House of Commons - Transport - Thirteenth Report

Select Committee on Transport Thirteenth Report

6 Economic regulation of airports

117. Under the Airports Act 1986, the CAA is responsible for the economic regulation of any airport with an annual turnover of at least £1 million in two of the last three years.[175] For the majority of these airports, economic regulation is limited. For airports designated by the Secretary of State, however, the CAA must conduct a price control review, generally every five years, setting the maximum level that each airport can charge airlines in the form of runway charges, aircraft parking charges and charges per passenger for the use of the terminal. The four airports currently designated include the three BAA-owned London airports of Heathrow, Gatwick and Stansted, and the local authority-owned Manchester Airport. In performing these regulatory functions, the CAA must have regard for its statutory duties, as detailed in Box 8.[176] Box 8: Statutory duties of CAA to be considered when setting price caps

Under section 39 of the Airports Act, the CAA must perform its regulatory functions in the manner it considers best calculated:

to further the reasonable interests of users of airports;

to promote the efficient, economic and profitable operation of such airports;

to encourage investment in new facilities at airports in time to satisfy anticipated demands by users of such airports;

to impose the minimum of restrictions; and

to take account of the UK's international obligations.

Civil Aviation Authority, Airports review—policy issues: Consultation paper, December 2005, para 10

118. Before it can set a price cap the CAA must, according to the Airports Act, make a reference to the Competition Commission.[177] The referral requests the Commission to report on the appropriate maximum limit on airport charges for the forthcoming five-year period. The Commission is also asked to evaluate whether the airport has pursued a course of conduct contrary to the public interest in the previous five years. The CAA must "have regard to" the Competition Commission's views when making its final decision on price caps, though it is not bound by them.[178]

119. When undertaking its last airport price control review for the three designated London airports, the CAA proposed a 'dual till' approach. Under a dual till approach, airport charges would be calculated with reference to the costs and revenues associated with providing aeronautical activities alone, removing the scope for commercial revenues, for example from shops, to reduce airport charges below the cost of providing aeronautical services. The Competition Commission, in its report on the CAA's proposals, said that in the longer term, a dual till approach would produce significantly higher airport charges than the existing single till approach, and concluded that the limited benefits of a dual till approach would be outweighed by significant disadvantages.[179]

120. The CAA accepted the Competition Commission's recommendations and adopted a 'single till' approach to inform its final decisions on price controls for Heathrow, Gatwick and Stansted in February 2003. It announced its decision in relation to Manchester Airport in March 2003. These decisions covered the period 2003/04-2007/08, and the CAA subsequently extended the price control at Manchester by a further year. In 2005, the CAA launched its current review, covering 2008/09-2012/13 for the BAA airports and 2009/10-2013/14 for Manchester Airport.[180]

EFFECTIVENESS OF THE CAA'S REVIEWS

121. Manchester Airports Group said that, on the whole, the CAA had conducted previous price control reviews in an effective manner and that, in considering potential improvements to the process, it had shown a willingness to take the views of the airport and its airline customers into account.[181] Other witnesses were more critical, however. The Airlines Consultative Committee at Stansted Airport (Stansted ACC) argued that reviews took up too much time and were too resource-intensive. It claimed that the CAA was too narrowly focussed on economic theories, with no understanding of the realities of operating an airline business in a competitive market place, and it argued that there needed to be more effective monitoring between airport reviews to ensure that there was compliance with the regulatory settlements and to enable users' concerns to be properly addressed.[182]

122. Dr Harry Bush, Director of the CAA's Economic Regulation Group, argued that the accusation that the CAA did not understand the economic models underlying modern low-cost aviation was "unfounded", and he pointed to a recent CAA review of the drivers of air transport demand in the UK as evidence of the CAA's appreciation of market issues.[183] The CAA told us that the designation of airports by the Government rather than by the regulator itself, the mandatory setting of price caps for five years, and the automatic referral to the Competition Commission, were all factors that limited the CAA's flexibility to tailor its regulation to the evolving airports market."[184]

123. The CAA's previous airport price control reviews have been criticised in some quarters for being lengthy and cumbersome, and for failing to understand and address the issues of concern to airports and airlines. We accept the CAA's argument that its flexibility is somewhat constrained by the framework within which it must conduct its economic regulation of airports. We therefore believe that the Government should review the whole process of price control.

