STB issues NPRM focusing on railroad sector’s cost of capital

The United States Surface Transportation Board (STB) an economic regulatory agency charged by Congress with the fundamental missions of resolving railroad rate and service disputes and reviewing proposed railroad mergers, recently issued a notice of proposed rulemaking focused on enhancing its methodology for determining the railroad industry’s cost of capital.

STB officials said this would be done by incorporating an additional model, it calls “Step MSDCF, into its calculation. 

“Each year, the Board determines the railroad industry’s cost of capital,” STB officials said. “This figure, which the Board calculates as the weighted average of the cost of debt and the cost of equity, is used in a variety of regulatory proceedings. The Board’s present methodology for calculating the cost-of-equity componentof the industry’s cost of capital relies on two models: the Morningstar/Ibbotson Multi-Stage Discounted Cash Flow Model and the Capital Asset Pricing Model.In the NPRM issued today, the Board proposes to add a third model, Step MSDCF, which when used in combination with the current two models, would enhance the robustness of the resulting cost-of-equity estimate during periods, like the present one, in which certain railroads are undertaking significant operational changes.”

STB added that comments to the NPRM are due by November 5, 2019, and replies are due by December 4, 2019.

In January, STB made its annual determination of revenue adequacy for United States-based Class I railroads for calendar year 2017.

STB said that a railroad is revenue adequate if it achieves a rate of return on net investment equal to at least the current cost of capital for the railroad industry for 2017, which the STB said was 10.04%.  

The 10.04% figure, said the STB, is compared by the STB to the 2017 ROI data obtained from the carriers’ Annual Report R-1 Schedule 250 filings, noting that a revenue adequacy figure has been calculated for each of the Class I freight railroads that were in operation as of December 31, 2017

The STB said it was directed by Congress to perform these revenue adequacy determinations annually. And for 2017 it found that four Class I railroads– BNSF Railway Company (10.7%), Norfolk Southern Combined Railroad Subsidiaries (10.05%), Soo Line Corporation (10.71%), and Union Pacific Railroad Company (14.08%) “achieved a rate of return on net investment equal to or greater than the agency’s calculation of the cost of capital for the railroad industry.”

Railroads under the 10.04% revenue adequacy threshold included: CSX (8.84%); Grand Trunk (7.69%); and Kansas City Southern (7.09%).

Wolfe Research analyst Scott Group observed in a research note that while annual revenue adequacy has no near-term regulatory implications, it is still an important metric longer term with future implications for potential rail regulatory reform.

“The rails averaged a 9.9% return on capital in 2017, up from 9.4% in 2016, but still down from a peak of 12% in 2013-2014,” Group wrote. “Additionally, average rail returns of <10% fell below the industry’s cost of capital for the first time in five years. We believe lower returns on capital should reduce pricing power on the STB to implement meaningful rail regulatory reform that could hurt rail pricing power.”