JOINT TRANSPORT RESEARCH CENTRE
Round Table, 2-3 October 2008, Paris

Discussion Paper No. 2009-7
October 2009

Competitive Interaction
between Airports, Airlines
and High-Speed RailSUMMARY AND CONCLUSIONS

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Summary & Conclusions — Discussion Paper 2009-7 — © OECD/ITF, 2009

TABLE OF CONTENTS

ABSTRACT .................................................................................................................................................41.

INTRODUCTION ............................................................................................................................. 52.

AIRPORT COMPETITION: REGULATION‐RELEVANT AIRPORT CHARACTERISTICS .......................... 7
2.1
2.2
2.3
2.4

Airport capacity constraints .............................................................................................. 7
Airport – airline relations ................................................................................................ 10
Hub functions .................................................................................................................. 12
Summary ......................................................................................................................... 14

3.

WHETHER AND HOW TO REGULATE ........................................................................................... 15

4.

CLIMATE CHANGE POLICY AND AIRLINE COMPETITION ............................................................. 17

5.

AIR‐RAIL COMPETITION AND THE SOCIAL DESIRABILITY OF HIGH‐SPEED RAIL ..........................19

6.

CONCLUSIONS ............................................................................................................................. 21

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ABSTRACTThis paper summarizes, structures, and provides some context for discussions of theRound Table mentioned in the title. The first part of the paper focuses on sources of market
power for airports and on policy responses. When an airport is congested and competition
with other airports is limited, regulation may be justified, and the dual till approach likely
works best. In other cases, however, policy should establish conditions for competition to
emerge as much as possible, instead of attempting to design a general regulatory
framework. The second part of the paper discusses elements of climate change policy inaviation. Including aviation in emission trading schemes is a sensible idea, but should not be
expected to produce major cuts in CO2 emissions from aviation; containing its growth
possibly is a more realistic, yet ambitious and not necessarily socially optimal, objective.
High‐speed rail is justified in some situations, but is not a general alternative for air travel
and certainly not a second‐best way to reduce greenhouse gas emissions from aviation.

Chair:David Thompson, Department for Transport, United Kingdom

Input papers: Tae Oum, University of British Columbia, andXiawen Fu, Hong Kong Polytechnic University, Hong Kong, China
David Starkie, Economics‐Plus Ltd, London, United Kingdom
Marco Kouwenhoven, Significance, The Hague, Netherlands
Ginés de Rus, University of Las Palmas, Spain
Peter Forsyth, Department of Economics, Monash University, Clayton, Australia

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1. INTRODUCTION

Air travel has become a commodity over the last two or three decades. Travel volumes
were boosted by a combination of income growth and lower real fares, and there is strong
competition on many origin‐destination pairs. Lower fares are the consequence of more
intense competition, which in turn was made possible by deregulation, first in the US andlater in Europe. While there is broad consensus that this evolution has increased the net
benefits generated by air travel, concerns remain about the economic efficiency of the airtransport industry. One such concern is that there may be excessive market power in somemarket segments. For example, the emergence of hub‐and‐spoke networks after
deregulation has reduced costs, but it has also allowed dominant carriers to charge hub
premiums and it may have helped them to deter entry. Another example relates to the up‐
stream services provided by airports. Airline competition does not imply airport competition,
and airports may enjoy location‐ or congestion‐driven market power. Institutionalarrangements including regulation affect the way such market power plays out. Other
market failures in aviation include Pareto‐relevant externalities2, such as marginal
congestion costs, and environmental impacts, such as noise and CO2 emissions. On the other
hand, regulatory interventions to try to correct for market failure also impose costs andimperfect information might lead to separate distortions.
This paper discusses the efficient functioning of the air transport industry and someissues arising. Like most economic activity, air transport is characterised by multiple market
failures. Here, we focus on the potential market power of airports (Sections 2 and 3), on
climate change (Section 4), and on the competitive effect and the social desirability of high‐speed rail (Section 5). In each case, we ask if the market failures are sufficiently serious towarrant implementation of costly and imperfect policy.
Section 2 starts with a basic observation on airports: the context in which they operate
is very varied and market power is more likely in some cases than in others. When airport
capacity in the region where an airport is located is scarce, that airport is served by a set ofcompeting airlines and is not very strongly reliant on hub traffic;, the airport most likely
enjoys substantial market power. But when airport capacity is abundant, local demand is
not of particularly great interest to airlines; airlines are strong, there is a large share of hub
traffic and market power is likely to be very limited.

