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Chapter 4

Competitive Rail Access: Issues Defined

Many aspects of freight rail policy are the subject of controversy. This chapter begins by outlining the essentials of the system and noting the basic differences in policy perspective among interested parties.

Pricing Practices for Freight Rates

The National Transportation Act, 1987 freed railways and their customers to negotiate charges and conditions for moving products, except for grain. The practice railways use to negotiate and establish prices has become one of the more contentious issues in the user/carrier relationship.

Termed 'differential pricing', it is the railways' practice of recovering the common costs of their network by charging different percentage mark-ups, over and above identifiable costs, depending on the responsiveness of shippers' demand for services to changes in freight rates. The result is that some users pay more than others to ship a given quantity of goods over a given distance.

Shippers that are especially dependent on rail — mainly bulk commodity producers — complain that differential pricing, when combined with the lack of competitive alternatives, results in their paying higher freight rates. Some shippers contend that the existence of differential pricing is evidence of a lack of competition.

Railways maintain that differential pricing is essential to recovering total costs and ensuring network sustainability, maintaining rail service to the largest number of shippers, and giving shippers of the least competitive traffic the lowest rates possible. In its defence, they cite both economic theory and the practice of other industries.1

Competition

Canada's railways face a far more competitive marketplace today than 30 or 40 years ago. Railways have seen a slow but inexorable decline in their total share of the freight transportation market, although they retain a considerable advantage in transporting bulk commodities over long distances.

The Evidence on Competition in the Rail Freight Sector

Although railways face effective competition overall, as suggested by the substantial downward trend in average freight rates and pass-through of railway productivity gains, there may be markets where competitive forces are not as effective. This box summarizes key results from data gathered on the extent of competition in the rail freight sector. Sources include the Panel's survey of shippers. For a detailed discussion of the data and findings, see the background paper on this subject on the CD-ROM accompanying the report. Intermodal competition. The data suggest that the amount of rail traffic actually contestable by truck is limited:
  • Large volumes of resource-based bulk commodities are moved by rail in particular geographic areas for which trucking is not an option.
  • It may be technically feasible to move half the rail freight by truck, but this does not mean that trucking is a cost-effective alternative for this traffic.
  • Trucks and railways each have inherent cost advantages, depending on the distances over which goods are transported.
Intramodal competition (direct). The data suggest that the potential is considerable:
  • An estimated two-fifths of Canadian rail traffic has access to direct rail competition. This is traffic that originates and terminates within 30 kilometres of points of interchange with a competitive railway. Moreover, this is likely to be the minimum amount of traffic with direct access.
  • For grain traffic, the corresponding estimate is 24%. However, almost two-thirds (64%) of grain traffic originates and terminates within 100 kilometres of a competing railway.
Intramodal competition (indirect). Results from the survey of shippers suggest that this exists only for some markets:
  • The survey of shippers confirmed some presence of market competition but could not quantify the impact on rates or service.
  • A small number of rail shippers indicated that for some facilities they were able to use a different carrier by shipping to or from a different destination or by using a substitute product.
Market competition. This does not appear to have had a significant overall influence, but there may have been effects by individual commodity, such as coal:
  • Between 1987 and 1998, changes in export prices do not appear to have been a dominant factor influencing changes in freight rates.

Competition in the markets served by the railways takes various forms; the distinctions between them take on considerable importance in the Panel's examination of the extent of rail competition. Three types of competition are relevant for this discussion:

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Rail Access Provisions and Competition

Rail access generally refers to one railway (the guest railway) operating trains over the tracks of another railway (the host). This could be a voluntary arrangement, resulting from commercial negotiation, or could arise from legislation or a regulatory decision. Access can also occur when a railway on whose lines a shipper is situated (the local railway) is required to deliver the shipper's traffic to an interchange point with a competitor railway at a negotiated or regulated rate.

Track access (operating trains over a host railway's tracks) also takes different forms. Access could be limited to running rights — permission to move traffic from one place to another — or might include broader 'traffic solicitation rights', where the guest railway is also permitted to compete directly with the host by soliciting business on the host's line.

The Canada Transportation Act contains two competitive access provisions: interswitching and competitive line rates (CLRs). Interswitching dates back to the early 1900s. CLRs, on the other hand, have been part of the regulatory framework only since 1987.

There is a connection between the adequacy of the rail access provisions and the extent of competition; the challenge is to define the nature of that connection and to develop a policy solution that serves all interests.

Some shippers believe that prevailing conditions (limited or non-existent commercial options) make them subject to non-competitive, even monopolistic behaviour. From their perspective, an obvious solution lies in greater access to allow for more competitive shipping options.

Railways believe there is inter- and intramodal competition, so that very few shippers are truly 'captive', and even those that are do not face unduly high rates. From their perspective, increased access would threaten their long-term ability to survive as commercial entities and thus undermine the rail transportation system generally.

