Freight Railroads: Updated Information on Rates and Competition  
Issues (25-SEP-07, GAO-07-1245T).				 
                                                                 
The Staggers Rail Act of 1980 largely deregulated the freight	 
railroad industry, giving the railroads freedom to price their	 
services according to market conditions and encouraging greater  
reliance on competition to set rates. The act recognized the need
for railroads to recover costs by setting higher rates for	 
shippers with fewer transportation alternatives. The act also	 
recognized that some shippers might not have access to		 
competitive alternatives and might be subject to unreasonably	 
high rates. It established a threshold for rate relief and	 
granted the Interstate Commerce Commission and the Surface	 
Transportation Board (STB) the authority to develop a rate relief
process for those "captive" shippers. GAO's reported on rates,	 
competition, and other industry trends in reports issued in	 
October 2006 and August 2007. This statement is based on those	 
reports and discusses (1) the changes that have occurred in the  
railroad industry since the enactment of the Staggers Rail Act,  
including changes in rail rates since 1985, (2) the extent of	 
captivity in the industry and STB's efforts to protect captive	 
shippers, and (3) STB's actions to address GAO's recent 	 
recommendations.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-07-1245T					        
    ACCNO:   A76688						        
  TITLE:     Freight Railroads: Updated Information on Rates and      
Competition Issues						 
     DATE:   09/25/2007 
  SUBJECT:   Competition					 
	     Cost analysis					 
	     Economic analysis					 
	     Federal regulations				 
	     Financial analysis 				 
	     Freight transportation				 
	     Freight transportation rates			 
	     Prices and pricing 				 
	     Railroad industry					 
	     Railroad regulation				 
	     Shipping industry					 
	     Strategic planning 				 
	     Transportation planning				 
	     Transportation policies				 
	     Transportation rates				 
	     Cost awareness					 

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GAO-07-1245T

   

     * [1]In summary:
     * [2]Background
     * [3]Railroad Industry Is Increasingly Healthy and Rail Rates Hav

          * [4]Railroad Industry's Financial Health Has Improved Substantia
          * [5]Industry Rates Have Generally Declined Since 1985
          * [6]While Generally Declining over the Long Term, Rates for Seve
          * [7]Railroads Have Shifted Costs to Shippers
          * [8]Reported Miscellaneous Revenue, Including Fuel Surcharges, I

     * [9]Captive Shippers Are Difficult to Identify But Concerns Rema

          * [10]Captive Shippers Remain Difficult to Identify, but Some Meas
          * [11]STB Has Taken Actions to Protect Captive Shippers but Effort
          * [12]Shipper Groups and Others Have Suggested Alternative Approac

     * [13]STB Has Taken Steps to Address Problems, but Actions Are Too
     * [14]Contact and Acknowledgements
     * [15]Related GAO Products

          * [16]Order by Mail or Phone

     * [17]PDF6-Ordering Information.pdf

          * [18]Order by Mail or Phone

Testimony

Before the Committee on Transportation and Infrastructure, House of
Representatives

United States Government Accountability Office

GAO

For Release on Delivery
Expected at 10:00 a.m. EDT
Tuesday, September 25, 2007

FREIGHT RAILROADS

Updated Information on Rates and Competition Issues

Statement of JayEtta Z. Hecker, Director
Physical Infrastructure Issues

GAO-07-1245T

Mr. Chairman and Members of the Committee:

We appreciate the opportunity to testify on the freight railroad industry.
As you know, over 25 years ago, Congress transformed federal regulation of
the railroad industry. After almost 100 years of economic regulation, the
railroad industry was in serious economic trouble in the 1970s, with
rising costs, losses, and bankruptcies. In response, Congress passed the
Railroad Revitalization and Regulatory Reform Act of 1976 and the Staggers
Rail Act of 1980. Together, these pieces of legislation substantially
deregulated the railroad industry. In particular, the 1980 act encouraged
greater reliance on competition to set rates and gave railroads increased
freedom to price their services according to market conditions, including
the freedom to use differential pricing--that is, to recover a greater
proportion of their costs from rates charged to shippers with a greater
dependency on rail transportation. At the same time, the 1980 act
anticipated that some shippers might not have competitive
alternatives--commonly referred to as "captive shippers"--and gave the
Interstate Commerce Commission (ICC), and later the Surface Transportation
Board (STB), the authority to establish a process so that shippers could
obtain relief from unreasonably high rates. However, only a rate that
produces revenue equal to at least 180 percent of the variable cost of
transporting the shipment can be challenged.

Policymakers continue to believe that the federal government should
provide a viable process to protect shippers against unreasonably high
rates, as well as address competition issues, while still balancing the
interests of both railroads and shippers. Over the past 10 years,
significant consolidation has taken place in the freight railroad
industry, while railroads--particularly Class I railroads^1-- have seen
their productivity and financial health improve. Railroad officials
express concern that any attempt to increase economic regulation will
reduce carriers' ability to earn sufficient revenues and limit future
infrastructure investment.

Since the passage of the Staggers Rail Act in 1980, we have issued several
reports on the freight railroad industry.^2 My comments today are based on
our most recent reports issued in August 2007 and October 2006, and cover
(1) the changes that have occurred in the railroad industry since the
enactment of the Staggers Rail Act, including changes in rail rates since
1985, (2) the extent of captivity in the industry and STB's efforts to
protect captive shippers, and (3) STB's actions to address our recent
recommendations. We reviewed STB documents to update the information in
our recent reports and conducted our review in September 2007 in
accordance with generally accepted government auditing standards.

^1As of 2004, a Class I railroad is any railroad with operating revenue
above $277.7 million.

