AN EVALUATION OF CP BAIL'S PROPOSED BEAVEfi TUNNEL by TED JOHN FBIESEN Comm. (Hon.), , The University of Manitoba, 1973 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE (BUSINESS ADMINISTRATION) THE FACULTY OF GRADUATE STUDIES (Commerce and Business Administration) Se accept this thesis as conforming to the reguired standard THE UNIVERSITY OF BRITISH COLUMBIA May 1980 i n Ted John Friesen, 1980 In presenting this thesis in partial fulfilment of the requirements for an advanced degree at the University of Brit ish Columbia, I agree that the Library shall make i t freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the Head of my Department or by his representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. Department The University of Brit ish Columbia 2075 Wesbrook Place Vancouver, Canada V6T 1W5 D E - 6 B P 75-5 I I E i i abstract CP B a i l i s experiencing capacity constraints on i t s western mainline between Calgary, Alberta and Vancouver, B.C. The c r i t i c a l bottleneck has been i d e n t i f i e d as the Soger's Pass section, which i s between Golden, B.C. and Bevelstoke, B.C. CP B a i l has examined several alternatives, and has concluded that t h i s bottleneck can best be overcome by nineteen miles of doublertracking. This would require the construction of an eight-Mile tunnel under Roger's Pass. CP S a i l ' s f i n a n c i a l evaluation of t h i s project reveals an unacceptably low rate of return on c a p i t a l invested. , This paper has two objectives, namely 1 ) to examine the p o t e n t i a l c o n f l i c t between the public d e s i r a b i l i t y of the tunnel investment and the f i n a n c i a l v i a b i l i t y of the investment, and 2 ) regardless of the outcome of the f i r s t objective, to i d e n t i f y and analyze al t e r n a t i v e methods of providing f i n a n c i a l compensation to CP B a i l so that i t w i l l proceed with the tunnel investment. •„ The analysis concludes that potential benefits brought on by the construction of the tunnel may make t h i s project desirable from a public point of view, even i f i t i s established that the tunnel i s not f i n a n c i a l l y viable to CP B a i l . The analysis of the alternative methods of providing f i n a n c i a l compensation point out that user pay financing alternatves are preferable from an economic viewpoint, but the analysis concludes that time constraints are such that public financing alternatives are optimal. i i i TABLE OF CONTENTS Chapter 1 Introduction ....................................1 1. 1 Ob jec t i ve s • « . • • ••••. • ••» »-• • • ••» •-•»••-• • «> • , 3 1.2 Outline Of Study ................................... 4 Chapter 2 A Major Bottleneck .............................. 6 2.1 The Early Years .................................... 6 2.2 Capacity Problem ................................... 11 2. 3 Alternatives •. • .•••...* •.• .. * • • ...•• • ..... • ..... ... * • . 20 Chapter 3 Fin a n c i a l Analysis ••...•....••....••••••..••....24 3.1 CP Rail's C r i t e r i a For Investment •••• ...24 3.2 Financial Evaluation ....................... ........ 27 Chapter 4 Economic And Financial C r i t e r i a . . . . a , ..4. »••••••• 37 4.1 Pr i c i n g In A Fi r s t - b e s t World ...................... 37 4.2 Second—best Horld . . • • • < . . . . . . . . . . . « . . • » . 4 5 Chapter 5 CP Rail's P r i c i n g P o l i c i e s ...................... 51 5.1 CP R a i l ' s P r i c i n g Strategy: Value-of-service ....... 51 5.2 CP B a i l ' s P r i c i n g Freedom ......<....................53 Chapter 6 Potential C o n f l i c t Associated With The Beaver Tunne 1 . •-• • .;.v. •'.: •-. . . . . . . . * • ; * / . ' . . . . . • . 5 9 6.1 Economic D e s i r a b i l i t y ........... .«,. .. , ..60 6.2 Non-economic C r i t e r i a ••...•••.•*»...•..•.......•... 69 6.3 Summary • ...:....•»» • ••'<»•'••• '•••'»••.<••. «« »•« 72 Chapter 7 Financing Alternatives .....................76 7.1 Public Financing ................................•..77 7.2 Dser Pay Alternatives ...................... ...87 7.3 The Preferable Financing Alternative .......,..,,.,.94 iv LIST OF TABLES Table I Table II Table III Table IV Table V Table VI Table VII Table VIII Table IX Table X Table XI Table XII Table XIII Table XIV Table XV Table XVI Table XVII Table XVIII Table XIX Table XX Table XXI Table XXII Forecasted t r a f f i c . Westbound Trains......... ,.15 Forecasted Westbound Commodity Tonneages....... 16 Forecasted Westbound Commodity Traffic.........18 Forecasted t r a f f i c . Westbound t r a i n s . . . . . . • . . . . 19 Expenditure timetable of proposed Beaver p r o j e c t . • • • • • • • . . , - . . . . . . . . . . . . . . . . 2 8 Beaver project. Forecasted c a p i t a l costs. ,29 Contributions from additional coal t r a f f i c . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Negative Contribution from additional grain t r a f f i c ................ ....... ...... ......... 33 Fin a n c i a l Analysis of Beaver Tunnel............35 Economic benefit of reduced need for grain-related r o l l i n g stock...... ....................63 Economic benefits of reduced demurrage charges on ships........................... .......••....••66 Net benefit of incremental grain t r a f f i c . . . . . . . 67 Beaver project a n a l y s i s . . . . . . . . . . . . . 73 CP B a i l . Net Income before tax... 82 Comparison of 50% CCA vs. 4% CCA • 83 Eff e c t of 5% reduction i n income tax rate during period of construe tion.........................85 Increase Statutory rates by a factor of four... 89 Cost-plus p r i c i n g p o l i c y . . . . . . . . ... ...... ......91 Variable Cost pricing......•••.•...............92 Fin a n c i a l Evaluation of the Beaver Project under minimum and maximum forecasted traffic..........99 F i n a n c i a l evaluation of the Beaver Project under minimum and maximum forecasted sustainable capacity... ................................... .101 Economic benefits of the Beaver Project under varying discount rates.. ...................... 103 V LIST OF FIGUJKES Figure 1 Track p r o f i l e and westward haulage capacity from Dunmore (Medicine Hat) to Vancouver....>,,,..., 13 Figure 2 Consumers1 Surplus................. .....39 Figure 3 Pricing and f i n a n c i a l implications for a Natural Monopoly...,v.^..«............................. 41 Figure 4 I n d i v i s i b l e investments.......................43 Figure 5 Price d i s c r i m i n a t i o n . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Figure 6 Economic j u s t i f i c a t i o n for subsidies., ......... 78 1 CHAPTER 1 INTRODUCTION Canada's f i r s t t r a n s c o n t i n e n t a l r a i l r o a d was completed i n 1885, a scant sixty-one months a f t e r the s i g n i n g of the o r i g i n a l c o n t r a c t between the Canadian P a c i f i c Railway and the Dominion government. The western l i n k p ierced a rugged b a r r i e r t h a t had p r e v i o u s l y stymied the flow of goods between Vancouver and the r e s t of Canada. The K i c k i n g Horse Pass i n the Bocky Mountains, the Soger's Pass i n the S e l k i r k s , and the Eraser Canyon are but a few of the d i f f i c u l t s e c t i o n s of track. By the time c o n s t r u c t i o n of the r a i l w a y began i n the mountains, CP B a i l was experiencing severe shortages of working c a p i t a l . The Railway's o b j e c t i v e was to complete the t r a c k at the lowest p o s s i b l e c o s t i n the l e a s t amount of time. The l i n e provided a l l the c a p a c i t y that was r e q u i r e d i n the l a t e nineteenth century. In the e a r l y years, passenqers, qeneral merchandise, and a g r i c u l t u r a l commodities made up the bulk of the t r a f f i c . As the Railway's f i n a n c i a l p o s i t i o n improved, and t r a f f i c grew, m o d i f i c a t i o n s were undertaken to i n c r e a s e the c a p a c i t y of the western mainline. The S p i r a l Tunnels on the western slope of the K i c k i n g Horse Pass were completed i n 1908. This reduced the grade from a high to a more acceptable 2.255. The Connaught Tunnel was constructed under Soger's Pass i n 1915. This reduced the grade as w e l l as eliminated a s e c t i o n of tr a c k that was i n a dangerous avalanche zone. Over the years, t r a f f i c continued t o grow and various improvements enabled the l i n e to handle the increased t r a f f i c . The i n t r o d u c t i o n of d i e s e l locomotives allowed heavier t r a i n s to 2 move. The length of sidings were increased to handle longer tra i n s . Central T r a f f i c Control led to fewer mainline delays and hence greater u t i l i z a t i o n of track and r o l l i n g stock. These engineering and technological advances have contributed to increasing the capacity of the western mainline. In the past decade, bulk commodities such as coal, sulphur, and potash have become increasingly important to CP H a i l . The mountain mainline i s the conduit for these commodities to flow in t o the Port of Vancouver. Company forecasts indicate that CP B a i l w i l l reach sustainable capacity on i t s western l i n k i n the near future. The c r i t i c a l bottleneck has been i d e n t i f i e d as the Soger's Pass section, which i s located between the c i t i e s of Golden and Bevelstoke.,Here the track climbs up the Beaver Valley (2.2% grade) to the mouth of the Connaught Tunnel. The steep westbound grade allows for the passage of only 15 westbound t r a i n s per day. CP B a i l has examined i t s a l t e r n a t i v e s , and has concluded that double-tracking here w i l l eliminate the bottleneck. Nineteen miles of track would be l a i d , with a maximum grade of 1%. Included i n t h i s project i s a new eight-mile long tunnel under Boger*s Pass. The expected cost of the project i s $102 m i l l i o n (1978 $). CP B a i l * s f i n a n c i a l evaluation of t h i s project reveals an inadequate rate of return on monies invested. 3 1.1 O b j e c t i v e s The f i r s t o b j e c t i v e of t h i s paper i s t o examine the p o t e n t i a l c o n f l i c t between the p u b l i c d e s i r a b i l i t y of the tunnel investment and the f i n a n c i a l v i a b i l i t y of the investment. CP B a i l e v a l u a t e s p o t e n t i a l investments on a discounted cash flow b a s i s , i . e . i n cremental cash outflows must be j u s t i f i e d by i n c r e m e n t a l cash i n f l o w s ( a l l on a discounted b a s i s ) . . I s i t p o s s i b l e , however, t h a t the t u n n e l c o u l d be p u b l i c l y d e s i r a b l e even though i t i s not f i n a n c i a l l y v i a b l e ? The tunnel i s not v i a b l e f i n a n c i a l l y because the Railway cannot c o l l e c t adeguate revenues, on the i n c r e m e n t a l t r a f f i c , through the p r i c i n g mechanism. But i t i s p o s s i b l e t h a t the i n c r e m e n t a l t r a f f i c i s w i l l i n g t o pay a g r e a t e r amount than the Railway can c o l l e c t . For example, i f the incremental t r a f f i c was g r a i n moving under the Crow's Nest r a t e s , the Bailway's p r i c e s are f i x e d by f e d e r a l s t a t u t e (below v a r i a b l e costs) . I t i s l i k e l y t h a t the s h i p p e r s of the g r a i n a r e w i l l i n g t o pay a greater charge. The d i f f e r e n c e between the p r i c e p a i d and the p r i c e that s h i p p e r s are w i l l i n g to pay i s an economic b e n e f i t . Thus the t u n n e l could be e c onomically d e s i r a b l e , while being f i n a n c i a l l y u n a t t r a c t i v e t o p r i v a t e i n v e s t o r s . A second example r e l a t e s to e x i s t i n g t r a f f i c . The t u n n e l may e l i m i n a t e d e l a y s to the e x i s t i n g g r a i n t r a f f i c moving under s t a t u t o r y r a t e s . Or i t may a l l c w l o n g e r , more e f f i c i e n t t r a i n s t o move over t h i s l i n e . These are economic b e n e f i t s which the r a i l w a y i s unable to charge f o r . T h i s t h e s i s e s t i m a t e s the economic but n o n - f i n a n c i a l benefits and contrasts the economic d e s i r a b i l i t y of the tunnel from the Canadian economy perspective r e l a t i v e to the f i n a n c i a l c a l c u l a t i o n of CP B a i l . Begardless of the outcome of the f i r s t objective, the second objective of t h i s paper i s to i d e n t i f y and analyze alternative methods of providing f i n a n c i a l compensation to CP B a i l so that they w i l l proceed with the tunnel investment.,, 1.2 Outline Of Study The second chapter documents the need fo r the proposed tunnel., a b r i e f history of the l i n e i s followed by a discussion of the physical capacity problem. A f i n a n c i a l analysis i s carried out i n the t h i r d chapter. CP's c r i t e r i a for investment are set out and applied to the proposed tunnel project. The fourth chapter discusses how economic theory and f i n a n c i a l c r i t e r i a can diverge under c e r t a i n investment conditions, e.g.,decreasing cost investment such as the proposed Beaver tunnel project. This chapter argues that value-of^service p r i c i n g (widely u t i l i z e d by railways) can s a t i s f y both economic and f i n a n c i a l c r i t e r i a , i . e . , i f railways had complete pricing freedom the f i n a n c i a l and economic analysis could be consistent with one another. .However, there are important r e s t r i c t i o n s on CP's p r i c i n g . Chapter 5 examines these constraints. I t has been Canadian government policy (reinforced by the National Transportation act of 1967) that railways should enjoy pricing freedom. The railways have u t i l i z e d price discrimination to 5 recover th e i r constant costs. However, there i s a r e s t r i c t i o n on t h e i r pricing freedom, namely the existence of the statutory grain rates. This has reduced the railways' a b i l i t y to recover constant costs. Constant costs do not vary with output, and therefore cannot be charged to s p e c i f i c movement of goods. The l a s t two chapters deal s p e c i f i c a l l y with the two stated objectives of t h i s paper. 6 CHAPTER 2 A MAJOfi BOTTLENECK Over the next few years, t r a f f i c i s forecast to increase on CP's already congested western mainline. This chapter w i l l discuss the major capacity constraint problem which CP i s facing on i t s western mainline between Calgary and Vancouver. Alternative solutions to this problem are outlined i n this chapter. A b r i e f history of the western mainline!s d i f f i c u l t mountain section precedes the discussion of the capacity constraint problem. 