Existing Regulatory Instruments

Interswitching
(Canada Transportation Act, sections 127-128)

A shipper with access to only one railway at the origin or destination of a haul can have the shipment transferred to another carrier — interswitched — at prescribed rates if the origin or destination is within a 30-kilometre radius of an interchange point.2 The rates last prescribed by the Canadian Transportation Agency were set to cover the average variable cost of performing interswitching, plus a 7.5% contribution to railway fixed costs.

Shippers told the Panel that interswitching is generally effective in promoting competition and fostering efficiency. For their part, the railways say that current interswitching rates make an inadequate contribution to fixed costs.

Running Rights
(section 138)

This provision allows federally regulated railways (including U.S.-based railroads operating in Canada) to apply to the Agency for running rights over the lines of any other federal railway.

The National Transportation Agency (in existence from 1988 to 1996) dealt with three requests for running rights in 1991: two were rejected on jurisdictional grounds, while the third was withdrawn before the Agency made a determination.

Under the Canada Transportation Act, there had been no applications for running rights until February 2001, when two were made. The applications are discussed in Chapter 5.

A broad spectrum of rail users told the Panel that restricting the availability of running rights to federally regulated railways limits the provision's utility in promoting competition. On the other hand, nearly all the railways argued that a broadened running rights provision would threaten the long-term viability of rail infrastructure and reduce rail operating efficiency. Several provinces opposed altering the existing running rights provision. Other provinces favoured expanded running rights.

Competitive Line Rates
(sections 129-136)

A shipper located outside the 30-kilometre interswitching limit can ask the Agency to establish a competitive line rate (CLR) for moving goods over the originating railway to an interchange point for transfer to a connecting railway. As a precondition, the shipper must first reach an agreement with the connecting carrier for the balance of the movement. Several additional restrictions are attached to the use of CLRs: they cannot be used at both the origin and the destination and they cannot apply on more than 50% of the route or 1,200 kilometres, whichever is greater. The Agency bases the CLR on a combination of the applicable interswitching rates and the revenue the railway generates in moving the same or substantially similar commodities over similar distances. A CLR lasts one year unless the shipper and carrier agree otherwise.

CLRs were introduced in the National Transportation Act, 1987 and amended in the Canada Transportation Act. In the period 1988-1992, the National Transportation Agency established five CLRs: four in consecutive years were for the same shipper, and all five permitted access to U.S. mainline railways. Since the Act came into force in 1996, the Agency has received no requests for CLRs.

Shippers maintain that the precondition and restrictions on using CLRs constitute an effective barrier to the relief they believe the provision was intended to give them. As well, they point to two general restrictions on obtaining relief from the Agency (discussed later in this section under Legal Provisions Determining Agency Relief).

For their part, the railways suggest that CLRs are used mainly as negotiating levers rather than as a means to correct justifiable rate concerns. Moreover, they contend that the Agency's rate-setting methodology is flawed, since actual rail network costs are not fully compensated.

Level of Service Obligations
(sections 113-116)

Railway companies must provide "adequate and suitable accommodation" for the carriage of traffic. A shipper that believes a carrier has not met this service obligation can file a complaint. After review, the Agency can order the railway to fulfil the obligations in a manner, and within a time period, the Agency deems proper. Since 1996, the Agency has received 18 level of service complaints.

Shippers maintain that level of service obligations are the foundation for existing and any future competitive access provisions. Lower rates that might result from Agency relief are of little value without assurances of adequate service. Also, some shippers see delays — resulting from the Agency's inability to issue interim ex parte orders on level of service disputes — as undermining the provision's effectiveness.

Right to a Rate
(sections 118 and 121-125)

A shipper that wants to move traffic, over either a single line route or a joint route operated by two or more railway companies, can ask the company or companies to issue a rate for moving the traffic. If the company refuses (in effect declining the business), the Agency can order the company to publish a rate. If the rate is for a joint route, the Agency can also apportion the rate between the railways.

Since 1988, the Agency has received only one such request and ordered the railway to set a rate between an origin and destination determined by the shipper.

Final Offer Arbitration
(sections 159-169)

Final offer arbitration (FOA) is available to shippers as a means of resolving disputes with carriers over rates or conditions of service. The process involves an independent arbitrator reviewing the final offers of the shipper and the carrier and deciding in favour of one or the other. The parties to an FOA can, and often do, keep the details of the arbitration confidential.

Twenty-three FOAs have been initiated since 1988 when the provision first came into force — most of them since 1996. The Panel heard that more than half the matters submitted for arbitration were settled by the parties before the end of the arbitration hearing, suggesting that the availability of FOA is an incentive to reaching a negotiated settlement.

