Revisions to the Board's Methodology for Determining the Railroad Industry's Cost of Capital
| Published date | 30 June 2020 |
| Citation | 85 FR 39154 |
| Record Number | 2020-14061 |
| Section | Proposed rules |
| Court | Surface Transportation Board |
Federal Register, Volume 85 Issue 126 (Tuesday, June 30, 2020)
[Federal Register Volume 85, Number 126 (Tuesday, June 30, 2020)]
[Proposed Rules]
[Pages 39154-39157]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-14061]
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SURFACE TRANSPORTATION BOARD
49 CFR Chapter X
[Docket No. EP 664 (Sub-No. 4)]
Revisions to the Board's Methodology for Determining the Railroad
Industry's Cost of Capital
AGENCY: Surface Transportation Board.
ACTION: Notice of proposed rulemaking; withdrawal.
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DATES: The Board is withdrawing the document published on October 4,
2019 (84 FR 53094), as corrected on October 18, 2019 (84 FR 55897), as
of June 30, 2020.
ADDRESSES: The docket for this withdrawn rulemaking is available at
www.stb.gov.
FOR FURTHER INFORMATION CONTACT: Nathaniel Bawcombe at (202) 245-0376.
Assistance for the hearing impaired is available through the Federal
Relay Service at (800) 877-8339.
SUPPLEMENTARY INFORMATION: On September 30, 2019, as corrected October
11, 2019, the Board issued a
[[Page 39155]]
notice of proposed rulemaking seeking public comment on its proposal to
change its existing methodology for determining the railroad industry's
cost of capital. Revisions to the Board's Methodology for Determining
the R.R. Indus.'s Cost of Capital (NPRM), EP 664 (Sub-No. 4) (STB
served Sept. 30, 2019), corrected (STB served Oct. 11, 2019).\1\
Specifically, the Board proposed incorporating an additional model,
referred to as the ``Step Multi-Stage Discounted Cash Flow Model''
(Step MSDCF), to complement its use of Morningstar/Ibbotson Multi-Stage
Discounted Cash Flow Model (Morningstar/Ibbotson MSDCF) and Capital
Asset Pricing Model (CAPM) in determining the cost-of-equity component
of the cost of capital. Based upon the comments and replies received in
response to the NPRM, the Board will withdraw its proposal and
discontinue this proceeding.
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\1\ References to the NPRM in this decision refer to the
corrected decision. The NPRM was published in the Federal Register
on October 18, 2019 (84 FR 55,897). On November 22, 2019, the Board
served a clarifying decision with a revised Appendix A detailing the
algebraic formula for its proposal.
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Background
Each year, the Board determines the railroad industry's cost of
capital and then uses this figure in a variety of regulatory
proceedings, including the annual determination of railroad revenue
adequacy, rate reasonableness cases, feeder line applications, rail
line abandonments, trackage rights cases, and rail merger reviews. The
annual cost-of-capital figure is also used as an input in the Uniform
Railroad Costing System, the Board's general purpose costing system.
The Board calculates the cost of capital as the weighted average of
the cost of debt and the cost of equity. See Methodology to be Employed
in Determining the R.R. Indus.'s Cost of Capital, EP 664, slip op. at 3
(STB served Jan. 17, 2008). While the cost of debt is observable and
readily available, the cost of equity (the expected return that equity
investors require) can only be estimated.\2\ Id. Thus, estimating the
cost of equity requires relying on appropriate finance models. Id.
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\2\ The Board must make ``an adequate and continuing effort to
assist . . . carriers in attaining revenue levels,'' which should,
among other objectives, ``permit the raising of needed equity
capital.'' 49 U.S.C. 10704(a)(2).
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In 2009, the Board began to calculate the cost of equity based on a
simple average of the estimates produced by CAPM and Morningstar/
Ibbotson MSDCF. See Use of a Multi-Stage Discounted Cash Flow Model in
Determining the R.R. Indus.'s Cost of Capital, EP 664 (Sub-No. 1), slip
op. at 15 (STB served Jan. 28, 2009). Since that time, the Board has
consistently found that the simple average of CAPM and Morningstar/
Ibbotson MSDCF has produced a reasonable estimate of the cost of equity
used to gauge the financial health of the railroad industry. See, e.g.,
R.R. Cost of Capital--2018, EP 558 (Sub-No. 22) (STB served Sept. 30,
2019); R.R. Cost of Capital--2017, EP 558 (Sub-No. 21) (STB served Dec.
6, 2018).
