THE DEVELOPMENT OF AIRPORTS REGULATION A COLLECTION OF REVIEWS

Collections series 5 THE DEVELOPMENT OF AIRPORTS REGULATION A COLLECTION OF REVIEWS Doug Andrew Tom Bass Stuart Condie David Matthew David Starkie Ralph Turvey

The University of Bath School of Management is one of the oldest established management schools in Britain. It enjoys an international reputation for the quality of its teaching and research. Its mission is to offer a balanced portfolio of undergraduate, postgraduate and post-experience programmes, research and external activities, which provide a quality of intellectual life for those involved in keeping with the best traditions of British universities.

THE DEVELOPMENT OF AIRPORTS REGULATION ~ A COLLECTION OF REVIEWS ~ COLLECTIONS SERIES 5 Editor Peter Vass Director, CRI University of Bath School of Management Compiled by Jan Marchant The University of Bath All rights reserved ISBN 1 85790 125 8

Centre for the study of Regulated Industries (CRI) The CRI is a research centre of the University of Bath School of Management. The CRI was founded in 1991 as part of the Chartered Institute of Public Finance and Accountancy (CIPFA). It transferred to the University of Bath School of Management in 1998. It is situated on the 8 th floor of Wessex House (North), adjacent to car park H. The CRI is an interdisciplinary research centre investigating how regulation and competition are working in practice, both in the UK and abroad. It is independent and politically neutral. It aims to produce authoritative, practical contributions to regulatory policy and debate, which are put into the public domain. The CRI focuses on comparative analyses across the regulated industries. CRI activities and outputs include: Regulatory statistics, information and analysis Discussion papers and Occasional papers Regulatory Briefs, Reviews and International series Research Reports and Technical papers Seminars, courses and conferences Direct links with regulated industries, the regulators, the academic community and other interested parties are an important feature of the work of the CRI. The CRI is non-profit making. Its activities are supported by a wide range of sponsors. BAA CIPFA Department of Trade and Industry Environment Agency National Audit Office NERA National Grid Transco Network Rail OFWAT RSM Robson Rhodes Royal Mail Thames Water United Utilities Wessex Water Further information about the work of the CRI can be obtained from:- Peter Vass, Director-CRI, School of Management, University of Bath, Bath, BA2 7AY or CRI Administrator, Jan Marchant, Tel: 01225 383197, Fax: 01225 383221, e-mail: mnsjsm@management.bath.ac.uk and from the CRI s web site, which includes events and the publications list. http://www.bath.ac.uk/cri/ Publications and publications list can be obtained from Jan Marchant as above.

PREFACE The CRI is pleased to publish The Development of Airports Regulation - A Collection of Reviews, its fifth collection of reviews drawn from the Regulatory Review and other CRI series. The previous collections have covered the development of energy and rail regulation and, more generally, regulatory practice and design. The idea for the collections arose, in part, because bringing together contributions from successive Regulatory Reviews provided insights, for example, into the development of regulation, but also because we often have requests from readers to the effect that it would be useful if we could bring together the material on, for example, energy. We have continued that philosophy with our fifth collection, and have returned to a sectoral theme. It is divided into two parts, airports regulation and its development as reflected in successive CRI regulatory reviews and three sectoral themes, concerned with economic pricing of scarce economic resources (airport slots), relationships with customers (noting that airlines are powerful customers ) and governance issues, focusing on the principal-agent relationship. We hope that the juxtaposition of regulatory development and specific themes will provide a broader, but integrating view, of airports regulation and policy. The contributions are reproduced as they were published, except for some presentational changes to achieve a common format. Revisions would have defeated the purpose of the historical perspective. Readers should be aware, of course, that institutional changes in particular have taken place, for example, Offer and Ofgas became Ofgem, in rail Opraf was taken over by the SRA, and Energywatch has replaced the Gas Consumers Council and the Electricity Consumer Committees. The CRI publishes a wide range of occasional and technical papers, research reports and regulatory briefs, and encourages those working in the field whether as academics or in other types of organisation to submit suitable material for consideration for publication. Enquiries and manuscripts should be addressed to: CRI, School of Management, University of Bath, Bath BA2 7AY. Peter Vass Director, CRI January 2004 iii

Publication acknowledgement The CRI was founded by the Chartered Institute of Public Finance and Accountancy (CIPFA), but it transferred to the University of Bath on the 15 October 1998, and is a research centre of the School of Management. CRI publications before that date were therefore published by CIPFA. For consistency, where reviews in this collection, or CRI publications cited in those reviews, were published before 15 October 1998 they refer to the University of Bath as the publisher. This is to recognise the fact that the University of Bath now holds the copyrights, and also to avoid the possibility of enquiries being made to CIPFA about publications now held at the University of Bath. This note is to formally acknowledge, however, that CIPFA was the original publisher of CRI publications prior to the 15 October 1998. Peter Vass Director CRI iv