Although some shippers see FOA as an effective dispute resolution mechanism, the extended time and expense involved in what amounts to a complex legal procedure have been criticized. The FOA process was amended recently as part of reform of the grain handling and transportation system; now a quicker FOA process is available for disputes involving freight charges of less than $750,000. Both shipper and carrier must file final offers simultaneously, instead of the shipper filing before the carrier. There is not yet enough experience with the new regime to know whether perceived faults have been corrected.

The mainline railways suggest that the FOA process gives shippers, having already negotiated rates in good faith, a further chance to reduce rates at no risk. They want to see FOA replaced by standard commercial arbitration.

Confidential Contracts
(section 126)

Since 1987, shippers and railways that agree on rates and service conditions have been permitted to do so in a confidential contract. Before the NTA 1987, all rates had to be published. As well CN and CPR were permitted to set rates collectively. The effect was that CN and CPR acted together to compete against other modes of transportation; they tended to compete against each other on the basis of service rather than price.

The NTA 1987 began the process of freeing the rail freight business to act on a more commercial basis, where confidential contracting is the norm. Most rail traffic now moves under confidential contracts. Some shippers expressed dissatisfaction at being unable to compare carriers' rates.3

Revenue Cap on Western Grain Rates
(sections 147-152)

As part of the package to reform the western grain handling and transportation system that came into effect on August 1, 2000, railway revenues are subject to a cap — total revenue for moving grain in any crop year (August 1 to July 31) cannot exceed a set amount, based on volume and length of haul.

In effect a replacement for the previous highly regulated rate regime, the cap was to allow flexibility in grain transportation rates while simultaneously giving protection to farmers by constraining the total revenues the railways could capture from moving grain.4

With 2000-2001 being the first applicable crop year, there is very little experience from which to draw conclusions. However, neither shippers nor carriers have expressed satisfaction with the new rules. Differential pricing is permitted, albeit within the cap. Some parties allege that carriers are recovering forgone revenues by other means. Others say the expected rate reductions have not materialized. For their part, the railways see the cap as arbitrary and unwarranted.

Legal Provisions Determining Agency Relief
The Act contains conditions or tests that must be met before the Agency can grant an applicant's request. Two provisions figure prominently.

Substantial Commercial Harm
(sections 27(2) and (3))

To grant relief, the Agency must be satisfied that the applicant would suffer "substantial commercial harm" if the relief were not granted. Shippers believe the provision constitutes an undue burden and an effective barrier to the relief the Act is supposed to provide. Carriers argue that the test is appropriate and prevents shippers from securing regulated remedies in situations where competition is already present.

Commercially Fair and Reasonable
(section 112)

This provision states that any rate or tariff established by the Agency must be "commercially fair and reasonable to all parties". Shippers see the test as an unacceptable barrier to relief.

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Rail Freight Carriers and Users

The Economic Environment

Financially, the railways have made significant strides in the past few years, with the strong North American economy playing an important role. Many rail users, on the other hand, particularly rail-dependent shippers of bulk commodities like coal and grain, have experienced financial difficulty stemming from market conditions particular to their own sectors.

Keenly aware of this dichotomy, the Panel identified two issues in its interim report: the economic prospects facing the sectors served by the railways and whether the current financial situation of the rail industry is sustainable over an entire business cycle. Critical to an assessment of these questions is an understanding of the evolving economic environment in which shippers and railways operate. In the fully commercial system that has developed, the economic prospects of railways and users are inextricably connected; in this environment a key consideration is the sustainability of the favourable economic conditions of the past few years.

Bulk commodity producers, whose fortunes are so vital to the railway industry, have experienced considerable difficulty in recent years, the main problem being excess global capacity, causing heavy downward pressure on many commodity prices. These problems are not new. In inflation-adjusted terms, the prices of Canada's natural resource-based exports have been in decline since the 1970s.

With transportation costs a major component of the delivered price of bulk commodities, important consequences flow from continued pressure on non-oil resource prices: producers will continue to look for ways to reduce total transportation costs, so Canada's rail transport system must be as competitive and efficient as possible.

Public Policy, Regulation and the Rail Transport Sector

The transformation of Canada's railway industry over the past three decades had four distinct sources:

As discussed in Chapter 2, regulatory change occurred in three stages. The National Transportation Act of 1967 greatly increased commercial rate-making freedom, enabling the railways collectively to compete more effectively against other modes. The 1987 law eliminated collective rate making and introduced confidential contracts, enhancing and encouraging rate and service competition among railways.

The Canada Transportation Act of 1996 focused mainly on operational issues, most significantly giving railways greater latitude to rationalize their physical infrastructure. Barriers to the discontinuance of rail lines were lowered, and the establishment of short line railways was encouraged. By 2000, CN and Canadian Pacific Railway accounted for less than two-thirds of the rail trackage in Canada — much reduced from before — and a sizeable short line industry had come into being.5 Since 1996, both CN and CPR have concentrated on becoming high-density, mainline carriers, much as their U.S. counterparts had done in the early 1980s.

