How Federal Railroad Policy Got Derailed

In Conrail and the 4R Act, Congress has created rolling disasters.

The federal government's two-year-old railroad policy is coming apart at the seams. Congress has already moved to patch it up, and major policy initiatives will probably be forthcoming within a year.

The Railroad Revitalization and Regulatory Reform Act of 1976, hailed by some as deregulation and scorned by others as a prelude to railroad nationalization, set out to rehabilitate and restructure the railroads "…so that this mode of transportation will remain viable in the private sector of the economy and will be able to provide energy-efficient, ecologically-compatible transportation services with greater efficiency, effectiveness, and economy." A combination of federal money and reforms was aimed at reorganizing seven bankrupt Northeast railroads, easing the regulatory burden, and slimming down the railroads' overbuilt network of trackage. The results have been somewhat less than overwhelming.

CONRAIL COMES BACK FOR BILLIONS MORE

The main challenge confronting the drafters of the "4R" Act was the dire situation in Northeast railroading, where decades of neglectful and punitive government policy had culminated in the bankruptcy of seven lines, including the mammoth Penn Central. Previous legislation, the 1973 Regional Rail Reorganization Act (or "3R" Act), had designated a United States Railway Association to come up with a unified reorganization of these railroads, but most of the particulars of USRA's plan remained unclear as of 1975. The final system plan and the 4R Act emerged in tandem, and what resulted was a Consolidated Rail Corporation funded with federal "investments" of $2.026 billion. That amount proved too little, for in April of this year Conrail came back to the federal well for an additional $1.283 billion in assistance and possible federal guarantees for $959 million more to be sought on the private loan market.

At this writing Conrail appears set to receive $1.274 billion amid USRA's announced fears that as much as $3.8 billion over and above the original federal "investment" could be needed. Some of the assumptions used in Conrail's latest projections are, if defensible, still optimistic. The railroad expects to reduce labor costs, which currently consume over 60 cents of every revenue dollar, by $500 million through 1982. Conrail assumes that if the 4R Act's employee protection funds run out, as seems likely, protection payments will not have to be paid by the company; likewise, that new taxes to prop up the Railroad Retirement Fund will not burden Conrail. Its management is counting on new measures to ease railroad regulation, and they assume that compensation paid by states and localities for Conrail operation of commuter trains and light-density branchlines will cover full costs.

If these assumptions don't hold up, the likelihood that the railroad will repay the government's "investment" and return to the private sector, as USRA intended, is greatly diminished. And the railroad's poor performance to date makes optimistic assumptions seem all the more unrealistic.

We can no longer simply attribute Conrail's shortfall to rail "mismanagement." For one thing, Congress has to shoulder the blame for some mismanagement of its own. When the 4R Act was signed into law in early 1976, Congress had narrowed down the proposed reorganized rail systems to two. The first choice, known as the "Three System East," would have sold strategic portions of the bankrupt rail lines to the Chessie System and the Southern Railway, two solvent railroads which compete with Conrail. The second choice was "Unified Conrail," incorporating most of the bankrupt trackage. Labor negotiations necessary for the Chessie and Southern transactions never came off, and Unified Conrail became reality on April 1, 1976, boosting Conrail's up-front costs from $1.85 billion to $2.026 billion. In the ensuing Congressional appropriations process the increased cost was simply robbed from a $250 million Conrail disaster fund included in the 4R Act's original authorization of $2.1 billion—leaving only $74 million, none of which was appropriated. Then $350 million worth of disasters hit: the Johnstown flood, the longest coal strike in history, and two hard winters. Up went Conrail's "shortfall."

Conrail has largely thrown off the "mismanagement" onus. Recruiting from seven Northeast railroads and outside industry, Conrail has assembled a respected management group who seem to have staked their personal reputations on Conrail's return to the private sector. The railroad accomplished its April 1976 transition without the clashing gears which marred the 1968 merger of the New York Central and Pennsylvania railroads into the Penn Central; this time the computers talked to each other, cars were kept on the move, the bills were paid. During 1976-77 Conrail's operating deficit approximated the $567 million forecast for the period (though the long-term projections worsened), and the railroad outdistanced the track rehabilitation goals set for it. Shippers have been expressing hesitant praise for Conrail's attentiveness, and rail competitors are publicly irked by Conrail's improved marketing.

