Freight rail is an important component of our nation’s economy. Approximately 42 percent of all inter-city freight in the United States, measured in ton miles, moves on rail lines. Freight rail is particularly important to producers and users of certain commodities. For example, about 70 percent of automobiles manufactured domestically, about 70 percent of coal delivered to power plants, and about 32 percent of grain moves on freight rail. Beginning in 1887, the Interstate Commerce Commission (ICC) regulated almost all of the rates that railroads charged shippers. Congress passed the Railroad Revitalization and Regulatory Reform Act in 1976 and the Staggers Rail Act in 1980, and these acts greatly increased the reliance on competition in the railroad industry. Specifically, these acts allowed railroads and shippers to enter into confidential contracts which set rates and prohibited the ICC from regulating rates where railroads had effective competition or if the rates had been negotiated between the railroad and the shipper. The ICC Termination Act of 1995 abolished the ICC and transferred its regulatory functions to STB. Taken together, these acts anchor the federal government’s role in the freight rail industry and have established numerous goals for regulating the industry, including the following: to allow, to the maximum extent possible, competition and demand for services to establish reasonable rates for transportation by rail. to minimize the need for federal regulatory control over the rail transportation system and to require fair and expeditious regulatory decisions when regulation is required. to promote a safe and efficient rail transportation system by allowing rail carriers to earn adequate revenues, as determined by STB. to ensure effective competition among rail carriers and with other modes to meet the needs of the public. to maintain reasonable rates where there is an absence of effective competition and where rail rates provide revenues which exceed the amount necessary to maintain the rail system and to attract capital. to prohibit predatory pricing and practices, to avoid undue concentrations of market power; and to provide for the expeditious handling and resolution of all proceedings. Two important components of the current regulatory structure are the concepts of revenue adequacy and demand-based differential pricing. Congress established the concept of revenue adequacy as an indicator of the financial health of the industry. STB determines the revenue adequacy of a railroad by comparing the railroad’s return on investment with the industrywide cost of capital. If a railroad’s return on investment is greater than the industry-wide cost of capital, STB determines that railroad to be revenue adequate. Historically, the ICC and STB have rarely found railroads to be revenue adequate, which many observers relate to characteristics of the industry’s cost structure. Railroads incur large fixed costs to build and operate networks that jointly serve many different shippers. While some fixed costs can be attributed to serving particular shippers, and some costs vary with particular movements, other costs are not attributable to particular shippers or movements. Nonetheless, a railroad must recover these costs if the railroad is to continue to provide service over the long run, and, to the extent that railroads have not been revenue adequate, this may indicate that they are not fully recovering these costs. Consequently, the Staggers Rail Act recognized the need for railroads to use demand-based differential pricing in the deregulated environment. Demand-based differential pricing in theory permits a railroad to recover their joint and common costs across its entire traffic base by setting higher rates for traffic with fewer transportation alternatives than for traffic with more alternatives. This means that a railroad might incur similar incremental costs in providing service to two different shippers that ship similar tonnages in similar car types traveling over similar distances, but that the railroad may charge quite different rates. In this way, the railroad recovers a greater portion of its joint and common costs from the shipper that is more dependent on railroad transportation, but, to the extent that the railroad is able to offer lower rates to the shipper with more transportation alternatives, the other shipper makes a contribution toward those costs. The Staggers Rail Act further required that the railroads’ need to differentially price its services be balanced with the rights of shippers to be free from, and to seek redress from unreasonable rates. Railroads incur variable costs—that is the costs of moving particular shipments—in providing service. The Staggers Rail Act stated that any rate that was found to be above 180 percent of a railroad’s variable cost for a particular shipment was potentially an unreasonable rate and granted the ICC, and later the STB, the authority to establish a rate relief process. In response, the ICC established two criteria for allowing a rail rate case. First, as stated in law, the rate had to be above 180 percent of the revenue-to- variable-cost (R/VC) ratio. Second, the shipper had to demonstrate that it had no other reasonable transportation alternative. Such a shipper is referred to as a “captive shipper.” The changes that have occurred in the railroad industry since the enactment of the Staggers Rail Act are widely viewed