CONTENTS Preface AIRPORTS REGULATION 1 Tom Bass Regulatory Review 1997: chapter 1 2 David Starkie Regulatory Review 1998/1999: chapter 1 3 Doug Andrew Regulatory Review 2000/2001: chapter 1 4 Ralph Turvey Regulatory Review 2002/2003: chapter 1 iii 1 13 25 39 SECTORAL THEMES 5 Pricing Access to Regulated Airports: Airport Charges and Slot Allocation David Matthew Proceedings 26, May 2001: chapter 6 6 Powerful Customers: Working with the Airlines Stuart Condie Proceedings 28, November 2001: chapter 6 7 Effective Governance and the Principal-Agent Problem: Lessons from Aviation Regulation Doug Andrew Proceedings 30, September 2002: chapter 5 59 73 91 v

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1 AIRPORTS REGULATION 1996/1997 Tom Bass Introduction The past year has been eventful. It has seen the CAA s final decision on BAA s charges and its introduction of conditions to implement the public interest findings made by the MMC in its five yearly review of BAA s London airports (MMC4). 1 The MMC has also reported on Manchester Airport (MMC5) and at the time of writing the CAA had just published the MMC report together with its own proposals: it will publish its final decision in October. 2 3 There have also been significant developments within the European Union. The European Commission has been working for several years on a Directive to require airport charges to be more transparent, non-discriminatory and cost-related and it published its draft in April 1997. 4 In the face of criticism from airlines about the cost and quality and the lack of competition in airport ground handling at major airports in Europe it finalised in 1 MMC4 (1996), BAA plc- A Report on the Economic Regulation of the London Airport Companies, MMC, June. 2 MMC5 (1996), Manchester Airport plc - A Report on the Economic Regulation of Manchester Airport plc, MMC, July. 3 CAA (1997), Review of Manchester Airport; CAA Proposals; A Consultation Document, August. 4 Commission of the European Communities, proposal for a Council Directive on Airport Charges, COM97 154, Brussels, April 1997. Acknowledgement This chapter was first published as Airport Regulation 1996-97, CRI Regulatory Review 1997, chapter 1, pp7-19, December 1997, University of Bath. Tom Bass at the time was in the Economic Regulation Group, Civil Aviation Authority (CAA) 1

AIRPORTS REGULATION 1996/1997 October 1996 a Directive to introduce a phased programme of liberalisation and during 1997 the UK government was working on the regulations which will give effect to this. 5 There were three significant developments which could affect the process of airport regulation itself. In August 1997 the new government published a Competition Bill. 6 It has unique implications for airport regulation. The government also announced a review of the sector regulators which, although specifically excluding transport regulation, could well have implications for it. Finally, and separately from the current review, Manchester Airport asked the government to discontinue the requirement for five yearly MMC/CAA reviews: this would mean that it would no longer be regulated by price cap but would remain subject to conduct regulation under the Airports Act and to general competition legislation. The conclusion of the 1996 Quinquennial Review of the BAA London Airports In last year s CRI Review Stuart Condie of BAA described the issues involved, the MMC s reasoning and the CAA s proposals. At that time the CAA was consulting the industry and users on these proposals and it made its final decision in October 1996. In developing its charging proposals the CAA had accepted the MMC s analysis of the major issues, of which the most important were: the valuation of assets; the impact of the net loss of income if and when duty free sales are abolished on routes within Europe, and the clear wish of users that the new formula should enable the Heathrow Terminal 5 project to go ahead. 5 Official Journal of the European Communities (1996), Council Directive 96/67/EC on Access to the Ground Handling Market and Community Airports, Brussels, October. 6 A prohibition approach to anti-competitive agreements and abuse of dominant position: draft Bill, DTI, August 1997. 2

TOM BASS On this latter point the MMC and the CAA were concerned about what would happen if planning permission were refused. Stuart Condie noted that BAA made a voluntary undertaking to seek a mid-term review in that event. However the CAA decided that it was also necessary to deal with the possibility that permission might be granted on conditions which would significantly reduce the scale of Terminal 5 or which would render BAA unwilling to proceed with it on the basis of the new formula, or that BAA might voluntarily reduce the scale of the project in order to secure planning permission. It therefore obtained an undertaking from BAA to cover all these possibilities. The most controversial aspect of the consultation concerned whether the new formula should be set to give a smooth transition in charges between the 1997-2002 quinquennium (Q3) and 2002-2007 (Q4). The 1952-1957 formula had been set at RPI-8 in the first two years, at RPI-4 in the third year and at RPI- 1 in the last two years, this profile being expressly designed to give a smooth transition into Q3. In recommending RPI-3 the MMC had in mind that higher values of X would appear to require sharp increases in charges in Q4, and these would be compounded by two further increases of 7½% to compensate for the loss of duty free. It therefore took a ten year rather than simply a five year view, recognising that this implied a higher rate of return in Q3 (8.5%) than in Q4 (6.7%). When it made its proposals the CAA decided that users should be given a chance to reconsider the issue of smoothing and it therefore put forward options for higher values of X, implying either large increases throughout Q4 or a one-off real increase of 35%-60% when Terminal 5 opens. The response of the airlines was unenthusiastic so the CAA adopted RPI-3 as recommended by the MMC. 7 However it noted that the additional funding which RPI-3 would yield over and above a formula limited to a 7 The actual formula is RPI-3 for Heathrow and Gatwick combined, with a provision that increases at Heathrow should be one percentage point higher than at Gatwick. For Stansted, which is still moving toward full profitability, it is RPI+1. 3

