Implications of the Recent

Eastern Coal Rate Decisions


C. Michael Loftus [1]

Slover & Loftus


In recent months, the Surface Transportation Board ( STB or Board ) has issued decisions in three major Eastern rate cases (the Eastern cases).[2] In each case, the challenged rates were very high and represented major increases over rate levels in the expiring contracts that preceded them.


These cases presented certain issues of first impression to the agency. In addition, the evidentiary records reflected the continuation of the trend in recent years to delve into ever-greater levels of detail with regard to virtually every element of stand-alone costs.


The Boards resolution of the issues in these cases brings into question the continuing efficacy of the Coal Rate Guidelines as a meaningful constraint on excessive rates for coal shippers in the East. The resulting rates substantially exceed the rates associated with the agencys western rate prescriptions over the past decade, even after differing cost of service factors are considered.


The purpose of this paper is to address a few of the major issues in the Eastern cases, and to consider what these cases may mean for the future of STB rate review. It should be noted, however, that petitions for reconsideration are pending in each case and that Commissioners Buttrey and Mulvey have just recently joined the STB. The decisions are also subject to appeal. Accordingly, the decisions may be far from final.


Reversal of Railroad Strategy on Market Dominance


A significant, but largely overlooked, aspect of the Eastern cases is the complete reversal in the carriers approach to market dominance. In past cases, carriers consistently, but unsuccessfully, claimed that their challenged rates were subject to effective competition stemming from the rate-constraining impact of interconnected electric grid, generation from other fuels (chiefly gas), build-out threats, potential motor carrier service, or other competitive factors. As recently as 1998-2002, the AAR and its member railroads vigorously resisted the elimination of product and geographic competition from the Boards market dominance analysis.[3] Throughout that multi-year effort, the carriers simultaneously insisted that: (i) their freedom to set rates even for captive plants was constrained by competitive factors such as competition in the electric utility business; and (ii) shippers that were not genuinely captive would nevertheless file STB rate cases.


Ultimately, the railroads effort to preserve the consideration of product and geographic competition failed, but defendants in rate cases remained free to contest market dominance on the basis of intramodal or intermodal competition. However, the carriers in the Eastern cases not only declined to contest market dominance, but instead embraced the absence of effective competition as an affirmative justification for their substantial rate increases. Past assertions that the carriers had established their rates in the midst of vigorous competition were replaced by claims that the railroads needed to set rates high on their captive traffic in order to be able to preserve their networks and serve their other customers. The carriers further claimed that the utilities were financially healthy and could easily afford the increases, particularly since they would spread the burden over their large numbers of ratepayers.


It is interesting to speculate whether the change in strategy originated with business or litigation concerns: that is, did the carriers and their counsel abandon the absence of market dominance defense in order to adopt an aggressive litigating position (i.e., a corporate decision to go for broke), or did the carriers prior business decisions to set the rates at 50+ mill levels mandate a shift in litigation strategy, as the carriers could not credibly claim that their rates reflected any concern for loss of the traffic due to competitive concerns)?


In any event, the carriers abandoned a line of defense that had never been well-received. A further benefit to the carriers of conceding, and even embracing, their market dominance was to provide some semblance of a rational defense to the shipper charge of gaming, discussed next.





The gaming of common carrier rates is, and, until the Board devises or accepts a reasonable solution, will remain a particularly challenging problem for shippers seeking a regulatory cap on unreasonable carrier rate demands. As the shippers argued throughout the Eastern cases, the ability of a regulated railroad to act unilaterally in setting the starting point for an analysis that prescribes rates on the basis of a percentage reduction has the inherent potential to defeat the effectiveness of the rate review methodology. Because the carrier sets the starting rate, the carrier can set the rate high enough so that it will end up with a substantial rate increase, even after application of the percentage reduction.


Consider a hypothetical where a captive shipper has an expiring contract with a rate of $10 per ton and the carrier offers a new contract rate of $15 per ton. The shipper then considers whether it should seek relief from the STB and concludes it might reasonably obtain a rate reduction of 15%, corresponding to a rate of $12.75 per ton. However, based on the Eastern cases, the shipper would be concerned that the carrier will set a common carrier rate on the order of $20 per ton if the contract offer is refused. Even assuming the shipper is successful, and further even obtains a percentage reduction of 20% in light of its high rate, the resulting rate of $16 per ton is still higher than the $15 contract rate the carrier offered. Moreover, the $16 rate is obtained only after the shipper dedicates approximately three years and several millions of dollars to the litigation, while paying the $20.00 per ton common carrier rate during the pendency of its case.

