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 airports throughout the world has been brisk. In the United States, however, it has not been embraced with the same enthusiasm. There are various reasons that have been proposed for this lack of interest, but the underlying feature is that in the United States airports do not have the urgent need for funds that exists in other countries.

In fact, in addition to revenue generated by the airport, local, and state funds, the federal government has spent on average approximately $1.6 billion on airport infrastructure projects in recent years. This figure is larger than the gross national product of many countries.

Municipalities and airport authorities in the U.S. are reluctant to give up control of an airport, even though it has been estimated that the largest U.S. airports could sell for as much as $5-6 billion.

The main reason for privatization is the recognition that government expertise in managing airports may be limited, and others can provide it with reduced costs, increased revenues, and improved and more efficient services. Potential private investors include equity investment funds, pension funds, government-backed export banks, constructors, equipment suppliers, trade and transport companies, public equity holders, and bondholders.

Additional reasons why airport sale/privatization has been slow in certain areas of the world include delays in dealing with political and labor factors; costs to compete and win bids; cumbersome regulations; and, reluctance of airlines to change.

In addition, airlines are afraid of a privatized airport passing on high acquisition costs (operating costs would decrease; revenue from commercial sources would most likely increase), and gaining more control over facilities (such as gates held by incumbent carriers under exclusive long-term leases). Airlines aren't necessarily interested in promoting competition, whereas a private operator would do everything possible to attract more service, utilize gates more efficiently, and create a competitive environment for ground-handling and support services.

Despite the hesitation, it is clear that airport privatization is the way of the future. It is important at this stage for the entire aviation community to be aware of what to expect and be able to adjust to the new form of ownership and/or management.

A History With Bonds
In general, large airports have depended to a greater extent on airport revenue bonds for development; smaller airports have tended to rely more on general obligation bonds.

Airport revenue bonds are secured through the revenue streams generated by airport operations and are typically tax-exempt. The principal source of revenue providing primary collateral is the revenue generated by the carrier use agreements.

On occasion, assignment of the financial risk for a development project is assumed by an airline. This tends to tie a carrier to a given airport, while eroding the airport authority's control over the airport.

For smaller airports, little revenue financing capability exists and, as a result, they are more dependent on state and local general obligation bonds. (General obligation bonds, like revenue bonds, are tax-exempt municipal bonds). Typically, there is no airport revenue stream to collateralize these bonds; it is the credit worthiness, and to some degree faith, of the state or local government which stands behind their issuance.

Although the ultimate responsibility for payment on general obligation bonds rests with the issuing government, on occasion airport revenues must be pledged in order to retire the bonds. This casts the issuing government in the role of guarantor of what amounts to revenue bonds, and typically arises when the airport's credit-worthiness is insufficient to offer revenue bonds.

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.

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.

Aeronautical Return Price Cap Approach
In trying to reduce the weaknesses of the ’single till' approach, the aeronautical price cap approach was created. The ’single till' approach limited only aeronautical charges, although it considered all activities of the airport in setting the value of ’X'. The setting of ’X' by regulators in the ’dual till' approach is done through a review that segregates aeronautical revenues and costs from total airport revenues and costs.

The dual-till approach treats the aeronautical area of each airport as a distinct business. The system encourages commercial development of non-aeronautical areas because they are not regulated.

Another important modification to the ’single till' approach is a mechanism whereby the airport will be able to seek approval for increases in charges for the purpose of specific, major new infrastructure investments. An airport applying for such an increase would need to gain the support of airport users. It also separates for the purposes of economic regulation the financial issues arising from major capital investments from those encountered in the normal operation of the airports.

Limited Government Oversight Approach
This approach is developed from the concept of countervailing power — the ability of an airport's customers to influence final pricing.

Air carriers have an implicit power over airports because of their ability to create administrative or cash flow problems by withholding or delaying payment of airport charges or taking a hostile or non-cooperative attitude in day-to-day matters. Therefore, airlines are seen as having as much market leverage as the airport operator, so rates are set on a free-market basis with disputes settled in the superseding court.

There are two basic airport costing and rate-setting methods used with this kind of regulation: the compensatory method and the residual method. Under the compensatory method, an airport establishes cost centers (airlines, concessionaires, etc.) to which airport costs are allocated. A schedule of rates and charges (landing fees, rental space, etc.) is then set to recover the costs from each center. Under the residual method, the airport first determines its overall costs and assigns a set of rates and charges, typically to the non-carrier vendors, which maximize total revenues. The airlines then are required to remit the difference between total revenues and total costs (i.e., the residual cost of airport operations).

About the Author
Giovanni Carnaroli serves as manager of consulting services for BACK Aviation Solutions, an aviation consulting firm specializing in strategic planning, management, and analysis services. He is a former senior economist with the Federal Aviation Administration, where he helped develop legislative proposals and rulemaking actions, and was involved in airport economic and funding analyses. He is an economics major from North Carolina State University, and received his MBA from the University of Maryland. He can be reached at (703) 330-0461.