AIRPORTS REGULATION 1996/1997 rate of return in Q3 of 7.5% rather than 8.5% (some 230m) would need to be taken into account when the next formula was set. In view of the importance of the link between the new formula and BAA s delivery of its capital expenditure programme the CAA also decided that its hitherto informal annual reviews of capital investment and other significant developments should be more structured, should go wider to embrace other issues such as the progress towards service level agreements and should lead to a published report to give users the opportunity to comment on and influence BAA s activities. The 1997 Quinquennial Review of Manchester Airport As well as the BAA London airports Manchester Airport is also designated by the government for quinquennial MMC/CAA reviews, and these follow one year behind BAA. The CAA therefore referred Manchester Airport to the MMC in December 1996, received the MMC report in July 1997 and published it, together with its own proposals in mid-august. At the time of writing it was consulting users and planned to issue its final report in October. There are many important differences between Manchester and the BAA London airports. It is owned by local authorities and, although other smaller local authority airports are subject to conduct regulation under the Airports Act, Manchester Airport is the only public sector body in the UK subject to price cap regulation. Its traffic has a different composition to that at London, with a much higher proportion of UK-originating and leisure passengers. Traffic has grown very fast, but less predictably than at London. Finally, it has just received planning permission for a second runway. 4

TOM BASS The MMC report had to cover many of the topics which were important in the earlier BAA review, including valuation of assets, the link between the price formula and the investment programme, cost of capital, the prospects for productivity improvements, the impact of the loss of duty free etc. However there were other issues specific to Manchester, including whether RPI-X regulation was the right approach for a public sector organisation and whether the greater unpredictability of Manchester s traffic required a volume adjustment in the formula. In the first three years of the present quinquennium traffic was 9% above forecast, leading to concern that forecasting errors could lead Manchester to make uncontrollable windfall gains or losses. The MMC also looked at comparisons with other airports and did a good deal of work comparing Manchester s costs and charges with those at Gatwick. The MMC concluded that RPI-X does provide incentives for Manchester Airport to improve efficiency, albeit these may be less for a public sector company under less pressure than a private company to pay dividends and it may also have a wider agenda including objectives such as regional economic development and job presentation and creation. On the volume term it noted that this would have to accommodate both under and over performance and would therefore lead to less stable and unpredictable changes which could lead charges to increase when demand was weakening and vice versa. It would also diminish Manchester s incentive to accommodate additional demand. Although several airlines called for a volume term the CAA was inclined to agree with MMC, and this was one of the issues in the autumn consultation. For the first time in an airport inquiry the MMC adopted for Manchester the net present value approach which it has used for other industries. It had previously used undiscounted figures and this change is not only a technical improvement but it also brings a consistency of approach with the other regulated industries. It used a discount rate of 7.75%. As with the BAA review the MMC recommended that asset values should be rolled forward 5

AIRPORTS REGULATION 1996/1997 by RPI. To do this it had to resolve the difficult problem of the appropriate initial valuation, and a specific complication arose from the fact that the most recent valuation, in 1995, was partial in that Manchester s newly constructed second terminal was included at historic cost less depreciation rather than at a figure which reflected subsequent falls in construction costs. Manchester would have preferred to roll forward from the last full valuation in 1990 but the MMC decided to use the 1995 valuation as the most recent estimate making allowance for the average level of working capital in the preceding five years. The MMC saw scope for efficiency gains over and above those projected by Manchester Airport and incorporated this view in its recommendations. In the case of duty free the MMC recommended that the expected net loss which would arise from July 1999 should be spread over the whole five years rather than, as with BAA, compensated by a separate D factor. The loss to Manchester is significant, and the CAA estimated that a separate increase would have to be about 1.63 per passenger in 1996/97 prices. The MMC s NPV approach to costs and revenues made it possible to spread the cost of the withdrawal of duty free in 1999 over the full five year period and this was also consistent with the airlines stated preference for gradualism in charges increases. The MMC recommended, and the CAA proposed, that Manchester s charges should fall in real terms by 6.6% in 1998/99 and by RPI-5 in the subsequent four years. This is equivalent to RPI-12 if the formula had allowed the separate recovery of the duty free loss. Although this figure may seem high it does of course apply only to airport charges revenue (ie, revenue from aircraft landing and parking and passenger terminal charges) which amounts to about half its total revenue. Both the MMC and the CAA believed that the proposed formula was consistent with the airport s planned capital investment programme, including the second runway and associated developments. Both bodies were also influenced by the detailed comparison which the MMC had done with Gatwick, which 6