Under CAPM, the cost of equity is equal to RF + [beta] x RP, where
RF is the risk-free rate of interest,\3\ RP is the market-risk
premium,\4\ and [beta] (or beta) is the measure of systematic, non-
diversifiable risk. Under CAPM, the Board calculates the risk-free rate
based on the average yield to maturity for a 20-year U.S. Treasury
Bond. The estimate for the market-risk premium is based on returns
experienced by the S&P 500 since 1926. Lastly, the industry beta is
calculated by using a portfolio of weekly, merger-adjusted railroad
stock returns for the previous five years.
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\3\ The risk-free rate of interest is an exogenously determined
interest rate at which investors may borrow or lend without fear of
default.
\4\ The market-risk premium is the predicted additional return
from investing in the market (in this case, the S&P 500) instead of
risk-free investments over the long term. It is calculated by
subtracting the risk-free rate from that market return.
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Under Morningstar/Ibbotson MSDCF, the cost of equity is the
discount rate that equates a firm's market value to the present value
of the expected stream of cash flows. Morningstar/Ibbotson MSDCF
calculates growth of earnings in three stages. In the first stage
(years one through five), the qualifying railroad's \5\ annual earnings
growth rate is assumed to be the median value of its three- to five-
year growth rate estimates, as determined by railroad industry analysts
and published by the Institutional Brokers Estimate System.\6\ In the
second stage (years six through 10), the growth rate is the simple
average of all of the qualifying railroads' median three- to five-year
growth rate estimates in stage one. In the third stage (years 11 and
onwards), the growth rate is the long-run nominal growth rate of the
U.S. economy. This long-run nominal growth rate is estimated by using
the historical growth in real gross domestic product plus the long-run
expected inflation rate.
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\5\ The Board determines the railroad industry's cost of capital
for a ``composite railroad,'' which is based on data from Class I
carriers that meet certain criteria developed in Railroad Cost of
Capital--1984, 1 I.C.C.2d 989 (1985), as modified by Revisions to
the Cost-of-Capital Composite Railroad Criteria, EP 664 (Sub-No. 3)
(STB served Oct. 25, 2017).
\6\ This data can be retrieved from Refinitiv (formerly Thomson
ONE Investment Management). See R.R. Cost of Capital--2018, EP 558
(Sub-No. 22), slip op. at 10.
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Most recently, in September 2019, the Board used the simple average
of CAPM and Morningstar/Ibbotson MSDCF to calculate the cost of capital
in Railroad Cost of Capital--2018, Docket No. EP 558 (Sub-No. 22). In
that proceeding, comments and supporting data from the Association of
American Railroads (AAR) showed a large increase in growth rates \7\
and the cost of capital over the prior year's figures.\8\ See generally
AAR Comments, Apr. 22, 2019, R.R. Cost of Capital--2018, EP 558 (Sub-
No. 22). According to AAR, lower tax rates and rail operating changes,
including precision scheduled railroading, among other factors,
contributed to analysts' higher growth expectations in 2018. See id. at
V.S. Gray 45-46. In Railroad Cost of Capital--2018, EP 558 (Sub-No.
22), slip op. at 3, the Board explained that the validity of its
existing methodology was not undermined simply because the cost of
capital turned out to be higher than expected. However, the high cost
of capital combined with the major operating changes within the rail
industry did prompt the Board to explore whether its methodology could
be improved with an additional model to capture different information.
In particular, the Board considered changes related to growth rates in
the second stage or middle horizon (years six through 10) of
Morningstar/Ibbotson MSDCF, leading to the NPRM in this docket.
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\7\ For example, the second stage growth rate estimate produced
by Morningstar/Ibbotson MSDCF produced a value of 19.88%, as
compared with the second stage growth rate value of 13.55% reflected
in the 2017 cost of capital. Compare R.R. Cost of Capital--2018, EP
558 (Sub-No. 22), slip op. at 17, with R.R. Cost of Capital--2017,
EP 558 (Sub-No. 21), slip op. at 18.
\8\ The 2018 cost of capital (12.22%) was 2.18 percentage points
higher than the 2017 cost of capital (10.04%).
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As proposed in the NPRM, Step MSDCF would calculate growth of
earnings in three stages. The first and third stages would be identical
to those of Morningstar/Ibbotson MSDCF. Unlike Morningstar/Ibbotson
MSDCF, however, the growth rate of the second stage (years six through
10) would be a gradual transition between the first and third stages.
The transition would begin at year six and step down or up in equal
increments each year towards the terminal growth rate (or third stage).
