Freight Rail Pricing: Contracts Provide Shippers and Railroads Flexibility, but High Rates Concern Some Shippers
Released: 2016-12-07T00:00:00

Letter

Background

Freight shipped by rail travels over an extensive network that consists of 140,000 route-miles across the United States. Freight railroads are generally privately owned and rely on their revenues to invest in maintenance and operations that support safe and efficient transportation services. During the last 40 years, the freight railroad industry has consolidated. Currently, the U.S. railroad industry includes seven major Class I freight railroads. Railroads carry a variety of commodities and may compete with each other and other shipping modes such as trucks and barges for business.

The Interstate Commerce Commission (ICC) was established in 1887, originally to regulate almost all of the rates that railroads charged shippers to ensure that the rates were reasonable and just. The Railroad Revitalization and Regulatory Reform act of 1976 and the Staggers Rail Act of 1980 were enacted in response to economic slowdown in the 1970s, with rising costs, losses in traffic and revenues to motor carriers, and bankruptcies affecting the railroad industry. These laws substantially reduced federal regulation and encouraged greater reliance on competition to set rates. In particular, the Staggers Rail Act gave railroads increased freedom to price their services according to market conditions, including the freedom to use differential pricing, a practice in which railroads can charge higher rates to shippers of commodities such as coal and chemicals, which are more dependent on the rail network. The ICC Termination Act of 1995 transferred the ICC’s regulatory functions to the Surface Transportation Board (STB), an independent adjudicatory body. The STB now serves as the industry’s economic regulator, resolving rate and service disputes between shippers and railroads for regulated goods shipped under tariff. The acts also allowed railroads and shippers to enter into confidential contracts to set terms and rates. STB has no authority to review the terms or rates for freight shipped by contract. To protect shippers served by only one railroad with no competitive shipping alternatives—known as “captive” shippers—from unreasonably high rates, STB established a process in which shippers that transport their freight by tariff could potentially challenge the reasonableness of a rail rate and seek financial relief from the railroads, a process that we refer to as a “rate-relief” process.

Some commodities were later exempted from STB’s jurisdiction, primarily commodities that could be shipped by boxcar or intermodal containers, in part because these goods can also be transported by other competitive alternatives such as barge or truck and are therefore unlikely to be captive. According to a Department of Agriculture report, these exemptions, in addition to contracts, effectively freed about 75 to 85 percent of freight traffic from economic regulation by STB. Currently, the most frequently transported commodities that could be subject to STB rate regulation, by tons shipped, are agricultural, specifically, grain soybeans, and sunflower seeds; assorted food items; coal; chemicals; and nonmetallic minerals.

Railroads are required, upon request, to offer tariff terms and rates to shippers, but railroads are not required to offer a contract. Contracts are confidential, mutually agreed upon, and may contain rates for specific routes and other service terms for a specific shipper. According to the selected railroads and shippers we spoke to, contracts generally contain multiple, shipper-specific O-D routes—agreements on terms and rates for specific shipments over specific shipping routes—because a shipper may have multiple routes. For example, according to a Class I railroad representative, a chemical production facility may receive its raw materials from multiple origins, with each route having agreed upon terms and rates, as shown in figure 1.

STB has the authority to review the reasonableness of rates and service terms for regulated commodities if shipped by tariff. Tariffs are a pricing document issued by the railroads showing rates that are usually not customer-specific. Tariffs also spell out the standard terms of the railroad. These standard terms differ by commodity, covering everything from loading specifications to billing procedures.

Under STB’s rate-relief process, in which it resolves disputes regarding the terms or rates in a tariff, in order for STB to review a rate as potentially unreasonable, the rate must not be under contract and the commodity must not be exempt from STB rate regulation. STB may then consider the reasonableness of a rate only if it also finds that the railroad has market dominance over the shipment at issue—that is, if (1) the rate is equal to or exceeds 180 percent of the railroad’s variable costs for providing specific services to the shipper and (2) the railroad does not face effective competition from other railroads or other modes of transportation. If STB decides the rate is unreasonable, it can order the railroad to pay reparations to the shipper for past shipments and decide the maximum rate the railroad is permitted to charge for future shipments.

Under its authority, STB considers the reasonableness of a challenged rate using one of its three tests, as chosen by the shipper. There is a financial limit imposed on the relief available depending on the test chosen:

Stand-Alone Cost (SAC): The most commonly used test is the Stand- Alone Cost test, which requires the shipper to design a hypothetical railroad, tailored to serve the specific route(s), to simulate the competitive rate that would exist in a perfectly efficient network. STB then compares the challenged rate to the hypothetical rate. During the rate relief process, both the railroad and the shipper have the opportunity to present their views to STB.

