Freight Rail Policy Stance: Revenue adequacy calculations should be used to inform regulators of the financial health of railroads, as intended by Congress, not to justify capping rail rates.
Why This Matters: Revenue adequacy was developed to assess of the financial health of U.S. freight railroads. Use of revenue adequacy as a justification for capping rail rates through government intervention would severely curtail continued investment and reverse decades of progress for U.S. freight railroads.
What is Revenue Adequacy?
Railroad revenue adequacy is a calculation developed and used by the Surface Transportation Board to assess the financial health of individual railroads. The calculation, which compares an individual railroad’s Return on Investment (ROI) with the railroad industry’s Cost of Capital (COC), measures whether the return a railroad earned was sufficient to attract investment capital. Revenue adequacy calculations are reported annually to Congress.
Revenue Adequacy Background
Years of government overregulation, which had both increased costs and limited revenue, led to the bankruptcies of major U.S. freight railroads in the 1970s. As the financial performance of these companies deteriorated, government regulators recognized the value of measuring whether railroads were earning adequate revenue. Legislation culminating in the Staggers Act of 1980 and subsequent Interstate Commerce Commission (ICC) rulemakings partially deregulated the rail industry and instituted the process used today to calculate revenue adequacy. The ICC, the predecessor to today’s STB, emphasized that this calculation was “designed to compute a minimum adequate revenue level only for Class I railroads.”
“In recent decades the problems of the railroad industry have become severe. Its 1979 rate of return on net investment was 2.7%, as compared to over ten percent for comparable industries.” President Jimmy Carter
Why It Matters Today
As originally conceived, the annual revenue adequacy calculation was not intended as a tool to regulate rates. However, in a 1985 decision in a case known as the “Coal Rate Guidelines,” the ICC elevated the calculation to one of the considerations for judging the reasonableness of freight rail rates through the “revenue adequacy constraint.” However, the process by which revenue adequacy should be applied in rate cases was never determined.
In 2015, the STB began a proceeding — Ex Parte 722, Revenue Adequacy — to consider issues associated with revenue adequacy, including how revenue adequacy should be applied in railroad rate cases; whether the intent of revenue adequacy was to establish a floor or a ceiling on rail rates; and the inputs for the COC determination.
The application of the calculation in railroad rate cases has the potential to significantly curtail railroad revenue, of which railroads invest 40 cents out of every dollar back into their networks.
The Path Forward
Railroads support efforts to improve the process for determining the reasonableness of freight rail rates provided that the process takes into account the fundamental economics of the railroad industry. Allowing railroads to generate only as much revenue as required to achieve revenue adequacy — as some shippers suggest — stands in stark contrast to the intent of railroad deregulation and the free market principles underlying it.
The continued ability of railroads to price their services based on demand — like all other private companies — will ensure they are able to effectively compete against their competitors, grow their market shares and invest at the levels necessary to sustain their world-class infrastructure.
Helpful to Know
Many economists argue that the annual revenue adequacy calculation actually overstates the financial health of a railroad company. Calculating the industry’s COCs using “book value” (the original cost of the investment) as opposed to “replacement value” (the cost to make the investment today) grossly overestimates the financial health of individual railroad companies.
Long-Term Revenue Adequacy
The ICC outlined that the revenue adequacy rate constraint should only be applied to a carrier that is revenue adequate for the “long term.” However the definition of “long term” has not been defined. Economists have noted that revenue adequacy should be consistently demonstrated over a period long enough to cover a business cycle.