A Review of National Railroad Issues

December 1975

NTIS order #PB-250622
OFFICE OF TECHNOLOGY ASSESSMENT

CONGRESSIONAL BOARD

Representative Olin E. Teague, Texas, Chairman

Senator Clifford P. Case, New Jersey, Vice Chairman

SENATE HOUSE

Edward M. Kennedy, Morris K. Udall,

Massachusetts Arizona

Ernest F. Hollings, George E. Brown, Jr.,

South Carolina California

Hubert H. Humphrey, Charles A. Mosher,

Minnesota Ohio ‘

Richard S. Schweiker, Marvin L. Esch,

Pennsylvania Michigan

Ted Stevens, Marjorie S. Holt,

Alaska Maryland

Emilio Q. Daddario

For sale by the Superintendent of Documents, U.S. Government Printing Office

Washington, DC. 20402 -Price $170
DIRECTORS OFFICE

Emilio Q. Daddario, Director

Daniel V. De Simone, Deputy Director

CONRAIL REPORT REVIEW PANEL

Robert Calhoun Prof. Thomas Sutherland

Sullivan & Worcester Princeton University

Lawrence Goldmuntz James Tapley

Economics & Science Planning, Inc. Southern Railway

A. Shefford Lang Prof. Robert Tollison

Association of American Railroads Texas A & M

OTA TRANSPORTATION PROGRAM STAFF

Gretchen S. Kolsrud, Ph.D., Program Manager

Mary E. Ames Larry L. Jenney

V. Rodger Digilio Beverly Johnson

Thomas E. Hirsch, 111 Teri Miles

Harbridge House, Inc., contractor

. . .

Ill
TECHNOLOGY ASSESSMENT BOARD EMILIO Q. DADDARIO

DIRECTOR

OLIN E TEAGUE, TEXAS, CHAIRMAN

CLIFFORD P. CASE, N. J., VICE CHAIRMAN O FFICE OF T ECHNOL OG Y A SSESSMEN T DANIEL V. DE SIMON E

EDWARD M KENNEDY, MASS. MORRIS K. UDALL, ARIZ. WASHINGTON , D.C. 20510

DEPUTY DIRECTOR

ERNEST F. HOLLINGS, S.C. GEORGE E. BROWN, JR.. CALIF.

HUBERT H. HUMPHREY, MINN. CHARLES A. MOSHER, OHIO

RICHARD S. SCHWEIKER, PA. MARVIN L. ESCH, MICH.

TED STEVENS, ALASKA MARJORIE S. HOLT, MD.

EMILIO Q. DA DDARIO

December 9, 1975

The Honorable Warren G. Magnuson

Chairman , Committee on Commerce

United States Senate

Washington, D. C. 20510

Dear Mr. Chairman:

On behalf of the Board of the Office of Technology

Assessment, we are pleased to forward a report: A

Review of National Railroad Issues.

—

This study is in keeping with your request, and that

of Senator Richard S. Schweiker of the Technology

Assessment Board, for a review of the United States

Railway Association’s Plan for restructuring the

bankrupt Northeast railroads.

This report is being made available to your Committee

in accordance with Public Law 92-484.

Sincerely, Sincerely,
OLIN E. TEAGUE, TEXAS, CHAIRMAN

CLIFFORD P. CASE, N. J., VICE CHAIRMAN O FFICE OF T ECHNOL OGY ASSESSMEN T DANIEL V. DE SIMONE

EDWARD M. KENNEDY, MASS. MORRIS K. UDALL, ARIZ. WASHINGTON . D.C. 20510

DEPUTY DIRECTOR

ERNEST F. HOLLINGS, S.C. GEORGE E. BROWN, JR., CALIF.

HUBERT H. HUMPHREY, MINN. CHARLES A. MOSHER. OHIO

RICHARD S. SCHWEIKER, PA. MARVIN L. ESCH, MICH.

TED STEVENS, ALASKA MARJORIE S. HOLT, MD.

EMILIO O. DADDARIO December 9, 1975

The Honorable Olin E. Teague

Chairman, Technology Assessment

Board

United States Congress

Washington, D. C. 20510

Dear Mr. Chairman :

This report, entitled A Review of National Railroad

Issues , was prepared by the Office of Technology Assessment in response to requests* received from Senator

Warren G. Magnuson, Chairman of the Senate Committee on

Commerce, and Senator Richard S. Schweiker of the OTA

Board.

The study will be used by the Commerce and Appropriations

Committees in the Senate and the House of Representatives

as they complete their deliberations on legislation

authorizing and appropriating funds for the reorganization

of the Northeastern railroads.

Preparation of this report was undertaken by the OTA

Transportation Assessment Program, under the supervision

of Dr. Gretchen Kolsrud, who was assisted by an ad hoc

task force of consultants knowledgeable in rail industry

operations and problems, a contractor, and by other

members of the OTA staff.

Sincerely, .

EMILIO Q. DADDARIO

Director

* See Appendix C

vii
Preface

In 1973, the financial disarray of the Northeast and mid-West

railroads led to the passage of the Rail Reorganization Act of 1973.

The Act established the United States Railway Association (USRA)

to develop a plan for a Consolidated Rail Corporation (CONRAIL) to

be formed of the financially distressed railroads. On February 26,

1974, USRA issued a Preliminary System Plan for CONRAIL, and on

26 July USRA submitted the Final System Plan to Congress.

This review was prepared in response to requests from the

Senate Commerce Committee and the House Subcommittee on Transportation and Commerce. This review is based on the Final System Plan

to maximize its utility to the Congress. This report examines

national railroad issues that were considered by the Committees in

preparing the implementing legislation for CONRAIL.

This review was accomplished in a three month period by OTA’S

Transportation Assessment Group supported by Harbridge House, Inc.

and a task force of individuals knowledgeable in railroad problems.

Contact was maintained with the Commerce, Appropriations and Budget

committees of the Senate and the House.

This assessment is a joint product, identifying different

possible points of view but not necessarily reflecting the opinion

of any individual.

7

1 Correspondence is attached in Appendix C

i x
TABLE OF CONTENTS

Page

EXECUTIVE SUMMARY . . ● . . . ● . ● . ● ● ● ● ● . . . . .

1. INTRODUCTION . . . . . . . . ● ● . ● ● . . ● . . .

A. Purpose and Scope of the Study. . . . . . . .

B. Organization of This Report . . . . . . . . .

11. FINANCIAL PROSPECTS OF THE INDUSTRY. .

A. ICC Projections. . . . . . . . . . . . . . . . . .

B. FNCB Projections . . . . . . . . . . . . . . . .

c . Modified FNCB Projections . . . . . . . . .

1. Projected Cash Shortfall . . . . . . . .

2. Financial Projections . . . . . . . . . .

D. Summary and observations . . . . . . . . . .

III. REHABILITATION OF ROADS AND FACILITIES

A. The Current Maintenance Situation . . . . .

B. Why Maintenance Is Deferred . . . . . . . .

c . Rehabilitation and Modernization Projects

1. Roads and Tracks ● **. .**  .

2. Yards and Terminals . . . . . . . . . .

E.

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Reasons for Federal Government Involvement . . . . . . . . . .

1. Financial Viability of the Railroad Industry . . , . . . . .

2. Non-Financial Public Objectives . . . . . . . . . . . . . . .

3. Energy and Environmental Benefits . . . . . ● ***9** *

Concerns Regarding Federal Involvement

In Rail Fixed Plant. . . . . . . . . . . . . . . . . . . . . . . . . ● 9 9 *

10 Financial Impact . . . . . . . . . . ● **m* *e** *e**. *a

2. Non-Financial Impact . . . . . . . . . . . . . . . . . . . . . . .

Summary and Observations . . . . . . . . . . ● ********4** *

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Iv. POTENTIAL IMPACTS OF RESTRUCTURING

u. s.

A.

B.

c .

D.

THE

RAILROAD INDUSTRY . . . . . . . . . ● . . . . . . . . . . . . . . . .

Current Options for Restructuring the Railroad

Industry . . 0 . . . . . 0 . . . . . . . . . . . . . . . . . . . .

Methodology for Forecasting the Impacts of

Restructuring the Railroad Industry . . . . . .

1. Evidence on Economies of Scale in the

Railroad Industry . . . . . . . . . . . .

2. Current Methodology . . . . . . . . . .

Merger Impacts . . . . . . . . . . . . . . . . .

Summary and observations . . . . . . . . . .

v . RATE REFORM ● . . ● ● . . . ● . . . . . . . . . . . .

A.

B.

c .

Do

Remaining Regulatory Constraints . . . . .

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1. The Form and Character of Proposed

Deregulation . . . . . . . . .

2. Limiting Monopolistic Dominance . . .

3. Rate Discrimination. . . . . . . . . . . . .

4. Place and Commodity Discrimination .

5. The “Free" Movement of Commodities

6. Public Benefits from ‘! Non-Rail”

Transportation . . . . . . . . . . . . ● e e *

7. Summary ● * * * * * * * * * *.**.....

Deregulation and Market Opportunities for

Railroads . . . . . . . . . . . . . . . . . . . . . . .

1. Railroad Supply Costs . . . . . . . ● * * *

2. Market Demands . . . . . ● ******.. .

Public Policy Toward Other Modes . . . . . .

1. The Effects of Public Investment

on Other Modes . . . . . . . . . . . . . , .

2. Deregulation of Other Modes ● ***** *

3. The Response of Rail Carriers to

Competitive Pressures . . . . . . . . . ,

Summarv and Observations . . . . . . . . . . . . w ..----- -

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x i i
VI. OTHER LEGISLATIVE ACTIONS . . . . . . . . . . . . . . . . . . . . . . . 69

A. Light-Density Lines . . . . . . , . . . . . . . . . . . . . . . . . . . . . 69

B. Discriminatory Taxation . . . . . . . . . . . . . . . . . . . . . . . . 69

c . Summary and Observations . . . . . . . . . . . . . . . . . . . . . . . 70

APPENDIX A ILLUSTRATIVE ANALYSIS OF ALTERNATIVE

PUBLIC INVESTMENTS IN RAIL FIXED PLANT

APPENDIX B REVIEW OF RECENT RAILROAD MERGER

HISTORY

APPENDIX C LETTERS OF REQUEST

APPENDIX D HARBRIDGE HOUSE STUDY TEAM MEMBERS

. . .

X111
LIST OF EXHIBITS

Page

EXHIBIT II-1

EXHIBIT II-2

EXHIBIT II-3

EXHIBIT II-4

EXHIBIT III-1

EXHIBIT III-2

EXHIBIT IV-1

EXHIBIT V-1

EXHIBIT V-2

EXHIBIT V-3

ICC Financial Projections (Modified),

1976 -1983, U.S. Class I Railroads

Less Bankrupts . . . . . . . . . . . ● . . . . . . . . ● ● ● ● ● 5

Projected Cash Shortfall, 1976-1985,

Group I and Group II Class I Railroads,

'Status Quo Projection' . . . . . . . . . . . . . . . . . . . . . . 8

Projected Cash Shortfall, 1976-1985,

Group I and Group II Class I Railroads,

FNCB Projections (Modified) . . . . . . . . . . . . . . . . . . 9

FNCB Financial Projections (Modified),

1976 - 1985, U. S. Class I Railroads

Less Bankrupts . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Estimate of Deferred Maintenance in

Track Materials for 25 Railroads. . . . . . . . . . . . . . . 16

Summary of Railroad Reports . . . . . . . . . . . . . . . . . 25

The Livingston Plan for Restructuring

the Railroad Industry . . . . . . . . . . . . . . . ● ****** * 32

Estimates of Traffic Diversions. . . . . . . . . . . . . . . . 59

Fresh Fruit and Vegetable Unloads for

41 Cities Originating in California,

1966-1974 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

Characteristics of the Markets for the

Modes of Intercity Freight Transportation . . . . . . . . . 65

x i v
EXECUTIVE SUMMARY

The railroad industry of the United States, exclusive of the currently

bankrupt roads, faces a cash shortfall of some $500 million annually over the

next decade against desired levels of expenditure. In addition, individual railroad companies face bankruptcy, with turmoil in the transportation system and

possible requirements for significant public costs as the result.

Rail freight service is not an obscure anachronism. It handles more

intercity freight than trucks and barges combined, and it will continue to play a

major role under virtually any imaginable scenario of the next decade. These

problems will simply not just “go away. ”

The range of legislative proposals discussed in the body of this report contains the elements of an appropriate response to the railroads’ problems,

at both the industry level and that of the individual weak roads. The proposals

also contain a significant danger of inappropriate solutions with serious adverse

consequences for the long-run viability of the industry. This summary attempts

to identify both the solutions and the dangers in turn.

solutions

A legislative package designed to appropriately address the problems

identified in this study would include:

● Rehabilitation. This would be a selective program of federal

assistance for the rehabilitation of railroad fixed plant. The

program would focus on those railroads which are weaker than

the industry average in terms of cash needs and potential

bankrupts. With this focus, and also through explicit criteria,

the rehabilitation would be directed at expenditures which pro- “

duce high cash returns to the railroads, concomitant benefits

in terms of service quality, and such societal aspects as energy

conservation and enhancement of the environment. The intent

would be to augment the limited cash flows available for this

purpose to the weaker roads and not to simply replace private

capital in the stronger sector of the industry. To be effective,

the public funds would have to be made available as outright

grants or as very low cost loans with terms which avoid burdensome interest or repayment features which would defeat

the objectives of the program.

x v
The amount and timing of funds would depend on events (particularly trends in the national economy), but would probably

be $3 billion to $4 billion, or something less than the total

$5 billion projected shortfall.

● Restructuring. The part of the problem to which restructuring

t may present solutions is not that of industrywide cash shortfall.

The massive nationwide restructuring exemplified by the Livingston Plan for four transcontinental rail systems is too uncertain as to its effects and, in any event, would be of limited

benefit in the ten-year horizon being discussed here. Less

ambitious restructuring, however, can contribute one means

of dealing with the bankruptcy problem. Legislation to enhance

this effect would include provision for some analytic and planning effort without which the federal government cannot act nor

even react rationally to voluntary industry-initiated proposals.

It would also include provision for the expeditious processing

of whatever voluntary restructuring proposals emerge from

the industry in its efforts to avoid the bankruptcy problem. In

addition, it would provide for the use of rehabilitation funds,

discussed above, as leverage to promote or encourage restructuring activity which appears desirable based on the financial

condition of specific roads and the planning process. (It should

be evident from the above that the planning process envisioned

must not be limited to producing a grand scheme for the railroads for the year 2000. It must deal with the short-term

specifics of individual railroad companies, routes, and markets

in the short term, but also be guided by a

spective.)

● Rates. Of the areas encompassed by this

lation is the most difficult in terms of the

impacts. This is due to the wide-ranging

longer range perreport, rate legis -

visibility of potential

nature of the impacts,

including effects on rail traffic, its relation to other modes,

and the cost of transportation to society. It is also due to the

limited amount of analysis (as opposed to doctrinaire beliefs,

of which there is no lack) currently available. The analytic

evidence that is available suggests that legislative “rate reform” contains much potential for disruptive effects both

within the rail industry and within the general economy. These

dangers will be discussed below. On the more positive side,

several observations can be made.

xvi
--Some rate flexibility should be provided to rail management,

downward to explore market opportunities and upward to

relieve the industry of some of its “loser” traffic, either

by covering costs or permitting the railroads to price themselves out of some markets. It is unlikely that rail carriers

will make significant rate reductions.

--To be effective, such flexibility must take into consideration

all regulatory restraints that currently apply to rail rates.

E, in practice, Sections 3 and 4 of the Interstate commerce

Act inhibit flexibility, they should be modified legislatively.

--Changes in this area should be made in such a way that truly

disruptive effects am avoided. One proposed approach is

to lift regulatory constraints gradually over time.

--Consideration must be given to regulatory change in other

transportation modes since the interactive effects may be

more significant and less well understood than the singlemode perspective.

● Other. Service on light-density lines which generates cash

losses for the railroads and which is required for the public

good should be subsidized with some form of public monies.

This will relieve the railroads of a financial burden which they

cannot afford and, by requiring overt rather than hidden subsidy, will provide a means of ensuring that real public needs

determine the service requirement.

Discriminatory taxation of rail property arises from the economics of an earlier era. It is not now appropriate and should

be effectively stopped.

The effects of these two actions will add approximately $100

million annually to railroad cash flows. This amount is

significant in relation to the cash needs of the industry over

the next ten years.

Dangers

As noted, the range of legislative proposals reviewed in this study

is believed to contain an appropriate response to the problems of the rail industry. In addition, however, numerous adverse impacts could also be experienced

I -Ill I - 7- - - xvi i
if inappropriate options are drawn from that same range of proposals. These

dangers should be kept in mind throughout the legislative process. They are

highlighted below:

● Rehabilitation. One major danger associated with rehabilitation is that of “overkill." This refers to the possibility of

federal assistance for marginal rehabilitation activities that

provide no cash gains to the industry and little public benefit

in terms of service gains or energy and environmental benefits.

Alternatively, such federal overkill would simply result in

replacing currently available private capital with public monies.

The other danger associated with federal rehabilitation assistance is that of attaching such stringent financial terms that

the funding cannot reach, or cannot benefit, the weaker railroads which need it most and which are otherwise forced to

defer maintenance that would provide relatively higher financial and public returns.

● Restructuring. The danger here is that history will repeat

itself and that undesirable mergers will be permitted to take

place while the voluntary restructuring aimed at the weaker

roads will be dragged through an endless procedural and

conceptual morass. A planned and expedited federal response

to (and participation in) industry-initiated restructuring appears

to be essential.

● Rates. The dangers associated with rate reform are very

real and involve adverse impacts on both the rail industry and

the public. If done carelessly, the revision of historical

regulatory treatment of the major modes could cause massive

shifts of traffic away from the railroads. In addition, unrestrained freedom in the rate area could cause widespread

increases in rail transportation costs. Such increases may be

inevitable--and even desirable--over an extended period of

time, but the potentially disruptive short-run impacts must be

minimized.

XVIII
-1-

1. INTRODUCTION

A Purpose and Scope of the Study

The launching of Conrail (Consolidated Rail Corporation) in the fall

of 1975 is the culmination of several years of planning and analysis. The reorganization of the bankrupt railroads in the Northeast and Midwest has required

hundreds of man-years of analytic effort, major legislation, and extensive formal and informal public debate at a total cost of tens of millions of dollars.

At

of the nation’s

little fanfare.

of the private,

the same time, legislative action of vital significance to the rest

railroad industry has been under consideration with relatively

The proposals under consideration include major restructuring

solvent carriers; billions of dollars of public investment in the

railroad fixed plant; and sharp changes in the regulatory principles and procedures that have developed and evolved over decades.

The Office of Technology Assessment, in addition to providing inputs

for the review of plans for the reorganization of the bankrupt railroads, has

been asked by the Transportation Subcommittees of the House and Senate Committees on Commerce to provide some analysis of the prospects for the solvent

remainder of the rail industry. This study by Harbridge House, Inc. , is intended

to assist in that effort.

The report frequently presents a range of possible impacts rather

than hard dollar estimates, and it often relies on the experience and judgment

of the study team and other knowledgeable sources. This is partly a product

of the legislative timetable which did not permit comprehensive original research

and analysis. Even more, it is a reflection of the inherent difficulty of projecting

the future of an industry which is subject to many conflicting influences. The

industry results are sensitive to the behavior of the nation’s economy; further,

to find binding evidence of conspicuous past success in general economic projections over the time frames with which the study is concerned is difficult

indeed: - Finally, it is a considerable handicap in a short-term study based on

existing analyses to find that little objective quantitative analysis of many facets

of the industry exists, even by those who are proposing significant and, from a

public perspective, expensive, legislative change.