2.1 The Early Years The Canadian P a c i f i c Hallway Syndicate and the Dominion government signed a contract on October 21,1880 which l a i d out the agreement f o r the construction of the transcontinental railway. The Canadian P a c i f i c Railway Company was incorporated on February 16,1881, ju s t one day aft e r Parliament had approved the terms of the contract. One provision i n the contract c a l l e d f o r the route to go through the Yellowhead Pass., The government of S i r John A. Macdcnald had chosen t h i s Pass on the basis of Sanford Fleming's surveys. The CPE had a more southerly route i n mind. I t commissioned Hajor A. B. Rogers, an American engineer, to search for a pass through the mountain ba r r i e r s . By the end of the 1881 surveying season, Rogers had decided that the Kicking Horse Pass would provide the route through the Bockies. The formidable granite walls and spires of the Selkirks were the l a s t remaining 7 obstacle. If a pass could not be found, the railway would have to fellow the »Big Bend' of the Columbia Biver, which p a r t i a l l y circumvents the S e l k i r k s . In 1883, Sogers located a r e l a t i v e l y low l e v e l pass (4275 feet verses the 5337 foot crest of the Kicking Horse Pass ) which today bears b i s name. The CPS applied to the government for permission to dive r t the route through t h i s Pass., Sanford Fleming was dispatched to report on the e f f i c a c y of t h i s route. His positive recommendation led to the government approval in the f a l l of 1883. The route would, after Golden, . . . p a r a l l e l the Columbia, crossing i t at Donald and running on to Beavermouth, where the Columbia i s joined by the Beaver Biver. The l i n e would then ascend the eastern slopes of the Selkirks to Soger*s Pass(altitude 4,275 feet) by following the Beaver and i t s t r i b u t a r y . Bear Creek, and run down the western slope i n the valley of the I l l e c i l l e w a e t River to the s i t e of Bevelstoke and a second crossing of the Columbia, which i n the i n t e r v a l had made a great swing around the northern end of the Selkirks. * The l i n e was constructed through Boger*s Pass i n 1885, but not without protest. & book, ou t l i n i n g the f o l l y of t h i s route, surfaced i n 1885. The anonymous author voiced strong objections. I do not hesitate to say that t h i s w i l l be a 8 public scandel i f the l i n e i s permitted to be taken in the threatened d i r e c t i o n . There w i l l be a perpetual r i s k of the stoppage of t r a f f i c , and at an immense cost, the l i n e w i l l have eventually to be changed round the Biver Columbia.? The Bailway attempted to convince i t s passengers, and perhaps i t s e l f , that i t had engineered a solution to the avalanche problem. Less than seven years a f t e r the completion of the mainline, the Company's description of the journey through the Pass matched the l o f t i n e s s of the surrounding peaks. The l i n e here leaves the Beaver[Valley] and turns up Bear Creek along continuing grades of 116 feet to the mile., The p r i n c i p a l d i f f i c u l t y i n construction on t h i s part of the l i n e was occasioned by the torrents, many of them i n splendid cascades, which come down through narrow gorges cut deeply into the steep slopes along which the railway creeps. The greatest of a l l these bridges crosses Stoney creek- a noisy r i l l flowing i n the bottom of a narrow, V-shaped channel, 295 feet below the rails-one of the l o f t i e s t railway bridges in the world.- A l l of the d i f f i c u l t i e s of the railway from snow in the winter occur between Bear Creek and the summit on the east and f o r a similar distance on the west slope of the Selki r k s , 9 and these have been completely overcome by the construction, at vast expense, of sheds, or more properly tunnels, of massive timber-work,? The Railway's reassuring prose was swept away, along with i t s snowsheds, by thundering avalanches. In 1899, eight people were k i l l e d i n an avalanche which engulfed Roger's Pass station. In 1910, sixty-two people died in a single avalanche..Instead of diverting "round the Biver Columbia", the Railway undertook a more dire c t approach—a tunnel. The five-mile long Connaugfat Tunnel was completed i n 1916, O r i g i n a l l y , i t was double-tracked, but i t was l a t e r switched to single-track i n 1958, i n order to accommodate t a l l e r r o l l i n g stock. The Canadian P a c i f i c Bailway has come a long way from the brisk November day in 1885 when Donald Smith pounded i n the l a s t spike. Smith's symbolic act had raised the capacity of the western mainline from zero to some stated l e v e l . I n i t i a l l y , the Bailway had a surplus of mainline capacity. / W i l l i an Van Home predicted that "...three or four t r a i n s each way w i l l carry a l l the business to be d o n e . " * Over the years, CP has increased i t s mainline capacity as i t s t r a f f i c grew. Investments designed to increase capacity f a l l i n t o two categories: d i v i s i b l e and i n d i v i s i b l e . . D i v i s i b l e investments add to capacity i n a continuous fashion. k portion of a d i v i s i b l e investment w i l l add to capacity, e.g./connecting addit i o n a l d i e s e l units to a t r a i n w i l l enable the t r a i n capacity to be expanded. Some examples of d i v i s i b l e capacity improvements include: 10 1. Longer and heavier trains (increased axle loading) 2. Longer sidings 3. /Reducing the distance between passing places tt. Increasing the speed of operations 5. Onit t r a i n s 6 . , Increased locomotive power, including robot engines 7. Central t r a f f i c c o n t r o l 5 I n d i v i s i b l e investments increase capacity i n a "lumpy" fashion, e.g. a 95? complete tunnel does not add to capacity, whereas the completed tunnel w i l l . Examples of t h i s type include the building of the S p i r a l Tunnels near F i e l d , B.C. , and the Connaught Tunnel under Roger*s Pass. These investments decreased the grade with the result of allowing heavier t r a i n s to move equipped with the same engine power, once the tunnels were in place, a quantum change i n r a i l capacity was r e a l i z e d . , 11 2.2 Capacity Problem CP R a i l i s now beginning to experience bottlenecks on i t s western mainline..Given i t s t r a f f i c forecasts and present plant, the Railway w i l l face capacity constraints i n the early 19QQ's. Defining capacity The term capacity has a number of meanings.. Transport Canada provides the following d e f i n i t i o n : [Capacity i s ] the number of tons or the number of vehicles of various types which can pass through a transportation f a c i l i t y i n a given period of time...* I t i s important to note that the concept of capacity i s multi-dimensional; time i s as c r u c i a l to the d e f i n i t i o n as quantities. a d i s t i n c t i o n can be drawn between absolute capacity and sustainable capacity, absolute capacity would mark the physical l i m i t s of t r a f f i c movement in a given period of time, given the exi s t i n g plant. Sustainable capacity i s that volume of t r a f f i c that can be sustained over a i n d e f i n i t e period of time, given the existing plant. This d i s t i n c t i o n i s important. For example, a s p e c i f i c l i n e of r a i l track may have a sustainable capacity of ten t r a i n s per day. By deferring maintenance, perhaps f i f t e e n t r a i n s per day can move., This i s absolute capacity., In the longer term, however, maintenance cannot be ignored. Therefore, i n t h i s example, i f our given period of time i s two years, i t may be possible to run f i f t e e n t r a i n s per day f o r , say, a year 1 2 before maintenance becomes c r i t i c a l . A r e l a t i v e l y longer maintenance period would now be required than i f maintenance was carried out every three months. The e f f e c t i v e sustainable capacity i s ten trains per day under eith e r a l t e r n a t i v e . By deferring maintenance, the railway runs a higher r i s k of derailment, which would reduce i t s throughput.,. The current capacity problem Railway and government forecasts indicate that the western mainline i s approaching sustainable capacity i n the near future. In 1975, Transport Canada issued a report on the state of freight transportation i n Canada. Based on f r e i g h t volume estimates developed by the Transportation Development Agency, the Report concludes that certain r a i l l inks w i l l begin to experience capacity constraints i n the coming decade. In p a r t i c u l a r , "...major f r e i g h t capacity problems w i l l occur on western r a i l l i n k s , p a r t i c u l a r l y i n the western mountain region..." 1' the Report goes on to forecast the capacity of the Golden-Vancouver l i n k as being 30 t r a i n s per day i n both directions. a (A CP source indicated that t h i s could be halved to determine the number of t r a i n s moving i n one d i r e c t i o n ) . A track p r o f i l e of CP's western mainline i s found i n Figure 1, part a. Four steep westbound grades can be i d e n t i f i e d , namely the climb up to Stephen, Glacier, Clanwilliam, and Notch H i l l . The westbound haulage capacity (of a 3000 horsepower diesel unit) associated with the western mainline i s contained i n Figure 1, part b. The four steep grades are the major 13 F i g u r e 1 Figure 1 sS 6000 o r-V) (.0 o 2 X O u - H — H M (—I : _+-W E S T W A R D H A U L A G E C A P A C I T Y O F 3 0 0 0 H P D I E S E L U N I T (IN G R O S S T O N S ) T R A C K P R O F I L E A N D W E S T W A R D H A U L A G E C A P A C I T Y F R O M D U N M O R E (MEDICINE HAT)• T O 1 V A N C O U V E R C P R a i l Vancouver 11/22/78 14 bottlenecks i n the system. CP B a i l has embarked on grade r e v i s i o n projects a t three locations, with the intention of reducing the westbound grades to a maximun grade of 1%. The double-tracking projects are taking place at Clanwilliam(4.5 miles), Notch H i l l ( 1 1 miles), and Stephen (5. 5 miles). CP has i d e n t i f i e d i t s western mainline bottleneck as being that section of track between Stoney Creek and Glacier. r The westward haulage capacity of a d i e s e l unit i s at i t s lowest point on the Glacier grade (Figure I ) . CP has estimated that the sustainable capacity of t h i s section i s f i f t e e n westbound trains per day.? The forecasts in Table I indicate that by 1982, given the present plant, the mainline would not have s u f f i c i e n t sustainable capacity to handle the projected t r a f f i c . as mentioned previously, the d i s t i n c t i o n between sustainable and absolute capacity i s c r u c i a l . The mainline could handle more than f i f t e e n westbound trains per day for some limited period of time. This paper i s adopting CP's stated capacity l e v e l (fifteen trains) as being the sustainable capacity, which i s then compared to net tonnes i n Table I I . The adoption of the figure of f i f t e e n westbound t r a i n s per day i s open to debate. an argument could be made that sustainable capacity i s , say, 14 or 16 trains per day. The selection of a s p e c i f i c f i g u r e has s i g n i f i c a n t implications, both as to the timing and f i n a n c i a l v i a b i l i t y , when evaluating any potential investment which would increase capacity. This w i l l be discussed at greater length in the next chapter. The t r a f f i c forecasts are another c r u c i a l area. This paper 15 TABLE I Forecasted traffic-Westbound Trains Present Plant Per Day 1979 1980 1981 1982 1983 1984 1985 Coal Grain Potash 3.04 3.06 3.17 .3.19 3.23 3.24 3.28 Sulpher Canmore Coal Passenger 1.00 1.00 1.00 .1 . 00 1 . 00 i.1.00 .71. 00 General 6.00 6.17 6.34 6.50 6.67 6.84 7.00 Merchandise TOTAL 13.19 13.38 14.16 15.06 15.66 16.03 16.23 Note: 1. The coal and bulk (grain, potash, sulpher, and Canmore Coal) t r a i n requirements have been calculated from the the net tonneage figures i n Table I I . a) I t i s estimated that each CP coal t r a i n w i l l carry 9003 net tonnes (CP f i g u r e ) . b) The bulk requirements used the October, 1976 figures (see T a b l e IV ) as a base. These were modified d o w n w a r d , as the 1978 bulk tonneage forecas i s s l i g h t l y less that the 1976 forecast, estimated that 3.15 tr a i n s per day would be required i n 1979. The revised forecast, based on 1978 data, indicates that 3.04 trains w i l l be required i n 1979. 2. The passengers and general merchandise t r a i n require-ments are drawn from the 1976 forecast (see T a b l e IV )• 16 TABLE I I F o r e c a s t e d Westbound Commodity T o n n e a g e s ( M i l l i o n n e t t o n n e s ) 1979 1980 1981 1982 1983 1984 1985 C o a l 1.0. 36 1.0. 36 1.2. 00 1.4. 36 15 .63 16. 27 16. 27 G r a i n 4. 55 • 4. 55 4. 64 4. 73 4 .73 4. 82 4. 82 P o t a s h 1. 14 1. 18 1. 27 1. 32 1 .41 • r . 45 1. 54 S u l p h u r 1. 73 1. 73 1. 82 1. 73 1 .73 l . 63 1. 63 Canmore C o a l • 13 • 13 • 13 • 13 .13 • 13 • 13 G e n e r a l M e r c h a n d i s e . . .4. 23 4. 55 4. 73 . , .4. .86 5 , 09 5. 7,7 5 . 54 22. 14 22 . 50 24. 59 27. 13 28 . 72 29. 57 29. 93 S o u r c e : CP R a i l , J a n u a r y , 1978. T h e s e a r e t h e Company's most p r o b a b l e f o r e c a s t s . 17 i s u t i l i z i n g CP's "most probable" forecasts. I f t h e i r "minimum" forecasts turned out to be the actual t r a f f i c l e v e l s i n future years, the Railway would not be facing a capacity problem u n t i l at least 1986, and probably much l a t e r than that (Table I I I ) . I t i s evident that there i s uncertainty regarding both t r a f f i c forecasts and the precise measure of sustainable capacity. However, i n order to carry out a f i n a n c i a l evaluation of t h i s project, figures must be selected. Since both Transport Canada and CP B a i l have set capacity at 15 westbound t r a i n s per day, i t i s not unreasonable to adopt th i s figure as sustainable capacity for the purposes of evaluation, of course, more than 15 t r a i n s per day could move i n the short-term, and t h i s would have implications as to the timing of the project. / Costing data r e l a t i n g to t h i s short-term capacity increase are however, not available. I t i s reasonable to use the "most probable" t r a f f i c forecasts for the major cal c u l a t i o n . The e f f e c t of a range of t r a f f i c forecasts on the project evaluation w i l l be ascertained i n the following chapter. 18 TABLE I I I Forecasted Westbound Commodity T r a f f i c ( m i l l i o n of net tonnes) Pessimistic forecast 1979 1980 1981 1982 1983 1984 1985 TOTAL 10.72 1.8.45 18 . 83 19. 99 19.40 19.72 20.17 Source: CP R a i l , January 1978. 19 TABLE IV Fore c a s t e d t r a f f i c (westbound t r a i n s ) Present p l a n t - most probable estimate Per day Coal Bulk Passenger General Merchandise TOTAL 1979 1980 3.09 3.64 .3.15 3.17 1.00 1.00 6.00 6.17 1981 4. 27 .3.29 1.00 1982 4. 58 3,39 1.00 6.34 6.50 1983 4.69 .3.47 1.00 6.67 1984 •4.88 .3.57 1.00 6.84 198 5 4,88 3.65 1.00 7.00 13.24 13.98 14.90 15.47 15 . 82 16.29 16. 