Hearings and Business Meetings
SD-366 Energy Committee Hearing Room 10:00 AM
Mr. Edward Hamberger
President and CEO, Association of American Railroads
EDWARD R. HAMBERGER
PRESIDENT & CHIEF EXECUTIVE OFFICER
ASSOCIATION OF AMERICAN RAILROADS
COMMITTEE ON ENERGY AND NATURAL RESOURCES
HEARING ON COAL SUPPLIES
MAY 25, 2006
On behalf of the members of the Association of American Railroads (AAR), thank you for the opportunity to discuss issues related to coal supply. AAR members account for the vast majority of freight railroad mileage, employees, and revenue in Canada, Mexico, and the United States, and, therefore, are directly involved in aspects of the coal supply chain.
Members of this committee should know, first and foremost, that contrary to what some rail critics wrongly claim, railroads’ coal delivery abilities are anything but broken. In 2005, U.S. railroads moved more coal than ever before, and are on pace to significantly exceed their 2005 coal movements in 2006.
Railroads also know that efficient coal transportation is critical to our nation’s economic well being and energy security, and they are committed to working with coal suppliers and consumers to ensure continued safe, cost-effective, and reliable service, as they currently do.
The more than 550 freight railroads operating in the United States today are a tremendous national asset, moving more freight, more efficiently, and at lower rates than any other freight rail system in the world. They account for more than 40 percent of our nation’s intercity freight ton-miles and deliver some two-thirds of our coal.
The global superiority of U.S. railroads is a direct result of a regulatory system, embodied in the Staggers Rail Act of 1980, that relies on market-based competition to establish nearly all rate and service standards. This limited regulation has allowed rail¬roads to improve their financial performance from anemic levels prior to Staggers to more moderate levels today, which in turn has allowed them to plow back hundreds of billions of dollars into improving the quality and performance of their infrastructure and equipment — to the immense benefit of their coal and other customers, and our nation at large.
Looking ahead, our economic prosperity and our ability to compete successfully in the global marketplace — and our ability to utilize our abundant domestic coal supplies — will depend critically on the continued viability and effectiveness of our freight railroads. But to be viable and effective, especially in the face of projected huge increases in freight transportation demand over the next 20 years, railroads must be able to both maintain their existing infrastructure and equipment and build the substantial new capacity required to handle the additional traffic they will be called upon to haul.
Overview of Coal
The ready availability of domestic coal as a primary energy source has been critical to U.S. economic development. U.S. coal production and consumption have been trending higher for decades, and in 2005 totaled more than 1.1 billion tons — higher than ever before and more than any country in the world except China.
The vast majority of coal in the United States is used to generate electricity, with smaller amounts used in industrial applications like fueling cement kilns or producing coke. Coal accounted for 50 percent of U.S. electricity generation in 2005, far more than any other fuel.
The amount of electricity generated by coal in the United States rose from 1.6 billion megawatthours in 1990 to 2.0 billion megawatthours in 2005 — an increase of 420 million, or 26 percent. But because overall U.S. electricity generation rose 33 percent during this period, coal’s share of total generation actually fell, from 52.5 percent in 1990 to 49.9 percent in 2005.
By contrast, natural gas’s share of U.S. electricity generation rose from 12.6 percent in 1990 to 19.0 percent in 2005. In fact, during the 1990s and into the first half of this decade, virtually no new coal-fired electricity generation capacity and no new nuclear facilities were built, but huge amounts of gas-fired capacity were added. According to data from the U.S. Department of Energy’s Electricity Infor¬mation Administration (EIA), net summer capacity for natural gas-fired electricity generation rose 211 gigawatts from 1994 to 2004, while net summer capacity for all other fuel sources combined actually fell three gigawatts.
Natural gas was the fuel of choice for new capacity for several reasons. Gas plants could be constructed relatively quickly and enjoyed an easier permitting process, and thus were less expensive to build. They were also considered to be “environmentally friendly.” Perhaps most importantly, though, it was assumed that natural gas would remain cheap and plentiful.
This, of course, did not happen. Over the past few years, the price of natural gas to utilities has skyrocketed, making gas-fired generation less competitive and sparking increased demand for electricity generated from other fuels, including steam coal. In contrast to the delivered price of natural gas, the delivered price of coal to utilities has remained basically flat, and on a per-Btu basis is far below the comparable figure for natural gas. In addition, demand for metallurgical coal rose sharply because of a boom in steelmaking worldwide.
This unexpectedly strong increase in the demand for coal, which occurred at the same time that demand for rail transportation overall was rising sharply (discussed further below), has in some cases exceeded the capability of coal producers to supply the coal and coal transporters to haul it. That’s not surprising, especially since utilities, by their actions, had long been disfavoring coal in favor of natural gas, and neither coal suppliers nor coal transporters have unlimited spare capacity on hand “just in case.”
Nevertheless, in recent months, freight railroads have come under frequent attack for their alleged role in forcing coal-fired power plants to reduce their coal stockpiles to dangerously low levels. In a few cases, power plants have allegedly had to curtail power production because of the unavailability of rail-delivered coal, and then had to purchase more expensive electricity on the spot market or generate electricity from more expensive fuels like natural gas.
Railroads are in constant communication with their coal customers, and make every effort to ensure adequate coal supplies. Despite railroads’ best efforts, there may be times when a particular plant has temporary acute shortages. This is an extremely rare occurrence. Even today, when railroads are hauling more traffic (including coal) than any time in their history and are facing capacity constraints on important corridors and at critical locations on the rail network, the overwhelming majority of coal customers are receiving adequate coal supplies.
Moreover, coal-fired power plants have been reducing their coal stockpiles since the early 1980s. A typical electric utility held nearly two months of full-load burn in the early 1980s; by the late 1990s, this had fallen to near one month. According to EIA data, coal stocks at electric power producers as a percentage of coal consumption fell from more than 30 percent in 1980 to 10 percent by 2000. The decision to reduce stockpiles was part of a deliberate utility effort to shift to just-in-time inventory practices to limit capital tied up in fuel stocks. With inventory reduced to this degree, utilities eliminated a traditional buffer to withstand supply disruptions (like the May 2005 PRB derailments noted below).
