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t r a n s p o r t t i p s 24 www.coalage.com March 2014 Coal-fired utilities and coal producers are both interested in the computation of rail- road revenue adequacy because the results feed into the maximum rates that railroads can charge. Producers are inter- ested because those rates may determine whether coal prices are competitive; utili- ties are interested because those rates may determine whether or not they can make money from the sale of electric energy. The calculation of an adequate return on investment (ROI) for railroads has been a matter of dispute since well before the Staggers Rail Act of 1980. Even though the Staggers Act deregulated most rail traffic, some shippers (notably coal-burning utili- ties) believed railroads' new freedom to raise rates was too much of a good thing. Their fears were partially substantiated when some of the western railroads found it nec- essary to negotiate their rates back down- ward from elevated rates they had imposed after the Staggers Act was passed. Rail infras- tructure improvements that followed Staggers were essential to opening the Powder River Basin to plants needing clean- er coal, but shipper suspicion of railroad over-charging stayed alive. On December 31, 2013, the Surface Transportation Board (STB) released its annual findings with respect to the railroad revenue adequacy of seven Class I railroads, Docket No. EP 552 (Sub-No. 17). On October 17, 2013, it had initially found that only two of the seven railroads were revenue adequate in 2012: Union Pacific and Norfolk Southern; however, BNSF had not yet refiled to reflect its adjusted revenue after the Berkshire pur- chase. After BNSF refiled its R-1 reports for 2010-2012 in compliance with Western Coal Traffic League's (WCTL) Petition for Declaratory Order (FD35506), BNSF was also found to be revenue adequate. The STB's average cost of capital to the freight rail industry was 11.12%. The individual 2012 ROIs can be as seen in Figure 1. Using a traditional approach, the Government Accounting Office (GAO) esti- mated in 1984 that the railroad cost of capital was 11.84%, remarkably close to the 11.12% number recently computed by STB in 2012. Although most railroads' ROI under depreci- ation accounting was higher than under RRB (Retirement-Replacement-Betterment) accounting, none of the Class I railroads the GAO evaluated had reached the traditional cost of capital level in 1984. Burlington Northern Santa Fe was the closest to revenue adequacy under that approach with a return of 9.6%. Basically, the GAO said they were all under-capitalized and had to raise their rates to maintain financial health. Multistage DCF Model The discounted cash flow (DCF) valuation approach is based on the theory that the value of a business or project is the sum of its expected future free cash flows, dis- counted at an appropriate rate. DCF anal- ysis is one of the most fundamental, commonly used valuation methodologies. It is a valuation method developed and supported in academia and is widely used in business. The prevalent form of the DCF model in practice is the single-stage DCF model. Stage 1 is an explicit projection of free cash flows, generally for five to 10 years. Stage 2 is a lump-sum estimate of the cash flows beyond the explicit forecast period. In addition to the two-stage DCF, there are multistage manifestations of the DCF model. The STB is currently using the multi- stage DCF model to determine the railroad's cost of capital; the name alone conjures the impression there are behind-the-scenes mathematicians cranking out undecipher- able numbers in support of higher rates. The WCTL prefers that STB use a more real- istic formula, which in their mind is repre- sented by the Capital Asset Pricing Model (CAPM). While CAPM generally leads the pack as one of the most widely studied and accepted pricing models, it too is not with- out its critics. Its assumptions have been criticized from the start as being too unreal- istic for investors in the real world. It is not Coal Age's intent to evaluate either or both methods, only to comment that both models operate with complex mathematics on estimates of revenue streams and discount rates. The board intends to have two proceedings to deal with the cost of capital calculation and the revenue adequacy calculation. It will establish further procedures for public comment, and will address the issues raised by the parties. The parties will con- tinue to duke it out using their own expert witnesses in STB Docket No. EP 664 (Sub- No. 2), decided December 20, 2013. The STB's position will be supported by AAR; WCTL's by the Alliance for Rail Competition and the Chlorine Institute. Positive Train Control In response to several fatal rail accidents between 2002 and 2008, Congress passed the Rail Safety Improvement Act of 2008, directing the Federal Railroad Admin- istration (FRA) to promulgate new safety regulations. These new regulations gov- ern different areas related to railroad safety, such as hours of service require- ments for railroad workers, Positive Train Control implementation, standards for track inspections, certification of loco- motive conductors, and safety at high- way-rail grade crossings. The train engineer blamed for the worst U.S. train crash in 15 years was sending and receiving text messages sec- onds before his crowded commuter train skipped a red light and collided head-on with a freight train. The Metrolink com- muter train plowed into a Union Pacific Railroad Performance: A Quick Look at a Few Railroad Measures Figure 1: Railroad revenue adequacy of seven Class I railroads. (Red = revenue inadequate) B Y D A V E G A M B R E L CA_pg24-25_V3_CA_pg46-47 3/11/14 2:42 PM Page 24