B. Organization of This Report

Following this Introduction,

projected financial prospects of the rail

Part II presents a discussion of the

industry, exclusive of the bankrupts,
- 2 -

and the physical implications of these projections. Part III discusses the rehabilitation of railroad fixed plant, alternate forms of federal involvement in such

rehabilitation, and the degree to which these alternatives may alter the projected

picture of the industry.. Part IV is an analysis of the potential contribution which

restructuring or revision of the corporate configuration of the solvent railroads

might make to a viable national rail system. Part V assesses the impact on

railroad tonnage and financial health which might result from a change in the

regulation of the rates charged by the rail mode and its competitors. Part VI

concludes the impact analysis with a brief review of other proposed legislative

changes.
- 3 -

II. FINANCIAL PROSPECTS OF THE INDUSTRY

The objective of this portion of the study is to provide an estimate

of the future financial and physical performance of the rail industry, exclusive

of the current bankrupts, based on the status quo --that is, in the absence of major legislative change. Of the many forecasts of overall performance and specific aspects such as tonnage, market share, and equipment requirements, we

focused on two fairly comprehensive projections, one made by the Interstate

Commerce Commission and the other done by the First National City Bank. Each

of these is discussed in detail below.

A. ICC Projections

The Interstate Commerce Commission’s (ICC) projection was recently performed by the ICC staff. 1 The approach taken in this study was relatively straightforward and, with several exceptions, consisted of forecasts

based solely on historical relationships. Traffic projections were generated for

each district on the basis of a regression analysis2 using gross national product

and key commodity production. These ton-mile estimates were then converted

to revenues based on projections from the 1963 -1974 time period.

operating expense projections were built up for each district by category of expense (wages, materials and supplies, fuel and power, depreciation

and retirements, and loSS and damage) using a regression analysis that related

these expenses to historical and projected ton-miles. Non-operating expenses

such as net rents and taxes were projected from 1973 actual debt outstanding as

of year-end 1973.

Dividends were initially projected on the basis of an analysis of historical payout ratios, but the resulting payout was regarded as being too unstable

to be a realistic forecast. An alternative projection of a fixed dollar amount,

equal to 1973 levels, was selected as being more consistent with past railroad

practice.

1This work, performed under the direction of Dr. Jack S. Ventura, is preliminary and is currently under revision. It has not been reviewed or approved by

the Commission or by individual Commissioners.

2Regression analysis is a mathematical technique for determining the relationship between two or more quantitative variables. In this instance, ton-miles

are the dependent variable, and gross national product and the production of

key commodities are the independent variable.
-4-

Equipment needs were projected separately by type of car. Fleet

requirements over the period were estimated based on ton-miles of key commodities, and year-end 1973 cars less anticipated retirements were subtracted

to arrive at a net requirement. Although no significant improvements in car

utilization were forecast, the resulting needs were regarded as low by the ICC

staff. The needs were assumed to be met by a combination of equipment debt

financing and leasing, with the proportions based on actual experience. The use

of an industry-wide average probably overstates the use of leasing by the solvent

carriers.

Track expenditures were projected to include historical levels plus

an increment to maintain fixed plant at its current level (normalized maintenance)

plus an additional amount to bring fixed plant up to its optimal condition over a

ten-year period (deferred maintenance). The estimates were developed from

Estimate of Deferred Maintenance in Track Materials for Twenty-Five Railroads,

by Thomas K. Dyer, Inc. Dyer's results were extrapolated on the basis of track

mileage to get totals by district for all railroads. This approach represents a

departure from the status quo in that it substitutes a “desired” level of expenditure for the extrapolation of past trends which characterizes most of the ICC

projections.

This is also true of the projections of roadway facility expenditures

which include an annualized (over ten years) amount for delayed capital improvements. This amount has been added to an account-by-account projection of

historical expenditures based on forecasts of traffic growth and assuming a continuation of technological substitution trends.

Exhibit II-1 shows the results of the ICC staff projections, in modified form, for the years 1976- 1983 for the Class I railroads exclusive of the

bankrupts (and one other railroad). The results have been modified in several

ways. For the 1974 year which was projected in the ICC work, we have substituted 1974 actual results. From the 1974 results and the 1978 and 1983 forecasts, we have interpolated to arrive at a 1973 - 1983 projection.

The projected shortfall for the eight-year period is about $3.6 billion

for the solvent rail industry, or an average of about $450 million per year. This

iS intended to give a feel for the results of the ICC staff projections. As would be

expected with a preliminary analysis of a very complex problem, there are some

difficulties in these numbers and the approach is, in fact, currently under revision. Among the problems are an incomplete accounting for the interest and

1WorK performed under Contract DOT-FRA45005 by Thomas K. Dyer, Inc. ,

Lexington, Massachusetts, dated May 3, 1974.
- 5 -

EXHIBIT II-1

ICC FINANCIAL PROJECTIONS (MODIFIED), * 1976-1983

U.S. CLASS I RAILROADS LESS BANKRUPTS

(Millions of Inflated Dollars)

Operating Revenues

Operating Expenses

Net Rents

Taxes

Net Railway Operating Income

Depreciation

$ 103,450

7,444

14,889

Cash Flow

Interest on Old Debt $ 2,109

Retirement of Funded Debt 3,172

Dividends 3,496

Net Cash Flow Available

Interest on New Equipment Debt $ 2,515

Other Equipment Cash Outlays 5,416

Roadway Facilities and Track Expenditures 8,581

Cash Shortfall

$140,620

-125.783

$ 14,837

+6, 856

$ 21,693

-8.777

$ 12,916

-16.512

$ (-3,596)

*

See text. These projections are based on preliminary staff work which has not

been reviewed or approved by the Commission or individual Commissioners.
- 6 -

repayment associated with debt outstanding as of year-end 1973, and a distortion

of the results of the Eastern district. The latter originates in an effort to exclude the Eastern bankrupts, and the projections for those roads were incompatible with those for the district as a whole, so that the projections for the

Eastern solvents are seriously distorted.

B. FNCB Projections

The second forecast of industry-wide railroad performance (exclusive

of the bankrupts) that was subjected to intensive review was done by the First

National City Bank (FNCB) as part of its review of the Final System Plan. These

projections were entirely independent of the ICC staff efforts and involved inputs

from the Association of American Railroads (AAR) and the Federal Railroad Administration (FRA). The methodology is fully documented in the September 1975

statement by John W. Ingraham, Vice President of the First National City Bank,

before the Transportation Subcommittees of the House and Senate Committees on

Commerce.

The approach taken by the FNCB is quite different from that used by

the ICC staff. The FNCB began with economic projections by Chase Econometric

Associates Inc. (Chase) and tonnage forecasts prepared from them. Expense

categories were projected from 1974 experience based on changes in tonnage and

inflation indices projected by Chase.

Maintenance of way was projected to include historical levels plus

“normalized” maintenance and catch-up over a 20-year period of existing deferred maintenance. These projections were based on the work by Thomas K.

Dyer, Inc. , referenced above, and were similar to the estimates of maintenance

of way made by the ICC staff in terms of the approach used and the results obtained--with two exceptions. First, the FNCB chose to “catch up” on current

deferred maintenance over 20 years rather than ten, on the basis that the normalized maintenance would in fact overlap with the deferred maintenance and

thus a ten-year catch-up would overstate the total maintenance requirement.

Second, the inflation indices projected by Chase were higher than those used by

the ICC; thus, the inflated dollar projections by the FNCB are higher.

Revenues were projected as a function of forecast operating expenses

and an operating ratio based on historical experience. This assumed a continuation of the recent general rate increases based on industry average expense increases.

1A Capital Market's Analysis of the Final System Plan as proposed by the United

States Railway Association, September 1975.
-7-

Interest expense and maturities of existing railroad debt were projected on the basis of a detailed schedule of existing debt issues.

Dividends were projected in accordance with an assumed fixed payout ratio of 45 percent of net income.

Estimates of new equipment needs were provided by the AAR and are

based on the Chase tonnage forecasts. They appear to be conservative.

A summary display of projected cash shortfall in the non-bankrupt

Class I railroads, taken directly from the FNCB’S September 1975 statement,

is shown as Exhibit II-2. It is for a ten-year period and thus is not directly

comparable with the ICC results.

Exhibit II-2 shows a ten-year shortfall of $21.1 billion. The accompanying text points out that if the availability of equipment debt is assumed, the

net shortfall represents about a $10-billion problem. This would be equivalent

to an annual average shortfall of $1 billion in inflated dollars.

c . Modified FNCB Projections

The Harbridge House study team believes that the FNCB projections

represent a workable forecast of rail industry performance, but that one assumption made in the forecasts --that in each year of the forecast period the cash

shortfall for that year is covered by long-term unsecured or mortgaged debt--

has resulted in a wide misunderstanding of the results. Although the FNCB

statement points out that such debt is beyond the financial capability of the industry and could not be available from private capital markets, the assumption

is built into the forecasts. As a result, the shortfall for any one year is borrowed and the shortfall for all subsequent years is swollen by the interest and

repayment requirement for the assumed borrowing. The effect is significant:

the $10-billion problem includes about $8 billion of interest and amortization.

Consequently, Harbridge House, with the cooperation of the FNCB,

has modified the FNCB projections to remove the assumption of non-equipment

debt. The forecast has also been modified slightly to reflect the existence of

an element of fixed cost in transportation expense so that this category varies

with 85 percent of the fluctuation in tonnage rather than directly.

The results of these modifications, restated to reflect the assumption that equipment debt will continue to be available to the rail industry, are

presented in Exhibit II-3.
-8-

EXHIBIT II-2

PROJECTED CASH SHORTFALL, 1976-1985

GROUP I AND GROUP II CLASS I RAILROADS

‘STATUS QUO PROJECTION’

(Billions of Dollars)

70

I

60 ‘

50 -

CASH

SHORTFALL

$21.1

PROCEEDS

OF IN40 CREASED

RATES

14.1

30

20 “ INTERNAL

CASH

GENERA- ‘

TION

10 36.6

0 ,

Source:

SOURCES

$50.7

1

USES

$71.8

$3. 2

6.6

12.7

10.4

I

-5. 1

5.7

13.1

15.0

FEDERAL INCOME TAXES

STATE AND

LOCAL TAXES

DEBT

INTEREST

DEBT

MATURITIES

DIVIDENDS ON EQUITY

CATCH-UP

MAINTENANCE

CA PITA L EXPENDITURES FOR ROAD

PROPERTY

CAPITA L EXPENDITURES

FOR

EQUIPMENT

FNCB Rail Industry Model based on Railroad R-1 Reports and information provided by the Federal Railroad Administration and the Association of American Railroads.
- 9 -

60

CASH

SHORTFALL

$5.0

50

40

30

INTERNAL

CASH

GENERATION

20-

10

0

EXHIBIT II-3

PROJECTED CASH SHORTFALL, 1976-1985

GROUP I AND II CLASS I RAILROADS

FNCB PROJECTIONS (MODIFIED)

(Billions of Dollars)

SOURCES

$49.6

$4.1 FEDERAL INCOME TAXES

6.6 STATE AND

LOCAL TAXES

7.4 DEBT INTEREST

8.2 DEBT

MATURITIES

6.4 DIVIDENDS ON

EQUITY

5.7 CATCH-UP

MAINTENANCE

13.1 CAPITAL

EXPENDITURES

FOR ROAD

PROPERTY

3.1 EQUIPMENT

WNPAYMENT

USES

$54.6
-1o1. Projected Cash Shortfall

As noted earlier, removal of the assumption that shortfalls are

covered by additional long-term non-equipment debt reduces the projected interest and maturities by about $8 billion. This is partially offset by increases

in dividends and taxes due to an increase in net income. The net effect, following the FNCB procedures, is to indicate a ten-year cash shortfall of $5.0 billion,

or an average of about $500 million per year. This is the estimated shortfall

that is relevant in addressing the question of the amount of unrestricted government grants required to permit industry, excluding the Northeast bankrupts, to

conduct a full-scale fixed plant maintenance program which includes catch-up of

previously deferred maintenance.

This projected shortfall assumes, as does the ICC projection, the

continued availability of equipment debt. If such financing is not available the

effect on railroad cash needs will be dramatic, increasing the ten-year shortfall

by about $7 billion. Several recent events have raised questions about the continued availability of such financing.

One such event was the publication of the FNCB statement itself,

which questioned the ability of the rail industry to carry significant additional

debt of any kind. An echo of this event was the recent delay in executing some

financing for a non-railroad subsidiary of a large and solvent railroad holding

company. The insurance company involved was apparently unwilling to accept

rail-related debt, at least in part because of the implications of the FNCB projections.

Another such event was the recent litigation over the position of

equipment debt creditors under Section 77J of the Bankruptcy Act. While the

study team made no analysis of the merits of either position, it appears that,

in the eyes of the financial community at least, the security of such financing

has been brought into question by the position of the Department of Transportation. This position, upheld in initial proceedings, essentially states that holders

of Conditional Sales Agreements should be obligated to receive payments due

from the government, rather than from the bankrupt railroad, and that the government, in return, should acquire a subordinate interest in the rolling stock which

serves as collateral. Financial community spokesmen say that it is not clear

whether the forecast amounts of equipment debt financing will be made available

by private capital markets.

2. Financial Projections

The FNCB produced separate projections for two subgroups of railroads, dividing the Class I non-bankrupt roads into Group I (Strong) and Group
-11-

11 (Weak), based on their standing with the financial community as reflected in

the mortgage rating of their existing non-equipment debt. Group I consists of

22 railroads with mortgage ratings of A or better; Group II contains 41 railroads

with ratings of Baa or below, or with no rated debt outstanding, The results of

the separate projections, modified as described above, are shown in Exhibit II-4.

They show that the projected cash shortfall for the weaker roads is somewhat

higher in relation to revenues than that for the stronger roads, but virtually identical in relation to projected expenditures for partial catch-up of deferred maintenance. The implication of the projections in both groups is that internally

generated cash will be sufficient to hold maintenance at a “normalized” level,

but not to make a significant reduction in existing deferred maintenance.

To a large extent, the lack of a sharper difference between the two

groups is a product of methodological limitations. The projections were not intended to reflect regional differences or trends in key commodities. Presumably,

the effect of such trends would be to increase the cash shortfall of the weaker

railroads and ‘decrease that of the stronger ones. Nevertheless, it is interesting that given the financial and operating status of the two groups as of 1974,

homogeneous forecasts of future performance blur much of the distinction between the two groups.

These projections say virtually nothing about the future performance

of individual railroads, Indeed, it might be concluded that given the projected

performance of the industry as a whole, and the certainty of individual variances

about that average, some railroads may perform enough below the average to

create additional railroad bankruptcies even if the forecasts for the industry are

correct to the nearest dollar.

In this realm, the concurrent research being sponsored by the

Federal Railroad Administration to develop an early warning system for predicting future railroad bankruptcies could be useful. This development should also

allow the ICC to more closely monitor the annual performance of individual railroad firms.

D. Summary and Observations

Several observations about the nature of “the railroad problem"

emerge from a review and analysis of rail industry performance projections.

In general terms, the problem at the industry-wide level is a cash shortfall of

about $500 million per year. If the projections are correct, the industry as a

whole will have sufficient cash over the next decade to operate, pay dividends,

repay interest obligations and maturing debt, and maintain rail fixed plant at its

current level of utility. Although the problem is not as large as some analysts

believe, the industry is not expected to generate sufficient cash resources to reduce the current level of deferred maintenance of fixed plant significantly.
-12-

EXHIBIT II-4

FNCB FINANCIAL PROJECTIONS (MODIFIED), 1976-1985

U.S. CLASS I RAILROADS LESS BANKRUPTS

(Millions of Inflated Dollars)

Group I

(Strong)

$177,741 Operating Revenues

140,983

3,361

17.376

$ 16,021 Net

6,938

Operating Expenses

Net Rents

Taxes

Railway Operating Income

Depreciation

$22,959 Cash Flow

2,142

3,102

4.937 

$ 12,778 Net

2,314

4,541

8.979

Interest on Old Debt

Retirement of Funded Debt

Dividends

Cash Flow Available

Interest on New Equipment Debt

Other Equipment Cash Outlays

Roadway Facilities and Track

Expenditures

Group II

(Weak)

$ 87,619

69,235

3,611

7,647

$ 7,126

2.676

$ 9,802

1,746

1,074

1.834

$ 5,148

1,041

2,037

4,127

$ (-3, 056) Cash Shorthll

Ten-Year Projection of Deferred Main-

$ 3,437 tenance, Catch-Up (Memo Entry)

$ (-2, 057)

$ 2,308
-13-

The remainder of this report is devoted to an examination of major

proposed solutions, but some points arise out of the forecasting experience itself.

One is that the impact of the assumption in the FNCB projections,

that cash shortfalls are relieved by borrowing at current private capital market

rates, is a dramatic warning that debt at such rates is not a solution. Requirements for interest and amortization of such debt can indeed double the size of

the problem.

A second observation is that the equipment debt market is a significant part of the projected sources of needed railroads funds and should be preserved.

A third point is that steps should be taken to improve the railroad’s

rate of return, or cash flows. This arises as a result of the financial community’s claim that such improvement is needed to preserve the availability of

equipment debt. It will also lessen the projected cash shortfall (either allowing more maintenance of fixed plant to be done or lowering the requirement for federal assistance). Dropping to the level of individual railroad

problems, general improvement of cash flows will lessen the risk, or severity,

of individual bankruptcies.
-14-

HI. REHABILITATION OF ROAD AND Facilities

A. The Current Maintenance Situation

Unlike other transportation modes, the railroads own and maintain

the network over which they haul traffic--namely, track and roadway. Recent

estimates indicate that the Class I railroads currently have a $32-billion investment in roadway and facilities. This investment includes:

● Land traveled by the right-of-way.

● Physical plant attached to the roadbed (including rail, ties,

and spikes).

● Bridges and tunnels.

● Supportive equipment, such as signaling systems, located along

the right-of-way.

● Yard facilities.

● Terminal facilities.

Ownership of these facilities carries with it costs of maintenance and

modernization. In 1974 the Class I railroads spent $2.3 billion to maintain roadways and facilities; this is equivalent to 14 cent from each dollar of revenue collected

during that year. In that same year $.5 billion was spent on modernization projects to upgrade the quality of these facilities.

The amount of maintenance that was not performed, but which should

have been, has received greater attention recently than the maintenance that was

actually done. For the last 15 to 20 years, railroad management has not engaged

in enough maintenance of way and structures to avoid the aggregate deterioration

of these facilities. 1

According to a recent Federal Railroad Administration study, in 1972

(the latest year for which appropriate data were available) the Class I railroads

would have had to lay an additional 372, 000 tons of rail and some 6 million ties

1

Yearly maintenance expenditure at a level which avoids any increased deterioration of roadway and facility is referred to as maintenance at normalized levels.
-15-

in order to meet normal replacement rates. At 1972 cost levels, this work represents an additional $364 million that should have been spent to keep pace with

roadway repair. Instead, this maintenance was deferred. Data on the aggregate of deferred maintenance in track materials are shown in Exhibit III-1. If

the Class I railroads had undertaken a concerted effort in 1972 to correct this

maintenance deficit, and if they had amortized the cost of this effort over ten

years, the additional cost in 1972 for ties and rail would have been some $583

million (at 1972 prices).

A number of important questions evolve from this deferred maintenance issue:

(i) Why was maintenance deferred in the first place?

(ii) What would federal assistance in the rehabilitation of fixed

plant involve ?

(iii) What are the reasons for federal involvement in rail fixed

plant ?

(iv) What are the concerns regarding federal involvement in rail

fixed plant ?

B. Why Maintenance Is Deferred

The high level of deferred maintenance among the bankrupt railroads is usually interpreted as an indication of the dismally cash-short conditions which they faced in the years prior to bankruptcy. Further, the existence

of deferred maintenance among the solvent railroads is regarded by many observers as an indication of the same shortages of cash in the industry generally.

Undoubtedly, railroads in a deteriorating financial position will be

very likely to defer maintenance programs which, under normal circumstances,

should be undertaken. This might mean that the number of miles of track included in the yearly planned maintenance program might be reduced. It might

also mean that the level of rail, ties, and spike replacement which occurs on

trackage included in the planned maintenance program is drastically curtailed.

In the extreme case the entire planned maintenance program might

be discontinued, with maintenance being performed only when it becomes absolutely necessary. However, there are alternative steps which can be taken to

avoid the need for maintenance. These might include:
-16-

o

0

0

0

“

o

0

o

0

0

0 I

I
-17-

• Orders to reduce train speed.