That’s one of the reasons I recently asked the Federal Energy Regulatory Commission (FERC) to investigate the entire supply chain — including utility management of coal inventories — that produces, transports, and receives the coal used to generate electricity at utility plants across the nation.
The rail transportation of coal was negatively affected in 2005 by especially serious weather-related problems in the western United States, which has become an increasingly important source of coal. In May 2005, two coal trains derailed on the heavily-used Southern Powder River Basin Joint Line (Joint Line) in Wyoming. The line is jointly owned and used by BNSF Railway and Union Pacific. Subsequent investigation found that the derailments were caused by a weakening of the roadbed due to the combination of accumulated coal dust and significant rain and snow over a short time period. The derailments and subsequent compre¬hen¬sive repair program disrupted the flow of trains to and from the SPRB to some degree for much of the rest of the year, and removal and cleaning of ballast will continue until the fall of 2006.
In early October, a severe thunderstorm dumped approximately 12 inches of rain in the Topeka, Kansas region, created runoff that caused bridge damage and extensive washouts on several major coal-carrying rail routes, impeding rail traffic nearly all of October until the last bridge was replaced.
Railroads recognize that these types of disruptions exert a substantial toll on rail customers as well as on the railroads themselves, which is why railroads work exceedingly hard to return their operations to normal service as quickly as possible. In 2005 and into this year, not every coal consumer has been able to obtain all the coal it has wanted as quickly as desired. This consequence of weather-related outages and capacity constraints throughout the coal production and logistical chain will be temporary, as long as policymakers do not overreact with inappropriate policy prescriptions.
The more important point is that, despite the weather- and capacity-related problems noted above, as well as periodic production disruptions at mines, railroads moved a phe¬nome¬nal amount of coal in 2005, and 2006 is well on its way to exceeding 2005’s record totals.
While the mines and railroads will produce and move substantially more coal in 2006 than ever before, it may be less than what some receivers want to fully rebuild inventories. But there should be no shortfalls that threaten electricity reliability. The National Electric Reliability Council (NERC) seems to agree. NERC is the umbrella organization for eight regional reliability councils whose members come from all segments of the electric power industry and account for nearly all electricity in this country. NERC’s mission is to ensure that the bulk power system in North American is reliable, adequate, and secure.
A week ago, NERC released its “2006 Summer Assessment” that examines the reliability of the North American bulk power system for the upcoming summer season. In reference to the nation as a whole and after noting the flooding and derailments last year, NERC noted that while it will be monitoring the supply of PRB coal, “Coal delivery limitations do not appear to present a reliability problem for this summer.”
NERC made similar assessments in reference to individual regions:
• Electric Reliability Council of Texas (ERCOT): “It is also anticipated that no significant problems with coal supply deliveries impacting reliability in ERCOT are expected this summer.”
• Florida Reliability Coordinating Council (FRCC): “...the PRB coal delivery issue is expected to be of minimal impact to regional capacity.”
• Midwest Reliability Organization (MRO - covers north central U.S.): “The MRO has surveyed the Powder River Basin coal delivery situation in the region and the results show that no direct impacts to the reliability of meeting peak electrical demand.”
• ReliabiltyFirst Corporation (RFC – covers northern Illinois, the Mid-Atlantic, and parts of the Northeast): “Deliveries of PRB coal are no longer limited due to last May’s derailment and subsequent track maintenance. Significant coal delivery problems are not expected for RFC members this summer.”
• Southeastern Electric Reliability Council (SERC): “The majority of SERC members to not rely on PRB coal. SERC members that do receive PRB coal have experienced some reduced deliveries, but are presently receiving sufficient PRB coal.”
• Southwest Power Pool (SPP): “The coal supply issue due to the PRB railroad issue is not considered to be a high-risk issue by SPP members regarding supply adequacy.”
• Western Electricity Coordinating Council (WECC): “A fuel supply survey taken last fall indicated that only a handful of coal-fired plants have been directly affected by last year’s coal delivery interruptions from the Powder River Basin coal fields. The operators of those plants reported experiencing supply interruptions during the summer and had reported that winter deliveries had returned to normal.”
NERC’s reliability appraisal will probably not stop rail critics from continuing to warn about the possibility of “rolling blackouts” and other untoward events this summer due to rail delivery issues. These misrepresentations serve no useful purpose.
In addition, last week FERC’s Office of Enforcement presented its summer energy market assessment for 2006. The assessment noted that “coal stockpiles ...are well above last year’s levels .... While worth watching, staff’s view is that coal stockpiles are likely to continue building.” FERC’s assessment notes a few areas where inadequate investment by the electric power sector could cause problems, saying it is “concerned about key load pockets where investment in needed infrastructure has not kept up with needs.”
While traffic out of the PRB is back up to normal volumes, the preventive cleaning of the ballast beneath the rails is still underway. Going forward, one of the root causes of the weather-related problems of 2005 — coal dust “blow off” — must be aggressively addressed. Just as with other coal delivery chain issues, the mines, utilities, and railroads must collectively identify, agree upon, and implement the best method to combat “blow off” so that the premature wear of rail infrastructure in the PRB can be eliminated.
Outlook for Coal
U.S. coal production and consumption will almost certainly continue to grow. In its Annual Energy Outlook 2006, released in December 2005, the EIA projects that U.S. coal production in 2015 will total 1.27 billion tons, a 140-million ton increase (12 percent) over the 1.13 billion produced in 2005. The EIA expects U.S. coal consumption to increase from 1.13 billion tons in 2005 to 1.28 billion tons in 2015, a 147-million ton increase.
DOE’s National Energy Technology Laboratory reports that 140 coal-fired generating plants in 41 states representing 85 gigawatts have been announced or are in development. If ultimately built, this new generation would increase annual U.S. coal requirements by some 300 million tons.
Coal’s future is not assured, however, mainly because it faces major environmental challenges. Among many, coal is perceived to be a dirty fuel whose emissions (of carbon dioxide, particulates, sulfur dioxide, nitrogen oxides, and mercury) pollute the environment and harm public health.
As members of this committee know, the view that coal is a “dirty” fuel has become increasingly out of date. Coal-based electricity generation is far cleaner today than it used to be. From 1980 through 2002, coal-based power generation rose 66 percent, but emissions of sulfur dioxide (SO2) from coal fell 39 percent in absolute terms and 64 percent on a per unit of generation basis, while nitrogen oxide emissions (NOx) fell 33 percent on an absolute basis and 60 percent per unit of generation.
