Federal Register, Volume 84 Issue 193 (Friday, October 4, 2019)

[Federal Register Volume 84, Number 193 (Friday, October 4, 2019)]
[Proposed Rules]
[Pages 53094-53097]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-21590]

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SURFACE TRANSPORTATION BOARD

49 CFR Chapter X

[Docket No. EP 664 (Sub-No. 4)]

Revisions to the Board's Methodology for Determining the Railroad
Industry's Cost of Capital

AGENCY: Surface Transportation Board.

ACTION: Notice of Proposed Rulemaking.

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SUMMARY: The Board proposes to incorporate an additional model to
complement its use of the Morningstar/Ibbotson Multi-Stage Discounted
Cash Flow Model (MSDCF) and the Capital Asset Pricing Model (CAPM) in
determining the cost-of-equity component of the cost of capital.

DATES: Comments on the proposed rule are due by November 5, 2019. Reply
comments are due by December 4, 2019.

ADDRESSES: Comments and replies must be filed with the Board either via
e-filing or in writing addressed to: Surface Transportation Board,
Attn: Docket No. EP 664 (Sub-No. 4), 395 E Street SW, Washington, DC
20423-0001. Written comments and replies will be posted to the Board's
website at www.stb.gov.

FOR FURTHER INFORMATION CONTACT: Nathaniel Bawcombe at (202) 245-0376.
Assistance for the hearing impaired is available through the Federal
Relay Service at (800) 877-8339.

SUPPLEMENTARY INFORMATION: Each year, the Board determines the railroad
industry's cost of capital and then uses this figure in a variety of
regulatory proceedings, including the annual determination of railroad
revenue adequacy, rate reasonableness cases, feeder line applications,
rail line abandonments, trackage rights cases, and rail merger reviews.
The annual cost-of-capital figure is also used as an input in the
Uniform Railroad Costing System, the Board's general purpose costing
system.
The Board calculates the cost of capital as the weighted average of
the cost of debt and the cost of equity. See Methodology to be Employed
in Determining the R.R. Indus.'s Cost of Capital, EP 664, slip op. at 3
(STB served Jan. 17, 2008). While the cost of debt is observable and
readily available, the cost of equity (the expected return that equity
investors require) can only be estimated.\1\ Id. Thus, ``estimating the
cost of equity requires relying on appropriate finance models.'' Pet.
of the W. Coal Traffic League to Inst. a Rulemaking Proceeding to
Abolish the Use of the Multi-Stage Discounted Cash Flow Model in
Determining the R.R. Indus.'s Cost of Equity Capital, EP 664 (Sub-No.
2), slip op. at 2 (STB served Oct. 31, 2016).
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\1\ The Board must make ``an adequate and continuing effort to
assist those carriers in attaining revenue levels,'' which should,
among other objectives, ``permit the raising of needed equity
capital.'' 49 U.S.C. 10704(a)(2).
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In 2009, the Board moved from a cost-of-equity estimate based
solely on CAPM to a cost-of-equity estimate based on a simple average
of the estimates produced by CAPM and Morningstar/Ibbotson MSDCF. See
Use of a Multi-Stage Discounted Cash Flow Model in Determining the R.R.
Indus.'s Cost of Capital, EP 664 (Sub-No. 1), slip op. at 15 (STB
served Jan. 28, 2009). In that decision, the Board cited to the Federal
Reserve Board's testimony in Methodology to be Employed in Determining
the Railroad Industry's Cost of Capital, Docket No. EP 664, which
stated that the use of multiple models ``will improve estimation
techniques when each model provides new information.'' Use of a Multi-
Stage Discounted Cash Flow Model, EP 664 (Sub-No. 1), slip op. at 15.
Furthermore, the Board stated that ``there is robust economic
literature confirming that, in many cases, combining forecasts from
different models is more accurate than relying on a single model.'' \2\
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\2\ Use of a Multi-Stage Discounted Cash Flow Model, EP 664
(Sub-No. 1), slip op. at 15 (citing David F. Hendry & Michael P.
Clements, Pooling of Forecasts, VII Econometrics Journal 1 (2004);
J.M. Bates & C.W.J. Granger, The Combination of Forecasts in Essays
in Econometrics: Collected Papers of Clive W.J. Granger, Vol. I:
Spectral Analysis, Seasonality, Nonlinearity, Methodology, &
Forecasting 391-410 (Eric Ghysels, Norman R. Swanson, & Mark W.
Watson, eds., 2001); Spyros Makridakis & Robert L. Winkler, Averages
of Forecasts: Some Empirical Results, XXIX Management Science 987
(1983)).
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Under CAPM, the cost of equity is equal to RF + [beta]xRP, where RF
is the risk-free rate of interest,\3\ RP is the market-risk premium,
and [beta] (or beta) is the measure of systematic, non-diversifiable
risk. Under CAPM, the Board calculates the risk-free rate based on the
average yield to maturity for a 20-year U.S. Treasury Bond. The
estimate for the market-risk premium is based on returns experienced by
the S&P 500 since 1926. Lastly, beta is calculated by using a portfolio
of weekly, merger-adjusted railroad stock returns for the prior five
years.
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\3\ The risk-free rate of interest is an exogenously determined
interest rate at which investors may borrow or lend without fear of
default.
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Under Morningstar/Ibbotson MSDCF, the cost of equity is the
discount rate that equates a firm's market value to the present value
of the expected stream of cash flows. Morningstar/Ibbotson MSDCF
calculates growth of earnings in three stages. In the first stage
(years one

