1. C O N F I D E N T I A L | www.oliverwyman.com Freight Rail Infrastructure: Will a Re-Regulated Industry Build it? May 28, 2009 John Larew Beyond the Crossroads Manufacturing, Transportation & Energy

2. 1 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Industries Capabilities Industries  Automotive  Aviation, Aerospace & Defense  Communications, Media & Technology  Energy  Financial Services –Corporate & Institutional Banking –Insurance –Retail & Business Banking Introduction Oliver Wyman A strategy consulting firm built around industry expertise  Industrial Products & Services  Health & Life Sciences  Retail & Consumer Products  Surface Transportation

3. 2 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Freight Rail and Economic Growth As a key enabler of economic growth, freight rail production closely tracks the performance of U.S. GDP. Source: Congressional Budget Office. Real GDP ($T 2001 USD) US GDP and Railroad Revenue Ton-Miles CAGR 3.1% US Rail Revenue Ton-Miles

4. 3 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Steady growth in Railroad capital expenditures Class I Railroad capital spending has grown significantly, driven primarily by road-related investment Source: AAR R1 Reports and Oliver Wyman analysis. Billions of Current Dollars Class I Capital Expenditures for Road and Equipment CAGR 1985-’06 2.0% 3.4% 2.8% CAGR 2000-’06 -0.4% 7.4% 4.4% Road Equipment Total Road as a % of total CAPEX

5. 4 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Road capex projection Under conservative assumptions, US Class I railroads will spend $6.6 billion to $7.0 billion annually on road capex by 2013. US Class I Railroads: Historical and Projected Road Capex Spend 1996-2013E, $ billions CAGR 2007-’13 2.6% Actual Projected 1.3% By 2013, the gap between the most bullish and bearish GDP-based forecasts is $0.4B 1985-2007 CAGR: 3.2% 2007-2013 CAGR: -0.9% – 2.6% Source: R-1 Reports filed with the STB; Bureau of Economic Analysis; International Monetary Fund; CBO; AAR – National Freight Capacity Study; Oliver Wyman analysis. Note: Long-term estimate is based on expected rail tonnage growth of 88% from 2006-2035 applied to GTMs. 1985-2007 historical growth rate of road capex adjusted downward for 2007-2013 in proportion to expected adjustment in GTM growth rate. 2008 retained flat based on information from interviews. US Class I dataset includes five US Class I railroads and US operations for two Canadian railroads. - 0.8% - 0.3% - 0.5% - 0.4% - 0.9% 0.1% - 0.5%

6. 5 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Growing Demand for Rail Infrastructure To maintain capacity adequate to demand, U.S. and Canadian rails will have to invest almost $150 bn by 2035 Projected stress on railroad network … Mileage by volume / capacity ratio  Despite recent downturn associated with the economy, the long-term forecast for freight tonnage will nearly double from current levels over the next 25 years  In the short term, North American rails have continued to invest in capex at a pace comparable to pre-crisis levels  An estimated $148B will need to be spent in order to accommodate the rail freight demand in 2035, including: –$95B on line haul expansion –$25B on bridges, tunnels and clearance –$10B on branch line upgrades Above capacity At capacity Near capacity Below capacity % of miles Sources: AAR Future Capacity Study; Oliver Wyman analysis

7. 6 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Where will this capital come from?  Nowhere? –The world is full of examples of needed infrastructure that was never built.  Shippers? –Industries that rely on expanded rail capacity can expect to pay rates that fully recover capital costs. –Shippers may contribute capital (as they have with car fleets) –Railroads may manage capacity bottlenecks by pricing some revenue- inadequate traffic off the system.  The public sector? –Investment tax incentives have a visible impact –Freight rail projects can compete for stimulus funds under American Recovery & Reinvestment Act –All four major Class I railroads have officers assigned to developing public-private partnerships.  Investors and lenders? –Markets may make more capital available if… ­Railroads earn their cost of capital (equity investment) ­Railroads maintain their creditworthiness (debt investment)

8. 7 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com What could “derail” this infrastructure development? The prospect of renewed economic regulation of freight rails jeopardizes the economic basis of freight rail expansion.  Since the passage of the Staggers Act in 1980, the economic deregulation of freight rails has produced staggering improvements in productivity and lower rates for shippers –For more than 20 years, shippers enjoyed the windfall benefits of overcapacity and vigorous competition for business  In recent years, complaints have mounted from the shipper community about service levels and higher rates; the prospect of partial re-regulation looms  Oliver Wyman’s analysis of the impact of re-regulation suggests two clear conclusions: –Re-imposing rate regulation would put the sustainability of freight rail infrastructure at risk –The likely alternatives to market-based rate setting are unlikely to benefit shippers on the whole

9. 8 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com The Deregulated Status Quo: A Success Story? The current regulatory process results in some of the lowest rail freight rates in the world. Comparative International Rail Freight Charges (US cents per tonne-kilometer) Source: Before the US House Subcommittee on Railroads, Hearing on the Status of the Surface Transportation Board and Railroad Economic Regulation: Testimony of William J. Rennicke, March 31, 2004, page II-38.

