Final Offer Arbitration and Competition 


November 2, 2000

Report to the Canada Transportation Act Review Panel, Toronto, Ontario, published at the Canada Transportation Act Review

The following article was presented to the Canada Transportation Act Review Panel in November 2000 in Toronto.

A.  Introduction

1. Whatever the reasons for the present state of the Canada Transportation Act, the pace and extent of deregulation of the federal railways was hasty and undue.  The two federal railways have a presence in the marketplace that is overwhelming. [1] Unleashing their market power on those who avail themselves of their products, without restraint by relevant market forces or a regulator, has been predictably devastating to those who have limited alternatives.

2. Other models for deregulation (for example, energy and telecommunications markets) disclose that favourable conditions must exist before deregulation occurs.  First, we expect that there will be a clamouring from competitor producers for access to the regulated, and usually monopoly, market.  Second, we expect to see a lot of innovation or technology in the relevant competitive market.   Usually, the technology is accelerating beyond the pace of the market power of the incumbent.  That way, deregulators can take comfort from the prospect that both competitor producers and innovators will discipline the inherently superior position of the incumbent deregulating entity.  The combination of the two can make a compelling case for deregulation.

3. Neither of these factors can be said to have existed at the time of CN was unleashed on the consumers of rail services in 1995/96.  Worse, there was only one other provider of rail services and it, too, enjoyed tremendous market power already and stood to benefit from the advent of the 1996 statute, which would wipe away certain shipper safeguards.

4. One would have expected to see a slow, careful and deliberate approach to deregulation of the two federal carriers.  Normally, there is also a strong case to be made for placing a regulator to oversee the transition from regulated to deregulated markets, particularly where the exposure of customers is so readily apparent.  Neither occurred.  Instead, the 1996 statute was rushed (for the misguided reason that conditions in the equity markets had to be ripe for the receipt of CN) and the regulator was emasculated.

5. Since deregulation started in a big way (1987), I maintain that only one remedy has been effective, although infrequently used.  That is final offer arbitration which, in some cases, has acted as a surrogate for competition.  There is no reason to believe that it will be replaced by anything that approximates its effectiveness or that is as fair.  Even when full-fledged running rights have been in place for a sustained period of time, the remedy should remain in place until

(a) sufficient head-to-head, intramodal and intermodal competition exists,
(b) substitutes for competition such as competitive line rates, running rights and other mechanisms are used in fact over a sustained period of time,
(c) competition policy is adequate and appropriate to address anticompetitive behaviour, and
(d) users have achieved the price-related benefits one would expect in a competitive environment.

B. Spotty Competition

6. The problem is not that there is no competition for the services of the railways.  In fact, at the macro level, there is competition between and among North American carriers.  The problem is that the competition is spotty and masks the effect of the natural monopoly enjoyed by the railways in captive markets.

7. Geographically, there are parts of Canada that benefit from significant intramodal and intermodal competition.  In the product markets, bulk resources enjoy very little competition, but manufactured products enjoy more.

8. Carriers are fond of arguing that an examination of their "system-wide" income reveals that they do not enjoy supra-competitive margins and thus are not abusing their dominance.  That is of little or no comfort to those who are being charged those high rents. 

9. Similar comments about service and innovation can be made about the carriers.  Service is spottier in captive markets and innovation is not brought about by the effects of other participants in the captive market, since there are none.

10. There is no regulator to address these issues and there are no market forces to deal with them, either.  The only parties with such abilities are the carriers themselves and they have a conflict over the outcome.

C. Differential Pricing

11. The basis for the assertion that differential pricing is justifiable is that it leads to lower overall costs, even for the captive shippers, and that it leads to a smaller deadweight loss to the economy as a whole.  I have witnessed the arguments for differential pricing but in the real world of competition there is no place for it.  The very fact that differential pricing is possible proves the fact of dominance.  Under perfect competition (in the absence of collusion), the producer is less likely, if not unlikely, to be able to price differentially because the market sets the price, not the producer.

12. One cannot imagine a customer willingly agreeing to pay a higher price for the rail service just because everyone else, including that customer's competitors, will get the benefit of overall reduced costs.  Differential pricing is the antithesis of competitive pricing in a relevant market.  It often results in shippers paying the carriers far more than they pay themselves.

13. The result of uninhibited differential pricing for the railways, however, is that railway margins far surpass what one would expect if there were adequate, effective, alternative and competitive means of transporting the goods of shippers.

14. From a policy perspective, one really has to wonder why one industry should be favoured over another.  By permitting the use of the carriers' market power to engage in differential pricing, we favour the rail industry over other, valid, industries that operate in competitive, if not hypercompetitive markets.  The effects on employment, access to capital, deployment of resources and regional development cannot be ignored.

D. Captivity

15. I often hear that there is no such thing as a captive shipper.  Naturally, I hear it from carriers.  The fact of the natural monopoly is self-evident: if there is a natural monopoly, there is captivity, to a greater or lesser degree, but captivity nevertheless.  It is qualitatively and quantifiably measurable.