53 Source: CP R a i l , October 1976 20 2.3 Alternatives A number of alternatives to increase mainline capacity are available to the Railway. These w i l l be discussed under the sub-headings of d i v i s i b l e and i n d i v i s i b l e investments.. D i v i s i b l e investments The sustainable capacity of the bottleneck could be increased by means of d i v i s i b l e investments. Additional train sets (locomotives, robots, r o l l i n g stock, and cabooses) could be bought and inserted into the system. The r e s u l t of t h i s would be increased queuing times at the bottleneck, and hence increased t r a n s i t times. This would adversely a f f e c t the qu a l i t y of service offerred by CP. Additional yard, sidings, and crews would be necessary under th i s scheme. There i s also the question of adding more locomotive power at the bottleneck, which would lead to greater speeds up the grade and/or longer t r a i n s . At the present time, up to thirteen locomotives are required to move t r a i n s up the Roger's h i l l . Four locomotives are located at the head end, four robots are placed i n the middle of the t r a i n , and four to f i v e "pushers" are added at the t a i l end., There are engineering problems associated with adding locomotives. The head end i s r e s t r i c t e d to 24 dri v i n g axles (six driving axles per locomotive) due to the drawbar-pull stress points. The f i r s t car has to endure the stress of pu l l i n g a l l the cars behind i t . The p o s s i b i l i t y exists of adding robot units or t a i l end pushers. However, additional 21 units on the t a i l end can lead to unacceptable "buff" forces. This i s e s s e n t i a l l y the reverse of drawbar stress. I f the engineering d i f f i c u l t i e s could be overcome, the lengthening of t r a i n s would s t i l l mean lengthening the sidings, and t h i s i s a costly undertaking i n the mountains. • • CP can increase capacity by making d i v i s i b l e investments.. However, these investments would lead to a lower qu a l i t y of service to the customer, e.g., increased t r a n s i t times. CP may f e e l that competitive forces w i l l not allow an increase i n r a i l t r a n s i t times. D i v i s i b l e investments would also r e s u l t in increasing variable costs, which may r i s e f a s t e r than the p r o f i t CP makes on the additional t r a f f i c . (This w i l l be delved into more f u l l y i n a l a t e r chapter). I n d i v i s i b l e investments a major i n d i v i s i b l e investment could also increase capacity, one p o s s i b i l i t y would be the e l e c t r i f i c a t i o n of the mountain mainline. an e l e c t r i f i e d line has s i g n i f i c a n t advantages over diesels when the l i n e contains steep grades. The cost of implementing this solution- $300 mi l l i o n i n 1975 d o l l a r s - i s the major drawback to t h i s alternative,*° a second track could be constructed i n order to reduce the grade and curvature for the westbound t r a i n s . The Connaught tunnel, completed i n 1916, had reduced the grade to 2.2%. Double-tracking could reduce the grade to 1$.,The fiailway could achieve t h i s i n two alternative ways. The f i r s t p o s s i b i l i t y would be to increase the size of the present tunnel i n order to 2 2 f a c i l i t a t e double-tracking. This tunnel had o r i g i n a l l y been double-tracked, but the introduction of higher r o l l i n g stock had forced the conversion to a single track i n 1958. , This alternative would require the construction of two s p i r a l tunnels belcw the e x i s t i n g tunnel, due to the 13 grade requirements. The engineering d i f f i c u t i e s , r e s u l t i n g t r a f f i c delays, and tight curvatures i n the tunnels has lead to the rejection of this a l t e r n a t i v e . The second alternative would include building a new eight-mile long tunnel under the Connaught tunnel. Eleven miles of new track would be b u i l t on the Beaver Valley approach. This would reduce the grade to 1$ and reduce the maximum curvature to 6%. This i s the a l t e r n a t i v e that CP has selected. The reduced grade and curvature associated with the nineteen miles of track would increase the mountain mainline capacity from the present f i f t e e n t r a i n s per day to nineteen t r a i n s per day (westbound).The t o t a l cost of t h i s project i s estimated to be $102 m i l l i o n (1978). M 23 Footnotes 1. fl. Kaye Lamb, History Of The Caqadian^ P a c i f i c fiailway (New York:Macmillan Publishing Co.inc.,1977),p.116. 2. Philo. Veritas, The CPE, An Appeal to Public. Opinion against the railway being car r i e d across the Selkirk range, that route being objectjonable from the danger of f a l l s from g l a c i e r s and from Avalanches, also generally on other matters (Montreal:Wm.douglas and Co., 1885) ,p. 52. 3. Canadian P a c i f i c Bailway, Annotated Time Table (Montreal:Canadian P a c i f i c Bailway,1892,p.39., 4. Van Home to Minister of Bailways, May 19, 1884, 5. A.F.Joplin and P.J. . Detmold, " B a i l C a p a c i t y — H i l l , there be s u f f i c i e n t ? " . Address to the Canadian Transportation Besearch Forum, Vancouver, June,1976, p.2. 6. Canada, Transport Canada, An interim Beport On Freight Transportation In Canada (Ottawa:Information Canada, 1975), p.11. 7. . Ibid, p. 52. ,• 8. Ibid, p.38. 9. "Economic Analysis Of Capital Spending Projects Beguired To Construct Second Main Track At Stephen, Beaver, Clanwilliam, And Notch H i l l Hith Maximum One Per Cent Compensated Grade And 6% curvature." (Vancouver: CP B a i l , 1976) , p . 11. 10. J o p l i n And Detmold, Op.cit., p.4. 11. "Beaver Tunnel And Grade Bevision Project"(Montreal:CP Bail) , 1978, p. 1. 24 CHAPIEB 3 FINANCIAL ANALYSIS This chapter w i l l present a f i n a n c i a l analysis of the proposed Beaver tunnel investment. The previous chapter has introduced the uncertainty associated with a) quantifying sustainable capacity, and b) t r a f f i c forecasts. ., The f i r s t section of t h i s chapter reviews the evaluation procedure u t i l i z e d . The second section contains the f i n a n c i a l analysis. The s e n s i t i v i t y of t h i s analysis to changes i n the t r a f f i c forecast and changes i n capacity i s examined i n the Appendix. 3.1 CP B a i l ' s C r i t e r i a For Investment The most widely recommended method of evaluating proposed c a p i t a l investments i s discounted cash flow analysis. A c a p i t a l investment w i l l generate i t s benefits i n future years. A firm wants to know whether the benefits generated over a number of years j u s t i f y the expenditure of monies, which usually occur early i n the time frame. Four points should be noted. F i r s t , the evaluation method i s incremental, i . e . the firm i s comparing incremental benefits to incremental costs.„ The incremental benefits include such items as savings brought on by the investment, and contribution margins (excess of revenue over variable costs) supplied by any a d d i t i o n a l production generated by the investment. Second, since benefits accrue over a period of years, the time value of money i s an important consideration. .,, The future costs and benefits of a project must be discounted to base year 25 i n crder to r e f l e c t the time value. The analysis i s concerned with cash flows and not accounting p r o f i t s , as the non-cash expense of depreciation impacts accounting p r o f i t s . This i s not to say that depreciation i s irrelevant to discounted cash flow analysis. In Canada, the Income Tax Act allows taxpayers to deduct a stated percentage of the asset every year for tax purposes. This deduction i s c a l l e d C a p i t a l Cost Allowance (CCA). As the CCA w i l l reduce the taxpayer's income tax payable (a cash outflow) i n any given year, i t i s a key consideration i n determining net cash flows. A higher CCA rate w i l l allow greater deductions i n early years than would a lower rate, and hence defer taxes to l a t e r years. The time value of money means that a r e l a t i v e l y higher CCA rate w i l l be more favourable when u t i l i z i n g discounted cash flow analysis., Third, the discount rate should r e f l e c t the firm's marginal cost of c a p i t a l . , The cost of c a p i t a l should be the "...the firm's weighted average cost of r a i s i n g funds at the margin."* I f the discounted cash inflows exceed the discounted cash outflows, the return to the firm i s greater than i t s marginal cost of c a p i t a l . The investment i s deemed to be b e n e f i c i a l to the firm, as the wealth of the owners has been increased. If discounted outflows are greater than the inflows, the firm i s earning a lower return than i t s marginal cost of c a p i t a l . On t h i s basis, the investment cannot be j u s t i f i e d . Fourth, as the cash flows are accruing i n the future, there i s uncertainty associated with forecasting t h e i r magnitude. CP B a i l ' s c r i t e r i a f o r investment conform to the above method. I t s guidelines state: When the investment of addit i o n a l c a p i t a l to serve an exis t i n g market segment i s contemplated, after establishing that existing t r a f f i c i s p r o f i t a b l e , the new investment must be considered to be incremental and must be supported by the incremental savings or contributions which i t generates.? 27 3.2 Financial Evaluation The f i n a n c i a l analysis of the Beaver project has been performed i n t e r n a l l y by the Railway. Estimates of the costs and benefits have been completed. The discount rate selected was 12% (after-tax) .3 Costs The expenditure timetable together with the costs of the Beaver project are presented i n Table 7. These are CP's figures, developed from i n t e r n a l engineering data. The construction would stretch over a four year period. The present value of the costs, based on a discount rate of 12%, are determined in Table VI. Benefits The benefits of the project are twofold, namely savings and contributions from additional t r a f f i c . 1. Savings The investment would reduce the grade and curvature of the mainline i n the Beaver Valley. This would lead to a reduced need fo r d i e s e l s , crews, f u e l , and maintenance. The exact value of the savings associated with the tunnel was not obtainable from CP. However, i t i s known that the present value of the Beaver project costs i s $7 3.8 m i l l i o n (Table VI). Company estimates also indicate that, given the current tax rates and c a p i t a l cost allowances, the present value of the cash shortfall(based on the most probable t r a f f i c forecasts) reguired to earn a 12$ rate of 28 TABLE V Expenditure timetable of proposed Beaver project 1979 $500,000 -engineering investigation and design approach to tunnel 1,100,000 -engineering investigation and design for. tunnel 1980 660,000 -land purchase 8,340,000 -grading and track for approach to tunnel 24,000,000 -tunnel construction 1981 14,500,000 -grading and track for approach to tunnel 28,000,000 -tunnel construction 1982 900,000 -signals, buildings, fences, etc 13,908,000 -grading and track for approach to tunnel plus track i n tunnel 10,092,000 -tunnel construction TOTAL $102,000,000 - (undiscounted) Source: CP R a i l CMarch 1978 estimates) 29 TABLE VI Beaver project Forecasted c a p i t a l costs (1978 constant $) Present value Q 12%- . 1979 $ 1,600,000 X :893 = $ 1,428,800 198Q 33,000,000 X . .797 = 26,301,000 1981 42,500,000 X .712 = 30,260,000 1982 24,900,000 X .636 = 15,836,400 $102 ,000,000 $ 73 ,826,200 30 re turn (after tax) i s $39.9 m i l l i o n . * This c a l c u l a t i o n includes project costs and the associated tunnel savings.• 2. Contributions from a d d i t i o n a l t r a f f i c This paper's computation of the benefits d i f f e r s from CP's, i n that contributions from additional t r a f f i c are included here. The Bailway excludes the contribution from additional t r a f f i c in i t s evaluation. But an argument can be made for i t s i n c l u s i o n . 5 The investment would permit addi t i o n a l t r a i n s to move over CP's western mainline. Any revenues greater than variable c o s t — contribution margin—accruing from t h i s a d d i t i o n a l t r a f f i c should be c l a s s i f i e d as a benefit derived from the investment, as the additional t r a i n s would not have moved i f the investment was not made. The sustained capacity of the present plant i s f i f t e e n westbound t r a i n s per day. Given the forecasted t r a f f i c mix in Table I, the Bailway would reach sustainable capacity i n 1982. I f the investment i s undertaken, mainline sustainable capacity would be increased by four t r a i n s per day. 6 The contributions generated from the additional t r a f f i c are detailed i n Tables VII and VIII. It i s forecast that coal w i l l provide the greatest portion of the incremental t r a f f i c . The i n c l u s i o n of the contribution from additional t r a f f i c in the evaluation assumes that the additional coal would not move on CP^s l i n e s i f the tunnel i s not b u i l t , i . e . , CP could not derive any portion of t h i s contribution i f an alternative route was selected.? The contribution per ton of coal moved i s derived from CP B a i l . This i s an after-tax contribution, based on expected coal rates, and 31 TABLE VII C o n t r i b u t i o n s from a d d i t i o n a l c o a l t r a f f i c 2 A) Gross c ont r i b u t ions 1. Additional coal Contribution Total Discount Present moved (millions per ton Contribution Rate = .12 Value of tons) (millions) (millions) 1983 1.273 $2.22 $2.83 .567 $1.6 1984 1.90.9 2.22 4.24 4.45 18.9 2013 Less: B) T r a i n sets r e q u i r e d 3 PRESENT VALUE OF CONTRIBUTIONS $20.5 Required. Cost per set Total Discount Present (Millions) (Millions) Rate = .12 Value (Millions) 1983 1.5 $ 9.0. $ 13.5 .567 $ 7.65 1984 .5 9.0 4.5 .507 2.28 $ 9.93 PRESENT VALUE OF CONTRIBUTIONS $ 10.57 million (Gross contribution less train sets) : ' Footnotes: 1. The base year f o r the present value c o n t r i b u t i o n s i s 1978. 2. Assume that the tunnel i s completed i n 198 2, and a d d i t i o n a l 32 Footnotes - TABLE VII - continued 2. coal starts moving i n 1983. It i s assumed that sustainable capacity i s reached i n 1982, during which 14.4 m i l l i o n tonnes of coal are moved (see Table I I ) . In 1983, with the tunnel completed, 15.6 m i l l i o n tonnes of coal move. It i s assumed that the difference between 1982 and 1983 (1.3 m i l l i o n tonnes) would not have moved i f the tunnel was not i n place. The additional coal moved i s therefore a benefit associated with the tunnel. The same rationale i s applied to the coal t r a f f i c moving between the years 1984 and 2013 (1.9 m i l l i o n tonnes per year). 3. A CP source indicated that approximately 1.1 t r a i n sets are required for every additional m i l l i o n tonnes of coal that are to move. Approximately two additional t r a i n sets w i l l be required to move the additional 1.9 m i l l i o n tonnes of coal beginning i n 1984. 1.5 of that t r a i n sets are bought i n 1983, as only 1.3 m i l l i o n tonnes (additional) w i l l move, and the extra .5 of a t r a i n i s added i n 1984. 4. Cost per t r a i n set i s $9.0 m i l l i o n (1978 $) - CP Source Engines $4.5 m i l l i o n R o l l i n g Stock 4.0 Miscellaneous § Caboose .5 $9.0 m i l l i o n 33 TABLE VIII Negative Contribution from additional grain t r a f f i c Additional grain Loss per 2 Total loss Discount Present moved (millions of tonne (millions) = .12 tonnes) 1984 1985 2013 0.091 0.091 7.69 7.69 ) .699 .699 .507 .3.944 Value (millions) $0.35 2.76 PRESENT VALUE OF GRAIN LOSS $3.1 Footnotes: 1. This is the CP estimate of additional grain moved i f the tunnel is built. 2. The loss per tonne is the variable cost (exclusive of subsidies) that Canadian Railways absorbed in 1977, as determined by Carl Gravely - Vancouver Express 15 January 1979. 34 does not include the costs of the additional t r a i n sets that would be needed to handle the greater amounts of coal t r a f f i c . The cost of the t r a i n sets has been obtained from CP sources.. This cost i s introduced into the cash flow analysis as the t r a i n sets become necessary (Table VII) . Any additional grain t r a f f i c that i s generated would provide a negative benefit, as CP does not recover i t s variable costs of moving grain. ,, The incremental loss i s determined in Table VIII. The complete f i n a n c i a l analysis i s presented i n Table IX. The present value of the benefits derived from the proposed investment are considerably less than the present value of the costs. A cash s h o r t f a l l of some $31 m i l l i o n i s indicated. Given CP* s desire to earn a 12$ rate of return, i t i s apparent that CP i s not enthusiastic about proceeding with t h i s project at this time. The Appendix w i l l examine the s e n s i t i v i t y of t h i s finding to changing assumptions.,, 3 5 TABLE IX Financial Analysis of Beaver tunnel (millions of discounted $) Costs Capital costs (years 1-4) * $ 73.8 Benefits S av i ag s $33.9 Contributions from additional t r a f f i c Coal 5 1.0.6 General Merchandise 1.0 Grain (loss) 4 (3.1) 42.4 Financial S h o r t f a l l $ 31.4 Footnotes: 1. TABLE VI 2. TABLE VII 3. Source; CP R a i l 4. TABLE VIII 36 Footnotes 1 . Peter Lusztig and Bernard Schwab, Managerial Finance In A Canadian Setting (Toronto: Holt, Rinehart And Winston, 1973) , p.76. 