The impact of trade liberalization following the Canada-U.S. and North American free trade agreements was far-reaching, accelerating North American economic integration, spurring Canada-U.S. trade, and playing a lead role in Canada's economic expansion. From 1993 to 1999, Canadian exports to the U.S. grew by 13% a year and now acount for 87% of all Canadian exports. Imports from the U.S. grew by 11% annually over the same period.6

The evolving operational structures of CN and CPR reflect these economic and regulatory trends. Both railways have pursued strategies to strengthen their position in the U.S. market and create links onward into Mexico. Building on long-held U.S. subsidiaries and more recent acquisitions, CN and CPR are now integrated corporations on a continental scale. Transborder traffic and traffic moving within the continental U.S. now account for about half of their total revenues. CN and CPR have effectively become North American companies domiciled in Canada.

Operational and Financial Performance

Traffic Volumes
As the Canadian and world economies have expanded, so has railway traffic volume. Traffic growth has been sluggish, however, proceeding at less than half the rate for overall industrial production. According to Statistics Canada, growth in railway industry traffic, measured in both tonnes and tonne-kilometres, amounted to only 0.8% per year between 1988 and 1999; since 1996, when economic growth has been robust, tonnes carried has grown by 1.5% per year and tonne-kilometres by 1.7% per year.7

The explanation lies in the rail industry's continued dependence on the bulk commodity sector. Because of its inherent service flexibility, trucking has benefited more than rail from growth in the new economy, despite significant efforts by railways to attract a greater share of high-growth, high-value traffic. As well, trucking has been the main beneficiary of growing north-south flows.

Freight Rates
Elimination of collective rate making and introduction of confidential contracts in 1987 put considerable downward pressure on freight rates. As measured by average revenue per tonne-kilometre, average freight rates have declined significantly since 1987.8 For example, Transport Canada indices show that average revenue per tonne-kilometre declined by 10% in nominal terms and 26% in real terms between 1988 and 1999 (using the GDP deflator to adjust for inflation).9

Transport Canada's indices also provide information for various commodity groups. There are significant differences between groups, but the average freight rate indices show that rates for the decade beginning in 1988 declined or were stable for every commodity group except grain — the only regulated commodity (Figure 4.1).

These figures do not reflect the experience of all shippers. It is possible, for example, that a decline in average rates for a particular commodity group reflects falling rates for a relatively small number of large shippers and increasing rates for a greater number of shippers with smaller volumes. It was in part to fill this information gap that the Panel conducted a survey of shippers.10

Fig 4-1

Freight rates for grain bear a closer look because their course is tied directly to changes in regulation. From 1988 to 1995, rates for transporting grain declined, with most of the downward movement between 1993 and 1995. In 1995, new legislation altered the regulatory regime, eliminating grain costing reviews and allowing inflation adjustments. Since then, grain rates have climbed to a level higher than at any point in the last decade. Rates might decline again, however, under the revenue cap enacted in 2000.

Operating Revenues
The combination of sluggish volume growth and declining average rates has resulted in little growth in railway operating revenue since the late 1980s (Figure 4.2). The effects of the business cycle are reflected in revenue levels, especially during the early 1990s recession and late '90s recovery. Railway operating revenue in 1999, a peak year for the economy, was not much above its level in the late 1980s, the previous peak period.

Productivity Growth
The standard measure of railway fixed plant productivity is traffic density, usually measured by gross ton-miles per mile (or tonne-kilometres per kilometre) of track operated. Over the past decade, traffic density has grown by about 80%, with most of the gains occurring since the mid-1990s and implementation of the Canada Transportation Act.

The Measurement and Behaviour of Rail Freight Rates

Rail freight rate behaviour was a matter of sharp controversy during the Panel's review. The key results of the Panel's investigation are summarized here. A background paper (on the CD-ROM accompanying the report) explains the data and presents a detailed discussion.

Transport Canada indices. Revenue per tonne-kilometre (R/TK) indices show stable or falling freight rates on average across all major commodity groups except grain between 1988 and 1999. The indices are designed to avoid some of the statistical problems associated with the use of raw R/TK data.

  • The freight rate index for total traffic declined by 10% in nominal terms and 26% in real terms between 1988 and 1999. Raw R/TK data show the same result, suggesting no significant change in overall traffic mix or length of haul.
  • Between 1988 and 1999, the indices declined or were essentially stable for all commodity groups except grain, with major declines for chemical and petroleum products and iron and steel.
  • There was a major decline in the index for 'other bulk' commodities (which includes coal, potash, iron ore and non-ferrous metal ores and concentrates) between 1995 and 1999, primarily because of coal.
  • After declining by 7%, the index for grain increased by 11% between 1995 and 1999, reflecting elimination of grain costing reviews and regulation with an inflation adjustment, as well as removal of subsidies. This result also excludes any change that may be associated with the new revenue cap.
Panel's survey of shippers. Respondents to the survey — 47% of domestic carload users, 58% of transborder carload users, and 57% of intermodal users — said they had experienced freight rate increases over the period 1995-2000. The sample was small, however.