● The rerouting of traffic around poor quality roadways.

● The reduction of train size over dilapidated trackage areas.

Each of these steps would reduce the need to send a specialized maintenance

crew out to maintain trackage.

cially

of the

press

Railroad accounting further magnifies the reluctance of the finanweak railroads to invest in maintenance of right-of-way because the bulk

dollars involved appear on financial statements as expenses, and thus dereported earnings.

Although high levels of deferred maintenance may be indicative of

railroad cash-flow problems, this does not necessarily mean that the decision

to defer maintenance is always inappropriate, or that it is always limited to

cash-starved roads. The decision to defer maintenance might be based on conscious attempts to invest funds in areas that promise to be most beneficial to

the overall profitability of the company. If the returns gained through the investment of funds in certain maintenance-of-way projects are not as high as the

returns gained from other kinds of projects, it would make sense to use the available funds elsewhere. Consequently, the less profitable maintenance projects

are deferred.

A related observation by knowledgeable rail industry sources is that

fixed plant maintenance expenditures produce a return that is spread over a long

period of time. Alternate projects with a quicker payback are likely to be favored

by rail management.

c . Rehabilitation and Modernization Projects

The proposals for federal assistance in the rehabilitation of rail

fixed plant involve the provision of public monies or loan guarantees to the railroads to enable them to better maintain and modernize their fixed assets. There

are many such proposals which differ in a number of respects. 1 However, in

terms of what gets done with the public investment, the proposals generally do

not distinguish between historical levels of fixed plant maintenance, normalized

maintenance, catch-up of deferred maintenance, or capital projects to modernize or upgrade the fixed plant.

1

See “A Review of Alternative Approaches to Federal Funding of Rail Rehabilitation, ‘f U.S. Congress, Office of Technology Assessment, September 1975.
-18-

Some of the projects that might be considered in a roadway and facilities rehabilitation program for improvement, modernization, and/or repair are

roads and tracks, and yards and terminals. Some specific rehabilitation projects are discussed below.

1.

ing:

Roads and Tracks

Rehabilitation projects on roads and tracks might include the follow-

● Replacement of Obsolete Rail and Ties. It has been estimated

that the

out rail

road by

average

results vary by railroad and over time but, overall, the average life of a tie is

estimated at 33.4 years and two-position rail has an estimated life expectancy of

54.2 years. 2

nation’s rail system today needs about $5.8 billion just to replace wornand ties.1 Annual replacement requirements are calculated for each railestimating tie and rail life based on physical characteristics (for example,

system weight of rail) and use (average system gross ton-miles). The

• Eliminate Steep Grades and Curves. Some routes, which may

have been laid out a hundred years ago, contain steep grades and curves which

slow the movement of traffic and often require added motive power. Further,

given the change in locomotive technology, many routes are not suitably laid out

for high-speed diesel engines. Modern construction techniques can eliminate

many of these problems and improve the design of the routes.

● Renovate Bridges. A washed-out bridge could put a railroad

or a large section of its network out of business since, in many cases, a bridge

may be the only link between two points. At times it might be possible to reroute traffic over an alternative route, but very often the strategic position of

bridges makes them vital to the functioning of a rail system. Bridge renovation

projects may be considered as important elements of a rehabilitation project.

● Renovate Tunnels. Tunnels, like bridges, are vital links between points. Many years ago tunnels provided the only way to get from one

side of a mountain to the other. Their age and the technological conditions under

1 A United States Rail Trust Fund, Prescription for a Modern Rail Transportation, by Milton J. Shapp (Pennsylvania Department of Transportation, 1974),

p. 15.

2

1bid. , p. 45.
-19-

which many tunnels were built imply that renovations or rehabilitation are nec -

essary for them. Further, unless tunnels are well maintained, leaks and caveins could be serious threats to the continuation of rail service.

● Improvements to Clearances. Equipment and machinery are

much larger and heavier today than they were years ago when many rail clear -

ances were built under bridges and tunnels. The undertaking of a clearance renovation project could result in a modal shift of this equipment traffic from track

to rail.

2. Yards and Terminals

Many of the greatest inefficiencies and much of the unnecessary cost

in the railroad industry can be traced to yards and terminals. In many large

metropolitan areas old scattered terminals are a factor leading to the dispro–

portionately high costs of originating and terminating freight. High per diem

rentals for cars and underutilization of the nation’s freight car fleet can also be

traced to yard and terminal inefficiencies. Switching improvements for tracks

and traffic lanes could reduce the time that cars spend in the yard, and cons e -

quently both improve their utilization and reduce their per diem cost.

D. Reasons for Federal Government Involvement

The reasons why the Federal Government should provide public monies

for the rehabilitation and modernization of rail fixed plant fall into two broad categories. One relates to the financial viability of the railroad industry; the other

involves non-financial public objectives associated with rail transportation.

1. Financial Viabilitv of the

Railroad Industrv

Those who see the primary benefits of Federal Government involvement in terms of enhanced financial viability of the railroad industry visualize

two main effects of improved fixed plant:

● Attraction of new traffic and avoidance of future traffic losses

(the result of improvements in transit time and reliability of

service).

• lmproved operating efficiencies.

One of the major concerns of shippers is the amount of time their

freight spends on the road between origin and destination points. If shippers
-20-

could be guaranteed that their freight would arrive within a specified and reasonable time period, they might be willing to ship by rail. However, as long as the

transit time by rail is longer than necessary and the movement is unreliable--

anything may be lost in transit from hours to days --shippers will refuse to suffer

the inconveniences of rail.

Improved operating efficiencies imply reduced operating costs. Examples of such inefficiencies which have been corrected and which can improve

operating costs have been cited by the United States Railway Association. While

specifically concerned with the bankrupt railroads, the same problems are associated with deteriorated rail fixed plant in the railroad industry overall:

●

●

●

●

●

●

Because of slow orders, through-freight trains between some

major yards and terminals now require up to twice the travel

time previously needed when track was maintained adequately.

This often makes it necessary to reduce the length of some

crew districts and to recrew more trains en route.

Slow orders also prevent efficient operation of high-priority

piggyback trains which must be dependable and fast in order

to compete in the time-sensitive markets.

Portions of some key yards are out of service because the

track cannot meet minimum Federal Railroad Administration

standards. This results in yard congestion and traffic delays.

Inadequate maintenance of facilities other than track also

results in traffic delays such as those caused by signal interruptions, inability to move controlled switches, and communications system failures.

Freight loss and damage payments from derailments from operations on poorly maintained track continue to increase.

The frequency of yard and mainline derailments makes "crisis"f

operations the norm, reducing planning or control of operations. 1

1 See ‘f Final Systems Plan, Supplemental Report, ” United States Railway Association, September 1975, p. 64.
-21-

2.

tion of rail

Non-Financial Public Objectives

The non-financial reasons for federal involvement in the rehabilitafixed plant include:

● Public Interest Considerations--the desire for a transportation system which is speedy, reliable, and efficient.

● Environmental Considerations --a hope that railway rehabilitation can avoid future traffic shifts toward alternative modes

that are more harmful to the environment, or that it will attract traffic away from alternative modes which are more

harmful to the environment.

● Energy Considerations --a hope that roadway rehabilitation can

avoid future traffic shifts toward less energy-efficient alternative modes, or that it will attract traffic away from energyinefficient modes.

● Military Considerations --the need for an efficient rail network

to transport defense-related materials.

To the extent that these considerations indicate that roadway rehabilitation is beneficial to the public sector, it would make sense to invest funds in

rehabilitate ion.

3. Energy and Environmental Benefits

The impact of freight movement by both railroads and trucks on

energy consumption and the environment are discussed in the following paragraphs.

a. Energy Consumption. In 1972 the U. S. railroads consumed

some 4.5 billion gallons of fuel in carrying some 784.3 billion cargo ton-miles

of freight, thus averaging 173.5 cargo ton-miles per gallon. In the same year

trucks moved 470 billion ton-miles using 9.4 billion gallons of fuel, for an average fuel consumption of 50 ton-miles per gallon. Thus, on the average, the railroads needed less than one-third (28 percent) of the fuel required by the trucks

to move one ton-mile of freight. On this basis, if 10 percent of the freight traveling by rail in 1972 had been forced to go by truck because of railroad bankruptcies,

abandonments, or other factors, an additional 1, 117 million gallons of fuel would

have been required. Conversely, a 10 percent shift from truck to rail would have

saved 669 million gallons in 1972. The ability to make such diversions from truck

to rail and, thereby, to achieve major fuel savings, would obviously be of
-22-

particular importance in terms of the national defense since, if the entire U.S.

rail network were to collapse, and if all of the freight carried by rail were diverted to truck, the additional fuel required (based on 1972 consumption rates)

would amount to some 11, 166 million gallons, or 265.9 million barrels of crude

oil. At current world prices this would add $3.5 billion to our deficit of payments.

b. Environmental Impact. A further decline of the railroads?

traffic volume would have serious environmental and land-use consequences for

this nation. Consider, for example, the relative impact of rail and truck service on air quality.

overall, emitted the

hydrocarbons (HC),

Based on 1972 fuel consumption data, railroads and trucks,

following average number of grams of carbon monoxide (CO),

and nitrogen oxides (NOx) per cargo ton-mile:

c o HC NOx

Rail 0.34 0.25 0.97

Truck 2.04 . 0.34 3.36

Thus, on the average, rail produced only one-sixth the amount of carbon monoxide, three-quarters the amount of hydrocarbons, and less than one-third the

amount of nitrogen oxides as trucks. If 10 percent of the freight traveling by

rail in 1972 had been diverted to truck, the combined rail-truck emissions of

carbon monoxide, hydrocarbons, and nitrogen oxides would have increased by

10.9 percent, 2.0 percent, and 8.0 percent respectively. A total diversion of

rail traffic to truck in 1972 would have more than doubled carbon monoxide emis -

sions and increased hydrocarbons and nitrogen oxide emissions by 20 percent

and 80 percent respectively. In terms of land use, highway rights-of-way consume 13.5 times as much land per mile of right-of-way as do railroads, excluding interchanges. 1

If investment in rail rehabilitation either avoids further traffic diversion or attracts traffic from other modes, this may be sufficient to justify

public investment in rehabilitation, even if there is no measurable financial

benefit to be gained from such an investment.

E. Concerns Regarding Federal Involvement

in Rail Fixed Plant

Those who oppose public investment in rail fixed plant, and even

some of those who favor it, have several concerns about the amount of assistance

1

See discussion paper prepared by Harbridge House for the New England Regional Commission, dated May 1975.
-23-

that should

structured,

1.

be provided as well as the way in which the assistance program is

Financial Impact

The concerns regarding the financial impact of federal involvement

in rail fixed plant rehabilitation are twofold. One is that the returns to the railroads in terms of financial viability may not be significant. The other is that

whatever the return, the public monies may simply replace private capital.

The impacts of rehabilitation efforts on projected cash flows of the

railroad industry is a function of the cost of money and the rate of return on expenditures. The industry-wide average cost of capital for the railroads has been

estimated at about 10 percent. For the weaker railroads this cost may be substantially higher. Government assistance in rehabilitation has been proposed at

a cost to the railroads ranging from 0 percent (outright grants) to approximately

8 percent in the form of loans or loan guarantees.

The other side of the cost vs. return relationship presents a problem

 since no one knows the rate of return for expenditures on rehabilitation. To a

large extent the return is not explicitly calculated by the railroads themselves.

Further, the benefits are frequently intangible, or are at least difficult to measure. For example, it is very difficult to attach a dollar estimate to the avoidance of future traffic losses through improved service quality resulting from

rehabilitation. Even the United States Railway Association (USRA), in its very

comprehensive and sophisticated analysis of the Northeast and Midwest bankrupts, presented a major rehabilitation program without explicit justification

in terms of rate of return.

Despite the absence of a definitive analysis of rates of return on rehabilitation expenditures, there is some evidence that they are generally low:

● The report of the Task Force on Railroad Productivity explored the marginal return on capital expenditures for the industry as a whole and estimated it to be approximately 5

percent. Because the analysis included roadway improvements

and new equipment, whose return is generally regarded as

relatively high, the implication is that the return on new investments in fixed plant is relatively low.

1

Improving Railroad Productivity, A Report to the National Commission on

Productivity and the Council of Economic Advisers (Washington, D. C. ,

November 1973).
-24-

● The deferred maintenance that currently exists is, in itself,

evidence that the return on such expenditures is low. Although

the more financially precarious railroads may defer maintenance because it is discretionary and because they have sharply

limited cash resources, the fact that even some well-managed

and financially healthy roads have deferred maintenance indicates that such expenditures are deemed to be unattractive

in terms of the rate of return. Exhibit III-2, a summary report of deferred maintenance by the railroads, indicates that

deferred maintenance is not restricted to the weaker roads.

● The Association of American Railroads, in its Staff Memorandum 75-20 (September 30, 1975), estimated the rate of return

on the USRA rehabilitation program to be approximately 1 percent. If a well-planned rehabilitation program for the bankrupt

roads with the deepest historical deferral of maintenance does

not show a measurable and significant financial return, it is unlikely that the financial return for rehabilitation in the rest of

the industry can be high.

Appendix A of this report presents a series of computations, using

purely hypothetical numbers, to illustrate the impact of federal funding for rehabilitation if financial returns are in fact low. The line of thought is that:

●

and

●

and

●

then

●

if the total range of rehabilitation projects available includes

relatively few high-return projects and an increasing amount

of lower return projects;

if the large amount of investment with the lower returns in

fact has low returns (e, g. , the 1 percent estimated by

AAR); —

if the federal assistance is structured so that it is used

the

in addition to the large amounts the railroads would spend on fixed

plant in the absence of government participation;

the return on the public investment in terms of financial benefits to the solvent railroads is very low (and, in fact, well below the opportunity cost of capital to the government of 10

percent established by the Office of Management and Budget). 1

1Office of Management and Budget, Circular A-94, revised March 27, 1972.
Railroad

EXHIBIT III-2

SUMMARY OF RAILROAD REPORTS

(Required by Ex Parte 305 for the 4th quarter 1974)

(Thousands of Dollars)

Boston & Maine

Burlington Northern

Chessie*

Chicago & North” Western

Delaware & Hudson

Denver Rio Grande

Erie Lackawanna

Illinois Central Gulf

Kansas City Southern

Louisville & Nashville

Missouri-Kansas-Texas

Missouri Pacific

Milwaukee

Norfolk & Western

Penn Central

Reading

Rock Island

Santa Fe

Seaboard Coast Line

Soo Line

Southern

Southern Pacific

St. Louis San Francisco

St. Louis Southwest

Union Pacific

Western Pacific

TOTAL

*

Chessie System failed to file reports.

Deferred Miles of % of Track

Maintenance Slow Orders Slow Order

$ 14, 725 39.8

54,804 -1,710.8

692,159

22,534

10,013

24,030

99,024

14,559

48,192

65,434

44, 823

81,612

64, 060

920,290

69,843

234,564

-—

77,594

- -

32, 854

61,134

26, 842

13,257

8,722

7,382

$2,668,478

7,960

443

45

658.3

1,153

247

1,053.6

1,931

178

3,254

895.8

10,494

27.9

4,710.8

1,494

666

1,358

1,503.5

3,736

65

634

144

67

47,469.5

1.7

13.8

53.6

35.8

1.4

10.8

7.6

9.4

9.8

57.8

1.4

21.5

6.0

26.7

1.1

43.3

7.2

4.7

28.8

15.2

20.3

9.7

29.3

.9

2.8

Source: Pennsylvania Department of Transportation, based on ICC data.
-26-

Although the evidence is hardly conclusive, it does suggest that there

is a significant danger that public monies may be invested for a marginal financial return.

Another issue illustrated numerically in Appendix A is that if federal

assistance is structured in such a way that the public money replaces (rather

than being used in addition to) private capital which would otherwise be invested

in fixed plant, the financial return is higher. However, if the federal investment

simply enables private investors to disinvest in railroads, it appears that the

public objectives are not being advanced.

2. Non-Financial Impact

As discussed earlier, two of the arguments in favor of federal involvement in the rehabilitation of rail fixed plant involve non-financial benefits.

One argument relates to the public interest in a speedy, reliable, and efficient

transportation system, which, in the case of rail, would be enhanced by fixed

plant rehabilitation. The other involves external benefits related to energy consumption and the environment.

In the case of deeply deferred maintenance with markedly deteriorated plant, as with a bankrupt railroad, the presence of a valid public interest

is clear. 1 Incremental investment in rehabilitation improves the efficiency,

speed, and reliability of transportation and attracts traffic to a mode with favorable characteristics in a social sense. Such rehabilitation, as noted above, also

tends to provide a favorable financial return to the railroad involved.

Where the measurable financial return is low, however, as in the

rehabilitation of fixed plant owned by a well-managed and relatively affluent

railroad, the picture changes. Although there is even less analysis of social

and service benefits in relation to the costs of rehabilitation than of financial returns, the study team is convinced that a high return on a rehabilitation project

tends to be a high return in all three senses (money, service quality, and external benefits), and is skeptical that low dollar returns are often accompanied

by high social or service benefits.

If the dollar return from a given rehabilitation project is low, what

is the value of the service benefits ?

● Speed. If speed is of value to shippers, decreases in transit

time will attract traffic and produce dollar benefits. (In fact,

1Assuming non-redundant fixed plant.
-27-

much evidence shows that existing and potential rail traffic

is inelastic with respect to transit time, )1

● Reliability. Again, its value to society can be measured by

the value placed on it by shippers and the resulting dollar returns. (Traffic is more elastic with respect to reliability

than speed.1 However, there are many reasons for Poor re--

liability other than the condition of the fixed plant. These include waybilling, blocking, and scheduling procedures. Further,

the reliability improvement associated with rehabilitation may

be small in relation to the cost. )

● Efficiency. Efficiency gains should appear as cost savings in

the financial analysis.

Similarly, external social benefits such as energy conservation and

environmental advantages are generally linked to traffic shifts which, in turn,

if significant, should show up as dollar returns in any financial evaluation. This

suggests the need for a rigorous cost-benefit analysis of projects requiring

federal assistance.

F. Summary and Observations

Several key points can be noted here:

● The financial rate of return on incremental fixed plant rehabilitation and modernization (i. e. , beyond that done by the solvent railroads without government assistance) is hard to

determine, is seldom calculated or presented, and is probably

low.

● As a solution to the financial problems of the solvent railroads,

additional debt at a cost comparable to private capital costs is

of little use as a source of funds for rehabilitation.

● Selective rehabilitation can preserve the fixed plant which keeps

some federal options open (e. g. , Confac).

● The form of assistance used is important--for example, incremental investment vs. replacing available railroad funds.

1 Forecast of Traffic and Revenues 1974 - 1980, Part 111, prepared by Temple,

Barker & Sloane, Inc. , under USRA Contract No. 50000, October 1974.
-28-

● Danger exists of a major non-selective expenditure of federal

funds for rehabilitation of fixed plant which contributes little

to the cash needs of the industry.

● The non-financial returns, such as service quality and energy

conservation, for those marginal rehabilitation projects with

low financial returns are probably not significant.

● Selective federal assistance in rehabilitation can be of significant use to a financially weak railroad.
-29-

IV. POTENTIAL IMPACTS OF RESTRUCTURING THE

U.S. RAILROAD INDUSTRY

This part of the report evaluates the potential impacts of restructuring the U.S. railroad industry. In particular, it focuses on the kind(s) of restructuring arrangements that might be necessary to sustain the overall viability

of the industry during the coming decade. In view of the desirability of promoting adequate economic growth of the railroads, the federal government should

encourage attempts to estimate the impacts of restructuring and evaluate both

the potential growth areas and the problem issues that are currently on the railroad industry horizon. The available evidence on these issues is synthesized

below, and is followed by a proposed methodology for quantifying the potential

impacts of these issues and the various options for restructuring the industry

with a reasonable degree of accuracy. These issues are discussed through:

● A series of options for restructuring the railroad industry.

These range from a large-scale planning scheme on one end

of the spectrum to purely voluntary integration on the other.