PERFORMANCE STILL SAGS

But despite management effort, performance has continued to sag. Since April 1976 the fraction of locomotives out of service has mounted from 13 percent to 22 percent, and for freight cars the figure rose last year from 12.8 to 13.8 percent. Conrail's freight car utilization—a key indicator of the productivity of money invested in rail operations—has slipped 13 percent from projected levels. The railroad does not appear likely to achieve the 28 percent improvement in utilization which USRA originally targeted for 1981. Conrail and USRA now agree with those who predicted in 1975 congressional testimony that the 28 percent target was optimistic.

Such errors cost. In Conrail's recent business plan for the period 1978-82, cash flow from operations falls short of USRA projections by $1.8 billion. About 25 percent of that shortfall owes to the lower than expected number of serviceable freight cars inherited by Conrail, and another 25 percent to traffic levels which are now missing USRA targets by about 10 percent. The remaining half of the shortfall results from sagging car utilization. Even though the railroad's volume is down, the lower utilization rate requires a higher number of freight car acquisitions. The railroad is also forced to pay out large sums of money to "rent" other railroads' freight cars detained on Conrail, a fleet of cars that often exceeds the number Conrail owns. All agree that substantial gains in car productivity must be racked up if Conrail is to avoid further sizeable shortfalls. Princeton University's transportation center, testifying before Congress in 1975, predicted that if USRA's projected 28 percent utilization improvement were not to be achieved Conrail could need as much as $5.38 billion from the government.

Conrail's critics, bolstered by a recent General Accounting Office report on freight car productivity, are demanding that the railroad immediately implement a new operations control system and improvements to shops and yards which could speed the flow of cars. Conrail, now in the midst of reorganizing managerial responsibility for car utilization and set to spend the first $14 million towards the operations control system, couldn't agree more that an integrated control system, computerized routing, and rehabilitated facilities would all be helpful. But officials are still plainly a bit taken aback by the complexity of instituting the $60 million system demanded. They see it taking four years to implement; no benefits will be realized until half the railroad is covered. Likewise, various improvements to physical facilities have been delayed due to the complexity of the cost/benefit tradeoffs involved.

All of which raises a question largely buried under the 4R Act's rhetoric: Is Conrail too big to be managed? Are good intentions, a skilled management, and massive rehabilitation enough to make a 17,000-mile, 90,000-employee railroad work?

POLITICS VS. ECONOMICS

This is a question which haunted those who drafted the 4R Act and its predecessor legislation. Congress wanted it both ways—political forces wanted the reorganized railroads to emerge as a company or companies which could survive on the open market, but no politician was content to let the market determine the size and structure of the rail reorganization. The same marketplace auction of railroad assets which would have conclusively defined the efficient shape of the reorganized railroads would, after all, have also delivered the coup de grace to approximately 12,000 miles of little-used track in the Northeast. Rather than permit this, Congress created USRA and instructed it to produce a plan for a "competitive" and "efficient" rail network.

Somewhere out there lay the nucleus of the rail system which the open market would truly sustain. Larger or smaller than Penn Central, one or several companies—which, we do not know. The bankrupt railroads and their predecessors could hardly serve as models for the reorganization; one cannot even call them the product of a free market. What seems to be relevant to today's market for railroad services—a highly decentralized management focused on profit-and-loss between individual terminals—could perhaps thrive in either a large or small railroad, but not with federal rules and dollars propping up old ways of operation. In any event, only a truly free market could have produced a sustainable reorganization.