[[Page 53095]]

through five), the qualifying railroad's \4\ annual earnings growth
rate is assumed to be the median value of its three- to five-year
growth rate estimates, as determined by railroad industry analysts and
published by the Institutional Brokers Estimate System.\5\ In the
second stage (years six through 10), the growth rate is the simple
average of all of the qualifying railroads' median three- to five-year
growth rate estimates in stage one. In the third stage (years 11 and
onwards), the growth rate is the long-run nominal growth rate of the
U.S. economy. This long-run nominal growth rate is estimated by using
the historical growth in real Gross Domestic Product plus the long-run
expected inflation rate.
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\4\ The Board determines the railroad industry's cost of capital
for a ``composite railroad,'' which is based on data from Class I
carriers that meet certain criteria developed in Railroad Cost of
Capital--1984, 1 I.C.C.2d 989 (1985), as modified by Revisions to
the Cost-of-Capital Composite Railroad Criteria, EP 664 (Sub-No. 3)
(STB served Oct. 25, 2017).
\5\ This data can be retrieved from Refinitiv (formerly Thomson
ONE Investment Management). See Railroad Cost of Capital--2018, EP
558 (Sub-No. 22), slip op. at 9 (STB served Aug. 6, 2019).
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Proposed Rule

The Board proposes to add an additional model, which the Board will
refer to as ``Step MSDCF'' to the cost-of-capital calculation, as
described below.\6\ Consistent with the Board's present methodology, in
which CAPM and MSDCF approaches each comprise 50% of the cost-of-equity
estimate, the Board proposes to calculate the cost of capital by using
the weighted average of the three models, with CAPM weighted at 50%,
Morningstar/Ibbotson MSDCF weighted at 25%, and Step MSDCF weighted at
25%.
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\6\ Step MSDCF is similar to the model presented in Aswath
Damodaran, Investment Valuation: Tools & Techniques for Determining
the Value of Any Asset 317 (3d ed. 2012).
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As the Board has stated previously, there is no single simple or
correct way to estimate the cost of equity for the railroad industry,
and many model options are available. Use of a Multi-Stage Discounted
Cash Flow Model, EP 664 (Sub-No. 1), slip op. at 15; see also Pet. of
the W. Coal Traffic League, EP 664 (Sub-No. 2), slip op. at 2, 20 (STB
served Oct. 31, 2016). The Board has acknowledged that ``by using
multiple models that are based on different perspectives and rely on
different inputs, the Board benefits because anomalies affecting one
model are less likely to affect the other.'' Pet. of the W. Coal
Traffic League, EP 664 (Sub-No. 2), slip op. at 3 (STB served Apr. 28,
2017). The Board has previously determined that a methodology that uses
multiple models is more robust than a methodology that utilizes only
one model, not because one model is ``conceptually or pragmatically
superior to the other,'' but rather because each has different
strengths and weaknesses. Pet. of the W. Coal Traffic League, EP 664
(Sub-No. 2), slip op. at 11 (STB served Oct. 31, 2016). Accordingly,
the Board finds that its cost-of-capital determinations could be
strengthened by the addition of a new model to improve the robustness
of its calculations.
Since 2009, the Board has found that the simple average of CAPM and
Morningstar/Ibbotson MSDCF has produced a reasonable estimate of the
cost of equity used to gauge the financial health of the railroad
industry. Most recently, in Railroad Cost of Capital--2018, EP 558
(Sub-No. 22), slip op. at 2-3 (STB served Aug. 6, 2019), discussed in
more detail below, the Board once again affirmed this established
methodology as reasonable. However, in that decision, the Board also
noted that, when appropriate, the Board has undertaken an examination
of whether changes to its cost-of-capital methodology may be warranted,
and stated that it expected to open a proceeding to further explore
whether modifications to its cost-of-capital methodology may be
appropriate. Id. at 3.
In the proceeding to update the railroad industry's cost of capital
for 2018, the Board received comments from the Association of American
Railroads (AAR) providing the information used to make the annual cost-
of-capital determination. See generally AAR Comments, Apr. 22, 2019,