● A methodology for forecasting the impacts of restructureing th e

railroad industry, including available evidence on the issues

of economies of scale and economies of density, and the presentation of a current methodology for estimating organizational economies of scale.

● A set of observations on the restructuring issue.

The history of merger waves in American industry and the fact that

merger frequencies have fluctuated sharply over time are well-documented topics.

Far less noted is the fact that merger frequencies tend to vary sharply among

industries and that a temporal distribution of merging firms is highly concentrated in certain types of industries. One of these types is the railroad industry

which, beginning around 1957 and continuing until the Penn Central bankruptcy

proceedings in 1970, has experienced significant structural reorganizations stemming from its most recent wave of merger activity. Although some of the benefits from the organizational changes in the railroad industry could have occurred

in the absence of merger, the extent to which mergers have induced structural

changes and allocative impacts warrants serious investigation.

At present, those railroads desiring merger must submit formal

applications and voluminous, supportive evidence to the Interstate Commerce

Commission for processing, evaluation, and adjudication. One of the recent
-30-

public policy dilemmas is that the ICC has decided to adjudicate each merger on

an ad hoc basis without developing any overall transportation criteria. This approach has had two undesirable features. First, some of the mergers which

have been proposed and approved may not represent the best of the possible alternatives. 1 Second, in many cases the merger proceedings have created additional intra-industry litigation. Nonetheless, in several cases the primary goal

of merger proceedings --improvement in internal efficiency with respect to both

the minimization of railroad operating costs and public interest considerations--

has been achieved.

A. Current Options for Restructuring the

Railroad Industry

Over the years public policy has required the railroads to provide

freight services under a complex array of rate, route, and safety considerations--many of which have been profit absorbing and even loss inducing. In order

to offer some relief from these considerations and constraints, rail planners

have been suggesting a variety of options designed to restructure the railroad

industry. The leading options and combinations thereof that might be considered

desirable to sustain the viability of the industry are listed briefly below:

● Procedures. This option involves the clarification of criteria

for the approval of voluntary merger proposals on the part of

the industry and the streamlining of approval procedures in

order to avoid the extreme delays experienced in the past.

This is essentially the “free market” approach which anticipates that efficient decisions will be made by private industry.

● Planning. This refers to proposals to create a planning apparatus on a national scale similar in approach to that taken

by the USRA in its analysis of the Northeast and Midwest Regions. The federal planning role could be undertaken in combination with any of the other options.

● Dealing with Railroad Bankruptcy. This option has a federal

role (that may be unavoidable) which involves a federal response to the bankruptcy of a railroad company. It can be an

ad hoc response or part of a planned approach to the restructuring issue.

1A brief review of the recent history of merger activity in the railroad industry

and the various criteria adopted by the Interstate Commerce Commission in

adjudicating rail mergers is presented in Appendix B.
-31-

● Financial Leverage. This option envisions the use of federal

funds (perhaps through a rehabilitation program) to promote

or encourage specific merger activity, either in response to

bankruptcy problems or as part of a wider plan.

• Massive Federal Restructuring. This is a combination of other

options adding to the design and implementation of a national

restructuring of the industry. It would undoubtedly involve a

nationwide planning effort and the extensive use of federal dollar leverage. It may or may not include significant shifts in

traditional ownership patterns (e. g. , Confac or nationalization).

The idea of a federally planned, massive redesign of the nation’s rail

system has been suggested before (as far back as the Ripley Plan in 1920). Its

advantages are appealing in view of the deficits facing the 20 Class I railroads

that are in or near bankruptcy at the present time. One issue is clear: the industry will experience some type of restructuring during the next decade. The

public policy issue is whether the changes will be involuntary (and perhaps inefficient) or voluntary in conjunction with some form of Federal Government

assistance.

One recent scheme for a wide-scale restructuring of the railroad industry was suggested by Henry Livingston and promoted by James Blaze at the

recent Transportation Research Forum meeting (1974). Essentially, the Livingston Plan envisions four transcontinental railroads, controlled by the Burlington Northern, Santa Fe, Southern Pacific, and Union Pacific systems. A

general map of these proposed systems is presented in Exhibit IV-1. In order

to support the attractiveness of consolidating railroads into four major forms,

the economics of railroad mergers needs to be examined and evaluated. The

following section, then, investigates the statistical evidence on the impacts of

railroad mergers and offers additional information on current methodologies to

verify and support conclusions of the Livingston Plan variety.

B. Methodology

Restructuring the Railroad Industry

Given the state of the art on the issue of restructuring the railroad

industry, it must be remembered that any forecasting of impacts can only produce tentative and qualified results. The discussion below will, first, synthesize evidence in the economics literature on the economies of scale research;

second, present a current methodology for estimating merger impacts; and,

third, offer more evidence on the methodology scheme.

, .,,1 , ) 75 . 4
-32-

EXHIBIT IV-1

THE LIVINGSTON PLAN FOR

RESTRUCTURING THE RAILROAD INDUSTRY

Source: James Blaze, "Towards a National Policy of Super Railroads.‘‘ Proceedings of the Fifteenth Annual Meeting, Transportation Research

Forum (San Francisco; October 1974). Map adapted by Blaze from

Nancy Ford, “A Plan for Tomorrow, ” Modern Railroads, September

1973 (an interview with Henry Livingston, V. P. , Clark, Dodge & Co.).

Other railroad restructuring proposals can be found in U.S. DOT,

Western Railroad Mergers, 1969; Herb Bixler, ‘Two Rival U. S. Rail

Systems Seen Preferable to One AT&T-Type Setup, ” Traffic World,

October 16, 1972; and Herbert Whitten, “Key to Railroad Economics--

A Rail Common Market, ” Handling and Shipping, December 1973.
-33-

1. Evidence on Economies of Scale in

the Railroad Industry

The conventional interpretation of “economies of scale” is decreasing unit costs with increases in firm size. In technical terms it refers to any

firm size smaller than the minimum point on the long-run average cost (LRAC)

function. Operations which increase firm size will necessarily increase unit

costs since the (LRAC) function is upward, turning to the right of the optimumsize firm. Operations in this range produce “diseconomies of scale." This

topic is extremely important, because of both its empirical fascination and its

public policy implications. For example, if economies of scale do exist in the

industry (i. e. , a decreasing cost industry), the traditional policy implications

are the justification of subsidies and the demands for marginal cost pricing. In

addition, the existence of economies of scale implies that larger size firms can

deploy their resources in a more efficient manner, a factor which lies at the

heart of any restructuring arrangement in the railroad industry.

A companion issue to economies of scale is that of economies of

density. This measure refers to a concentration of traffic on “denser" routes

as a cost-saving effort. Instead of using output as a measure of size, the researcher who is studying density usually deploys gross ton-miles per mile of

track as its measure. 1 While some efficiency gains can undoubtedly be produced by rerouting into denser mainlines, evidence on the benefits of pursuing

density economies as a product of a restructuring has not been compelling. 2

Research studies in recent years have generally supported the notion

originally introduced in the well-known Doyle Report,3 of allowing more intermodal mergers and intra-industry combinations on a provisional basis. 4 Yet,

1

See U. S. Department of Transportation, “Western Railroad Mergers” (Washington, January 1969).

2

Railroad Route Rationalization and Fixed Plant Maintenance? Association of

American Railroads, AAR Staff Studies Group, Staff Memorandum 75-20 (September 30, 1975).

3 National Transportation Policy} U.S. Senate Report 445, 87th Congress, 1st

Session, 1961.

4

Freight Transportation: A Study of Federal Intermodal Ownership Policy,

Robert C. Lieb (New York, Praeger publishers, 1972).
-34-

these recommendations were not based on any empirically strong evidence suggesting that larger companies would be more efficient and thereby more

profitable.

The pioneering study for measuring scale economies in the railroad industry was provided by Healy,1 who used correlation analysis to relate

the size of railroad firms to rates of return. He specifically argued that the

higher the rate of return for a given size railroad, the more likely it would be

in a smaller size group. Furthermore, based on pre-1960 data, Healy claimed

that any size railroad exceeding 10,000 employees was likely to experience diseconomies of scale.

Other studies in that era concentrated on the estimation of cost functions in the railroad industry, most notably those studies by Borts's2 and Meyer's

group3 at Harvard. More recent analyses in rail merger effects and on rail cost

functions have been developed by Gallamore,4 Moore, 5 and Griliches.6 Very

recent rail cost studies that rely on underlying production function methodologies

have been presented by Keeler7 and Kneafsey.8

 The general conclusions

1

The Effects of Scale in the Railroad Industry, Kent T. Healy (New Haven, Connecticut, Yale University Press, 1961).

2 "The Estimation of Rail Cost Function, “George H. Borts, Econometrics,

XXVIII (January 1960), pp. 108-131.

3

The Economies of Competition in the Transportation Industry , John R. Meyer,

Morton J. Peck, John Stenason, and Charles Zwick (Cambridge, Massachusetts,

Harvard University Press, 1959).

4

“Railroad Mergers: Costs, Competition, and the Future Organization of the

Railroad Industry, “Ph.D. dissertation, Robert E. Gallamore (Harvard University, 1968). (This source, although unpublished, has been widely quoted

on the scale economy issue. )

5

Freight Transportation Regulation? Thomas G. Moore (Washington, The American Enterprise Institute for Public Policy Research, 1972).

6

“Cost Allocation in Railroad Regulation, "Zvi Griliches, Bell Journal of Economics and Management Science 3 (Spring 1972), pp. 26-41.

7

‘Railroad Costs, Returns to Scale, and Excess Capacity, ” Theodore E. Keeler,

Review of Economies and Statistics 56 (May 1974), pp. 201-208.

8

"Costig in Railroad Operations: a Proposed Methodology, James T. Kneafsey,

M. I. T. /F. R.A. Studies in Railroad Operating Cost Economies, Vol. 13 (March

1975).
-35-

emanating from these studies are either that the evidence suggests constant returns to scale or that there are no strong positive scale economies. The only

exceptions are certain economies for individual railroad firms, for certain linehaul and terminal operations, and even perhaps for regional operations (although

 It is antici- sufficient empirical tests have not yet been thoroughly developed).1

pated, however, that additional evidence will be shown on this matter in the future” with the linkage of cost and production function methodologies, especially

on those suggested in the recently completed studies mentioned above.

2. Current Methodology

The conditions under which gains from economies of scale may follow from merger in the railroad industry are ambiguous. One way is to relate

the frequency of mergers in the railroad industry to the types of other industries

in which high merger rates are found. At this point it is imperative to clarify

assumptions which must be made to limit the scope of this discussion. Demand

considerations obviously play an important role in determining the optimum size

of a firm in any industry. However, demand conditions facing the railways in

the short run will be considered given and constant throughout. This assumption of constant demand allows attention to be focused on the railroads production function.

Under competitive conditions the optimum size of a railroad is limited

by the absence of cost incentives which would encourage the railroad to grow

and by the presence of cost forces which would discourage growth. If increasing returns to scale exist, a railroad should expand its scale of plant to take advantage of lower cost. In order to transfer this analysis to the production function, from which the cost functions are derived, it should be assumed that for the

small scale of plant the production function exhibits increasing returns, and for

the larger than optimum scale of plant it exhibits decreasing returns. Therefore, at some point on the production surface there is a boundary line where increasing returns diminish and decreasing returns set in. The optimum scale of

plant will be located along this boundary line.

The production function will also yield information on the expansion

path that the railroad will follow in increasing its output through increasing plant

size, as long as pertinent information is available concerning the cost of the

factors of production. Assuming given production service and non-factor costs,

1

“Mergers, Technical Change, and Returns to Scale in the Railroad Industry, ”

James T. Kneafsey, Proceedings of the Transportation Research Forum 13

(November 1972), pp. 439-458.
-36-

both the expansion path of the firm and the boundary line between decreasing and

increasing cost can be derived. If this is the case, the optimum scale of plant

can be determined directly from the expansion path by analyzing, through the

first-order conditions, the effects on output incurred by the change in size due

to movements along the expansion path. The issue in this case is: To what extent have mergers increased the size of railroads?

a. Technical Change and Growth Rates. In industries other than

railroads where markets are fairly evenly divided among many small sellers,

the increase in monopoly power through a few acquisitions will be too small to

increase prices and profits. This suggests that in order for merger rates to be

high, a few firms must account for a substantial share of industry output. In the

railroad industry, relatively few Class I railroads account for a substantial share

of the industry output. Also, the larger the barriers to new entry, the longer a

gain in earnings from reduced competition is likely to continue and, thus, the

greater the incentive for merger. This condition is clearly the case in the railroad industry, where substantial entry barriers exist.

On the economies-of-scale hypothesis, one would predict that in the

sectors where mergers are an adaptation to changes in the relative efficiencies

of various sizes of railroads, there will be a concurrent change in the average

size of the railroad. In other words, if changes in the shape of the long-run

average cost curve are sufficient to induce numerous mergers, a sufficient number of old firms can be expected to grow, and any new firms entering the industry

will be required to do so on a larger scale than previously, so that the average

size of the firms in the industry will increase.

If economies of scale are significant, merger activity should be inversely related to industry growth. 1 The reason for this hypothesis is that with

rapidly growing demand, it is easier to achieve the requisite size for the

minimum-cost firm through the construction of new capacity. If the scale of

output that corresponds to minimum cost is larger, it will probably be difficult

to provide quickly the requisite market for an efficient level of output in the absence of rapid growth and demand. Thus, the smaller the rate of growth of an

industry, the greater the likelihood that mergers will be more attractive to

growth in firm size. Because the growth rates of firms in the railroad industry

have been relatively low in recent years, the preconditions for mergers as an

avenue to effective restructuring in the industry appear to exist.

1

See "Economic Disturbance Theory of Mergers,“ by Michael Gort, The Quarterly Journal of Economics, LXXXIII, November 1969.
-37-

b. Managerial Talents. A frequent reason for mergers seems to

be the difference between two firms in the quality of managerial skills. These

differences are often independent of the size of the firm. In the short run, however, the total supply of managerial talent of high ability is fixed. But the larger

the firm, the more intensively this fixed supply of superior managerial talent is

utilized. In periods when there is a shift of managerial talent within the industry,

some of the superior managerial talent will leave the railroads and go elsewhere,

and there will be a more than proportional rise in the number of managerial talents with untested abilities. As a result, the dispersion among firms in the railroad industry in the quality of managerial skills should increase and, in turn,

lead to conditions where a rise in merger activity could be expected,

C. Econometric Analysis. With new trackage construction having

been barred to the railroad companies long ago, the most dramatic means of

growth available to railroad management since the late 1950's has been through

merger. 1An important issue in analyzing merger impacts and in attempting to

provide a foundation for recommending future restructuring involves pre-merger

and post-merger performance tests. For mergers to have been historically attractive on the average, post-merger performance should have outranked premerger performance by a significant magnitude. 2 In order to test this hypothesis, two research groups (at M. I. T. and Harvard) have independently been conducting analyses on merger impacts and scale economies in the railroad industry.

The theory underlying these analyses can be labeled the “economies

of organizational scale" and is based on neoclassical economic production function theory. Briefly stated, this theory relates measures of output (like gross

ton-miles) to a set of organizational inputs (like managerial expenses, technological innovations, and financial base) and conventional factors (like labor inputs

and fuel). This theory is based on a specification in functional form of

where Q is output; t is the time period; L is labor; E is energy; K is capital;

M, T, and F represent the management, technological, and financial variables,

respectively; and A, æ , and ß are parameters. This model has been econometrically tested with a set of railroad data (time series) for pre-merger conditions

1 For a thorough documentation of this topic, see "Railroad Mergers: Costs,

Competition and the Future Organization of the American Railroad Industry,"

by Robert E. Gallamore, op. cit.

2

This test can be conducted in accordance with standard statistical practices.
-38-

(3 and 5 years preceding merger) and post-merger conditions (3 and 5 years

after merger) to generate separate coefficients for M, T, and F in both cases.

The theory further implies that economies of scale should be split

into three organizational factors of managerial, technological, and financial attributes. That management quality is important to the success of a merger is

unquestioned. In the most spectacular failure of a merger, note the following:1

The immensely profitable freight operations of PCT's [Penn Central

Transportation's] predecessors became unprofitable almost overnight following the disastrous PRR-NYC-NH [Pennsylvania Rail RoadNew York Central-New Haven] mergers. The mergers caused this

sudden collapse by undermining managerial morale and swelling the

scope of operations to an inefficient level.

Similar arguments can be generated for the separate technological

and financial effects that might be attributed to mergers. For example, a railroad firm that is in or near bankruptcy may represent, among other reasons,

an attractive financial investment to a solvent acquisition-minded railroad. In

this sense, and under appropriate conditions, mergers might be considered a

partial remedy to certain bankruptcy cases. The inference of this approach,

then, is that if any or all of these factors are important in the statistical analysis, estimates can be made of the future impacts (or cost savings) attributable

to restructuring.

The preliminary evidence indicates that these organizational scale

economies are significantly different by the equivalent of a growth rate differential of approximately 1.2 percent. In other words, the post-merger effects exceeded the pre-merger impacts, on the average, by 1.2 percent. Applying this

differential to restructured railroads in 1985 requires the use of a 1985 forecast

for rail ton-miles and revenues. Using the Chase Econometrics Associates,

Inc. macroeconomic forecast of economic variables and the M. I. T. railroad

ton-mile model produces an outside estimate of $24 billion in rail revenues for

that year. Applying the 1.2 percent organizational scale to this number suggests that, under ideal conditions, the 1985 impact of a restructuring of the industry could yield up to an additional $300 million in revenue.

1

“Consolidated Rail Corporation: Phoenix or Albatross." by Charles M. Rice,

ICC Practitioners’ Journal (May-June 1975), p. 405.
-39-

C. Merger Impacts

The organizational impacts of mergers were considered in the preceding sections. This section addresses the restructuring of physical plant,

which is frequently cited as another major benefit to be gained from merger.

Because there are two archetypical forms of merger, namely (i) parallels and

(ii) end to end, each must be addressed separately.

Parallel mergers are reputed to allow the consolidation of traffic

onto a single line, the abandonment of the released mainline track, and the consolidation of rail classification operations into a single yard with the abandonment of duplicate facilities and a reduction in the overall work force. These

benefits have proved to be extremely elusive. First, union agreements on work

rules and staffing have generally frustrated any substantial attempts to realize

these work force reductions, except in cases like the Baltimore and Ohio/

Chesapeake and Ohio consolidation. Second, ‘the yards do not appear to be duplicated facilities. Each yard served is the point of origination or termination

of a substantial amount of local traffic, and it is difficult to close them down

entirely. Where the yards are large, the diversion of traffic from one to the

other is likely to cause an excess in capacity. To build a consolidated classification yard which is larger, automated, and efficient is expensive and requires

capital that many financially weak railroads cannot easily assemble. Finally,

abandonment of the excess mainline is extremely difficult because those industries and communities served by the line will fight the abandonment process due

to the adverse economic impact that such an abandonment would have on them

directly.

Therefore, few short-term benefits can be realized by the merger.

There may also be (as there was in the case of the Penn Central) a degree of

management confusion on procedures, computer systems, and operating protocol which must be overcome before the merger begins to reflect efficient operations. Thus, parallel mergers are currently in disrepute.

End-to-end mergers are alleged to be a different case entirely. The

Livingston Plan, mentioned previously, with its four transcontinental lines is a

good example. By placing carriers end to end to achieve a single line from origin to destination, only one carrier is involved instead of the two or more which

are frequently used today. This type of merger would allow run-through trains

to be scheduled which bypass yards, only stopping to pick up or drop off preblocked sets of cars. By avoiding classification, both terminal time and switching costs would be eliminated. Transcontinental times would be competitive

with trucks, and traffic could be attracted.

, .,, ! - -
-40-

The problem with this view is that very little traffic travels transcontinentally. In fact, a very high percentage of total carload shipments travel

less than 1,500 miles. To achieve the volumes needed to make up efficient

trains, present management contends that it is necessary to consolidate cars

going in the same general direction and to reclassify along the route as branching cars drop off and new cars appear.