Political forces, on the other hand, inexorably led USRA to settle for tinkering with old railroad maps. Under continuing pressure to reduce federal investment in "duplicating" railroads USRA ultimately acquiesced in the obvious: Unified Conrail. Now Conrail suffers the problems of size; it cannot get managerial decisions consistently implemented down the line. One industrial shipper quoted recently in a Railway Age traffic poll echoed many Conrail shippers when he said, "The attitude is good, but the system is not responsive to customer needs because of the size of the organization."

What then? Perhaps the "continuing reorganization" provided for in the 4R Act and hinted at in Conrail's recent business plan. The railroad's increasing willingness to work with shippers owning their own trains and the ongoing management reorganization both tend towards greater decentralization of profit responsibility. One major USRA study of Conrail freight operations suggests that the net effect of this should be for marketing departments to break away from the physical structure of Conrail, link up with similar departments of other railroads, and organize interline freight services independent of company route structures.

How Conrail fares will affect the taxpayer long after the present appeal for additional funding. Waiting in the wings are the owners and creditors of the estates of the seven bankrupt railroads who were, in exchange for 48,000 miles of track, 400,000 acres of land, 185,000 pieces of rolling stock, and 4,000 buildings, given preferred and common Conrail stock subordinated to the government's prior claims. Accompanying the stock are "certificates of value" which guarantee that in a federal court proceeding still a decade away the holders will be given at least a "constitutional minimum" of compensation for assets conveyed to Conrail. If Conrail performs poorly and their Conrail stock commands little, the US Treasury must make up the difference between the stock's worth and the constitutional minimum promised by the certificate of value. The amounts involved remain unclear, of course—depending as they do upon current litigation surrounding the legal minimum valuation of railroad assets and on Conrail's performance. While the court handling the matter recently described creditor claims in the billions of dollars as "fantasy," the final amount could easily be several times the $685 million allocated by USRA for conveyance assets.

REGULATORY REFORM LAGS

Analysts in the Ford administration saw as few others did that the prime cause of the Northeast railroad problem was regulation. To secure the Conrail reorganization and prevent future railroad bankruptcies elsewhere, they resolved to lift some of the Interstate Commerce Commission's burdensome restrictions, in the second of the three major thrusts of the 4R Act. As the legislation approached passage, an internal Department of Transportation memorandum announced "reasonable success" in preserving the bill's "regulatory reform" from frantic attacks by various transportation interests. The memo writer continued, though: "The ICC is unhappy with the whole thrust of the legislation and would be most pleased to see it undone…the Commission is left with a large amount of discretion which could be used to frustrate the overall objective of the legislation.…We must…await the ICC's action in implementing the various reform provisions before declaring a victory."

This proved to be prophecy. With only a handful of railroad freight rates having been filed with the ICC under the reformed procedures, DOT lamented in October 1977 that "the caution of the railroad industry in using the new provisions, the time required to promulgate new standards and procedures, and the interpretations given certain crucial 4R Act provisions by the Congress, preclude a full test of the attempted reforms within the 20 months since passage of the Act." DOT criticized the ICC for implementing reform provisions "in ways that discourage, rather than encourage, the railroads from using the ratemaking flexibility the Congress sought to accord them."

What were these regulatory reforms, and how were they derailed? First, railroads were freed to lower freight rates down to the variable costs of providing the service, and amendments were made to the ICC's authority which prohibit the agency from engaging in "umbrella ratemaking"—the practice of holding up one carrier's rate levels to protect the traffic of a competitor. On the other side, the 4R Act removed the Commission's authority to set maximum rate levels on traffic where effective competition is judged to exist. The most remarked reform was the creation of a "no-suspend zone" in which railroads could freely adjust individual rates up or down by as much as seven percent per year. Originally intended by DOT as a quick-and-easy way to offer rate flexibility while the ICC was churning out revised procedures to implement the other reforms, and cast as a permanent, gradually widening zone of ratemaking freedom, the no-suspend zone was almost killed in the House of Representatives and emerged in the 4R Act as a two-year experimental zone applicable only where "effective competition" exists.