Moreover, coal’s environmental performance will continue to improve through the use of “clean-coal” technologies. Coal-based utilities, the DOE, and others are investing billions of dollars each year on R&D projects directed toward improving the environmental performance of coal-based electricity generation.
For example, DOE is engaged in showcasing promising technology to establish the technical and economical feasibility of zero-emissions systems with hydrogen co-production while completely eliminating the environmental concerns associated with coal use. The ultimate goal of this project — dubbed FutureGen — and similar research efforts is to develop new commercially-viable coal-fired power plants that would remove 95-99 percent of SO2, NOx, particulate matter, and mercury; achieve 50-60 percent thermal efficiency, a vast improvement over current levels; and capture and sequester carbon dioxide on a massive scale.
Clean-coal efforts got a major boost in the Energy Policy Act of 2005, which included several provisions that authorized funding and investment tax credits for clean-coal projects, including advanced coal gasification technologies, pulverized coal technologies, generating equipment, and air pollution control equipment.
Today, the most highly-anticipated clean-coal systems are “integrated coal gasification combined cycle” (IGCC) systems, in which crushed coal is mixed with steam and oxygen under high temperature and pressure to produce a gaseous mixture that is burned in a high efficiency gas turbine to produce electricity. The exhaust heat from the gas turbine is recovered to produce steam to power steam turbines, greatly improving thermal efficiency. The main advantage of IGCC, though, is its ability to remove carbon and other impurities from coal before the coal is burned, rather than trying to filter the impurities out of post-combustion exhaust. Today, numerous IGCC projects are being considered at sites across the country.
Because coal offers such extraordinary promise as a source of fuel for a range of appli¬cations, it is critical that policymakers encourage coal use, support continued clean coal research and development, and refrain from restricting the ability of coal producers, consumers, or transporters from playing their respective roles in the coal production and logistics chain. The use of coal for these purposes frees up natural gas to be used in other applications, such as chemical production and other high-end manufacturing applications for which there is often no practical substitute.
The Rail Transportation of Coal
Because coal is consumed in large quantities throughout much of the country, while most production is focused in a relatively small number of states, an efficient coal transportation system is a necessity. Thanks to railroads (and other transportation modes), coal transportation in the United States has become so sophisticated that regionally-defined markets need no longer exist. Rather, coal can be transported essentially from wherever it is mined to wherever consumers want to burn it.
All major transportation modes except airlines carry large amounts of coal. According to the EIA, 64 percent of U.S. coal shipments were delivered to their final domestic destinations by rail in 2004, followed by truck (12 percent); the aggregate of conveyor belts, slurry pipelines, and tram¬ways (12 percent); and water (9 percent, of which 8 percentage points were inland waterways and the remainder tidewater or the Great Lakes). The rail share has been trending higher, in large part a reflection of the growth in PRB coal that often moves by rail. PRB coal production more than doubled from 200 million tons in 1990 to an estimated 429 million tons in 2005.
Coal is by far the highest-volume single commodity carried by rail, and railroads are moving more coal today than at any time during their history. In 2005, Class I carriers originated 7.20 million carloads of coal (23 percent of total carloads), equal to 804 million tons (42 percent of total tonnage). Coal has long been a major source of rail revenue as well. Class I gross revenue from coal in 2005 was $9.4 billion, or 20 percent of total gross revenue. Coal is also carried by dozens of non-Class I railroads.
Rail coal traffic has been trending upward at a faster rate than coal production. From 1981 (the first full year following Staggers) through 2004, rail ton-miles of coal nearly tripled, whereas U.S. coal production rose 38 percent. Rail coal traffic increases to utilities are continuing today. Railroads helped move a record 427 million tons of PRB coal in 2005 and could see a 10 percent increase in 2006. Eastern railroads too are expecting to set new coal-hauling records in 2006. In 2005, for example, Norfolk Southern (NS) experienced a 6.3 percent increase in coal volume to utilities, even though electricity generation in NS’s service region rose just 3.7 percent. In the first quarter of 2006, NS experienced a 7 percent increase in utility coal volume.
Coal hauling on railroads has become much more sophisticated than it used to be. Most coal on railroads moves in highly productive unit trains, which often operate around the clock, use dedicated equipment, generally follow direct shipping routes, and have lower costs per unit of coal shipped than non-unit train shipments.
In addition, technological advances have led to more powerful and fuel efficient locomotives; distributed power operating practices that allow more coal to move in each train with greater reliability and safety; improved signaling systems; stronger, more durable track; lighter, higher-capacity coal cars (in 2005 the average coal car carried 111.7 tons, up 14 percent from the 98.2 tons in 1990); and higher capacity, faster coal loading and unloading systems, to name a few.
Improvements in train operations — including distributed power, more accurate short-term demand forecasting, and more efficient dispatching and routing — have also helped railroads meet the needs of their coal customers as efficiently and cost effectively as possible.
Railroad Coal Rates
Since it recognizes both distance and weight, revenue per ton-mile (RPTM) is a useful surrogate for railroad rates. In 2004 (the most recent year for which RPTM data are available), average RPTM for coal was 1.59 cents, by far the lowest such figure among major rail commodities. In inflation-adjusted terms, 2004 RPTM for coal was 63 percent lower than in 1981 and 28 percent lower than in 1994. Moreover, the general pattern of significant reductions in coal RPTM applies to coal movements in railroad-owned cars, for movements in non-railroad-owned cars, and for movements of different lengths.
The average decline in railroad coal rates from 1981 to 2004 (down 32 percent in nominal dollars, down 63 percent in inflation-adjusted terms) is in sharp contrast to average U.S. electricity rates, which rose 38 percent from 1981 to 2004 in nominal terms and fell 25 percent in inflation-adjusted terms.
Numerous studies have found that, historically, rail coal rates have fallen. For example:
• A September 2004 study by the EIA found that rail rates for coal fell nearly 42 percent on a revenue per ton basis from 1984 to 2001, and that railroad revenue per ton-mile for coal fell 60 percent on an inflation-adjusted basis from 1979-2001 — compared with a decline for barges of 38 percent and an increase for trucks of 73 percent. An October 2000 EIA study came to similar conclusions.