10. 9 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Rail Rates Since Deregulation The case for a deregulated freight rail industry used to be very simple… STB Rail Rate Index, 1985-2007 Real revenue per ton-mile (index, 1985 = 100)

11. 10 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Rates since the “Rail Renaissance” …but advocates of re-regulation are getting more of a hearing now that real rates are no longer in long-term decline STB Rail Rate Index, 1985-2007 Real revenue per ton-mile (index, 1985 = 100)

12. 11 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Dating the Rail Renaissance  2005 — BNSF Railway’s earnings cover its cost of capital (Q3)  2004 — Industry revenue per carload increases in real terms — Aggregate employment at class ones increases  2003 — Revenue per carload increases in nominal terms — Revenue per ton-mile increases in real terms  2002 — Ratio of track miles to route miles ends 20-year decline — Industry revenue per ton mile increases in nominal terms  2001 — Gross ton miles shipped by rail grows faster than by truck  1998 — First published complaint in Scrap magazine of inadequate supply of gondola cars

13. 12 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com …and the Post-Renaissance  2005 — Trend to declining rail unit costs (adjusted RCAF) reverses — Price of rail wheels increases 40 percent year over year  2006 — Carloads in Q4 decrease versus prior year quarter — GAO investigates rail competitiveness — STB introduces “maximum markup” methodology  2007 — Re-regulation bills introduced in U.S. House and Senate — STB introduces small-shipper rate challenge procedures  2009 — Bill to subject STB-regulated common carriers to federal antitrust enforcement clears Senate Committee

14. 13 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Capital Expenditures as Percent of Revenue for Various Industries Average 1996-2005 Source: Lefthand chart: U.S. Census Bureau. Righthand chart: Value Line 2005. Industries are not exact matches across charts due to different data sources. Return on Equity (%) for Various Industries, 2005 How Attractive is Freight Rail for Equity Investors? Freight rail is among the most capital-intensive industries, but ranks lowest in return on equity.

15. 14 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Why the fuss over deregulated rates? Market-based pricing means differentiated pricing; shippers with fewer competitive options pay more. Distribution of Shipment Revenues by Revenue-to-Variable Cost Ratio Percentage of total revenues in 2005 Highly Competitive Competitive Less Competitive Source: Surface Transportation Board Commodity Revenue Stratification Report for 2005: Summary of Revenues and URCS Variable Costs by Two-Digit STCC and Revenue-to-Variable Cost (R/VC) Ratio Category, based on 2005 Waybill data; Oliver Wyman analysis. In a deregulated environment, less competitive shipments pay a higher contribution over variable costs

16. 15 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Share of Total Revenues Generated by Traffic with R/VC Ratio >180, By Major Commodity Percentage share, 2005 Which industries contribute more? Coal and chemicals are examples of commodities with a higher proportion of traffic moving at R/VC ratios of 180 or greater. Average for All Commodities = 31.3% Source: Surface Transportation Board Commodity Revenue Stratification Report for 2005: Summary of Revenues and URCS Variable Costs by Two-Digit STCC and Revenue-to-Variable Cost (R/VC) Ratio Category, based on 2005 Waybill data; Oliver Wyman analysis. Preliminary

17. 16 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Potential Impact of Re-Regulation Proposals to re-impose rate regulation on freight rail could severely deplete the cash flow that sustains infrastructure investment. If rates were capped at a revenue to variable cost ratio (R/VC) of 1.80, railroads could lose ~$3.7B of revenue and 30% of their contribution to fixed costs Impact of lowering rates to 180 R/VC Analysis of rates >180 R/VC, 2005 Coal Products Chemical Products Misc Farm Products Petroleum & Coal Products Stone & Glass Products Transportation Equipment Food Products Nonmetallic Minerals Metal Products OtherTotal

18. 17 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com How significant are “captive” shippers? Virtually all major traffic origins/destinations are served by two or more rail carriers. Number of Class I Railroads Serving Economic Areas, 2004 Source: Freight Railroads: Industry Health Has Improved, but Concerns about Competition and Capacity Should Be Addressed, GAO, October 2006. GAO analysis of BEA and GIS data. In 1994, 21 percent of tonnage had access to only one railroad. By 2004, that number had declined to 10 percent. # of railroads (includes ownership/trackage rights) 5 or more (11) 2-4 (137) 1 (27) 0 (2)

19. 18 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com Does deregulation penalize the little guy? Oliver Wyman research suggests that small shippers are not systematically disadvantaged in rate-setting. % of shippers ranked by magnitude of deviation off formula % deviation from formula Percent Deviation of Actual Shipment Price From Predicted Rate Ranked 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Large shippers: >100 cars/year  Small shippers: between 50 & 100 cars/year Disguised Waybill Sample Source: Before the US House Subcommittee on Railroads, Hearing on the Status of the Surface Transportation Board and Railroad Economic Regulation: Testimony of William J. Rennicke, March 31, 2004, page II-38. Comparison of actual freight rates with expected (formula) prices indicates that there is not a significant pattern of preferential pricing for any one group. Any shipper, large or small, is just as likely to receive discounts or pay a premium price.

20. 19 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com So what about vulnerable shippers? Competition—in all its forms—continues to be a powerful protection  Rail competition — commercial negotiation –Largest users (utilities) leverage their generation portfolios –Industrial development as a competitive lever  Modal competition –Before the downturn, fastest growing freight rail segment was the truck competitive intermodal segment –Bulk shippers make strategic use of barge-competitive sources  Source competition –Railroads do not have true monopoly power even over “captive shippers”  For the exceptions, there is the possibility of regulatory relief  …But, the freight rail industry cannot change economic geography

21. 20 CASECODE-FILENAME (YYYYMMDD Descriptor).ppt © Oliver Wyman  www.oliverwyman.com