Simplified SAC: The simplified SAC seeks to create a cost-effective alternative to the SAC test. The simplified test eliminates or restricts the evidence parties can submit to the actual operations and services provided by the railroad.

Three Benchmark: The Three Benchmark test is faster and less rigorous, but limits the potential return for a successful rate challenge. STB determines the reasonableness of a challenged rate by examining three benchmarks, or tests, that assess rate markups.

Between 1996 and 2016, STB reviewed 50 rate reasonableness cases. Of these cases, 36 used the SAC rate case process, 5 used the simplified SAC, 5 used the three benchmark process, and 4 used a different methodology. To date, most of the 50 STB rate cases have been for coal (32) or chemical (16) shippers. Among the 50 cases brought before STB since 1996, about half (26) were settled without an STB decision, while those that were decided by STB were split fairly evenly in favor of the shippers (11) or the railroads (10).

Contracts Provide Certain Advantages, and Their Use by Certain Shippers Has Increased

Contracts Are Private and Include Negotiable Terms

According to representatives of the four Class I railroads we spoke to, while contracts’ and tariffs’ terms and rates are developed using similar methodologies, they may contain key differences. For example, selected stakeholders said that contracts are often customized to a specific shipper and may reflect the railroad’s and shipper’s preferences for a given route or shipment. Figure 2 describes the similarities and differences between contracts and tariffs, based on our interviews with representatives from the four largest Class I railroads and selected shippers, pertinent laws, as well as sample contract language and tariffs provided by the railroads.

Railroad representatives said they rely on publicly available standard terms to govern shipments over their network, regardless of whether the shipments are moving under contract or tariff. These terms are unique to each railroad and potentially negotiable for shipments under contract—as are all aspects of a contract. A railroad’s standard terms cover all aspects of a shipment, from loading specifications to billing procedures, and may be contained in multiple documents. As a result, according to one railroad representative, contracts typically incorporate or reference all of the railroad’s applicable standard terms unless certain terms are specifically negotiated by the shipper.

Sample contract language provided by three Class I railroads show contracts may also include negotiable terms not typically found in tariffs, such as volume commitments, discounts, and service standards. However, according to two shipping associations representing coal shippers, in recent years, contracts have become more standardized and often reference other governing documents that spell out additional rules and conditions. More specifically, a representative from one of these shipper associations said that some contract features have become more difficult to negotiate, in part, because of the increased standardization. For example, they told us most contract negotiations now are generally limited to rates, fuel surcharges, train size, loading and unloading timeframes, and volume commitments.

According to three of the selected Class I railroads and a representative from a shipper association, to start a contract negotiation, typically a shipper may issue a request for proposal outlining its needs or informally contact the railroad. Railroad representatives said the railroad will typically respond with a standard contract. One railroad representative told us the railroad may administer thousands of contracts at any given time, so maintaining standard terms across their contracts allows the railroad to manage its business portfolio and operations more efficiently. For example, a representative from another Class I railroad said its standard terms allow it to efficiently handle different shippers’ cars on the same train.

Contract and Tariff Rates Are Based on Similar Market Factors

According to representatives from the four Class I railroads we interviewed, they individually determine contract and tariff rates based on a number of similar market factors associated with the supply and demand for the commodity the shipper plans to transport. Because railroads must offer a tariff rate upon request, railroad representatives said they consider more general market factors in determining tariff rates. Selected shippers told us that tariff rates are usually, but not always, higher than contract rates, and sometimes are the same, in part, because contract rates, according to a railroad representative, can be negotiated and reflect market factors specific to the shipper as well as discounts for volume commitments. In our discussions with the four Class I railroads, they said they look at the extent of competition when determining contract and tariff rates. According to one railroad representative, this includes considering customer feedback, past experience, and market research to determine the level of three types of competition:

Competition from other forms of transportation: Generally, a railroad can charge more if it does not have to compete with another railroad or other transportation forms, such as barge, pipeline, or truck. As a result, a shipper served by more than one railroad or competitive alternative can create more leverage during contract negotiations. For example, representatives of the selected railroads told us if they are competing with the trucking industry for business, they may offer lower rates to obtain the shipper’s business.