The 4R Act also set time limits for ICC investigation of proposed rates and reallocated the burden of proof in many cases to those who seek suspension of rate proposals. The Commission was required to promulgate clear standards and expedited procedures for hearing cases involving seasonal, regional, or peak-period rates; rates for ancillary rail services; rates involving capital investments of $1 million or more; and intrastate rates.

While these reforms add up to a noticeable limitation of the ICC's traditional power to suspend rail rates because they are "unreasonable," the 4R Act conspicuously avoided tampering with other ICC authority to throw out rates which it judges to be "discriminatory," "preferential," or "prejudicial." But the worst impediments to the so-called "new era in competitive pricing" which Congress proclaimed in the 4R Act seem to have resulted from ICC reluctance to part with authority. Foremost of the examples is a still-running imbroglio over "market dominance."

The 4R Act required the ICC to establish that a railroad possesses "market dominance" before proceeding to consider disallowing the railroad's proposed rate as being unreasonably high. Though the basic idea was to limit the ICC's suspension power—market dominance had to be established and did not by itself constitute sufficient evidence for suspension—the provision unfortunately ended up illustrating some of the pitfalls of trying to "reform" rather than eliminate regulation. The market dominance test dragged into ICC practice for the first time all the ambiguities and contradictions of latter-day antitrust. Rather than define market dominance in the 4R Act, Congress relegated the matter to ICC rulemaking.

In March 1976 the Commission proposed standards which according to DOT studies would have yielded findings of market dominance in 90 percent of all proposed rail rate hikes. Seven different fact patterns were set forth, any one of which would have preserved the ICC's authority to intervene on market dominance grounds. Following a storm of criticism, the Commission in August issued new standards which looked not much different. Finally in October 1976 the ICC formally adopted market dominance standards. One of these was based on market share, but precluded consideration of potential competition, of competition by unregulated private carriers, of geographic competition among producers of the product being hauled, or of competition between the product being hauled and its substitutes. Another standard hinged on an arbitrary rate/variable cost ratio which the ICC, strangely, had made progressively more restrictive throughout the course of the hearings. A final one rested on the existence of shipper investment in rail equipment, although the 4R Act had already preempted this area by providing special rate freedoms for services involving capital investments. Charging that the ICC's ruling was capricious and "so vague as to be irrational," the Department of Transportation, the Federal Trade Commission, and the Department of Justice all sharply criticized the ICC market dominance stance in the US Court of Appeals. There the matter festered, until recently, when the ICC won its case. In words which must rankle those who plugged for regulatory reform, Judge Harold H. Leventhal opined that "the Commission in putting into operation a new regulatory scheme [is] entitled to an extra dollop of judicial deference." Deference as well as illogic was applied by the court which said of the ICC's rate/variable cost ratio, "We in no way intimate that we think the Commission erred in its approach or result. We only say that we do not sufficiently comprehend its reasoning."

Market dominance was hardly the sole case of foot-dragging by regulators. Similarly, the ICC opened consideration of seasonal and other special rate proposals by announcing its intention to require rigid sets of cost and revenue data from the railroads—relenting only after more intense protest from DOT and the Justice Department. When it came to the reform provisions for ancillary rail services, the Commission proposed to require railroads to decrease line haul rates in every situation where an ancillary service was separated from the existing point-to-point tariff and priced individually. Protests were rejected when the ICC promulgated the final rules in summer 1977, and DOT's petitions for reconsideration were put off. Result to date: no rate proposals offered by the railroads under this "rate flexibility" provision.

So where does this leave regulatory reform? Despite opposition, the 4R Act accomplished some lasting steps in the drive to whittle down ICC control of the railroad industry: the largely-intact freedom to lower rates down to variable cost, the shifting of the burden of proof away from suspension, the numerous minor restrictions upon the potential for ICC delay in rate cases. For its part, the Commission has moved to defuse criticisms of its administrative slowness. And ICC consideration is currently being given to exempting rail rates for agricultural commodities from minimum rate regulation, to permit railroads to compete with truckers who carry these commodities exempt from regulation. Still, surveying the no-suspend zone fiasco and the market dominance mess, Washington tongues are clucking that deregulation has been tried and failed. The railroads almost unanimously disagree. Says Conrail: "The 4R Act did not provide the fundamental regulatory reform necessary to strengthen the rail industry." Or, in the words of Southern Pacific president D.K. McNear: "A new policy should be written in such a way that the bureaucracy cannot subvert it."