2. "Guidelines For Developing The Economics Of Major Spending Proposals" (Montreal: CP R a i l , 1974), p. 1. 3. CP wants to earn 12% (after-tax) on prospective investments. The Snavely Report on the Costs of Transporting Grain set CP Rail's weighted average cost of funds at 20.8% before taxes and 11.31% a f t e r taxes. 4. "Beaver project analysis", CP R a i l , 1978, p.4. 5. CP included the contribution from a d d i t i o n a l t r a f f i c in i t s 1976 analysis, but c l e a r l y excluded i t i n t h e i r 1978 analysis, where i t stated "...that none of the above calculations include any f i n a n c i a l benefits generated by add i t i o n a l contributions from t r a f f i c which otherwise could not have moved account capacity r e s t r i c t i o n s " , p.6. However, CP's "Guidelines for Developing the Economies of Major Spending Proposals" do mention contributions. See footnote 2 above.. 6. Other bottlenecks would then become c r u c i a l . I t must be noted that the western mainline i s mostly s i n g l e -tracked. Transport Canada states that "...based on the mix of t r a f f i c (unit t r a i n s , fast f r e ights, slow freights, passenger trains) presently experienced, i t can be expected that mainline r a i l l i n k s , single track with ce n t r a l i z e d t r a f f i c control, w i l l have a capacity limintation of 30-40 t r a i n s in both directions. 1? Transport Canada, op.ci t . , p.13. By halving the figures to obtain a single d i r e c t i o n capacity, the numbers become 15-20 t r a i n s per day., 7. For example, CP might ship the incremental coal t r a f f i c to Prince Rupert via CN's l i n e . I f t h i s was possible, CN and CP would s p l i t the contribution. However, t h i s type of alternative i s beyond the scope of t h i s paper. 3 7 CHAPTEB 4 ECONOMIC AND FINANCIAL CBITESIA In a perf e c t l y competitive, or f i r s t - b e s t world, prices egual marginal costs and resources are allocated i n t h e i r most e f f i c i e n t manner. A marginal cost pricing strategy can lead to f i n a n c i a l d e f i c i t s i n decreasing cost industries. An i n d i v i s i b l e or lumpy investment such as the Beaver tunnel can be a source of decreasing costs. The f i r s t section of thi s chapter outlines the theory of marginal cost pricing, with an emphasis on i t s application to decreasing cost i n d u s t r i e s . , I t w i l l be shown that t h i s i s a si t u a t i o n where economic and f i n a n c i a l c r i t e r i a diverge. The second section explains that, given that the r e a l world i s imperfectly competitive, marginal cost p r i c i n g i s not necessarily the optimal pricing strategy. Bather, value-of-service p r i c i n g can s a t i s f y both economic and f i n a n c i a l c r i t e r i a . 4.1 Pricing In A Fi r s t - b e s t World The concept of welfare Microeconomic theory assumes that people derive u t i l i t y from the consumption of goods.. U t i l i t y i s , i n i t s e l f , not measurable. Consequently, interpersonal comparisons cannot be made, and i t i s thus impossible to set maximization of u t i l i t y as a welfare objective. The usual objective of welfare theory i s the maximization 38 of net benefits to society. , The benefit i s the public's willingness to pay, and benefits can be measured by means of a demand curve..Costs can be thought of as benefits which must be foregone. The economist's demand curve i s a c o l l e c t i o n of points which relate the public's willingness to pay f o r a good for the various quantities offered. The area below a demand curve represents the worth of the goods to society. The worth i s the r e l a t i v e willingness to pay, i . e . , what the public i s w i l l i n g to forego i n terms of alternative goods available. At price Pb i n Figure 2, the quantity Qb i s demanded.. The tria n g l e APB i s known as the consumer's surplus, which i s the "...maximum sum of money a consumer would be w i l l i n g to pay f o r a given amount of the good, less the amount he ac t u a l l y pays. *M The diagram shows that at price Pb, many consumers are able to buy at a price below the marginal value they attach to the good. The price charged i s the consumers' marginal willingness to pay. I f no market d i s t o r t i o n s or other e x t e r n a l i t i e s e x i s t , the demand curve i s the marginal benefit curve f o r society. The marginal cost curve indicates what each additional increment of production w i l l cost. Cost i s defined to be the loss of benefit, or the opportunity foregone, that society incurs by producing that item of output. . Assuming no e x t e r n a l i t i e s , the opportunity costs are the market price of the inputs. HeIfare economic theory desires to maximize net benefits to society. Under perfect competition, net benefits are maximized where .HB=HC. This indicates that the marginal benefit to society Figure 2 CONSUMERS' SURPLUS 40 of the l a s t item produced just equals the marginal benefit foregone (cost) by producing that item. The price must equal MB=MC i f the benefits are to be maximized. To put i t another way, "...the optimum of the general welfare corresponds to the sale of everything at marginal c o s t . " 2 Marginal cost p r i c i n g , decreasing costs, and f i n a n c i a l d e f i c i t s Marginal cost p r i c i n g can lead to f i n a n c i a l d e f i c i t s under conditions of decreasing costs. The standard example i s the "natural" monopoly, where economies of scale lead to decreasing average costs (Figure 3 ) . F i r s t , the monopolist sets h i s price Em such that MR=MC. There i s no f i n a n c i a l d e f i c i t . Assuming the demand curve i s the marginal benefit curve, the welfare maximizing solution sets P=MC, at the point where the MC curve intersects the demand curve (or the marginal willingness to pay). This leads to price Pw and output Qw. Thus, the welfare maximizing solution has l e d to increased output and lower prices. Set benefits (the area under the marginal cost curve) have increased., However, average cost exceeds pr i c e , and a f i n a n c i a l d e f i c i t r e s u l t s . The shaded rectangle ABEF denotes the magnitude of the f i n a n c i a l d e f i c i t . A d e f i c i t can be avoided i f the monopolist i s allowed to set i t s price Pm, or i f a regulatory price Pr i s imposed. But the d e f i c i t i s avoided only at the detriment of welfare considerations.~ output Qr i s produced under the regulatory solution. This i s Qw-Qr l e s s than would have been produced under the welfare maximizing solution. 41 Figure 3 Pricin g and f i n a n c i a l implications for a Natural Monoply Source: Adapted from J. H i r s h l e i f e r , Price Theory and Applications: p.290 42 The welfare loss i s the triangle between Qw and Qr, bounded by the demand curve (marginal willingness to pay) and the MC curve (marginal cost of production). One can see that the absence of a regulatory solution would lead to an even greater welfare loss. In Figure 3, the relationship between costs and output i s a smooth continuous function. I n d i v i s i b l e investments can bring on decreasing average costs. In Figure 4, the plant s i z e s between A and £ are not attainable because of the physical c h a r a c t e r i s t i c s of the "lumpy" investment. The industry can produce beyond Qx, with plant size A. This leads to sharply increasing marginal costs. An alternative i s the undertaking of an i n d i v i s i b l e investment i n order to attain plant size fi. .,. (This assumes that the smaller increments to capacity do not exist).,The long-run curves, LBHC and LBAC, are not continuous, as would be the case i f an i n f i n i t e number of SBHC and SBAC curves were possible. In t h i s Figure, only two plant sizes are attainable.,If the cost-input relationships SRMC* and SBAC1 are given, the r e l a t i o n s h i p to i t s r i g h t , SBHC2 and SBAC2, i s attainable only by means of an i n d i v i s i b l e expenditure. An example of such a "lumpy" investment would be a tunnel or a bridge. The completed tunnel w i l l provide a s t e p - l i k e increase in capacity. Half a tunnel would have no e f f e c t on capacity. When t h i s investment i s completed, i . e . plant s i z e B has been attained, output to the r i g h t of Qx leads to lower average costs than what would have been the case i f the investment had not been undertaken. In t h i s way, the investment leads to decreasing average costs in the output range Qx to Qy..„• 45 F i g u r e 4 I n d i v i s i b l e I n v e s t m e n t s S o u r c e - W.G. W a t e r s " P r o d u c t i o n T h e o r y and C h a r a c t e r i s t i c s o f T r a n s p o r t C o s t s " , September 1977, p. 17 44 In Figure 4, assume that output i s Qx, with cost-output relat i o n s h i p SBHC* and SBAC*. The industry i s approaching capacity. Plant A can produce beyond output Qx. Beyond this point, average and marginal costs r i s e rapidly.. Given plant size A, the demand curve intersects the AC curve i n a region of increasing costs. An i n d i v i s i b l e investment i s undertaken, leading to cost-output relationships SBHC2 and SBAC2. The average costs of plant A and B are equal at output Qx. Given the plant size B, the demand curve intersects the AC cost curve in a region of decreasing costs. Setting P=SMC anywhere i n t h i s range would lead to f i n a n c i a l d e f i c i t s . o 45 4.2 Second-best World In the r e a l , or second-best world, imperfections e x i s t i n the marketplace. Marginal cost p r i c i n g may not lead to optimal resource a l l o c a t i o n i n any one industry due to v i o l a t i o n of the marginal cost p r i c i n g r u l e i n other sectors of the economy. Value-of-service p r i c i n g It has already been indicated that marginal cost p r i c i n g i n a decreasing cost industry leads to a d e f i c i t . an alternative p r i c i n g strategy i s value-of-service p r i c i n g (also known as price discrimination). .Under value-of-service p r i c i n g , d i f f e r e n t consumers pay d i f f e r e n t prices. The demand curve in Figure 5 i l l u s t r a t e s that certain buyers are w i l l i n g to pay a higher price than P1, the int e r s e c t i o n of the demand curve and the marginal cost curve. I f a unique price PI were established, the average cost would exceed average revenue, which would lead to a f i n a n c i a l d e f i c i t . Price discrimination allows for the recovery of f u l l costs by imposing higher prices on certain buyers. Jules Dupuit examined the pricing problem in an a r t i c l e written in 1849 .3 a bridge served as an example. I t connected a r e s i d e n t i a l area with a factory. The workers were free to walk around the long way, and avoid the bridge. The t o l l of 5 centimes yielded 5000 francs per year, which was i n s u f f i c i e n t to cover average costs. Dupuit suggests a lower t a r i f f for the workers. This could be achieved by dress d i s t i n c t i o n , a sp e c i a l pass, or by the time of day. He goes on to show how t h i s t a r i f f would yield 46 Figure 5 . Price Discrimination PRICE Q3 Q± Qt Output 47 revenue of approximately 8000 francs, which would be s u f f i c i e n t to recover average costs. The argument i s then extended to railways and canals. Dupuit was l i k e l y one of the e a r l i e s t advocates of value-of-service p r i c i n g . The (pricing) solution rests on the general p r i n c i p l e that the price asked f o r should not be the cost of the service related to the producer, but a sum related to the importance which the consumer attaches to the service. * Dupuit f e l t that goods or people should move as long as the variable costs are met. The minimum rate eguals variable costs, while price discrimination i s practiced on the be n e f i c i a r i e s who are w i l l i n g to pay a higher rate i n order to cover the f i n a n c i a l d e f i c i t . Value-of-service pricing has been advanced as an economically and f i n a n c i a l l y acceptable solution i n a second-best world. k perfectly-discriminating monopolist i s , for example, economically e f f i c i e n t . Since each buyer's marginal willingness to pay (demand price) i s thus equal to the s e l l e r ' s Marginal Cost of production there i s no s o c i a l gain available f o r increasing or decreasing output. / So the perfectly discriminating monopolist cannot be said to produce 'too l i t t l e ' or too 'much' from the point of view of economic e f f i c i e n c y . ? 48 The perfectly-discriminating monopolist does not e x i s t i n the r e a l world. However, arguments have been made that value-of-service pricing i s e f f i c i e n t i n a second-best world. Baumol and Bradford state that marginal cost p r i c i n g w i l l lead to d e f i c i t s which must be overcome by taxation, and taxation w i l l bring on d i s t o r t i o n s i n the economy. Therefore, they argue that government revenue needs are a constraint i n the guest for optimal resource a l l o c a t i o n . Given that society i s searching for a solution to t h i s second-best problem, the authors advance the argument that the maximization of welfare w i l l occur under a type of value-of-service p r i c i n g . Prices are determined by the e l a s t i c i t y of demand. ... the s o c i a l welfare w i l l be served most e f f e c t i v e l y not by setting prices egual or even proportional to MC, but by causing unegual deviations i n which items with e l a s t i c demands are priced at l e v e l s close to their MC. The prices of items whose demands are i n e l a s t i c diverge from their MC by r e l a t i v e l y wider margins,* Value-of-service p r i c i n g i s f i n a n c i a l l y acceptable i n the seccnd-best world because i t allows s e l l e r s to set t h e i r prices at a l e v e l egual to or above marginal costs, thereby reducing the consumers* surplus and eliminating the d e f i c i t which would have been brought on by the decreasing cost industry i f a unique price equal to marginal cost had been set. I t i s important to note that t r a f f f i c which can just pay i t s marginal cost does move under value-of-service pricing.„ 49 In summary, under f i r s t - b e s t conditions, marginal cost pricing leads to optimal resource a l l o c a t i o n and maximization of welfare to society. Under conditions of decreasing costs, marginal cost p r i c i n g w i l l r e s u l t i n a f i n a n c i a l d e f i c i t . This suggests that economic and f i n a n c i a l c r i t e r i a diverge. Under conditions of second-best, however, v a l u e - o f - s e r v i c e pricing overcomes the decreasing cost dilemma by eroding the consumers' surplus. &n argument was presented which states that s o c i a l welfare i s maximized (under conditions of second-best) under a value-of-service p r i c i n g policy. The industry which practices value-of-service p r i c i n g can produce at the output where price equals marginal cost and s t i l l recover average costs. , 50 Footnotes 1. Alfred Marshall (1925) quoted in E.J.Mishan, Elements of Cost-Benefit Analysis (London:George Allen and Onwin Ltd. , 1972), p.26. 2. Harold Hotelling, "The General Helfare In Relation To Problems Of Taxation And Of Bailway And U t i l i t y Rates". Econometrica 6 (1939), p.242. 3. , Jules Dupuit, "On T o l l s And Transport Charges", International Economic Papers. 1 (1962), pp. 14-16. 4. Ibid, p. 31. 5., Jack H i r s h l e i f e r , Price Theory And Applications (Englewood C l i f f s : Prentice H a l l , 1976), pp.295-296., 6., l i l l i a m Baumol and David Bradford "Optimal Departures From Marginal cost P r i c i n g " i n American Economic Beview 60 (1970), p. 267. 