Full Costing Review

General Costing Review

For years now general farm organizations, including the CFA, and other groups like the WCWGA and CWB have been calling for a costing review.  (W-P March 13/April 3, 2008).  A coalition of such groups released a study in the spring of 2008 by U.S.-based Travacon Research saying that, based on the outdated revenue formula, railways are earning more than 50% above their costs, much higher than the 20% rate of return deemed reasonable when the cap was created.

Parliament had passed Bill C28 in February, 2008, which improved the ability of shippers to challenge railway fees and performance.  Shippers were expecting a general costing review to be initiated by the CTA following the legislated changes to the Act.  However, the federal government has refused to have a costing review until the Rail Freight Service Review is completed.

Not only are the railways are opposed to the idea of a costing review, they have expressed strong opposition to the idea of being regulated at all:

"Canada has been moving towards a more commercial system for 25 years.  They want to turn back the clock …” (CN)

T"he Canadian economy needs less regulation, not these kinds of archaic solutions.” (CP)

'creeping regulation” is transferring income from railways to farmers and is “unfair”.(CN)

"This will have consequences and as grain revenues fall, it could have an impact on company decisions”. (CN)

Background

Regulation of grain freight rates has evolved from a complex, cost-based methodology with maximum rate scales to a revenue-based approach that caps aggregate revenues. 

Regulated under the WGTA until 1995, costing reviews were conducted regularly in 1984, 1988, and 1992.  Even though the WGTA was repealed in 1995, rates continued to be based on the 1992 costing.  The Estey review in 1998 recommended the rate cap be repealed and replaced with a revenue cap, and that “the economies effected thereby be passed on to the farmer”.  Subsequently, the 1999 Kroeger review established the revenue cap.  

It is noteworthy that Working Group 1 in the 1999 review, dealing with rates and revenues, asserted “under the revenue cap framework, overall railway revenues are expected to decrease as a result of commercial forces while at the same time providing more price flexibility to encourage efficiencies”.  However, pretty much the opposite has come to pass.  Indeed, KAP’s analysis shows that “the railway companies have become increasingly competent at maximizing their earnings by getting as near to the cap as they can”.  Here’s the table they put together:

Crop Year

Revenue % of Cap

2000-01

99.2

2001-02

96.2

2002-03

94.4

2003-04

99.9

2004-05

99.9

2005-06

100.4

2006-07

100.1

2007-08

107.9

It is also noteworthy that the 1999 Working Group 1 recommended a costing review be done during the 2004-05 crop year to “evaluate the effectiveness of the western grain transportation provisions”.  Even though it is now six years overdue, such a review has not been conducted.

Current Costing Reviews

While a full costing review has been refused, the CTA has been directed to conduct two current reviews that have direct cost implications for grain shippers:  1) the Cost of Capital Methodology Review; and 2) the Industry Development Fund Review. 

The bottom line is that there is money on the table and these reviews are one-sided:  a) all components of the reviews will increase railway revenues if their recommended changes are adopted; and b) the reviews are not looking at changes that would reduce the revenue cap. 

Increases to railway revenues from these reviews would be achieved prior to a full costing review being done and become part of the status quo.

Through ongoing reforms in the regulatory framework the railways gained a stronger commercial position and price flexibility in exchange for a revenue cap.  Now, they are seeking relief from the constraints of the cap by creating as many opportunities as possible for generating more revenue under the cap.

An initial analysis of the two reviews follows.

Cost of Capital Methodology Review

Review Process

Issues under Review

The issues below are copied directly from the CTA’s draft Terms of Reference, i.e. draft Request for Proposals to consultants to conduct their Cost of Capital Review.  Initial analytical comments from APAS are in bold Italics.

Current and Recurring Issues raised re the current Cost of Capital Methodology

The following briefly outlines certain current and recurring issues raised by the railways pertaining to the Agency’s cost of capital methodology, specifically with regard to the determination of capital structure and capital structure cost rates. The Agency’s responses to these issues can be found in its annual determinations pertaining to the crop year cost of capital rate for the transportation of western grain.

Capital Structure:  Agency uses an actual book-based capital structure for the railways, as opposed to a deemed capital structure

Market value vs. Book Value – Railways favour market value capital structure.

The CTA currently uses book value. 

Book value is an audited, accurate representation of railway capital value.

Book value is a consistent and dependable way of estimating value that reflects actual business practice and performance.

Book value avoids both conjecture both what current market value might be and the vagaries of changing market conditions.

The railway request for using market value will increase their revenues, not because market value is a better or more logical way of representing capital value.

Deferred taxes given weight in capital structure and assigned a zero cost rate – Railways favour excluding deferred taxes from capital structure.

Deferred taxes are a source of working capital, a permanent one if the taxes are continuously deferred.

Because deferred taxes are zero rated by the CTA, this dilutes the overall costing rate allowed to the railways in proportion to deferred taxes’ share of total capital.  Excluding them would increase the cost of capital the railways would be allowed to charge.

Non-rail debt – what is allowable non-rail debt?  One railway submits that certain types of debt should be classified as non-rail debt and included in equity.

The ToR does not elaborate on this about so it is difficult to comment.

However, if additional debt IS included in equity, it would provide a larger base from which to calculate the cost of capital, thus increasing railway revenue.