2

A Pareto‐relevant externality is an external effect whose removal, by one or other intervention, would
lead to a potential Pareto‐improvement, i.e. an increase in overall economic welfare.

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After the diagnosis in Section 2, Section 3 asks about the remedies. Is regulation
required, and what type of regulation is available to avoid abuse of market power? In
answering these questions, the aim is to strike a balance between market failure andregulatory failure. Competition, while not perfect, arguably works quite well in many
situations. Furthermore, devising a regulation that alleviates one or several shortcomings ofthe market while maintaining appropriate incentives regarding prices, quality of service andsystem capacity, is no small feat. Given this trade‐off, the preferable approach is to create
an institutional environment stimulating competition and turn to regulation where
necessary on a case‐by‐case basis, rather than attempting to come up with a general‐purpose regulatory framework. In case regulation is required to contain location‐ orcongestion‐generated market power, care needs to be taken that good investment
incentives are retained and excessive use of available capacity is avoided. Among thearchetypical forms of regulation, the dual till approach seems best suited for majorcongested airports. These issues are the subject of a sizeable literature, and our treatment
just touches upon some elements.
Aviation accounts for a small [e.g. some 3.2% in Europe in 2004 (Anger et al., 2008)]
share of CO2 emissions. This share is expected to grow fast, and aviation emissions cause
greater radiative forcing than those from many other sources. For these reasons, the sector
is widely expected to contribute to efforts to reduce greenhouse gas emissions. From a cost‐
minimization perspective, shares and growth patterns are not relevant as such. Instead, thequestion is how aviation abatement costs compare to those of other sectors. Section 4
discusses the potential impacts of greenhouse gas abatement policies on aviation. Aviation’s
abatement efforts should be guided by its abatement costs compared to the costs of othersectors, and including aviation in emission trading systems is one step in that direction. If
aviation is confronted with prevailing carbon prices3, it would most likely engage in a limited
amount of abatement and would need to acquire permits in excess of its historical emission
levels, at least when demand grows as expected. The reasons for the limited abatement
potential are that demand for air travel is not very elastic in the aggregate, and thattechnological fixes are scarce – and most likely will remain so in the foreseeable future.
Where capacity constraints are strictly binding, putting a price on carbon would affectvolumes to an even smaller extent, instead triggering a transfer of scarcity rents to ownersof carbon rights.
Given the limited scope for cheap greenhouse gas abatement in aviation, Section 5 asks
if it makes sense to increase the availability of high‐speed rail alternatives. High‐speed rail
can substitute for air transport on mid‐range distances and produces fewer emissions pertrip, especially when electricity is produced in non‐carbon‐intensive ways. However, life‐
cycle emissions, relevant in an ex ante analysis, for rail arguably are high, given the highemissions from track infrastructure construction (see e.g. Chester and Horvath, 2008) and3

6

Prices prevailing at the time of the Round Table – current prices are lower because of reduced
overall economic activity.
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maintenance. However, a broader comparison of costs and benefits shows that (a) high‐speed rail links are socially desirable in a certain set of circumstances and should not beviewed as a general alternative to air transport, and (b) environmental benefits play a fairly
minor role in the overall evaluation of high‐speed rail projects.

2. AIRPORT COMPETITION: REGULATION‐RELEVANT AIRPORT CHARACTERISTICS

This section provides an overview of potential sources of market power for airports.
The degree of competition faced by an airport varies strongly with market conditions. While
this is an obvious statement, it is worth making explicit what market conditions one has inmind when analysing airport market power. We discuss the role of capacity constraints,
relations with airlines and hub functions. Airports may also derive market power from theirlocation. Overlap between airports’ catchment areas limits this market power, and in“multi‐airport regions” competition among airports can be intense. We touch upon theseissues where relevant. This section also mainly focuses on airports’ aeronautical activities.
Non‐aeronautical activities are an important source of revenue and the demand for suchservices is complementary to the demand for aeronautical services. Furthermore, for atleast some non‐aeronautical services, airports enjoy market power. These issues are
addressed in Sub‐section 2.1. Questions regarding how regulation, when required, shouldtake account of interactions between aeronautical and non‐aeronautical activities are thesubject of intense debate among academics and practitioners, and are briefly discussed in
Section 3.
2.1.