• A June 2002 study by the U.S. General Accounting Office (GAO) found that from 1997 through 2000, “In virtually every market we analyzed — both in the East (Appalachia) and in the West (Powder River Basin) — rates decreased.” The June 2002 study was a follow-up to a similar April 1999 GAO study, which found that “In general, real rail rates for coal shipments have fallen since 1990. This was true for overall rates and for the specific long-, medium- and short-distance transportation corridors/ markets.”
• A March 2001 econometric analysis found that after controlling for changes in commodity mix, shippers were receiving some $27.8 billion per year (in 1996 dollars — equivalent to some $33 billion in today’s dollars) in rate reductions as a result of changes that took place in the rail industry between 1982 and 1996. Of the $27.8 billion in annual savings, $8.6 billion (equivalent to $10 billion in today’s dollars) accrued to coal shippers.
• In a December 2000 report, the Surface Transportation Board (STB) found that “shippers would have paid an additional $31.7 billion for rail service in 1999 if revenue per ton-mile had remained equal to its 1984 inflation-adjusted level.” Given the volume of coal moved by rail, coal shippers undoubtedly accounted for much of these savings.
• A 1999 study by Resource Data International (RDI) found that the decline in the delivered price of coal to coal-fired power plants from 1989-1997 was virtually identical for plants served by only one railroad (30 percent) as for plants served by more than one railroad (31 percent). RDI noted that “coal price data do not suggest that single-rail served shippers are disadvan¬taged relative to multiple-rail served shippers.” RDI also found that 7 of the top 10 lowest-cost U.S. coal-fired plants were served by just one railroad — suggesting that factors other than delivery mode have a greater influence on the competitiveness of power plants.
Other measurements of rail rates point to the cost-effectiveness of rail coal service. For example, coal is near the bottom among all major commodities in terms of gross revenue per carload originated. The average for 2005, $1,304, is 15 percent lower than the compa¬rable inflation-adjusted average for 1990. That there is any decline in this measure is astounding, given the increase in average length of haul for rail coal movements from 539 miles in 1990 to 751 miles in 2004.
Likewise, revenue per ton of coal originated in 2005 ($11.68) was less than half the average for all commodities ($24.61). In inflation-adjusted terms, average revenue per ton for coal was 25 percent lower in 2005 than in 1990.
Faced for decades with falling returns, railroads, like any other industry, would ordinarily have had an incentive to extract capital from its coal business. However, highly successful productivity-enhancing programs during this period allowed declining returns to coexist with increased investment.
It is true that some rail coal rates have increased in 2004 and 2005, but as explained in more detail below, railroads need to increase their coal revenues if they are to make the reinvest¬ments in their systems that will be necessary for them to meet future coal transportation needs.
Capacity is a Challenge Everywhere in Transportation Today
There is a tremendous amount of strength and flexibility in our nation’s transportation systems, but it is clear that all freight modes in the United States, including railroads, are facing serious capacity challenges today, and that these challenges will only worsen over time if action is not taken.
For U.S. freight railroads, year-over-year quarterly carload traffic has risen in nine of the past ten full quarters, and intermodal traffic has increased in each of the past 16 full quarters, year-over-year. U.S. railroads today are hauling more freight that ever before.
These traffic increases have resulted in capacity constraints and service issues at certain locations and corridors within the rail network. In fact, excess capacity has disappeared from many critical segments of the national rail system.
The reality that rail assets are being used more intensively is reflected in rail traffic density figures. From 1990 to 2005, traffic density for Class I railroads — defined as ton-miles per route-mile owned — more than doubled. (Other measures of traffic density, such as car-miles per mile of track, have also shown substantial increases.) Of course, different rail corridors differ in their traffic density and their change in density over time, and individual railroads differ in the degree to which their capacity is constrained overall. Still, there is no question that there is significantly less room to spare on the U.S. rail network today than there was even a couple of years ago.
In light of current capacity and service issues, some shippers and others have inappropriately blamed railroads for not having enough infrastructure, workers, or equip¬ment in place to handle the surge in traffic. Perhaps railroads and their customers could have done a better job of forecasting and preparing for the sharply higher traffic volumes of recent years. But to contend that railroads can afford to have significant amounts of spare capacity on hand ‘just in case’ — or that shippers would be willing to pay for it, or capital providers willing to finance it — is completely unrealistic. Like other companies, railroads try to build and staff for the business at hand or expected to soon be at hand. “Build it and they will come” is not a winning strategy for freight railroads.
Over the past couple of decades, Class I railroads have shed tens of thousands of miles of marginal trackage. They had no choice — they could not afford to keep these marginal and unprofitable lines, and they freed resources for use on higher priority core routes. Most of the miles that were shed were transferred to short-line operators, and most of these remain part of our rail network. Even if railroads could have afforded to retain this mileage — and again, they could not — most was in locations that would not help ameliorate today’s capacity constraints.
In part, this is because long-lived rail infrastructure installed long ago was often designed for types and quantities of traffic, and origin and destination locations, that are dramatically different than those that exist today. For example, only within the last two decades has Powder River Basin coal taken on the enormous importance it currently enjoys. Similarly, the explosive growth of rail intermodal traffic is mainly a phenomenon of the past 20 years.
When business is unexpectedly strong, railroads cannot expand capacity as quickly as they might like. Locomotives, for example, can take a year or more to be delivered following their order; new entry-level employees take six months or more to become hired, trained, and qualified; and it can take a year or more to plan and build, say, a new siding. And, of course, before investments in these types of capacity enhancements are made, railroads must be confi¬dent that traffic and revenue will remain high enough to justify the enhance¬ments for the long term, and that the investment will produce benefits greater than the scores of alternative possible investment projects. Again, in this regard railroads are no different than their customers.
Meeting Future Coal Transportation Needs
As noted earlier, since 1990 railroad coal movements have sharply increased along with coal production and consumption. With coal demand expected to continue to rise for the next decade and beyond, railroads will be called upon to move much more coal than they do today.
Railroads’ past performance strongly suggests that they will be able to handle this increased demand for coal transportation. From 1990 to 2005, U.S. coal production rose 10 percent, while rail coal tons originated rose 26 percent and rail coal ton-miles rose well over 50 percent — both multiples of the growth in coal production. This market response by railroads can continue only if railroads’ ability to make the necessary investments in their networks is not constrained.