as positive. The railroad industry’s financial health improved substantially as it cut costs, boosted productivity, and “right-sized” its networks. Rates generally declined between 1985 and 2000 but increased slightly from 2001 through 2004. Concerns about competition and captivity in the industry remain because traffic is concentrated in fewer railroads and, although rates have declined for most shippers, some shippers are paying significantly higher rates than others. While it is difficult to precisely determine the number of shippers who are “captive” to one railroad, our preliminary analysis indicates that while the extent of potential captivity may be dropping, the share of potentially captive shippers who are paying the highest rates— those substantially above the threshold for rate relief—has increased. There is widespread consensus that the freight rail industry has benefited from the Staggers Rail Act. Specifically, various measures indicate an increasingly strong freight railroad industry. Freight railroads’ improved financial health is illustrated by increases in productivity, volume of shipments, and stock prices. Freight railroads have also cut costs by streamlining their workforce and “right-sizing” their rail network, through which the railroads have reduced track, equipment, and facilities to more closely match demand. These measures are shown in figure 1. Freight railroads have also expanded their business into new markets – such as the intermodal market - and implemented new technologies, including larger cars, and are currently developing new scheduling and train control systems. Some observers believe that the competition faced by railroads from other modes of transportation has created incentives for innovative practices, and that the ability to enter into confidential contracts with shippers has permitted railroads to make specific investments and to develop service arrangements tailored to the requirements of different shippers. Rail rates across the industry have generally declined since enactment of the Staggers Rail Act. Because changes in traffic patterns over time (for example, hauls over longer distance) can result in increases in lower priced traffic and a decrease in average revenue per ton mile, it can present misleading rate trends. Therefore, we developed a rail rate index to examine trends in rail rates over the 1985-2004 period. These indexes account for changes in traffic patterns over time which could affect revenue statistics but do not account for inflation. As a result, we have also included the price index for the gross domestic product. Although there has been a slight upturn in rates from 2001 through 2004, the industry continues to experience rates that are generally lower than they were in 1985. During this time some costs have also been passed on to shippers, such as having shippers provide equipment. There was a steep decline in rates from 1985 to 1987 when rates dropped by 10 percent. Rates continued to decline, although not as steeply, through 1998. Rates increased in 1999, then dropped again in 2000. In 2001 and 2002 rates rose again. Rates were nearly flat in 2003 and 2004, finishing approximately 3 percent above rates in 2000, but 20 percent below 1985 rates. This is shown in figure 2. These data include rates through 2004. According to freight railroad officials, shippers, and financial analysts, since 2004 rates have continued to increase as the demand for freight rail service has increased, rail capacity has become more limited, and as a result, freight railroad companies have gained increased pricing power. A number of factors may have contributed to recent rate increases. Ongoing industry and economic changes have influenced how railroads have set their rates. Since the Staggers Rail Act was enacted, the railroad industry and the economic environment in which it operates have changed considerably. Not only has the rail industry continued to consolidate, potentially increasing market power by the largest railroads, but after years of reducing the number of its employees and shedding track capacity, the industry is increasingly operating in a capacity-constrained environment where demand for their services exceeds their capacity. In addition, the industry has more recently increased employment and invested in increased capacity in key traffic corridors. Additionally, changes in broader domestic and world economic conditions have led to changes in the mix and profitability of traffic carried by railroads. Concerns about competition and captivity in the railroad industry remain because traffic is concentrated in fewer railroads and even though rates have declined for most shippers since the enactment of the Staggers Rail Act, some shippers are paying significantly higher rates than other shippers—a reflection of differential pricing. There is significant disagreement on the state of competition in the rail industry. In 1976, there were 63 Class I railroads operating in the United States compared with 7 Class I railroads in 2004. As figure 3 shows, 4 of these Class I railroads accounted for over 89 percent of the industry’s revenues in 2004. While some experts view this concentration as a sign that the industry has become less competitive over time, others believe that the railroad mergers and acquisitions actually increased competition in the rail industry because STB placed conditions on the mergers intended to maintain competition.