Airport capacity constraints

Airports’ physical capacity to handle flights is determined mainly by runway andterminal capacity. Investments in physical capacity are lumpy (e.g. it makes no sense tobuild half a runway) and projects often take a very long time to implement, so that capacity
levels cannot be matched perfectly with changing demand levels4. Lumpiness implies that
airports can have excess capacity or, when demand grows, can become congested forextended periods of time5. Airport congestion means that access to the airport is a rival
good: an additional take‐off or landing implies increased time and operating costs for otherflights, or – when technical capacity is reached – requires another flight to be omitted. In
other words, the opportunity cost of an additional flight is positive. Scarce capacity needs to
4

Technological improvements may decrease the lumpiness of airport capacity.

5

The polar cases where capacity is always abundant or there is always excessive congestion areunattractive from an economic point of view.

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be allocated somehow. Economics prescribes that charging the opportunity cost of a flight isan efficient allocation mechanism, but determining this cost is not straightforward6 and few
airports use congestion‐dependent access charges.7 Some US airports and many EU airports
use slot constraints to manage capacity utilisation.
An airport that is not overly constrained by regulation or by bilateral agreements withairlines can set access charges in line with its objectives (e.g. maximising profit, revenue or
output), of course subject to constraints imposed by demand for the airport’s services andcompetition from other airports or transport modes. Scarcity of capacity, i.e. congestion, is asource of pricing power for the airport vis‐a‐vis airlines, because the airport has some degreeof monopoly power over a scarce input to airline traffic. Pricing power means that an accesscharge can be set that is (inversely) related to an airline’s elasticity of demand for access tothe airport. Such pricing power can exist in multi‐airport regions, if the joint capacity of theregion’s airports is low compared to the demand for air travel, and airports compete in
Bertrand or Cournot fashion (Van Dender, 2005).
Does pricing power for airports lead to welfare losses that require a policy intervention?
As noted above, when a facility of limited capacity becomes congested, it is efficient in the
short run to charge a price for access equal to the marginal social cost. The main componentof such an access charge is the cost of delays imposed on other airplanes seeking access tothe airport during the congested period. It was also noted that the existence of congestion
confers pricing power on airports, so it could in principle set a price equal to marginal social
cost. However, it is generally not the case that profit‐maximising airports charge welfare‐maximising charges. If the airport is a profit‐maximising monopolist, it will leverage themarket power from scarce capacity to charge higher prices than the welfare‐maximisingones (and thus withhold capacity). In oligopoly markets, this leverage is smaller but notabsent. If the airport pursues other objectives than profit maximisation, other prices result
and their relation to efficient charges changes accordingly. Output maximisation, forexample, likely results in less than efficient charges.

6

Apart from difficulties in defining cost functions, there is the question of to what extent airlines withlarge market shares at an airport internalise part of the congestion cost at that airport. Brueckner
and Van Dender (2008) show how incentives to internalise depend on market structure. The
existence of a small competitive fringe is sufficient to destroy internalisation incentives. Daniel andHarback (2008) provide evidence of limited or no internalisation at major US airports, suggesting that
Pigouvian charges are desirable in many cases.

7

The paucity of congestion charges at airports may be related to regulation (allowing weight‐based
charges only), to a lack of welfare‐ or profit‐maximizing behaviour at airports (perhaps as aconsequence of interest‐groups’ lobbying efforts), or to agreements between airlines and airports.
Furthermore, slot allocation mechanisms, such as those in operation throughout Europe and at someUS airports, can substitute for congestion charges to some extent, in principle. Whether prevailingslot allocation mechanisms can mimic congestion charges is a point for debate, but without a well‐functioning secondary slot market they most likely do not.