Capital Structure Cost Rates:

Cost of Debt:  Based on historic cost of debt reflected in most recent fiscal year, one railway, in the current climate of rising financing costs, favours some method of projecting future debt costs. This was not an issue when financing cost rates were declining year over year.

The cost of debt through financing should be determined by the most recent actual financing costs, not some future projection.

The fact the railways did not raise this issue when costs were declining is evidence of attempts to artificially raise capital costing rates.

Cost of equity – Calculated by three methods (CAPM, DCF & ERP), with Agency giving primary weight to CAPM – One railway favours use of the average of CAPM & DCF.

The advantages of the current practice of giving primary weight to CAPM are amply demonstrated by the CTA’s reference to the issue in the review’s Terms of Reference:

"The reason for the CAPM being chosen is that it is widely known and accepted in regulatory and financial practice and allows for a transparent, quantifiable projection, incorporating reconcilable data from the market as a whole, as well as a company specific factor (beta), to arrive at a cost of common equity forecast that is not subject to the degree of conjecture required to estimate an expected growth rate or risk premium, as is the case with the DCF and EPR methods respectively.”

Market risk premium component of CAPM – Agency uses 45 year time period and Canadian data. Railways object to the time period and data source, favouring a longer time period and the use of American data.

The effect on the Cap of going to a longer time period is not clear.

The use of American data seems inappropriate, since it would not apply to the context of Western Canadian grain shipment and would represent a higher risk market environment in the U. S. 

Appropriateness of a grain risk adjustment assessed annually, with Agency consistently determining that none should apply. Railways favour including a grain risk premium.

Prior to 1997 the CTA applied a grain risk adjustment of minus 1%; currently the adjustment is zero.

On the general level of capital investment (i.e. as opposed to investing in some other industry), grain freight presents no risk over time for the railways. 

On the contrary, the industry in Western Canada is a captive market.

Grain production is large and has been growing, so the railways are being handed access to a large and stable market.

Even at the operational level, grain presents lower risks than most commodities and is unlikely to pose a liability threat.)

Summary

For all of these issues, revenues to the railways will increase if the CTA adopts their recommendations.

None of the requests from the railways appear to fit the spirit of the CTA’s responsibilities to regulate a monopoly sector and none appear to be justifiable in relation to the CTA’s current procedures or to widely accepted accounting practices.

The interests of producers in all of these issues are not being defended.

The timing of the Cost of Capital review is interesting since requests for a general costing review have been denied.

Industry Development Fund (IDF) Review

When railways make financial contributions to facilities owned by others, the IDF allows railways to pass part of the cost to producers through the revenue cap:

For the purposes of this section, if the Agency determines that it was reasonable for a prescribed railway company [currently CN and CP] to make a contribution for the development of grain-related facilities to a grain handling undertaking that is not owned by the railway company, the company’s revenues for the movement of grain in a crop year shall be reduced by any amount that the Agency determines constitutes the amortized amount of the contribution by the company in the crop year.

The railways contend that they have the right to retain ownership of the IDF contribution deducted from the revenue cap.  APAS signed on in October, 2009 to KAP’s submission to the CTA’s review of the IDF.  They argue convincingly that the CTA should not accept the railways’ contention.  Here is their central argument:

"It is the submission of Keystone Agricultural Producers that the Agency does not have the legislated authority to reduce the capped revenue of a railway company by the added cost of capital calculated on the value of remaining amortized IDF contributions.

Section 150(5) of the Canada Transportation Act (the Act) allows railways to pass on a portion of the costs associated with investments in grain handling infrastructure to grain shippers through an increase in allowable freight rates.   There is no indication that the intention of the legislation is to allow railways to pass on the total cost of these investments as has been previously claimed.  The issue with deducting the cost of capital in addition to the amortized value of IDF contributions is that it does just that. 

The development of the grain handling infrastructure funded through IDF contributions result in additional profits for the contributing railway through efficiencies associated with larger car block shipments.  These profits are not restricted by the revenue cap and the legislation already makes exceptions that allow for the railways to pass on the cost of the incentives used to encourage these efficiencies.  The contributing railway company should then expect to pay for at least a portion of this investment.

The legislation clearly states that the reduction of the railway’s capped revenues is to be the “amount that the Agency determines constitutes the amortized amount of the contribution by the company.”  The addition of the cost of capital being calculated on the remaining initial investment would accurately reflect a cost of ownership or the general costs incurred by the railway.  In Section 157 of the Act, the Agency is provided the authority to develop methodologies to determine railway costs, including cost of capital, which the legislation then call on the Agency to apply to regulatory calculations including the VRCPI .  In the case of Section 150(5) of the act, the Agency is neither directly nor implicitly instructed to apply this calculation to the value of an IDF contribution. 

We understand the challenge the Agency has in balancing the interests of the various actors involved in Canada’s grain handling and transportation system while still trying to promote growth and efficiency.  The foundation of our position that the Agency may not include the cost of capital in the reduction of a railway’s capped revenues related to an IDF contribution is that the railway companies must share the financial cost of investments that will earn them additional profits through increased efficiencies.  The Maximum Grain Revenue Entitlement exists first and foremost to protect captive grain shippers from a limited competition market.  Other considerations are secondary to this goal."