Another problem for the industry which may not be alleviated by merger is the ability of shippers to control the routing of traffic. This power,

granted to shippers specifically by the Interstate Commerce Act, tends to spread

traffic out over the possible routes between the origin and destination of the shipment. 1 For example, there are more than 200 separate routes listed in the tariff between Washington, D. C. , and Chicago. If 25 to 30 of these routes are commonly used, the volume of flow between the two cities is so low that direct trains

are out of the question. This may also be caused partly by railroad freight

offices which solicit traffic for their railroad even if it causes extremely circuitous travel. Although this solicitation guarantees a railroad a portion of the

total revenue, it may not cover variable costs on this movement of traffic.

Thus, the role of mergers to improve efficiency, lower costs, consolidate traffic, improve service, and attract new revenues appears to be cloudy.

D. Summary and Observations

Although an industry-wide restructuring is hailed by some as the

answer to the problems of the railroad industry, it seems clear to the study team

that it is not. It is likely, however, that some federal involvement in restructuring is desirable, if not inevitable, at least at the level of individual weak railroads. Observations arising from this review include the following:

● In the near term, massive and federally directed restructuring

of the industry would have a limited impact on projected industry problems, particularly in view of the time required to plan

and implement such action.

1

James Sloss, Thomas S. Humphrey, and Forrest N. Krutter, Chapter 3, “The

Opportunity for Rationalization of Railroad Networks Through Reduction in Circuitry and Multiplicity of Authorized Routes, ” An Analysis and Evaluation of

Past Experience in Rationalizing Railroad Networks, Studies in Railroad Operations and Economies, Volume 16, M. I. T. Report No. R-74-54, Department

of Civil Engineering, February 1975.
-41-

● Merger activity tight be a productive response to the problems

of individual railroad bankruptcies.

● In the longer run, massive restructuring will probably be necessary if the financial conditions of the railroad industry deteriorate below the levels currently projected.

• If there is to be a significant federal role in restructuring, planning on a nationwide scale should yield more effective outcomes:

--procedural reform should be accompanied by the clarification of criteria for approval of voluntary mergers.

--Use of federal dollar leverage to promote or encourage mergers should be related to some overall perspective.

--Merger as a solution (or, better, as a preventive measure)

to a bankruptcy problem can be facilitated with prior planning

efforts.
-42-

V. RATE REFORM

All, or nearly all, of the current proposals for rate reform provide

for some measure of deregulation. Therefore, the following discussion will assume that rate reform will take that direction.

The most important factors determining the revenue effects of deregulation on the viability of the rail industry are discussed below. These factors

can generally be categorized as (i) remaining regulatory constraints; (ii) deregulation and opportunities for market exploitation; and (iii) public policy toward

other modes. It should be noted that because of the short time allocated for the

task of analyzing the effect of deregulation of rail rates and services, only the

most tentative estimates have been made.

A. Remaining Regulatory Constraints

The nature of current deregulatory proposals must be viewed in light

of the historical record of rail regulation and the regulation of other modes.

The regulation of railroad industry rates has historically had five

basic objectives:

(i)

(ii)

(iii)

(iv)

(v)

To limit the railroads from exploiting their dominance over

some transportation markets. (Section 1 of the Interstate

Commerce Act)

To prevent discrimination among shippers in like circumstances. (Section 2 of the Interstate Commerce Act)

To prevent undue discrimination among places and commodities. (Sections 3 and 4 of the Interstate Commerce Act)

To adjust rates so that commodities might move freely.

(Hoch-Smith Resolution)

To restrict the power of the railroads to nullify the benefits

flowing from public expenditures on other modes of transportation. (National Transportation Policy)
-43-

1. The Form and Character of

Proposed Deregulation

Most of the rate reform proposals currently being set forth are aimed

at (i) softening Section 1 of the Interstate Commerce Act; (ii) de facto repeal of

the Hoch-Smith Resolution; and (iii) modifying National Transportation Policy.

None of them propose any changes in Sections 2, 3, and 4 of the Act.

It might be useful to briefly review the significance of each of the objectives of rate regulation and how they may be affected by deregulation. It is

probably important to recognize that while each of the statutory provisions intended to carry out an objective has its own body of Commission and court interpretation, they are all interrelated--for example, increased flexibility in ratemaking hinges on Sections 3 and 4 as well as on Section 1. Thus, restraint

removed in one provision or set of provisions may bring into force another element of regulation, thereby limiting the revenue effects that might be expected.

2. Limiting Monopolistic Dominance

Section 1 of the Interstate Commerce Act has generally provided relief to shippers and others from unjust and unreasonable treatment by a rail carrier(s). The fundamental idea behind Section 1 is that the rail carriers, by reason of greater or lesser market control, have the power to be unreasonable and

unjust, and that it is in the public interest for the use of such power to be

controlled.

The concept of justness and reasonableness held by the Commission

and the court has evolved over a long period of time, since the advent of federal

regulation. It is probably fair to say that the Commission has tended to hold a

proposed rate to be unreasonable and unjust under Section 1 if (i) it marked too

large a break with an existing rate or (ii) it was inconsistent with other rates on

the same commodity or like commodities. The Commission has sometimes,

but by no means as a regular policy, declared a rate unreasonably low because

it was below variable cost, or unreasonably high because it greatly exceeded full

cost. Further, in order to reinforce its holding, the Commission has very frequently under Section 1 invoked the Rule of Ratemaking [Section 15(a)], National

Transportation Policy, or the Hoch-Smith Resolution.

Most of the deregulatory proposals currently being discussed would

make cost the prime if not the sole measure of justness and reasonableness under Section 1. Reflecting the preoccupation of economists with marginal cost

pricing, no rate could be held unjustly or unreasonably low if it equaled or exceeded variable cost. There does not appear to be a similar concern with the
-44-

high side, although some bills would limit annual increases to some percentage

figure, or would have the Commission ascertain market dominance and protect

shippers against its exercise by a dominating carrier or carriers. Less concern

with the high side doubtless owes to the belief that competition, in most circumstances, will protect shippers from unreasonably high rates. It should be noted

that none of the current bills requires the Commission to evaluate the relationships of all existing rates to cost. Furthermore, in the absence of protest or

Commission action, a rail carrier may set rates below variable cost.

The rationale for changes in Section 1 is proclaimed to be prevention

of the recurrence of instances where the Commission has required rates below

variable cost (cross subsidy), or has held rates above variable cost (to protect

transportation revenues). The Administration, in particular, believes that cross

subsidy by the railroads is not currently justified, and that modes other than rail

should not be protected where the effect is to limit the railroads’ share of the

market.

Presumably, relief from below-cost rates and freedom to reduce

rates to divert traffic from other modes would bolster the rail industry’s financial position. Because of the asserted existence of pervasive intermodal competition, the Administration purports not to fear that the railroads could push

rates to unreasonably high levels. This would be especially true if the powers

of rate associations to engage in collusive pricing were curtailed, as the Administration proposes. However, some bills proposed by others would retain

controls on

3.

the freedom of the railroads to raise rates.

Rate Discrimination

Section 2 of the Interstate Commerce Act does not permit the railroads to differentiate among shippers in like circumstances. While the Commission and the courts have given this statutory provision fairly restricted interpretation, it has, nevertheless, forced the carriers to price and to provide services

on a quite uniform basis. For example, carriers are not permitted to favor

particular shippers in the supply of freight cars. It is probably accurate to say,

however, that Section 2 would not pose a serious barrier to an increase in rate

flexibility. No bills propose any changes in Section 2.

4. Place and Commodity Discrimination

Sections 3 and 4 are among the most treasured sections of the Interstate Commerce Act. Section 3 restricts each rail carrier from differentiating,

or participating in differentiating, in rates among commodities and places. Section 4 contains a flat prohibition against higher rates for shorter hauls than
-45-

longer ones on the same line, and also against the sum of short-haul rates being

less than a long-haul rate when all are on line. Local interests all over the country and port complexes would vigorously oppose tampering with Section 3. In the

past the Rocky Mountain states have prevented repeal of Section 4. No bill seriously being considered would change Sections 3 and 4 in any respect. The question is: Would the two sections significantly hinder the railroads in exercising

rate flexibility ? The answer is almost certainly yes. How much, however, is

unclear.

The evolution of regulatory policy and interpretation has been

steadily toward equal rates for equal transportation services regardless of the

associated cost circumstances. Local interests have been impatient at being

served by weak, high-cost rail carriers, or at being off the main line of heavy

traffic flows. When pressed by these interests, the Commission has tended to

grant rate parities (as in the case of port competition) or to require mileage

scales. In neither instance are differences in particular costs of service important considerations. A rail carrier will often find it necessary to extend a

reduced rate beyond the desired application or face the prospects of its being

canceled by the Commission. The Commission has found it especially difficult

to deal with rate differentials caused by the unevenness of water competition. A

significant proportion of recent Commission orders for cancellation have been

under Section 3.

It is not certain what results would derive from a weakened Section

1, with the language of Section 3 being retained in its present form. It should

be noted that proposals for the modification of Section 1 do not declare rates below variable cost to be ipso facto unlawful. In order to avoid violation of Section

3, a carrier may choose to maintain below-cost rates, unless there is complaint.

However, because compliance with Section 3 requires only that rate differences

be removed, a carrier has the option of raising a rate that is already well above

cost (low operating cost) in order to bring it to the level of a rate just covering

variable cost (high operating cost). Under a weakened Section 1, the Commission would find it difficult to prevent such action. (This assumes that proposed

legislation does not intend for variable cost to be defined as a system-wide

average. )

On balance, Section 3 is likely to limit the downside flexibility of

rail pricing. A carrier will be reluctant to lower a particular rate which could

yield increased net revenues if a whole set of rates must also be reduced. Indeed, the combination of proscription of below-cost rates under Section 1 and undue discrimination under Section 3 may lead to rate increases which, under the — .

present Section 1, would be disallowed. In short, Section 3 is not an impotent

statutory provision nor is it likely to be revised in any important respect. All

evidence is that local interests are too strong in its support.
-46-

Section 4 rules prohibiting higher rates for shorter hauls are widely

regarded today as being toothless. So-called 4th Section relief is automatically

granted by the Commission to rail carriers for operations on circuitous routes.

Railroads are also frequently given relief where they are in competition with

water carriers at end points, but not at intermediate points. The application of

both Sections 3 and 4 can be set aside in order to permit a rail carrier to meet

the competition of another rail carrier or another mode. That is, a rail carrier

may differentiate in rates between localities if participation in the traffic of one

transportation market depends on meeting competitive rates whereas in the other,

it does not. Thus, as in the case of the Robinson-Patman Act, “making” competition can be held to be different from simply meeting it.

Today the operations of railroads are such that terminal costs tend

to dominate the total cost picture. Differences in costs in different terminals

may be more important than the distances between the terminals. This, of

course, imposes strong pressures on the carriers to avoid application of the 4th

Section. It is probably an open question, however, as to whether the Commission, with the present language of Section 4, could permit rail carriers, generally, to price themselves out of high-cost intermediate markets by granting 4th

Section relief. If not, Section 4 would continue to be a prime constraint on pricing flexibility and the freedom of the carriers to get out of “loser” markets.

5. The “Free” Movement of Commodities

The Hoch-Smith Resolution and continuing pressures from all regions

of the country to make transportation as ubiquitous and cheap as possible have

resulted in low rates on a good many basic commodities and service at competitive rates to production areas which generate low densities of traffic and, therefore, are characterized by high costs of rail services. In many of these situations particular costs have not been covered, requiring internal or cross subsidy

through the imposition of higher rates than costs on other commodities, between

other pairs of points. Presumably, elasticities of demand for the transport of

the lower paying commodities have been high, while they have been low for the

higher paying commodities. This has allegedly resulted in the maximum possible movement of commodities and the highest possible national transportation

benefits.

In order to assure revenues sufficient to support a pattern of rate

uniformity and transportation ubiquity, requiring cross subsidy, the Commission

has been compelled to curb intramodal and intermodal competition among the

regulated carriers. (It has also led to hostility on the part of the Commission

toward non-regulated carriers. ) If competition were allowed to wash away surpluses above costs, the transportation “burden” (i. e. , cross subsidy) could not
-47-

be borne. The Commission has interpreted National Transportation Policy as

forbidding competitive “dissipation” of high-profit revenues through rate reductions if the loss of those revenues would jeopardize cross-subsidized transport. 1

For various reasons the Administration has asserted that deliberate

cross subsidy cannot be tolerated and, therefore, that constraints on competition

need no longer be imposed on the carriers. More important, perhaps, the Administration contends that the Commission should be enjoined from holding rates

below variable cost. If the Administration’s views find their way into legislation,

below-cost rates might be raised by the carriers. Assuming that such rates are

indeed demand elastic, transportation revenues would fall; profits, however,

should rise. Whether the demand for shipment of basic commodities is rate

elastic is a question that is discussed later. In any case, whether or not gross

transportation revenues rise or fall, higher net to the carriers should result

from raising below-cost rates. Congress will have to decide whether the effect

on basic commodity flows, either in rates or volumes, is important.

In this regard, in a proceeding involving increases of rates on fresh

fruits and vegetables from Western producing points, the ICC very recently held

the increases as unjust and unreasonable, even though in many instances the exi sting rates failed to cover variable costs. The Commission based its decision,

at least in part, on the adverse effects of higher rates on consumers. 2

6. Public Benefits from “Non-Rail”

Transportation

Over the years a great deal of public money--federal and local--has

been spent on transportation. Some of it has been deliberately intended to provide competition to railroads; most of it has had that effect. In response, the

railroads, to some extent, have reduced rates across the board or have been

slower to raise them. Perhaps more often, however, the rail carriers have

maintained and elevated their rates (namely, through successive rounds of general increases in recent years); have accepted declining revenues; and have allowed their facilities to deteriorate. Where they have reduced rates, the railroads have tended to do so on a selective basis, aimed directly at competition

(carriers) from which traffic could be diverted. Quite naturally, competitive

— — . ———

1 For example , 309 ICC 347, 359 (1960) .

2

Investigation and Suspension Docket No. 8944, Fresh Fruits and Vegetables,

Transcontinental & Western Points, December 30, 1974.
-48-

modes--mostly truckers and water carriers --have been offended by the rail carriers’ sharply focused pricing tactics. Not surprisingly, either, local interests

which have benefited by truck and water transportation services have supported

their benefactors against the rail carriers.

In 1940 water-served geographic areas succeeded in inserting in

National Transportation Policy a stricture on “unfair” and destructive competitive practices” and an admonishment that the Commission should “preserve the

inherent advantages of each [mode]. “ At that time Congress clearly had in mind

the preservation of water transportation. This was balanced in the 1940 Act by

amending the Rule of Ratemaking [Section 15a(2)] to provide that the Commission

should “give due consideration, among other factors, to the effect of rates on

the movement of traffic by the carrier or carriers for which the rates are prescribed. “ Supposedly, this would limit to a single mode consideration of the

justness and reasonableness of rates. In the years after World War II, however,

when truck and water competition to railroads became exceedingly keen, the

Commission frequently invoked the “unfair and destructive competitive practices”

and the “inherent advantages” provisions of National Transportation Policy to

head off rail rate reductions. (It should be noted at this point that the Commission seldom rejected rail reductions aimed at truck and water carriers that

handled only exempt commodities since they were outside the regulated family. )

Commission policy was hostile to rate cuts which would only redivide traffic

among competing modes and produce lower total transportation revenues. In

the Commission’s view, this simply placed greater shares of the “transportation burden” on other traffic. The railroads sharply criticized the Commission,

accusing it of unfairly protecting other modes at their expense. In 1958 Congress

attempted to counter this criticism by further amending the Rule of Ratemaking

[Section 15a(3)] to require that “Rates of a carrier shall not be held up to a particular level to protect the traffic of any other mode of transportation, giving

due consideration to the objectives of the National Transportation Policy declared

in this Act. “ However, for some years after 1958 the Commission appeared to

give greater heed to the latter part of the above-quoted amendment and thus the

railroads continued to purport to be greatly dissatisfied with Commission rate

policies.

The Administration’s regulatory reform would attempt to dissuade the

Commission from its protective views with respect to regulated carriers. A first

step would be to eliminate cross subsidy and, therefore, the need to “support”

the transportation burden. Hence, the Administration’s bill would permit all rates

to be raised at least to variable cost. Presumably this would free up the rail carriers to reduce other rates at w-ill, as long as they remained above variable cost.

The extent of such reductions would depend on definitions of variable cost. If

variable cost were interpreted to be a system-wide average variable, as it now

is by the Commission, rate reductions would probably be moderate and widely
-49-

applicable. However, pricing at economists’ long-run marginal cost (i. e.,

particular costs of particular movements) could result in substantial and highly

selective rate cuts. Whether they would pass the test under Sections 3 and 4

would be a further question.

Depending on how variable cost is calculated, the Administration’s

proposed changes may be more apparent than real. In a recent speech the ICC’S

general counsel contended that the Commission has not rejected a rate reduction

in ten years on the grounds that it would constitute unfair and destructive com1 That may onlyy mean that the railroads have been ‘-

petition to another mode.

willing to press the decision made in the Ingot Molds case2 in 1965, a decision

which denied a rate reduction request on those grounds.

7. Summary

From the above, it appears that the extent to which the financial

circumstances of the railroads can be improved by changes in regulation will

depend, as far as regulation is concerned, on (i) the rigor with which Sections

3 and 4 of the Interstate Commerce Act are applied to differentiation by the railroads in rates and (ii) definitions of variable cost. If Commission enforcement

of Sections 3 and 4 were to be diffident, and if variable cost were equated to

long-run marginal cost, the railroads would enjoy sufficient freedom to exploit

many market situations. Only competition would constitute restraint. HOW much

rat es would go up or down, and how much new net revenues would be brought in,

would depend on cross elasticities and on own elasticities of demand for rail services. Rate and revenue changes would also depend on how much the rail carriers

would want to exploit short-run inelasticities which, as a result of such exploitation, might turn elastic in the long run.

With regard to regulatory change, it should be noted that the Administration has announced its intention to propose some deregulation of truck transportation. Depending on the precise nature of such proposals, they might be expected to intensify competition between road and rail and, therefore, lessen the

cross elasticities between the two modes. One study has predicted that up to 5

percent of 1985 rail traffic would be diverted to truck. 3 This topic requires a

1

“Deregulators Challenged by ICC Counsel, ” press release, ICC.

2

323 ICC 758, 392 U.S. 571.

3

Paul O. Roberts and James T. Kneafsey, " Energy Use Implications of Proposed

Change in the Regulation of the Railroad and Motor Trucking Industries. “ A

study prepared for the Federal Energy Administration by the M. I. T. Center for

Transportation Studies, October 1975.
-50-

more detailed discussion of truck markets, truck costs, and their competitive

impact on the railroad, matters which can only be touched upon here.

B. Deregulation and Market 0pportunities

for Railroads

Economists assert that sellers will try to maximize profit on each

and every transaction, and that they will attempt to “discriminate” among buyers in order to get the most that each buyer is willing to pay. All of this, of

course, is with an eye to the more or less long-run willingness of buyers to buy.

Too much short-run exploitation may “kill the goose. "

The protections which buyers have against maximum exploitation

(i. e. , total monopoly power) come from two sources: competition among

sellers, and the law and its enforcement. The law may even be enforced in

such a way that sellers derive negative profits from a given transaction or set

of transactions, a situation which they will presumably accept only on condition

of being protected from the law or from competition in the exploitation of other

transactions.

The Administration contends that in todays transportation markets

. competition provides ample protection to buyers to permit retractions in the

scope and application of the law. Administration spokesmen point to the presence of truckers, water carriers, pipelines, and even air carriers, as well as

railroads, in many transportation markets. Implicit in the withdrawal of regulation is not only the removal of protection to carriers against competitive losses

of cross-subsidizing revenues (umbrella rate making), but also the freedom for

regulated carriers of all modes to rid themselves of negative profit transactions

(cross subsidy).

Therefore, in anticipating the effects of deregulation, some rates

can be expected to go up while others come down. Economically, whether or

not they do depends on (i) an individual railroad’s supply costs; (ii) perceived

rate elasticities; and (iii) the disposition on the part of the railroads toward independent action on rates. Each of these is discussed below.