R.R. Cost of Capital--2018, EP 558 (Sub-No. 22). The supporting data
submitted with AAR's filing reflected a significant increase in growth
rates \7\ and the cost of capital. Specifically, the 2018 cost of
capital (12.22%) is 2.18 percentage points higher than the 2017 cost of
capital (10.04%). According to AAR, lower tax rates and rail operating
changes, among other factors, contributed to analysts' higher growth
expectations.\8\ At present, three of the four qualifying railroads
included in the Board's cost-of-capital calculations have implemented
some form of operating changes, which are generally referred to as
``precision scheduled railroading.'' \9\
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\7\ The second stage growth rate estimate produced by
Morningstar/Ibbotson MSDCF (i.e., the average of the qualifying
railroads' individual three- to five-year median growth rates)
produced a value of 19.88%, which is significantly higher than the
second stage growth rate value of 13.55% reflected in the 2017 cost-
of-capital decision. See R.R. Cost of Capital--2018, EP 558 (Sub-No.
22), slip op. at 17; R.R. Cost of Capital--2017, EP 558 (Sub-No.
21), slip op. at 18 (STB served Dec. 6, 2018). Likewise, CSX
Corporation's first stage growth rate rose significantly from 15.66%
in 2017 to 27.43% in 2018. See R.R. Cost of Capital--2018, EP 558
(Sub-No. 22), slip op. at 17; R.R. Cost of Capital--2017, EP 558
(Sub-No. 21), slip op. at 18.
\8\ See AAR Comments, V.S. John Gray 45-46, Apr. 22, 2019, R.R.
Cost of Capital--2018, EP 558 (Sub-No. 22) (``Based on train-miles
reported in Annual Report Form R-1, 2015 and 2016 were recession
years for the railroad industry, and train-miles have not yet
recovered to 2014 levels--even if unit trains (mostly coal) are
excluded. Thus, it is not surprising that analysts now have higher
growth expectations, especially when considering other factors such
as lower tax rates and the implementation of precision scheduled
railroading.'').
\9\ See Letter from E. Hunter Harrison, then-Chairman & Chief
Exec. Officer, CSX Corp., in response to August 14, 2017 letter from
Board Members, at 1, www.stb.gov (open ``Rail Service Data'' under
``Quick Links'' and select ``CSX Response, Service Outlook and
Milestones, August 24, 2017'' hyperlink); see also, U.S. Dept. of
Agric. Grain Transp. Report 2 (Dec. 20, 2018), http://dx.doi.org/10.9752/TS056.120-20-2018.
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Significant operating changes that occur over a relatively short
period of time can have a unique effect on the Board's annual cost-of-
capital determination, particularly if they are neither one-time events
\10\ nor expected to cause permanent changes in the industry's growth
rates. Once significant operating changes are fully implemented, any
rate of growth that accompanied the operating changes may not continue
to increase at the same level. Because the operating changes will, and
future railroad changes that are currently unknown could, have a
significant impact on the Board's cost-of-capital determination, the
Board finds that now is an appropriate time to consider the addition of
a model that could improve its methodology for estimating the cost-of-
equity component of the cost of capital.
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\10\ For example, significant operating changes like precision
scheduled railroading are not like the enactment of the Tax Cuts and
Jobs Act, Public Law 115-97, 131 Stat. 2054 (2017), which was a one-
time occurrence that merited a one-time adjustment to the cost of
capital. See R.R. Revenue Adequacy--2017 Determination, EP 552 (Sub-
No. 22) et al., slip op. at 1-3 (STB served Dec. 6, 2018).
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As described in more detail below, the Board finds that the
addition of Step MSDCF, when used in combination with the current
Morningstar/Ibbotson MSDCF and CAPM, could enhance the robustness of
the resulting cost-of-equity estimate during periods, like the present
one, in which certain railroads are undertaking significant operating
changes. Furthermore, consistent with the Board's previous finding,
supported by extensive economic literature, that averaging multiple
models--based on different perspectives, relying on different inputs,
and with different strengths and weaknesses--would produce estimates
that are more robust