The results include shipper experience in 2000, which the Transport Canada indices do not. It may also be that a large number of small shippers are experiencing rate increases, but overall these are offset by declines in freight rates on larger-volume movements.

Pass-through of productivity gains. The evidence shows that a substantial portion of railway total factor productivity gains of recent years were passed on to shippers — about 40% between 1995 and 1999. Over the period 1988-1999, an estimated 75% of the gains in total factor productivity were passed through to shippers. The considerable pass-through of productivity gains suggests the presence of substantial competition, overall, in rail markets.

Fig 4-2

Revenue ton-miles per employee is the most common measure of labour productivity. In contrast to the surge in fixed plant productivity engendered by the Act, improvements in labour productivity have been more gradual.

Gains in traffic density and labour productivity are significant, but both chart output relative to just one input used in the production process and so do not provide a complete picture. A more appropriate measure is total factor productivity (TFP), calculated as the ratio of an index of all rail output to an index of all inputs.11

Between 1988 and 1999, the TFP of Canada's railways increased by 43% — with more than half the gain occurring since 1995 (Figure 4.3). The average sharing of productivity gains can be tracked by comparing TFP with a measure of input prices paid relative to output prices received, or total price performance (TPP). As railways face increased input prices, they must increase output prices, but competitive pressures limit their ability to do so. Productivity enables firms to absorb increased input prices. Comparing TPP and TFP shows both productivity and the extent to which that productivity is passed through, on average, to customers. Tracking TPP shows that before the mid-1990s, rail productivity was not sufficient to offset declines in average rail prices relative to prices paid for inputs, and railways were weakening financially. Between 1988 and 1999, about 75% of the productivity gains achieved were passed on to shippers. In more recent years, railways have retained a greater proportion — about 60% since 1995. Whether this trend will continue remains to be seen.12

Fig 4-3

Financial Performance
Profitability in the 1990s: The railways' significant progress in improving bottom line performance is evident in several indicators. A key statistic, long used to assess financial performance in transportation, is the operating ratio — operating costs as a percentage of operating revenues (Figure 4.4: since operating costs are the numerator and operating revenue the denominator, a decline in the ratio corresponds to an improvement in operating profitability.) In the space of nine years, 1991 through 1999, the combined operating ratio of Canada's two Class I freight railways improved from levels well over 90% to below 80%.

Also of significance, and evident in Figure 4.4, is how Canadian railways have improved their performance relative to that of their U.S. counterparts. Through much of the 1990s, U.S. operating ratios were routinely better than those of the Canadian Class I carriers. By 1999, however, this gap had closed, and Canada's railways posted results better than those of the U.S. companies.13

Fig 4-4

Profitability Compared to Other Industries
It is also instructive to compare railway profitability with that of other industries. Here too, different indicators are relevant; each has its own methodological limitations, but the measures are in broad agreement. Using either return on capital employed or return on equity, the conclusion is clear: even with the record results of recent years, railway profitability is comparable to but certainly not greater than that of other Canadian businesses (Table 4.5).14 At the same time, the response of the investment community reflects a positive outlook on the way railways are being managed in the face of present and future challenges.

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Rail Capital Expenditure Sustainability

The Panel's mandate included consideration of the overall effectiveness of the current legislative and regulatory framework in sustaining the high levels of capital expenditures required to enhance productivity and promote innovation. At the same time, there is an important overlap between capital expenditure sustainability and competitive rail access. Measures to enhance competitive rail access could have an impact on capital expenditure sustainability, an issue the Panel identified in its interim report.

Fig 4-5

Concern about capital expenditure sustainability arises from a simple reality. A study undertaken for the Panel estimates that the Class I freight railways will need to make capital investments of about $1.3 billion in each of the next five years just to renew depreciating assets.15

Historical Capital Spending

Figure 4.6 summarizes the railway industry's net capital investment between 1955 and 2000.16 It shows how challenging capital sustainability will be: in 27 of the 44 years shown, the railways invested less than the level needed just to maintain their capital stock. In the decade between 1985 and 1995, the rail system's capital depreciation exceeded investment every year by a figure ranging from $100 million to $700 million; 1997 was the first year since 1985 that investment exceeded the level of depreciation.