DESIGNATION

124. David Starkie of Case Associates, a firm of competition and regulatory economists, argued that there were anomalies in the selection of designated airports. For instance, he questioned why BAA's Scottish airports had not been designated, despite enjoying similar regional dominance to BAA's London airports. He told us that it was debatable whether designation was still the best way of dealing with dominant airports or whether airports could instead be subject to normal competition law, with its focus on the abuse of dominant position. He said that any benefits of retaining designation had to be balanced against the significant costs involved in price regulation, and he highlighted the example of Australia, where price caps were removed in 2002 despite the absence of directly competing airports.[185]

125. Mr Starkie suggested that, as an alternative to the total removal of designation, Manchester and Stansted alone could be de-designated. In the case of Manchester he argued that Liverpool was a "ferocious competitor" and he highlighted the drive within Manchester Airport to reduce its operating costs independently of any regulatory pressure.[186] He further argued that the ownership of Manchester by local authorities made it a special case, with local governments normally being expected to act in the public interest. In relation to both Manchester and Stansted he said that the threat of future designation could provide the incentive to control behaviour, and he pointed out that BAA already capped its Scottish airports on a voluntary basis.[187]

126. Dr Bush told us that, in determining whether or not to designate an airport, the Secretary of State needed to consider whether the absence of economic regulation would allow the airport to raise its charges to airlines. He argued that in the instance of Heathrow this was probably the case, because Heathrow was a natural monopoly. Similarly, he suggested that it may be true for certain elements of Gatwick, but conceded that it might be less true "for some elements of Stansted and Manchester."[188] He said that the CAA was conducting market analyses to determine the level of competition for each of the four designated airports, and that it would enter into discussions with the Government if it thought it was appropriate to de-designate any of them. He noted that ultimately, however, it was for the Government to determine which airports were designated.[189]

127. The Minister said the Government had no objection to de-designation in principle. She said that criteria—including profitability and the extent of monopoly power—had been set out ten years previously for determining whether there was a case for lifting the designation of an airport, and that it was for the airports concerned to advance arguments for de-designation against these criteria. She told us that the Government would need to be assured that a model for competition existed and that re-designation would not be required a few years down the line.[190]

128. We recommend that the Government review the continuing need for the designation of airports subject to economic regulation by the CAA as a matter of principle, and that it publish an assessment of the relative merits of this approach compared to the use of standard competition legislation to regulate the abuse of dominant position by airports. The Government should consider de-designating Manchester and Stansted as a first step. This review should be informed by experiences in other countries, such as Australia, where price controls were removed in 2002. If the Government decides to retain the principle of designation, we recommend that it further consider whether designation is best conducted by the Secretary of State, or whether the flexibility of the CAA would be improved if it were allowed to designate which airports should be subject to price controls.

COMPETITION COMMISSION

129. A number of witnesses criticised the automatic referral of the CAA's airport price control reviews to the Competition Commission. Manchester Airports Group believed that the referral was both inappropriate and unhelpful. It argued that what was effectively a duplicated review process produced an "enormous" additional administrative burden for the regulated company.[191] It also argued that the CAA, given its role as overall regulator of the industry, was far better placed than the Competition Commission to make decisions in this area. It concluded that it was a highly unsatisfactory arrangement, which appeared to add no value in terms of the CAA meeting its objectives, and should therefore be brought to an end at the earliest opportunity.[192] The Chairman of the Better Regulation Commission said that, by bringing an automatic referral to the middle of the process rather than allowing for one at the end, a route of appeal for the regulated community was effectively removed. He argued that, from the perspective of an independent observer, it represented an "odd situation" and he hoped that, if all parties were agreed, the Government would look to correct this anomaly.[193]

130. The CAA agreed that the automatic referral to the Competition Commission could add to the complexity of the review process in terms of accountability, time and cost. Dr Bush explained that the referral extended the price control review process by 6-12 months and that, in the last instance, it had cost BAA and Manchester Airports Group £1.5 million each, although he pointed out that some of that work would otherwise have been undertaken by the CAA, meaning that the net figure would be lower.[194] He detailed other disadvantages, including some duplicated effort and the possible incentive for some parties to hold back issues until the process reached the Competition Commission stage.