TOM BASS reinforced the view that there was further scope for reductions in staff costs, and hence in charges, at Manchester. The MMC also made two public interest findings against Manchester. First that it had provided inadequate information on the costs and revenues associated with the supply of utilities and second that it had inadequate procedures for consultation with airlines, as evidenced by the failure to provide information, an unwillingness to involve airlines closely in investment appraisal and the absence of formal management procedures when investment was undertaken. The CAA therefore proposed to place conditions on Manchester s permission to levy airport charges to remedy these two findings. However in the case of the finding on consultation it put forward, but did not propose, the idea that X might be set at 6 rather than 5 in the last four years pending the CAA s being satisfied that adequate consultations were in place. It asked the airlines and Manchester Airport to consider whether this was necessary and, if so, whether it was equitable and workable. EU Ground Handling During 1997 the government was preparing regulations to give effect to the EU Ground Handling Directive. The main provisions of the Directive are as follows: - From 1 January 1998 any airline will be free in principle to carry out its own check-in at any airport open to commercial traffic. States may grant exemptions to limit the number because of problems of space and capacity but all exemptions will have to be approved by the Commission. - From the same date airlines will be able to self-handle airside, (ie, after departing passengers have checked in and passed through customs, immigration and security) but only at airports with more than one million passengers a year. Because of greater concern about airside constraints states will 7

AIRPORTS REGULATION 1996/1997 8 be able to limit the number of self-handling airlines to no fewer than two: if they wish to limit it to one airline or ban it altogether they will have to give an exemption which the Commission can overturn. - From 1 January 1999 airports will have to allow any supplier to offer ground handling services landside where the airport has over three million passengers. Exemptions can be given to restrict the number to two provided one is wholly independent by 2001. From 1 January 2001 this will be extended to airports with over two million passengers. - Again from 1 January 1999 third party handlers will be able to provide airside services at airports with over three million passengers, falling to two million in January 2001, but states may limit the number of handlers to two, of which one must be independent of the airport by 2001. If a state wishes to maintain a handling monopoly by an airport or by an airline it will have to seek an exemption which will be subject to the Commission s approval. However unlike other exemptions this may not be renewed beyond four years. There were two main areas of concern. Airports felt that the problem identified in the complaints to the Commission were already better dealt with under existing legislation - specifically under Section 41 of the Airports Act which deals with exploitative, restrictive, discriminatory, exclusive or predatory behaviour. The CAA has used the Act to require competitive baggage handling at Manchester, including competitive tender. Ground handling at the UK s larger airports is already competitive and the problems which the Directive addresses do not exist to the same extent as in the countries at which it was primarily aimed. The Directive covers airports with one million passengers or more, a threshold which was generally considered unnecessarily low. The procedures for securing compliance will involve the CAA in an enforcement, and in some cases also a selection, role and, depending on how events develop, could involve additional resources, and hence costs.

TOM BASS At the same time airlines were concerned about the rate at which the Directive will take effect at European airports. Some key aspects do not come in until 2001. There was also strong airline resistance to the scope which airports could still have for limiting the number of handlers. For example until 2002 a restriction to two could result in a duopoly of an airport s own handler and the dominant airline. The timings, threshold, limitations and derogations are summarised in Table 1. Table 1: EC Ground Handling Directive Date of effect Third Party Handling Landside Third Party Handling Airside Self Handling Landside Threshold 01/01/98 All airports open to commercial traffic Self Handling Airside 1mppa 25K tonnes pa 01/01/99 3mppa or 2 million in 6 months 75K tones pa or 50K tonnes in 6 months 01/01/01 2mppa 50K tonnes pa 3mppa or 2 million in 6 months 75K tones pa or 50K tonnes in 6 months 2mppa 50K tonnes pa Limitations by member state May limit to two [1] May limit to two [4] Exemptions (to be approved by Commission) May limit to two [1][3] Monopolies may be retained for at most four years [2] May be limited [3][4] May ban or limit to one [3] [1] From 1/1/2001 one supplier must be independent of airport and dominant airline although a member state may request that this be deferred until 31/12/2002. [2] Two periods of two years. [3] Exemptions are for three years maximum but may be renewed. [4] Must be selected on relevant, objective, transparent and non-discriminatory criteria 9

AIRPORTS REGULATION 1996/1997 EU Airport Charges Directive In April 1997 the Commission published its proposed Directive. The objective is to secure that charges meet three basic principles. They must be non-discriminatory as between intra- Europe (including domestic) services, transparent and costrelated. It is for individual member states to implement that Directive. As with ground handling the UK is the only EU country which already has mechanisms for meeting these objectives - elsewhere they remain to be created. Concerns about charges can be resolved through the complaints procedure under Section 41 of the Airports Act and, for the BAA London airports and Manchester, through the quinquennial review process as well. Again it is questionable whether the proposed Directive will add any value. Unlike the UK system of RPI-X regulation at designated airports it gives no incentive to increase efficiency and reduce costs. It is somewhat prescriptive and if taken too literally the cost-relatedness requirements could be unacheivably precise or prevent acceptable degrees of price differentiation and commercial innovation. The traffic thresholds at which the Directive would apply are even lower than for the Ground Handling Directive - 250,000 passengers per annum and this raises questions about the need for such requirements and the realism of their enforcement. However, as with ground handling, UK airlines would welcome the application of the three basic principles at a number of European airports at whom the Directive is primarily aimed. The Competition Bill The new government s Competition Bill s main significance for the sector regulators is that UK competition law would be 10