To help ensure that adequate coal-carrying capacity is specifically available to meet future coal transportation needs, railroads are taking a variety of actions. For example, events of the past year show that it takes time to adjust to fluctuations in coal supply and demand, so railroads are emphasizing the need for coordinated, timely planning with customers and suppliers. To this end, railroads meet regularly with coal companies and electricity producers to determine how to best conform rail transportation offerings to their needs. These joint efforts include such objectives as meeting peak period demand and performing track maintenance as efficiently and unobtrusively as possible.
In addition to trying to balance earnings with investment needs, railroads are taking other steps to position future capital investment to support future capacity for coal and other traffic. For example, they are encouraging the use of public-private partnerships for rail infrastructure projects, especially in cases where a fundamental purpose of the project is to provide public benefits or meet public needs. Railroads are also advocating a tax incentive program for infrastructure investments that expand capacity, and they are continuing to aggressively seek productivity and technological enhancements to improve operations.
Railroads are successfully increasing productivity — tons of coal per train have been steadily increasing, for example — and are seeking ways to improve interchange speed and throughput at rail/barge terminals. Finally, railroads know that substantial additional coal movements will require substantial new investments in infrastructure and equipment, and individual railroads are taking up this challenge.
Railroading is a network business, meaning that operational improvements or investments in one location can affect rail traffic a thousand miles away. For this reason, even investments made on rail lines that do not carry substantial volumes of coal can have a positive effect on railroads’ coal-carrying operations.
From 1980 through 2005, Class I railroads invested nearly $360 billion (and short lines spent additional billions) to maintain and improve infrastructure and equipment, with most of this spending indirectly or directly benefiting coal movements. After accounting for depreciation, freight railroads typically spend $15 billion to $17 billion per year — equal, on average, to around 45 percent of their operating revenue — to provide the high quality assets they need to operate safely and efficiently.
Moreover, rail capital spending, which is already enormous, is expected to rise to around $8.3 billion in 2006, up from around $5.7 billion just four years earlier. This huge increase demon¬strates the diligence with which railroads are responding to the capacity and service issues.
Railroads essentially have no choice but to reinvest enormous sums back into their systems. It takes an enormous amount of money to run a freight rail system; it simply cannot be done on the cheap. The rail industry is at or near the top among all U.S. industries in terms of capital intensity. From 1995-2004, U.S. Class I railroads spent, on average, 17.8 percent of their revenue on capital expenditures. The comparable figure for U.S. manufacturing as a whole was just 3.5 percent. Similarly, in 2004, Class I railroad net investment in plant and equipment per employee was $667,000 — more than eight times the average for all U.S. manufacturing ($78,000).
The following is just a sampling of the diverse types of capacity- and service-enhancing investments individual railroads have recently made or will soon make that will directly or indirectly benefit coal shippers:
• BNSF took delivery of 1,300 rapid-discharge aluminum coal cars in 2005, as well as 288 new locomotives, of which approximately 90 were assigned to coal service. BNSF plans to add 362 more locomotives in 2006, half of which will be used in coal service. Planned investments directly related to its coal business over the next couple of years include $500 million to $800 million on track and terminal expansions; well over $1 billion on new locomotives; and more than $1.2 billion for additional aluminum rapid discharge train sets. Over the past decade, BNSF has spent more than $2.2 billion on investments specifically aimed at increasing coal-carrying capacity.
• Likewise, Union Pacific has spent enormous sums on its coal service, including more than $1 billion over the past eight years on locomotives and another $1 billion on track capacity enhancements specifically for coal. Major projects include completing the $35 million Marysville, Kansas bypass to expedite PRB coal trains; completing a $40 million Denver bypass to ease the flow of eastbound trains; a new siding on the North Fork branch line in Colorado; several sidings in Southern Illinois to support coal growth; and continuing a multi-year effort to install centralized traffic control on the Central Corridor East/West mainline in Iowa. In 2006, UP will acquire more than 500 new coal cars and dozens of additional locomotives to support coal.
• Earlier this month, BNSF and UP agreed on plans to build more than 40 miles of third and fourth main line tracks, at a cost of about $100 million over the next two years, to meet current and future forecasted demand for PRB coal. This project is in addition to the construction of 14 miles of a third main line track completed last year and an additional 19 miles of the third main line currently under construction and scheduled to be fully operational in September 2006. The total cost of this nearly 75-mile capacity expansion will be about $200 million.
• In 2006, Canadian National will spend $1.2 billion to $1.3 billion on capital programs in the United States and Canada. Included are the reconfiguration of the key Johnston Yard in Memphis, a gateway for CN’s rail operations in the Gulf of Mexico region; siding extensions in Western Canada; and investments in CN’s Prince Rupert, British Columbia, corridor to capitalize on the Port of Prince Rupert’s potential as an important traffic gateway between Asia and the North American heartland.
• In 2005, Canadian Pacific finished its biggest capacity enhancement project in more than 20 years by expanding its network from Canada’s Prairie region to the Port of Vancouver. The project increased the capacity of CP’s western network by 12 percent and improved the route structure from Canada’s Pacific coast to the United States. Like other carriers, CP has added new sidings on congested corridors; taken delivery of dozens of new locomotives and newer, higher-capacity freight cars; and hired and trained hundreds of new employees, many of whom will be in the United States.
• CSX plans to spend around $1.4 billion per year on capital expenditures in 2006 and 2007, up from $1 billion in the previous few years, with much of the spending benefiting coal. For example, major investments in the Southeast Express Corridor from Chicago to Florida will enhance coal movements to the growing Southeast market, and a new connection at Willows, Illinois provides a new route and improved capacity for western coal over the St. Louis gateway. In 2005, CSX rebodied 1,336 bottom-dump hoppers and repaired an additional 1,933 coal gondolas and bottom-dump hoppers. In 2006, CSX will rebuild 1,100 bottom-dump hoppers and repair an additional 1,341 coal cars. From 2005-2007, CSX will acquire 300 new locomotives, many of which will be in coal service.
