Coal Transportation by Railroad – In a Regulatory World Unlike FERC -by- Michael F. McBride

1. Coal Transportation by Railroad – In a Regulatory World Unlike FERC-by-Michael F. McBride Energy Bar Association Meeting Washington, DC December 3, 2009

2. Coal and the Railroads – An Overview • Coal is 50% of electricity generation – but will it last? • Railroads haul 71% of the coal for electricity. • Coal is 40% of railroad tonnage, 20% of revenues, but a substantial percentage of the railroads’ net income (due to low unit costs). • No coincidence that the four largest U.S. railroads – BNSF, CSX, Norfolk Southern, and Union Pacific – are the four-largest coal-carriers. • The regulatory system is largely broken, with BNSF described as “revenue-inadequate” by the STB a week before Warren Buffett agreed to pay an $18 billion acquisition premium for it!

3. Overview (Cont’d) • Under current STB precedents, the BNSF acquisition premium will lead to higher asset values, lower BNSF’s perceived return (making it more “revenue inadequate”), and make more BNSF rates immune from STB regulatory scrutiny (by effectively raising the STB’s “jurisdictional threshold” of 180% of “variable costs”). • The STB uses “stand-alone costs” for its rate standard for coal cases. Most complex standard possible. • SAC cases cost more than $5 million – and years -- to present. • Yet railroads are immune from the antitrust laws to the extent they are “subject to regulation.” • Legislation is being considered to change some of this.

4. Why Is Railroad Transportation of Coal Important? • The U.S. mines over 1 billion tons of coal annually. • Most coal is used to produce electricity. • As of 2008, 50% of electricity comes from coal (http://tonto.eia.doe.gov/energyexplained/index.cfm?page=coal_home#tab2); gas is 20%. Coal will remain a substantial percentage of the mix for decades. • Until recently, EIA actually forecast the percentage of electricity from coal would increase to 58% by 2030. Now, the forecast could be much lower – 32% -- IF a substantial number of nuclear plants come on line. • Railroads carry, at least some of the way, 71% of coal to power plants. (http://tonto.eia.doe.gov/energyexplained/index.cfm?page=coal_mining

5. The Railroads’ Share of Delivered Coal Prices • Rail share increased in recent years, because Western coal (primarily Powder River Basin (PRB) in Wyoming and Montana) is most economical and abundant source of low-sulfur coal to comply with the CAA. Trains are typically 100 cars or more. • Some coal is used at mine-mouth, and moved by conveyors or special over-sized trucks. Some moves by barge or truck, or even pipeline. Still, railroads predominate. • And, given distances, rail costs are typically significantly more than 50% of the delivered cost of Western coal (sometimes as high as 80%). In the East, transportation is a lesser percentage of the delivered cost than in the West, but it is often over 30% of the delivered price (despite higher coal prices in the East), and has been increasing due to higherand higher rail transportation rates.

6. Railroad Monopoly Power Is Increasing • Rail monopoly pricing power is increasing – rates increasing at amounts greater than inflation (4-6%), even though overall volumes of coal transported by rail have been down during the recession. Who gets the “monopoly rents?” and “Where is the regulator?” • For almost 25 years, the ICC (now known as the Surface Transportation Board, or STB) has set rail rates for “captive” traffic at the highest level economists could justify. And, contract transportation is not regulated. • To be fair, some “differential pricing” was adopted in the Staggers Rail Act of 1980, to eliminate federal subsidies of the railroads, and so as to reduce regulation of railroads. • But competition was supposed to prevail “to the maximum extent possible,” and rates were to be regulated only where no competition. Instead, much competition was lost due to mergers, switching barriers, and contractual restrictions.

7. Why Is Rail Monopoly Power Increasing? • There were over 40 large railroads in 1980, whereas today 4 large railroads carry over 90% of the freight. • It is no coincidence that the 4 largest U.S. railroads are the ones that carry over 90% of the nation’s coal. As Willie Sutton would say, “That’s where the money is!” • Coal represents approximately 20% of the U.S. railroad industry’s gross revenues. Coal rates are considered among the most profitable, and account for the largest percentage of the railroads’ net income by commodity. • The STB also allows the railroads to use other anti-competitive rate quotations (no “bottleneck rates”) and operational practices (“paper barriers”).

8. What Is Regulated? • Only “captive” traffic regulated. The statute says that a railroad may charge “any rate” unless an “absence of effective competition.” • If no competition, the rate must be “reasonable.” • The Western railroads, at least, generally concede that there is “an absence of effective competition” for coal movements. • So the STB usually has jurisdiction to set the rate.

9. What Is a “Reasonable” Rate? • What is a “reasonable” rate? Complex problem, because some traffic is captive, and some is competitive. Differential pricing is therefore needed. • In The Economics of Regulation, Professor Kahn opined that the highest rate any captive customer should ever be charged is the “stand-alone cost” rate, or SAC rate. • The railroads convinced the ICC, in Coal Rate Guidelines, Nationwide, 1 I.C.C.2d 520 (1985), aff’d sub nom. Consolidated Rail Corp. v. ICC, 812 F.2d 1444 (3rd Cir. 1987), to use the SAC test for determining maximum “reasonable” coal rates, and it is still the test used today.