131. The CAA told us that it would prefer a shift towards the standard regulatory model, in which the CAA could reach its view and then leave it to the regulated companies—in this instance, the airports—to decide whether they wished to appeal to the Competition Commission. Dr Bush pointed out, however, that airlines had reservations about such a move because they would have no right to appeal to the Competition Commission.[195] This suggestion was reflected in the evidence we received from a number of airlines. Virgin Atlantic told us that the experience of the regulatory process in 2003 showed "the importance of the regulator also being performance-reviewed, particularly when difficult economic issues are the bones of contention."[196]

132. A Department for Trade and Industry consultation on regulatory reform in 1998 indicated that the Government was keen to align the framework for airports regulation with the framework used for other industries, and the CAA explained to us that it had been the Government's stated policy for some years that the involvement of the Competition Commission in the CAA's economic regulation should move towards the standard model.[197] The Minister told us that the Government had previously planned to remove the automatic referral on the basis of a consensus between all of the affected parties, but that it had subsequently changed its mind due to a perceived break-down in this consensus.[198]

133. We are concerned that the automatic referral of CAA price control review decisions to the Competition Commission adds 6-12 months to the review process and also appears to result in a duplication of effort and extra costs to the regulated airports. We note the concerns of some airlines that the removal of the automatic referral might undermine their opportunity to influence the outcomes of future reviews, but we believe that this could be compensated for by the efforts of the CAA to incorporate the views of airlines at other stages of the review process. The institutional model for the economic regulation of airports is anomalous. We recommend that, as of the next price control review, the Government implement its own 1998 proposals to make CAA airport review decisions subject to the standard regulatory model, in which the CAA reaches airport price control decisions based on its own review and the airports, as the regulated organisations, subsequently have the right of appeal to the Competition Commission.

CONSTRUCTIVE ENGAGEMENT

134. As part of the price control review begun in 2005, the CAA introduced the concept of "constructive engagement", whereby airports and their airline customers are given the opportunity to reach agreement on a number of issues (see Box 9) with the CAA acting as a facilitator. The CAA continues to lead on some technical issues where it considers it has a competitive advantage and, in the absence of agreement, a decision on a price cap is reached through a traditional process where the regulator takes the lead. The CAA argued that by introducing constructive engagement, "the normal business of commercial airport/airline interaction should be reinforced by the regulatory process, rather than interrupted by it."[199]Box 9: Responsibilities of airlines and airports in the constructive engagement process

Under constructive engagement, airports and their airline customers are asked to identify:

volume and capacity requirements;

the nature and level of service outputs;

opportunities for operating cost efficiencies;

the nature and scale of the investment programme;

the efficient level of future capital expenditure associated with that programme;

the revenues from non-regulated charges by the airport to airlines over the price control period; and

the elements of service quality and investment to which specific financial incentives should be attached and—depending on what progress can be made—the details of such financial incentives.

Civil Aviation Authority, Airport Regulation: the process for constructive engagement, May 2005, p 6

135. Several airlines welcomed the introduction of constructive engagement. British Airways supported the CAA's approach, while cautioning that it needed to be realistic about the scope for agreement, and its Director of Government and Industry Affairs said that it appeared to represent a sensible and appropriate response by the CAA to the criticism levelled at it following the previous quinquennial review.[200] Manchester Airports Group concurred, saying that while it was too early to judge whether the new approach would lead to a more effective review process, preliminary indications at Manchester appeared positive.[201] Virgin Atlantic told us that, so far, it seemed to be working well, with the airlines being consulted seriously on BAA's short-, medium- and long-term plans for Heathrow and Gatwick for the first time. It pointed out, however, that the strain of this process on airline resources could be significant, particularly for smaller airlines.[202]

136. While constructive engagement appeared to be working well at Manchester, Heathrow and Gatwick airports, it did not appear to have been successful at Stansted. The airline customers of Stansted argued that BAA was to blame for this outcome. The Airlines Consultative Committee at Stansted Airport (Stansted ACC) said that BAA had "stonewalled" the constructive engagement process, arguing that it had a record of consistently refusing to provide sufficient information to enable airlines to participate in an adequate and informed consultation process.[203] Michael O'Leary, chief executive of Ryanair, explained that for 15 months, Stansted airlines had been requesting details of the traffic forecasts used by BAA in formulating its Stansted Generation 2 consultation document, only to receive them the day before publication of the report.[204] Mr O'Leary claimed that the airlines had been told that the figures used by BAA were developed internally, without any consultation with airlines or passengers, and that no reports existed detailing the work undertaken by consultants, for which the BAA had, he suggested, paid £20 million.[205]

