Select Committee on Transport Fourth Report


3 Regulation

The regulatory framework

Economic regulation of the aviation industry

19. The CAA is the independent regulator for civil aviation in the UK. Set up in 1972, it is responsible for air safety, airspace regulation, economic regulation and the protection of consumers. In its role as economic regulator, it controls prices at four 'designated' airports: Heathrow, Gatwick, Stansted and Manchester.

20. Section 43 of the Airports Act 1986 requires the CAA to make a reference to the Competition Commission every five years, which is charged first, with recommending the level of airport charges that designated airports should be able to charge and second, investigating whether the airport operator has "pursued […] a course of conduct which has operated or might be expected to operate against the public interest."[23]

21. In its report on Aviation, our predecessor committee wrote that:

We consider that a regulatory system in which two bodies do the same job twice, and wrangle over the extent of one another's powers and responsibilities, must increase the costs of regulation. Still more significantly, it must act as a considerable barrier to a clear, coherent policy on aviation, which is essential for the future of the industry. The relationship between the CAA and the Competition Commission needs to be resolved.[24]

22. In our report on The Work of the Civil Aviation Authority, we recommended that:

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.[25]

23. A decade has passed since the Government made those proposals, and the relationship between the CAA and Competition Commission has not changed. When the subject arose in the present inquiry, Dr Harry Bush of the CAA agreed that the process of setting price controls was "over-complicated […] with the best wishes to the Competition Commission the sooner we clear them out of the process the better."[26] With the price controls for the next five years being almost set and the Competition Commission's market inquiry, the opportunity to reform the process by which price controls are set has passed. Dr Bush from the CAA described the current state of affairs thus: "the Government has said that it will think about the regulatory issues that arise once the Competition Commission has finished its market inquiry because at that point it will know the market within which regulation is taking place".[27]

24. On 9 October 2007, the Secretary of State for Transport (Rt. Hon. Ruth Kelly MP) announced that Sir Joseph Pilling would lead a strategic review of the Civil Aviation Authority. The review will be "complementary to (but separate from) the Competition Commission enquiry into BAA, which may comment on CAA's specific powers for the economic regulation of airports".[28] It will take into account the conclusions of the Eddington report on the links between transport and economic productivity and the Stern review of the economics of climate change.[29]

25. The Competition Commission should not automatically be involved in the review of airport charges. Instead, it should be a body to which the airport operators may go if they wish to appeal. We welcome the Government's announcement of the strategic review of the CAA, and hope that Sir Joseph Pilling will take note of the consensus that has emerged around the question of the nature of the future relationship between the CAA and the Competition Commission.

Designation

26. Airports are designated for the purpose of economic regulation under section 40 of the Airports Act 1986. Airports are designated for the purpose of price control if any of the following criteria apply:

  • the airport, either alone or together with any other airport(s) in common ownership or control, has or is likely to acquire, substantial market power; and
  • domestic and EC competition law may not be sufficient to address the risk that, absent regulation, the airport would increase and sustain prices profitably above the competitive level or restrict output or quality below the competitive level; and
  • designation under Section 40 of the Airports Act 1986 would, taking account of the magnitude of the risk identified in (2) and its detrimental effects were it to materialise, deliver additional benefits (i.e. over and above competition law) which exceed the costs and potential adverse effects of such designation (i.e. the incremental benefits are positive).[30]

27. In our inquiry into the work of the Civil Aviation Authority, we recommended that "the Government should consider de-designating Manchester and Stansted".[31] The Government has completed its review of designation at Stansted and Manchester, and announced its decisions to de-designate Manchester but to leave the status of Stansted unchanged on 15 January 2008.[32] The Secretary of State made her decision following advice from the CAA and public consultations, and a review by Professor Martin Cave of the Warwick Business School. She decided that Manchester should be de-designated on the grounds that it does not have significant market power. The decision to preserve Stansted's designated status was 'more finely balanced' than the decision on Manchester, but the Secretary of State decided that all three criteria for designation had been met.[33]

28. However, in its evidence to the DfT's review, the CAA advised the DfT that Stansted did not hold a position of substantial market power, that existing regulation was sufficient and that continued designation would not deliver any additional benefits.[34] This was consistent with oral evidence given to us by Dr Harry Bush on 21 November 2007.[35] The DfT's decision to take the opposite view was based largely on supplementary consultation with the airlines, and was taken with an awareness of the fact that the circumstances of BAA's London airports may change after the Competition Commission completes its market inquiry.

29. We agree with the CAA that economic regulation should only apply where there is a need for it, and therefore welcome the Department's decision to de-designate Manchester airport. Although Stansted will remain a designated airport for the immediate future, we are confident that the circumstances of BAA's common ownership will change in the foreseeable future, either through the actions of the Competition Commission or BAA.

Charges

What is an airport charge?

