Railway freight haulage is not a sector that springs to mind when one stops to consider industries that will benefit in the transition to a low carbon economy. However, if it was added that moving freight over long distances by rail rather than road is three times more fuel and emissions efficient, then the proposition changes significantly.

With diesel prices up 300% over the last 15 years to over US$4.00 per gallon, the cost advantage enjoyed by rail freight operators over their road bound rivals is becoming increasingly material. Combined with a longer term ambition to replace diesel locomotives with high efficiency electric alternatives, it likely that rail operators will continue to increasingly leverage the efficiency advantages that they enjoy. Add to this equation such developments such as battery recharging for locomotives through regenerative braking and tougher, legislated, safety standards, it is safe to stay that the future potential of rail is significant indeed.

In North America the long distance rail freight sector is a significant economic constituent. It is dominated by six industry giants – Canadian National, Canadian Pacific, Burlington Northern Santa Fe (BNSF), Union Pacific, Norfolk Southern and CSX Corporation. All but BNSF are stock exchange listed, and in combination possess a market capitalisation of over US$150 billion. Over the last five years they have invested a combined US$60 billion in capital expenditure, yet at the same time have delivered exceptional shareholder returns.

In 2012 alone, these six firms will invest over US$13 billion on CapEx to improve the sectors’ capacity, efficiency, safety, transportation speed and reach. The size of this expansion is staggering against a backdrop of a sluggish global growth and weak consumer demand.

The investment merits of the industry are certainly compelling; a point not lost to Warren Buffett, whose Berkshire Hathaway (BRK) vehicle invested US$ 26 billion to acquire BNSF in 2010.

The release of BRK’s third quarter 2012 results highlight how successful the acquisition has been. For the quarter, BNSF reported earnings of US$937m, up 22 percent year-on-year.

In 2010 BRK made the following prescient observation in its annual report which perhaps illustrates once again why Warren Buffett is acclaimed for his investment foresight:

“… railroads have major cost and environmental advantages over trucking, their main competitor. Last year BNSF moved each ton of freight it carried a record 500 miles on a single gallon of diesel fuel. That’s three times more fuel-efficient than trucking is, which means our railway owns an important advantage in operating costs. Concurrently our country gains because of reduced greenhouse emissions and a much smaller need for imported oil. When traffic travels by rail, society benefits… The railroad will need to invest massively to bring about this growth, but no one is better situated than Berkshire to supply the funds needed.”

Another appealing aspect of the sector is its highly cash generative nature – which is something of a rarity in the area of clean energy investing!

To illustrate the point, consider American west coast leader Union Pacific. As a company, Union Pacific generated US$4.4 billion net operating cashflow in the first three quarters of 2012. In addition to investing $2.9 billion back into the business, it also paid $860 million in dividends. Unlike many US listed corporations who use tax havens to hold cash offshore, Union Pacific management sees the benefit of optimising its balance sheet and has undertaken share repurchases of $1.2bn in 2012 to date. Since 2007, Union Pacific has repurchased a staggering US$ 7 billion of its outstanding shares, effectively its entire free cashflow! Endorsed by its bankers, this strategy will continue to benefit shareholders without adversely impacting Union Pacific’s investment grade credit rating.

The extent to which the North American rail freight sector has undergone a transformation over the last two decades cannot be overstated. In the last five years, the gains have continued to surprise to the upside by almost any measure. Union Pacific has increased its return on equity from an average 14 percent over 2008-2010 to a record high 20 percent in 2012 and has delivered compound annual growth in earnings per share of 19% since 2007 – driving a more than doubling of its share price over the same period.

As noted, higher diesel fuel prices have increased the pricing power of the rail freight sector considerably in recent years. However, the industry has (in the main) focused on using this relative strength to build a long term sustainable competitive advantage against road freight.

To again quote from Union Pacific’s recent result announcement, customer satisfaction levels reached an all time record high of 94% in the third quarter 2012 relative to 87% at the start of 2010. Employee and public safety scores are also at record levels and are very prominent aspects of that company’s results briefing. Train velocities (average speed) are also at record highs, rising 2.4% annually since 2008 despite significant improvements in fuel efficiency (over 1% annually). Union Pacific’s average train size also continues to rise at a rate of 2.7% annually. The list goes on.

By comparison, the East Coast rail freight firms of CSX Corp and Norfolk Southern have been less than impressive in the last two years. Both generated around 30 percent of revenue from the transportation of coal in 2010, relative to only 20% at Union Pacific. The more than 20% decline in CSX and Norfolk US coal shipments over 2012 has materially undermined the strongly positive momentum in the rest of their business. There are several reasons for this. One is that the collapse of the US natural gas price over 2011-2012 (currently around US$3.70/MMBTU, down more than 50% from long term US averages) combined with the Environmental Protection Agency’s ongoing battle to tighten air emission requirements in our view have permanently undermined the US electricity generation industry’s historic reliance on coal. Reduced electricity demand from a sluggish economy and increased wind farm capacity have also weakened the commerciality of coal fired power generation to the point where out-dated plants are now being progressively and permanently removed from operation.

In concert, these impacts have meant that CSX Corp and Norfolk Southern have reported year-to-date volumes down 1% in comparison with a marginally positive year-to-date performance of Union Pacific, largely due to their differing magnitudes of exposure to coal shipments. For a high fixed cost business, this 2% relative swing in total volume change has a significant cost to earnings, resulting in a 20% differential in earnings growth for CSX and Norfolk vs Union Pacific in 2012 alone.

If anything, the coal sector volume pressure will only intensify the rail sector’s move into building something called intermodal freight capacity, given the significant additional volume potential. Intermodal shipping involves moving freight by road to centralized rail depots prior to long distance rail haulage to another such depot before final distribution by road. Norfolk reported domestic intermodal volumes up 11% year-on-year in third quarter 2012, while CSX reported volumes up 8%.

At a time of record fiscal budget deficits, the scope for the US and Canadian governments to continue to invest in road infrastructure to assist interstate trucking is severely constrained, particularly when the private sector is almost entirely funding the dramatically more efficient rail freight alternative. We therefore continue to see strong growth prospects for the North American rail freight sector, particularly as economic growth slowly ratchets up from current levels. Given the far greater energy and carbon emissions efficiency of rail, this is an area of distinctly positive achievement arising as we move to the low carbon economy of the future.

Note: Tim Buckley is investment manager at Arkx. While Arkx is an investor in Union Pacific, CSX Corp. and Norfolk Southern, this article is provided to detail clean energy industry developments that have relevance in the Australian context and should not in any way be taken as investment advice. Arkx is a Sydney based investment management company that invests in the leading, listed international clean energy companies.