Photograph by Bloomberg via Getty Images

Joining the two companies might be good for shareholders, but less great for the economy.

By David Z. Morris
November 25, 2015
November 25, 2015

Last week, Canadian Pacific Railway made a $28.4 billion takeover bid for Norfolk Southern that would create North America’s third-largest railroad by revenue behind Union Pacific and BNSF. The combined company would own over 32,000 miles of track—more than enough to circle the globe—and control just over 20% of the North American market.

But there are still some major barriers to getting the deal done.

To start with, Norfolk’s leadership quickly rebuffed the offer, which it characterized as “low-premium” because it was only 8% above its share price as of Nov. 17. The other problem is regulators, who would likely be hesitant to approve a megamerger in a sector that’s already arguably short on competition.

The bid, made in cash and stock, is a new chapter in one of the most dramatic recent stories in the railroad industry. In 2011, Bill Ackman’s Pershing Square Capital Management acquired a large stake in Canadian Pacific, at the time one of the least efficient North American railroads. After some contentious jockeying with leadership, Ackman pulled renowned rail industry veteran Hunter Harrison out of retirement and installed him as CEO. Harrison set about an aggressive cost-cutting and asset-trimming program that has produced amazing results.

“They really turned [Canadian Pacific] into a lean and mean company,” says Devan Robinson, president of the financial advisory firm Fairlead and a close railroad watcher.

Norfolk Southern, like Canadian Pacific CP before it, could be a smoother operator. Railroad efficiency is measured by the industry standard “operating ratio,” with a lower number reflecting a leaner operation. Norfolk Southern’s operating ratio was 69.2% in 2014, while Canadian Pacific’s was 64.7% and trending sharply downward. Yesterday, Harrison highlighted his yen for efficiency (and perhaps courted Norfolk Southern shareholders) by declaring that some of Norfolk’s rail yards are “not needed” and would be quickly sold off following a merger.

In addition to the promise of a streamlined Norfolk Southern, there are some big fundamental synergies between the two companies. Norfolk Southern NSC controls rail primarily up and down the U.S. East Coast, while Canadian Pacific’s lines run largely east-west along the U.S.-Canadian border. Together, the two networks could connect East Coast ports with a huge swathe of North America.

Norfolk Southern stock has rallied on the offer, while Canadian Pacific’s is up slightly, reflecting investor enthusiasm.

But there’s a real chance that regulators will stop it from happening at all. “The U.S. Surface Transportation Board have shown no hesitation in shutting this kind of thing down,” says Robinson— as they did in 2000 when BNSF tried to merge with Canadian National. Railroads are particularly prone to monopoly thanks to high capital requirements—there are currently only seven major North American railroads. With much of the economy dependent on them, further consolidation could have serious systemic effects. In fact, a 2013 study by a group representing railroad customers found that rail freight rates rose 76% from 2003 to 2013 following industry consolidation.

In that already challenging context, Robinson says Canadian Pacific would have to work hard to reassure regulators that customers would benefit from the merged company’s efficiency. There’s also little chance the deal would get approval without Norfolk leadership support, so Canadian Pacific may have to substantially sweeten its offer. Canadian Pacific failed to execute a proposed merger as recently as last October, when it reportedly advanced an offer to CSX.

Along with customers, the other likely losers in the merger would be Norfolk Southern employees, who would be squarely in Harrison’s cost-cutting crosshairs.

For more about the rail industry, watch this Fortune video:

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