TOM BASS aligned much more closely with Articles 85 and 96 of the Treaty of Rome, with consequent repeal of the relevant parts of the existing legislation. The sector regulators other than the CAA already have concurrent powers with the Director General of Fair Trading to enforce existing legislation. Airports regulation is different: the CAA does not have concurrent powers but has separate powers under the Airports Act. It has an agreement with the DGFT on which issues (ie, aviation related) should go in the first instance to the CAA and those (which are mainly or wholly non-aviation related) should go to the DGFT. The Airports Act provides for the Secretary of State to resolve any difficulties to which these separate powers may give rise. At the time of writing the government had proposed to give concurrent powers under the new Bill to those sector regulators which already had them and to consider whether to do so for the CAA in respect of its airports regulation duties. This gave rise to the question of whether the CAA s existing powers to deal with complaints should remain, be modified or repealed. The Government s review of regulation As a separate process, and as discussed elsewhere in this review, the President of the Board of Trade has set in train a review of sector regulation. Although it specifically excludes the transport regulators the government has said that it may draw inferences from the review. The review is not questioning the basic philosophy of price cap regulation, but among the issues with which it is dealing are whether the separate industries should have separate regulators or whether regulation should be more collegiate. The CAA is different in that as well as being an economic regulator it provides air traffic control services and regulates the safety of airlines and airports. It has a board consisting of a chairman and executive and part-time directors. 11

AIRPORTS REGULATION 1996/1997 Decisions on Airports Act complaints and on the quinquennial review of London and Manchester airports are normally taken jointly by the Group Director Economic Regulation and a parttime director. Designation of airports for quinquennial reviews Finally Manchester Airport has asked the government to consider removing the requirement for quinquennial reviews. Since the request was made during preparations for the recent MMC reference it had no direct influence on the MMC s conclusions or on the CAA s proposals. However it raises the broader issue of the point at which the larger and more dominant airports are sufficiently open to competitive forces and/or are in sufficiently close but open relationships with their customers for the need for specific regulation to diminish or to cease. This will be an important issue for 1997/98 and will no doubt feature in next year s CRI review. 12

2 AIRPORTS REGULATION 1997/1998 David Starkie Introduction Both Manchester and the London airports of the BAA are subject to a five yearly review of their charges. The review of the former takes place one year later than the latter and, notwithstanding this lag, there is a period in the five-year sequence when it is a time for reflection, the formal review process having run its course. The year under review sees the start of such a period: the CAA announced in October 1997 its final decision on charges at Manchester Airport and the conditions required to implement the public interest funding made by the MMC in its July 1997 report. With the 1995-97 round of reviews thus concluded, the focus had shifted, first, to monitoring and compliance, with the CAA publishing in July 1998 an interim report detailing development since the review of BAA s London airports (the CAA s final report is expected around the turn of the year) and, second, to the process of airport regulation itself. Significant in the latter context was the Governments publication of three proposals as part of the utilities regulation review, which taken together would move airport regulation closer to the standard regulatory model. There were, however, no developments on another significant issue namely Manchester Airport s request to be subject to conduct regulation under the Airports Act and to general competition legislation, but not to be regulated by a cap on charges. Acknowledgement This chapter was first published as Airport Regulation 1997-98, CRI Regulatory Review 1998/9, chapter 1, pp7-17, January 1999, University of Bath. David Starkie, Economics-Plus Limited 13

AIRPORTS REGULATION 1997/1998 Similarly, at the time of writing, there was little to report on European legislation in relation to airport regulation. The Commission has yet to respond to the consultation on a proposed Directive on airport charges, and has yet to bring forward a revised Directive on the allocation of runway slots at Community airports. What was significant however was the affirmation by the EU Finance Ministers that duty free sales are to be withdrawn for intra-european travel from mid-1999. This will have important implications for the airport industry, not least for the contingent price caps at BAA London airports and at Manchester. The conclusion of the 1997 Quinquennial Review of Manchester Airport In last year s CRI review, Tom Bass of the CAA described how Manchester differed in a number of important respects from BAA s London airports, not least the fact that Manchester remains in the public sector and is the only public sector body in the UK subject to price cap regulation. He then outlined the basic issues involved in the MMC s review, the Commission s reasoning and the CAA s proposals. 1 At the time the CAA was consulting on these and it reached its final decision in October 1997. 2 When the authority published its own proposals in August 1997, it had accepted the MMC s analysis and most of its recommendations on airport charges. On the latter the MMC had recommended that airport charges at Manchester should continue to be regulated by reference to an RPI-X formula applied to average revenue yield per passenger. The issue had been whether an RPI-X formula was appropriate for a public sector 1 Civil Aviation Authority (1997a), Review of Manchester Airport - CAA Proposals, A Consultation Document, London. 2 Civil Aviation Authority (1997b), Economic Regulation of Manchester Airport, 1998-2003, (CAP 679), London. 14