• Kansas City Southern (KCS) is busy integrating its Kansas City Southern dé Mexico subsidiary fully into the railroad’s other operations. KCS plans to spend $120 million in the United States and another $96 million in Mexico in 2006. Particular attention will be given to the construction of new tracks and other improvements at the railroad’s Shreveport hub; improvements on the “Meridian Speedway” between Shreveport and Meridian, Mississippi to augment the new rails, new sidings, and new drainage system installed in 2005; and the expansion of rail yards, track upgrades, and new sidings on its “Tex-Mex” subsidiary.
• Norfolk Southern (NS) will purchase more than 220 new locomotives from late 2005 through mid-2006 to augment the hundreds purchased over the past few years. Scores of these locomotives are dedicated to coal. NS is also in the midst of its largest-ever locomotive rehabilitation program — in 2005, 491 locomotives were overhauled and 29 were rebuilt; another 420 will be overhauled and 52 rebuilt in 2006. NS is investing $60 million to add track capacity for coal movements between Memphis and Macon, Georgia, and $42 million to build five miles of new line to improve rail service at a coal-fired power plant.
Rail capacity is a function of personnel in addition to infrastructure, and railroads have been aggressively hiring and training crews to expand capacity. After decades of steady decline, rail employment has been on the increase since 2004. According to STB data, the number of Class I train and engine employees (essentially, engineers and conductors) rose from 61,113 in December 2003 to 69,658 in December 2005, an increase of 14 percent in just two years. The number of maintenance of way and structures employees rose from 32,925 in December 2003 to 34,227 in December 2005, an increase of 4 percent. Overall Class I employment rose 8 percent from December 2003 to December 2005.
Other steps railroads are taking to enhance capacity and improve service include examining and, where appropriate, revamping their operating plans with an eye toward improved asset utilization and enhanced fluidity. Railroads are also engaging in innovative collaborations with each other and are constantly developing and adopting new technologies. For example, railroads are developing and implementing complex computer models to optimize train movements and trip planning. Railroads are also working with customers to improve planning and communication
Railroads Must Be Financially Healthy to Expand Coal Capacity
Railroad efforts to improve their ability to transport coal cost an enormous amount of money and point to why railroads are implementing a new “commercial paradigm.”
Since Congress passed the Staggers Act, railroads have only slowly made partial progress toward the goal of long-term financial sustainability, which is essential if railroads are to have any hope of meeting future capacity needs.
This slow progress is documented in the STB’s annual revenue adequacy determinations. A railroad is “revenue adequate” — i.e., it is earning enough to cover all costs of efficient operation, including a competitive return on invested capital — when its rate of return on net investment (ROI) equals or exceeds the industry’s current cost of capital (COC). This standard is widely accepted, approved by the courts, and similar to that used by public utility regulators throughout the country. It is also consistent with the unassailable point that, in our economy, firms and industries must produce sufficient earnings over the long term or capital will not flow to them. As a prominent Wall Street rail analyst recently noted, “Earning the cost of invested capital is not the end goal, but the entry ticket to the race, a credit without which Wall Street will squeeze investment.”
During the more than 25 years in which railroad revenue adequacy determinations have been made, railroads have significantly narrowed the COC vs. ROI gap, but a gap still remains.
Railroad coal customers and their trade association representatives are among the most vocal proponents of restrictions on rail earnings, but utilities certainly understand the importance of long-term financial sustainability.
A spokesman for a major Florida electric utility, for example, noted, “If we can’t make an attractive invest¬ment for the shareholder, then we are going to have a very difficult time going in the marketplace and competing for dollars.”
Likewise, in an advocacy piece on the need for adequate investments in electricity transmission infrastructure, a representative of the Edison Electric Institute (EEI – the major trade association for investor-owned utilities), wrote:
“I cannot overemphasize the need for FERC to establish and put into effect a durable regulatory framework that says if I prudently invest a dollar in transmission infrastructure, that I will be able to fully recover that dollar, along with my cost of capital, through electricity rates. Such a framework is essential to raising the substantial and nearly unprecedented amount of capital necessary to construct needed, cost-effective transmission facilities.”
Earlier this month, EEI released a document that defends the sometimes significant price increases electricity consumers are facing in many parts of the country. EEI writes:
“Clearly, electricity is an indispensable commodity that is crucial to our daily lives and to our nation’s continued economic growth. And the costs needed to reinforce the nation’s electric power system are worthy long-term investments. The bottom line is that we are living in a rising cost environment, and electricity prices have been a great deal for many years. Even with expected rate increases, electricity prices are projected to remain below the rate trends of other goods and services. In fact, the national average price for electricity today is significantly less than what it was in 1980, adjusted for inflation.
Of course that is small comfort to customers who will be opening costlier electric bills in the coming months. And no one — utility, regulator, or customer — is eager to see electricity prices increase. The unavoidable reality, however, is that we all must address the fact that in order to ensure that electricity remains affordable and reliable, we must help shoulder the expense of reinforcing and upgrading our electricity infrastructure. It is the only way to be certain that electricity will be there when we need it, and at a price we can afford over the long term”
Railroads wholeheartedly agree with the sentiment expressed in this statement. It is critical to our nation’s economy and standard of living that we upgrade and reinforce our electricity infrastructure.
We also think that EEI’s statement above is just as valid, if not more so, if the word “electricity” were changed to “freight railroading.” Looking ahead, the United States cannot prosper in an increasingly competitive global marketplace if our freight railroads are unable to meet our growing transportation needs, and increasing railroad capacity is critical in meeting these needs. Like utilities, railroads must be able to both maintain their extensive existing infrastructure and equipment and build substantial new capacity. Railroads could not do this if their earnings were unreasonably restricted, any more than utilities could.
Railroads think the Congressional Budget Office (CBO) summarized the situation appropriately when it recently noted, “As demand increases, the railroads’ ability to generate profits from which to finance new investments will be critical. Profits are key to increasing capacity because they provide both the incentives and the means to make new investments.”
Recent Railroad Financial Results Are a Positive Development
Without question, 2005 was a good year for railroads financially — revenue and net income were both up substantially. Frankly, it’s about time the rail industry had a year like 2005, and they need more like it going forward. Improved rail earnings should be viewed as a welcome development because it means that railroads are better able to justify and afford the massive investments in new capacity and upkeep of their existing systems that need to be made.
That said, no one should be confused regarding railroads’ relative profitability in 2005. In 2005, when railroads were hauling record levels of traffic and had sharply higher-than-historical profitability, rail industry earnings were still substandard compared to other industries.