See NPRM, EP 664 (Sub-No. 4), slip op. at 5, 10-11. Furthermore, the
NPRM proposed to calculate the cost of capital pursuant to the weighted
average of the
[[Page 39156]]
three models, with CAPM weighted at 50%, Morningstar/Ibbotson MSDCF
weighted at 25%, and Step MSDCF weighted at 25%. Id. at 3.
In response to the NPRM, the Board received comments and replies
from AAR and Western Coal Traffic League (WCTL), as well as comments
from Roger J. Grabowski, Managing Director of Duff & Phelps. AAR's
primary argument is that incorporation of Step MSDCF is unwarranted
because the 2018 cost-of-capital figure was a ``data anomaly'' caused
by an unusual combination of market factors that affected the inputs
used in Morningstar/Ibbotson MSDCF. (AAR Comments 1-2.) According to
AAR, Step MSDCF would neither remedy what caused the 2018 anomaly in
the first place nor prevent future anomalies of the same kind. (Id. at
3.) AAR also identifies problems in Step MSDCF that it argues would
need to be corrected before the Board could adopt it. (Id. at 23-25.)
As an alternative to Step MSDCF, AAR encourages the Board to move the
observation date (the date upon which the data for the cost of capital
is drawn) from the last Friday in December to the last Friday in
January to prevent a future anomaly ``should that rare event reoccur.''
(Id. at 3.) WCTL also opposes the Board's Step MSDCF proposal, although
for different reasons. WCTL states that Step MSDCF represents, at best,
a modest improvement to the Board's cost-of-capital methodology and
argues instead that both Step MSDCF and Morningstar/Ibbotson MSDCF
should be eliminated from the Board's cost-of-capital methodology
completely. (WCTL Comments 2, 19-20.) According to WCTL, the Board
should reconfigure its cost-of-capital methodology to rely on CAPM
alone, with some additional modifications. (Id. at 5-8.) Dr. Grabowski
suggests that the third-stage growth rate of MSDCF may be incorrectly
estimating the railroads' cost of equity and proposes a modification to
it. (Grabowski Comments 1, 4.)
Discussion
Although the Board found that its current cost-of-capital
methodology remained reasonable, the Board proposed including Step
MSDCF in its cost-of-equity calculation in an attempt to improve its
methodology in light of the 2018 cost of capital and recent operating
changes within the rail industry. However, the comments in response to
the NPRM indicate that adding Step MSDCF may not be a necessary change
to the Board's cost-of-capital methodology at this time. AAR
persuasively argues that the 2018 cost-of-capital figure was an anomaly
caused by a mismatch between declining stock prices and lagging growth
rate estimates in December, that the Board's approach does not
effectively address the anomaly, and that Step MSDCF has technical
issues. (See AAR Comments 8-13, 20-22, V.S. Villadsen 5-15.) Although
WCTL criticizes aspects of AAR's analysis, (WCTL Reply 3-5), it does
not dispute AAR's demonstration of the cause of the anomaly. AAR and
WCTL agree that adding Step MSDCF to the Board's cost-of-capital
methodology would provide little to no meaningful benefit. (See AAR
Comments 29; WCTL Reply 2.) Given this record, the Board will withdraw
its proposal to add Step MSDCF to its cost-of-equity calculation.
The Board will not pursue AAR's suggestion that, in lieu of the
proposal, the Board permanently move the observation date for stock
price and growth rate inputs from the end of December to the end of the
following January. (See AAR Comments 26.) The events that occurred in
2018 are by AAR's own account ``unusual,'' (AAR Comments 3), and using
a January date raises other issues, such as whether a January data
point includes information not available at the end of the prior year.
See Railroad Cost of Capital--2008, EP 558 (Sub-No. 12), slip op. at 9
(STB served Sept. 25, 2009).\9\
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\9\ As WCTL points out, in Railroad Cost of Capital--2008, EP
558 (Sub-No. 12), slip op. at 10, the Board rejected AAR's similar
proposal to use March 31, 2009 data, in favor of WCTL's data that
was drawn from the end of the year. (WCTL Reply 5.)
