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Is There an Answer to the Railroad Mess?

Jan. 4, 2023
The threatened rail strike appears to have awakened policymakers.

COMMENTARY

After confronting the near disaster of a nationwide railroad strike, policymakers appear to have realized that the time has come to actually do something about the disastrous state of America’s freight railroads. But that raises the inevitable question of what realistically can be done to fix a system that has periodically descended into chaos since Congress passed rail deregulation in 1980.

Thus far, the Surface Transportation Board (STB), successor to the old Interstate Commerce Commission, has yet to make any serious headway at dealing with the latest service crisis that began in 2017. However, on Dec. 19, 2022, it gave shippers an early Christmas present by announcing rules embracing ratemaking and dispute resolution reforms that shippers had sought for years.

“The two rules attempt to strike a balance between the competing interests of various stakeholders,” stated STB chairman Martin J. Oberman. “I am confident that either program will provide shippers with access to more meaningful rate relief than was previously available to them.”

Kimberly Wise White, vice president of Regulatory and Scientific Affairs for the American Chemistry Council (ACC), was laudatory. “These new procedures are an important move in the right direction that will provide the STB, railroads and shippers with a speedier option for resolving small rate cases in the absence of effective market competition,” she said.

According to the ACC, by being able to challenge the rates railroads charge shippers and making it easier to do so, the new rule will reduce the time and costs involved. Under the current system, the cost to do so ranges between $4 million and $5 million and the process can take five years on average, which makes it useless for shippers in need of quick resolution of these rate issues.

If all goes according to plan, the rules are scheduled to go into effect in 2023. However, the Association of American Railroads earlier registered its unhappiness with the proposed changes and strongly hinted that the Class 1 railroads may choose to challenge them in court, asserting that the proposed imposition exceeds the board’s legal authority.

However welcome these changes may be to shippers, in the end they won’t do anything to help make the trains run on time. Regular readers of MH&L—and especially rail shippers—are well aware of the depths of the service crisis that arose over the past five years because of a severe cost-cutting operations model embraced by most of the Class 1 railroads called Precision Scheduled Railroading (PSR).

Costs that have been slashed over the last half decade include firing large numbers of employees who were essential for operating the railroads, as well as those who dealt directly with customers. Other actions that damaged service involved the extensive mothballing of rail equipment and closing of railyards.

Cult of the Operating Ratio

Not only did management gut the workforce before COVID-19, they laid off even more workers after the pandemic started. Even when freight demand and traffic picked up in December 2020, before the end of the pandemic’s first year, the railroads chose not to rehire staff, resulting in a larger work burden for those who remained, and further reductions in service.

All of this arose from a theory some have called “the cult of the operating ratio” (OR), which was central to the PSR concept. The theory, concocted by former CSX head E. Hunter Harrison, holds that by lowering a railroad’s operating ratio, you create greater value for shareholders. The idea is that slashing costs in the short term also will boost dividends and increase stock value in the short term.

If you don’t work in trucking or the railroads you might not have heard of an OR, which most other businesses in competitive markets find too simplistic for assessing shareholder value. It is calculated by dividing a company’s total operating costs by its net sales—if a railroad generates $100 in revenue while it spends $65 on costs, its OR is 65. The theory is that the lower the OR the more profitable is the operation. It ignores, for example, the cost of debt and long-term capital investment needs

The OR is a crude measurement that only made sense to pay attention to in the heavily regulated environment prior to 1980, where participants are expected to charge the same rates for the same services.

Harrison—and the Wall Street hedge fund managers who exploited his idea—sold investors on the idea that by screwing costs down and improving the OR, a rail company’s stock should be worth more. Of course, this also means backing off capital spending wherever possible, and avoiding investing in future business development where the only opportunities for growth exist but require a higher OR, such as growing intermodal operations where the profit margin is lower but is the only area where today’s railroads can grow their business.

After Congress took action in early December to end the threat of the rail strike at President Biden’s request, the major rail unions petitioned the President to take further action by issuing an executive order compelling the railroads to institute the kind of changes to their sick leave policy the workers had demanded when they threatened to strike.

The addition of sick days was believed to be necessary by union members precisely because of leave restrictions imposed by the railroads who found themselves short-handed precisely because of the massive layoffs they imposed in their pursuit of lower ORs through application of PSR.

At this point, it is not clear whether President Biden would be inclined to issue the executive order sought by the unions, or if issued, whether it would stand up to court review. (Railroad labor law is unique in its scope and complexity, differing from other federal labor standards.)

Searching for Answers

Earlier in 2022, separate bills also were introduced in the House and Senate designed to strengthen the STB’s role in regulating the railroads and imposing service standards, but they were backed by only a handful of Democratic Representatives and Senators, lacking bipartisan support. No hearings were held on either bill, and to be considered again the measures would need to be re-introduced in the new Congress that begins this week.

During the legislative tussle over the rail labor collective bargaining agreement that Congress eventually passed, several Republican Senators took a stand supportive of granting the union members the sick leave terms they had sought. However, it is not known how they will react to these other proposals if they are reintroduced now that the Republicans control the House.

In addition, it isn’t clear at this point whether simply strengthening the STB’s hand will help shippers by improving rail service. Last year both the board and Congress held hearings where shippers testified to many of the same horror stories they had been complaining about for years, along with some new ones. In reaction, the board then issued orders requiring the railroads to improve their service, train and add new staff, and report on a weekly basis about their progress.

They failed to do so in a manner deemed acceptable and the STB threatened them with fines. The problem is that the level of the fines the board can impose under law at this time are too small to create any real incentive for the multi-billion dollar railroads to comply. In mid-December, the STB held another two days of hearings where shipper witnesses vividly described persisting service failures. A specific target was Union Pacific and its practice of calling service embargoes, previously called only to deal with rare instances of excessive congestion on their lines.

The board expressed outrage over the fact that while UP called only five embargos in 2017, in 2022 it imposed more than 1,000 by early December.

Solutions supported by shippers include establishing permanent reporting requirements that would reveal how well major railroads are delivering service to their customers. Also sought are minimum standards for the delivery of efficient, timely and reliable rail service, and issuance of the long-overdue rules for allowing reciprocal switching.

Those of you who have been following my coverage of this issue may be aware of my suggestion of adopting a public utilities commission approach to rail regulation. When that was roundly ignored, I also suggested that policymakers could look towards changing the fiduciary duty of rail corporate leadership away from a total focus on maximizing shareholder financial returns to include the duty for making sure that railroads adhere to their common carrier obligation.

The Department of Labor recently said those responsible for investing pension plan money could apply ESG (environment, social and governance) principles to their investment decision-making rather than confining their investment decisions solely to assessments of financial returns. If plan investors can include environmental concerns, why not let them include the common carrier obligation for railroads?

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