Competition from other freight being shipped to the same market: A chemical shipper, as part of its comments to STB’s 2011 competition proceeding, stated that rail rates may impact a shipper’s ability to compete nationally and globally. According to railroad representatives we spoke to, they examine commodity markets to ensure they are pricing rates to allow shippers to be competitive. For example, a railroad representative told us it examines the rates it charges domestic crude oil shippers to ensure it remains competitive with imported crude oil. Representatives from the railroad industry also said understanding the extent of geographic competition within a market ensures the railroad maintains volume over their network. If rates are priced too high, a shipper may lose business and transport less freight. However, according to coal and grain shippers we interviewed, tariff rates may not always reflect current commodity market conditions.

Competition through substitution: Some shippers may be able to obtain a commodity it needs from a different location, or it may use an alternative commodity. For example, a railroad told us a power plant may choose to obtain its coal from another mine or switch from coal to natural gas if prices make doing so advantageous and the plant is able and configured to do so.

Contract and tariff rates also reflect the characteristics of a given shipment. More specifically, representatives from the four Class I railroads we interviewed said the rates reflect the characteristics of the commodity being shipped and its particular origin and destination. For example, a shipper association representing chemical shippers and a railroad representative said that commodities such as toxic inhalation hazards are more expensive to ship under contract and tariff because of their hazardous nature and liability concerns. In addition, railroad representatives also told us rates may vary by distance, and longer routes may be more expensive.

Railroads rely on selling freight transportation services at a particular rate to recover their operating and infrastructure costs. However, while representatives from all four Class I railroads we spoke to told us they do not develop their rates to provide transportation based on these costs, they also said they will not typically set rates below the cost of providing rail transportation. According to a Department of Agriculture report, the costs associated with providing rail transportation for each shipment, such as maintenance and rail crew costs, serve only as a floor below which rates should not go and bears little relationship to individual rail rates, which are closer to what the shippers are willing and able to pay. According to a representative from one Class I railroad, competitive factors may sometimes require the railroad to charge less than its costs to ship. However, railroads can also charge higher rates where its network is highly valuable to its shippers.

Volume Commitments and Other Contract Features Provide Advantages to Shippers and Railroads

Selected shippers and railroad representatives also said contracts generally provide key advantages by allowing for increased financial and logistical certainty for both parties. According to selected shippers we spoke to, they prefer to maintain the minimal number of contracts to meet their transportation needs. A shipper association said shippers can more efficiently manage multiple routes under one contract because of the stability in rates over the duration of the contract. As a result, according to the railroad representatives, shippers often request contracts covering multiple routes—potentially up to thousands of routes, according to one railroad representative—because managing each route under a separate contract, or by tariff, would be too complex to administer. For example, one chemical shipper told us it may move one or two carloads per day across 1,000 separate routes over a year. In addition, contracts allow shippers and railroads to customize terms to better fit their shipping needs, such as offering guaranteed pickup and delivery times or specific services. For example, according to one railroad representative, in a contract with multiple routes, a railroad may offer a lower rate on some routes, while increasing rates on others, to allow a shipper to break into a new market. Another railroad representative said the railroad can also provide additional logistics services at a lower cost within a contract that contains multiple routes because the economy of scale offered by a large contract allows the railroad to provide services at a lower rate due to gains in efficiency.

Furthermore, according to representatives from three Class I railroads, a contract’s overall volume commitment and certainty helps the railroads better plan future investments. Specifically, one railroad representative said a contract allows the railroad to allocate locomotives and rail crews more efficiently and ensure a consistent source of revenue. As a result, contracts generally include agreements on the amount of volume a shipper is willing to commit. Railroad representatives and selected shippers told us that the guaranteed volume from a contract may also create additional leverage for the shipper during contract negotiations. To gain additional volume guarantees, railroads and shippers said railroads typically offer discounted rates to shippers in exchange for volume commitments. Railroad representatives also said these discounts may be for one, multiple, or all of the routes in contract, and they said the more volume a shipper is willing to commit, the better deal it can expect to receive. However, if the shippers fail to meet their expected volume commitment, they may be subject to financial penalties. Moreover, according to one railroad representative, higher-volume shippers are also more likely to request custom terms.

However, some selected shippers said tariffs may provide advantages in certain situations. For example, they said contract negotiations may be too long and costly for shippers with infrequent or small volume shipments. Furthermore, according to coal shippers, in some instances, the tariff rate may be the same as the contract rate, and shippers incur potential penalties associated with failing to meet contractual volume commitments.