Return on equity (ROE) is commonly used as an indicator of short-term profitability. According to Business Week data covering the S&P 500, in 2005 the average ROE for the four largest U.S. railroads was 12.3 percent — a substantial improvement over the 7.8 percent recorded in 2004, but still well below the 16.1 percent average for all firms in the S&P 500 for 2005. The railroad ROE was well below the median for chemical companies in the S&P 500 (18.7 percent) and only moderately higher than the median for electric utilities (10.8 percent) in the S&P 500.
Data from the Fortune 500 tell a similar story. In 2005, the median ROE for the railroads in the Fortune 500 was 14.1 percent, less than the Fortune 500 median of 14.9 percent and well below the ROE of numerous major rail customer groups. In each of the 20 years from 1986 to 2005, the median ROE for Class I railroads was less than the median for all Fortune 500 companies, and in 15 of the 20 years, the median railroad ROE was in the lowest quartile among Fortune 500 industries.
Thus, even the improved rail earnings in 2005 are generally no more than (and in most cases less than) what non-regulated companies and industries earn.
In any case, whatever may be the minimum level of earnings, profitability, or solvency considered adequate by financial analysts to declare a railroad “healthy” for short-term invest¬ment purposes, the primary question vis-à-vis those who want to impose earnings restrictions on railroads is whether a railroad’s long-term profitability has reached the point at which regulatory or legislative reactions should be contemplated. Short-term improvements in profitability, short-term attainment of adequate revenues, accumulations of cash reserves, dividend pay-outs, and other similar measures do not signal that the necessary level of long-term profitability on rail operations has been achieved. Only a return on investment exceeding the cost of capital over a sustained period can begin to indicate a sustainable financial environment.
Reregulation is Not the Answer to Railroad Capacity and Service Problems
Self-interested advocacy groups from time to time propose amendments to the Staggers Act or changes to the regulatory regime it spawned that would fundamentally alter the landscape in which railroads operate, grievously harm our nation’s transportation system, and deviate sharply from Congress’s intent in passing Staggers.
Most recently, some rail critics, including some coal consumers and their representatives, have wrongly seized upon railroads’ “record profits” in 2005 and the coal delivery problems mentioned earlier to support their claims that the government should take a far more active role in railroad operations, both in terms of setting rates and in terms of mandating service parameters. Their proposals are bad public policy and should be rejected.
Railroads have had to battle efforts to reregulate the industry since the Staggers Rail Act partially deregulated railroads in 1980. And while it is beyond the scope of this testimony to discuss in detail why reregulatory legislation (like S. 919, the “Railroad Competition Act of 2005”) is wrongheaded, certain important points should be made.
The primary objective of those who call for rail reregulation is lower rail rates, even though, as discussed above, railroads are not earning excessive (or even adequate) profits. Lower rail rates would translate directly into lower rail earnings. But proponents of reregulation ignore the fact that needed investments, like most private investment decisions in our economy, are driven by expected returns. The hundreds of billions of dollars invested in U.S. freight railroads since Staggers would not have been provided if not for the investors’ expectation that the opportunity for a competitive return promised by Staggers would remain.
Under reregulation, rail managers could not commit, and rail stockholders would not supply, investment capital under the conditions needed to improve service and expand capacity, because the railroads considering such investments would not have a reasonable opportunity to capture the benefits of those investments. Disaster might not occur overnight, but there would be little or no capacity expansion — something that certainly would have a near-term and significant adverse effect on coal and other shippers.
The financial community, on whom railroads depend for access to the capital they need to operate and expand, has consistently supported the view that, under reregulation, an era of capital starvation and disinvestment would return. They understand that no law or regulation can force investors to provide resources to an industry whose returns are lower than the investors can obtain in other markets with comparable risk.
That’s why, in testimony to the U.S. Senate in May 2001, Morgan Stanley’s James Valentine cautioned that rail customers “need to be careful what they wish for, as their efforts to drive rates lower will likely only cause more capital to leave the industry and service to dete¬riorate.” It’s also why, in a January 2004 research report, John Barnes of Deutsche Bank warned, “In the beginning, there would be short-term benefit [from reregulation] for captive shippers through lower rates. However, instant gratification usually comes with a headache the next morning, and there would be no Advil strong enough for the long-term damage associated with railroad re-regulation…[O]ver the long-term, everyone would share in the hangover: share¬holders, customers, railroads, the entire transportation system, the U.S. and global economies. In the worst case scenario, … a repeat downward spiral of the railroad industry, similar to the 1970s, could occur, with multiple bankruptcies that could cripple the transportation system.”
Again, coal users in the electric power industry know this point is true, even if they maintain that railroads are somehow different from other industries in this regard.
For example, the National Rural Electric Cooperative Association has noted that it “believes that the best way to attract capital to transmission at reasonable rates is to give investors greater certainty that they will receive a return on their investment.” The rail industry can think of no better way to create uncertainty for their own capital providers “that they will receive a return on their investment” than proposals such as S. 919. It would mean less rail capacity when we need more.
At their most basic level, proponents of railroad reregulation believe that railroads charge too much and that the use of differential pricing by railroads is unfair. They fail to understand that a railroad must balance the desires of each customer to pay the lowest possible rate with the requirement that the overall network earn enough to pay for all the things needed to keep it functioning now and into the future. Simply put, no amount of rhetoric about “competition” or “fairness” or “captivity” can change the fact that if a railroad cannot cover its costs, it cannot maintain or expand its infrastructure and provide the services upon which its customers and our nation depend. Self-serving pleas to reregulate railroads must be considered within this context.
Indeed, when one looks behind what proponents of reregulation are urging upon Congress to be “fair” and “balance” shippers’ needs with the railroads’ needs, it is clear that “fairness” and “balancing” are euphemisms for “subsidizing,” and that the needs of the railroads and the general public are nowhere to be seen.
Many of those who support rail reregulation wrongly claim that their proposals are consistent with the spirit of the Staggers Act. As a point of fact, proposed changes to the current railroad regulatory regime are based on a fundamental misrepresentation of what the Staggers Act was all about.