1. Railroad Supply Costs

Since 1920 regulation has encouraged collective action in pricing by

the railroads. The rule of ratemaking adopted in that year directed the Commission to regulate rates to provide a fair return on fair value to groups of carriers

or to the industry as a whole. While that particular version of the rule of ratemaking was in effect only until 1933, it has had an enormous impact on rate reg-
-51-

regulation . That, and a great national flow (as contrasted with regional) of commerce during and after World War I, emphasized ratemaking for the system (i. e. ,

all rail carriers) rather than by and for individual carriers. Costs tended to be cal -

culated in the same way that rates were set for groups of carriers. For example,

Rail Form A, the formula for rail cost-finding, is based on the cost relationships

of all railroads (with some regional variations). Also, in the determination of

costs in a particular rate situation, there is a strong tendency both on the part of

the Commission and the carriers themselves to rely on averaging. As a result,

in cases before the Commission ruling costs tend not to be those which economists

would term long- run marginal but rather a statistical averaging acress a more or

less wide range of supply situations. This is important with respect to whether,

and by how much, the railroads will raise rates on movements on which they are,

statistically at least, losing money. It may be noted that partly because of regulatory reemphasis on specific expense/revenue relationships, the carriers themselves have often been unsure about whether they were better off or worse off

with a given category of traffic.

The movements which are regarded today as losers generally derive

from three, or possibly four, different situations. One is the transcontinental

flow of fresh fruits and vegetables. These rates reflect as much as any the HochSmith admonition that rates on agricultural commodities should be kept low. They

originally rose out of the efforts of all of the rail carriers participating in trans -

continental traffic to encourage its growth. In those days the Western carriers,

especial 1 y, had enormous amounts of unused capacity and, therefore, marginal

costs were undoubtedly very low. Very important, too, the industry regarded itself as being in a growth phase. Today the excess capacity is gone because of

abandonments and plant wearout. Further, because of the high cost of capital,

the railroads do not look very far ahead. Also, the transcontinental rates on

which fresh fruits and vegetables move generally involve at 1east two carriers,

and oft en several. Thus, inasmuch as one carrier may profit and another may

lose on a given movement, the rate division question is relevant.

A second loser situation is the short haul of raw materials. Logs,

butts, bolts, and sand and gravel have traditionally shown up in the ICC’s burden

studies as producing revenues far below variable cost. Rates on these commodities were generally set low in the days when the railroads had a headlock on the

outbound flows of finished goods but where there was market competition for the

inbound flows. Today the rail carriers share the outbound flows with the truckers.

Important in the ratemaking question is the fact that to a very considerable extent

these rates are local to individual carriers.

A third category of losers is branchlike traffic. Here the traffic

flows taken as a whole simply do not cover their costs, at least on the originating or terminating carrier lines. The situation, of course, is aggravated if
-52-

the branchlike traffic is primarily in the first two categories noted above, as it

often is. An important question here is whether the branchlike traffic is a system

loser or only a loser for the branchlike carrier. As things are now, if traffic on

a given branchlike loses money for the originating or terminating carrier, the line

becomes a candidate for abandonment regardless of the system effect. This means

that a carrier is able to take unilateral action on service (i.e. ,

but not on rates, even though it may be preferable to raise rates

don service.

The fourth category of loser traffic is relatively new

abandonment)

rather than abanon the rail scene.

It has derived from two situations: one is relatively high terminal costs; the other

is the enormous increase in opportunity costs of rail use of urban land. Thus, individual carriers may lose on traffic originations or terminations in large metropolitan areas. The circumstances surrounding this traffic are not unlike those for

branchlike traffic (i. e. , service provision lies in the hands of one carrier but

the quotation of rates often does not).

In all four of these supply categories the question is whether the net

cash flow of the railroads would be increased by raising rates. Interestingly

enough, in the one category where single railroads both originate and terminate

the traffic (i. e. , the local movement of raw materials), rates have not been

raised substantially. Indeed, there is some evidence that they have been set

to meet truck and water competition. This, of course, suggests that while revenues may not cover average variable costs, they are above out-of-pocket (marginal) costs.

Because of the lack of data, it is not possible here to go beyond ICC

average supply costs for these categories of traffic to determine the extent to

which actual costs vary from the average. However, within a class or categories

there appears to be a great deal of variability on the test of net cash flow contribution to the system as a whole; therefore, a great deal of the traffic in each

of the four categories discussed must produce positive results on cash flows, and

a great deal negative. That is to say, by the measure of ICC variable cost, much

traffic which shows up to be profitable, in fact, produces negative cash flows, and

vice versa. This raises two important questions: one is whether the variable cost

which is being referred to in almost all of the proposals for regulatory change has

any consistent relationship to the real test of profitability--namely, net cash flow

contribution; and two, how costs for joint rates will be determined. It is not

likely that there is any close or consistent relationship between ICC variable

cost and the true test of profitability for a railroad company.

a. Variable Cost. Opportunity cost, which is the true economic

test of desirable resource allocation, and for which variable cost is a poor surrogate, varies greatly from railroad to railroad and from time to time. It is
-53-

also highly subjective in the sense that it represents the way in which the management of a company sees its opportunities. A management decision to devote

company resources to a given activity will raise the opportunity costs of all other

activities. This is especially true when a compmy is operating at or near capacity. Then an increase in one activity means a decrease in another, or, alternatively, it will require major outlays for additional capacity. Then, too, the

owners (i. e. , investors) may simply have other uses for their money and may

force Up the discount rate on future inflows of cash. This has, for examples

counteracting influences on the cost of branchlike operations, none of which is

recognized in the usual variable cost formula. The high cost of money spent on

maintenance tends to drive actual maintenance expenditures down, yet the opportunity costs of not doing maintenance may be very high if services are to be

continued.

The utilization of capacity on one line as compared to another, traffic

densities, terminal capacities, back hauls, and many other factors all conspire

to make cost in one situation different from another even though distances, lading

weights, and commodities may be the same. To ignore these differences leads

to departures from actual costs and concealment of the real effects on cash flows.

In various studies done for the U.S. Railway Association, these submerged cost

variations were reported to be as high as 600 percent. A further problem is that

if rates give accord to cost economies of high-density flows, and diseconomies

of low-density flows, the high densities will tend to get higher and the low densities lower. This will tend to have increasingly favorable effects on larger communities and increasingly adverse effects on smaller ones.

As a practical matter, the pure administrative problem of pricing

and the negative goodwill created by differentiating markets precisely according

to cost would indispose the carriers to a strictly literal policy of pricing according to the immediate effect on cash flows. Nevertheless, under rate deregulation

the carriers, individually and some of them together, by incentive pricing would

probably encourage traffic flows in a good many markets, at the same time deliberately pricing themselves out of other markets. But that disposition will be

countervailed by remaining regulatory constraints, as suggested earlier. Therefore, all things considered, the railroads cannot be expected to respond to demand

elasticities in the classic way of sellers. This, of course, makes the job of estimating the profit effects of regulatory change much more difficult. In addition,

there is the complicating problem that most rates are published for the accounts

of two or more carriers. Then, the cost conditions on two or more railroads

must be considered in setting rates. This matter deserves more examination.

b. Joint Rates. The Interstate Commerce Act requires the railroads to publish joint rates with other rail carriers and also with water carriers.

No one proposes to relieve them of that obligation. (Indeed, there is a great deal

of opinion that a similar requirement should be imposed on regulated truckers
-54-

who are not now so burdened. ) Also, for a great deal of rail traffic there are

competitive routings with varying participations by many carriers. (Thirty -

three percent of the Penn Central’s traffic is interlined. ) As of now, the decision

as to what a rate shall be for pairs of points, each of which is on one or more

different railroads, is a matter of negotiation among all of the participating carriers, some of which offer alternative routes. Thus, the varying costs of all of

them must be taken into account. Obviously, then, an averaging process is involved. The Commission is often drawn into this process on the complaint of

shippers.

For many years, particularly after 1920, collective ratemaking was

practiced, although it was quite clearly illegal under the antitrust laws. In 1948

the Reed-Bulwinkle Act specifically exempted collective ratemaking from the

scope of the antitrust laws, providing each rate bureau’s procedures were sanc -

tioned by the Commission. For all intents and purposes the carriers are allowed,

as before, to collude in setting rates. It may be concluded that the necessity of

obtaining consent or acquiescence from a number of carriers has not added to the

flexibility of ratemaking.

The Administration and others now wish to reduce the extent of collective ratemaking. The proposals offered vary, but in the main they would limit

joint ratemaking to those carriers participating in a single through route. Of

course, some carriers such as the Penn Central participate in many competing

through routes. The Penn Central might agree to a lower rate on one route than

on another, but the Commission is not likely to permit it if there is discrimination in favor of one connecting carrier over another. However, assuming that

there are separate routes which involve different carriers, the possibility exists

for rate competition among railroads, something which, as a practical matter,

has not existed for many years, and to which most of the industry would be adverse.

However, if it could exist as a result of regulatory changes, then individual railroad supply costs would be of much greater sign if i cane e than they are now.

The matter is important. If the railroads continue with collective

ratemaking, with or without regulatory sanction, changes in rates will be slow

in coming and modest in their proportions. If there is real competition among

railroads, rate changes may be frequent and sharp. However, whether they

will be tolerated by the industry or by shippers is very uncertain. Recognizing

that competition among the railroads must necessarily be extremely uneven, in

the past communities have simply refused to accept the side differences in rates

which would tend to result from this unevenness.

It is probable that if the railroads were really competing with each

other, some rat es on manufactured goods would come down by 30 percent to 50
-55-

percent. 1

In the short run that would probably result in very much reduced revenues and profits to the railroads; in the long run (i.e. , 15 years) it might,

because of high long-term elasticities, lead to enormously increased revenues

and, possibly, much larger profits. Left to themselves or to their investors,

the railroads will surely not be willing to accept short-run losses to achieve

long-run gains. That raises the final point in this discussion about railroad

supply costs.

The railroads’ discount rate on the future is, generally, very high

today, as it has been for some years now. This is partly attribuyable to high

interest rates and inflation, but it is also due to the fact that rail investors as

a whole see very gloomy long-run prospects for the industry. Thus income

streams 15 to 20 years in the future have very little value to the railroads and

their investors. This obviously affects railroad supply curves in that supply

costs for the short run are relatively lower than for the long run, and the rail -

roads are likely to respond more strongly to short-run demand conditions than

to long-run expectations. This should be borne in mind when considering the

market situations which the rail roads would face in deregulation.

2. Market Demands

There are really two questions which need to be asked about the response of the railroads to transportation market conditions: one is what the own

elasticities and cross elasticities of demand are; the second is whether the railroads are already at rates yielding maximum profit. The second question, of

course, involves the extent to which the rail carriers will change prices if they

are granted some degree of deregulation.

a . Own Elasticities. The conventional wisdom among transportation people has been that the demand for agricultural commodities and raw materials transportation is quite elastic, while for manufactured goods it is not. The

assignment of ratings in both the Uniform Freight and the National Motor Freight

classifications represent this point of view. Raw materials get low ratings and

manufactured goods tend to get high ones. Regulation has generally adopted and

tended to support this structure. Of course, as discussed earlier, in efforts to

exploit high elasticities, rates may have been pushed below costs, and once down,

it is difficult to get them up again. This is because, at least in part, in many

instances transportation demand which has been elastic to start with has turned

inelastic as a result of inelasticities of supply in the producing industries. In the

long run, the demand for some commodities, such as apples grown in the state

1

See the 1969 burden study issued by the U.S. Department of Transportation.

I .,, , -
-56-

of Washington, might be elastic, but producers, consumers, and politicians live

in the short run. For this reason, and others, the Commission has been reluctant to allow rate increases on these commodities which, although they might

increase rail revenues and profits, would be harsh to shippers.

As already noted, the railroads are likely to exploit short-run elasticities even at the expense of long-run profits. Thus, assuming low cross elasticities, rail rates on agricultural commodities and long-haul raw materials can

be expected to rise, increasing both revenues and profits. The effects on net

cash flow could be substantial. With deregulation, rates might increase 50 percent or more, revenues from those commodities might rise perhaps 30 percent,

and profits might increase by more than either since present losses would be

eliminated. It is a good prospect for the railroads. However, the effect of rate

increases on consumers and producers might be quite adverse, perhaps justifiably so.

In this regard it should be pointed out that the Penn Central has done

a special study on revenue-cost relationships reported on in the USRA’s recently

issued supplemental report. It stated that in the sample of traffic tested, 30

percent of the carloads did not generate revenues adequate to cover “short-run

variable costs. " It can be speculated that a good deal of that losing traffic would

be immune to cross elasticities, and that in the short run rate increases would

generate added revenues and profits.

The short haul of raw materials does not offer a clear prospect for

increased revenues or for increased profits, even assuming that many movements

are now losing money. In the first place, the Commission has posed very little

difficulty to the carriers in setting rates on these commodities at any level they

found desirable, at least this has been true with respect to intermodal competition.

Exempt carriers, which the Commission tends not to protect, handle this traffic.

A great many movements are local to a single railroad, so there is no complication with respect to joint rate publication. It appears that this traffic contributes

some positive net cash flow and that an increase in rates would shift traffic to

competing modes and reduce net cash flow. Consequently, deregulation would

probably make little difference. It needs to be said, however, that as roadways

deteriorate, net cash flow will be threatened. Either the railroads must maintain

their plants at satisfactory levels for operation or they must raise rates to simply

get out of the business, whichever most favorably affects cash flow. That is not

hampered much now by regulation, except possibly under Section 3.

1

A recent study prepared for the National Commission on Productivity shows

that rail shares of fruit and vegetable traffic from West Coast producing points

to Northeast Corridor markets are 75 percent or more.
-57-

On the basis of the 1972 ICC Rail Revenue Contribution statement,

it is possible to determine the increase in net revenues which would result from

eliminating by commodity classes the deficits below variable cost of movements

over the United States as a whole. The 1972 contribution statement shows that

25 commodity classes did not yield revenues sufficient to cover ICC variable

costs. The deficit was approximately $234 million. This is considered to be a

minimum figure for the amount by which the railroads net cash flow would increase if they were permitted to extricate themselves from losing traffic. Remembering that actual costs may vary widely from the average, it is also true

that rates vary widely from average revenues. Therefore, even though average

revenue may cover average cost for a commodity class, thus showing no deficit

for the class, many individual rates may be below average cost. Eliminating

those deficits might produce another $200 million to $300 million. Relying on

average variable costs as the true costs of individual movements, the elimination of rates below them might yield $500 million per year in net positive cash

flow.

b. Cross Elasticities. A good deal of experience in the transportation industries suggests that cross elasticities are high for the transportation

of manufactured goods, at least they have been from rail to truck. This view

has been pretty much adopted by deregulatory proposals, especially those from

the Administration. Also, as indicated above, own elasticities have been thought

to be relatively low. (One may quarrel with the latter assumption for the long

run where plant locations are variable. ) Thus, it can be assumed that increases

in rail revenues and profits must come about through diversions from competitive

modes to rail caused by reductions in rail rates (i. e. , there will be little induced traffic). Also, increases in revenues and profits accruing to rail from

rat e reductions must imply that other modes cannot meet the rail rate reductions.

The latter, however, may be a difficult assumption to sustain. Indeed, if some

deregulation of trucking is granted, as the Administration proposes, the diversion

may well be from rail to truck. (It should perhaps be recalled that among the early

justifications for truck regulation was the protection of the railroads. ) Moreover,

as discussed earlier, if intrarail competition is fostered by deregulation, the rail

carriers may simply share the same traffic with each other at lower rates.

In order to enclose the universe of possible revenue increases from

diversions of manufactured goods from other modes, the 1972 Census of Transportation, which covers only manufactured goods, has been used to assume the

following:

( i ) Freight shipments of 30,000 pounds or more shipped 500 miles

or more constitute the traffic which is attractive to rail.
-58-

(ii) The average of revenues per 100 pounds, taken from the 1

percent waybill sample and adjusted from 1972 to 1975 rate

levels for Eastern Territory to Western and reverse, represents the revenues which the railroads are now receiving from

30, 000-pound-plus shipments going over 500 miles.

(iii) Only annual volumes of 5 million tons or more comprise sufficient tonnages to be attractive to the railroads for diversion.

(iv) Rate reductions of 25 percent would divert traffic to rail.

(v) Net revenues over rail variable costs now average 50 percent.

Based on these assumptions, the amounts of tonnages which would be

diverted if the railroads raised their existing national shares of these tonnages

from the present shares to an arbitrary 75 percent were estimated. This, at

revenues per ton adjusted as indicated above, would produce $1, 732.8 million

in increased revenues, and net cash flows over operating costs of more than $575

million. Adjusting revenues for rate reductions, and assuming no induced traffic,

revenues would then amount to $1, 299.6 million, and new net cash flows would be

$144.0 million (see Exhibit V-l).

Despite the apparent attractiveness of the results of such an action,

the likelihood of 75 percent of the tonnage shipped being diverted to rail appears

low. An examination of Exhibit V-1 reveals that rail market share currently

exceeds 75 percent for only one commodity: flour. Gasoline, for which rail holds

a 1 percent market share; petrol residual, with 5.5 percent; and fuel oil, with 7.1

percent, are extremely unlikely to be captured, even with a 25 percent reduction

in rates, since water and pipeline movements, with final local distribution by

truck, are extremely competitive. On the other end of the scale, high-value goods

such as textiles, with 8.5 percent rail share, and machinery, with 20.6 percent,

are unlikely to divert substantially to rail from truck because of the importance

of the high-quality service levels they receive by truck. The loss of these five

commodities would reduce the total projected revenue increase by $649.1 million

(with no rate reduction) to $1,083.7 million. After the rate reduction is taken

into account, the revenue drops to $812.7 million and profits drop to $90.2 million.

Proposals for deregulation seem to assume that the railroads have

not reduced rates on manufactures either generally or selectively because regulation prevents them from doing so. Contradicting that view is the fact that

the railroads have requested and received round after round of general increases

which have brought the index of freight rates in July 1975 to a level ten points

above the wholesale price index, 1969 being 100 for both.
-59- ’

EXHIBIT V-1

ESTIMATES OF TRAFFIC Diversions

20

2011

203

2033

204

2041

208

209

22

24211

24311

26

2621

26311

264

28

281

2818

2819

28211

28999

29

29111

29113

29114

29116

29117

29119

30

32

3295

33

3312

335

34

35

36

3711

Food . . . . . . . . . .

Meat . . . . . . . . . .

Canned & Pres Fruit . .

Canned Fruit . . . . . .

Grain Mill Products . .

Flour . . . . . . . . .

Beverages . . . . . . .

Misc Food Preparations .

Textiles . . . . . . . .

Lumber . . . . . . . . .

Veneer&Plywood . . . .

Pulp, Paper . . . . . .

Paper . . . . . . . . .

Paperboard, Pulpwood . .

Converted Paper . . . .

Chemicals . . . . . . .

Indus Chemicals . . . .

Indus Organ Chemicals .

Indus Inorgan Chem . . .

Plastics . . . . . . . .

Chemical Products . . .

Petrol & Coal Prod . . .

Gasoline . . . . . . . .

Fuel Oil . . . . . . . .

Petrol, Lubri Oil . . .

Asphalt, Pitches . . . .

Petrol Residual . . . .

Petrol Refin Products .

Rubber . . . . . . . . .

Stone, Clay, Glass . . ●

Non-petal & Mineral . .

Prim Metal Products . .

Prim Iron & Steel . . .

Non-ferrous Metal . . .

Fabricated Metals . . .

Machinery . . . . . . .

Elec Machinery . . . . .

Motor Vehicles . . . . .