Freight by Contract Has Increased, and Shippers Said Some Contract Features Have Changed

Contract usage across the most frequently transported commodities regulated by STB has generally increased or stayed relatively the same in recent years. Specifically, from 2005 through 2014, the ton-miles shipped under contract for these commodities have increased by 6 percent, from about 705,000 ton-miles to about 800,000 ton-miles, a measurement that combines weight and mileage. In 2014, about 76 percent of regulated freight was shipped by contract. However, according to railroad representatives, each railroad’s business differs. Figure 3 shows the percent of selected commodities with regulated rates by ton-miles shipped under contract from 2005 through 2014.

From 2005 to 2014, the percentage of coal and chemicals shipped under contract has increased when measured on a ton-mile basis. Specifically, in 2005, 55 percent of all chemical shipments, measured in ton-miles, were shipped by contract; by 2014, that percentage had increased to 85 percent. Similarly, over the same time period, the ton-miles of coal shipped increased from 86 percent to 94 percent. A representative of a shipper association said chemical shipments under contract increased, in part, because the potential for improved negotiated terms may provide additional certainty and lower rates. Both coal and chemicals are also heavily dependent on the railroad’s network.

We were unable to obtain contract duration data from selected railroads and shippers, but selected coal and grain shippers as well as a railroad representative told us that the duration of contracts has generally decreased during the last 10 years. According to another rail representative, contract duration depends on the commodity and the market; for example, this official said shippers in markets that change frequently may prefer shorter contracts. Additionally, representatives from two selected shipper associations that represent various commodities told us the duration of contracts has decreased over the years, with longer contracts becoming increasingly uncommon, though they prefer longer contracts because of their rate stability. A coal-shipper association representative also told us current coal contracts are typically for about 3 to 5 years, in part because a shorter contract would result in more frequent contract renegotiation. Another coal shipper association representative said the duration of contracts to transport coal has gotten shorter, mostly because of the increased uncertainty in the energy market. In the past, we have reported that the duration of contracts has declined, in part, because of the railroads’ desire to quickly react to shifting market demand. One railroad representative we spoke to said as markets become more dynamic, shippers can continue to expect to receive shorter contracts.

In addition, selected shippers told us the railroads may also be shifting certain costs to shippers. More specifically, according to a grain shipper, railroad service commitments that used to be common are no longer included in contracts. Further, one coal shipper said the railroad previously supplied its own personnel to load the coal, but now, with no reduction in rates, the shipper is required to do so.

Some Selected Shippers with Fewer Shipping Options Said They Have High Rates for Some Contract Routes and Limited Recourse for Rate Relief for Tariffs

Selected Shippers with Fewer Options Said They May Have High Rates for Some Routes in Contracts

Despite the volume discounts and other advantages to contracts with multiple O-D routes, some shippers said that contracts effectively constrain them into paying higher rates on some routes, because railroads will propose contracts with multiple O-D routes where some of the routes are priced unreasonably high, in the shippers’ view. This is particularly an issue for shippers that are “captive”—that is, shippers served by a single railroad without an economically viable transportation alternative because a trucking or barge route either does not exist or would be too costly. Figure 4 below illustrates the ways in which a shipper can be captive on all routes or just some routes.

Eight of the nine shippers we interviewed stated that captive shippers have no other options than the one railroad that serves them, which can result in higher freight rail rates. Further, according to our analysis of a 2011 STB proceeding on rail competition, 6 of the 11 shippers that provided comments to the proceeding about being a captive shipper said that captive shippers have no other options than the railroad that serves them, which can result in higher rates. Additionally, a 2010 study commissioned by the STB concluded that captive shippers tend to pay higher shipping rates than otherwise similar shippers with access to additional railroad or water competition.

As previously discussed, the selected railroads we interviewed said they develop prices based on market forces and the railroad’s supply of available equipment and rail lines. This is the basis for differential pricing, a pricing strategy where railroads charge shippers with few or no other options more than shippers with more options for their freight. Differential pricing is permitted and encouraged in the rail freight market by design. The Staggers Rail Act of 1980, which reduced the economic regulation of railroads, provided that rail rates should be set by the competitive market forces to the maximum extent possible. According to railroad officials, railroads make up for lower revenues from highly competitive routes by charging higher rates in less competitive routes where they have market dominance. All four railroads and the Association of American Railroads also said that railroads use differential pricing to charge the highest rate shippers are willing to pay so railroads can cover infrastructure costs.

