every terminal area in the country. It also recognized that in most instances access was not the issue. Typically, the customer simply wanted a lower price for the service it would continue to receive from the same railroads that had always served it.

    Accordingly, the Board’s competitive access rules were designed to distinguish requests for access to efficient joint service from requests for lower rates. When the Board applied its rules to requests for mandatory reciprocal switching, it found no case where access to efficient joint service had been denied to a rail customer.

    "Bottleneck" Regulation. More recently, opponents of the existing regime of price regulation have argued for "bottleneck" regulation as a means of obtaining access. Whereas the Board now looks for evidence that rates from origin to destination are too high or that efficient access is being denied to a particular location, the "bottleneck" regulation advocates have sought to have the Board dictate the railroads’ interchange points and the rates for "bottleneck" portions of interline movements without having to demonstrate that there is any competitive need for this interference in the railroads’ business dealings.

    Last year the Board denied this request for pervasive new rate regulation in the name of open access. The Board determined that, absent a demonstration that a shipper has been denied efficient routing, it will not get into the business of regulating the railroads’ operations; and, as a general matter, if the overall rate from origin to destination is reasonable, the Board will not involve itself in the railroads’ rates or revenue divisions for pieces of movements.

    Trackage Rights. Most recently, some shippers, in the name of open access, have promoted new schemes to require railroads to permit other railroads to move over their tracks.

    Voluntary trackage rights arrangements, like voluntary reciprocal switching arrangements, are common in the rail industry. But they are far from universal, and are never undertaken lightly. They can substantially affect the business and operations of both the railroad owning a rail line (the "landlord") and the railroad using the rail line (the "tenant").

    Typically, in a voluntary arrangement the prospective landlord and tenant negotiate intensively concerning:

  • • The price the tenant will pay for use of the line, which may be a set dollar amount, a per-car charge, or a cost-sharing arrangement;

    • Whether the tenant will only use the landlord’s line to connect with another line ("overhead" rights) or will be allowed to serve some or all of the rail customers located on the line;

    • The relative priority that the landlord’s and tenant’s trains will have when operating at the same time on the line; and

    • Their respective rights if disputes arise under their agreement. Disputes under those agreements are typically resolved like most other commercial disputes, by courts or arbitrators, not by the Board.

  • The terms of these voluntary agreements vary widely, according to the business needs and priorities of the parties.

    The proponents of mandatory trackage rights oppose allowing railroads to decide when such rights make commercial and operational sense. They would require railroads to offer trackage rights, but require the Board to dictate the terms and regulate the provision of those rights. Under the most limited of their proposals, any railroad would be entitled to operate its trains over any portion of another railroad’s tracks that constituted a "bottleneck." Under a more far-reaching proposal, any railroad would be entitled to operate its trains over any portion of any other railroad, whether or not it constituted a "bottleneck." Either proposal would result in a massive restructuring of the rail industry, and would require pervasive new regulation of rail-to-rail pricing and operations.

     

    Return to Regulation?

    Mandatory trackage rights and other such proposals would in effect eliminate the Board’s current rate reasonableness and competitive access regime. They would return the industry to the pre-Staggers era of heavy-handed regulation. Mandatory trackage rights, for example, would require the Board to deal anew with a number of basic price regulation issues:

  • • Should a railroad be allowed to set differential, market-based trackage rights fees?

    • If so, should the trackage rights fee be deemed reasonable so long as the overall origin-destination rate to the shipper did not exceed a reasonable level?

    • Should trackage rights fees be different for access to different shippers, different line segments, different railroads?

    • Should the railroad’s revenue adequacy or inadequacy be taken into account in determining the reasonableness of the trackage rights fee?

  • Those proposals in turn would raise many non-price issues, requiring the Board to become even more intrusive in the rail industry:

  • • Should only shippers served solely by one carrier and unable to ship economically by another mode receive trackage rights or should every shipper be entitled to open access?

    • Should trackage rights be mandatory to an auto ramp or intermodal facility, where nothing prevents a competing carrier from building its own facility?

    • How would the Board resolve capacity constraints and priority issues? Would a neutral, nonprofit entity dispatch the track and resolve operating conflicts? Would such an entity handle spot requests from shippers for service and offers from railroads to provide service and "clear" the market by matching requests and offers?

    • Should trackage rights be mandated even if the owner’s traffic filled a line to capacity? Should the owner be required to construct additional capacity for another railroad’s traffic? If so, how would the costs be allocated?

    • Would there be any limit to the length of trackage rights? Would a solely served shipper hundreds of miles from any other railroad be entitled to receive trackage rights service?

    • Could a railroad obtain trackage rights even if none of the movement would take place on its own track?

    • Would small railroads as well as large be subject to mandatory trackage rights orders? If not, why not?

  • The justification most commonly given for such a pervasive new regulatory regime is "competition." But regulation is not competition. Regulation is governmentally administered prices and operations. Open access schemes that require regular regulatory attention would help revitalize the regulatory industry rather than the railroads. But they would do nothing for most consumers except add the cost of more regulation to their freight bill.

     

    Conclusion

    Ironically, the very success of deregulation since the Staggers Act has provided some of the impetus for open access proposals in the rail industry. Railroads are doing better financially, and time has dimmed some shippers’ recollections of the serious damage that misguided regulation can do to the efforts of the industry to provide quality service at competitive prices.

    None of the major railroads has yet reached the level of earnings that will cover its long-terms costs of replacing its current system. The fact that they are making progress toward that goal is cause for celebration that deregulation is working. It is not cause for imposing a pervasive new open access regulatory structure on the industry.

    Selected Readings

    LEXIS "Trans" library : Coal Rate Guidelines—Nationwide (August 8, 1985) (railroad economics).

    Midtec Paper Corp. v. Chicago and North Western Transp. Co. (December 15, 1986) (terminal trackage rights and reciprocal switching).

    Vista Chemical Co. v. Atchison, Topeka & Santa Fe Ry. (February 6, 1989) (reciprocal switching).

    Central Power & Light Co. v. Southern Pacific Trans. December 31, 1996) ("bottleneck" regulation).


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