^2See GAO, Freight Railroads: Industry Health Has Improved, but Concerns
About Competition and Capacity Should Be Addressed, GAO-07-94 (Washington,
D.C.: Oct. 6, 2006) and Freight Railroads: Updated Information on Rates
and Other Industry Trends, GAO-07-291R (Washington, D.C.: Aug. 15, 2007).
In addition, see the list of related GAO products at the end of this
report.

In summary:

           o The changes that have occurred in the railroad industry since
           the enactment of the Staggers Rail Act are widely viewed as
           positive, since the financial health of the industry has improved
           and most rates have declined since 1985. The freight railroad
           industry's financial health improved substantially as railroads
           cut costs through productivity improvements; streamlined and
           right-sized their rail networks; implemented new technologies; and
           expanded business into new markets, such as the intermodal
           market.^3 Over 20 years rates have generally declined for most
           shippers and most railroad rates have declined since 1985.
           However, they began to increase in 2001, and in 2005 rates
           experienced a 9 percent annual increase over 2004^4--the largest
           annual increase in twenty years--and rates increased for all 13
           commodities that we reviewed. In addition, over 20 years, railroad
           companies have shifted other costs to shippers, including railcar
           ownership. Revenues that railroads report as "miscellaneous
           revenue"--a category that includes some fuel surcharges--increased
           more than ten-fold from $141 million in 2000 to over $1.7 billion
           in 2005. We have recommended that STB revise its data collection
           methods to more accurately collect data on railroad revenue.

           o It is difficult to precisely determine how many shippers are
           "captive" because available proxy measures can overstate or
           understate captivity. However some data indicate that potentially
           captive traffic appears to have decreased, while at the same time,
           data also indicates that traffic traveling at rates significantly
           above the threshold for rate relief has increased. In October
           2006, we reported that STB's efforts to protect captive shippers
           have resulted in little effective relief for those shippers. We
           also reported that economists and shipper groups have proposed a
           number of alternatives to address remaining concerns about
           competition and capacity - however, each of these alternative
           approaches have costs and benefits and should be carefully
           considered to ensure the approach will achieve the important
           balance set out in the Staggers Act of allowing the railroads to
           earn adequate revenues and invest in its infrastructure while
           assuring protection for captive shippers from unreasonable rates.

           o STB has taken some actions to address our past recommendations,
           but it is too soon to determine the effect of these actions. Our
           October 2006 report noted that the continued existence of pockets
           of potentially "captive shippers" raised questions as to whether
           rail rates in selected markets reflected justified and reasonable
           pricing practices, or an abuse of market power by the railroads.
           Based on STB's statutory authority to adjudicate unreasonable
           rates and to inquire into and report on railroad practices, we
           recommended that the Board undertake a rigorous analysis of
           competitive markets to identify the state of competition
           nationwide and to determine in specific markets whether the
           inappropriate exercise of market power is occurring and, where
           appropriate, to consider the range of actions available to address
           such problems. STB has awarded a contract to conduct this study;
           while this is an important step, it will be important that these
           analysts have the ability that STB has through its statutory
           authority to inquire into railroad practices as well as sufficient
           access to information to determine whether rail rates in selected
           markets reflect justified and reasonable pricing practices or an
           abuse of market power by the railroads. We also recommended that
           STB review its method of data collection to ensure that all
           freight railroads are consistently and accurately reporting all
           revenues collected from shippers. While STB has revised its rules
           on establishing and collecting fuel surcharges, these rules did
           not address how surcharges are reported in the Carload Waybill
           Sample and STB has not yet taken steps to accurately collect data
           on other miscellaneous revenues. STB has also taken a number of
           steps to revise its rate relief process. Specifically, in October
           2006, STB refined the rate relief process to reduce both the
           expense and length of the process. In September 2007, STB
           simplified the rate relief process for small shippers and created
           a separate new process for medium size shipments. It is too soon
           to tell what effect these changes will have and we have not
           evaluated the effect of these changes.

^3The intermodal market consists of containers and trailers that can be
carried on ships, trucks, or rail.

^4We constructed rate indexes to examine trends in rail rates over the
1985 to 2005 period. In our August 2007 report, we reported a 7 percentage
point change in the rate index. Using 1.0 as our 1985 base we reported the
change 0.8 to 0.87 from 2004-2005. This 7 percentage point change
translates into an annual increase of 9 percent. In this testimony we
refer to the annual increase and not the percentage change in the rate
index.

Background

In the past, the ICC regulated almost all of the rates that railroads
charged shippers. The Railroad Revitalization and Regulatory Reform Act of
1976 and the Staggers Rail Act of 1980 greatly increased reliance on
competition to set rates in the railroad industry. Specifically, these
acts allowed railroads and shippers to enter into confidential contracts
that set rates and prohibited ICC from regulating rates where railroads
had either effective competition or rates negotiated between the railroad
and the shipper. Furthermore, the ICC Termination Act of 1995 abolished
ICC and transferred its regulatory functions to STB. Taken together, these
acts anchor the federal government's role in the freight rail industry by
establishing numerous goals for regulating the industry, including to

           o allow, to the maximum extent possible, competition and demand
           for services to establish reasonable rates for transportation by
           rail;
           o minimize the need for federal regulatory control over the rail
           transportation system and require fair and expeditious regulatory
           decisions when regulation is required;
           o promote a safe and efficient rail transportation system by
           allowing rail carriers to earn adequate revenues, as determined by
           STB;
           o ensure the development and continuation of a sound rail
           transportation system with effective competition among rail
           carriers and with other modes to meet the needs of the public and
           the national defense;
           o foster sound economic conditions in transportation and ensure
           effective competition and coordination between rail carriers and
           other modes;
           o maintain reasonable rates where there is an absence of effective
           competition and where rail rates provide revenues that exceed the
           amount necessary to maintain the rail system and attract capital;
           o prohibit predatory pricing and practices to avoid undue
           concentrations of market power; and
           o provide for the expeditious handling and resolution of all
           proceedings.