51 CHAPTER 5 CP RAIL'S PRICING POLICIES This chapter w i l l examine CP R a i l ' s pricing strategy. A major pricing r e s t r i c t i o n that a f f e c t s CP R a i l i s Statutory grain rates. These w i l l be discussed i n the second section of th i s chapter. 5.1 CP Rail's P r i c i n g Strategy: Value-of-service CP R a i l has pursued a value-of-service pricing strategy since i t s inception. Under t h i s p r i c i n g strategy, rates are set according to what the market w i l l bear. , The value-of-service pricing i s common i n the ra i l r o a d industry. The most f a m i l i a r use of the value-of-service p r i n c i p l e i s found i n r a i l r o a d rate-making, where higher rates are charged f o r shipment of goods of higher value, the rate d i f f e r e n t i a l s being far higher than those which could be j u s t i f i e d by any cost differential.» CP B a i l f i t s the description of a third degree price discriminator, i . e . the buyers are segmented in t o groups which have d i f f e r e n t demand curves with d i f f e r e n t e l a s t i c i t i e s . The groups pay d i f f e r e n t prices, which e n t a i l varying contributions to the recovery of CP B a i l ' s constant costs. Those groups having l e s s e l a s t i c demand curves w i l l make r e l a t i v e l y larger contributions, as they have a greater a b i l i t y to pay. .However, a positive feature of t h i s p r i c i n g strategy i s that i t allows 52 t r a f f i c to move that can barely afford to pay i t s variable costs. as long as the t r a f f i c pays a rate higher than i t s variable cost, i t i s making a contribution to CP R a i l ' s constant costs. Competition i s a major force i n determining the extent to which CP R a i l can practice value-of-service pricing. .Competition influences the buyers* e l a s t i c i t i e s , and competition from other transport c a r r i e r s places an e f f e c t i v e c e i l i n g on CP Rail*s prices. , 53 5.2 CP B a i l ' s P r i c i n g Freedom I t i s the policy of the Canadian government to grant a wide pricing latitude to Canadian railways. Of course, t h i s was not always so. In the early twentieth century, the Board of Bailway Commissioners was created i n order that railway rates could be regulated. The federal Cabinet remained the f i n a l a r b i t r a r . Following World War Two, CP B a i l applied to the (now) Board of Transport Commissioners for numerous rate increases to cover the costs of i t s post-war investments. 2 The rate increases were large because the base on which the price increases could be made was shrinking. F i r s t , export grain moved at Statutory Bates. Second, trucking competition began to siphon o f f the Bailway*s high value, low bulk commodities. In 1958, the Diefenbaker government abrogated the railways* pricing freedom. I t froze r a i l rates and introduced subsidization i n l i e u of frei g h t rate increases. In the following year, the HacPherson Commission was created to examine the whole guestion of f r e i g h t rates. The Commission's report was a watershed f o r railway p r i c i n g in Canada. The Beport of the Commission "...made the concept of competition the cornerstone of i t s new philosophy of rate regulation." 3 The Commission noted the importance of value-of-service p r i c i n g , and of i t s acceptability to the Government. Without the low rates a good deal of the bulk t r a f f i c would not have moved at a l l because transportation costs would have been too high i n proportion to the value of the 54 commodity to make t h e i r shipment profitable—whereas the finished goods, because of t h e i r greater value, could and did move at higher rates. The railways thus obtained a volume of t r a f f i c which might not otherwise have come into being and they did so with the encouragement of the Federal Government which saw i n the low-rate p o l i c y a further means of stimulating the development of primary production i n Canada.* The philosophy of the HacPherson Commission was embodied into the National Transportation act of 1967. The l e g i s l a t o r s hoped to foster "..an economic, e f f i c i e n t , and adequate transportation system..,", and competition was to be the foundation of t h i s policy. In situations where i t was i n the public interest that railways should move t r a f f i c at non-compensatory rates, the federal government would provide a subsidy. The Act was not the s i q n a l for t o t a l de-regulation. The Canadian Transport Commission was given the power to regulate railway rates i f i t was established that a rate(s) was p r e j u d i c i a l to the public i n t e r e s t (Section 23). The Act also prescribed that the minimum rate l e v e l should be variable cost, i . e . the rates must be compensatory. The regulatory power of the C.T.C. With respect to railway rates has been used sparingly since 1967. On the whole, the National Transportation Act has 55 .••brought about a large reduction i n the regulation of railway p r i c i n g by the Canadian Transport Commission (formerly the Board of Transport Commissioners),? B e s t r i c t i o n on CP .'Bail's p r i c i n g freedom a major r e s t r i c t i o n on CP B a i l ' s pricing freedom exists today. This r e s t r i c t i o n i s commonly referred to as the Crow's Nest Bates, having been negotiated i n an agreement of the same name in 1897./ The terms of the agreement c a l l e d for the C.P.B. to construct a railway from Lethbridge, alberta to Nelson, B.C., via the Crow's Nest Pass.., The C.P.B. / Would receive a cash subsidy of approximately $3.4 m i l l i o n from the Dominion government, and 3^-755,733 acres of land from the B r i t i s h Columbia government. In return, the C.P.B. agreed to reduce i t s freight rates, i n perpetuity, on grain and f l o u r moving eastward to Port William. at the time, the agreement was a t t r a c t i v e to both parties. The Bailway received a cash subsidy and land grant f o r a line which provided access into the mineral-rich Koo ten ays. The Dominion government secured lower freight rates on grain, f l o u r , and s e t t l e r s ' e f f e c t s , f i f t y thousand coal-bearing acres to be chosen out of the p r o v i n c i a l land grant, the right to regulate rates oo a l l of the C.P.B.*s l i n e s , and a concrete Canadian presence i n an amerlean-dominated region of southwest B.C. The terms of the agreement ca l l e d f o r a rate reduction i n 5 6 stages, with the f i n a l rate to become e f f e c t i v e on September 1, 1899. These low rates only remained in e f f e c t u n t i l 1902, due to competitive pressures brought on by the Canadian Northern Bailway. The Manitoba government had agreed to subsidize the l a t t e r railway's l i n e as a quid pro quo f o r lower f r e i g h t rates. The l i n e was completed i n 1902, and the C.P.R. lowered i t s rates from the Crow l e v e l in order t o meet the competition. This s i t u a t i o n lasted u n t i l 1918, at which time the i n f l a t i o n brought on by the F i r s t World War led the government to suspend the Crow Bate. Declining grain prices on the world market brought grain rates down to the Crow l e v e l i n 1922. The suspension of the agreement was l i f t e d by the Mackenzie King government i n 1924. The C.P.B. objected, and complied with the terms of the agreement in the narrowest possible way. Only the 289 delivery points i n existence at the time the agreement was signed were allowed to use the rate. Points constructed after 1897 were charged a higher rate. This int e r p r e t a t i o n was upheld by the Supreme Court of Canada, That chain of events did not s i t well with the King government, and i t quickly moved to incorporate the Crow's Nest Bates into the Bailway act. Thus, in 1925, the Crow's Nest Bates became Statutory Bates., In 1927, export grain moving to P a c i f i c ports was made e l i g i b l e f o r the Statutory Bates. The Port of C h u r c h i l l was added l a t e r . , In 1961, the Diefenbaker government included rapeseed i n the l i s t of grains e l i g i b l e f o r the Statutory Bate. 57 The situation today CP R a i l receives 0.55 cents per tonne-mile f o r grain products that move under Statutory Rates., In the 1950's, i t became apparent to CP that these rates were not compensatory, i . e . they did not cover the variable cost of moving the grain. However, the P r a i r i e provinces did not agree. But i t was not u n t i l 1975 that the federal government appointed the Snavely Commission to study the costs of transporting grain by r a i l i n Canada. , A l l interested and affected parties were encouraged to make submissions. The Commission then dealt methodically with each s i g n i f i c a n t issue. The Report of the Snavely Commission j u s t i f i e d CP S a i l ' s position. Drawing on 1974 cost data, the Report indicated that CP B a i l ' s revenue derived from Statutory Bates f e l l $54.! m i l l i o n short of covering the variable cost of moving that grain. 6 Under the terms of the Bailway Act, CP B a i l cannot refuse to move export grain., This r e s t r i c t i o n on CP R a i l ' s pricing freedom adversely a f f e c t s i t s a b i l i t y to recover constant costs. To put t h i s another way, the Statutory Bates preclude the u t i l i z a t i o n of value-of-service p r i c i n g on the movement of export grain. Furthermore, i t i s possible that t h i s pricing r e s t r i c t i o n can detrimentally a f f e c t the v i a b i l i t y of potential investments, such as the Beaver tunnel. This p o s s i b i l i t y w i l l be explored i n the following chapter. 58 Footnotes 1. James Bonbright, P r i n c i p l e s Of Public U t i l i t y Sates (New York: Columbia University Press,1961), P.378. 2. The Board of Transport Commissioners granted increases of 218 i n 1946, 20% in 1949, 17% i n 1951, 9% i n 1952, 7% i n 1953, and 11% i n 1957. , 3. Howard Darling "Transport Policy i n Canada: The Struggle of Ideologies verses R e a l i t i e s " i n fiailway Freight Bates: & Source Book (Montreal: CP B a i l , 1973), p.25-4. irevor D. Heaver and James C. Nelson, Bailway P r i c i n g Under Commercial Freedom:The Canadian Experience (Vancouver:centre For Transportation Studies,1977), pp. 151-152., 5. Ibid, p. 150. 6. Carl Snavely, Beport on the Costs of Transporting Grain by B a i l (Ottawa: Queens Printer, 1976)., 59 CHAFFER 6 POTENTIAL CONFLICT ASSOCIATED BITH THE BEAVEfi TUNNEL This chapter w i l l examine the potential c o n f l i c t between the public d e s i r a b i l i t y and the f i n a n c i a l v i a b i l i t y of the Beaver tunnel investment. A f i n a n c i a l analysis of the Beaver tunnel investment was undertaken i n Chapter 3 . I t was c l e a r l y established that the proposed investment was not f i n a n c i a l l y viable to CP R a i l . This chapter w i l l now turn to the question of the public d e s i r a b i l i t y of the tunnel. This w i l l be discussed under two headings: economic d e s i r a b i l i t y and non-economic d e s i r a b i l i t y . , To state the objective another way: do economic and non-economic factors exist which could lead to the project being desirable from a public point of view, even i f the proposed investment i s not f i n a n c i a l l y viable to private investors? 5 60 6.1 Economic D e s i r a b i l i t y Hany of the economic benefits associated with the project have already been included in the f i n a n c i a l analysis. Operating savings was one of the benefits. The tunnel would lead to a reduced need, and hence cost, for d i e s e l s , maintenance, fu e l , and labour. Since costs can be considered to be opportunities foregone, reduced costs can be considered to be increased benefits. Bescurces are freed to flow elsewhere, while output has not diminished. The reduced cost may be passed on to the shippers i n the form of lower freight rates, or i t may increase CP Bail's p r o f i t and hence i t s return on investment, lower fre i g h t rates would be an economic benefit accruing to shippers. CP B a i l would pass benefits on to the shipper i f competitive factors made i t expedient to do so. In either case, the savings are a net benefit to Canada as a whole. Another economic benefit i s contributions from additional t r a f f i c that would not have moved i f the tunnel was not b u i l t . The contribution margin (price l e s s variable cost) which CP derives from the additional t r a f f i c has already been recognized as a benefit, and i s included in the f i n a n c i a l analysis above. Eased on the above benefits, the f i n a n c i a l a n a lysis has shown that the proposed tunnel investment i s not f i n a n c i a l l y viable., There are, however, a d d i t i o n a l economic benefits associated with t h i s project that have not been included i n the f i n a n c i a l analysis. This section w i l l introduce and quantify certain s i g n i f i c a n t economic benefits, that are not exploitable by CP B a i l , which may cause public d e s i r a b i l i t y of the project 61 to diverge from the f i n a n c i a l v i a b i l i t y . A major constraint on CP Hail*s a b i l i t y to u t i l i z e price discrimination has been i d e n t i f i e d i n Chapter 5..This constraint i s Statutory grain rates. CP B a i l moves a considerable amount of grain over i t s western mainline to the port of Vancouver.J As t h i s stretch of track has become more congested i n recent years, the grain t r a f f i c has become subject to greater delays. There i s a ccst associated with these delays. The construction of the Beaver tunnel would ease congestion, lessen delay times, and hence reduce the grain car cycle time. CP B a i l can presumably reap the benefits of lesser delays through price adjustments to i t s customers. As noted above, the rate on Statutory grain t r a f f i c cannot be altered. Therefore, with respect to Statutory grain t r a f f i c , the benefits of lesser delays accrue to the grain shippers. The benefits accruing to the public from decreasing grain delays w i l l be discussed under three headings; 1) reduced need for r o l l i n g stock, 2) reduced costs connected with grain shipment delays, and 3) contributions accruing to the grain producers from a d d i t i o n a l grain t r a f f i c that would not have moved i f the tunnel was not b u i l t . Beduced need for grain-related r o l l i n g stock The construction of the tunnel would lead to a reduced need for r o l l i n g stock. This i s an economic benefit and should be included in the o v e r a l l economic analysis. CP B a i l did not include savings associated with grain-62 related r o l l i n g stock i n i t s f i n a n c i a l analysis because i t has not been purchasing grain-related r o l l i n g stock i n recent years, and has no plans to purchase t h i s type of r o l l i n g stock in the future as long as Statutory Bates remain i n e f f e c t , 2 Grain car shortages became the rule in the 1970 's as the aging boxcar f l e e t diminished. The deteriorating s i t u a t i o n forced the federal government to purchase grain hopper cars for the Canadian railways, paid for with public funds, ? In early 1979, the Canadian Wheat Board ordered a further 2000 hopper cars, at a cost of $82-$89 mi l l i o n s , to be paid f o r out of the Board's revenues. Due to increasing volume and replacement considerations, additional purchases of grain hopper cars w i l l have to be made in the coming decade. I t i s reasonable to assume that the cost cf these cars w i l l be borne by the federal government and/or the grain producers, as CP B a i l has shown no i n c l i n a t i o n to purchase these cars due to the non-compensatory rates. The construction of the Beaver tunnel would lead to a reduced car cycle period for CP B a i l ' s grain t r a f f i c on i t s western mainline. A reduced car cycle period would translate into a reduced need for grain hopper cars., The c a l c u l a t i o n of the present value of savings associated with a faster car cycle period are presented i n Table X. The savings associated with a f a s t e r car cycle time are determined by estimating the potential savings i n the grain car purchase program.,Without the tunnel, i t i s assumed that 800 new hopper cars per year are required i n the period 1983-1992. (It i s estimated that 10,000 hopper cars w i l l be required by Canadian 63 TABLE X E c o n o m i c b e n e f i t o f r e d u c e d n e e d f o r g r a i n - r e l a t e d r o l l i n g s t o c k (Base y e a r - 1978) ( D i s c o u n t r a g e = .12) I f 800 h o p p e r c a r s p e r y e a r we need i n t h e p e r i o d 1983-1992, t h e n t h e : a) E c o n o m i c b e n e f i t o f 5 p e r c e n t f e w e r c a r s (..05) (800) (.