[[Page 53096]]

when averaged together,\11\ the addition of Step MSDCF would improve
the cost-of-capital determination, including during periods of
significant operating changes.
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\11\ See Pet. of the W. Coal Traffic League, EP 664 (Sub-No. 2),
slip op. at 11 (STB served Oct. 31, 2016).
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Like Morningstar/Ibbotson MSDCF, Step MSDCF proposed here would
continue to calculate growth of earnings in three stages. The first and
third stages would be identical to those of Morningstar/Ibbotson MSDCF.
In the first stage (years one through five), the qualifying railroad's
annual earnings growth rate would be the median value of its three- to
five-year growth rate estimates and, in the third stage (years 11 and
onwards), the growth rate would be the long-run nominal growth rate of
the U.S. economy. The growth rate of the second stage (years six
through 10) would be a gradual transition between the first and third
stages. The transition would begin at year six and step down or up in
equal increments each year towards the terminal growth rate (or third
stage). The algebraic formula for Step MSDCF is described in full in
Appendix A.
The Board proposes to add Step MSDCF to its cost-of-capital
methodology based in part on input from commenters in prior
proceedings. Since the Board's adoption of its current hybrid
methodology in 2009, Western Coal Traffic League (WCTL) has opposed the
Board's use of Morningstar/Ibbotson MSDCF in its cost-of-equity
calculation. One of WCTL's primary criticisms has been that using the
average of all of the qualifying railroads' median growth rates in
stage one as the growth rate in stage two is unreasonable because
three- to five-year forecasts of earnings growth will not likely be
accurate for ten years. See Use of a Multi-Stage Discounted Cash Flow
Model, EP 664 (Sub-No. 1), slip op. at 8-9. Additionally, WCTL has
argued that Morningstar/Ibbotson MSDCF lacks a transition mechanism,
which prevents smooth transitions between stages. See Pet. of the W.
Coal Traffic League, EP 664 (Sub-No. 2), slip op. at 9 (STB served Oct.
31, 2016).
In affirming the reasonableness of Morningstar/Ibbotson MSDCF's
second-stage growth rate, the Board has noted that (1) the returns of
individual firms should revert to the industry average over time, (2)
it is not realistic to predict growth for individual companies beyond
five years, and (3) attempting to create smoother transitions between
the stages would add more complexity to the model but would not
guarantee more precision, in part, because the cost of equity cannot
ever be truly known. See Pet. of the W. Coal Traffic League, EP 664
(Sub-No. 2), slip op. at 13 (STB served Oct. 31, 2016). The Board
continues to believe that Morningstar/Ibbotson MSDCF is reasonable. At
the same time, there are other reasonable models based on different
perspectives, relying on different inputs, and with different strengths
and weaknesses. Forecasting growth rates in years six through 10 is
inherently imprecise, and it is not possible to predict whether one
model will better reflect future events, particularly when those events
must be judged over decades of differing market characteristics. The
Board's proposal to incorporate another model to improve the robustness
of its overall cost-of-equity estimate implies neither that the Board
expects to achieve perfect precision across models nor that the Board's
existing models are inadequate. The Board finds it is reasonable to
continue to rely on Morningstar/Ibbotson MSDCF as one aspect of its
cost-of-capital methodology.
Even so, the Board recognizes that the significant operating
changes undertaken by certain individual railroads have given those
railroads a significant increase in growth rates that flows through to
the second stage of Morningstar/Ibbotson MSDCF, and it is always
possible that future railroad changes could have a similar effect.
Specifically, because the second-stage growth rate in Morningstar/
Ibbotson MSDCF uses the simple average of all qualifying railroads'