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Airports offer non‐aeronautical services, which are complementary to aeronauticalservices, and for which the airport enjoys some market power. Consequently, profit‐
maximizing airports may reduce access charges in order to boost total profits. This effectpulls in the opposite direction of the pricing‐power effect for access charges, moving theaccess charge in the direction of the efficient ones (without necessarily equating both). Theinteraction between aeronautical and non‐aeronautical charges also depends on how one orboth components are regulated (see Section 3).
The deviation between unregulated and efficient charges depends on various
circumstances, and its direction and size cannot be determined in general terms. Oum andFu (2008) point out that airport competition is a critical factor in determining the difference:an airport facing stiff competition from nearby airports will be inclined to set low
aeronautical charges, whereas absence of such competition likely implies higher thansocially optimal charges. In balance, whether any difference between profit‐ and welfare‐maximizing prices justifies a regulatory intervention is not clear. If costless and perfectregulation were available, the recommendation would obviously be to introduce it.
However, regulation is imperfect and costly. If, as may well be the case, allowing airports tointroduce congestion charges as they please yields more efficient capacity use than is
obtained when there are no congestion charges, then the welfare loss from having non‐optimal charges may be small or non‐existent compared to the costs of regulating thosecharges.
In the long run, airport capacity is variable. Of course, this does not mean that capacity
should be expanded to eliminate congestion. Instead, it should be expanded to the point
where the marginal costs of doing so equal the marginal benefits. Given the often very highcosts of adding capacity (land, environmental impact, etc.), many airports are likely toremain strongly congested. At any rate, the argument for congestion‐based access charges
is just as valid for the long run as it is for the short run. A different question is whether
airports will provide roughly optimal levels of capacity. Since airports can benefit fromcongestion, it seems likely they will provide less than socially optimal capacity, at least when
they maximize profits. This suggests that congestion pricing is more attractive when it isconstrained by (potential) competition. When airports pursue different objectives, andwhen they are subject to regulatory constraints, capacity decisions are obviously affected.
Section 3 discusses some interactions between regulation and capacity provision.
In multi‐airport regions, airports face joint capacity constraints in addition to airport‐
specific constraints: they partly share the same airspace and the same land‐access transport
network. Both of these facilities are congestion‐prone. For the case of airspace, in a Cournot
market structure congestion confers pricing power upon airports (i.e. the ability to set prices
higher than marginal social cost, where the latter includes marginal congestion costs)8. The
8Adapting the framework of Van Dender (2005) to the case of shared congestion‐prone facilities
shows there is pricing power when airports are Cournot competitors, but not when they are
Bertrand competitors. However, Cournot (quantity or capacity) competition seems the more

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arguments on airport‐specific capacity hence in principle extend to the case of sharedairspace constraints.
Summing up, the argument in this section is that congestion at airports or airspace
generates pricing power for (independent) airports and renders a congestion charge
desirable for efficiency’s sake. While there is no guarantee that a charge that is optimal
from an airport’s point of view is also the socially optimal charge, the welfare resulting fromairports’ setting unregulated charges may very well be higher than the welfare obtained
when there are no congestion charges. Depending on one’s view of the costs of regulation,
it hence is not clear that congestion‐based airport pricing for given airport capacity should
be an object of specific regulation. However, decisions on capacity levels may require closer
attention.
2.2.

Airport‐airline relations

In order to isolate the impacts of congestion effects, we assumed in sub‐section 2.1 that
airports are independent of airlines, i.e. airlines act as price‐takers vis‐a‐vis the airport.
However, vertical relations between airlines and airports may lead to deviations from such
independence. Close vertical ties between an airport and one or several airlines reduce theairport’s business risk of investing in long‐lived sunk assets, but imply a risk of making entry
by competing airlines more difficult. When there is sufficient competition among airports,
the latter risk is small and there are likely to be net benefits. But when there is less airport
competition, the costs of limiting competition may well outweigh the benefits of reducing
business risk.
An airport serving a strong local market and subject to capacity constraint may enjoy
market power, depending on which airlines serve the airport and on the nature of its
relations with these airlines. For example, an airport served by a dominant network carrier
may be in a weak bargaining position with that carrier (so that market power is effectivelytransferred to the airline), whereas an airport served by several network carriers tends toenjoy a stronger position because of competition among the carriers9. Airports that mainly
depend on low‐cost carriers are in a particularly weak bargaining position, because suchcarriers are much less tied to a particular geographical market (and hence to a particular
airport) than network carriers (e.g. Starkie, 2008). Furthermore, airports and airlines serving
smaller cities also face more price‐elastic demand, limiting their capability to translate any