$43, 000) = $1.72 m i l l i o n p e r y e a r P r e s e n t v a l u e o f s a v i n g s ( d u r i n g 1983-1992) (d =.12) $1.72 X 3.591 = $6,2 m i l l i o n 0 1 4 - 4 ) b) E c o n o m i c b e n e f i t o f 1 0 - p e r c e n t :fewer c a r s P r e s e n t v a l u e o f s a v i n g s (1983 - 1992, d = .12) $1.72 X 3.591 = $12.4 m i l l i o n N o t e : The c a p i t a l c o s t s o f t h e h o p p e r c a r s a r e $43,000 (1978 $) 64 r a i l w a y s i n the next s i x years. I f 50%, or 5000 c a r s , are needed by CP B a i l , the average annual reguirement i s 833 cars.) I f the c o n s t r u c t i o n of the tunnel i s proceeded w i t h , smaller number of c a r s are needed to maintain the same throughput. In 1974, f o r example, CP*s average g r a i n car c y c l e period was 28.5 days. I t i s not known how many fewer c a r s would be needed i f the tunnel i s b u i l t . Therefore, two percentages, 10% and 5%, were used i n the c a l c u l a t i o n s . Industry sources s t a t e that the grain car c y c l e time has been reduced to 17-18 days i n 1979. ? I f the Canadian r a i l w a y s are able to reduce the g r a i n car c y c l e time by 35% i n the l a s t f i v e years through various i n n o v a t i o n s , i t i s t h e r e f o r e not unreasonable t o expect, t h a t by removing the major bottleneck on i t s western m a i n l i n e , CP B a i l can reduce i t s g r a i n car c y c l e period by a f u r t h e r 10%. The b u i l d i n g of the tunnel would the r e f o r e generate an economic b e n e f i t to the general p u b l i c and/or the i g r a i n producers. CP B a i l cannot e x p l o i t any p a r t of t h i s economic b e n e f i t through i t s p r i c i n g p r a c t i c e s due to the Statutory Bates. Beduced cost s connected with reduced g r a i n shipment d e l a y s Canada's g r a i n t r a n s p o r t a t i o n system has been d e t e r i o r a t i n g i n recent years. The d e t e r i o r a t i o n has lead to g r a i n shipment delays on the west c o a s t , s and the delays can be t r a n s l a t e d i n t o c o s t s . I n the present and f u t u r e time frames, the delays bring on demurrage charges, i n the a d d i t i o n , the l o s s of goodwill undergone by our g r a i n customers can lead to reduced grain s a l e s . 65 There are many reasons for grain shipment delays, such as railway bottlenecks, r a i l c a r shortages, deteriorating branch l i n e system, inadequate port f a c i l i t i e s , labour disputes, and natural phenomenem. Table XI presents a scenario which attempts to quantify the cost of the qrain shipment delays connected with the leaver bottleneck. / F i r s t , i t i s assumed that construction of the tunnel w i l l lead to a reduction of demurrage charges by 5% during the period 1983-2002, and that demurrage charges w i l l average $10 million per year during t h i s period.* Contributions accruing to grain producers from additional t r a f f i c that would not have moved i f the tunnel was not b u i l t The construction of the Beaver tunnel and resultant greater capacity would allow additional grain t r a f f i c to move over the western mainline, The contribution (price less variable cost) derived by the farmers on t h i s a d d i t i o n a l grain i s an economic benefit. However, CP B a i l would incur an ad d i t i o n a l l o s s as this export grain would move at a non-compensatory rate. The net benefit i s arrived at by subtracting the incremental CP B a l l cost from the grain producers 1 incremental benefit. Two scenarios are presented i n Table XII. The f i r s t scenario assumes that the completed Beaver tunnel allows an extra 500,000 tonnes of grain to move to Vancouver every year during the period 1983-2002.' The second scenario doubles the incremental amount to 1 m i l l i o n tonnes per year. (It i s assumed that producers derive a contribution margin of $17.55 per 66 TABLE XI Economic benefits of reduced demurrage changes on ships The average demurrage charge on the West Coast i s taken to be $10 m i l l i o n per year during the period 1983 - 2002. I f the beaver tunnel reduces the demmurage costs by 5%, then, Present Value of benefits (d = .12) $10 m i l l i o n (.05) 4.763 = $2.4 m i l l i o n (t24-t4) 67 TABLE X I I Net b e n e f i t of i n c r e m e n t a l g r a i n t r a f f i c (Base year = 1978) S c e n a r i o 1: I t i s assumed t h a t an a d d i t i o n a l 500,000 tonnes of g r a i n , would to Vancouver over the CP m a i n l i n e due t o c o n s t r u c t i o n o f the Beaver t u n n e l . The p r e s e n t v a l u e of the b e n e f i t s (d = .12) d u r i n g the p e r i o d 1983 - 2002 i s : 500,000 (17 . 55) 4. 763 = , $ 41 i 8 : . m i l l i o n ( t24- t4) The p r e s e n t v a l u e of CP R a i l l o s s (d=.12) i s .. 500,000 (7.69) 4.763 = $1.8.3 m i l l i o n . .: The p r e s e n t v a l u e of the f e d e r a l b r a n c h l i n e s u b s i d y i s : 500,000 (2.78) 4.763 = $ 6.6 m i l l i o n 24.9 m i l l i o n The p r e s e n t v a l u e o f the net b e n e f i t to the p u b l i c : 16 . 9 m i l l i o n S c e n a r i o 2: An a d d i t i o n a l 1,000,000 tonnes of g r a i n c o u l d move t o Vancouver over the CP m a i l i n e due t o c o n s t r u c t i o n of the Beaver t u n n e l . The p r e s e n t v a l u e of the net b e n e f i t s (d =.12) d u r i n g the p e r i o d 1983 - 2002 a r e : 1, 000, 000 (17.55 - (.7.69 + 2.78)) 4. 763 = $ 33.7 m i l l i o n 68 tonne,® and t h a t CP R a i l l o s e s $7.69 per t o n n e 9 ) . The completed t u n n e l would e a s i l y f a c i l i t a t e the shipment cf an e x t r a m i l l i o n tonnes per year, as CP S a i l has i n d i c a t e d that the jump i n c a p a c i t y provided by the tun n e l would be i n excess of ten m i l l i o n tonnes per year. The net b e n e f i t i s some $17 m i l l i o n under the f i r s t s c e n a r i o , and some $34 m i l l i o n under the second s c e n a r i o . T h i s paper u t i l i z e d the p r i v a t e s e c t o r d i s c o u n t r a t e i n the computation of economic b e n e f i t s . Some economists argue, however, t h a t the p r i v a t e s e c t o r d i s c o u n t r a t e does not p r o p e r l y r e f l e c t s o c i e t y ' s view on resource a l l o c a t i o n s between present and f u t u r e . T h i s s o c i a l time preference r a t e w i l l be lower than the p r i v a t e s e c t o r r a t e . The Appendix I I w i l l r e - e v a l u a t e the economic b e n e f i t s u t i l i z i n g a lower d i s c o u n t r a t e . N a t u r a l l y , a lower d i s c o u n t r a t e w i l l l e a d t o a hi g h e r economic b e n e f i t present value, which i m p l i e s that the proposed p r o j e c t i s even more f e a s i b l e . .. When the lower discount is applied, the economic benefits more than cover the f i n a n c i a l s h o r t f a l l , under both the less optimistic and more optimistic scenarios. 69 6.2 Non-economic C r i t e r i a There are non-economic considerations which would make the Beaver project desirable from the public viewpoint even though i t i s not viable f i n a n c i a l l y . This section w i l l examine certain of the non-economic considerations. Regional expansion Regional expansion has long been a goal of the federal government. The j u s t i f i c a t i o n of t h i s goal stems from the belief that geography should not be the sole c r i t e r i o n i n determining the economic well-being of Canadians. Hence transfer payments are made from the "have" provinces to the "have not" provinces. While i t i s conceptually easy to talk of "have" and "have not" provinces, each province w i l l contain "have" and "have not" regions, Canada's central government uses a variety of mechanisms to a l l e v i a t e regional economic differences. I t has established the Department of Regional Economic Expansion, for example, which has designated s p e c i f i c geographic regions to be e l g i b l e for grants to manufacturing enterprises. The objective of these mechanisms i s to bring about the re d i s t r i b u t i o n of income and expand the i n d u s t r i a l base of the West. Building the tunnel may f i t i n with the federal government's desire for regional expansion. As such, the subsidization of the c a p i t a l costs of the tunnel may be a better c o s t - e f f e c t i v e method of achieving t h i s goal i n the P r a i r i e s and 70 Kootenay r e g i o n s than, f o r example, a negative income t a x plan or DREE grants., The use of t r a n p o r t s u b s i d i e s t o promote r e g i o n a l expansion has o f t e n been c r i t i c i z e d on the grounds o f economic e f f i c i e n c y , v i s . r e s o u r c e s flow to the s u b s i d i z e d mode t h a t would otherwise be employed elsewhere..This i s not an i s s u e i n t h i s s e c t i o n , as i t has been reco g n i z e d t h a t r e g i o n a l expansion i s a non-economic g o a l of the government.. The s u b s i d i z a t i o n of the Beaver t u n n e l would l i k e l y be seen as another handout to the CPR, but i t i s more than t h a t . The Railway would b e n e f i t , as i t would be r e a l i z i n g a 12% r a t e of r e t u r n on i t s investment. But the subsidy would a l s o be a couvert subsidy to the workers, farmers, and c o r p o r a t i o n s of the West, as a d d i t i o n a l western resources would move to export p o s i t i o n s . D e s i r e f o r an "adequate" t r a n s p o r t i n f r a s t r u c t u r e The d e s i r e f o r an "adequate" t r a n s p o r t i n f r a s t r u c t u r e i s r e l a t e d t o the g o a l of r e g i o n a l expansion, but d i f f e r s i n that i t i s more encompassing. D e f i n i n g "adeguate" i s an im p o s s i b l e chore, as "adequate" to the reader w i l l l i k e l y d i f f e r from the w r i t e r ' s view of "adeguate". For the purposes o f t h i s paper, an "adequate" t r a n s p o r t i n f r a s t r u c t u r e i s one t h a t can move a l l the t r a f f i c which can pay g r e a t e r or equal to the marginal economic c o s t s of moving t h a t t r a f f i c . The CP western m a i n l i n e i s one of the v i t a l l i n k s i n 71 Canada's t r a n s p o r t i n f r a s t r u c t u r e . I t i s e s p e c i a l l y e f f i c i e n t i n the novement of bulk goods. In l i g h t of r e s o u r c e shortages and our i n c r e a s i n g l y competitve p o s i t i o n i n world markets, the demand f o r Canadian r e s o u r c e s w i l l be strong i n the f u t u r e . . The resources must be a b l e t o move t o p o r t s i f they a r e to be exported. Given t h a t T r a n s p o r t Canada has f o r e c a s t i n c r e a s i n g c o n g e s t i o n on our r a i l l i n k s , the f e d e r a l government could j u s t i f y a subsidy t o CP S a i l on two grounds: 1) the balance of payment argument and 2) d i v e r s i f i c a t i o n of r i s k . The balance of payments argument i s general,and proceeds l i k e t h i s : our t o u r i s t and c a p i t a l account d e f i c i t s c o n t i n u e to grow. Canada's merchandise account has been i n a s u r p l u s p o s i t i o n d u r i n g the past few years. G r a i n e x p o r t s c o n t r i b u t e approximately $3 b i l l i o n per year t o our merchandise account. But the merchandise s u r p l u s has not o f f s e t the other d e f i c i t s . T h e r e f o r e , i t i s recommended t h a t Canada take s t e p s to ensure t h a t t h e r e are no unnecessary impediments i n the growth of our merchandise s u r p l u s , a " l e s s than adequate" r a i l i n f r a s t r u c t u r e would be such an impediment.. The d i v e r s i f i c a t i o n of r i s k argument r e l a t e s to the f r a g i l i t y of our mountain r a i l l i n e s . The CP mainline terminates i n Vancouver, while the CN m a i n l i n e s p l i t s i n t o two l i n e s a t Bed Pass J u n c t i o n , with one l i n e t e r m i n a t i n g i n Vancouver, and the other ending i n P r i n c e Bupert. a l l these l i n e s are prone to c l o s u r e from avalanches, s l i d e s , and f l o o d s . I t could be f e d e r a l p o l i c y t o a s s i s t i n the e a s i n g o f b o t t l e n e c k s on both the CP and CN l i n e s so as to d i v e r s i f y the r i s k of an extended c l o s u r e . 7 2 6.3 Summary The f i r s t objective of t h i s paper has been to examine the pot e n t i a l c o n f l i c t between the public d e s i r a b i l i t y and f i n a n c i a l v i a b i l t y of the Beaver tunnel investment. The analysis carried out in t h i s chapter has shown that there are economic benefits associated with the Beaver project that were not included in CP Bail's f i n a n c i a l anaysis,, The economic benefits may make the project desirable from a public point of view. Table XIII summarizes the quantifiable c r i t e r i a of the Beaver project which have been presented in t h i s paper. The public d e s i r a b i l i t y of the project was explored from two viewpoints. The examination of the economic factors indicate that potential benefits to the public do e x i s t i f the tunnel i s b u i l t . An attempt to quantify these benefits was undertaken in order to determine the r e l a t i v e magnitudes.. The non-economic factors provided q u a l i t a t i v e reinforcement to the argument supporting the d e s i r a b i l i t y of the tunnel. I t i s important to note that the potential benefits which would accrue to the public cannot be exploited by CP B a i l through i t s current value-of-service pricing policy., Acceptance of t h i s statement makes i t possible to conclude that potential c o n f l i c t may well e x i s t , and that the Beaver project may well be f i n a n c i a l l y viable i f CP B a i l ' s p r i c i n g freedom extended to the domain of export grain. „• Given that the Beaver tunnel i s not f i n a n c i a l l y viable, and given that the constraint which impedes CP B a i l ' s pricing freedom may a f f e c t the f i n a n c i a l v i a b i l i t y of the Beaver 73 TABLE XIII Beaver Project Analysis (Base year = 1978 discount rate - .12) Financial Costs Capital Costs (years 1-4) Financial Benefits Savings Contribution from additional t r a f f i c Coal General Merchandise Grain Financial s h o r t f a l l $ 73.8 m i l l i o n $ 33.9 10.6 1.0 3.0 42.5 m i l l i o n $ 31.3 m i l l i o n Economic benefits not available to CP R a i l Less Optimistic More optimistic Hopper car savings 51 fewer cars $ 6.2 .'.10% fewer cars 12.4 Reduced demurrage charges 2.4 2.4 Incremental grain t r a f f i c 0.5 m i l l i o n tonnes 1.6.9 1.0 m i l l i o n tonnes 33.7 TOTAL $ 2 5.5 m i l l i o n $ 48 . 