[Federal Register Volume 85, Number 126 (Tuesday, June 30, 2020)]
[Proposed Rules]
[Pages 39154-39157]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-14061]


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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; withdrawal.

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DATES: The Board is withdrawing the document published on October 4, 
2019 (84 FR 53094), as corrected on October 18, 2019 (84 FR 55897), as 
of June 30, 2020.

ADDRESSES: The docket for this withdrawn rulemaking is available at 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: On September 30, 2019, as corrected October 
11, 2019, the Board issued a

[[Page 39155]]

notice of proposed rulemaking seeking public comment on its proposal to 
change its existing methodology for determining the railroad industry's 
cost of capital. Revisions to the Board's Methodology for Determining 
the R.R. Indus.'s Cost of Capital (NPRM), EP 664 (Sub-No. 4) (STB 
served Sept. 30, 2019), corrected (STB served Oct. 11, 2019).\1\ 
Specifically, the Board proposed incorporating an additional model, 
referred to as the ``Step Multi-Stage Discounted Cash Flow Model'' 
(Step MSDCF), to complement its use of Morningstar/Ibbotson Multi-Stage 
Discounted Cash Flow Model (Morningstar/Ibbotson MSDCF) and Capital 
Asset Pricing Model (CAPM) in determining the cost-of-equity component 
of the cost of capital. Based upon the comments and replies received in 
response to the NPRM, the Board will withdraw its proposal and 
discontinue this proceeding.
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    \1\ References to the NPRM in this decision refer to the 
corrected decision. The NPRM was published in the Federal Register 
on October 18, 2019 (84 FR 55,897). On November 22, 2019, the Board 
served a clarifying decision with a revised Appendix A detailing the 
algebraic formula for its proposal.
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Background

    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.\2\ Id. Thus, estimating the 
cost of equity requires relying on appropriate finance models. Id.
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    \2\ The Board must make ``an adequate and continuing effort to 
assist . . . 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 began to calculate the cost of equity 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). Since that time, the Board has 
consistently 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. See, e.g., 
R.R. Cost of Capital--2018, EP 558 (Sub-No. 22) (STB served Sept. 30, 
2019); R.R. Cost of Capital--2017, EP 558 (Sub-No. 21) (STB served Dec. 
6, 2018).
    Under CAPM, the cost of equity is equal to RF + [beta] x RP, where 
RF is the risk-free rate of interest,\3\ RP is the market-risk 
premium,\4\ 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, the industry beta is 
calculated by using a portfolio of weekly, merger-adjusted railroad 
stock returns for the previous 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.
    \4\ The market-risk premium is the predicted additional return 
from investing in the market (in this case, the S&P 500) instead of 
risk-free investments over the long term. It is calculated by 
subtracting the risk-free rate from that market return.
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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 through five), the qualifying railroad's \5\ 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.\6\ 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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    \5\ 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).
    \6\ This data can be retrieved from Refinitiv (formerly Thomson 
ONE Investment Management). See R.R. Cost of Capital--2018, EP 558 
(Sub-No. 22), slip op. at 10.
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    Most recently, in September 2019, the Board used the simple average 
of CAPM and Morningstar/Ibbotson MSDCF to calculate the cost of capital 
in Railroad Cost of Capital--2018, Docket No. EP 558 (Sub-No. 22). In 
that proceeding, comments and supporting data from the Association of 
American Railroads (AAR) showed a large increase in growth rates \7\ 
and the cost of capital over the prior year's figures.\8\ See generally 
AAR Comments, Apr. 22, 2019, R.R. Cost of Capital--2018, EP 558 (Sub-
No. 22). According to AAR, lower tax rates and rail operating changes, 
including precision scheduled railroading, among other factors, 
contributed to analysts' higher growth expectations in 2018. See id. at 
V.S. Gray 45-46. In Railroad Cost of Capital--2018, EP 558 (Sub-No. 
22), slip op. at 3, the Board explained that the validity of its 
existing methodology was not undermined simply because the cost of 
capital turned out to be higher than expected. However, the high cost 
of capital combined with the major operating changes within the rail 
industry did prompt the Board to explore whether its methodology could 
be improved with an additional model to capture different information. 
In particular, the Board considered changes related to growth rates in 
the second stage or middle horizon (years six through 10) of 
Morningstar/Ibbotson MSDCF, leading to the NPRM in this docket.
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    \7\ For example, the second stage growth rate estimate produced 
by Morningstar/Ibbotson MSDCF produced a value of 19.88%, as 
compared with the second stage growth rate value of 13.55% reflected 
in the 2017 cost of capital. Compare R.R. Cost of Capital--2018, EP 
558 (Sub-No. 22), slip op. at 17, with R.R. Cost of Capital--2017, 
EP 558 (Sub-No. 21), slip op. at 18.
    \8\ The 2018 cost of capital (12.22%) was 2.18 percentage points 
higher than the 2017 cost of capital (10.04%).
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    As proposed in the NPRM, Step MSDCF would calculate growth of 
earnings in three stages. The first and third stages would be identical 
to those of Morningstar/Ibbotson MSDCF. Unlike Morningstar/Ibbotson 
MSDCF, however, 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). 
See NPRM, EP 664 (Sub-No. 4), slip op. at 5, 10-11. Furthermore, the 
NPRM proposed to calculate the cost of capital pursuant to the weighted 
average of the