Although shippers have the option of challenging a tariff rate before the STB, they do not have this option for challenging rates they view as unfair if agreed to in a contract, since the STB has authority to review tariff rates but not contract rates. Although contracts are negotiated between railroads and shippers, some shippers told us that because contracts often contain rates for multiple routes, they may be pressured to accept higher rates they view as unfair as part of the package of rates they agree to, particularly if some of the shipper’s routes are captive. Specifically, three selected shippers said this situation can arise when faced with a contract containing multiple O-D routes where they view some routes as priced too high by the railroads. In this situation, they have two choices: 1) accept the contract and pay higher rates for some routes, or 2) reject the contract and opt instead to move their freight by tariff, which could result in higher prices for all the routes since, as previously discussed, shippers and railroads said that tariff rates are generally higher than contract rates. According to two of the shippers we interviewed, combining captive and competitive routes together in one large contract can create high rates on captive routes. In contrast, officials from one railroad said that the STB tariff rate-relief process prevents railroads from forcing shippers to pay unreasonable rates, even in contracts. The railroad representatives said this occurs because railroads do not want to have a rail rate case before the STB and a shipper that thought a contract rate was unreasonable could always ask for the tariff in place of the contract to be able to file a rate case.

The STB Tariff Rate-Relief Process Can Be Complicated and Expensive

When an STB rate case is an option, six of the interviewed shippers said that STB tariff rate-relief cases are complicated, time consuming, and expensive, in part, due to the challenges in determining reasonable and unreasonable rates. Consequently, these shippers said they are deterred from pursuing cases or from requesting tariff rates from railroads in order to pursue a rate case. An STB staff member said that when a rate case involves hundreds of O-D pairs, resolving the case can take substantial resources and time for STB, the railroads, and the shippers involved in the litigation. This STB staff member also stated that cases can take up to 3 years and be so costly that some shippers may think it is not worth bringing a case.

The STB rate-relief process was designed, in part, to maintain reasonable rates for captive shippers. However, determining reasonable versus unreasonable rates can be challenging given the market forces involved. Once a rate case is filed, STB must determine whether the rate is reasonable because it allows a railroad to earn adequate revenue for its fixed costs, or whether the rate is unreasonable because it allows the railroad to earn more than adequate revenue from its market dominance. According to economic literature, differential pricing allows railroads to collect adequate revenue to cover all costs and earn a reasonable return on their investments. Railroads not earning adequate revenue to remain in business and to adapt their network to meet future shipper demands would be problematic for both railroads and the shippers that rely on them. However, some research shows that railroads may be recovering from the rising costs, losses, and bankruptcies in the 1970s. For example, according to two economic studies of railroad economics, the Class I railroads may now be earning adequate returns on investment, and perhaps sometimes in excess of adequate returns, so measures to reduce the amount contributed by captive shippers to railroad returns may be appropriate. More recently, in September 2016, STB determined that four Class I railroads were revenue-adequate for the year 2015, specifically that these railroads achieved a rate of return equal to or greater than STB’s calculation of the average cost of capital to the freight rail industry.

STB is currently reviewing its rate relief process as required in the Surface Transportation Board Reauthorization Act of 2015. In June 2016, STB released an Advance Notice of Proposed Rulemaking outlining measures to expedite its handling of SAC rate cases. Comments were due in August 2016. STB staff said that measures such as standardizing evidence submissions would expedite SAC cases for purposes of fairness to litigants and improving overall agency efficiency. They also said that since the current proceeding on expediting SAC rate cases had just begun, it was too soon to know how changes might affect the SAC process.

Agency Comments

We provided a draft of this product to STB for comment prior to finalizing this report. We received technical comments from STB which we incorporated as appropriate.

We will send copies of this report to appropriate congressional committees. In addition, we will make copies available to others upon request, and the report will be available at no charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact me at (202) 512-2834 or Flemings@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made key contributions to this report are listed in appendix I.

Appendix I: Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the individual named above, other key contributors to this report were Andrew Huddleston, Assistant Director; Sarah R. Jones, Analyst-in-Charge; Namita Bhatia Sabharwal; Herbert J. Bowsher; Stephen M Brown; Russell C. Burnett; Ross A. Gauthier; Richard A. Jorgenson; Grant M. Mallie; Cheryl M. Peterson; Malika Rice; Kelly L. Rubin; Amelia (Michelle) Weathers; Alwynne Wilbur; and William T. Woods.