The Board Withdraws Proposal to Revise its Methodology for Determining the Railroad Industry’s Cost of Capital

On June 23, the Board withdrew its proposal to revise its methodology for calculating the cost-of-equity component of the railroad industry’s cost of capital by incorporating a third model, based on comments and replies the Board received in response to the notice of proposed rulemaking (NPRM).  Revisions to the Board’s Methodology for Determining the R.R. Indus.’s Cost of Capital, Ex Parte 664 (Sub-No. 4) (STB served June 23, 2020). 

The Board issued an NPRM in September 2019, as corrected in October 2019.  Revisions to the Board’s Methodology for Determining the R.R. Indus.’s Cost of Capital, Ex Parte 664 (Sub-No. 4) (STB served Oct. 11, 2019).  Under the proposed rule, the Board would incorporate a third model, called “Step Multi-Stage Discounted Cash Flow Model” (Step MSDCF), in addition to the two models (the Capital Asset Pricing Model (CAPM) and the Morningstar/Ibbotson Multi-Stage Discounted Cash Flow Model (MSDCF)) currently used in the methodology.  Id., slip op. at 3.  Step MSDCF would continue to calculate growth of earnings in three stages, like MSDCF.  The first and third stages would be the same as those of MSDCF.  The growth rate of the second stage (years six through 10) of Step MSDCF “would be a gradual transition between the first and third stages.”  Id., slip op. at 5.  Under the proposal, the Board would calculate the cost of capital by using the average of the three models, weighted as follows: CAPM at 50%, MSDCF at 25%, and Step MSDCF at 25%.  Id., slip op. at 3. 

In response to a motion for clarification filed by the Association of American Railroads (AAR), the Board issued a clarifying decision in November 2019 with a revised Appendix A of the NPRM, which detailed the algebraic formula for the proposal and extended the comment period.  Revisions to the Board’s Methodology for Determining the R.R. Indus.’s Cost of Capital, Ex Parte 664 (Sub-No. 4) (STB served Nov. 22, 2019). 

The Board received comments and replies from AAR and Western Coal Traffic League (WCTL), and comments from Roger J. Grabowski, Managing Director of Duff & Phelps.  Revisions to the Board’s Methodology for Determining the R.R. Indus.’s Cost of Capital, Ex Parte 664 (Sub-No. 4) (STB served June 23, 2020), slip op. at 3-4.  AAR primarily argued that the proposed changes were driven by concern over the 2018 cost-of-capital calculation but “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.”  Id., slip op. at 4.  AAR also identified problems regarding Step MSDCF that AAR claimed would need to be corrected before the Board adopted the proposal.  Id.  WCTL asserted that “Step MSDCF represents, at best, a modest improvement to the Board’s cost-of-capital methodology” and argued instead that “both Step MSDCF and Morningstar/Ibbotson MSDCF should be eliminated.”  Id.  Dr. Grabowski suggested that the third-stage growth rate of MSDCF could be incorrectly estimating the cost-of-equity, and he proposed a modification to the rate.  Id.

The Board stated that the comments indicate that incorporating Step MSDCF may not be a necessary change to the cost-of-capital methodology at this time.  Id.  According to the Board, AAR had persuasively argued that the 2018 cost of capital figure was an anomaly, that the Board’s proposal did not effectively address the anomaly, and that Step MSDCF has technical issues.  Id.  However, the Board declined to adopt “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.”  Id.  The Board also declined to adopt alternative proposals suggested by WCTL.  Id., slip op. at 5.  The Board ordered that its proposal to revise the cost of capital methodology is withdrawn, and the proceeding is discontinued.  Id., slip. op at 6.

Board Member Oberman commented that he concurred with the Board’s decision for the reasons stated, but that he was “writ[ing] separately to emphasize [his] 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.”  Id. (Board Member Oberman, commenting).

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