Transcript Slide 1

Coal Transportation by Railroad – In
a Regulatory World Unlike FERC
-byMichael F. McBride
Energy Bar Association Meeting
Washington, DC
December 3, 2009
Coal and the Railroads –
An Overview
 Coal is 50% of electricity generation – but will it last?
 Railroads haul 71% of the coal for electricity.
 Coal is 40% of railroad tonnage, 20% of revenues, but a
substantial percentage of the railroads’ net income (due
to low unit costs).
 No coincidence that the four largest U.S. railroads –
BNSF, CSX, Norfolk Southern, and Union Pacific – are the
four-largest coal-carriers.
 The regulatory system is largely broken, with BNSF
described as “revenue-inadequate” by the STB a week
before Warren Buffett agreed to pay an $18 billion
acquisition premium for it!
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Overview (Cont’d)
 Under current STB precedents, the BNSF acquisition
premium will lead to higher asset values, lower BNSF’s
perceived return (making it more “revenue inadequate”),
and make more BNSF rates immune from STB regulatory
scrutiny (by effectively raising the STB’s “jurisdictional
threshold” of 180% of “variable costs”).
 The STB uses “stand-alone costs” for its rate standard
for coal cases. Most complex standard possible.
 SAC cases cost more than $5 million – and years -- to
present.
 Yet railroads are immune from the antitrust laws to the
extent they are “subject to regulation.”
 Legislation is being considered to change some of this.
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Why Is Railroad Transportation of Coal
Important?
 The U.S. mines over 1 billion tons of coal annually.
 Most coal is used to produce electricity.
 As of 2008, 50% of electricity comes from coal
(http://tonto.eia.doe.gov/energyexplained/index.cfm?pa
ge=coal_home#tab2); gas is 20%. Coal will remain a
substantial percentage of the mix for decades.
 Until recently, EIA actually forecast the percentage of
electricity from coal would increase to 58% by 2030.
Now, the forecast could be much lower – 32% -- IF a
substantial number of nuclear plants come on line.
 Railroads carry, at least some of the way, 71% of coal to
power plants.
(http://tonto.eia.doe.gov/energyexplained/index.cfm?pa
ge=coal_mining
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The Railroads’ Share of Delivered Coal Prices
 Rail share increased in recent years, because Western coal
(primarily Powder River Basin (PRB) in Wyoming and Montana) is
most economical and abundant source of low-sulfur coal to comply
with the CAA. Trains are typically 100 cars or more.
 Some coal is used at mine-mouth, and moved by conveyors or
special over-sized trucks. Some moves by barge or truck, or even
pipeline. Still, railroads predominate.
 And, given distances, rail costs are typically significantly more than
50% of the delivered cost of Western coal (sometimes as high as
80%). In the East, transportation is a lesser percentage of the
delivered cost than in the West, but it is often over 30% of the
delivered price (despite higher coal prices in the East), and has been
increasing due to higher and higher rail transportation rates.
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Railroad Monopoly Power Is Increasing
 Rail monopoly pricing power is increasing – rates increasing at
amounts greater than inflation (4-6%), even though overall volumes
of coal transported by rail have been down during the recession.
Who gets the “monopoly rents?” and “Where is the regulator?”
 For almost 25 years, the ICC (now known as the Surface
Transportation Board, or STB) has set rail rates for “captive” traffic
at the highest level economists could justify. And, contract
transportation is not regulated.
 To be fair, some “differential pricing” was adopted in the Staggers
Rail Act of 1980, to eliminate federal subsidies of the railroads, and
so as to reduce regulation of railroads.
 But competition was supposed to prevail “to the maximum extent
possible,” and rates were to be regulated only where no
competition. Instead, much competition was lost due to mergers,
switching barriers, and contractual restrictions.
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Why Is Rail Monopoly Power Increasing?
 There were over 40 large railroads in 1980, whereas
today 4 large railroads carry over 90% of the freight.
 It is no coincidence that the 4 largest U.S. railroads are
the ones that carry over 90% of the nation’s coal. As
Willie Sutton would say, “That’s where the money is!”
 Coal represents approximately 20% of the U.S. railroad
industry’s gross revenues. Coal rates are considered
among the most profitable, and account for the largest
percentage of the railroads’ net income by commodity.
 The STB also allows the railroads to use other anticompetitive rate quotations (no “bottleneck rates”) and
operational practices (“paper barriers”).
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What Is Regulated?
 Only “captive” traffic regulated. The statute says that a
railroad may charge “any rate” unless an “absence of
effective competition.”
 If no competition, the rate must be “reasonable.”
 The Western railroads, at least, generally concede that
there is “an absence of effective competition” for coal
movements.
 So the STB usually has jurisdiction to set the rate.
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What Is a “Reasonable” Rate?
 What is a “reasonable” rate? Complex problem, because
some traffic is captive, and some is competitive.
Differential pricing is therefore needed.
 In The Economics of Regulation, Professor Kahn opined
that the highest rate any captive customer should ever
be charged is the “stand-alone cost” rate, or SAC rate.
 The railroads convinced the ICC, in Coal Rate Guidelines,
Nationwide, 1 I.C.C.2d 520 (1985), aff’d sub nom.
Consolidated Rail Corp. v. ICC, 812 F.2d 1444 (3rd Cir.
1987), to use the SAC test for determining maximum
“reasonable” coal rates, and it is still the test used today.
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The “Stand-Alone Railroad”
 Shipper must “construct” a “stand-alone railroad,” or
SARR, which is the basis for determining a SAC rate, is
constructed (on paper) using either the existing route
and existing traffic or a more efficient route (as the
Complainant chooses).
 Generally, the Complainants use the existing rail routes.