3.6

1.8

4.6

1.5

2.6

1.5

1.0

.3

1.8

3.6

1.8

1.5

3.0

3.6

1.5

3.6

15.4

3.0

2.4

2.4

2.1

4.2

15.0

8.7

3.9

1.5

2.7

4.2

2.1

2.4

1.5

2.7

4.2

1.4

3.6

3.0

2.1

5.4

37.4

11.3

17.4

33.1

46.2

87.8

20.4

33.4

8.5

46.3

60.6

52.1

58.7

72.0

51.3

42.0

56.1

40.7

42.6

41.5

17.4

11.5

1.0

7.1

15.1

22.6

5.5

14.5

23.4

21.3

69.2

42.1

44.0

21.4

25.1

20.6

30.3

57.9

1.3

.2

.8

.5

1.2

.2

.1

.2

1.7

1.1

.8

1.8

2.6

.8

1.5

9.2

1.2

1.0

1.0

.4

.5

.2

.6

.6

.3

.1

.6

.5

.5

1.0

1.1

1.8

.3

.9

.6

.6

3.1

2.7

1.4

3.5

1.1

2.0

.7

.2

1.4

2.7

1.4

1.1

2.3

2.7

1.1

2.7

12.4

2.3

1.8

1.8

1.6

3.2

11.3

6.5

2.9

1.2

2.0

3.2

1.6

1.8

1.1

2.0

3.0

1.1

2.7

2.2

1.6

4.1

+ 1.4

+ 1.2

+ 2.7

+ .6

+ .8

+ .5

+ .1

+ 1.2

+ 1.0

+ .3

+ .3

+ .5

+ .1

+ .3

+1.2

+ 3.2

+ 1.1

+ .8

+ .8

+ 1.2

+2.7

+11.1

+5. 9

+2.3

+ .9

+ 1.9

+ 2.6

+ 1.1

+ 1.3

+ .1

+ .9

+ 1.2

+ .8

+ 1.8

+ 1.6

+ 1.0

+ 1.2

31.91

63.33

26.22

22.43

27.20

23.74

30.59

26.63

62.40

26.49

20.66

28.37

27.90

23.64

35.68

19.81

16.68

33.89

28.05

29.86

11.12

21.88

25.35

25.35

31.61

12.59

20.74

25.35

55.91

29.12

28.30

23.89

32.54

36.31

42.83

64.86

58.62

60.10

Total Revenue Increase (no rate reduction)

Profit

Total Revenue Increase (2.5% rate reduction)

Profit (unchanged costs)

44.7

76.0

70.8

13.5

21.8

15.3

2.7

74.9

26.5

6.2

8.5

14.0

2.4

10.7

23.8

53.4

37.3

22.4

23.9

13.3

59.1

281.4

149.6

72.7

11.3

39.4

65.9

61.5

37.9

2.8

21.5

39.3

29.0

77.1

103.9

58.6

60.1

(000,000)

S1,732.8

577.6

1,299.6

144.4
-60-

A greater likelihood is that the carriers will cut rates selectively

where they are now constrained from doing so and where actual costs are below

ICC variable. How much this would affect the net cash flow of the industry as a

whole is extremely difficult to estimate, bearing in mind that Sections 3 and 4 of

the Interstate Commerce Act would still apply. It is apparent that few rail carriers will knowingly reduce rates if they anticipate that the truckers will competitively reduce theirs in response. Indeed, it is probable that the railroads

are much more sensitive to the prospect of competitive interactions than are the

truckers with whom they compete. (Theirs is a much more monolithic industry. )

Also, the natural response of an industry in a state of secular decline, such as

the railroads, is to reduce capacity and exploit inelastic demands. As a general

proposition, the railroads, facing the high cost of capital, would be disinclined

to reduce any rates which required new infrastructure capacity from which

capital investment could be recovered only in the longer term. Therefore, one

may anticipate that the carriers will make relatively few and small cuts on any

rates. However, that does not argue against their being permitted to make increases on losing traffic.

In a recent study for the Federal Energy Administration, the M. I. T.

Center for Transportation Studies examined the impact of the Administration’s

deregulation bills and concluded that (i) the competitive environment for full

truckload trucking would be increased after passage of the bills and (ii) this

would have negative competitive impacts on many rail commodities, with diversion from rail to truck. This finding was predicated on the ability of trucking,

particularly irregular route common carriers and exempt haulers, to reduce

rates more than rail and, as a consequence, to increase the ratio of rail to truck

tariffs.

The key determinant is the existence of sectors of the trucking industry, such as those named above, which can make good use of independent truckers, the so-called owner operators. These individuals operate without terminals,

with very little overhead expense, and generally at labor rates which are considerable y lower than those of unionized employees. They own their equipment

and can offset depreciation against their income taxes. In addition, they can

typically amortize the equipment expense over considerably more miles of utilization per year than most LTL common carriers. The result is operating costs

which fall in the range of rail prices.

In contrast, the railroads face an extremely difficult period in the

future which will make it difficult for their management to concentrate on the

‘Roberts and Kneafsey, op. cit.
-61-

complex marketing and ratesetting functions required. At a time when revenues

do not equal expenses they must identify commodities whose rates can be lowe red to be competitive with trucks, but not so much that there is a negative contribution. At the same time rates on rail inelastic commodities must be raised,

while on “losers” they must be raised enough to rid themselves of the haul. The

job is complex, to say the least. The conclusion of the M. I. T. study is that the

deregulation bills alone will probably have a net impact which is negative and

which will cause rail traffic to be diverted

c . —Public Policy Toward Other Modes .

It is obvious that public policy

mous adverse impact on the viability of

to truck.

toward other modes has had an enorthe U.S. railroads. Whether public

support for and stimulation of the other modes has produced benefits equal to

or greater than the decline in railroad output capability is an interesting, but

at this point a somewhat academic, question. What is important, however, is

what public policy may be expected toward the other modes and how it will affect

the viability of the railroads. If in the 1950’s and the 1960’s public expenditures

on highways and waterways had been sharply curtailed, the demand for rail t rans -

portation would unquestionably have increased. It does not necessarily follow,

however, that the increased net cash flows generated by higher damands and,

presumably, higher rates would have been reinvested in rail facilities. The

net result of the increase in profits might be an increase in the flow of rail capital funds out of the industry.

Another aspect of public policy is the regulation of modes other than

rail. The regulation of both trucking and domestic water transport, at least

in part, was i reposed at the federal level at the behest of the railroads on

grounds of “fair and impartial regulation of all modes. " Following 1935 in the

case of the truckers, and 1940 with the water carriers, the Commission imposed

minimum rates on both modes which relieved the railroads of some competitive

pressures. Unfortunately for the railroads, Congress exempted agricultural

and bulk commodities from regulation and left private carriage largely uncircumscribed. Thus, the railroads have been unprotected by regulation in those transportation markets. As the market interests of the railroads, forced by their cost

structures, have shifted more and more away from manufactures and less-thancarload shipments, the incursions of exempt and private carriage have become

more and more important. The rail industry wearied early of attempting to limit

the scope of exempt and private carriage, and turned to efforts to free the railroads from regulation in some measure. It should be noted, however, that the

Commission began to extend its protective "umbrella" to the other modes. Thus,

the railroads purported to be whiplashed by no regulation in one major segment
-62-

of their markets and by regulation devoted to the protection of other modes in

another. Recognizing that about 40 percent to 50 percent of rail carloads centain

commodities which are exempt either by truck or water, and that they compete

with proprietary carriers as well as regulated carriers of other modes in the

rest of their markets, the question is whether the railroads would gain or lose

by across-the-board deregulation which might relieve proprietary carriers of

present operational constraints. This question cannot be answered easily.

1. The Effects of Public Investment

on Other Modes

Public investment in other modes obviously affects the railroads through

the rates charged by competing modes which, in turn, depend on the costs of the

other modes. Publicly paid for improvements which do not improve the competitive position of truckers and water carriers vis-a-vis the railroads do not have an

adverse impact on the railroads. For example, "farm to market” roads have

probably, if anything, benefited the rail carriers. However, those improvements

which shorten truck running times between major traffic-generating points, or

which permit higher loadings, tend to reduce operating costs and intensify competition with rail. The interstate system, of course, has done both of those things

and has been responsible for an enormous diversion of traffic from rail to truck.

The straightening and deepening of waterway channels have had similar effects.

Some may assume that since the interstate system is now three-quarters or more finished and most of the navigable waterways in the United States have

been improved to permit barge tow operation, the railroads are not likely to feel

much new and additional impact. Such a conclusion, however, ignores several

probable developments. One is that the adverse impact of the interstate system

is likely to continue for some time as shippers and even whole communities adjust to the availability of low-cost truck transportation. Exhibit V-2 shows recent traffic shifts from rail in commodities which not long ago were handled primarily by rail. The commodities in question are fresh fruits and vegetables

raised in California and shipped to markets in the Midwest and the East. The

erosion of traffic to trucks represents the continuing impact of the interstate

highway system on rail traffic.

A second circumstance

near completion, highway interests

provement is the primary system.

is that while the interstate system may be

have indicated that the next target for imBecause the primary system includes many

heavily traveled truck routes, its improvement would probably cause further

diversions from rail.

A third probable development is the continued relaxing of size and

weight restrictions on trucks. Recently the gross weight limit on the interstate
EXIIIBIT V-2

FRESH FRUIT AND VEGETABLE UNLOADS FOR 41 CITIES ORIGINATING IN CALIFORNIA

1966 - 1974

(Thousands of Carlots and Carlot Equivalents)

“ Includes TOFC/CCFC movements.

“ ● Estimated 75% to 95% complete for different cities.

Note: Due to rounding, numbers may not add to totals.

Source: Fresh Fruit and Vegetable I nload Totals, United States Department of Agriculture, Consumer Marketing Service.

Feasibility Study of Perishables Transportation, prepared for the National Commission on Productivity, October 1975, pp. 42-43
system was raised to 80, 000 pounds. On most of the tollway system between

Boston and Chicago the gross limit is now 130,000 pounds in double-bottomed

rigs. It is not impossible to imagine that such a limit could be extended over

the whole interstate system, especially if it can be proved that it saves fuel.

A fourth prospect is that parts of the waterway system which have 9-

foot channels will be deepened to 12 or 15 feet. The recent debate over the damage to Lock and Dam 26 on the Mississippi River is a case in point. The Corps

of Engineers, which has operational responsibility, has recommended an increased size of lock and greater channel depths since it anticipates that in the

future channels upstream will be deepened and the capacity of locks increased.

All of the above eventualities brought about by public policy would

continue to encourage shifts of traffic from rail. Perhaps they are justified in

terms of the public interest despite their adverse effects on the financial viability

of the railroads. Instead of cutting back on public investment in other modes, it

may be preferable to invest public funds in railroads. Whichever is done, however, it is reasonable to expect that it will follow a finding that net benefits to the

economy as a whole would probably result.

2. Deregulation of Other Modes

A simple assumption might be that if water and truck regulations

were modified to reduce regulation and make the modes more competitive, then

their retraction would confront the railroads with more intense competition and

shift more traffic away from them. The recent study for the Federal Energy

Administration (FEA), cited earlier, has suggested such a consequence. The

Administration has conveyed the impression, however, that the result of deregulation would be reductions in rail rates and increases in rail traffic. The question is: Which eventuality is more likely? It may be worthwhile to explore current

regulatory conditions and how they impact this question.

As far as costs are concerned, and in other respects as well, truck

operations divide into five categories of carriers: regular route regulated common, irregular rout e regulated common, for-hire exempt, contract, and proprietary (see Exhibit V-3). It is useful to examine these individually because

each is quite different and offers a different competitive edge to the railroads.

As will be seen, the LTL regular route common carrier is not the competitive

threat to the railroads posed by the irregular route truckload carrier or a proprietary carrier which also holds licenses to operate contract trucking operations.

a. Regular Route Common Carriers. These carriers handle mainly

less-than-truckload shipments and thus compete only with rail freight forwarder

and rail shipper associations. The latter categories consist largely of truckload
EXHIBIT V-3

CHARACTERISTICS OF THE MARKETS FOR THE MODES OF

INTERCITY FREIGHT TRANSPORTATION

Total Trucking *

(412)

Pipelines Inland Waterway Railroads Regulated Truck

(431)

Private Truck Air

(Barge) (768) (170) (242) (3)

(596) Owner

Unit Train Carload TOFC Contract Common Operator Private Fleet

.—— —

TL LTL LTL

X300 < 600 ‘ 600

Livestock Manufacturing Manufacturing

Agriculture Food Food

Food Metals Other

Metals Other

Manufacturing Other

*1970 ton miles (in billions).

* *principal Categories:

Size of shipment: minimum shipment LTL TL/CL Bulk

Length of haul: intracity ‹ 600 miles >600 miles

Competitive commodities: manufacturing, livestock, agriculture, coal, mining, lumber, petroleum, glass,

chemicals, other.

Source: Paul O. Roberts, and James T. Kneafsey, "Energy Use Implications of Proposed Change in the Regulation

of the Railroad and Motor Trucking Industries. " A Study Prepared for the Federal Energy Administration

by the M. I. T. Center for Transportation Studies, October 1975.
-66-

shipments which provide the railroads with head-to-head competition. Because

of regulation, however, each of them suffers some disability in achieving the

lowest possible costs for truck movement. Presumably, if this disability were

removed, costs would descend further and, probable, rates as well.

b. Irregular Route Common Carriers. These carriers hold certificates from the ICC to handle commodities generally or specified commodities

within specified geographic areas. The commodity authorization can be quite

broad, as can be the geographic authorization. Irregular route carriers, which

tend to be smaller and considerably more numerous than the regular route carriers, handle the truckload movements of non-exempt commodities in many instances, using owner operators (drivers who own their own tractors and trailers).

In general, competition among them tends to be quite vigorous. Their common

carrier service obligations as regulated carriers tend not to be onerous since

truckload lots generally pay their own way. However, because of the limits on

what many of them may carry, they tend in some measure to have unbalanced

loads which inflate costs. These are filled by acquiring separate operating

rights in the reverse direction. Given freedom from certificate constraints

they could more easily obtain truckload movements in both directions. In that

process rates would come down and the traffic on which the railroads now make

relatively high profits would be adversely affected.

c . Exempt Operations. Anyone with a truck or barge can handle

exempt commodities free of economic regulation. This includes regulated as well

as proprietary carriers. Regulated carriers, however, may not mix exempt

and regulated commodities on the same vehicle (barge); in that case, they all

become regulated. 1

The prime disability which truck carriers of exempt commodities

endure is unbalanced hauls. Because exempt commodities are primarily agricultural, traffic tends to flow from rural to urban areas. The manufactured

goods which move back to the rural areas cannot be handled by carriers that do

not hold certificates. This, of course, is a boon to the regulated carriers which

can have a regulated move in one direction and an exempt move in the other.

However, it has a tendency to lessen competition for the transport of both exempt

and regulated commodities. For those unregulated carriers which make the

transport of exempt commodities a regular business, the disability of unbalanced

loads is lessened by their freedom to trip-lease to regulated carriers for back

hauls. If entry restrictions were eased and the ability to back haul regulated

commodities granted or trip-leasing were more widely permitted, the dichotomy

of exempt and regulated transportation would be lessened, thereby reducing the

cost and the rate-inflating factor of empty or partial back hauls, and making them

even more of a competitive threat than they are at present.

1

They may now be mixed on the same barge tow, but not in the same barge.
-67-

d. Proprietary Carriers. The law permits buyers and sellers of

goods to truck them if they have title to them. Ownership, however, cannot be

a subterfuge for entry into for-hire transportation. In this regard the “primary

business” of the owner and transporter of goods must not be transportation.

Because of this constraint, proprietary carriers tend to be afflicted with backhaul problems although the affliction is more acute for small shippers than for

large multiplant concerns which have a greater opportunity for two-way traffic

f lows, Also, proprietary carriers may transport exempt commodities freely.

Recently, however, under limited circumstances, proprietary carriers have been

able to get contract carrier permits. Where these have been granted, the problem of empty back hauls in private truck operations has been reduced, The

easing of corporate haul restrictions to include subsidiaries, proposed in the

Administration’s truck bill, will also have a competitive impact.

e. Contract Carriers. Today contract carriers tend to be largely

extensions of proprietary carriers; the Commission is seldom reluctant to grant

contract carrier permits where the carrier essentially serves one shipper. In

that situation the contract carriers labor under much the same constraints as the

proprietary carriers.

Although the content of the Administrationfs proposals for the deregulation of trucking has not as yet gone to the Hill, indications are that these proposals will soften restrictions on both proprietary and contract carriers. This

will put additional rate pressures on the railroads.

3. The Response of Rail Carriers to

Competitive Pressures

Evidently the Administration’s view is that increased competitive

pressures on the railroads will result in lower rates all around which will redound to the benefit of the general public. This may result, although the distribution of benefits may be uneven--favoring urban areas more than rural areas

insofar as reduced rates are associated with relatively high densities of traffic.

As far as the railroads are concerned, the effects of increased competition and lower rates may accelerate via a decline of their role in transportation. An important aspect of this is the willingness of existing railroads to react

to competitive challenges with new investments in technological improvements.

That, in turn, depends, at least in part, on the railroads being able to rid themselves of losing traffic. Freeing them of their losses, however, will not alone

encourage them to make new investments unless they see the prospect of traffic

growth and increased net cash flow. This question should be explored more fully

in subsequent studies.
-68-

D. Summary and Observations

The observations arising out of this discussion are only tentative in

terms of magnitude but the overall outline seems clear. If the railroads are to

rid themselves of losing traffic (i.e. , traffic which does not make a contribution to overhead and profit), then upward rate flexibility must be a part of the

new legislation. Conversely, competition with truckload traffic and inland waterways will require downside flexibility in rail pricing. Taking all factors into

account, Section 3 of the Interstate Commerce Act is likely to limit such

flexibility.

Competition with the truckers would inevitably be increased by passage

of the Administration’s truck bill, and unless other legislation increases user

charges on the trucks and initiates them on waterways, the ability of the railroads to lower prices to capture new traffic appears to be limited. A key point

here is the system nature of the rail ratemaking process and the necessity for

two or more railroads to agree on relative elasticities. Even where cross-inelasticities are low, as well as own elasticities as they are reputed to be in

agriculture, it is doubtful whether the Commission will allow their exploitation

through higher rates because of the repercussions of rate increases on producers

and consumers.

Finally, investment policy for both highways and waterways is important to the railroads. New programs of infrastructure development in either can

result in reductions in operating cost and increased competition to the railroads.

Likewise, size-weight laws and the use of multi-unit combinations on the interstate system can have potentially negative impacts.
-69-

VI. OTHER LEGISLATIVE ACTIONS

In addition to the three major legislative actions discussed above

(Rehabilitation, Part III; Restructuring, Part IV; and Rate Reform, Part V),

many other actions directed at improving rail service and/or the viability of

the railroad industry are under consideration by Congress. Some, such as the

several proposals to transfer ownership of fixed rail plant to state or federal

government entities, involve massive change

study, Two lesser changes in the status quo

here. They are (i) the avoidance of railroad

(ii) the prohibition of discriminatory taxation

A. Light-Density Lines

In recent years the general issue

and are outside the scope of this

have been selected for discussion

losses on light-density lines and

of railroad property.

of rail service on light-density

branchlines has received a great deal of attention and analysis. One particular

aspect of this issue which is of concern to this study is the impact of avoidance

of losses related to such operations on the cash needs of the solvent railroad

industry. Whether the avoidance results from abandonment of service or from

subsidy, and the distribution of subsidy costs among federal, state, or local

government entities or shippers, is not at issue here.

The amount of money involved in light-density line losses has been

subject to much debate. The industry’s own estimate of annual losses is approximately $130 million. About $40 million of this amount is attributable to the

bankrupt roads. Advocates of the retention of branchlike service argue that this

estimate overstates the true cost. For the purpose of this study $75 million appears to be an acceptable order-of-magnitude estimate of light-density line

losses that might be avoided by the solvent railroads if the service is subsidized

or abandoned.

B. Discriminatory Taxation

Several legislative proposals contain provisions which would bar the

taxation of transportation facilities at rates that exceed those applicable to other

commercial or industrial facilities. Because of the disruptive effect that such

legislation might have on local taxing jurisdictions which have historically relied

on revenues from high tax rates on, or assessments of, rail property in particular, the proposals generally provide for a period of several years before the

prohibition of discriminatory taxation becomes effective Although no quantitative analysis of the extent of this practice has been unearthed, it appears from
-70-

discussion with knowledgeable industry sources that such legislation might eliminate about $25 million to $30 million of the industry’s $200 million estimated

annual property tax bill.

c . Summary and Observations

Two key observations emerge here:

● The gains to the railroads through the elimination of lightdensity line losses by subsidy or abandonment, and the prohibition of discriminatory taxation, are direct cash gains.