DAVID STARKIE company given the different incentives that such a company might have with respect to maximising earnings per share when its shareholders might also have a wider agenda including regional economic development and job creation. The MMC felt that in spite of these complications, the formula did provide an incentive for Manchester airport to improve efficiency and the CAA concurred. One subsidiary, but potentially significant, issue on which the CAA invited comment in its proposals was the possible addition to the formula of a volume adjustment term. The argument for such an adjustment is that short run costs do not change pro rata with the level of airport traffic. For example, Manchester s financial model suggested that a 5 per cent increase in passenger numbers would lead to short-run costs increasing by just over 1 per cent. Consequently large variations in financial performance result when actual traffic differs from the forecasts used when the price-cap formula is set, and this has led to suggestions that charges might be lower when passenger traffic turns out to be higher than expected and vice versa, thus reducing the corresponding variation in revenues. Compared to ideas advanced for the sharing of the profits of the regulated industries, an approach using a volume adjustment term linked to revenues need not dilute the incentives to reduce costs (although it might reduce incentives to squeeze more output from existing capacity). 3 The MMC considered a volume adjustment term for Manchester at some length and had noted in its report the CAA s view that the argument for such a term was much stronger for Manchester than for BAA s London airports, given the more volatile nature of the traffic at the former. However, the MMC did not recommend it because, amongst other things, it would have led to 3 The Public Electricity Suppliers and British Gas are examples of regulated utilities with price controls designed so that the permitted level of total revenue has a volume adjustment achieved through having both a fixed revenue component and an element (for example 50 per cent) which varies with changes in volume, as well as being indexed to the RPI. 15

AIRPORTS REGULATION 1997/1998 less stable, more unpredictable charges. At the time of its proposals the CAA accepted the MMC s recommendation but, nevertheless, invited views on this conclusion before making a final decision. 4 Manchester continued its opposition to a volume adjustment term and in the absence of a strong constituency amongst other respondents in favour of such a modification, the Authority decided not to change its initial conclusion. The MMC had recommended that the formula for the forthcoming quinquennium should be set at RPI-6.6 in 1998/99 and at RPI-5 in the subsequent four years. In reaching this view the MMC considered that there were still substantial opportunities for increasing productivity (by 4.6 per cent per annum); that to sustain the underlying traffic forecasts on which the financial projections were based, expenditure on sales development and marketing would need to be much less than Manchester were assuming; and that there were still significant cost savings to be achieved with respect to the provision of utility and other out-sourced services. On the other hand, it was recognised that the expansion of airport capacity would be associated with some increases in operational requirements and therefore costs and, importantly, that Manchester, with a heavy dependence on liquor and tobacco sales, would suffer a significant reduction of net income with the abolition of duty free sales for intra-european travel from mid-1999. The CAA had initially accepted the MMC recommendations on the setting of the formula but following the consultation on its proposals, it decided to modify some of the Commission s assumptions. The effect of these modifications on the financial projections was small, except for the revision to the duty free income. Here it was decided that the substitute sales of non-duty free goods would be less than the MMC had assumed (only 17 per cent of the loss of income would be recouped, rather than the 4 The authority was inclined to the view that the resulting fluctuation in charges would have been too extreme to be acceptable to users, inspite of its observation that a significant number of airlines and airline representative bodies favoured some form of volume term. 16

DAVID STARKIE previously assumed 25 per cent) but that the loss of duty free sales would occur from July 1999 rather than April as assumed in the original financial projections. The net effect of the revised assumptions led the Authority to conclude that the price formula should be RPI-5 in all five years of the quinquennium. Because the duty free adjustment was consolidated into the price-cap formula, provision had to be made for the possibility that the intention to withdraw duty free sales may be modified, postponed or even cancelled altogether. Since the Authority is not able to adjust the formula on its own initiative, it has obtained an assurance from Manchester that the airport will co-operate in a review should the need arise. With regards to public interest issues, the MMC had found certain inadequacies in Manchester s procedures for consultation with its customers and in the provision of cost information on its charges for utilities. As a consequence, the Authority asked Manchester to report by the end of 1997 on its arrangements for consultation on its capital investment plans, on the structure of both regulated and non-regulated charges, and on the quality of service provided. It also plans annual reviews of Manchester s consultation process, starting in the spring of 1999. BAA London Airport: an interim regulatory report When the CAA published in October 1996 its decision [CAP 664] on the price cap at the three BAA London airports for the period 1997/8 to 2001/2, it indicated its intention to publish an annual regulatory review of BAA s activities at the three airports. 5 The first such annual report is expected around the turn of the year, but in July 1998 the CAA published an interim 5 Civil Aviation Authority (1996), Economic Regulation of BAA, London airports 1997-2002, (CAP 664), London. 17