three- to five-year median growth rate estimates from the first stage,
the growth rates in the middle horizon (years six through 10) will be
similar to the averages of growth rates in the short term (three- to
five-year estimates). By drawing upon the three- to five-year growth
rate estimates twice, Morningstar/Ibbotson MSDCF is more sensitive to
growth rate changes in the short term, which may involve anomalous
increases or decreases, relative to a model with a gradual transition
between the first and third stages. While reasonable, Morningstar/
Ibbotson MSDCF may not capture information relevant to the middle
horizon in the same way as other models.\12\ Therefore, the Board's
cost-of-equity estimate could yet be made more robust by adding a
model, like Step MSDCF, that reflects a different perspective for the
middle horizon.\13\
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\12\ The Board has repeatedly rejected WCTL's argument that
Morningstar/Ibbotson MSDCF should be abandoned due to what WCTL
argues is its flawed second-stage growth rate, but the Board has not
previously considered how a MSDCF variation with a different second-
stage growth rate could supplement Morningstar/Ibbotson MSDCF. The
Board proposes that Step MSDCF could be useful as a supplement,
rather than a replacement, for Morningstar/Ibbotson MSDCF because,
while Step MSDCF adds a different perspective with respect to growth
rates, Step MSDCF may not necessarily be more reasonable than
Morningstar/Ibbotson MSDCF in certain periods or over the long term.
\13\ In comments submitted for the 2018 cost-of-capital
proceeding, AAR stated that Morningstar/Ibbotson MSDCF ``assumes
`that over a middle horizon, growth of any particular company will
lie more in line with the industry as a whole,'' which means that
``other companies `catch' their industry growth leaders, or the
leaders fall back to the rate of the slower growth railroads.''
Accordingly, AAR argued that ``[a]ny attempt to change the second
stage to a transition stage is corrupting the intent of the model.''
AAR Comments, V.S. John Gray 45, Apr. 22, 2019, R.R. Cost of
Capital--2018, EP 558 (Sub-No. 22). The Board does not propose to
modify Morningstar/Ibbotson MSDCF in this decision. Instead, the
Board proposes to add a new model that relies on different
assumptions to be used alongside Morningstar/Ibbotson MSDCF. This
approach allows the Board to introduce a model that will have a
moderating influence on Morningstar/Ibbotson MSDCF while also
maintaining the integrity of Morningstar/Ibbotson MSDCF.
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The Board proposes to retain the same CAPM that it has used to
calculate the cost of capital since 2008. See Methodology to be
Employed in Determining the R.R. Indus.'s Cost of Capital, EP 664, slip
op. at 2. The Board's current methods for determining the railroad
industry's beta and estimating market-risk premium are reasonable.
Furthermore, recent operating changes have not demonstrated similar
issues in the cost-of-equity estimates produced by CAPM as they have
for Morningstar/Ibbotson MSDCF. Accordingly, the Board proposes that to
reduce the impact of short-term operating changes on the cost of
capital, it is not necessary for the Board to modify CAPM.
CAPM, generally, is a backward-looking model while MSDCF is more
forward-looking, each looking at different market data. R.R. Cost of
Capital--2018, EP 558 (Sub-No. 22), slip op. at 3. To maintain an equal
balance between forward-looking and backward-looking models, the Board
proposes to use a weighted average of the three models in its cost-of-
equity calculation, with CAPM weighted at 50%, Morningstar/Ibbotson
MSDCF weighted at 25%, and Step MSDCF weighted at 25%. Furthermore,
because the Board has not found that MSDCF is superior to CAPM, or vice
versa, it is reasonable to use a weighted average of the three models
that allows both model types to continue to contribute equally to the
cost of equity.
When applied over a 10-year historical analysis period, the
weighted average of the three models results in a lower variance than a
forecast relying on