5;.million 74 project, and given that q u a l i t a t i v e arguments e x i s t which reinforce the public d e s i r a b i l i t y of the project, how can the federal government best provide f i n a n c i a l assistance to enable CP to build t h i s project? The f i n a l chapter w i l l analyze the financing alternatives., 75 Footnotes 1. ft CP Hail source stated that Statutory grain t r a f f i c accounts f o r 20%-25% of the tonne-miles on i t s western mainline., 2. CP B a i l states: "The l a s t boxcars suitable for carrying grain were purchased i n the early 1950* s.1', P«13* CP B a i l booklet. 3. , During the period 1973-1977, the f e d e r a l government purchased 8000 hopper cars at an approximate cost of $284 millions. 4. "Flow Of Grain Cars Hay Not Sweep Away Wheat Load", Financial Post. 27 October 1979. 5. During the 1977/78 crop year ending July 31, an average of roughly 25 vessels per day were waiting to be loaded , on the West Coast. 6. For the period August 1, 1976 to October 31, 1978, the Canadian Wheat Board paid out a t o t a l of $21.9 m i l l i o n in demurrage charges system-wide., 7. Canada exported approximately 22 m i l l i o n tonnes of grain in the crop year 1977-1978. ,It i s estimated that t h i s figure must r i s e to 30 mi l l i o n tonnes by 1985 i f Canada i s to maintain our present market share. 8. The figure of $17.55 per tonne was determined by setting the contribution margin equal to 15% of the grain producers* realized price of $117 per tonne for #1 Canadian Western Bed Spring. The figure of 15% i s a conservative estimate. The grain producers* marginal cost of production on the incremental quantities of grain would be considerably less than on the i n i t i a l production, as the land may well have remained i n fallow without t h i s production. Of course, t h i s argument makes no allowance f o r the contribution margins that producers might have earned i f they had switched to crops for domestic consumption/processing instead of producing the incremental quantities of export grain. 9. The figure of $7.69 per tonne was supplied by C a r l Snavely, based on 1977 costs. 76 CHAPTER 7 FINANCING ALTERNATIVES The previous chapter examined the hypothesis that the f i n a n c i a l v i a b i l i t y of the Beaver tunnel may diverge from the public interest. The f i n a n c i a l evaluation determined that CP H a i l cannot earn what i t considers to be an adequate rate of return on t h i s project. I t was shown that an additional infusion of approximately $31 m i l l i o n would be required i n order for the project to earn a 12% rate of return. I t was further explained that r e s t r i c t i o n s on CP Rail's p r i c i n g freedom prohibit the Railway from exploiting certain economic benefits which would accrue to the grain producers i f the tunnel was built.„ This chapter w i l l analyze several alternative methods of financing the s h o r t f a l l . Each of the alternatives would require the impetus of the federal government, as i t i s the federal government which must transform the "public i n t e r e s t " into action. The financing alternatives f a l l into two broad categories, namely public financing and user pay. , 7 7 7.1 Public financing Public financing alternatives would involve a d i r e c t or i n d i r e c t payment to CP B a i l . Three options w i l l be discussed: 1) subsidy, 2) accelerated c a p i t a l cost allowance, and 3) income tax reduction. Subsidy Subsidies may be j u s t i f i e d on a number of grounds, including promotion of regional development, national unity, and economic e f f i c i e n c y . I t i s the l a t t e r type which i s of primary interest here. In a decreasing cost firm, subsidization can be j u s t i f i e d on the basis of e f f i c i e n c y . The rationale behind t h i s transfer i s that the general welfare increase brought on by marginal cost pricing would more than offset the welfare decrease suffered by the taxpayers making up the subsidy. In Figure 6, setting P=SMC yields a consumer surplus of the t r i a n g l e ABC.\ F u l l - c o s t pricing would lead to a loss of surplus GFCE. The tax-financed subsidy i s j u s t i f i e d because the additional surplus created by marginal cost pricing i s greater than the amount of the subsidy HECB. Two barriers stand i n the way of acceptance of t h i s l i n e of reasoning. F i r s t , CP B a i l ' s p r i c i n g on i t s marginal t r a f f i c i s net necessarily at or near marginal cost. Second, the welfare gain brought on by the combination of subsidization and marginal cost pricing i n one sector of the economy only holds i f a l l sectors of the economy are p r i c i n g at marginal cost. .In t h i s 7 8 Figure. 6 E c o n o m i c j u s t i f i c a t i o n f o r s u b s i d i e s P R I C E S o u r c e ; J . H e a d s , " T r a n s p o r t S u b s i d i e s ; A n o v e r v i e w " , p . 5, 79 case, the tax levied i n other sectors of the economy to finance the subsidy may bring on a welfare loss i n these sectors as large as the welfare gain i n the subsidized sector. Also, i t has been suggested that "... there i s l i t t l e need today for transport subsidies i n Canada i n order to meet economic e f f i c i e n c y c r i t e r i a . ' ? 2 The points above indicate that i t would be d i f f i c u l t to j u s t i f y the subsidy on grounds of economic e f f i c i e n c y . However, the government could use non-economic arguments such as regional development and national unity to j u s t i f y payment of a subsidy. In the case of the proposed tunnel, would the subsidy be a one-time contribution toward the c a p i t a l costs, or would i t be an on-going subsidy to finance operating d e f i c i t s ? The l a t t e r alternative would pose severe accounting d i f f i c u l t i e s in this case. A fixed subsidy toward construction costs has the advantage of no unforeseen escalation problems i n future years, and the fact that the government knows exactly towards what project i t s money i s being committed. A case i n point i s the Branch Line subsidy, which i s designed to maintain and r e h a b i l i t a t e p r a i r i e branch l i n e s . In retrospect, i t i s now clear that i t i s r e a l l y a quid pro quo for losses suffered by the railways on the transport of export grain. & disadvantage of the fixed subsidy i s that i t i s a sunk cost on the part of the government, and the Railway may alter i t s pricing practices i n the future after i t has received the subsidy. It has been stated that an acceptable subsidy policy should include government control of the r e c i p i e n t * ^ pricing p o l i c i e s and l e v e l of service.,; The provision implies greater 8 0 government regulation, whereas the National Transportation act recently released CP B a i l from much of i t s regulatory constraints. On the whole, a direct subsidy i s an unfavourable financing alternative f o r the reasons outlined above. ,In addition, the subsidy i s a p o l i t i c a l l y d i f f i c u l t course of action f o r the government to follow, as Canadian P a c i f i c has been oft c r i t i c i z e d i n the past for receiving government handouts,, accelerated c a p i t a l cost allowance The c a p i t a l assets of a company generally depreciate over time, as well as simply wearing out, the assets are subject to economic obsolescence. The Income Tax act allows taxpayers to deduct a stated percentage of the asset every year for tax purposes. This deduction i s known as Cap i t a l Cost allowance. There are a number of asset classes, r e f l e c t i n g the di f f e r e n t c h a r a c t e r i s t i c s of assets..Similar assets are grouped i n one cl a s s . Simply stated, the Capital Cost allowance (CCA) reduces the taxpayer's income tax payable. I t i s thus a key consideration in determining net cash flows, and hence the e f f i c a c y of any pa r t i c u l a r investment., The CCa provides a tax s h i e l d . , The present value of the tax shield i s ; PV of tax shield= cdt/(k+d) c=capital investment d=max.,rate for CCa on declining balance basis 81 t=the firm's marginal tax rate k= discount r a t e 3 Would accelerated CCA be useful to CP B a i l financing of the s h o r t f a l l ? Two points should be noted. F i r s t , the Company must have the necessary taxable income i n order to take advantage of the additional deduction. Second, When tax rates are high, a growing firm w i l l be able to finance a substantially larger f r a c t i o n of i t s investment from retained p r o f i t s under an accelerated depreciation plan than with normal depreciation allowances f o r tax purposes.* CP Bail does have a s u f f i c i e n t taxable income to be able to u t i l i z e accelerated CC&. The taxable income of the Bailway for the previous f i v e years i s found i n Table XIV. With respect to the second point, CP Bail's marginal tax rate of 46% i s s u f f i c i e n t l y high f o r the Company to reap the tax advantages of the accelerated CCA., a financing scenario containing the e f f e c t of the accelerated CCA i s presented i n Table XV.,In t h i s example, the CCA rate f o r the tunnel only (excluding the track and approaches) i s raised from 4% (the current rate i n the Income Tax Act) to 50%. The net e f f e c t i s very advantageous to CP, in that an additional $16.2 m i l l i o n i s generated i n t e r n a l l y . The entire f i n a n c i a l s h o r t f a l l of $31 million would not be covered by the 50% CCA. However, th i s measure could be part of a package, and therefore should not be dismissed out of hand. There i s ample precedent for accelerated CCA. For example, 82 TABLE XIV CP R a i l Net Income before tax (millions of dollars) 1973 $ 7.3.2 1974 91.7 1975 65.5 1976 104.9 1977 114.6 1978 (estimate) 123.1 83 TABLE XV Comparison of 50% CCA v i s 4% CCA Celt Present Value of tax s h e i l d = C a p i t a l c o sts of tunnel only $63.2 m i l l i o n Present Value of t a x s h i e l d -CCA = 4% 63.2 C i 2 + ' 0 4 ) $ 7 ' 3 m i l l i o n Present Value of T a x s h i e l d -CCA = 501 63.2 (. * 12 +—14u"^ 23 . 5 m i l l i o n The d i f f e r e n c e i s : $; 16. 2 m i l l i o n 84 manufacturing equipment can today be written i n a two year pericd, compared to i t s reqular 20% (declininq balance) maximum in the early 1970*s. Certain s p e c i f i c asset classes, e.g. po l l u t i o n controls and energy-efficient equipment, also q u a l i f y f or a two year write-off. Another example rel a t e s to a i r c r a f t . In the mid-1970' , when a i r l i n e s were experiencing f i n a n c i a l d i f f i c u l t i e s , the maximum allowable CCA was raised from 25% to 40%. This s p e c i a l provision lapsed in May 1976 . Accelerated CCA i s a very favourable financing alternative fo r both CP and the government. It i s an acceptable f i s c a l practice employed many times i n the past. I t requires no cash outlay from the qovernment, and CP gains only af t e r making the investment. This alternative has the further advantage of being p r o j e c t - s p e c i f i c . Income tax reduction A reduction i n CP B a i l ' s marginal tax rate could help to finance the s h o r t f a l l . The federal government could agree, for example, to an across-the- board income tax reduction of 5% during the period of construction(1 9 8 0 to 1 9 8 3 ) . , The present value of the reduction i s determined to be $17 m i l l i o n i n Table XVI. Some precedent does exist for general income tax reductions. In 1973 , the federal corporate income tax rate was lowered by 6% to 42% for manufacturing and processing industries., This f i s c a l measure was designed to stimulate Canada's manufacturing and processing sectors. While t h i s tax TABLE XVI Effect of 5% reduction i n inoometax rate during period of tunnel construction (1980 - 1983) Assuming a net income before tax of $125 m i l l i o n for the four year period 1980-1983, a 5% reduction, i n income tax rate would y e i l d a saving of $6.25 m i l l i o n . The present value of the reduction i s .(d. = .12) $6.25 m i l l i o n X 2.712 = $16.95 (t5-t2) 8 6 reduction may be an acceptable stimulus f o r an entire economic sector, i t would be unacceptable to grant such concessions to a single company. Many other companies would f e e l that they should also be el g i b l e f or the same reduction. This d i f f e r s from the C C A case where the fa s t write-offs apply to s p e c i f i c asset classes. 87 7.2 Dser Pay Alternatives The f i r s t section of t h i s chapter explored several public remedies which would ease and/or eliminate the prospective Beaver tunnel f i n a n c i a l d e f i c i t . This section w i l l examine a user-oriented remedy. A r e s t r i c t i o n on CP R a i l ' s p r i c i n g freedom prevents the Railway from capturing economic benefits which accrue to grain producers. It has already been established that grain moving under the Statutory Bates does not cover the variable costs of moving that grain. The Snavely Commission reported that, in 1974, the variable cost of transporting grain on CP's r a i l network was covered i n the following proportions: 1) users-37.7??, 2) CP fiail-43.5%, and 3) federal government-18.8%. Removal or modification of the Statutory Bates would have a posi t i v e e f f e c t on CP B a i l ' s cash flows. Two sets of alternatives w i l l be examined below. The f i r s t analysis w i l l examine the incremental cash flows that would accrue to CP B a i l as a r e s u l t of an increase i n the Statutory Bates. In t h i s section, i t i s assumed that the amount of grain moved via CP's western mainline remains constant at the 1977 l e v e l . This alternative i s plausible because i t i s reasonable to expect that CP B a i l would apply part of the incremental revenue toward the tunnel d e f i c i t (and hence build the tunnel) i f the government increased the Statutory Bates. The second set of alternatives uses the same pricing scenarios as the f i r s t , but applies them only to the incremental grain that would not have moved i f the tunnel was not b u i l t . 88 This set of alternatives conforms to the accepted rules of project evaluation, i . e . comparing incremental revenues to incremental costs. It i s assumed that the tunnel would allow for the movement of an additional 500,000 tonnes of grain. Increase Statutory Bates by a factor of four through a value-of-service policy Under t h i s scenario. Statutory Bates are increased by a f a c t c r of four. I t i s assumed that the average length per train t r i p i s the distance between Medicine Hat and Vancouver, which i s 822 miles.. In 1977, approximately 4.55 m i l l i o n tonnes of grain moved at Statutory Bates over CP B a i l ' s western mainline. This i s equivalent to 3.74 b i l l i o n tonne-miles.,The Statutory Bate yields 0.55 cents per tonne-mile. Quadrupling the rate would increase i t to 2.2 cents per tonne-mile. The factor of four i s not out of l i n e when a comparison i s drawn between the Statutory Bate and the United States grain rate. Between Pincher Creek, alberta and Vancouver,B.C.a distance of 748 miles, the Statutory Bate y i e l d s 0.99 cents per tonne.. In 1977, the Burlington northern levied a rate of 3.95 cents per tonne between Shelby, Montana and Seattle, Washington, a distance of 74 3 miles., Table XVII shows that CP B a i l would derive an additional $183 m i l l i o n on e x i s t i n g grain t r a f f i c and $30.9 m i l l i o n on incremental t r a f f i c . 