Only in the CP&L decision did the Board even address the gaming question.[4] Therein, the Board found that the potential gaming of common carrier rates had been established, but that no reasonable solution to the problem had been presented. Furthermore, the Board appeared to equate railroad gaming with so-called shipper gaming in the form of including high rate non-issue traffic in the stand-alone traffic group. The parties have shown that the percent reduction methodology is susceptible to manipulation by parties: by a defendant railroad in setting a challenged rate at an artificially high level to limit the impact of a SARR [stand-alone railroad] over-recovery, and by a complaining shipper in grouping a challenged rate with non-issue traffic that is much higher rated to generate a larger rate reduction. CP&L at 32. The Board went so far as to state that:


Given a traffic group with sufficiently highly rated non-issue traffic, the percent reduction approach could brand any rate level established by a defendant railroad as unreasonable (assuming that the R/VC percentage exceeds the jurisdictional threshold). This potential could encourage a shipper to challenge an otherwise reasonable rate, or enable a shipper to obtain an inordinate rate reduction, simply by selecting a traffic group with much higher-rated traffic.


CP&L at 31.


What the Board now categorizes as gaming was previously found by the ICC to be an essential aspect of the stand-alone cost analysis. In particular, in Coal Rate Guidelines, Nationwide, the Commission observed that:


The parties will have broad flexibility to develop the least costly, most efficient plant. The plant should be designed to minimize construction (or acquisition) and operating costs and/or maximize the carriage of profitable traffic. In selecting the route of a SAC railroad, for instance, an overriding factor may be the effort to lower costs by taking advantage of economies of density.Generally, a stand-alone railroad would attempt to fully utilize plant capacity, adding other profitable traffic in order to reduce the average cost of operation. . . .


The ability to group traffic of different shippers is essential to theory of contestability. It allows the captive shipper to identify areas where production economies define an efficient subsystem or alternative system whose traffic is divertible to a hypothetical competitor. Without grouping, SAC would not be a very useful test, since the captive shipper would be deprived of the benefits of any inherent production economies. The railroads and shippers agree on the propriety of grouping to develop a SAC model, but they disagree on what traffic should be included in a stand-alone system.


We see no need for any restrictions on the traffic that may potentially be included in a stand-alone group.


Coal Rate Guidelines, Nationwide, 1 I.C.C.2d 520, 543-44 (1985), affd sub nom. Consolidated Rail Corp. v. United States, 812 F.2d 1444 (3d Cir. 1987) (emphasis added).


In the space of nineteen years, the agency charged with the responsibility of protecting captive shippers has gone from (a) developing a rate review standard premised on allowing shippers to obtain the benefits associated with economies of density by liberal grouping of traffic, to (b) condemning the practice of grouping as a manipulative tactic that could result in the reduction of otherwise reasonable rates.[5]


In any event, the Board essentially punted on the railroad gaming issue, finding each of CP&Ls proposed alternatives to the straight percentage reduction methodology to be unacceptable, but declining to offer any solution of its own. While the Board welcomed proposals for appropriate alternatives to be used in the future, the Board found that in the absence of such an alternative, it would not depart from its precedent.



The Critical Impact of Operating Cost Determinations


Beyond the gaming issue, the single most important issue driving the results of the Eastern cases was the Boards selection of an operating plan (and associated operating costs) for the SARR. In each case, the Board rejected the shippers efforts to streamline the incumbents existing operations, and thereupon accepted -- without significant analysis -- the operating plans proposed by the defendant carriers. The locomotive, crew, and other costs associated with the operations advocated by the defendants added largely insurmountable costs to the SARR systems during each year of the 20-year DCF models.