RAIL MAP DUE FOR CHANGES?

Congress expressed its unhappiness with ICC policy toward rail mergers by mandating new procedures in the 4R Act. The reasons for dissatisfaction were compellingly evident. The collapse of the Penn Central symbolized the failure of railroad managements to reap savings promised by "regional" mergers of parallel railroads like the old New York Central and Pennsylvania. The PC collapse also illustrated the futility of the ICC's trying to shore up weak railroads by requiring "strong" merger partners to take them in; forced inclusion of the fiscally woebegone New Haven railroad was a prime cause of the Penn Central bankruptcy. Finally, the failure of the Rock Island railroad in 1975 after a 12-year ICC delay in approving a Union Pacific-Rock Island merger proposal demonstrated the need for greater freedom in railroad restructuring.

The 4R Act set time limits for Commission action upon merger petitions and created an experimental "expedited merger procedure" for rail restructuring proposals brought jointly by carriers and the DOT. Amid railroad complaints about uncertainty and loopholes, the new procedure has so far languished in disuse. But this may change. Burlington Northern, a Chicago-Pacific Northwest originator of lumber, grain, and coal traffic, has petitioned to merge with the Frisco line, which would give BN commodities single-line access to the South and Gulf ports. The Norfolk & Western and Chessie System have jointly applied to extend their Appalachian-based operations over the Detroit, Toledo & Ironton railroad; Michigan-based Grand Trunk Western has filed a competing bid for DT&I to get some of those Cincinnati-Great Lakes coal loadings for itself.

Talks have also begun, and then stalled, between two sets of southern and western lines. Southern Railway, which operates as far east as Washington, DC, held discussions with the Missouri Pacific Lines, which reach as far west as Pueblo, Colorado. More recently, California-based Southern Pacific Lines bought a 4.8 percent interest in, and opened merger talks with, Seaboard Coast Line Industries, which operates trains as far north as Chicago and as far east as Richmond, Virginia. These merger talks stalled, but Southern Pacific turned around and announced an agreement to purchase Rock Island's Tucumcari, New Mexico-St. Louis trackage.

But these are romances between prosperous eligibles, end-to-end mergers designed to remove obstacles to single-line rail service between important markets. Still unresolved is the fate of weaker roads located principally in the Midwest. Some, like Sunbelt-based Kansas City Southern, are hanging tough and talking of expansion. Insolvent Rock Island refuses to die (with the government holding its major creditor angrily at bay) and recently proposed a novel plan for track-sharing by Midwestern grain-haulers. Others, like the Chicago & Northwestern, the Illinois Central Gulf, and the Missouri-Kansas-Texas, keep improving facilities in anticipation of potential suitors. The troubled Milwaukee Road, which filed for bankruptcy December 19, 1977, appears to be a candidate for partial abandonment despite the road's persistent pleas for inclusion into unwilling Burlington Northern. Given the extensive overbuilding of railroad track in the Midwest—Iowa, Kansas, and Minnesota nearly match such states as Ohio and Pennsylvania for rail mileage—even the relatively prosperous lines may see abandonments before railroad restructuring is over.

What role will the federal government take in all this? "We do not want, nor do I believe we need, a 'Conrail West,'" said Transportation Secretary Brock Adams at a hearing convened last January to consider federal assistance to the bankrupt Milwaukee and Rock Island lines. Instead, the Federal Railroad Administration will knock heads together in an attempt to force track-sharing agreements which could permit scrapping redundant facilities. In its arsenal FRA packs not only the power to speed merger proposals before the ICC but also $1.6 billion provided in the 4R Act for railroad rehabilitation assistance. Several Midwestern railroads have already sold redeemable preference shares to Washington in exchange for assistance, but most of the fund remains, and FRA has promised to use it as "leverage" in accomplishing the agency's restructuring objectives.

