Financial Perspective

As part of the rate-making process, an extensive analysis is performed of an airport's revenues, expenses, and investment during the test year and pro-forma period. The results of this analysis quantify the proper recognition of an airport's operation and maintenance expenses, depreciation, and income taxes, as well as establishes the investment or rate base upon which the utility is entitled to earn a fair return. This provides the financial basis from which a regulator may determine whether rates warrant changes.

A criticism of ROR regulation is that it does not create incentives for airports to operate efficiently and keep costs down.

ROR Price Cap Approach
Economic regulation could be used as a mechanism to offset some of the airport power in cases where the operator sets the tariffs. Instead of rate of return regulation, a better alternative may be the use of a ’price cap' model. This is the approach widely used in other countries to bridge the two tariff methodology extremes (where government sets all tariffs on one end and where the operator sets all tariffs on the other).

Price caps define certain airport tariffs in advance of the bidding process and fix them for the life of the operator contract (increasing only at the rate of inflation). Price caps represent a price floor to the operator (providing a degree of certainty in which to develop its bid), and a price ceiling to the government (insuring that the operator cannot extract a monopolistic rate of return).

Airport tariffs included under price caps are based on a set of baseline tariffs. Future tariffs could increase by no more than inflation, adjusted by an efficiency factor (or ’X' factor).

The ’X' factor represents the reduction of fees (or benefits granted to users) required of an operator. In addition, prices would be increased by the cost of infrastructure improvements. For example, if a fee is set at $1 per 1000 lbs in 2000, and inflation is 3 percent, then the airport operator would establish a price of $1.03 per 1000 lbs in 2001 (less the ’X' factor). If infrastructure projects to aeronautical areas of the airport, costing $5 million were completed, and represent $0.25 per 1000 lbs, then the fee would be adjusted to $1.28 per 1000 lbs. The ’X' factor is to be established in advance. Assuming that the ’X' factor for 2001 has been set at 5.0 percent, then the fee would be set at $1.23 per 1000 lbs. The $0.05 per 1000 lbs represents the savings pushed to the airlines as the benefit of the price cap structure.

The operator could achieve the ’X' factor tariff reductions under price caps by:
• Reducing costs in aeronautical areas;
• Subsidizing aeronautical costs from non-aeronautical areas through revenue development; or
• Shifting costs (to the extent possible) to non-aeronautical areas.

The first two options are the desired outcomes, but the third is a concern because it simply pushes airline costs to unregulated areas. On a net basis, the airlines would receive no benefit. This is what should be avoided at all efforts in structuring price cap regulation because, at least on a conceptual level, the ’X' factor represents the cost efficiency of private management that is shared with the airlines. The ’X' factor is calculated to achieve targeted price reductions to the airline users in the aeronautical areas.

While the CPI-X regulation limits only aeronautical charges, the setting of ’X' includes a review of all revenues and costs. Regulators have tended to view the setting of a price cap on aeronautical charges as a lever with which to control the overall ROR of airports. This approach in which all airport activities are considered for purposes of economic regulation is known as a "single till" approach to economic regulation.

The CPI-X formula with its components of inflation and an efficiency factor does not explicitly take into account capital costs in setting price caps. There is a danger that the regulated company may be discouraged from investing if it's uncertain about price caps in future periods allowing a return on capital expenditure incurred in the current period. In practice, the regulator has to consider capital costs in setting the value of ’X'.

CPI-X regulation serves as a model for regulatory regimes of other industries and in many countries. It is seen as a better alternative than ROR regulation because it provides greater incentives for cost efficiency, is simpler to operate, and is less vulnerable to capture.