[[Page 39156]]

three models, with CAPM weighted at 50%, Morningstar/Ibbotson MSDCF 
weighted at 25%, and Step MSDCF weighted at 25%. Id. at 3.
    In response to the NPRM, the Board received comments and replies 
from AAR and Western Coal Traffic League (WCTL), as well as comments 
from Roger J. Grabowski, Managing Director of Duff & Phelps. AAR's 
primary argument is that incorporation of Step MSDCF is unwarranted 
because the 2018 cost-of-capital figure was a ``data anomaly'' caused 
by an unusual combination of market factors that affected the inputs 
used in Morningstar/Ibbotson MSDCF. (AAR Comments 1-2.) According to 
AAR, Step MSDCF would neither remedy what caused the 2018 anomaly in 
the first place nor prevent future anomalies of the same kind. (Id. at 
3.) AAR also identifies problems in Step MSDCF that it argues would 
need to be corrected before the Board could adopt it. (Id. at 23-25.) 
As an alternative to Step MSDCF, AAR encourages the Board to move the 
observation date (the date upon which the data for the cost of capital 
is drawn) from the last Friday in December to the last Friday in 
January to prevent a future anomaly ``should that rare event reoccur.'' 
(Id. at 3.) WCTL also opposes the Board's Step MSDCF proposal, although 
for different reasons. WCTL states that Step MSDCF represents, at best, 
a modest improvement to the Board's cost-of-capital methodology and 
argues instead that both Step MSDCF and Morningstar/Ibbotson MSDCF 
should be eliminated from the Board's cost-of-capital methodology 
completely. (WCTL Comments 2, 19-20.) According to WCTL, the Board 
should reconfigure its cost-of-capital methodology to rely on CAPM 
alone, with some additional modifications. (Id. at 5-8.) Dr. Grabowski 
suggests that the third-stage growth rate of MSDCF may be incorrectly 
estimating the railroads' cost of equity and proposes a modification to 
it. (Grabowski Comments 1, 4.)

Discussion

    Although the Board found that its current cost-of-capital 
methodology remained reasonable, the Board proposed including Step 
MSDCF in its cost-of-equity calculation in an attempt to improve its 
methodology in light of the 2018 cost of capital and recent operating 
changes within the rail industry. However, the comments in response to 
the NPRM indicate that adding Step MSDCF may not be a necessary change 
to the Board's cost-of-capital methodology at this time. AAR 
persuasively argues that the 2018 cost-of-capital figure was an anomaly 
caused by a mismatch between declining stock prices and lagging growth 
rate estimates in December, that the Board's approach does not 
effectively address the anomaly, and that Step MSDCF has technical 
issues. (See AAR Comments 8-13, 20-22, V.S. Villadsen 5-15.) Although 
WCTL criticizes aspects of AAR's analysis, (WCTL Reply 3-5), it does 
not dispute AAR's demonstration of the cause of the anomaly. AAR and 
WCTL agree that adding Step MSDCF to the Board's cost-of-capital 
methodology would provide little to no meaningful benefit. (See AAR 
Comments 29; WCTL Reply 2.) Given this record, the Board will withdraw 
its proposal to add Step MSDCF to its cost-of-equity calculation.
    The Board will not pursue AAR's suggestion that, in lieu of the 
proposal, the Board permanently move the observation date for stock 
price and growth rate inputs from the end of December to the end of the 
following January. (See AAR Comments 26.) The events that occurred in 
2018 are by AAR's own account ``unusual,'' (AAR Comments 3), and using 
a January date raises other issues, such as whether a January data 
point includes information not available at the end of the prior year. 
See Railroad Cost of Capital--2008, EP 558 (Sub-No. 12), slip op. at 9 
(STB served Sept. 25, 2009).\9\
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    \9\ As WCTL points out, in Railroad Cost of Capital--2008, EP 
558 (Sub-No. 12), slip op. at 10, the Board rejected AAR's similar 
proposal to use March 31, 2009 data, in favor of WCTL's data that 
was drawn from the end of the year. (WCTL Reply 5.)
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    The Board also declines to adopt WCTL's alternative proposals. The 
Board has explicitly rejected some, such as WCTL's requests to either 
move to a CAPM-only approach or to change the Morningstar/Ibbotson 
MSDCF regarding cashflows and growth rates, (WCTL Comments 2), in prior 
decisions.\10\ WCTL's other suggestion, that Morningstar/Ibbotson 
MSDCF's ``variability'' is a reason to abandon it, (WCTL Comments 16-
17), has been implicitly rejected in the Board's decisions finding that 
Morningstar/Ibbotson MSDCF and CAPM each have their own strengths and 
weaknesses that, when averaged together, lead to a more robust 
result.\11\ And all of WCTL's arguments, including that the Board 
should address the generally accepted accounting principles treatment 
of operating leases as debt for purposes of the cost of capital, (WCTL 
Comments 29-30),\12\ go beyond the scope of this proceeding exploring 
whether the Board's methodology could be improved with an additional 
model to capture different information, addressing the types of results 
that occurred in 2018.\13\
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    \10\ 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 1-2 (STB served Sept. 28, 2018); 
Pet. of the W. Coal Traffic League, EP 664 (Sub-No. 2), slip op. at 
2 (STB served Aug. 14, 2017); Pet. of the W. Coal Traffic League, EP 
664 (Sub-No. 2), slip op. at 2, 5, 9, 11-13 (STB served Apr. 28, 
2017); Pet. of the W. Coal Traffic League, EP 664 (Sub-No. 2), slip 
op. at 11, 14, 17-18, 20 (STB served Oct. 31, 2016); Use of a Multi-
Stage Discounted Cash Flow Model, EP 664 (Sub-No. 1), slip op. at 
12-13.
    \11\ See Pet. of the W. Coal Traffic League, EP 664 (Sub-No. 2), 
slip op. at 11 (STB served Oct. 31, 2016).
    \12\ WCTL raised this argument previously in Railroad Cost of 
Capital--2015, EP 558 (Sub-No. 19), slip op. at 4-5 (STB served Aug. 
5, 2016), and the Board declined to adopt it.
    \13\ Dr. Grabowski's suggestion that the third-stage growth rate 
of Morningstar/Ibbotson MSDCF may incorrectly estimate the 
railroads' cost of equity, and his proposed new approach to 
estimating the long-run nominal growth rate, (Grabowski Comments 1, 
4), is similarly beyond the scope of the question raised in this 
proceeding.
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Conclusion