Rail Freight Carriers and Users — Highlights

  • The succession of legislative and regulatory reforms begun in 1967 and accelerated in 1987 and 1996 is responsible for the resurgence of the Canadian railway industry and its renewed ability to provide efficient and effective services.
  • Gains in operational efficiency and financial health came about through major improvements in productivity spurred by reorganization and rationalization.
  • Railway profitability is comparable to but no greater than that of other Canadian businesses. These results are recent, however, and were achieved in a period a high economic growth generally.
  • Financial results at CN and CPR compare well with those of their U.S. counterparts.
  • The shippers on which railways depend most — bulk commodity producers — have been under considerable financial pressure recently, chiefly because of long-term decline in non-oil bulk commodity prices.
A central question facing policy makers is whether the current, comparatively favourable circumstances of railways can be sustained. Railways' current health is a recent phenomenon, and rail's ability to weather an economic downturn in its current configuration is untested. Public policy changes and the economic boom helped create the current situation, but their effects must inevitably run their course.

Productivity and profitability gains may be harder to achieve in the future than they were in the past. Large cost savings were achieved by reducing miles of track and numbers of employees. New efficiencies may have to be found in less immediately fertile ground — improved management of existing physical and human assets and capital investments in technology and infrastructure.

This uneven pattern of investment occurred in the context of railways' unique characteristics as capital users and change in the policy, legislative and regulatory regime.

Railways are among the most capital-intensive businesses. Capital invested in railways is relatively immobile for the short and medium term. This provides a significant barrier to the entry of new competitors on specific corridors and injects an element of caution into significant new investments by existing companies. However, it also permits large profit gains as traffic density rises.

There is also a considerable lag between the time capital is invested (or assets are depreciated) and when productivity improvements (or evident decay in the system) occur. Railways could be subject to years or even decades of under-investment before obvious system failure; likewise, years of sustained investment are usually required to make up for past neglect.

Fig 4-6

Impact of the Regulatory Environment

Each successive public policy milestone influenced the railways' ability to obtain capital. The National Transportation Act, 1987 opened the railways to rate competition but did not allow them to dispose easily of unprofitable lines or otherwise restructure, so that costs remained high. Combined with the economic downturn in the early 1990s, capital spending fell well below levels of depreciation and stayed there for the next decade.

When CN was privatized by the CN Commercialization Act of 1995, it suddenly gained shareholders who expected a return on their investment. For the first time, CN had to address the same cost-of-capital price signals as its main competitors, and the government was no longer the guarantor of debt. That year also saw an end to most federal subsidies to shippers. With few exceptions, railway revenues would now come from shippers hiring their services at commercially negotiated rates. Since then, the share price response has reflected confidence on the part of investors that the railways are being managed successfully.

The next milestone, the Canada Transportation Act of 1996, allowed railways to dispose of rail lines as business, not regulated, decisions. The positive impact on the bottom line was felt immediately and has continued, assisted by a buoyant economy. The mainline railways shed unprofitable lines, increased traffic density, and rehabilitated operating ratios from near-disastrous levels, in the process turning unattractive commercial investments into plausible ones. The Act's new approach to rail line disposal effectively stimulated the short line industry.

Since 1996, the mainline railways have made significant new investments in their systems, with almost all the funds coming from revenues and relatively little from the debt and equity markets.17 Unlike other modes, railways own almost all the infrastructure they use. Since the government's withdrawal from rail ownership and most subsidies, railways and their investors have been the only sources of new capital for maintenance or expansion.

Capital Uncertainties

Economic Prospects
With cash flow as the predominant source of capital for railways, the availability of capital is extremely sensitive to both overall economic demand and sectoral variations. Current medium-term forecasts generally see overall economic growth continuing. Although railways should be able to continue to fund investment from cash flow, certain risks — emanating from the economic and competitive circumstances facing bulk commodity shippers, the possibility of an extended economic slowdown, or more modest economic changes such as shifts in the mix of traffic being moved — could cause unanticipated reductions in revenue.

Investment Beyond Maintenance Levels
The $1.3 billion for annual capital investment mentioned earlier covers only straight-line depreciation; it does not allow for normal volume growth, major improvements in productivity or new technologies. The character of railway investments changed significantly in the late 1990s, as compared to the previous decade. A large proportion of more recent spending was in areas such as information systems and new locomotives and freight cars. This trend is likely to continue. Much of the railways' productivity gains in the mid- to late 1990s came mainly from rationalizing infrastructure. Finding opportunities for further rationalization will be more difficult. Future productivity improvements are far more likely to arise from significant and sustained investment in new systems, equipment and innovative technologies.

Ability to Attract Investors
The Class I freight railways have only recently approached performance figures in line with those of their U.S. counterparts and other businesses. They will be challenged to demonstrate that they can perform adequately through less robust economic times.

The Policy Environment
Canada's rail freight industry has emerged only recently from a tight regulatory embrace. Because the financial health of the rail sector is recent as well, the future legislative and regulatory environment takes on additional importance from the perspective of potential investors. How the government addresses the cluster of policy issues — potential rail mergers, taxation, proposals for rail access, and the grain regime — will all feed into investor calculations about CN and CPR.

