In the past, the ICC regulated almost all of the rates that railroads charged shippers. The Railroad Revitalization and Regulatory Reform Act of 1976 and the Staggers Rail Act of 1980 greatly increased reliance on competition to set rates in the railroad industry. Specifically, these acts allowed railroads and shippers to enter into confidential contracts that set rates and prohibited ICC from regulating rates where railroads had either effective competition or rates negotiated between the railroad and the shipper. Furthermore, the ICC Termination Act of 1995 abolished ICC and transferred its regulatory functions to STB. Taken together, these acts anchor the federal government’s role in the freight rail industry by establishing numerous goals for regulating the industry, including to allow, to the maximum extent possible, competition and demand for services to establish reasonable rates for transportation by rail; minimize the need for federal regulatory control over the rail transportation system and require fair and expeditious regulatory decisions when regulation is required; promote a safe and efficient rail transportation system by allowing rail carriers to earn adequate revenues, as determined by STB; ensure the development and continuation of a sound rail transportation system with effective competition among rail carriers and with other modes to meet the needs of the public and the national defense; foster sound economic conditions in transportation and ensure effective competition and coordination between rail carriers and other modes: maintain reasonable rates where there is an absence of effective competition and where rail rates provide revenues that exceed the amount necessary to maintain the rail system and attract capital; prohibit predatory pricing and practices to avoid undue concentrations of provide for the expeditious handling and resolution of all proceedings. While the Staggers Rail and ICC Termination Acts reduced regulation in the railroad industry, they maintained STB’s role as the economic regulator of the industry. The federal courts have upheld STB’s general powers to monitor the rail industry, including its ability to subpoena witnesses and records and to depose witnesses. In addition, STB can revisit its past decisions if it discovers a material error, or new evidence, or if circumstances have substantially changed. Two important components of the current regulatory structure for the railroad industry are the concepts of revenue adequacy and demand-based differential pricing. Congress established the concept of revenue adequacy as an indicator of the financial health of the industry. STB determines the revenue adequacy of a railroad by comparing the railroad’s return on investment with the industrywide cost of capital. For instance, if a railroad’s return on investment is greater than the industrywide cost of capital, STB determines that railroad to be revenue adequate. Historically, ICC and STB have rarely found railroads to be revenue adequate—a result that many observers relate to characteristics of the industry’s cost structure. Railroads incur large fixed costs to build and operate networks that jointly serve many different shippers. Some fixed costs can be attributed to serving particular shippers, and some costs vary with particular movements, but other costs are not attributable to particular shippers or movements. Nonetheless, a railroad must recover these costs if the railroad is to continue to provide service over the long run. To the extent that railroads have not been revenue adequate, they may not have been fully recovering these costs. The Staggers Rail Act recognized the need for railroads to use demand- based differential pricing to promote a healthy rail industry and enable it to raise sufficient revenues to operate, maintain and, if necessary, expand the system in a deregulated environment. Demand-based differential pricing, in theory, permits a railroad to recover its joint and common costs—those costs that exist no matter how many shipments are transported, such as the cost of maintaining track— across its entire traffic base by setting higher rates for traffic with fewer transportation alternatives than for traffic with more alternatives. Differential pricing recognizes that some customers may use rail if rates are low—and have other options if rail rates are too high or service is poor. Therefore, rail rates on these shipments generally cover the directly attributable (variable) costs, plus a relatively low contribution to fixed costs. In contrast, customers with little or no practical alternative to rail—”captive” shippers—generally pay a much larger portion of fixed costs. Moreover, even though a railroad might incur similar incremental costs while providing service to two different shippers that move similar volumes in similar car types traveling over similar distances, the railroad might charge the shippers different rates. Furthermore, if the railroad is able to offer lower rates to the shipper with more transportation alternatives, that shipper still pays some of the joint and common costs. By paying even a small part of total fixed cost, competitive traffic reduces the share of those costs that captive shippers would have to pay if the competitive traffic switched to truck or some other alternative. Consequently, while the shipper with fewer alternatives makes a greater contribution toward the railroad’s joint and common costs, the contribution is less than if the shipper with more alternatives did not ship via rail. The Staggers Rail Act further requires that the railroads’ need to obtain adequate revenues to be balanced with the rights of shippers to be free from, and to seek redress from, unreasonable rates. Railroads incur variable costs—that is, the costs of moving particular shipments—in providing service. The Staggers Rail Act stated that any rate that was found to be below 180 percent of a railroad’s variable cost for a particular shipment could not be challenged as unreasonable and authorized ICC, and later STB, to establish a rate relief process for shippers to challenge the reasonableness of a rate. STB may consider the reasonableness of a rate only if it finds that the carrier has market dominance over the traffic at issue—that is, if (1) the railroad’s revenue is equal to or above 180 percent of the railroad’s variable cost (R/VC) and (2) the railroad does not face effective competition from other rail carriers or other modes of transportation. 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. Rail rates generally declined between 1985 and 2000 but increased slightly from 2001 through 2004. Likewise, rail rates have declined since 1985 for certain commodity groups and routes despite some increases since 2001, but rates have not declined uniformly, and some commodities are paying significantly higher rates than others. For example, from 1985 through 2004, coal rates declined 35 percent while grain rates increased 9 percent. Concerns about competition and captivity in the industry remain because traffic is concentrated in fewer railroads. It is difficult to determine precisely how many shippers are captive to one railroad. Nevertheless, our analysis indicates that the extent of potential captivity appears to be dropping, but that the percentage of all industry traffic running at rates substantially over the statutory threshold for rate relief—traffic traveling at rates over 180 percent R/VC—has increased. Furthermore, some areas with access to only one Class I railroad have higher percentages of traffic traveling at rates that exceed the statutory threshold for rate relief. This situation may reflect reasonable economic practices by the railroads in an environment of excess demand, or it may represent an abuse of market power. There is widespread consensus that the freight rail industry has benefited from the Staggers Rail Act. Ten of the 11 members of our expert panel believed that the Staggers Rail Act has had a strongly positive overall effect on freight railroad companies, while 8 believed the Staggers Rail Act had a strongly positive effect on shipping companies. In addition, various measures indicate an increasingly strong freight railroad industry. Freight railroads’ improved financial health is illustrated by a general increase in return on investment since 1980, as shown in figure 1. Freight railroads have also cut costs by streamlining their workforces; right-sizing their rail networks; and reducing track miles, equipment, and facilities to more closely match demand. 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. Clifford Winston, Deregulation of Network Industries – What’s Next? (Washington: AEI- Brookings Joint Center for Regulatory Studies: 2000), pp. 43-44. Freight rail is an important component of our nation’s economy. Approximately 42 percent of all intercity 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 and about 70 percent of coal delivered to power plants moves on freight rail. Rail rates across the freight railroad industry have generally declined since the enactment of the Staggers Rail Act. Because changes in traffic patterns over time (for example, hauls over longer distances) can result in a decrease in the average revenue per ton-mile, purely relying on cents per ton-mile can present misleading industrywide rate trends. Therefore, we developed a set of rail rate indexes to examine trends in rail rates over the 1985 through 2004 period. These indexes account for changes in traffic patterns over time that could affect revenue statistics but do not account for inflation. To provide a measure for inflation, we also included the price index for the gross domestic product (GDP) in figure 2. From 1985 through 1987, rail rates dropped by 10 percent and then 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.