30. There are two types of relevant charge under the Airports Act 1986. Section 36 of the Act defines 'airport charges' as:

  1. charges levied on operators of aircraft in connection with the landing, parking or taking off of aircraft at the airport (including charges that are to any extent determined by reference to the number of passengers on board the aircraft, but excluding charges payable by virtue of [section 73 of the Transport Act 2000 (charges for services) [and penalties payable by virtue of sections 38C and 78A of the Civil Aviation Act 1982])]; and
  2. charges levied on aircraft passengers in connection with their arrival at, or departure from, the airport by air.[36]

Fifth quinquennial review of charges

31. Airport charges are set over five year periods. At present we are in the fourth of these, and the CAA is currently consulting on the level of charges that will apply in the fifth quinquennium between 2008 and 2013. It published its final price control proposals on 20 November 2007, and is expected to publish its decisions in March 2008. It is possible that the CAA's estimate of the cost of capital will increase, given the uncertainty in the financial markets.

The basis of charges

32. Airport charges are reviewed on the grounds of providing for an appropriate level of new investment and a rate of return commensurate to the cost of capital necessary for such investment to be carried out.[37] The specific factors taken into consideration are:

Capital expenditure (capex)
Capex describes the expenditure required for the acquisition of a long-term asset.

Regulatory Asset Base (RAB)
The RAB is a proxy value of the airport's regulated operating assets, upon which the owners of the airports earn a return.

Cost of capital
The cost of capital is the weighted average of its two components: the cost of debt and the cost of equity.

Depreciation of assets
The rate at which assets reduce in value.

Operating expenditure (opex)
Opex is an airport's operating expenditure on the day-to-day running of business (e.g. for staff, utilities, day-to-day maintenance etc).

Other revenues
Other non-regulated income comes from retail sales, property and non-aeronautical revenues (mainly other charges to airlines).

Forecasts of traffic
The assumptions regarding numbers of passengers passing through the airport over the specified period.[38]

Regulatory Asset Base regulation and 'gold-plating'

33. In both its written and oral evidence to the Committee, easyJet questioned the appropriateness of basing charges upon a regulatory asset base (RAB). In its written submission to the Committee, it argued that:

    Regulatory Asset Base (RAB) regulation does not work well for large or lumpy investment, and dictates price paths that are inconsistent with those that would be expected in a competitive market. For example, under RAB regulation, prices charged by an airport increase significantly when new investment is undertaken, and then fall over time as passenger numbers increase. However in a competitive market, we would expect to see the reverse pattern.[39]

34. In oral evidence to the Committee, Mr Nicol explained that in easyJet's view, RAB regulation enabled BAA to "spend and spend and spend and we [the airlines] are the ones who have to pick up the bill."[40] When we asked Mr Nicol what the alternative to RAB regulation would be, he argued that the only real solution would be to have someone other than BAA owning the new facilities.[41]

35. Whether anyone would want to take up such an opportunity is, in our view, doubtful. If BAA retained control of all the other airport facilities, such ownership would be very isolated and would not alter BAA's dominant position to any real extent. The real problem in the airports sector is that there is a need for economic regulation at all. The fact that regulatory asset base regulation brings problems of its own is another issue entirely. Piecemeal ownership of terminals by companies other than BAA is not radical enough a solution to the problem of BAA's monopoly.

36. The ability to "spend, spend, spend" leads, according to easyJet, to BAA over-investing in new facilities to maximise the value of its regulatory asset base:

    The level of gold plating which we felt was going on at Stansted was just too high. It is a relatively small thing, but to give a cast iron example, the suitability of the infrastructure to take the A380. No Stansted operator operates anything like an A380. No airline that I can think of is going to put an A380 into Stansted in the coming decades, so why are we the users, particularly easyJet and Ryanair, going to be expected to pay for that?[42]

37. The construction of a second runway at Stansted has now been overshadowed by the consultation on development at Heathrow. This point about accommodating the A380 arose in a recent Westminster Hall debate on that expansion. In the debate, it was argued that the advent of quieter aeroplanes such as the A380 might mean less local opposition on noise pollution grounds to airport expansion. The Government was urged to mandate lower noise levels from airlines and aeroplane manufacturers.[43]

38. The long-term business case for the A380 as a 'superjumbo' is predicated upon a healthy continuation of the 'hub and spoke' model of air travel. The point about Stansted is that it is not—and almost certainly never will be—a hub and spoke airport, so there is no point preparing it for an aeroplane that is designed with that purpose in mind. Other new aeroplanes will presumably be less polluting as the technology improves, but this is unlikely to show a benefit for many years.

