Financial Perspective

Financial Perspective In an argument for privatization, a former FAA economist analyzes current airport business practices By H. Giovanni Carnaroli, Manager, Consulting Services, BACK Aviation Solutions July 2000 The sale of...

Principles of Economic Regulation
In the U.S. as in the rest of the world, the transfer of the day to day operation of the airport to a third party operator substantially increases the need to create effective economic regulation. Regulatory oversight becomes especially important because airports possess certain characteristics of natural monopolies.

An airport operator may have the opportunity to use its market power to extract above-market tariffs for some revenue areas. Because such price-setting behavior runs counter to the national objectives of any sovereign country in promoting economic development and efficient markets, the country's regulator (DOT, etc.) must develop the theory, the methodology, and the implementation of guidelines required to create effective economic regulation and oversight of airport tariffs.

The principal objectives of the economic regulation are designed to:
• Promote the sound development of civil aviation;
• Establish a system of regulation of the airport that serves the interests of airport users.
• Implement economic regulation that protects airport users from potential abuse of market power by the airport operator and leads to economically efficient pricing of airport services; and
• Encourage the economically efficient development and operation of the airport.

The airport activities on which the regulator can impose regulation are defined in terms of their monopolistic relationships. In considering ways to shape the economic regulatory framework, the regulator is faced with a choice among various levels of regulation — being mindful that each successive level of regulation demands a greater government role and incurs greater costs.

In the event of a sale/privatization of an airport, the major issues at stake are how much investment is required, and whether to proceed with a long-term lease, trade sale, or a stock flotation. In case of an outright sale, whereas a trade sale would allow ownership and management to be the same entity, a stock flotation would have many shareholders with diversified agendas.

Currently, there are four economic regulation approaches being used at airports around the world:
• Rate of Return (ROR)
• ROR Price Caps
• Aeronautical Price Caps
• Limited Government Oversight

Rate of Return (ROR)
The rate of return (ROR) approach views the airport as a public utility, and the role of the regulator is to prevent the airport from acting as a monopoly and setting prices too far above cost.

At the heart of ROR regulation is a concept known as the regulatory compact. In most instances, an airport is a monopoly, and is provided with an opportunity to earn a reasonable return on the assets dedicated to its public service business. The other side of the regulatory compact is that an airport has an obligation to serve all customers and it must provide adequate service at reasonable rates. Rate-of-return regulation and the obligation to serve were not designed for competitive markets.

In setting airport charges, the regulatory body allows an airport to recoup all of its prudent operating expenses plus a reasonable return on capital investment. Setting charges is a complex procedure that involves a time-consuming process. Every policy or rule used in the process creates an incentive or disincentive to both the airport operator and user.

There are four basic steps of ROR regulation to determine the proper charges, or revenue requirement, for an airport:
• Determining the utility's gross revenues for the time period under review;
• Determining the allowable operating expenses, including taxes and depreciation, for the same time period;
• Calculating the dollar amount of assets used to provide service; and
• Determining the proper rate of return that should be applied to the rate base in order to reasonably and adequately compensate the airport operator.

The first three elements of determining the revenue requirement involve accounting policies and techniques. A major responsibility of a regulator is the prescription of accounting systems and the development of a representative cost of providing utility service for rate-making purposes.

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