reasonable assumption for airspace competition. In the case of ground access, airports share the
network with non‐airport users, and this undoes market power.
910LAX is an example of an airport serving several network carriers. Experts observe that LAX is not
managed very efficiently but still does well, a situation presumably made possible by its market
power. ATL is very efficiently managed, maybe partly because of the weaker market position it
holds, with a single dominant carrier.
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market power into higher prices10. Low‐cost carriers do benefit from dominating an airport,
however, through lower airport charges (see below).
Starkie (2008) discusses how relations between smaller airports and low‐cost airlines in
the UK have been revolutionised through the emergence of vertical supply contracts. These
are long‐term contracts (up to 20 years) that stipulate access charges for low‐cost carriers
and are not exclusive (in contrast to many long‐term vertical contracts in the US). The
contracts allow airports to generate a normal rate of return and arguably make appropriate
investments in quality and capacity, a commercial requirement imposed on them by themarket for corporate control of commercial airports11. Given the market structure in whichthese airlines and airports operate, the absence of increasing returns to scale, and thesatisfactory commercial market outcome, Starkie (2008) argues strongly that there is noneed for regulation in this segment of the aviation industry.
The good performance of airports and airlines in these markets leads to spillovers
elsewhere: vertical relations between the main full‐service carrier at Manchester Airport andthe Airport have been revised, similar models are used in commercial and publicly‐owned
airports (suggesting that competition matters more than ownership at the margin12), and theincreased presence of low‐cost carriers in long‐haul markets may imply that this businessmodel will be used outside the traditional short‐haul segment served by low‐cost airlines.
Is the UK model transferable to the rest of Europe and the US? The geographicalprerequisites for the UK system to work – a large number of small airports with overlapping
service areas – are present in much of continental Europe, though not everywhere.
However, no country has the same long experience with privatisation as the UK, and thismay render replication of the UK model less than straightforward.
In the context of major airports and full‐service carriers, Oum and Fu (2008) emphasize
that, while airports have little market power vis‐a‐vis an airline when that airline dominates
the airport, the airport has an incentive to co‐operate with such a carrier because such co‐operation allows the airport to boost non‐aeronautical revenues. As airports, for example in
the US, are being “commercialised”, they become geared towards the exploitation of non‐aeronautical activities to maximise profits. While some US airports historically have been
10

Apart from lower willingness to pay for air travel in smaller markets, the high price elasticity facing
an airport or airline derives from overlap between airports’ service areas. Even if different airports
or airlines in fact serve separate destinations, potential entry into overlapping destinations may besufficient to discipline incumbents.

11

Concentration of airport ownership may emerge in this market, and could form a basis for oversightby competition authorities.

12

However, the competition among regional airports in the UK is generated by outbound passengers
using low‐cost carriers. It is not clear that this market segment would have developed as strongly
under more widespread public ownership of airports, and in this sense ownership is not neutral withrespect to competition.

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heavily dependent on airlines through exclusive gate use agreements, the development ofcommon use infrastructure has increased their independence from airlines, allowing them topursue strategies to benefit from integration with airlines. Hence, while integration
between airlines and airports in the US does not disappear with commercialisation of
airports, its form tends to be more advantageous for airports, because of the reduced grip
airlines have on capacity decisions.
The above suggests that not all forms of vertical integration are per definition suspectfrom the airport’s or regulator’s point of view. However, integration should not mean loss of
independence for either party. For example, Fraport (Frankfurt airport) became strongly
integrated with its dominant airline, Lufthansa, when it acquired partial ownership of the
airport. This evolution is seen as problematic from the airport’s point of view and from a
broader concern about market power. For example, such ownership forces Fraport to share
information on performance and on pending strategic decisions with the airline13.
Nevertheless, full vertical separation between airlines and airports is not necessarily
required to maintain sufficient competition. Airlines could own terminals at an airport (anddecide on its capacity) as long as there are common use facilities as well. With vertical
integration, the main concern is to avoid exclusive access for the home carrier or, moregenerally, avoid limitations on access by competing airlines.
While vertical integration should not be avoided in general, it may generateconsiderable market power in some market segments. Integration between airlines andairports generates airline‐airport bundles. Consumers may have a choice between various
bundles, but they are imperfect substitutes14, and airlines and airports may enjoy
considerable market power in some market segments. The degree to which airline‐airport
bundles are substitutes also depends on passenger characteristics. For example, while
leisure passengers in the UK may have various choices, it is arguable that the choice set issmaller for business travellers. Hence, some form of policy intervention may be justified insome situations.
2.3.

