In this edition of Sustainable Times, Luke Smith, Assistant Fund Manager, considers the role of railways in the transition towards a lower carbon world.
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In brief
- Railways offer a much less carbon intensive method for moving both people and freight than cars and lorries.
- North American railways can be attractive investment opportunities given their focus on freight and ownership of their own networks and infrastructure.
- Canadian Pacific Kansas City, a Canadian/US-listed railway, is an important holding in the Premier Miton Diversified Sustainable Growth Fund.
The role of railways in the transition towards a lower carbon world
Luke Smith discusses the role of railways in the transition towards a lower carbon world, and how railroads in North America have business models that can make them compelling investment opportunities. Canadian Pacific Kansas City, one of North America’s most important railroads, is held in the Premier Miton Diversified Sustainable Growth Fund under the Sustainable Infrastructure theme.
The UK vs US railway industries
Author E.M. Forster is reported to have said that “Railway termini are our gates to the glorious and the unknown. Through them we pass out into adventure and sunshine, to them, alas! we return.”
The views of the Anglo-Irishman could hardly be further from those of today’s traveller on Britain’s railways, which have become a symbol of national dysfunction. Amidst the strikes, delays and controversies surrounding rail in Britain it can be easy to forget the potential commercial and environmental benefits of rail as a technology.
Across the Atlantic in North America, “railroads” offer not only a means of investing in sustainable infrastructure but also compelling business fundamentals, such as growing profits and cash generation. As the world grapples with the challenge of providing sustainable low-carbon ways to move goods and people, rail offers a compelling solution.
According to the Association of American Railroads, railroads are three to four times more efficient than using trucks for moving freight. They say that while freight railroads amount for around 40% of US long distance freight volumes (measured by ton-miles), they account for only 1.7% of US transportation-related greenhouse gas emissions. Similar statistics abound for passenger travel, with the UK’s Rail Delivery Group citing new carbon calculations in 2023 showing that travelling by rail from London to Edinburgh emits 10 times less carbon dioxide than travelling by car and 13 times less than by plane.
Yet, as evidenced by prominent failures in the UK, no matter how sustainable they may be, railways do not necessarily make high quality businesses. This cannot be said for North America’s railroads, where top players have shown themselves to be capable of delivering strong profit margins and a compelling investment proposition.
There are two critical differences between the rail industries in the UK and North America. In the UK there is a separation between the train operators who run train services and the track owner and infrastructure manager, Network Rail.
In North America train companies own their infrastructure as well as operate train services. While this is costly for the companies, it gives them much more control over the service that they can deliver to their customers and offers them complete discretion over scheduling.
It also means that geographical network coverage is important and can be an important competitive differentiator for individual companies. North American railroads are therefore big investors in projects that contribute to the continent’s stock of sustainable infrastructure.
The other key difference is in how railways are used and what this means for their profitability. In the UK railways are predominantly used to transport people, whereas in the US they are almost exclusively orientated towards moving freight.
For much of the post-war period passenger rail has struggled to generate consistent profits in much of the world, the UK included. Passenger rail tends to be more highly regulated, meaning higher costs for operators, and revenues are often unpredictable. Freight is less regulated, meaning costs are often lower, and long-term contracts with customers offer a higher degree of revenue predictability.
Canadian Pacific Kansas City (CPKC) is a company that exemplifies how successful North American railways can be as businesses. Ownership of its track and infrastructure, combined with a strong corporate culture, have allowed it to deliver excellent operational performance.
According to relevant metrics, customers typically receive their freight when they expect and need it. This increases rail freight’s attractiveness versus trucking, railroads’ main competition.
CPKC’s network coverage stretches from coast to coast and from Mexico to Canada, the only railroad to do so, offering a key point of differentiation versus its peers, most of which are focused on one of either the East or West coast.
An increased focus on sustainability by businesses globally seems likely to drive growth for CPKC, which as discussed offers a much lower carbon means of shifting freight.
While by no means guaranteed as a policy development, any attempt at introducing carbon pricing at a US-wide level could well help drive further demand.
Historically, the US rail industry struggled to deliver shipments reliably to customers, but recent changes in organisational philosophy, compounded in CPKC’s case by its reputation for operational efficiency, should help tempt customers from trucking.
CPKC should also, in our view, look to benefit from other global trends, particularly the increasing rivalry between the US and China. These tensions have led to an increased focus by the US government to bring critical manufacturing back from China to the United States or its allies, a policy of which Mexico stands to be a particular beneficiary.
CPKC could benefit in many ways given its coverage stretches into Mexico and given that a North American manufacturing renaissance is likely to drive improved volume growth across its network.
Canadian Pacific Kansas City’s share price vs peers (total return with dividends reinvested)
Source: Bloomberg 21.06.2019 – 18.06.2024. Chart rebased to 0 on 21.06.2019. The performance information presented on this page relates to the past. Past performance is not a reliable indicator of future returns.
Despite the strength of CPKC’s business model, rail is by no means riskless for either company profits or the environment.
One particular risk in the US is that of devastating accidents causing injuries, deaths and catastrophic environmental damage.
Trains in the United States may well carry hazardous chemicals and other materials, which is compounded by US anti-competition legislation that makes it difficult for railroads to exercise discretion over what they carry.
In February 2023 a train operated by Norfolk Southern, one of CPKC’s competitors, derailed in East Palestine, Ohio.
This, and the subsequent response to the accident, led to the release of toxic chemicals into both local waterways and the air, and led to the evacuation of all residents living within one mile of the accident. Needless to say, this resulted in significant costs, exposed the company to litigation and caused significant environmental damage and hammered the company’s share price.
Risks notwithstanding, the managers of the Premier Miton Diversified Sustainable Growth Fund remain convinced by both the investment case and the environmental case for Canadian Pacific Kansas City. Rail will be vital in the drive to achieving lower carbon emissions from the transportation of goods and with a focused approach on delivering strong operational performance and likely growth in demand from the re-shoring and friend-shoring (sourcing from friendly countries) of manufacturing, CPKC seems likely to benefit in the years ahead.
Luke Smith, Fund Manager