16. On a qualitative analysis, there are shippers that are either or both

(a) logistically captive (either there are literally no intramodal or intermodal alternatives or they are not adequate), and
(b) statutorily captive (they cannot avail themselves of the remedies in the Act because they are not applicable or there is nothing compelling the carriers to make them available).

17. On a quantitative analysis, in captive markets we expect and find that

(a) price is not closely coupled to cost (instead, we hear that the next available substitute supplier prices roughly in the same neighbourhood as the carrier, justifying its rates accordingly; however, traditional market dominance analysis, where substitutes are readily available, is not possible in the case of a natural monopoly.  The whole point is that there is no substitute that is readily available.  Therefore, the carrier can price right up to the incremental cost of the next best alternative (which in some cases does not exist) and earn monopoly profits, even if that next best alternative is competitive in its markets),

(b) productivity gains are not passed on to the customer (instead of the markets determining the extent to which the end users will benefit from the pressures of competition which yield innovation to the benefit of everyone in the supply chain, the carriers keep them - in all cases involving a final offer arbitration in which I have been involved, rates have been flat or have risen over the same period of time that rail costs have decreased - and they can be breathtaking margins), and

(c) surpluses are misallocated (100% of the consumer surplus arising from the exercise of the market power held by the carriers flow to the carriers, begging the question why as a policy matter we would prefer carriers' shareholders and employees over an allocation of that surplus to shippers and their customers, shareholders and employees) and perhaps even misused (to fend off intrusions into that surplus that might arise as a result of more effective surrogates for competition if not actual competition).

 E. The Competition Act

18. Since 1996, the Competition Act has applied to the railways as a matter of law.  Unfortunately, the Competition Act is not effective against those railways any more than it is effective against any natural monopoly.  This is not a defect in the Competition Act, since no antitrust statute anywhere in the world is designed to do so.  It does, however, highlight the deficiency in transportation policy (which, as a specialized tool, has a much greater likelihood of regulating carriers in a desirable fashion than the more general Competition Act).

19. The conspiracy provisions of the Competition Act (to essentially prove collusion) require evidence at a criminal standard of proof.  This is highly unlikely to come from captive shippers who are prone to retribution.

20. The abuse of dominance provisions require evidence at a civil standard of proof that the effect of the abuse is a substantial lessening of competition.  Well, where there is no competition, there is no lessening.  Case closed.  Besides, there is no other railway in those captive markets that is seeking entry and, therefore, the Commissioner has nothing to say about the matter.

21. The price discrimination provisions only apply to articles and not services.

22. The predation provisions also require evidence at a criminal standard of proof but the reasons for their ineffectiveness is not material to the point of high margins, but low margins to grab business or discipline a competitor, among others.

F. Remedies

23. Final offer arbitration is the only remedy currently in use and has proven to be effective in certain circumstances.  It has been used sparingly and with great trepidation.  Conditions must be ripe for its use and, so far, it has been necessary to have second carriers at interchanges willing to take traffic away from the federal carriers even though those second carriers offer no better rates.  Shippers have had to endure pain to use the remedy.  It is a remedy of last resort and often secures longer-term agreements, demonstrating that even the railways find the terms of reference in final offer arbitration agreeable.  It is also a very fair form of dispute resolution in that there is no bias built into the system.  This remedy cannot be removed, nor can it be modified.  There should be no conditions precedent to its use:  to add them would have such a chilling effect as to nullify its use.  I predict it would rarely be used.  The hurdles are high enough already.  It is not even right to say that it can be removed if another remedy was to be put in its place.  Even full-fledged running rights would require substantial and sustained experience to even consider removing the final offer arbitration provisions.  Running rights have not worked and the jury is not even out yet as to whether they can work.

24. Running rights require far more attention and monitoring than a remedy like final offer arbitration.  I am personally in favour of full-fledged running rights: all persons being able to run over all rail lines, whether federal, provincial, domestic or foreign.  I have no fear of the railways' ability to exercise their creativity to deal with that possibility.  But I do fear the railways' ability to frustrate the use of those rights, as well as the ability of the federal carriers to exercise their market power to discipline short lines and provincial railways.  That is why any such remedy has to be implemented after ample time to consider ramifications in the market with a long transition period to measure effectiveness.

25. Just because Canadian railways are not afforded the same benefits in the United States today, does not mean that U.S. railways should not have that ability in Canada.  It would be for the benefit of Canadian enterprise.  I know this is no more popular than allowing foreigners in on the airline industry.  Let's face it, though.  CN is owned primarily by Americans and may be governed out of Fort Worth in any event.  CP is not far behind.  Do we want the benefits of competition for the rest of the economy that is dependent on rail, though?  I say that the answer is an emphatic "yes".

26. Enhanced agency powers to deal with interswitching to the next interchange, as opposed to the radial limit of 30 kilometres, would be a welcome addition as well.  Access to the Agency likely is still necessary for the vast majority of captive shippers for the transition to the time when market forces prevail in the supply of rail services at the point of origin, which is where it counts.

[1] Although the comments expressed below are made in respect of the federal railways, they are in some cases applicable to the provincial railways as well.