This amorphous term ESG encompasses a wide spectrum of information and considerations but is so often assumed to mean something it does not. To paint a better picture of what the term ESG actually means, each month we will be outlining examples of what ESG integration looks like in practice across a variety of sectors, through the lenses of risk, opportunity, and impact.
- Sector: Industrials
- Industry: Rail Transport
- ESG Issue: Service Governance, Quality, and Safety
Risk: Poor safety standards & labor shortages
On February 3, 2023, a Norfolk Southern freight train, carrying two crew members and one trainee, derailed and exploded in the small community of East Palestine, Ohio. Approximately 20 of the more than 100 railcars were carrying hazardous materials, including the highly flammable and toxic substance vinyl chloride. A preliminary report shows the derailment was caused by an overheated rail car axel, to which the crew members were not alerted with sufficient time to prevent the disaster. Norfolk Southern CEO Alan Shaw admitted during a Senate hearing into the incident that the company’s safety protocols were not enough.i While no injuries or deaths were immediately reported in the initial accident, an urgent risk of an uncontrolled explosion emerged in the days after the derailment.ii On February 6th, a ‘controlled burn’ of vinyl chloride was conducted to mitigate the explosion hazard. The incident has required a substantial and costly cleanup of the ground soil and ground water across East Palestine and the surrounding area.
Reputational risks, fines, and lawsuits from poor safety standards. In response to the derailment in East Palestine, the National Transportation Safety Board (NTSB) opened a special investigation into Norfolk Southern’s operations, citing up to five incidents dating back to late 2021.iii The Ohio and Pennsylvania Attorneys General have launched separate investigations into the accident, and Ohio’s Attorney General has already filed a 58-count civil suit against the rail company. Meanwhile, the Environmental Protection Agency (EPA) has ordered Norfolk to cover all costs associated with the cleanup.iv, v Also in response to the incident, Transportation Secretary Pete Buttigieg has called for higher maximum fines for railroad safety breaches.vi Right now, these fines may be a rounding error for the rail companies, but that could change if the consequences become more severe.
While the derailment in East Palestine is still under investigation, the incident has also shone a bright light on an industry that had already been garnering negative attention for its labor practices.
Did you know?
About 1,000 derailments occur each year, according to the Federal Railroad Administration. In the last 8 years, derailments resulting in the release of hazardous materials, like that in East Palestine, have cost rail companies $100 million in equipment damage and $53 million in track damage.
Operational risks from labor shortages. Although employment in rail transportation remained relatively stable for most of the past 25 years, it declined by 40,000 jobs from November 2018 to December 2020, nearly 30% of the workforce.vii Employment decline in the industry was, of course, further exacerbated by COVID-19. As lockdowns lifted, however, employment levels remained stagnant, even as the demand for shipped goods increased.viii Staff shortages have resulted in worsening work conditions including longer shifts, sometimes as long as 19 hours.ix A tight labor market has not helped the situation, and the result has been ongoing and long-running labor union disputes centered on working conditions.x
Trade groups and customers have blamed operational delays and servicing issues on companies continuing to understaff their operations. Labor concerns are directly connected to quality and safety within the rail industry and the safe transportation of goods is key to maintaining a license to operate.
Companies that poorly manage the quality and safety of their operations will not only have to deal with increased costs from fines and cleanups, but potentially significant reputational risks associated with incidents like the derailment in East Palestine that reduce a company’s license to operate. A more hesitant and potentially smaller customer base, coupled with a tight labor market plagued with labor disputes, could pose real issues to these businesses.
“They’ve cut labor below the bone, really. In order to make up for the shortage of labor, they are overworking and abusing the workforces they have.”Surface Transportation Board Chair Marty Oberman, speaking about Class I freight railroads to the House Transportation Committee
Opportunity: Investing in modernization
As service quality remains top of mind for the rail industry, modernization can go a long way to improve operational efficiency. It can also reduce costs in the long run. More training for drivers on better speed management can potentially result in a reduction of energy costs by up to 10%.xi Investments in operational software that optimize fuel consumption can reduce fuel costs, while innovations in materials and aerodynamic locomotive design can provide speed and resilience, as well as a competitive edge over peers.
The rail industry is a relatively lower carbon method of transportation, but there is still room for improvement. According to the International Energy Agency, 55% of the energy consumed by the global rail industry in 2020 was generated by diesel (85% of it used to power trains), 44% by electricity, and 1% by biofuels. Reducing the carbon emissions resulting from the burning of diesel will therefore be critical for the industry to decarbonize. Rail operators are slowly starting to think about the transition to electrification, and some are beginning to consider the use of renewable energy to power rail electrification, although costs to transition remain high. Hybrid locomotives could be an interesting way forward. Some are also exploring the potential to use hydrogen gas as a power source, although technology and infrastructure development will be required.xii
Impact: Disrupted service, disrupted economy
Impacts to broader supply chains. Labor shortages impact not only the rail companies themselves, but also the industries that rely on freight to transport their goods and services. Two of the hardest hit industries resulting from labor shortage service delays have been agriculture and energy. Service disruptions have forced companies across both industries to limit production and in some cases temporarily shut downing facilities. The cost to the grain industry, for example, has been over $100 million in lost revenues as well as additional freight expenses. Ultimately, consumers bear the burden of these costs in inflated prices and fewer options are the grocery store.xiii
Impacts to people. While the derailment in East Palestine and its depth of destruction is still under investigation and assessment, the incident has been marked as an ecological disaster, requiring a massive clean-up of area ground water and soil. Aside from the initial derailment, which forced thousands of residents of East Palestine and the surrounding communities to immediately evacuate, the EPA has since found that the burning of the hazardous materials has resulted in dioxin levels in the area’s soil – which poses cancer risks – hundreds of times higher than the threshold deemed safe.xiv It’s perhaps unsurprising as residents have complained of dead and sick animals and wildlife in the area, including sickness among the residents themselves.xv Though Norfolk Southern has been mandated to cover costs associated with the cleanup, residents have been burdened with immediate costs associated with evacuation and displacement. Meanwhile, the long-term damage to residents’ health is yet to be known, and who exactly will bear the burden of those costs is likely to be litigated down the line.
Questions an analyst might ask
- Does the company have regularly tested and effective emergency response procedures? Are external safety audits regularly conducted?
- Does the company have objectives or targets for quality and safety? Is management responsible for those goals? Does the company provide public reporting on service safety issues?
- How does the company identify potential risks requiring emergency response, who has responsibility for emergency preparedness, and what are the protocols for communicating with external stakeholders?
- How is the company navigating a tight labor market and attracting skilled employees?
- How is the company innovating to create operational efficiencies through modernization?
The bottom line
The quality, safety, and governance of rail services are key to understanding the likelihood and frequency of train derailments. How companies manage these issues will also crucially influence their ability to attract loyal customers and skilled workers.
ESG information can equip investors with the data and insights they need to make more informed decisions on, for example, the likelihood of operational disruptions in the rail industry stemming from poor management of these issues. ESG information can also offer a lens and a perspective into how rail companies are capturing opportunities through modernization, to create efficiencies and decarbonize operations.
And finally, some investors may want to better understand the role that the rail industry has in the broader economy and its impact on people’s livelihoods.
Breaking down the rail industry through the lenses of risk, opportunity, and impact offers three different ways investors can look at ESG information and apply it to inform their objectives.
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