 The Complainant uses current costs for the assets, and
offsets as much of the total costs as possible by the
revenues from all traffic other than that at issue.
 The Complainant must satisfy the STB that its
“operational plan” for the SARR will work.
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Why Is Rail Transportation Such a Large
Percentage of the Delivered Price?
 If the SARR will collect more total revenues than its
costs, including a reasonable return, over 10 years, relief
is available.
 But, such relief available to few coal shippers in recent
years, for various practical reasons.
 Those who prevail have had to pay over $5 million – in
one case, almost $8 million – to present a case. The
filing fee alone was over $170,000 until Congress
stepped in, temporarily, to cut it to $350.
 So, the deck is stacked in favor of the railroads,
especially for coal rates.
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Regulatory Picture -- High Rates
 Eastern cases were uniformly lost because the SARR in
the East is not as efficient (but a new one, for Seminole
Electric v. CSX, is pending review; will it work?).
 Some Western cases were being won, until the STB
altered its SAC test to look at “segments”. PPL Montana
and Otter Tail Power Company lost despite high rates.
(DC Circuit affirmed PPL Montana.)
 Now, the rules revised, so the “jurisdictional threshold”
(R/VC = 180%) is so high that the SAC rate is
sometimes below that, and the rate is therefore set at
180%. Recent examples: KCP&L v. UP and OG&E v.
UP. No judicial review due to stipulations.
 In another recent case, the SAC rate was set at an R/VC
ratio of 240%, yet Basin Electric still won reparations of
$345 million from BNSF. (Review pending.)
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Recent STB Coal Rate Cases
Oklahoma G&E v. BNSF (No.
42111)
2009
180% R/VC ratio by stip. – rate
reduced 8-10% (+ reparations)
Western Fuels v. BNSF (No.
42088)
2009
240% R/VC ratio – reduced
above 50% (+ $345 million)
AEP Texas North v. BNSF (No.
41191 (Sub-No. 1))
2009
No reparations/relief pre-2012;
236-256% R/VC ceiling 2012-20
KCP&L v. UP (No. 42095)
2008
180% R/VC ratio (by stip) –
reduced 8-12% (+$30 mill.)
Otter Tail v. BNSF (No. 42071)
2006
$13.49 v. $11.99/ton (SAC) –
but no relief (cross-subsidy)!
Xcel v. BNSF (No. 42057)
2004
16-21% Rate Increase
Reduction (after larger increase)
Duke Power v. NS (No. 42069)
2003-04
No relief (possible phasing)
Duke Power v. CSX (No. 42070)
2003-04
No relief (possible phasing)
CP&L v. CSX (No. 42072)
2003-04
No relief (possible phasing)
PPL Mont. v. BNSF (No. 42054)
2002
No relief (cross-subsidy)
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Derailments and a New Regulatory
Issue – Coal Dust
 New challenges: two derailments in 2005 in the PRB –
UP and BSNF blamed coal dust (“trespass!!”).
 FERC held hearing in 2006 on impact on reliability.
 Some utilities, public power entities, and coops wonder if
the way the PRB was constructed and maintained may
have been the problem. In May 2009, BNSF put coal
dust “emission limits” in a tariff, and the matter is now
before the STB.
 STB considering revising its costing system, which may
delay rate decisions and shift costs to hazmat (and coal,
if maintenance costs are higher than thought).
 Coal shippers believe they’ve already paid for
maintenance, and that their shipments are the most
efficient on the railroads.
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Warren Buffett, Acquisition
Premiums, and the BNSF Railway
 The recent offer by Berkshire Hathaway to buy
all of BNSF Railway at a premium of about 30%
is in part a bet on coal for a while to come.
 Believe it or not, BH does not need STB approval
to acquire BNSF, because it does not “control”
any other railroad.
 And, believe it or not, but previously, the STB
refused to take regulatory action to protect
customers from substantial premiums, even with
Alfred Kahn explaining why it is bad public policy
to permit them to affect asset valuations.
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Legislative Efforts--Antitrust
 Railroad Antitrust Enforcement Act of 2009,
S. 146/H.R. 233
- S. 146 reported to full Senate on March 5 by vote
of 14 – 0. Key elements of S. 146 will be included
in the STB reform legislation being drafted by
Chairman Rockefeller.
- Provisions included in Senate regulatory bill.
- H.R. 233 passed the House Judiciary Committee
on September 16.
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Regulatory Legislation
 Senate Commerce Committee “consensus” legislation to change
regulatory rules – but the SAC test apparently will remain
 Railroads will likely have to quote “bottleneck rates,” but at what
price (i.e., will “lost contribution” be kept)?
 Anti-competitive contracts may be outlawed, but they likely will be
subject to increased regulatory scrutiny.
 “Reciprocal switching” (i.e., switching) may be improved (costbased?), but generally not a coal issue.
 House T&I Committee – probably will also have a bill, but we don’t
know what the contents will be. Past bills similar to Senate bill.
 Legislative environment is favorable to a bill, especially with current
Chairmen, but lots of competing matters occupying the Members.
 Senator Rockefeller wants to get this resolved in this Congress.
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Legislative Issues
 Should the STB be a more aggressive regulator?
 Should railroads be required to be more competitive?
 Does increasing “revenue adequacy” mean that less
differential pricing is needed than before, so that
ratemaking could be simplified?
 Or will railroads succeed in preserving the existing
system, including treatment of acquisition premiums?
 And will the antitrust laws apply to railroad actions that
theoretically could be regulated?
 Stay tuned. This has been a battle for 25 years, but it
may be nearing a resolution.
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Questions?
 For more information, please feel free to call:
Michael F. McBride
Van Ness Feldman, PC
1050 Thomas Jefferson Street, NW, Suite 700
Washington, DC 20007-3877
(202)298-1989
[email protected]
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