Short Line Railways and Capital Investment

An important by-product of the Canada Transportation Act was a short line rail sector that has evolved to become a vital element of the national rail freight system. Short line operators are important to customers because they offer choice in access or access where the alternative was no rail line at all. In addition to providing some local service, short lines are also important to mainline railways as feeders and collectors connecting to their own higher-density operations. Large rail company or small, the capital sustainability issue is the same: as inherently intense consumers of capital, railways need to be able to maintain an investment pace sufficient to maintain system performance and enhance productivity.

In comparison with CN and CPR, the nature of the short line industry and its limited history make a solid understanding of capital sustainability more elusive. However, by their nature, many short lines are low-traffic-density operations. Profits are marginal.

Very little direct information is available on capital spending by short line railways. For the most part, however, short lines need to invest in track renewal and upgrading. Many are already engaged in such programs. In the coming decade, short lines will need to replace or rebuild many of their locomotives. The most challenging capital expenditures facing short lines in the coming years are those required to upgrade track structures to handle the new mainline standard of 286,000-lb. freight cars. Many short lines lack the traffic base to accommodate such investments, and it remains to be seen what will happen to railways that cannot afford to upgrade to handle heavier cars.18

As with the Class I railways, the principal source of funds to renew short line assets is future earnings. Potential investors look for a diverse traffic base, reasonable prospects for growth and a solid relationship with a long-haul rail partner.

Some short lines have reported traffic increases since taking over from CN or CPR and have developed long-term reinvestment plans. Others have faced financial crisis because an important shipper has closed operations, or because of unanticipated and unavoidable major expenses. Still others can eke out a profit sufficient to stay in operation but are unlikely to survive in the longer term if essential spending cannot be funded and operating capacity degrades. In a few instances, capital renewal is not commercially justified, but municipalities — sometimes in conjunction with shippers — have stepped in to maintain a railway line while contracting out day-to-day operations to a short line operator.

Absent sufficient funds generated directly from revenues or investors, the options are few. Provincial governments have provided some capital funding for short lines. Saskatchewan, Ontario and New Brunswick have provided some assistance with start-up costs or directed funds to specific projects. Quebec has a program to match private investments in short line capacity rehabilitation and expansion. Another potential source of funds is the long-haul partners, though this option has yet to make itself felt to any significant degree.

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Conclusions

Economic and Financial Prospects

Inherent in the task of providing policy guidance is the need to anticipate future circumstances and events about which only prudent guesses can be made. One of the biggest unknowns is the financial prospects for the railways and their users. Canada's Class I freight railways are viable commercial firms for the first time in many decades. The railways' most important customers are operating under severe financial constraints, however, and will likely continue to do so. Railway revenues from those sources appear to have little upside room. Meanwhile, in their current configuration as fully commercial enterprises, the railways have prospered in the comparatively easy circumstances of a strong economy. A responsible regime must anticipate that the railways' revenues and profits will fluctuate as the wider economy follows the inevitable business cycle.

A second note of caution stems from understanding that a large proportion of the railways' productivity gains of recent years came through one-time cost shedding and restructuring of physical assets. Future efficiencies may come more slowly and at a higher investment cost.

The Panel's message is that policy makers and legislators can count on neither large reservoirs of railway profits nor great gains in operational efficiency to maintain an effective, competitive rail system. Balancing user demands for lower rates with the railways' need for revenues sufficient to maintain the system will not be easy. The Panel believes that the overarching policy goal should be to build on the new-found vigour of the rail system, target the problems that persist, and resist sweeping measures that hold the potential to create more difficulties than they solve.

Capital Sustainability

The Panel believes that Canada's mainline railways are now well positioned to make the capital expenditures needed to sustain and improve their systems, a finding that could not have been made a decade ago.

The last few years have seen a significant surge in capital investment. The railways have sensed an improved investment climate, with CN privatization and the Canada Transportation Act providing freedom to manage assets. Capital expenditure sustainability must be evaluated over the whole business cycle, however.

Another important influence is taxation. There are two issues: taxation of railways compared to other industries, and rail taxation levels in Canada compared to those in the United States.

Railways face the same income tax rates as other industries, but questions have been raised about capital cost allowances for amortizing investments. The latter are particularly important in comparing taxation in Canada and the U.S. For example, rail cars and equipment are depreciated more slowly in Canada. Railways are also subject to municipal property taxes and fuel taxes levied by provinces. This is relevant in comparing taxation levels for railways and road transport. Because road infrastructure is publicly provided, no equivalent of property tax is paid on that infrastructure. Road users pay fuel tax, but it is widely regarded as a user charge for road infrastructure, whereas provincial taxes on rail fuel have no such rationale.