Two kinds of prognosis are possible for the nation's railroads. One views the additional Conrail funding, ICC intransigence on regulatory reform, and the deepening federal financial stake in Midwestern railroading as indicators of backdoor nationalization. Other evidence could be cited: the newly fashionable references to how "well" Canada has muddled along with one nationalized railroad and one private railroad (with allusions to Conrail and Chessie), a DOT study due in the autumn which will comprehensively recommend future federal assistance in railroad financing and restructuring; H. R. 8485, introduced by Congressman Florio to investigate the feasibility of rail nationalization; and recent calls for federal takeover made by state officials concerned about railroad safety. There is the precedent set by Amtrak, the government-sponsored "for-profit" passenger train corporation which appears about to be formally nationalized in view of its $500-million-a-year-and-rising deficits. A recently aired DOT recommendation for a slimmed-down Amtrak system now must undergo nationwide hearings culminating in definitive restructuring recommendations by the end of the year. Legislation has already been introduced to put Amtrak on the dole permanently. How it got there, and why it stays, is perhaps best symbolized by the recent resignation of Amtrak president Paul Reistrup, who cited his "frustration" with continual Congressional interference in Amtrak's operation.

The failure of regulatory reform to accomplish substantial deregulation of the railroad industry has seriously retarded the railroads' chances for prosperity. It has become an urgent necessity—no longer just a talking point—for railroads to make some bold departures from traditional practice if they are to survive commercially. Any one railroad could probably hire enough lawyers and apply the pressure in the right places to get away with these changes now, but for the synergism to work many railroads have to change. And this change will occur only after deregulation—there are not enough "heroes" in the industry for it to be otherwise. While deregulation would help, however, it is not sufficient. What is driving even the relatively prosperous railroads to the wall is the ever-narrowing gap between truck and rail costs. Continual improvements to the highway system and liberalized maximum truck weights have caused a dramatic drop in linehaul truck costs to the point where rail is now seldom cost-competitive at distances of less than 500 miles. This tax-money subsidy to the truckers' right-of-way cost helps to explain the appeal among rail managements for federal right-of-way rail assistance and even ownership. It is an issue whose time is yet to come.

All these forces are converging in time for preparation of the FY 1980 budget, making some form of increased federal involvement—perhaps comprehensive assistance programs and outright nationalization of Amtrak—an unfortunately likely prospect.

Other forces pull in the opposite direction, however. Conrail's efforts to segment its markets into manageable units and the growth of shipper-managed trains possess considerable turnaround potential, perhaps enough to permit the railroad to buy its way out of its uncomfortable association with the federal government. Further regulatory reform initiatives from DOT and the rail industry seem almost certain, though no timetable has been set. With growing railroad merger activity, a Midwest restructuring might emerge without substantial federal aid. Overall, lessening economic demand for rail service reflects itself in a growing political impatience with paying railroad deficits—which is one reason rail unions are increasingly leery of complete railroad nationalization.

The Railroad Revitalization and Regulatory Reform Act of 1976 has not been a success. Advertised as a "new" departure from traditional transportation policy, it actually fell entirely within that tradition of ad hoc, superficial legislation aimed at "solving" deep-rooted problems with large doses of taxpayers' money and cosmetic reform. For railroad policy, it will be "back to the drawing board" in the next few months. Will a federal takeover, or revitalized private sector railroads, be in the offing? The answer lies around the bend.

William D. Burt worked on the Railroad Revitalization and Regulatory Reform Act of 1976 as a legislative assistant to a congressman on the House transportation subcommittee. He holds master's degrees in transportation planning and management and is employed in the railroad industry. This article is one of several sponsored by the Sabre Foundation Journalism Fund.

Copyright 1978 by the Sabre Foundation