[[Page 53097]]

the average of CAPM and Morningstar/Ibbotson MSDCF alone. For the
period 2009 through 2018, the average of CAPM and Morningstar/Ibbotson
MSDCF produces a cost of equity ranging from 10.31% to 13.86% with a
standard deviation of 1.18. Over the same period, the weighted average
of the three models produces estimates between 10.25% and 13.46% with a
standard deviation of 1.09. See Appendix B.
Adding Step MSDCF to the Board's current methodology for
calculating the cost of capital is consistent with the Rail
Transportation Policy. 49 U.S.C. 10101. For instance, having a
methodology that more robustly estimates the cost-of-equity component
of the cost of capital would better ensure that rail carriers are
allowed to earn adequate revenues. Section 10101(3); see also Standards
for R.R. Revenue Adequacy, 364 I.C.C. 803, 811 (1981), aff'd sub nom.
Bessemer & Lake Erie R.R. v. ICC, 691 F.2d 1104 (3d Cir. 1982)
(concluding that ``the only revenue adequacy standard consistent with
the requirements of [The Staggers Rail Act of 1980] is one that uses a
rate of return equal to the cost of capital''). As noted, Morningstar/
Ibbotson MSDCF is more sensitive to growth rate changes in the short
term relative to Step MSDCF, and Step MSDCF may be better suited for
some periods, or even over the long run.
Interested parties are invited to comment on the proposed use of
Step MSDCF described above in conjunction with CAPM and Morningstar/
Ibbotson MSDCF currently used by the Board. Parties are encouraged to
address issues such as the most appropriate way to integrate the three
models into the cost-of-capital calculation, including the particular
weighting that each model should have.

Regulatory Flexibility Act

The Regulatory Flexibility Act of 1980 (RFA), 5 U.S.C. 601-612,
generally requires a description and analysis of new rules that would
have a significant economic impact on a substantial number of small
entities. In drafting a rule, an agency is required to: (1) Assess the
effect that its regulation will have on small entities, (2) analyze
effective alternatives that may minimize a regulation's impact, and (3)
make the analysis available for public comment. Sections 601-604. In
its notice of proposed rulemaking, the agency must either include an
initial regulatory flexibility analysis, section 603(a), or certify
that the proposed rule would not have a ``significant impact on a
substantial number of small entities,'' section 605(b). Because the
goal of the RFA is to reduce the cost to small entities of complying
with federal regulations, the RFA requires an agency to perform a
regulatory flexibility analysis of small entity impacts only when a
rule directly regulates those entities. In other words, the impact must
be a direct impact on small entities ``whose conduct is circumscribed
or mandated'' by the proposed rule. White Eagle Coop. v. Conner, 553
F.3d 467, 480 (7th Cir. 2009).
The Board certifies under 5 U.S.C. 605(b) that this rule would not
have a significant economic impact on a substantial number of small
entities as defined by the RFA. Cost of capital is calculated for those
Class I carriers that meet certain criteria developed in Railroad Cost
of Capital--1984, 1 I.C.C.2d 989 (1985), and modified in Revisions to
the Cost-of-Capital Composite Railroad Criteria, EP 664 (Sub-No. 3)
(STB served Oct. 25, 2017). Therefore, the Board's proposed methodology
will apply only to Class I rail carriers, and there will be no impact
on small railroads. A copy of this decision will be served upon the
Chief Counsel for Advocacy, Office of Advocacy, U.S. Small Business
Administration, Washington, DC 20416.
Additional information supporting the Board's revised proposal is
contained in the Board's decision (including appendices) served on
August 4, 2016. To obtain a copy of this decision, visit the Board's
website at http://www.stb.gov.
It is ordered:
1. The Board proposes to revise its methodology for determining the
railroad industry's cost of capital as set forth in this decision.
Notice of this decision will be published in the Federal Register.
2. Comments are due by November 5, 2019. Reply comments are due by
December 4, 2019.
3. A copy of this decision will be served upon the Chief Counsel
for Advocacy, Office of Advocacy, U.S. Small Business Administration.
4. This decision is effective on its service date.

By the Board, Board Members Begeman, Fuchs, and Oberman.
Jeffrey Herzig,
Clearance Clerk.
[FR Doc. 2019-21590 Filed 10-3-19; 8:45 am]
BILLING CODE 4915-01-P