10. The “Stand-Alone Railroad” • Shipper must “construct” a “stand-alone railroad,” or SARR, which is the basis for determining a SAC rate, is constructed (on paper) using either the existing route and existing traffic or a more efficient route (as the Complainant chooses). • Generally, the Complainants use the existing rail routes. • The Complainant uses current costs for the assets, and offsets as much of the total costs as possible by the revenues from all traffic other than that at issue. • The Complainant must satisfy the STB that its “operational plan” for the SARR will work.

11. Why Is Rail Transportation Such a Large Percentage of the Delivered Price? • If the SARR will collect more total revenues than its costs, including a reasonable return, over 10 years, relief is available. • But, such relief available to few coal shippers in recent years, for various practical reasons. • Those who prevail have had to pay over $5 million – in one case, almost $8 million – to present a case. The filing fee alone was over $170,000 until Congress stepped in, temporarily, to cut it to $350. • So, the deck is stacked in favor of the railroads, especially for coal rates.

12. Regulatory Picture -- High Rates • Eastern cases were uniformly lost because the SARR in the East is not as efficient (but a new one, for Seminole Electric v. CSX, is pending review; will it work?). • Some Western cases were being won, until the STB altered its SAC test to look at “segments”. PPL Montana and Otter Tail Power Company lost despite high rates. (DC Circuit affirmed PPL Montana.) • Now, the rules revised, so the “jurisdictional threshold” (R/VC = 180%) is so high that the SAC rate is sometimes below that, and the rate is therefore set at 180%. Recent examples: KCP&L v. UP and OG&E v. UP. No judicial review due to stipulations. • In another recent case, the SAC rate was set at an R/VC ratio of 240%, yet Basin Electric still won reparations of $345 million from BNSF. (Review pending.)

13. Recent STB Coal Rate Cases

14. Derailments and a New Regulatory Issue – Coal Dust • New challenges: two derailments in 2005 in the PRB – UP and BSNF blamed coal dust (“trespass!!”). • FERC held hearing in 2006 on impact on reliability. • Some utilities, public power entities, and coops wonder if the way the PRB was constructed and maintained may have been the problem. In May 2009, BNSF put coal dust “emission limits” in a tariff, and the matter is now before the STB. • STB considering revising its costing system, which may delay rate decisions and shift costs to hazmat (and coal, if maintenance costs are higher than thought). • Coal shippers believe they’ve already paid for maintenance, and that their shipments are the most efficient on the railroads.

15. Warren Buffett, Acquisition Premiums, and the BNSF Railway • The recent offer by Berkshire Hathaway to buy all of BNSF Railway at a premium of about 30% is in part a bet on coal for a while to come. • Believe it or not, BH does not need STB approval to acquire BNSF, because it does not “control” any other railroad. • And, believe it or not, but previously, the STB refused to take regulatory action to protect customers from substantial premiums, even with Alfred Kahn explaining why it is bad public policy to permit them to affect asset valuations.

16. Legislative Efforts--Antitrust • Railroad Antitrust Enforcement Act of 2009, S. 146/H.R. 233 • S. 146 reported to full Senate on March 5 by vote of 14 – 0. Key elements of S. 146 will be included in the STB reform legislation being drafted by Chairman Rockefeller. • Provisions included in Senate regulatory bill. • H.R. 233 passed the House Judiciary Committee on September 16.

17. Regulatory Legislation • Senate Commerce Committee “consensus” legislation to change regulatory rules – but the SAC test apparently will remain • Railroads will likely have to quote “bottleneck rates,” but at what price (i.e., will “lost contribution” be kept)? • Anti-competitive contracts may be outlawed, but they likely will be subject to increased regulatory scrutiny. • “Reciprocal switching” (i.e., switching) may be improved (cost-based?), but generally not a coal issue. • House T&I Committee – probably will also have a bill, but we don’t know what the contents will be. Past bills similar to Senate bill. • Legislative environment is favorable to a bill, especially with current Chairmen, but lots of competing matters occupying the Members. • Senator Rockefeller wants to get this resolved in this Congress.

18. Legislative Issues • Should the STB be a more aggressive regulator? • Should railroads be required to be more competitive? • Does increasing “revenue adequacy” mean that less differential pricing is needed than before, so that ratemaking could be simplified? • Or will railroads succeed in preserving the existing system, including treatment of acquisition premiums? • And will the antitrust laws apply to railroad actions that theoretically could be regulated? • Stay tuned. This has been a battle for 25 years, but it may be nearing a resolution.

19. Questions? • For more information, please feel free to call: Michael F. McBride Van Ness Feldman, PC 1050 Thomas Jefferson Street, NW, Suite 700 Washington, DC 20007-3877 (202)298-1989 mfm@vnf.com