The critical element in the Boards analysis was its refusal to accept any modifications in the sources of coal for the SARRs individual trains or the size of the trains, thereby precluding the SARR from achieving the efficiencies inherent in trainload service. The obvious teaching of the decisions is that a shipper faces a high burden in having the operations of its SARR differ from the actual operations of the incumbent railroad, and that the shipper must demonstrate that the different operations will be acceptable to the other shippers in the traffic group and connecting carriers, in addition to showing that the operations would be feasible and efficient. The decisions, however, leave unclear what sort of evidence (e.g., direct testimony from shippers whose traffic is included in the group as to what they would find acceptable in the stand-alone world) will suffice. Another apparent teaching is that once the Board decides that the shippers operating plan is flawed, the railroads plan will be accepted regardless of how flawed it might be, especially in terms of complying with the least-cost, most-efficient principle of stand-alone cost analysis.


Some clarification on this issue may be forthcoming when the Board rules on pending petitions for reconsideration. One of the issues presented is whether the stand-alone operating plans submitted by the railroads (and accepted by default by the Board) were less efficient than real-world operations. It remains to be seen how this issue will be resolved, because Chairman Nober indicated serious concern at oral argument in the cases that SARR operations should not be less efficient than real-world operations. The railroads, however, now have acknowledged in their reconsideration replies that when faced with the complainants decisions to eliminate the use of so-called gathering or marshalling yards in the vicinity of the coal mines, they calculated SARR operating expenses on the basis of assumptions that:


! the SARR would replace the real-world gathering operations with smaller trains traveling from a single origin to a destination (or interchange) with as few as two railcars; or


! the SARR would replace the real-world gathering operations (under which a single train makes stops at several origin mines to build a full train) with an approach whereby trains shuttle cars from a single mine at a time to SARR yards that are located in areas far more distant from the mines that the real-world gathering yards.


In either case, the SARR operations posited by the carriers and accepted by the Board introduce massive inefficiencies and greatly increased operating costs compared to real-world operations. These overstated operating costs drove the vast bulk of the difference between the Boards operating cost findings and the operating cost levels advocated by the complainants.



Cost Indexing


Another significant aspect of the decisions involves the use of the Rail Cost Adjustment Factor Unadjusted for Productivity (RCAF(U) ) to index operating costs over the 20-year stand-alone cost discounted cash flow (DCF) model used to evaluate the reasonableness of the rates.


In the Eastern cases, the Board escalated SARR revenues and costs using sharply divergent indices, with costs determined through the use of the Boards RCAF(U) index and revenues escalated at a much slower rate. The disparity between the cost index and the rate index caused the SARRs financial performance to deteriorate over the 20-year DCF model.The shippers in the Eastern cases had argued that SARR expenses should be escalated using the Rail Cost Adjustment Fact Adjusted for Productivity (RCAF(A) ), which increases at a more gradual rate than the RCAF(U) because it reflects improvements in railroad productivity.[6]


In the Eastern cases, the Board acknowledged that the stand-alone railroads would likely experience some productivity improvements over their 20-year lives, but not as much as the railroad industry as a whole. See, e.g., CP&L at 27 (While it is difficult to imagine that there would not be some areas in which the [SARR] might realize productivity improvements over the course of the SAC analysis period, the potential impact of such improvements is far less than it would be for existing railroads, which make changes incrementally as older technology assets wear out or become obsolete.). However, the Board did not credit the stand-alone railroad with any productivity gains on the basis that the only choice presented was between the RCAF(U) and the RCAF(A).




In the two Duke decisions (but not the CP&L decision), the Board found that phasing, one of the constraints adopted in the original Coal Rate Guidelines but never before applied, may be an appropriate means of ameliorating the impact of the otherwise permissible rate increases imposed upon Duke. It remains to be seen whether this consideration would be workable in practice.


In particular, the Board commented in Duke/NS that [i]n proposing ways to apply the phasing constraint, the parties should be mindful that any approach should tie the phasing constraint to the revenue needs of the defendant railroad. See Duke/NS at 40. The Board added, however, that the application of the phasing constraint nevertheless should provide some restraint to a railroads pricing even if the railroad falls far short of the Boards measure of revenue adequacy or has only a small base of potentially captive shippers to cover its revenue shortfall. Id.