A number of studies conclude that railway taxation levels are higher than levels for other transport modes and higher in Canada than in the U.S. The competitiveness and profitability of Canadian railways would be enhanced by a more level playing field. Taxation is not the responsibility of the Minister of Transport, but it is an outcome of policies of all three levels of government that adversely affects rail relative to other modes.

The issues of differential pricing and competitive access cannot be separated completely from the issue of capital sustainability. The Panel urges care in addressing pricing and competition issues. In considering competitive access proposals, their impact on capital expenditure sustainability must be weighed carefully. There is ample evidence in both Canada and the United States that poorly crafted regulatory policies can threaten capital sustainability, ultimately damaging the very parties the policies were designed to help. The profits and capital expenditures of recent years can not be used as an excuse to alter the balance unreasonably between shipper and railway interests. Indeed, in the long run, the interests of railways and shippers are the same.

Concerning the short line sector, it is evident that whatever shortfall there might be in capital formation, significant modifications to the current regulatory regime do not offer a solution. The ability of short lines to generate sufficient capital depends almost entirely on their success in generating sufficient traffic and revenues, not on one or another of the regulatory instruments now available or proposed. The Panel notes, however, that individual short lines may be more vulnerable than the mainline railways to the financial impact of any single regulatory decision (especially regarding running rights or freight rates), since a short line's single shipper may account for as much as a third of the short line's total traffic.

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Notes

1 For a discussion of differential pricing, including its relevance to competitive rail access, see the background paper on the CD-ROM accompanying this report.

2 Under certain circumstances — application by the shipper and subject to the 'substantial commercial harm' provision, the Act permits interswitching at distances greater than 30 kilometres.

3 Where a confidential contract exists, the shipper is precluded from using FOA unless all parties to the contract agree. The terms of the confidential contract are binding on the Agency in the event of a level of service complaint.

4 Previously, the Agency set a maximum rate scale based on the distance grain would be transported. The rate was adjusted annually to reflect changes in an index of railway costs.

5 Transport Canada, Transportation in Canada, 2000 Annual Report, p. 81.

6 Transportation in Canada, 2000, p. 63.

7 In comparison, industrial production as measured by Statistics Canada increased at a rate of nearly 2% per year from 1988 to 1999 and 3.7% per year between 1996 and 1999.

8 Average revenue per tonne-kilometre or per ton mile is a standard measure of the average rates railways receive from the sale of services.

9 The trend in raw revenue per tonne kilometre data is corroborated by the indices developed by Transport Canada, which standardize the mix of commodities and length of haul and are designed to avoid the measurement problems associated with the use of raw revenue per tonne kilometre data. The Panel acknowledges that revenue per tonne kilometre is an imperfect measure. It can be affected not only by changes in freight rates but by changes in the mix between high-yielding and lower-yielding traffic, by changes in the length of haul, and by other factors. Despite these imperfections, the Panel believes the measure provides useful insight into overall rate trends. A full discussion of the issues relating to the measurement and behaviour of freight rates appears in a background paper available on the CD-ROM.

10 The results are discussed in a background paper, available on the CD-ROM, in conjunction with a discussion of the Transport Canada freight rate indices.

11 Total factor productivity for the Canadian railway industry is discussed at some length in the background paper on freight rates on the CD-ROM.

12 This is discussed in greater detail in a background paper on the CD-ROM.

13 Deterioration in U.S. railway operating ratios during the late 1990s period of high economic growth reflects difficulties resulting from mergers and restructuring.

14 Return on capital employed is the ratio of operating income to average capital employed, where the latter is frequently defined as the sum of long-term debt (including the current portion) plus shareholders' equity. Return on capital employed has the advantage that the numerator, operating income, reflects the underlying income-generating capability of the business itself and is not affected by how the firm chooses to finance its operations through debt or equity. Return on equity is the most basic accounting measure of profitability, because it is the one most directly related to shareholder value creation, the main goal of the firm. Using return on equity as the basis of comparison between firms or industries is difficult, however, because it is affected by how the firm chooses to finance its operations, which can vary greatly, and also because return on equity reflects the numerous special and extraordinary items that can affect a firm's net income, as opposed to its operating income.

15 The Conference Board of Canada, "The Effectiveness of the CTA Framework in Sustaining Railway Capital Spending", paper prepared for the Canada Transportation Act Review (CTAR), March 2001.

16 These expenditures are net in the sense that the data in the figure represent the new investment after subtracting the consumption of railway assets as represented by depreciation. All data are expressed in constant 1992 dollars and represent depreciation considerably higher than what the railways report each year. Using embedded historical asset values will understate the capital expenditures required to replace assets as they are consumed. For example, an asset purchased 20 years ago for $100,000 would require considerably more than $100,000 to replace it today.

17 The Conference Board of Canada, The Effectiveness of the CTA Framework.

18 Research and Traffic Group, "Sustaining Capital Requirements for the Short Line Railway Industry", paper prepared for CTAR, February 2001.

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