137. The Stansted airlines argued that there was a lack of incentive for BAA to participate in constructive engagement. Mr O'Leary argued that the process could only work if penalties were imposed on any party failing to engage and that, while there was a built-in penalty for the airlines—in the form of higher airport charges—there was no equivalent for BAA.[206] Stansted ACC told us that the process was bound to fail in circumstances where BAA was under "no threat of competition being introduced" and therefore free from any form of regulation designed to ensure that it does not abuse its dominant position.[207] In addition, it said that constructive engagement could not work while BAA remained able to incur substantial expenditure without the agreement of users.[208]

138. Mike Toms of BAA suggested, however, that the failure of constructive engagement at Stansted was not due to any reticence or lack of incentive on the part of BAA, but was instead due to the Stansted airlines failing to respond "with the same degree of engagement" as airlines based at Heathrow and Gatwick.[209] He argued that BAA had adopted the same approach and culture, and had provided the same information—including its capital expenditure programme, its traffic forecasts and its analysis of operating costs—at each of its three South East airports.[210] Keith Jowett of the Airport Operators Association added that the CAA had noted that the additional information being sought by Stansted airlines was "not pertinent to the process of constructive engagement".[211]

139. David Starkie suggested that the apparent failure of constructive engagement at Stansted might have resulted from a clash of two very different cultures. He argued that BAA retained much of the culture of its nationalised industry roots, while the low-cost airline customers of Stansted were driven by a totally different commercial culture, which made it very difficult for them to agree with BAA on a forward investment programme.[212]

140. We welcome the introduction by the CAA in its current airport price control review of the concept of 'constructive engagement'. Where it works well, we are hopeful that it will improve the efficiency of the review process and produce outcomes which all parties find acceptable. We see this process as further reducing the need for an automatic referral to the Competition Commission. We are disappointed by the failure of constructive engagement at Stansted Airport, however, and we note that bringing airlines and airports together is not in itself enough to ensure agreement. We believe that the strategy needs to be developed further to include structured and balanced incentives, such as the imposition of penalties, for the different parties to engage fully with the process. We recommend that the CAA conduct an assessment of the use of constructive engagement in relation to the current price control review at each of the designated airports, to identify good practice and areas requiring further attention. In particular, the CAA should ensure that the burden placed by the process on the resources of smaller airlines does not prohibit their involvement.

BAA dominance of London airports market

141. In 2005, 63% of UK air passengers travelled through one of the BAA-owned airports at Heathrow, Gatwick, Stansted, Glasgow, Edinburgh, Aberdeen and Southampton. In London, the proportion was 92%.[213] The Transport Committee said in 2003 that the dominant position of BAA in London meant that the ownership of the UK's airports was "deeply flawed."[214] The Committee concluded that:

"It is ineffective and inappropriate to have a single private sector operator controlling such a large part of our aviation infrastructure. If the Government is wedded to the idea of maintaining BAA in its current form, it must undertake a thorough review of the way in which it is regulated […] In our view it would be more appropriate to break up its monopoly."[215]

142. During the course of our inquiry, a number of witnesses again raised the monopoly issue.[216] In June 2006, BAA accepted a takeover bid from a consortium led by Ferrovial, a Spanish construction company.[217] At the same time, the Office of Fair Trading launched a market study of UK airports, including the dominant position of BAA, designed to determine whether or not to make a market investigation reference to the Competition Commission. The Office of Fair Trading expects to complete the study by late 2006.[218] We remain of the opinion that the BAA monopoly should be broken up. We are pleased to note that the Office of Fair Trading has launched an investigation into the UK airports market and we hope it will report its conclusions sooner rather than later.

175 With the exception of those airports managed by the Secretary of State, or owned or managed by the CAA. Back

176 Ev 189, para 41; Civil Aviation Authority website, http://www.caa.co.uk Back

177 Unless the Secretary of State directs otherwise. Back

178 Civil Aviation Authority, Airports review-policy issues: Consultation paper, December 2005, para 3.35; Civil Aviation Authority website, http://ww.caa.co.uk Back

179 Competition Commission, BAA plc: A report on the economic regulation of the London airports companies, November 2002, Summary, paras 1.4-1.12 Back

180 Civil Aviation Authority, Airports review-policy update, May 2006, para 1.5; Civil Aviation Authority, Airports review-policy issues: Consultation paper, December 2005, para 1 Back

181 Ev 83, para 2.19 Back

182 Ev 259, paras 3.3-3.5 Back

183 Q 151 Back

184 Ev 1, paras 60-61 Back

185 Ev 154, paras 3-4 Back

186 Q 449 Back