While the Staggers Rail and ICC Termination Acts reduced regulation in the
railroad industry, they maintained STB's role as the economic regulator of
the industry. The federal courts have upheld STB's general powers to
monitor the rail industry, including its ability to subpoena witnesses and
records and to depose witnesses. In addition, STB can revisit its past
decisions if it discovers a material error, or new evidence, or if
circumstances have substantially changed.

Two important components of the current regulatory structure for the
railroad industry are the concepts of revenue adequacy and demand-based
differential pricing. Congress established the concept of revenue adequacy
as an indicator of the financial health of the industry. STB determines
the revenue adequacy of a railroad by comparing the railroad's return on
investment with the industrywide cost of capital. For instance, if a
railroad's return on investment is greater than the industrywide cost of
capital, STB determines that railroad to be revenue adequate.
Historically, ICC and STB have rarely found railroads to be revenue
adequate--a result that many observers relate to characteristics of the
industry's cost structure. Railroads incur large fixed costs to build and
operate networks that jointly serve many different shippers. Some fixed
costs can be attributed to serving particular shippers, and some costs
vary with particular movements, but other costs are not attributable to
particular shippers or movements. Nonetheless, a railroad must recover
these costs if the railroad is to continue to provide service over the
long run. To the extent that railroads have not been revenue adequate,
they may not have been fully recovering these costs.

The Staggers Rail Act recognized the need for railroads to use
demand-based differential pricing to promote a healthy rail industry and
enable it to raise sufficient revenues to operate, maintain and, if
necessary, expand the system in a deregulated environment. Demand-based
differential pricing, in theory, permits a railroad to recover its joint
and common costs--those costs that exist no matter how many shipments are
transported, such as the cost of maintaining track-- across its entire
traffic base by setting higher rates for traffic with fewer transportation
alternatives than for traffic with more alternatives. Differential pricing
recognizes that some customers may use rail if rates are low--and have
other options if rail rates are too high or service is poor. Therefore,
rail rates on these shipments generally cover the directly attributable
(variable) costs, plus a relatively low contribution to fixed costs. In
contrast, customers with little or no practical alternative to
rail--"captive" shippers--generally pay a much larger portion of fixed
costs. Moreover, even though a railroad might incur similar incremental
costs while providing service to two different shippers that move similar
volumes in similar car types traveling over similar distances, the
railroad might charge the shippers different rates. Furthermore, if the
railroad is able to offer lower rates to the shipper with more
transportation alternatives, that shipper still pays some of the joint and
common costs. By paying even a small part of total fixed cost, competitive
traffic reduces the share of those costs that captive shippers would have
to pay if the competitive traffic switched to truck or some other
alternative. Consequently, while the shipper with fewer alternatives makes
a greater contribution toward the railroad's joint and common costs, the
contribution is less than if the shipper with more alternatives did not
ship via rail.

The Staggers Rail Act further requires that the railroads' need to obtain
adequate revenues to be balanced with the rights of shippers to be free
from, and to seek redress from, unreasonable rates. Railroads incur
variable costs--that is, the costs of moving particular shipments--in
providing service. The Staggers Rail Act stated that any rate that was
found to be below 180 percent of a railroad's variable cost for a
particular shipment could not be challenged as unreasonable and authorized
ICC, and later STB, to establish a rate relief process for shippers to
challenge the reasonableness of a rate. STB may consider the
reasonableness of a rate only if it finds that the carrier has market
dominance over the traffic at issue--that is, if (1) the railroad's
revenue is equal to or above 180 percent of the railroad's variable cost
(R/VC) and (2) the railroad does not face effective competition from other
rail carriers or other modes of transportation.

Railroad Industry Is Increasingly Healthy and Rail Rates Have Generally Declined
Since 1985, Despite Recent Rate Increases

The changes that have occurred in the railroad industry since the
enactment of the Staggers Rail Act are widely viewed as positive. In
addition, rail rates have generally declined since 1985, even though rates
began to increase in 2001 and experienced a 9 percent annual increase
between 2004 and 2005--the largest annual increase in 20 years. Likewise,
rail rates have declined since 1985 for certain commodity groups and
routes despite some increases since 2001, but rates have not declined
uniformly. Railroads have also shifted other costs to shippers, such as
the cost of rail car ownership, and have increased the revenue they report
as miscellaneous more than 10-fold between 2000 and 2005.

Railroad Industry's Financial Health Has Improved Substantially

There is widespread consensus that the freight rail industry has benefited
from the Staggers Rail Act. Various measures indicate an increasingly
strong freight railroad industry. Freight railroads have also cut costs by
streamlining their workforces; right-sizing their rail networks; and
reducing track miles, equipment, and facilities to more closely match
demand.^5 Freight railroads have also expanded their business into new
markets--such as the intermodal market--and implemented new technologies,
including larger cars, and are currently developing new scheduling and
train control systems.

^5Clifford Winston, Deregulation of Network Industries - What's Next?
(Washington: AEI-Brookings Joint Center for Regulatory Studies: 2000), pp.
43-44.