First, nothing in the Staggers Act is meant to imply that the only competitive force that matters is rail-to-rail competition, that service to a shipper by a single railroad is equivalent to monopoly power, and that all rail shippers therefore have a right to service by more than one railroad. Rather, Staggers was premised on the understanding that the market — not regulatory or legislative fiat — would determine which markets have sufficient demand to sustain multiple railroads and which do not. Staggers encourages the creation of additional competition through private investment and initiative, but it does not seek to artificially manufacture additional competition through governmental intervention. The overwhelming number of rail customer facilities (including coal fired power plants) are, and always have been, served by only one railroad, because the economics never justified service by more than one railroad. Regulatory proposals to mandate two-railroad service are an attempt by rail customers to obtain from the government that which the market will not give them.
Second, Staggers did not bestow on railroads a special public service obligation, verging on the governmental, to subsidize other businesses, compensate for regional disadvantages or characteristics, or serve as the instrument for advancing other local, regional, or national objectives at the railroads’ own expense. Railroads should not be considered to be public utilities, any more than the companies that supply coal or any other input to utilities should be.
Third, Staggers was not meant to force a railroad to price one shipper’s movements at the same rate as another shipper’s movements, or to cap rates at some percentage of variable costs. Instead, Staggers explicitly recognized differential pricing as essential for railroads. Only by pricing in accordance with the varying demands for rail service (with reasonable regulatory protections against unreasonable rates) can railroads efficiently recover all of their costs, serve the largest number of customers, and maintain the viability of the rail system. Differential pricing benefits all shippers, because lower prices to some shippers generate revenue which otherwise would have to be raised from those with the strongest demand for rail transportation.
Of course, coal shippers are not always thrilled with the prices they are able to negotiate with railroads for coal transportation, any more than they are always happy about the prices they are able to negotiate with mines for coal supplies. Virtually every purchaser of goods or services, including railroads, would like to get a better deal than what they have from their suppliers. But there is no question that, since Staggers, the vast majority of railroad rates are market-based and driven by competition — just as Staggers intended.
Fourth, Staggers was not meant to be a vehicle through which one railroad could be forced to make its facilities available for use by another railroad. Under current regulation, unless a railroad is found to have engaged in anti-competitive conduct, it can determine for itself how to utilize its assets. In other words, the market prevails absent anti-competitive conduct.
Fifth, Staggers was not intended to prevent railroads from engaging in practices that improve efficiency, or from offering incentives to shippers that make efficiency improvements themselves. Thus, for example, railroads typically offer shippers incentives (in the form of lower rates) to move their product in larger, more cost-effective shipments. The lower rates, which reflect railroads’ cost savings, result in more efficient movements and increased competitiveness in the marketplace. Under this system, the market — not railroads — decides whether investments in facilities designed to handle more efficient shipments are appropriate.
Sixth, nothing in the Staggers Act supports efforts to cast aside the fundamental tenet of the economics of competition that says that where competition exists, there should be no regulatory intervention. Because the vast majority of rail freight movements are subject to a wide array of competitive forces — including geographic competition, product competition, competition from trucks and barges, countervailing shipper power, plant siting, long-term contracts, and technological or structural changes — the vast majority of rail movements should likewise be free of governmental oversight. Reregulatory proposals like S. 919 would unjustifiably subject huge swaths of rail traffic to governmental oversight.
Finally, Congress, through Staggers, has provided (and the Interstate Commerce Commission and the STB have implemented) effective remedies to protect shippers from abuse of market power or anti-competitive behavior. But Staggers was not designed to allow those unhappy with either the rates they are charged or STB decisions in rate cases to simply abandon the use of sound economic principles as a basis for rate decisions or to ignore the fundamental principle that railroads need to earn sustainable revenues.
Remedies for rail rates claimed to be unreasonably high are available if it can be shown that the railroad does not face effective competition for the issue traffic and that the rates are, in fact, unreasonably high. Upon finding a rate unreasonably high, as it has done many times, the STB can award reparations and/or prescribe maximum reasonable rates for the future.
The fact remains, though, that absent governmental subsidies, shippers must be willing to pay for the rail service they say they need, and the market is far superior to the government in determining who should pay.
U.S. freight railroads do a remarkable job in meeting the needs of an extremely diverse set of shippers. Railroads move hundreds of thousands of railcars and tens of millions of tons to and from thousands of origins and destinations every day, and no commodity accounts for more carloads and tons than coal. The vast majority of these shipments arrive in a timely manner, in good condition, and at rates that shippers elsewhere in the world would love to have.
Railroads work extremely hard to keep their coal service as responsive and productive as possible. They meet regularly with coal companies and electricity producers to help ensure that rail service conforms to customer needs. They invest billions of dollars each year in infra¬structure and equipment. These investments, along with technological improvements that enable them to use their assets more productively, have allowed railroads to increase their coal-carrying capacity and capability as coal demand has climbed.
Still, it is clear that the rail transportation of coal, and the entire coal logistical chain, can be improved, and railroads are eager to work constructively with coal suppliers and coal consumers to find reasonable ways to achieve this goal.
Policymakers can take a number of steps to help ensure that needed investments are made in rail infrastructure to support coal transport. First, they can reject calls to reregulate railroads. Reregulation would make it impossible for railroads to earn enough to sustain their operations and attract the capital necessary for expansion, thereby suppressing the rail industry’s ability to meet the nation’s rapidly growing appetite for coal.
Second, they can create legislative certainty regarding the level and timing of required emissions reductions and other coal-related environmental issues, thereby removing roadblocks that currently hinder both utility and rail investments.
Third, policymakers can encourage the use of public-private partnerships for rail infra¬struc¬ture projects and pass tax incentives for projects that expand rail capacity.
Finally, I urge members of this committee and others in Congress to thoroughly consider the promise that coal offers our nation and the railroads’ critical role in transporting coal. Railroads have in the past, and can in the future, furnish the capacity required to meet coal demand if destructive economic regulation is not permitted to suppress rail earnings and reduce railroads’ ability to make the investments they need. Operating within the competitive marketplace, railroads can continue their cooperative initiatives with utilities and coal suppliers to deliver to consumers exceptional efficiency and value.
Through technological advances, innovative service offerings, competitive rates, aggressive reinvestment programs, and other factors, railroads have shown their willingness and ability to provide high value transportation service to coal shippers throughout the country, and they look forward to having the ability to continue to do so.