    For the reasons discussed above, the Board will withdraw its 
proposal to incorporate Step MSDCF into its methodology for determining 
the railroad industry's cost of capital and discontinue this 
proceeding.
    It is ordered:
    1. The Board's proposal to modify its existing cost-of-capital 
methodology by incorporating Step MSDCF is withdrawn. This proceeding 
is discontinued.
    2. Notice of the Board's action will be published in the Federal 
Register.
    3. This decision is effective on the date of service.
    Decided: June 23, 2020.
    By the Board, Board Members Begeman, Fuchs, and Oberman. Board 
Member Oberman commented with a separate expression.

Board Member Oberman, commenting:
    While I concur in the Board's decision for the reasons stated 
therein, I write separately to emphasize my conviction that the Board 
should continue to closely scrutinize the extent to which equity 
markets are incentivizing railroads to reduce operating ratios and 
whether and how such efforts might result in changes to the Board's 
cost-of-capital figure.
    It must be emphasized that the annual cost-of-capital determination 
directly impacts important aspects of the Board's oversight duties. For 
example, the Board uses its cost-of-capital determination in a variety 
of regulatory proceedings, including railroad revenue adequacy 
determinations, feeder-line applications, rail line abandonments, 
trackage rights cases, and rail merger reviews. The

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annual cost-of-capital figure is also an input into the Uniform 
Railroad Costing System and therefore has a direct bearing on rate 
reasonableness cases.
    Equity markets' incentivizing railroads to lower operating ratios 
could translate into increases in the cost-of-capital figure. My 
concern is that, as a result, a railroad might be found to be revenue 
inadequate even when, in reality, it is financially healthy. Likewise, 
a higher cost-of-capital figure can affect whether a particular 
commodity shipment is above or below the 180% R/VC threshold and is 
therefore eligible for rate review by the Board.
    Separately and in addition to the above matters, the need for 
continued scrutiny arises from my increasing concern that there is a 
point beyond which the demands of equity markets for a return of 
capital may impact the ability of the railroads to meet their common 
carrier obligations and may deprive the network of the capital it 
requires to support the needs of the public and the national defense.
    Finally, given that the United States and the entire world are 
presently facing health and economic crises, and that these crises have 
adversely affected the railroad industry along with the other parts of 
the economy, I recognize that my above stated concerns are not as 
immediate as they might otherwise be. Nevertheless, as the economy 
recovers and the railroad industry regains its full strength, the 
concerns outlined above may well reoccur and warrant the continued 
scrutiny I have urged.

Jeffrey Herzig,
Clearance Clerk.
[FR Doc. 2020-14061 Filed 6-29-20; 8:45 am]
BILLING CODE 4915-01-P