● Although less complex and more limited in scope than the .

major legislative options explored above, the gains from these

two lesser steps, totaling perhaps $100 million annually, are

significant in relation to the total cash shortfall projected in

Part H, above.
APPENDIX A

ILLUSTRATIVE ANALYSIS OF ALTERNATE PUBLIC

INVESTMENTS IN RAIL FIXED PLANT

In the absence of hard quantitative analysis, it is worth looking at the

impact of rehabilitation in very general terms. Exhibit A-1 shows a hypothetical

array of discretionary expenditures for fixed plant rehabilitation in terms of rate

of return. It indicates a small number (dollar value) of expenditures with very

high rates of return and a large dollar value with low rates of return. This relationship is quantified in Exhibit A-2, which shows the investment and returns

for a series of hypothetical incremental investments.

Short-run (5- to 10-year) cash returns have been separated to illustrate the fact that many rehabilitation returns are either intangible or so protracted in timing that they are of little interest to a management whose primary

concern is immediate-term cash flows.

Exhibit A-3 shows four hypothetical cases of investments selected

from Exhibit A-2.

Case 1 indicates that the railroad industry, left to its own devices,

would invest in rehabilitation down to an 11 percent level of total return, producing

an annual cash return in the short run of $3, 550 on an investment of $35,000. No

government assistance is involved.

Case 2 illustrates the effect of adding $10,000 of government funds to

the total railroad investment. Such a public investment adds $200 to the railroads short-run annual return, but the assumption that the government funds are

provided to the railroads at an effective interest cost of 2 percent offsets this

gain and the incremental investment does nothing for the railroads financially.

Case 3 shows the effect of a federal assistance program structured

to replace $5,000 of railroad funds with public funds, and adds only $5,000 to the

total program undertaken by the railroads alone in Case 1. Here we see incremental return to the railroads of $550, after consideration of the 2 percent

cost associated with the federal funds. Part of the gain results from an assumed

reduction in the railroads’ cost of capital from 10 percent to 9 percent, based on

their reduced need for funds. The cost to the government of providing the $550

gain to the industry is $800, assuming a 10 percent opportunity cost of public

funds (less the 2 percent borne by the railroads).

Case 4 shows

incremental return to the

cost to the government.

I -1 , T

a sharper reduction in railroad investment, with an

industry of $1, 050, which is greater than the assumed
A-2

EXHIBIT A-1

RETURN ON INVESTMENT

‘Total Dollars of Rehabilitation Projects
A-3

Investment

($ in

thousands)

5,000

5,000

5,000

5,000

5,000

5,000

5,000

5,000

5,000

EXHIBIT A-2

HYPOTHETICAL RANGE OF REHABILITATION PROJECTS

Cumulative

Total

Return

50%

40%

30%

20%

15%

13%

11%

10%

9%

Short-Run

Cash

Return

0%

20%

15%

12%

10%

8%

6%

3%

1%

Investment

($ in

thousands)

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

Total

Return

2,500

4,500

6,000

7,000

7,750

8,400

8,950

9,450

9,900

Short-Run

Cash

Return

o

1,000

1,750

2,350

2, 850

3,250

3,550

3,700

3, 750
A-4

o

ww - W w

o

0

0

.

0

0

0

.

I

00 0

00 0

00 0

, ,
A-5

Cases 3 and 4, which involve the release of funds that would otherwise

be spent by the railroads, raise serious public policy questions. If the federal investment simply enables private investors to disinvest, perhaps in the form of

higher dividends, it does not appear that the public objectives have been advanced.

These cases would look very different if the hypothetical numbers in

Exhibit A-2 showed a generally higher rate of return. For example, a nearbankrupt railroad with a history of severe cash shortages might have an available

block of fixed plant projects with short-run cash returns of more than 10 percent

which it could not undertake without federal assistance. Thus, the returns on

incremental federal investment would be substantially higher in any of the hypothetical cases involving public funds. Such returns could help the railroad to

avoid bankruptcy.

The fact that the use of actual rather than hypothetical numbers in

the above illustrations may well result in a very different picture of the returns

associated with federal assistance in the rehabilitation of rail fixed plant underscores the need for research into actual returns, financial and non-financial, to

provide a basis for sound public policy.
APPENDIX B

REVIEW OF RECENT RAILROAD MERGER HISTORY

Creation of the Interstate Commerce Commission in 1887 was a

general reflection of the trend toward more reliance on administrative agencies

in dealing with major social problems as well as a specific response to the

unfolding railroad problem. The complex and varied nature of the problem

necessitated the creation of an agency with maneuverability and versatility, one

whose functions would not defy too greatly the traditional ‘‘separation of powers

principle.

With implementation of the Act to Regulate Interstate Commerce in

1887, the railroads and rate-setting associations were required to adjust the

rate determination process and rate structures to comply with the establishment

of the Commission.

The Transportation Act of 1920 instructed the Interstate Commerce

Commission to prepare and adopt a plan for the consolidation of the railway

properties of the United States into a limited number of systems. Following the

Transportation Act of 1920, the ICC was converted from an agency devoted to

facilitating private collusion to an “outright public cartel,”1 which was vested

with the power of minimum rate regulation; given control of entry into, exit

from, and capital formation in the industry; and granted a variety of means for

endeavoring to equalize the rate of return between the financially strong and

financially weak railroads. 2 The prohibition of pooling prescribed in the original

Act of 1887 was changed to allow for discretionary approvals of pooling arrangementsts. 3 The famous Ripley consolidation plans for equalizing disparities among

1 Many writers have espoused the view but none has pursued it more vigorously

than George W. Hilton in ‘What Went Wrong, " Trains, XXVII (January 1967),

p. 42.

2

The ICC provided a return of 5.5 percent on a fair value of investment as a

target for 1920 and 1921, after which the target was 6.0 percent. If a railroad’s

rate of return exceeded the maximum, it was required to retain half the excess

in a contingency reserve and to deposit the other half in a fund administered by

the ICC for loan purposes to the weaker railroads. This provision proved unworkable, mainly because of the depression, and in 1933 the Emergency Transportation Act ended any effort to set a target rate of return for the industry.

3

For an inquiry into the effects of cartel agreements on rates, tonnage shares,

and profits of the major Eastern railroads in the last three decades of the
B-2

the various railroads were a result of the 1920 Act, but the stronger railroads

were not interested in assisting the limping ones and had the legal right to refuse

to do SO. 1

1. Merger Criteria

The ICC published the Complete Plan of Consolidation2 in 1929 under

which any consolidation had to conform to the configuration designed in the plan

and be in the public interest. None of the consolidated systems proposed under

the plan was ever effected, and very few rail consolidations occurred during the

period of the 1920 statute. However, the Transportation Act of 1940 repudiated

the concept of a master plan for rail unifications and, instead, insisted that all

proposals to purchase, lease, merge, consolidate, or otherwise acquire control

of railway properties were to be examined on their own merits in the light of

certain criteria as specified by Congress in Sec. 5(2)(c) of the Interstate Commerce Act of 1887. The 1940 Act redefined the criteria as follows:3

(1) the effect of the proposed transaction upon adequate transportation service of the public; (2) the effect upon the public interest of

the inclusion, or failure to include, other railroads in the territory

involved in the proposed transaction; (3) the total fixed charges resulting from the proposed transactions; and (4) the interest of the

carrier employees affected.

nineteenth century, see Paul W. MacAvoy, The Economic Effeats of Regulation:

The Trunk-Line Railroad Cartels and the Interstate Commerce Commission Before 1900. According to MacAvoy, there were four major reorganizations of the

cartel, each of which was occasioned by failures from “cheating” by some of the

members. Each reorganization was an attempt to provide means for detecting

deviations from the agreed rates and to provide penalties for such deviations.

In general, if it was possible for an individual railroad to increase its profits by

being loyal to a cartel agreement rather than being disloyal, the cartel would

likely be stable. However, the evasion of regulation by individual railroads and

the reduction of the powers of the ICC by courts induced the eventual collapse of

cartel rates.

1

In fact, the Transportation Act of 1940 repealed the Ripley Plan for consolidations and substituted other criteria.

2

In the Matter of Consolidation of the Railways of the United States into a Limited

Number of Systems, 159 ICC 522 (1929).

3

The Transportation Act of 1940, Sec. 5(2).
B-3

In addition to the statutory requirements, the ICC seems to have

adopted a set of ad hoc criteria as a result of its being left to adjudicate each

case "on its own merits. At various times these criteria appear in merger

cases presented to the ICC. The ad hoc criteria involve (i) speed of delivery;

(ii) economy and frequency of service; and (iii) the appropriate provision and

most efficient use of general and specialized transport facilities. 1 Thes e

criteria have actually evolved as an attempt to clarify the ambiguities of the

term “public interest, " which is specified in the statutory criteria, and to maintain some degree of intramodal, competitive traffic flow. They represent factors

which are important determinants influencing traffic on given routes and which

have a direct bearing on a shipper’s choice of routes. Because mergers bring

about structural changes, the protection of public and private interests with

respect to routes and traffic volume are frequently evaluated in terms of these

ad hoc criteria.

In an actual merger case, the applicants resort to demonstrating

the beneficial impacts of what has been described above as the ad hoc “set. "

The ICC then attempts to evaluate this deluge of favorable data with evidence

presented by protectors and interveners. It is assumed that the applicants will

carry out their promised and planned operating changes. Only occasionally does

the ICC subsequently spot-check a unified railroad for confirmation purposes.

This “surveillance” is one area where the regulatory agency (and not only in the

railroad industry) needs to improve its efforts.

The most recent upward trend in rail mergers dates from 1957 when

the Interstate Commerce Commission approved the consolidation of the Louisville

and Nashville Railroad with the Nashville, Chattanooga, and St. Louis Railway.

Since that time the trend of rail mergers has accelerated until, at present, a

large proportion of the major carriers has either actively considered consolidation or has submitted formal merger proposals for ICC approval. Recent

cases vary in complexity, from relatively simple proceedings involving acquisition of stock control in order to simplify corporate structures, to highly complex

cases involving several large competing railroads. In the case of certain Eastern

railroads, the trend toward consolidation signifies resort to a means of preserving

the profitability of rail lines under private operation. In contrast, the issues in

the applications of some Western railroads, which have generally been more

profitable than those in the East, have shown a more direct concern with the

question of competition versus regulated monopoly, first in railroad services

over certain routes and, second, between railroads and their alternative transportation modes.

1

For a discussion of these criteria, see James T. Keafsey, The Economics

of the Transportation Firm (Lexington, Massachusetts, D. C. Heath and Company, 1974), pp. 68-69.
B-4

It is alleged that most merger proceedings tend to be handled uniquely

without much attention being devoted to the ways in which each merger affects the

overall operational and geographical structure of the industry.

Another commonly raised issue related to mergers is the fact that

the process of adjudicating mergers has been unduly slow. Seemingly endless

rounds of legal maneuvering and regulatory deliberations have created an impres -

sion of wheel-spinning, the costs of which some people feel are barely offset by

the post-merger savings. For example, one of the simplest combinations to effectuate--consolidation of the Chicago Great Western into the Chicago and North

Western--was proposed in early 1964, approved by the ICC in 1967, but sent

back to the ICC in January 1968 because of federal court litigation. Similarly,

the Burlington Northern merger scheme was conceived in 1957, reviewed by the

ICC for several years, rejected in 1966, reconsidered and approved in 1967,

contested in 1968, and finally implemented in 1969.

The railroads have been confronted with both the intensification of

external competition from other modes of transportation and increased operational costs from within the industry itself--problems for which only soundly

conceived mergers were hoped to offer solution. If the case discussed below

is representative of all mergers in the industry, it is important to assess the

impact of mergers on the performance characteristics and resource allocation

decisions of railroad companies.

2. A Brief History of Railroad Negotiations

Behind the Penn Central Merger

The merger of the Pennsylvania Railroad Company (PRR) and the

New York Central Railroad Company (NYC) was originally proposed in January

1957. At this same time studies relating to the proposed merger were authorized. These studies were completed in substance by January 1959, when the

NYC discontinued its merger plans on the grounds that its officials believed that

as long as the PRR controlled the Norfolk and Western Railway Company (N&W)

a merger would create an "unbalanced competitive situation’? in the East and

perhaps ultimately result in nationalization of the independent railroads. At that

time consideration was given to the fact that the N&W was in the process of

purchasing the Virginian Railroad Company. After its merger discussions with

the PRR were terminated, the NYC began to purchase capital stock in the Baltimore and Ohio (B&O). Shortly after February 1959, the NYC entered into

negotiations with the Chesapeake and Ohio Railway Company (C&O) and the B&O,

looking toward the possibility of a so-called two-party railroad system in the

East composed of the NYC, C&O, and B&O on the one hand, and the PRR and

its satellites (including the N&W) on the other. The NYC's action in pursuing

the C&O and B&O arrangement was largely founded on the consummation of the
B-5

N&W - Virginian merger, 1 which it had not opposed other than seeking limited

conditions.

On June 14, 1960, the C&O filed an application with the Commission

under Section 5 of the Interstate Commerce Act for authority to control the B&O.

Even though the C&O was opposed to inclusion of the NYC in this proposed transaction, negotiations continued between the NYC and the B&O. The discussions

were halted abruptly when the C&O, through ownership and stock exchange assents, acquired more than 50 percent of the B&O's outstanding capital stock.

The reaction of the NYC was to file an application under Section 5 for authority

to control the B&O jointly with the C&O. These matters were heard on a consolidated record. During the pendancy of these transactions, the ICC approved

the merger of the Delaware, Lackawanna, and Western Railroad Company into

2 The NYC did not Oppose this merger despite the the Erie Railroad Company.

fact that its officials felt that it would lose substantial traffic as a result. The

PRR also supported this merger despite its estimates of loss of traffic.

On March 17, 1961, the N&W filed applications under Section 5 of the

Act to merge, purchase, control, and/or lease the properties of the New York,

Chicago, and St. Louis Railroad Company (Nickel Plate); Wabash Railroad

Company (Wabash); and the so-called Sandusky line of the Connecting Railway

Company, a PRR subsidiary. The NYC intervened in these proceedings prior

to hearing and filed a petition seeking inclusion under Section 5(2)(d) of the Act.

In October 1961, after the C&O had contracted to purchase approximately 61

percent of B&O stock, and after the NYC determined that it had little, if any,

chance of obtaining joint control of the B&O with the C&O, or of effectuating an

NYC - C&O - B&O merger, the NYC advised the PRR that it was ready to resume

negotiations leading to merger. It was the belief of the president of the NYC that

if the transactions embracing the N&W, Nickel Plate, and Wabash, and the control of the B&O by the C&O, were consummated, the NYC could not compete

with these two systems independently. While the action of the NYC in seeking

merger with the PRR was in large measure defensive, the former believed that

a PRR/NYC System divorced from the N&W and competing with an expanded

N&W System and a C&O/B&O System would offer the Eastern section of the

United States a competitively balanced railroad system. As a result of negotiations with the PRR, the NYC withdrew its application in the C&O/B&O proceedings

and its petition for inclusion in the N&W proceeding.

Negotiations between the PRR and the NYC were conducted during

the latter part of 1961. The merger agreement was signed on January 12, 1962,

1

Finance Docket? No. 20599.

2

Finance Docket. No. 20707.
B-6

with the approval of both boards of directors and with subsequent approvals by

the respective shareholders. Although the outcome was not apparent for several

years, the merger application was finally effectuated in April 1968. The Pem

Central case was a merger that was completely different from any previous one

because it involved the combination of two large-size companies into what is

presently the largest railroad system. Of course, the declaration of bankruptcy

by the Penn Central in June 1970 is a well-documented topic.

The net effect of the complications resulting from current merger

proceedings is the raising of pertinent, more aggregative questions of public

policy. For example, the president of the Chicago and Eastern Illinois has

stated the following: 1

Any merger proposal involving two or more railroads has advantages and disadvantages irrespective of whether the railroads are

operating in the ‘black’ or in the ‘red. ’ The effect of the merger

on the railroads involved, on their employees, competing railroads,

individual shippers, and others must be subordinated to what is considered to be in the best interest of the public. The Interstate Commerce Act attempts to safeguard the rights of those who may have

conflicting interests in a merger proceeding by providing for participation of interested parties in public hearings, for the issuance

of reports, and for the filing of petitions for rehearing, reconsideration, etc. Finally, after administrative remedies are exhausted,

provision is made in the Interstate Commerce Act for review of the

Commission’s order in the courts. Carriers operating in the ‘black’

who can successfully meet the requirements of the statute relating

to railroad mergers are more likely to strengthen the overall U. S.

transportation system than those operating in the ‘red’ who are permitted to merge in the hope that the merged company can achieve

results one or more of the railroads parties to the merger could

not achieve while operating as a separate entity. We cannot have

a strong transportation system without strong healthy railroads.

Despite the piecemeal efforts to achieve mergers in the West, the

ICC has been reluctant to approve any of them unless some type of overall plan

is first developed which will meet national transportation policy requirements

and the nebulous (public interest) criterion. Even without an overall plan, however, a prevailing and important empirical issue continues to be investigation

of the impacts of mergers on which public policy considerations for restructuring

can be developed.

1

Statement by Kenneth C. Davis, Trains, XXVII (January 1967), p. 42.
APPENDIX C—

Narch 20, 1975

Honorable Olin E. Teague

Chairman

Office of Technology Assessment

Room 2311 Rayburn House Office Bui1ding

Washington, D.C. 20515

Dear Mr. Chairman:

Within the next six months, the Senate Commerce Committee wi11 be expected

to evaluate and make recommendations to the Senate concerning the Final

System Plan for reorganization of rail service in the 17 state region

covered by the Regional Rail Reorganization on Act of 1973. The Preliminary

System Plan has already been submitted to the Corgress by the United

States Railwat ASSociation and is now being reviewed by the Rail Services

Planning Office of the Interstate Commerce Commission, and by the staff

of the Committee.

The Preliminary Plan has brought into focus a number of very important

questions concerning the largest industrial reorganization ever attempted.

The Senate Commerce Committee would very much appreciate any assistance

that the Office of Technology Assessment could provide in reviewing this

Plan and the issues it raises about the future of rail Service in this

region which contains 42% of the Nations population and over 50% of the

Nation’s manufacturing production.

The Office of Technology Assessment could provide this Committee with

assistance which WOUld be tremendously useful and important in connection

with our statutory responsiblities and we respectfully urge your favorable e

consideration of this request. In view of the extremely limited amount

of time remaining to evaluate the Preliminary Plan, an Expeditious considerate on of this request will be appreciated.
I

c-2

In recent weeks, the staff of your Transportation

Assessment Program has worked closely with the staff of “

the Subcommittee on Transportation and Commerce to ensure

that the results of OTA's “Review of the Final System

Plan” will be helpful to the Subcommittee in its consideration of such plan.

The Office of Technology Assessment is providing

a much–needed service to Congress in that it has the

resources -- in both money and manpower –- to conduct

studies that will contribute to sound and responsible

legislation. Further, studies of the rail problem at this

timer will have immediate ’legislative benefit, since the

Congress is presently considering the largest corporate

and financial reorganization in history.

As Chairman of the Subcommittee on Transportation

and Commerce, I would like to take this opportunity to

underscore the importance of additional studies on rail

transportation, and to commend the Office of Technology
c-3

Mr. Emilio Q. Daddario

Page Two

July 21, 1975

Assessment for the important research that has already

been undertaken.

I look forward to, our continuing cooperation.

Sincerely, I

chairman

Subcommittee on Transportation

and Commerce
APPENDIX D—

Harbridge House Study Team Members

G. Gerald O'Donahoe

Joel D. Krauss

Suphia Sieczkowski

Lorraine J. Goldstein

James T. Kneafsey

Robert A. Nelson

Pau1 O. Roberts