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The Board also declines to adopt WCTL's alternative proposals. The
Board has explicitly rejected some, such as WCTL's requests to either
move to a CAPM-only approach or to change the Morningstar/Ibbotson
MSDCF regarding cashflows and growth rates, (WCTL Comments 2), in prior
decisions.\10\ WCTL's other suggestion, that Morningstar/Ibbotson
MSDCF's ``variability'' is a reason to abandon it, (WCTL Comments 16-
17), has been implicitly rejected in the Board's decisions finding that
Morningstar/Ibbotson MSDCF and CAPM each have their own strengths and
weaknesses that, when averaged together, lead to a more robust
result.\11\ And all of WCTL's arguments, including that the Board
should address the generally accepted accounting principles treatment
of operating leases as debt for purposes of the cost of capital, (WCTL
Comments 29-30),\12\ go beyond the scope of this proceeding exploring
whether the Board's methodology could be improved with an additional
model to capture different information, addressing the types of results
that occurred in 2018.\13\
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\10\ Pet. of the W. Coal Traffic League to Inst. a Rulemaking
Proceeding to Abolish the Use of the Multi Stage Discounted Cash
Flow Model in Determining the R.R. Indus.'s Cost of Equity Capital,
EP 664 (Sub-No. 2), slip op. at 1-2 (STB served Sept. 28, 2018);
Pet. of the W. Coal Traffic League, EP 664 (Sub-No. 2), slip op. at
2 (STB served Aug. 14, 2017); Pet. of the W. Coal Traffic League, EP
664 (Sub-No. 2), slip op. at 2, 5, 9, 11-13 (STB served Apr. 28,
2017); Pet. of the W. Coal Traffic League, EP 664 (Sub-No. 2), slip
op. at 11, 14, 17-18, 20 (STB served Oct. 31, 2016); Use of a Multi-
Stage Discounted Cash Flow Model, EP 664 (Sub-No. 1), slip op. at
12-13.
\11\ See Pet. of the W. Coal Traffic League, EP 664 (Sub-No. 2),
slip op. at 11 (STB served Oct. 31, 2016).
\12\ WCTL raised this argument previously in Railroad Cost of
Capital--2015, EP 558 (Sub-No. 19), slip op. at 4-5 (STB served Aug.
5, 2016), and the Board declined to adopt it.
\13\ Dr. Grabowski's suggestion that the third-stage growth rate
of Morningstar/Ibbotson MSDCF may incorrectly estimate the
railroads' cost of equity, and his proposed new approach to
estimating the long-run nominal growth rate, (Grabowski Comments 1,
4), is similarly beyond the scope of the question raised in this
proceeding.
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Conclusion
For the reasons discussed above, the Board will withdraw its
proposal to incorporate Step MSDCF into its methodology for determining
the railroad industry's cost of capital and discontinue this
proceeding.
It is ordered:
1. The Board's proposal to modify its existing cost-of-capital
methodology by incorporating Step MSDCF is withdrawn. This proceeding
is discontinued.
2. Notice of the Board's action will be published in the Federal
Register.
3. This decision is effective on the date of service.
Decided: June 23, 2020.
By the Board, Board Members Begeman, Fuchs, and Oberman. Board
Member Oberman commented with a separate expression.
Board Member Oberman, commenting:
While I concur in the Board's decision for the reasons stated
therein, I write separately to emphasize my conviction that the Board
should continue to closely scrutinize the extent to which equity
markets are incentivizing railroads to reduce operating ratios and
whether and how such efforts might result in changes to the Board's
cost-of-capital figure.
It must be emphasized that the annual cost-of-capital determination
directly impacts important aspects of the Board's oversight duties. For
example, the Board uses its cost-of-capital determination in a variety
of regulatory proceedings, including railroad revenue adequacy
determinations, feeder-line applications, rail line abandonments,
trackage rights cases, and rail merger reviews. The
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annual cost-of-capital figure is also an input into the Uniform
Railroad Costing System and therefore has a direct bearing on rate
reasonableness cases.
Equity markets' incentivizing railroads to lower operating ratios
could translate into increases in the cost-of-capital figure. My
concern is that, as a result, a railroad might be found to be revenue
inadequate even when, in reality, it is financially healthy. Likewise,
a higher cost-of-capital figure can affect whether a particular
commodity shipment is above or below the 180% R/VC threshold and is
therefore eligible for rate review by the Board.
Separately and in addition to the above matters, the need for
continued scrutiny arises from my increasing concern that there is a
point beyond which the demands of equity markets for a return of
capital may impact the ability of the railroads to meet their common
carrier obligations and may deprive the network of the capital it
requires to support the needs of the public and the national defense.
Finally, given that the United States and the entire world are
presently facing health and economic crises, and that these crises have
adversely affected the railroad industry along with the other parts of
the economy, I recognize that my above stated concerns are not as
immediate as they might otherwise be. Nevertheless, as the economy
recovers and the railroad industry regains its full strength, the
concerns outlined above may well reoccur and warrant the continued
scrutiny I have urged.
Jeffrey Herzig,
Clearance Clerk.
[FR Doc. 2020-14061 Filed 6-29-20; 8:45 am]
BILLING CODE 4915-01-P