89 Increase Statutory rates by a factor of four TABLE XVII CBase year = 1978, d = .12) Revenue at 0.55$/tonne mile (0.55 X 3.74 b i l l i o n tonne-miles) $20.57 Revenue at 2.2$/tonne mile (2.2 X 3.74 b i l l i o n tonne-miles) 82.28 (2.2 X 4.11 m i l l i o n tonne-miles) ^ g 0 4 Difference 61.71 9.04 Less Federal Branch Line Subsidy 23.3 2.56 Cash increase to CP R a i l $38.41 $6.48 Present Value of inflows 1983-2002 (d=.12) $38.41 (4.763) $182.95 m i l l i o n 6.48 (4.763) $30.86 million (;t24-t4) 90 Cost-plus pricing policy This p r i c i n g scenario takes into account input from the grain farmers. The United Grain Growers suggested that a grain rate be set by increasing the variable cost of grain movement by ... the r a t i o of r a i l revenues to the r a i l variable cost on other bulk commodities transported by r a i l in western Canada and sold on the world market. 5 I t was decided to use the r a t i o of two bulk commodities to arrive at a rate factor. In 1977, the weighted average of r a i l revenues to r a i l variable cost of c o a l and sulphur shipped in western Canada was 1.43.,The variable cost of moving grain in 1977 was approximately $15.50 per tonne. 6 Table XVIII determines that the cost-plus p r i c i n g policy would net CP B a i l an additional $334 m i l l i o n on existing traffic(1977 l e v e l ) , and $37 m i l l i o n on i t s incremental grain t r a f f i c . Pricing at variable cost The variable cost of CP B a i l ' s grain movement was $15.50 per tonne i n 1977. However, CP B a i l received only $3.96 per tonne from the grain producers. The incremental revenue flowing to CP under a variable cost p r i c i n g system i s presented i n Table XIX. The e x i s t i n g grain t r a f f i c (1977 levels) would contribute an additional $190 m i l l i o n , while incremental grain t r a f f i c 91 TABLE XVIII Cost-plus p r i c i n g policy (Base year = 1978 d =.12) Cost-plus rate $15.50 X 1.43 = $22.17 per tonne Less Federal Branch Line Subsidy 2.78 Cost-plus rate to users $T9T39 per tonne Exi s t i n g grain Incremental t r a f f i c grain (millions) Revenue-cost-plus rate C4.55 m i l l i o n tonnes X 19.39) $88.2 (0.5 m i l l i o n tonnes X 19.39) $ 9.7 Less Revenue @ Statutory Rate (4.55 m i l l i o n tonnes X 3.96 tonnes) 18.0 (.0.5 m i l l i o n tonnes X 3.96 tonnes) ' 2.0 Incremental revenue $70.2 $ 7.7 Present Value of inflows 1983-2002 $70.2 (4.763) $334.4 7.7 (4.763) $36.7 92 TABLE XIX Variable Cost Pr i c i n g (Base year = 1978, d =.12) Variable cost of moving grain Less:Statutory revenue Branch-line subsidy Incremental revenue to CP $ 3.96 2.78 $15.50 per tonne 6.74 8.76 per tonne Existing grain t r a f f i c Incremental grain Revenue (4.5 5 m i l l i o n tonnes X 8.7 6) (_Q. 5 m i l l i o n tonnes X 8.76) $ 39.9 $ 4.4 Present Value of inflows 1983-2002 (39.0) (4.763) $190.0 m i l l i o n (4.4) C4.763) $21.0 m i l l i o n 9 3 contributes $21 m i l l i o n . In summary, i t i s apparent that the user pay scenarios applied to grain would substantially increase CP R a i l revenues. A s n a i l proportion of the incremental revenues associated with the existing grain t r a f f i c would cover the tunnel shortfall..The incremental revenue derived from the incremental grain t r a f f i c c l o s e l y approximates the f i n a n c i a l s h o r t f a l l under the four times and cost-plus scenarios., 94 7.3 The Preferable Financing alternative The f i r s t section of t h i s chapter dealt with c e r t a i n public sector alternatives to financing the tunnel s h o r t f a l l . The second section presented a number of user pay alte r n a t i v e s . ., An argument was made i n Chapter 6 that potential economic benefits may make the project publicly desirable. Yet these benefits cannot be captured by CP B a i l due to pricing restrictions.,Both public sector financing alternatives and user pay alternatives have been presented. Which i s preferable? From an economic viewpoint, the user pay alternatives are preferable. I f the project i s economically j u s t i f i e d , i t should be possible f o r CP to exploit the users' willingness to pay. This avoids possible d i s t o r t i o n s brought on by a tax i n one sector to subsidize the tunnel. On the other hand, the government may fee l that regional development/ national unity considerations are best served by advancing public financing solutions and leaving Statutory Rates as i s . I t i s even possible that the federal government could force CP B a i l to build the tunnel without any f i n a n c i a l compensation..The shareholders of CP B a i l would then, i n e f f e c t , absorb the s h o r t f a l l . Given, however, the inattention paid to grain movement by CP B a i l in the past two decades because of non-compensatory rates, i t i s unlikely that the government would resort to t h i s alternative. Given that demand for grain w i l l be strong i n the forseeable future; given that Canadian grain exports are expected to r i s e from 22 mil l i o n tonnes i n the crop year 1977-78 to 30 mil l i o n tonnes i n 1985; given that the Soger's Pass 95 section i s the c r i t i c a l bottleneck on CP's western mainline; and given the long lead times associated with this project, every e f f o r t should be made to get t h i s project started as quickly as possible. I b i s must be reflected i n the selection of a financing a l t e r n a t i v e . , Keeping these factors i n mind, i t would appear that public financing a l t e r n a t i v e s are preferable. The user pay alternatives are sound, both from an economic and f i n a n c i a l point of view. But the modification of the Statutory Bates i s a delicate p o l i t i c a l guestion that i s best viewed i n the context of long-term problems. T r a f f i c forecasts indicate that the Soger's Pass bottleneck i s a c r i t i c a l capacity constraint i n the short-term. The public financing schemes discussed above have a common c h a r a c t e r i s t i c : CP B a i l receives a f i n a n c i a l benefit i n the form of a cash payment or tax reduction. The subsidy i s a cash payment, and would be the most controversial i n the eyes of the public.„The income tax reduction i s a l e s s v i s i b l e benefit, as the public does not see money flowing from the public c o f f e r s to CP.j accelerated c a p i t a l cost allowance i s the least controversial method, and has the added advantage of being very p r o j e c t - s p e c i f i c . 96 Footnotes 1.. See John Heads, "Transport Subsidies: an Overview", Address to the Canadian Transportation Research Forum, Winnipeg, June 1978, pp. 4-5. ; 2. „• Ibid, p. 15. .• 3., Peter Lusztig and Bernard Schwab, Managerial Finance In a Canadian Setting (Toronto: Holt,Rinehart,and Winston, 1973) p.69-70. U. Richard Goode, "accelerated allowances as a Stimulus To Investment", Quarterly Journal of Economics 69 (19 55) p.200. ,• ~ 5. Carl Snavely, Report On The Costs Qf Transporting Grain By R a i l (Ottawa: Queens Printer,1976), p.66. 6. "Grain Loss Climbs", Vancouver Express 15 January 1979. 97 • appendix I S e n s i t i v i t y analysis The f i n a n c i a l evaluation u t i l i z e s CP's "most probable" t r a f f i c forecasts and a sustainable capacity figure that i s open to debate. Adoption of different figures f o r t r a f f i c forecasts and/or sustainable capacity can dramatically a f f e c t the timing of the project. T r a f f i c forecasts CP has produced "minimum" t r a f f i c forecasts (Table I I I ) , Under t h i s scenario, only 20.17 m i l l i o n net tonnes would move in 1985. This could e a s i l y he handled by the present plant. The evaluation carried out i n Chapter 3 showed that 27.13 million net tonnes could move i n 1982 without a d d i t i o n a l r a i l capacity (Table I I ) . I f "minimum" t r a f f i c forecasts are used, i t i s apparent that the only substantial benefit of a tunnel would be the savings i n eguipment and operating costs associated with lower grades. Given "minimum" t r a f f i c forecasts, CP estimates the savings to be $27.J m i l l i o n s . This i s l e s s than hal f of the discounted costs of the tunnel($73.8 m i l l i o n ) . Any contributions from additional t r a f f i c would only be gained far i n t o the future. Therefore, there w i l l be a substantial timing delay before capacity constraints are such that the tunnel investment i s needed. 9 8 CP has not produced "maximum t r a f f i c forecasts i n i t s 1978 analysis. However, i f one u t i l i z e d t r a f f i c forecasts that were greater than the most probable forecasts, the sustainable capacity would be reached e a r l i e r , thereby c a l l i n g for an increment to capacity. : The l e v e l of savings would be s u b s t a n t i a l l y the same as under the most probable t r a f f i c forecasts, as the tunnel could not be completed any sooner than 1982, which i s the same completion date as under the most probable forecasts., The f i n a n c i a l evaluations under minimum and maximum t r a f f i c forecasts appear i n Table XX. The valuation of the benefits are rough estimates only., The purpose of this Figure i s to i l l u s t r a t e the magnitude d i f f e r e n t i a l s of minimum and maximum forecasts., Sustainable capacity For the purposes of t h i s paper, a figure of 15 t r a i n s (one-way) has been selected as a measure of sustainable capacity. Both CP and Transport Canada have adopted t h i s figure.,Given the most probable t r a f f i c forecasts, i f sustainable capacity could be raised to 16 trains per day, the Railway would not encounter congestion problems u n t i l 1985 (Table I ) . , However, i f sustainable capacity was only 14 trains per day, congestion would become serious by the end of 1982. Starting construction i n 1979 would lead to tunnel completion i n the end of 1982. Thus, t h i s lower sustainable capacity figure would c a l l for a r e l a t i v e l y e a r l i e r s t a r t i n g date., TABLE XX Financial Evaluation of the Beaver Project under minimum and maximum forecasted t r a f f i c (millions of discounted $) Minimum forecast Maximum forecast Costs Capital:.Costs $73.8 $73.8. Benefits $27.1 1 $35.03 Savings 2 Contributions from: Coal 1.1 .21 Gen. Mchse. .1 2 Grain (.3) 28.0 (5) 53.0 Present value of shortfall $45.8 $20.8 Footnotes: . :~ . . . \ .' 1. Source: CP R a i l 2. The contribution are estimates based on available data. 3. It i s assumed that the savings would be s l i g h t l y higher under maximum forecasts than most probable, v i s $35.0 m i l l i o n v. $33.9 m i l l i o n . 100 The f i n a n c i a l evaluation under minimum and maximum sustainable capacity i s presented in Table XXI. Here again the valuation of the benefits are estimated roughly. I t should be noted, however, that the evaluation i s sensitive with respect to a sustainable capacity figure. The minimum figure produces a coal contribution of $ 2 1 m i l l i o n , as compared to no coal contribution under the maximum fi g u r e . It should be noted that none of the options explored above in the s e n s i t i v i t y analysis show the funnel to be a f i n a n c i a l l y viable project. The analysis has shown that the evaluation i s sensitive to varying forecast and sustainable capacity figures, but the end resu l t i s the same: the tunnel i s not f i n a n c i a l l y viable. , TABLE XXI Financial evaluations of the Beaver Project under minimum and maximum forecasted sustainable capacity (millions) MINIMUM MAXIMUM C14 trains per day) (16 trains per day) Costs Capital Costs $73.8 $73.8 Benefits \ .... $35.0 $27.1 Savings Cont— from: Coal 21 0 Gen. Merck. 1 .5 Grain (5) 53.0 0 27.6 Present Value ($20.8) ($46.2) 102 Appendix II Varying Discount Kates The u t i l i z a t i o n of varying discount rates w i l l s i g n i f i c a n t l y a l t e r the present value of the economic benefits. The discount rate of 12% i s the private sector discount rate which has been u t i l i z e d throughout t h i s paper. Assume that the discount rate of 8% more c l o s e l y r e f l e c t s the s o c i a l time preference rate. The lower discount rate leads to s i g n i f i c a n t l y higher present values, as i s shown i n Table XXII. 103 TABLE XXII ECONOMIC BENEFITS" OF THE BEAVER PROJECT UNDER VARYING DISCOUNT RATES (BASE YEAR = 1978) LESS OPTIMISTIC MORE OPTIMISTIC 1 . Di scount rate = 8% Hopper car sav ings 5% fewer cars 10% fewer cars Incremental g r a i n t r a f f i c 0.5 m i l l i o n tonnes 1.0 m i l l i o n tonnes $8.5 m i l l i o n Reduced demurrage charges 3.6 25.4 $3775" $17.0 m i l l i o n 3.6 50.9 $71 .5 2. D i s c o u n t r a t e = 12% Hopper car sav ings 5% fewer cars 10% fewer cars Reduced demurrage charges Incremental g r a i n t r a f f i c 0.5 m i l l i o n tonnes 1.0 m i l l i o n tonnes $6.2 2.4 16.9 $2~5T5 $12.4 2.4 33.7 $48.5 104 Bibliography Baumol, William, ana Bradford, David "Optimal Departures From Marginal Cost P r i c i n g . " American Economic Review, ,60 (1970); Bonbright, James. P r i n c i p l e s of Public U t i l i t y Bates. Hew York: Columbia University Press, 1961. Canada, Transport Canada. An Interim Report on Freight Transportation i n Canada. Ottawa; Information Canada, 1975. "Canadian P a c i f i c : Whipping Boy i n the West." Winnipeg Tribune. 27 October 1976 Canadian P a c i f i c Railway. Annotated Time Table Montreal, 1892. CP B a i l . "Beaver Tunnel and Grade Revision Project." Montreal, 1978. (Typewritten) CP B a i l "Economic analysis of C a p i t a l Spending Projects Beguired to Construct Second Main Track at Stephen, Beaver, Clanwilliam, and Notch H i l l with Maximum One Per Cent Compensated Grade and 6S5 Curvature." Vancouver, 1976. (Typewritten) CP B a i l . "Guidelines for Developing the Economics of Major Spending Proposals.•« Montreal, 1974. (Typewritten) Darling, Howard. "Transport Policy i n Canada: The Struggle of Ideologies verses Realities.* 1 In Railway, Freight Bates: A Source Book. Montreal: CP B a i l , 1973. Dupuit, Jules. "On t o l l s and Transport Charges.'! International Economic Papers. 1 (1962), pp. 7-31. "Flow of grain cars may not sweep away wheat load.V F i n a n c i a l post. 27 October 1979, Goode, Bichard. "Accelerated Allowances as a Stimulus to Investment.*? Quarterly Journal of Economics. 69 (1955), pp. 191-220. "Grain Loss Climbs." Vancouver Express. ,15 January 1979. 105 Heads, John. "Transport subsidies: An overvie w. " Address to the Canadian Transportation Research Forum, Winnipeg, June 1978. Heaver, Trevor D. , and Nelson, James C. Bailway P r i c i n g Under Commercial Freedom: The Canadian Experience, Vancouver: Centre For Transportation Studies, 1977. H i r s h l e i f e r , Jack., Price Theory and Applications. Englewood C l i f f s : Prentice H a l l , 1976. Ho t e l l i n g , Harold. "The General Welfare in Belation to Problems of Taxation and of Bailways and U t i l i t y Bates." Econpmetrica 6 (1938) , pp. 212-269. , J o p l i n , A. F. # and Detmold, P. J . , " B a i l Capacity--will There Be S u f f i c i e n t ? " Address to the Canadian Transportation Research Forum, Vancouver, June 1976. Lamb, W. Kave. History of the Canadian P a c i f i c Bailway., New York: Macmillan Publishing Co. Inc., 1977., Lightheart, David. ,CP B a i l , Vancouver, B.C. Interview July 1978. Lusztig, Peter and Schwab, Bernard. Managerial Finance in a Canadian Setting, Toronto: Holt, ainehart, and Winston, 1973. Nishan, E. J. Elements of Cost-Benefit Analysis. London: George Allen and Dnwin Ltd., 1972. Snavely, C a r l . Beport on the Costs of Transporting Grain by B a i l , Queens Prin t e r , 1976. Veritas, Philo. The CPB. An Appeal to Public Opinion Against the Bailway being Carried across the Selkirk Bange, that Boute being objectionable from the Dagger ofi F a l l s from Glaciers and from Avalanches, also Generally pa otheif Matters. , Montreal: Wm. Douglas and Co.,1885.
UBC Theses and Dissertations
An evaluation of CP Rail’s proposed Beaver Tunnel Friesen, Ted John 1980
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