Airport fights case for price control

A dispute with airlines hinges on how assets are valued, says BRIAN FALLOW. Other infrastructure owners enjoying monopolies are watching with interest.

High noon is approaching in a conflict between Auckland airport and the airlines about whether landing charges include monopolistic returns beyond allowable limits.

On September 4, the Commerce Commission begins 10 days of public hearings as part of its inquiry into whether price control should be imposed on Auckland, Wellington and Christchurch airports.

The commission's preliminary view, in a draft report released early last month, is that in Auckland's case price control is warranted.

Auckland International Airport (AIA) argues that under the present "light-handed" regulatory regime, a form of price control already exists.

"Airport companies are effectively only allowed to achieve a return equivalent to the WACC [weighted average cost of capital] on the assets employed, plus a recovery for costs," it says.

So the dispute turns on how to value airports' assets.

Pricing principles put forward in the commission's draft report would wipe about $100 million from AIA's asset base for price-setting purposes.

The principles have drawn fire not only from the airport companies and their shareholders but from owners of other infrastructure assets with natural monopoly characteristics, such as UnitedNetworks.

But not all the interested bystanders are critical of the commission's preliminary view.

The NZ Shipping Federation is concerned that many seaports are now adopting the same asset valuation method - anchored in replacement costs.

This could push up costs for port users.

Todd Energy also backs the draft report's approach.

But the most enthusiastic support, unsurprisingly, comes from the airlines' representative body, Barnz.

The commission's work, it says, confirms the airlines' strongly held view that AIA had no justification for increasing its landing charges 8.5 per cent last year and has no justification for increasing them 5 per cent next month, and again in September next year.

"In light of the evidence of monopoly pricing which the commission has now confirmed, albeit in its draft report, imposition of controls at [Auckland and Christchurch] is essential to maintain the credibility of the light-handed regime," Barnz says in its submission.

"If price control is not imposed, this would reduce the threat of price control and undermine the light-handed regulatory regime, which could lead to the airports imposing further monopoly prices and greater inefficiencies."

The commission's draft report values specialised airfield assets such as runways, taxiways and aprons on a depreciated historic cost basis, rather than on the basis of optimised depreciated replacement cost (ODRC).

Auckland airport points out that the decision to revalue its assets on an ODRC basis was taken when the Government was still its majority owner.

"Contrary to the commission's views, the Government of the day that floated AIA did want the assets valued, both in the accounts and for the purposes of charges levied to customers, on the basis of the current values of the assets," says the airport company's submission.

Valuing on an historic cost basis raises the question of which historic cost to use, it says.

Is it the value at which assets were originally bought by the old Airport Authority, or the value placed on them when vested in the airport company (based largely on discounted cashflow valuation), or the value when the company was privatised?

By contrast, a valuation whose starting point is replacement cost is more likely to approximate the price that an efficient new entrant would pay.

"AIA believes it would be more practical for the commission to focus on whether airports have been abusing their market power by setting prices that result in the generation of revenues in excess of those an efficient firm would require to enter the market."

One of the pricing principles espoused in the commission's draft report is that today's consumers should bear only today's costs.

It "optimises out" from the asset base calculation land that is held for a future second runway, on the grounds that it is not "used or useful".

AIA says the proposition that consumers should bear only present costs has little or no relevance in a market characterised by investments in assets that are large, lumpy and have long lives, and which therefore will provide services well into the future.

It is also contrary to the concept of marginal cost pricing, which is forward-looking in nature.

Both the Auckland Regional Council and Auckland City (the largest shareholder in the airport company) reject any suggestion that the land for a second runway should be sold and compulsorily re-acquired when needed.

"The land provides for the future development of key public infrastructure of regional and national significance," says the regional council.

Another of the commission's draft pricing principles is: "Prices should allow for a 'normal' rate of return to be earned by suppliers on average over the medium term.

"Normal returns should be based on an appropriately determined asset base and rate of return."

But the airport company says it could be argued that normal returns are the absolute minimum shareholders should reasonably expect. To increase shareholder wealth and achieve real value, a return higher than the WACC is required.

UnitedNetworks, whose distribution networks serve 30 per cent of the country's electricity consumers and 50 per cent of gas consumers, says the rate-of-return approach to regulation embodied in the commission's draft report is exactly the wrong way to go.

"This form of regulation diverts firms' attention from meeting customer needs ... and weakens their incentives to minimise costs or to use their assets in more efficient ways - for example, by using existing electricity or gas assets to deliver telecommunications services.

"A better approach would be output-based - that is, it would place more emphasis on the extent to which a service under consideration meets customer needs, including the willingness of the customer to pay the price for the quality of service delivered."

Quite how to establish that willingness to pay in the case of monopoly services UnitedNetworks does not say.

The airport company points to the countervailing power of its customers, the airlines.

"The economic power of the airlines, particularly in aggregate via their global alliances, far exceeds that of AIA.

"The airlines have the ability to impact significantly on AIA's returns and profitability via relatively small changes in flight schedules - for example, by changes in aircraft type and code-sharing arrangements - without detrimentally affecting the service level to their customers."

Barnz disputes this, and the commission's draft report does not buy it either.

The airport company not only questions the logic of the analysis in the draft report, it also says the financial information on which it is based contains errors.

Correcting those errors results in the annual net efficiency gains of price control being reduced from a net benefit of $2.4 million to a net cost of $47,000, it says.

Even if the commission's calculations were soundly based, a net benefit of $2.4 million is too small to warrant the imposition of price control, the company says.

"This sum is well within any reasonable margin of error."

Barnz, however, contends that the commission has significantly underestimated the benefits of price control on Auckland airport.

It puts them in the range $15.4 million to $16.7 million a year.

* Declaration of interest: Brian Fallow is a (small) shareholder in Auckland International Airport.