Industry Rates Have Generally Declined Since 1985

Rail rates across the freight railroad industry have generally declined
since 1985 despite a recent increase. Rates began to rise in 2001 and
experienced a 9 percent annual increase from 2004-2005, which represents
the largest annual increase in rates during the 20-year period from 1985
through 2005. This increase also outpaced inflation--about 3 percent in
2005. However, despite these increases, rates for 2005 remain below their
1985 levels and below the rate of inflation.^6 Because the set of rail
rate indexes we used to examine trends in rail rates over time does not
account for inflation we also included the price index for the gross
domestic product (GDP) in figure 1.

^6We constructed rate indexes to examine trends in rail rates over the
1985 to 2005 period. These indexes define traffic patterns for a given
commodity in terms of census region to census region flows of that
commodity, and we calculated the average revenue per ton-mile for each of
these traffic flows. The index is calculated as the weighted average of
these traffic flows in each year, expressed as a percentage of the value
for 1985, where the weights reflect the traffic patterns in 2005. By
fixing the weights as of one period of time, we attempted to measure pure
price changes rather than calculating the average revenue per ton-mile in
each year. Over time, changes in traffic patterns could result in a
substitution of lower priced traffic for higher priced traffic, or vice
versa, so that a decrease in average revenue per ton-mile might partly
reflect this change in traffic patterns. The rate index for the overall
industry was defined similarly, except that the traffic pattern bundle was
defined in terms of broad commodity, census region of origin, and mileage
block categories. For comparison, we also present the price index for
gross domestic product over this period.

Figure 1: Trends in Industry Rail Rates, 1985-2005

While Generally Declining over the Long Term, Rates for Several Commodities Have
Increased in Recent Years

Rates for several commodities in 2005 remain lower than in 1985. Similar
to overall industry trends, rates for individual commodities have
increased from 2004-2005. In 2005, rates increased for all 13 commodities
that we reviewed. Figure 2 depicts rate changes for coal, grain,
miscellaneous mixed shipments, and motor vehicles from 1985 through 2005.

Figure 2: Rate Changes for Coal, Grain, Miscellaneous Mixed Shipments, and
Motor Vehicles, 1985-2005

Railroads Have Shifted Costs to Shippers

Over 20 years, freight railroad companies have shifted other costs to
shippers. Our analysis shows a 20 percent shift in railcar ownership
(measured in tons carried) since 1987. In 1987, railcars owned by freight
railroad companies moved 60 percent of tons carried. In 2005, they moved
40 percent of tons carried, meaning that freight railroad company railcars
no longer carry the majority of tonnage (see fig. 3).

Figure 3: Tonnage Carried by Railcar Ownership, 1987-2005

Reported Miscellaneous Revenue, Including Fuel Surcharges, Increased Ten-Fold
Since 2000

In 2005 the amount of industry revenue reported as miscellaneous increased
ten-fold over 2000 levels, rising from about $141 million to over $1.7
billion (see fig. 4). Miscellaneous revenue is a category in the Carload
Waybill Sample for reporting revenue outside the standard rate structure.
This miscellaneous revenue can include some fuel surcharges,^7 as well as
revenues such as those derived from congestion fees and railcar auctions
(in which the highest bidder is guaranteed a number of railcars at a
specified date). In 2004, miscellaneous revenue accounted for 1.5 percent
of freight railroad revenue reported. In 2005, this percentage had risen
to 3.7 percent. Also, in 2005, 20 percent of all tonnage moved in the
United States generated miscellaneous revenue.

^7Fuel surcharges are charges associated with recouping the cost of fuel.

Figure 4: Miscellaneous Revenue Tracked in Carload Waybill Sample,
2000-2005

Captive Shippers Are Difficult to Identify But Concerns Remain and Past STB
Actions Have Led to Little Effective Relief

In October 2006, we reported that captive shippers are difficult to
identify and STB's efforts to protect captive shippers have resulted in
little effective relief for those shippers. We also reported that
economists and shipper groups have proposed a number of alternatives to
address remaining concerns about competition - however, each of these
alternative approaches have costs and benefits and should be carefully
considered to ensure the approach will achieve the important balance set
out in the Staggers Act.

Captive Shippers Remain Difficult to Identify, but Some Measures Indicate
Captivity Is Dropping in the Railroad Industry

It remains difficult to determine precisely how many shippers are
"captive" to one railroad because the proxy measures that provide the best
indication can overstate or understate captivity. One measure of potential
captivity--traffic traveling at rates equal to or greater than 180 percent
R/VC--is part of the statutory threshold for bringing a rate relief case
before STB.^8 STB regards traffic at or above this threshold as
"potentially captive," but, like other measures, R/VC levels can
understate or overstate captivity.^9 Since 1985, tonnage and revenue from
traffic traveling at rates over 180 percent R/VC have generally declined.
(see fig. 5). In 2005, industry revenue generated by traffic traveling at
rates over 180 percent R/VC dropped by roughly half a percent. Tonnage
traveling at rates over 180 percent R/VC dropped by a smaller percentage.

^8Another condition of bringing a rate relief case before STB is a
railroad not facing effective competition from other rail carriers or
other modes of transportation.

^9For example, it is possible for the R/VC ratio to increase while the
rate paid by a shipper is declining. Assume that in Year 1, a shipper is
paying a rate of $20 and the railroad's variable cost is $12; the R/VC
ratio--a division of the rate and the variable cost--would be 167 percent.
If in Year 2, the variable costs decline by $2 from $12 to $10 and the
railroad passes this cost savings directly on to the shipper in the form
of a reduced rate, the shipper would pay $18 instead of $20. However,
because both revenue and variable cost decline, the R/VC ratio--$18
divided by $10-- increases to 180 percent.