AIRPORTS REGULATION 1997/1998 report. 6 The interim report had two purposes. The first was to record the actions taken by BAA in response to specific issues raised by the MMC and CAA at the last quinquennial review. The second was to identify those issues on which the CAA would be focusing as background to preparing future regulatory reports. Although the CAA was satisfied that the airports had complied with the conditions imposed upon them at the time of the review, in the interim report the view was expressed that the five yearly review process may provide an insufficient incentive for the airports to invest in facilities that reflect the requirements of airlines in the longer term, and to the extent that the price-cap has the effect of allowing airports to earn a uniform rate of return on all investments, there was a risk that they will be indifferent as to the composition of the capital programme. In addition, it was felt that airports may be deterred from proceeding with more risky ventures even where these would benefit users. 7 Because of these potential concerns, the CAA sought the views of users on the 10 year capital programme for London airports which the BAA issued in November 1997. In the event, the CAA was struck by the low level of response generally from users both to its own consultation and to that of BAA on an issue as significant as capital expenditure, given its implications for capacity, for the level of charges, and for service quality. In this light, the CAA raised as an issue for future consideration, the option of the Authority examining more closely BAA s investment plans, as well as playing a more active part in both setting service standards and securing compliance with them. This, of course, draws the regulator into a more detailed examination of the industry but one that would not be out of line with that adopted by other utility regulators. The CAA and the 6 Civil Aviation Authority (1998), BAA London Airports: An Interim Regulatory Report, London. 7 With an allowable return based on a portfolio of projects with different risk/return profiles, it is not immediately obvious why this should be the case. 18

DAVID STARKIE MMC reviews of BAA, in contrast, may be judged to have been light handed: in 1991 the MMC relied largely upon BAA s projections of both operating and capital expenditure. These expenditures were taken less on trust in 1996 but it is arguable whether the MMC or the CAA really got to grips with them. They did not, for example, subject proposed investments to detailed scrutiny or suggest specific modifications. Therefore, the CAA in raising the issue of whether it should examine BAA s investment plans in more detail, is perhaps seeking to align its approach more closely with that of the other utility regulators. Airports and the Utilities Regulation Review The Airports Act gives the CAA powers to investigate complaints about anti-competitive behaviour by any of the regulated airports, and to impose remedies if the complaint is justified. The Director General of Fair Trading (DGFT) powers to investigate courses of conduct preventing, restricting or distorting competition also extend to airports. These powers are set to be strengthened by the Competition Bill. It is important to note, however, that, unlike the other regulators of the privatised utilities, the CAA does not enjoy concurrent powers with the DGFT. Although the government review of utility regulation, A Fair Deal for Consumers, considered that airports had a number of distinctive features which tended to distinguish them from the usual utility industries, there were nevertheless no factors which clearly justified differentiation. 8 It was also considered that a consistent approach would contribute to better and more costeffective regulation. Consequently, the Government believed that airport regulation should be brought into line with the standard utility model. In this model the price-cap reviews are 8 Department of Trade and Industry (1998a), A Fair Deal for Consumers: Modernising the Framework for Utility Regulation, Cmnd, London. 19

AIRPORTS REGULATION 1997/1998 generally undertaken by the industry specific regulator and only in the event of a dispute is reference made to the MMC. With the airport reviews, in contrast, the MMC undertakes the initial review. The CAA subsequently makes a decision: neither BAA nor Manchester has the right of appeal. The Government, therefore, sought views on two key changes to the system of airport regulation, both of which would require primary legislation. These were: the CAA would become the single regulator for airports, and would carry out the periodic reviews of the designated airports and make its own decision on the appropriate price cap, (as for the other utilities, the regulator would be able to refer its decision to the MMC in circumstances where there was a disagreement between the regulator and regulated companies); the CAA should be given concurrent powers with the DGFT as strengthened by the Competition Bill. In addition, the Government also sought views on whether the CAA should, in exercising its functions under the Airports Act, be given the new primary duty to protect consumers and whether in this context the term consumer should cover both providers of air services and the users of these services. Following the consultation, the Government confirmed its intention to implement both if the proposed key changes and to give the CAA a primary duty to protect the interests of the consumers. 9 In addition, it is now considering extending to airports other proposals in the consultation paper, including the proposal to issue statutory guidance on social and environmental objectives and proposals in relation to service standards. 9 Department of Trade and Industry (1998b), A Fair Deal for Consumers: The Response to Consultation, London. 20