The phasing issue has been deferred pending resolution of petitions for reconsideration of the stand-alone cost analysis. The manner in which the Board reconciles these competing interests will dictate the value of the phasing constraint to captive shippers.



Why So Much Technical Error?


Pleadings filed after the initial decisions revealed a large degree of technical error in the Eastern rate case decisions. The origin of the error is unclear, but invites consideration. Is the Boards staffing level insufficient? Have the cases become so complex that the agency no longer has the ability to apply its SAC standard to them? And if so, who is to blame? Did the shippers err by failing to account for sufficient complexity, or did the carriers present too much factual and analytical complexity for the staff to be able to follow? Or is it the case that both parties are to blame for inadequately documenting their evidentiary filings?


Whatever the explanation, it is now unquestionably the case that shippers and railroads must scrutinize the workpapers supporting any rate case decision in exacting detail.



East versus West


Since most decided and pending coal rate cases involve western unit train coal movements, there is considerable interest in what the Eastern cases may portend for western coal movements. Some of the Boards major rulings will likely apply with equal force and effect in western cases. For example, the indexing issues described above relating to the use of the RCAF(U) to project SARR operating costs and the use of a productivity-influenced measure to project SARR revenues will presumably, if not corrected on reconsideration, apply equally in western cases, although western shippers may also adopt other approaches for recognizing more limited productivity gains.


Other issues, such as the acceptance of railroad SARR operating plans that are less efficient and more expensive than the incumbent railroads operations, seem likely to be limited to the East. Western cases frequently involve traffic groups that consist entirely of unit train coal movements and entail less likelihood of the sorts of radically unrealistic and inefficient railroad-sponsored SARR operations that were accepted in the Eastern cases. Nonetheless, the Eastern cases will likely cause any deviation from existing operations, such as rerouting of crossover traffic, to be analyzed more closely.


Gaming may also be implicated in western cases, particularly as in TMPA the Board found that the maximum reasonable rate was governed by the stand-alone cost analysis and not the jurisdictional threshold.


[1] The author gratefully acknowledges the assistance of Andrew B. Kolesar III of Slover & Loftus in the preparation of this paper. The views expressed herein are solely those of the author and Mr. Kolesar and not of the firm of Slover & Loftus or any client.

[2] See Docket No. 42069, Duke Energy Corp. v. Norfolk Southern Ry. (STB served Nov. 6, 2003 and Feb. 3, 2004) (Duke/NS); Docket No. 42072, Carolina Power & Light Co. v. Norfolk Southern Ry. (STB served Dec. 23, 2003) (CP&L); Docket No. 42070, Duke Energy Corp. v. CSX Transp., Inc. (STB served Feb. 4, 2004) (Duke/CSXT).

[3] See Ex Parte No. 627, Market Dominance Determinations -- Product and Geographic Competition (STB served Dec. 21, 1998 and July 2, 1999), remanded by Association of American Railroads v. STB, 237 F.3d 676 (D.C. Cir. 2001), Ex Parte No. 627, Market Dominance Determinations -- Product and Geographic Competition (STB served April 6, 2001) (reaffirming on remand that the exclusion of product and geographic competition is consistent with the National Rail Transportation Policy), affd, Association of American Railroads v. STB, 306 F.3d 1108 (D.C. Cir. 2002).

[4] The Board s initial decisions in the two Duke cases found that the challenged rates had not been shown to exceed maximum reasonable levels and thus never reached the gaming issue.

[5] Significantly, railroad defendants can, and routinely do, contest in detail the traffic group that has been proposed by a shipper, and the Board routinely evaluates these challenges in detail. See, e.g., CP&L at 15-19; Docket No. 42056, Texas Municipal Power Agency v. The Burlington Northern and Santa Fe Ry. (STB served March 24, 2003) (TMPA) at 15-26; Docket No. 42022, FMC Wyoming Corp. v. Union Pacific R.R. (STB served May 12, 2000) at 31-35.

[6] The RCAF(U) is a price index that measures only changes in the prices of certain inputs to railroad service. In contrast, the RCAF(A) is a cost index that also reflects changes in the level of costs relative to changes in output. For example, the RCAF(A) reflects the impact of changes in both fuel prices and locomotive fuel efficiency, whereas the RCAF(U) considers only the former and ignores the latter.

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