Figure 5: Tonnage and revenue generated from Traffic Traveling at Rates
Equal to or Greater Than 180 percent R/VC, 1985-2005

While traffic traveling at rates over 180 percent R/VC has generally
declined, traffic traveling at rates substantially over the threshold for
rate relief has generally increased from 1985 to 2005 (see fig. 6). This
traffic declined in 2003 and 2004, but rose in 2005.

Figure 6: Tonnage Traveling at Rates over 300 Percent R/VC, 1985-2005

Some areas with access to one Class I railroad also have more than half of
their traffic traveling at rates that exceed the statutory threshold for
rate relief. For example, parts of New Mexico and Idaho with access to one
Class I railroad had more than half of all traffic originating in those
same areas traveling at rates over 180 percent R/VC. However, we also
found instances in which an economic area may have access to two or more
Class I railroads and still have more than 75 percent of its traffic
traveling at rates over 180 percent R/VC, as well as other instances in
which an economic area may have access to one Class I railroad and have
less than 25 percent of its traffic traveling at rates over 180 percent
R/VC.

STB Has Taken Actions to Protect Captive Shippers but Efforts Have Led to Little
Effective Relief

STB has taken a number of actions to provide relief for captive shippers.
While the Staggers Rail and ICC Termination Acts encourage competition as
the preferred way to protect shippers and to promote the financial health
of the railroad industry, they also give STB the authority to

           o adjudicate rate cases to resolve disputes between captive
           shippers and railroads upon receiving a complaint from a shipper;
           o approve rail transactions, such as mergers, consolidations,
           acquisitions, and trackage rights;
           o prescribe new regulations, such as rules for competitive access
           and merger approvals; and
           o inquire into and report on rail industry practices, including
           obtaining information from railroads on its own initiative and
           holding hearings to inquire into areas of concern, such as
           competition.

Under its adjudicatory authority, STB has developed standard rate case
guidelines, under which captive shippers can challenge a rail rate and
appeal to STB for rate relief. Under the standard rate relief process, STB
assesses whether the railroad dominates the shipper's transportation
market and, if it finds market dominance, proceeds with further
assessments to determine whether the actual rate the railroad charges the
shipper is reasonable. STB requires that the shipper demonstrate how much
an optimally efficient railroad would need to charge the shipper and
construct a hypothetical, perfectly efficient railroad that would replace
the shipper's current carrier. As part of the rate relief process, both
the railroad and the shipper have the opportunity to present their facts
and views to STB, as well as to present new evidence.

STB also created alternatives to the standard rate relief process,
developing simplified guidelines, as Congress required, for cases in which
the standard rate guidelines would be too costly or infeasible given the
value of the cases. Under these simplified guidelines, captive shippers
who believe that their rate is unreasonable can appeal to STB for rate
relief, even if the value of the disputed traffic makes it too costly or
infeasible to apply the standard guidelines.

Despite STB's efforts, we reported in 2006 that there was widespread
agreement that STB's standard rate relief process was inaccessible to most
shippers and did not provide for expeditious handling and resolution of
complaints. The process remained expensive, time consuming, and complex.
Specifically, shippers we interviewed agreed that the process could cost
approximately $3 million per litigant. In addition, shippers said that
they do not use the process because it takes so long for STB to reach a
decision. Lastly, shippers stated that the process is both time consuming
and difficult because it calls for them to develop a hypothetical
competing railroad to show what the rate should be and to demonstrate that
the existing rate is unreasonable.

We also reported that the simplified guidelines also had not effectively
provided relief for captive shippers. Although these simplified guidelines
had been in place since 1997, a rate case had not been decided under the
process set out by the guidelines when we issued our report in 2006. STB
had held public hearings in April 2003 and July 2004 to examine why
shippers have not used the guidelines and to explore ways to improve them.
At these hearings, numerous organizations provided comments to STB on
measures that could clarify the simplified guidelines, but no action was
taken. STB observed that parties urged changes to make the process more
workable, but disagreed on what those changes should be. We reported that
several shipper organizations told us that shippers were concerned about
using the simplified guidelines because they believe the guidelines will
be challenged in court, resulting in lengthy litigation. STB officials
told us that they--not the shippers--would be responsible for defending
the guidelines in court. STB officials also said that if a shipper won a
small rate case, STB could order reparations to the shipper before the
case was appealed to the courts.

Since our report in October 2006, STB has taken steps to refine the rate
relief process. Specifically, in October 2006, STB revised procedures for
deciding large rate relief cases. By placing restraints on the evidence
and arguments allowed in these cases, STB predicted that the expense and
delay in resolving these rate disputes would be reduced substantially. In
September 2007, STB altered its simplified guidelines for small shippers
to enable shippers who are seeking up to $1 million in rate relief over a
5-year period to receive a STB decision within 8 months of filing a
complaint. STB also created a new rate relief process for medium size
shipments to allow shippers who are seeking up to $5 million in rate
relief over a 5-year period to receive a STB decision within 17 months of
filing a complaint. Additionally, STB also stated that all rail rate
disputes would require nonbinding mediation.