Duty free sales for intra-eu travel DAVID STARKIE At the time of the reviews of BAA London Airports and Manchester the final outcome of the decision taken in 1991 to bring intra-eu duty and tax free trade to an end, was uncertain in the light of strong opposition in certain quarters. However at the meeting of the finance ministers of the member states in May 1998 the original decision was upheld and it now appears very likely that from July next year such sales will be restricted to those travelling on flights to destinations outside the member states. This development is of considerable significance for the finances of airports generally in view of the so called single till approach. This approach matches, in the light of the traffic forecast, the cash-flow required to finance an appropriate investment programme and to give shareholders an adequate return on their funds, with the combined revenues anticipated from price capped activities and from those (eg, retailing) not subject to price control. If total expected revenues exceed the finance requirements, operational charges are reduced via the price cap, and vice versa. The elimination of intra-eu duty free sales reduces one of the two income streams and thus ceteris paribus, reduces the stringency of the price-cap. In the case of Manchester Airport, for example, if duty free sales for inter-eu travel had continued, the CAA judged that the value of X for the current quinquennium would need to have been 11.5 rather than the 5.0 finally decided upon. At congested airports such as Heathrow and Gatwick (although not necessarily at Manchester where an additional runway is under construction) this reduction in the stringency of the price cap is consonant with the more efficient pricing of congested facilities. At such airports, the continual fall in air traffic charges which the single-till approach has helped to bring about, has greatly advantaged the incumbent airlines by adding to the scarcity rents that these airlines are able to obtain from 21

AIRPORTS REGULATION 1997/1998 passengers keen to use services at congested airports. 10 It is the existence of fares premia, and the rents that follow from them, that has made the proposed alliance of British Airways and American Airlines so controversial and has encouraged rent seeking behaviour. 11 Of course, if air traffic charges were increased to reflect the intensity of demand, the rents would flow to the airport operator and thus profits and cash flow would exceed the level considered reasonable for a regulated industry. It is a conundrum yet to be addressed by the regulators. Conclusion The year under review concluded the 1995/1997 round of airport reviews with the final decision on charges at Manchester Airport announced by the CAA in October 1997. The outcome of the latter was a price cap of RPI-5 from April 1998 compared with RPI-3 during the previous five years. With this process completed, attention has shifted to monitoring and compliance, and to the consistency of the regulatory process applying to airports viz other regulated utilities. The CAA s interim review of compliance at the three BAA London airports raised the issue of whether in future the Authority should examine more closely BAA s investment plans. This would be a potentially significant development, particularly in view of the Government s intention that the CAA is to become the single regulator for airports, carrying out the periodic reviews. Although such a development would result in an approach which would not be inconsistent with the practice adopted by other utility regulators, it would nevertheless have the effect of drawing the regulator into a more detailed examination of the industry. This would be contrary to the proposal put forward by Manchester Airport. Manchester has 10 Although published tariffs are not necessarily higher at Heathrow, the average ticket yield is higher and reflects the sale of fewer seats at discounted prices, see Starkie D (1998), Allocating airport slots: a role for the market?, Journal of Air Transport Management 4,2, 111-116. 11 The European Commission s proposals for the reallocation of BA and AA s Heathrow slots has had the effect of reallocating the scarcity rents. 22

DAVID STARKIE proposed that it would be subject to conduct regulation under the Airports Act and to general competition legislation, but not to be regulated by a cap on charges. It is an interesting proposal because it raises fundamental questions particularly regarding the nature of the airport monopoly; whether an airport s market power extends to all airline services; and whether in some circumstances airlines have significant counterveiling power. Another potentially significant development is the decision to limit the scope of duty free sales from mid-1999. Following a meeting of the finance ministers of member states in May 1998, this decision now looks certain to go ahead and, as a consequence, it has been necessary to introduce adjustments to the price-cap formula to compensate for the likely loss of income from this source. The need for such adjustments draws attention to the peculiarities of the single-till approach which has the effect of driving down charges at capacity constrained airports at a time when such charges might have been expected to increase. But, how one squares a circle between the airlines, the airport and the wider community, when the airport facility is the source of significant scarcity rents, is a question yet to be seriously addressed. 12 12 Beesley M E (1999), Airports: Regulatory Reform? IEA. 23

AIRPORTS REGULATION 1997/1998 24

3 AIRPORTS AND AIRSPACE REGULATION Doug Andrew Introduction For the Civil Aviation Authority (CAA) the main event in UK airport regulation was the beginning of the process leading up to the next quinquennial reviews of the BAA designated airports and Manchester Airport. 1 This was launched with the publication by the CAA of a consultation paper which sought views on the issues the reviews should address. 2 The paper stated that: The best approach to future airport regulation may differ from that taken in the past. It may also differ from the approaches adopted in some other regulated industries. The current price caps at the BAA London airports were set in 1996 following a reference to the then Monopolies and Mergers Commission (MMC). They initially covered the five years from 1997/98 to 2001/02. For Manchester Airport, the only other airport designated by the Government for price control, the existing price cap was set a year later in 1997, again after a 1 The BAA designated airports are Heathrow, Gatwick and Stansted. Under the 1986 Airports Act the CAA has to set a price cap on charges to airlines every five years at the designated airports (including Manchester). This follows a mandatory reference to the Competition Commission. 2 Issues for the Airport Reviews - Consultation Paper - July 2000. Acknowledgement This chapter was first published as Airports and Airspace Regulation, CRI Regulatory Review 2000/2001, Millennium edition, chapter 1, pp9-23, February 2001, University of Bath. Doug Andrew at the time was Group Director, Economic Regulation, Civil Aviation Authority (CAA) 25