Service quality and rebates

39. In our report on passengers' experiences of air travel, we agreed with the CAA "that the [regulatory] regime could be further improved by introducing penalties for poor performance."[44] A small proportion (4% at Heathrow and 3% at Gatwick) of revenue depends on these penalties. The final price control proposals published by the CAA on 20 November 2007 make 60% of Heathrow's and 40% of Gatwick's capital programmes for the next five years subject to rebates.[45]

40. The quality of service provided by BAA was brought up by all of the airlines in their oral evidence. Dr Paul Ellis from British Airways said that "we have had poor service in respect of the management of security at the BAA airports in the most recent year or so."[46] Don Langford of American Airlines said that "over the past few years BAA has actually been less responsive to operational issues."[47] Mr Langford gave the example of getting flight crew through security control posts. He told us that there had been occasions when air crew had been held up because they were sitting behind deliveries of non-time critical supplies.[48]

41. This is exactly the sort of problem that rebates are designed to avoid. When we put the point about prioritisation of crew at checkpoints to BAA, Mr Kyran Hanks (Economics and Regulation Director) pointed out that "as part of the next regulatory settlement there has been an agreement made with the airlines at both Heathrow and Gatwick to put a service quality incentive on the airports to minimise the queues at those control posts."[49]

42. Appendix C of the Civil Aviation Authority's price control proposal document sets out 'triggers' for BAA to pay rebates to airlines in respect of poor service. Triggers set on capital projects, such as the refurbishment of Heathrow's Terminals 1-4 and the construction of new facilities, ensure that money BAA receives from the fees it charges gets spent on the projects it has agreed with the regulators.

43. Service quality will be assessed in seven key areas:

  • The availability of seats in departure lounges
  • The cleanliness of terminal facilities
  • The ease of way-finding
  • The display of flight information
  • The length of central security queues
  • Passenger sensitive equipment
  • The efficiency of baggage carousels in arrival areas

44. We pressed the CAA and Competition Commission on why they felt that BAA needed a programme of incentives to meet minimum standards of service quality. Mr Martin Stanley of the Competition Commission explained that "it would be a strange regulator […] that says, 'Here is the money that you can get for landing charges over the next five years but it does not matter what service quality.'"[50]

45. It was, and remains, our view that BAA should be doing a lot of things covered by the incentives anyway. We have no issue with the principle of performance-related pay as applied through service quality rebates. We do, however, regret the apparent need for such targets. If there were no position of market power in the UK airports sector—if there was real competition for traffic—airport owners would not need incentives from an external regulator.

46. In its report on the economic regulation of the London airports, the Competition Commission stated that "the total amount of revenue at risk needs to be sufficiently large to incentivize BAA to maintain the agreed standards."[51] They "note that, in many anti-trust regimes, penalties for infringement may be equal to 10 per cent of an enterprise's revenue and that this is considered an appropriate incentive to compliance."[52]

47. We believe that the percentage of revenue subject to rebates should be higher, as suggested by the Competition Commission. The comparison of the regulation of BAA to an anti-trust regime lends further weight to our view that BAA's market position is fundamentally anti-competitive.


23   Airports Act 1986, section 43 Back

24   Transport Committee, Aviation, para 115 Back

25   Transport Committee, The Work of the Civil Aviation Authority, para 133 Back

26   Q 15 Back

27   Q 17 Back

28   'Strategic review of the Civil Aviation Authority', Department for Transport press release 2007/0139, 9 October 2007 Back

29   Department for Transport, The Eddington Transport Study, December 2006. HM Treasury, Stern Review: The Economics of Climate Change, October 2006. Back

30   'Decision on proposed designation and de-designation criteria for airports', Department for Transport press release 2008/004, 15 January 2008 Back

31   Transport Committee, The Work of the Civil Aviation Authority, para 128 Back

32   'Decision on proposed designation and de-designation criteria for airports', Department for Transport press release 2008/004, 15 January 2008 Back

33   ibid. Back

34   CAA, De-designation of Manchester and Stansted airports for price control regulation: the CAA's advice to the Secretary of State, 10 November 2007, www.caa.co.uk Back

35   Q 25 Back

36   Airports Act 1986, section 36 Back

37   Competition Commission, BAA Ltd: A report into the economic regulation of the London airports companies (Heathrow Airport Ltd and Gatwick Airport Ltd), 28 September 2007, para 4.1 Back

38   ibid. Back

39   Ev 124, para 13 Back

40   Q 172 Back

41   Q 173 Back

42   Q 174 Back

43   HC Deb, 12 December 2007, col 116WH Back

44   Transport Committee, Passengers' Experiences of Air Travel, para 75 Back

45   CAA, 'CAA issues its price control proposals for Heathrow and Gatwick airports', www.caa.org.uk, 20 November 2007 Back

46   Q 149 Back

47   Q 169 Back

48   Q 150 Back

49   Q 253 Back

50   Q 22 Back

51   BAA Ltd: A report into the economic regulation of the London airports companies, Appendix L, para 40 Back

52   ibid. Back


 
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