Shipper Groups and Others Have Suggested Alternative Approaches That Have Costs
and Benefits

Shipper groups, economists, and other experts in the rail industry have
suggested several alternative approaches as remedies that could provide
more competitive options to shippers in areas of inadequate competition or
excessive market power. These groups view these approaches as more
effective than the rate relief process in promoting a greater reliance on
competition to protect shippers against unreasonable rates. Some proposals
would require legislative change, or a reopening of past STB decisions.^10

These approaches each have potential costs and benefits. On the one hand,
they could expand competitive options, reduce rail rates, and decrease the
number of captive shippers as well as reduce the need for both federal
regulation and a rate relief process. On the other hand, reductions in
rail rates could affect railroad revenues and limit the railroads' ability
and potential willingness to invest in their infrastructure. In addition,
some markets may not have the level of demand needed to support
competition among railroads. It will be important for policymakers, in
evaluating these alternative approaches, to carefully consider the impact
of each approach on the balance set out in the Staggers Act. The targeted
approaches frequently proposed by shipper groups and others include the
following:

           o Reciprocal switching: This approach would allow STB to require
           railroads serving shippers that are close to another railroad to
           transport cars of a competing railroad for a fee. The shippers
           would then have access to railroads that do not reach their
           facilities. This approach is similar to the mandatory
           interswitching in Canada, which enables a shipper to request a
           second railroad's service if that second railroad is within
           approximately 18 miles. Some Class I railroads already interchange
           traffic using these agreements, but they oppose being required to
           do so. Under this approach, STB would oversee the pricing of
           switching agreements. This approach could also reduce the number
           of captive shippers by providing a competitive option to shippers
           with access to a proximate but previously inaccessible railroad
           and thereby reduce traffic eligible for the rate relief process
           (see fig. 7).

^10Another proposal, articulated by economists Curtis Grimm and Cliff
Winston, calls for the elimination of STB. This proposal recognizes that
captive shippers have likely been hurt by a lack of competition, but it
states that allowing the Department of Justice to review rail mergers
instead of STB and ending the potential for reregulation of the industry
could lead railroad officials and shippers to negotiate an agreement to
address remaining rail competition concerns. Curtis Grimm and Clifford
Winston, "Competition in the Deregulated Railroad Industry: Sources,
Effects, and Policy Issues," (AEI - Brooking Institution. Washington,
D.C.: 2000).

Figure 7: Reciprocal Switching

           o Terminal agreements: This approach would require one railroad to
           grant access to its terminal facilities or tracks to another
           railroad, enabling both railroads to interchange traffic or gain
           access to traffic coming from shippers off the other railroad's
           lines for a fee. Current regulation requires a shipper to
           demonstrate anticompetitive conduct by a railroad before STB will
           grant access to a terminal by a nonowning railroad unless there is
           an emergency or when a shipper can demonstrate poor service and a
           second railroad is willing and able to provide the service
           requested. This approach would require revisiting the current
           requirement that railroads or shippers demonstrate anticompetitive
           conduct in making a case to gain access to a railroad terminal in
           areas where there is inadequate competition. The approach would
           also make it easier for competing railroads to gain access to the
           terminal areas of other railroads and could increase competition
           between railroads. However, it could also reduce revenues to all
           railroads involved and adversely affect the financial condition of
           the rail industry. Also, shippers could benefit from increased
           competition but might see service decline (see fig. 8).

Figure 8: Terminal Agreements

           o Trackage rights: This approach would require one railroad to
           grant access to its tracks to another railroad, enabling railroads
           to interchange traffic beyond terminal facilities for a fee. In
           the past, STB has imposed conditions requiring that a merging
           railroad must grant another railroad trackage rights to preserve
           competition when a merger would reduce a shipper's access to
           railroads from two to one. While this approach could potentially
           increase rail competition and decrease rail rates, it could also
           discourage owning railroads from maintaining the track or
           providing high-quality service, since the value of lost use of
           track may not be compensated by the user fee and may decrease
           return on investment (see fig. 9).

Figure 9: Trackage Rights

           o "Bottleneck" rates: This approach would require a railroad to
           establish a rate, and thereby offer to provide service, for any
           two points on the railroad's system where traffic originates,
           terminates, or can be interchanged. Some shippers have more than
           one railroad that serves them at their origin and/or destination
           points, but have at least one portion of a rail movement for which
           no alternative rail route is available. This portion is referred
           to as the "bottleneck segment." STB's decision that a railroad is
           not required to quote a rate for the bottleneck segment has been
           upheld in federal court.^11 STB's rationale was that statute and
           case law precluded it from requiring a railroad to provide service
           on a portion of its route when the railroad serves both the origin
           and destination points and provides a rate for such movement. STB
           requires a railroad to provide service for the bottleneck segment
           only if the shipper had prior arrangements or a contract for the
           remaining portion of the shipment route. On the one hand,
           requiring railroads to establish bottleneck rates would force
           short-distance routes on railroads when they served an entire
           route and could result in loss of business and potentially subject
           the bottleneck segment to a rate complaint. On the other hand,
           this approach would give shippers access to a second railroad,
           even if a single railroad was the only railroad that served the
           shipper at its origin and/or destination points, and could
           potentially reduce rates (see fig. 10).

^11The U.S. Court of Appeals for the Eighth Circuit affirmed STB decision
that a bottleneck carrier generally need not quote a separate rate for the
bottleneck portion of the route. Mid-American Energy Co. v. Surface
Transportation Board, 169 F. 3d 1099 (8th Cir.: Feb. 10, 1999). The D.C.
Circuit affirmed STB holding that separately challengeable bottleneck
rates can be required whenever a shipper has a contract over the
nonbottleneck segment of a through movement. Union Pacific Railroad v.
Surface Transportation Board, 202 F. 3d 337 (D.C. Cir.: 2000).

Figure 10: Bottleneck Rates

           o Paper barriers: This approach would prevent or, put a time limit
           on, paper barriers, which are contractual agreements that can
           occur when a Class I railroad either sells or leases long term
           some of its track to other railroads (typically a short-line
           railroad and/or regional railroad). These agreements stipulate
           that virtually all traffic that originates on that line must
           interchange with the Class I railroad that originally leased the
           tracks or pay a penalty. Since the 1980s, approximately 500 short
           lines have been created by Class I railroads selling a portion of
           their lines; however, the extent to which paper barriers are a
           standard practice is unknown because they are part of confidential
           contracts. When this type of agreement exists, it can inhibit
           smaller railroads that connect with or cross two or more Class I
           rail systems from providing rail customers access to competitive
           service. Eliminating paper barriers could affect the railroad
           industry's overall capacity since Class I railroads may abandon
           lines instead of selling them to smaller railroads and thereby
           increase the cost of entering a market for a would-be competitor.
           In addition, an official from a railroad association told us that
           it is unclear if a federal agency could invalidate privately
           negotiated contracts (see fig. 11).

Figure 11: Paper Barriers

STB Has Taken Steps to Address Problems, but Actions Are Too Recent to Be
Evaluated

STB has taken some actions to address our past recommendations, but it is
too soon to determine the effect of these actions. In October 2006 we
reported that the continued existence of pockets of potential captivity at
a time when the railroads are, for the first time in decades, experiencing
increasing economic health, raises the question whether rail rates in
selected markets reflect justified and reasonable pricing practices, or an
abuse of market power by the railroads. While our analysis provided an
important first step, we noted that STB has the statutory authority and
access to information to inquire into and report on railroad practices and
to conduct a more rigorous analysis of competition in the freight rail
industry. As a result, we recommended that the Board undertake a rigorous
analysis of competitive markets to identify the state of competition
nationwide and to determine in specific markets whether the inappropriate
exercise of market power is occurring and, where appropriate, to consider
the range of actions available to address such problems.

STB initially disagreed with our recommendation because it believed the
findings underlying the recommendation were inconclusive, their on-going
efforts would address many of our concerns, and a rigorous analysis would
divert resources from other efforts. However, in June 2007, STB stated
that it intended to implement our recommendation using funding that was
not available at the time of our October report to solicit proposals from
analysts with no connection to the freight railroad industry or STB
proceedings to conduct a rigorous analysis of competition in the freight
railroad industry. On September 13, 2007, STB announced that it had
awarded a contract for a comprehensive study on competition, capacity, and
regulatory policy issues to be completed by the fall of 2008. We commend
STB for taking this action. It will be important that these analysts have
the ability that STB has through its statutory authority to inquire into
railroad practices as well as sufficient access to information to
determine whether rail rates in selected markets reflect justified and
reasonable pricing practices, or an abuse of market power by the
railroads.

We also recommended that STB review its method of data collection to
ensure that all freight railroads are consistently and accurately
reporting all revenues collected from shippers, including fuel surcharges
and other costs not explicitly captured in all railroad rate structures.
In January 2007, STB finalized rules that require railroads to ensure that
fuel surcharges are based on factors directly affecting the amount of fuel
consumed. In August 2007, STB finalized rules that require railroads to
report their fuel costs and revenue from fuel surcharges. While these are
positive steps, these rules did not address how surcharges are reported in
the Carload Waybill Sample. In addition, STB has not taken steps to
address collection and reporting of other miscellaneous revenues--revenues
deriving from sources other than fuel surcharges.

As stated earlier, STB has also taken steps to refine the rate relief
process since our 2006 report. STB has made changes to the rate relief
process that it believes will reduce the expense and delay of obtaining
rate relief. While these appear to be positive steps that could address
longstanding concerns with the rate relief process, it is too soon to
determine the effect of these changes to the process, and we have not
evaluated the effect of these changes.

Mr. Chairman, this concluded my prepared statement. I would be happy to
respond to any questions you or other Members of the Committee may have at
this time.

Contact and Acknowledgements

For questions regarding this testimony, please contact JayEtta Z. Hecker
on (202) 512-2834 or [19][email protected] . Individuals making key
contributions to this testimony include Steve Cohen (Assistant Director),
Yumiko Jolly, and John W. Shumann.

Related GAO Products

Freight Railroads: Industry Health Has Improved, but Concerns About
Competition and Capacity Should Be Addressed. GAO-07-94. Washington, D.C.:
Oct. 6, 2006).

Freight Railroads: Updated Information on Rates and Other Industry Trends.
GAO-07-291R. Washington, D.C.: Aug. 15, 2007.

Freight Railroads: Preliminary Observations on Rates, Competition, and
Capacity Issues. GAO-06-898T. Washington, D.C.: June 21, 2006.

Freight Transportation: Short Sea Shipping Option Shows Importance of
Systematic Approach to Public Investment Decisions. GAO-05-768.
Washington, D.C.: July 29, 2005.

Freight Transportation: Strategies Needed to Address Planning and
Financing Limitations. GAO-04-165. Washington, D.C.: December 19, 2003.

Railroad Regulation: Changes in Freight Railroad Rates from 1997 through
2000. GAO-02-524. Washington, D.C.: June 7, 2002.

Freight Railroad Regulation: Surface Transportation Board's Oversight
Could Benefit from Evidence Better Identifying How Mergers Affect Rates.
[20]GAO-01-689 . Washington, D.C.: July 5, 2001.

Railroad Regulation: Current Issues Associated with the Rate Relief
Process. GAO/ [21]RCED-99-46 . Washington, D.C.: April 29, 1999.

Railroad Regulation: Changes in Railroad Rates and Service Quality Since
1990. GAO/ [22]RCED-99-93 . Washington, D.C.: April 6, 1999.

Interstate Commerce Commission: Key Issues Need to Be Addressed in
Determining Future of ICC's Regulatory Functions. GAO-T-RCED-94-261
Washington, D.C.: July 12, 1994.

Railroad Competitiveness: Federal Laws and Policies Affect Railroad
Competitiveness. GAO/ [23]RCED-92-16 . Washington, D.C.: November 5, 1991.

Railroad Regulation: Economic and Financial Impacts of the Staggers Rail
Act of 1980. GAO/RCED-90-80. Washington, D.C.: May 16, 1990.

Railroad Regulation: Shipper Experiences and Current Issues in ICC
Regulation of Rail Rates. GAO/ [24]RCED-87-119 . Washington, D.C.:
September 9, 1987.

Railroad Regulation: Competitive Access and Its Effects on Selected
Railroads and Shippers. GAO/ [25]RCED-87-109 , Washington, D.C.: June 18,
1987.

Railroad Revenues: Analysis of Alternative Methods to Measure Revenue
Adequacy. GAO/ [26]RCED-87-15BR . Washington, D.C.: October 2, 1986.

Shipper Rail Rates: Interstate Commerce Commission's Handling of
Complaints. GAO/RCED-86-54FS. Washington, D.C.: January 30, 1986.

(544144)

This is a work of the U.S. government and is not subject to copyright
protection in the United States. The published product may be reproduced
and distributed in its entirety without further permission from GAO.
However, because this work may contain copyrighted images or other
material, permission from the copyright holder may be necessary if you
wish to reproduce this material separately.

To view the full product, including the scope
and methodology, click on [27]GAO-07-1245T .

For more information, contact JayEtta Z. Hecker at (202) 512-2834 or
[email protected].

Highlights of [28]GAO-07-1245T , a report to House Committee on
Transportation and Infrastructure

September 25, 2007

FREIGHT RAILROADS

Updated Information on Rates and Competition Issues

The Staggers Rail Act of 1980 largely deregulated the freight railroad
industry, giving the railroads freedom to price their services according
to market conditions and encouraging greater reliance on competition to
set rates. The act recognized the need for railroads to recover costs by
setting higher rates for shippers with fewer transportation alternatives.
The act also recognized that some shippers might not have access to
competitive alternatives and might be subject to unreasonably high rates.
It established a threshold for rate relief and granted the Interstate
Commerce Commission and the Surface Transportation Board (STB) the
authority to develop a rate relief process for those "captive" shippers.
GAO's reported on rates, competition, and other industry trends in reports
issued in October 2006 and August 2007. This statement is based on those
reports and discusses (1) the changes that have occurred in the railroad
industry since the enactment of the Staggers Rail Act, including changes
in rail rates since 1985, (2) the extent of captivity in the industry and
STB's efforts to protect captive shippers, and (3) STB's actions to
address GAO's recent recommendations.

[29]What GAO Recommends

In October 2006, GAO recommended that STB analyze the state of competition
and consider appropriate actions. GAO also recommended that STB review
their method of data collection to ensure that all freight railroads are
consistently reporting all revenues collected from shippers.

The changes that have occurred in the railroad industry since the
enactment of the Staggers Rail Act are widely viewed as positive, since
the financial health of the industry has improved and most rates have
declined since 1985. The freight railroad industry's financial health
improved substantially as railroads cut costs through productivity
improvements and new technologies. However, rates began to increase in
2001, and in 2005 rates jumped nearly 9 percent--the largest annual
increase in twenty years--and rates increased for all 13 commodities that
we reviewed. Revenues that railroads report as "miscellaneous revenue"--a
category that includes some fuel surcharges--increased more than ten-fold
from $141 million in 2000 to over $1.7 billion in 2005.

It is difficult to precisely determine how many shippers are "captive"
because available proxy measures can overstate or understate captivity.
However some data indicate that potentially captive traffic appears to
have decreased, while at the same time, data also indicates that traffic
traveling at rates significantly above the threshold for rate relief has
increased. In October 2006, we reported that STB's rate relief process to
protect captive shippers have resulted in little effective relief for
those shippers. We also reported that economists and shipper groups have
proposed a number of alternatives to address remaining concerns about
competition--however, each of these alternative approaches have costs and
benefits and should be carefully considered.

STB has taken some actions to address our past recommendations, but it is
too soon to determine the effect of these actions. Our October 2006 report
noted that the continued existence of pockets of potentially "captive
shippers" raised questions as to whether rail rates in selected markets
reflected reasonable pricing practices, or an abuse of market power. We
recommended that the Board undertake a rigorous analysis of competitive
markets to identify the state of competition. STB has awarded a contract
to conduct this study; while this is an important step, it will be
important that these analysts have STB's authority and access to
information to determine whether rail rates in selected markets reflect
reasonable pricing practices. We also recommended that STB ensure that
freight railroads are consistently reporting all revenues, including
miscellaneous revenues. While STB has revised its rules on fuel
surcharges, these rules did not address how fuel surcharges are reported
and STB has not yet taken steps to accurately collect data on other
miscellaneous revenues. STB has also taken a number of steps to revise its
rate relief process. While these appear to be promising steps, it is too
soon to tell what effect these changes will have and we have not evaluated
them.

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References

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  19. mailto:[email protected]
  20. http://www.gao.gov/cgi-bin/getrpt?GAO-01-689
  21. http://www.gao.gov/archive/1999/rc99046.pdf
  22. http://www.gao.gov/archive/1999/rc99093.pdf
  23. http://www.gao.gov/cgi-bin/getrpt?GAO/RCED-92-16
  24. http://www.gao.gov/cgi-bin/getrpt?GAO/RCED-87-119
  25. http://www.gao.gov/cgi-bin/getrpt?GAO/RCED-87-109
  26. http://www.gao.gov/cgi-bin/getrpt?GAO/RCED-87-15BR
  27. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1245T
  28. http://www.gao.gov/cgi-bin/getrpt?GAO-07-1245T
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