Hub functions

Airlines use hub‐and‐spoke networks to connect origins and destinations between which
demand is not sufficiently dense to allow profitable direct services. This implies that hub‐and‐spoke networks become less competitive when the density of demand increases (e.g.
13

It is also conceivable that Lufthansa and Fraport have differing views on the desirability of capacity
expansion at Fraport and on Fraport’s relationship with nearby Hahn airport (used by a low‐costcarrier and for freight). Fraport gave up its ownership of Hahn airport in early 2009.

14

Imperfect substitution follows from differences in service quality (airport access times, parking costs,
expected delays, flight frequencies, etc.; see Ishii et al., 2009) and from consumer loyalty
programmes such as frequent flier programs. Product differentiation can also occur within airports,
e.g. with similar but not identical services offered by low‐cost and full‐service carriers.

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because of income growth and continuing agglomeration of economic activity) and when thecosts of providing service decline (e.g. with low‐cost business models being applied in lessdense markets). While hub‐and‐spoke structures save costs, they also are a source ofmarket power for airlines, as suggested by the evidence on the existence of hub premiums15.
But what about the relationship between hub status and airport market power?
Market power is weaker for an airport that focuses strongly on connecting traffic16.
Airports compete for hub functions, and this weakens the position of airports with airlines.
Furthermore, airlines offer competing hub‐and‐spoke networks, and this indirectly weakens
the benefit of a particular hub’s location. In general, hub functions are not very strongly
dependent on location, so they are not strongly dependent on airport location. Airlines are
particularly interested in combining hub functions and serving a strong local market in asingle airport, so that hub airports with small local markets are in a particularly weak
position with respect to their home carrier. In Europe, this classification arguably applies tomost hub airports except London Heathrow and Paris Charles De Gaulle. The potential formarket power in this situation lies mainly with the home carriers, less with the airports.
Since generating competition within such hubs is difficult, competition between hubs andthe creation of alternative airports in the hub’s catchment area is desirable to limit hub‐related market power.
The major, successful hub airports tend to be located where there is strong local origin‐destination demand, because of complementarities between hub and local demand fromthe airline’s point of view (allowing, amongst other things, airlines to charge hub premiums).
In addition, the trend is for the number of hub competitors to decline, as the number of
independent major airlines declines. One view is this means that the market is increasingly
oligopolistic and a candidate for regulation17. A different view is that even with fewer major
airlines, there usually is a competitive fringe that disciplines major carriers and therefore
reduces the need for regulatory intervention. For this to hold, access conditions in major
airports need to support the existence of such a fringe18.

15

Hub premiums may reflect quality or cost differences instead of, or in addition to market power.
Borenstein (2005) presents suggestive evidence that hub premiums are smaller in multi‐airport
regions in the US, so that factors other than pure product characteristics and costs may be involved.

16

The ticket tax introduced in The Netherlands in 2008 illustrates the importance of hub competition(for Schiphol Airport), as the tax is four times higher for long‐haul traffic than for European traffic.
Transfer passengers are fully exempted from the charge. In early 2009, political debate on thedesirability of the ticket tax as such re‐emerged after reports on Schiphol’s loss of market share, andthe tax will be abolished as of July 2009.

17

Consolidation probably will reduce the number of hubs (e.g. the DL‐NW alliance may very welleliminate one or more of its current six hub airports), so that airline consolidation leads toconcentration of traffic at airports, with potentially detrimental effects on competition.

18

Daniel (1995) and Daniel and Harback (2008) find no evidence of internalisation of congestion costs
at major US airports and attribute this finding to the existence of a competitive fringe.

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Apart from hub competition, mergers and alliances of airlines tend to weaken airports’positions, all else being equal. But if airports respond by co‐operating, as may become thecase for Aéroports de Paris and Schiphol, for example, then airports’ countervailing powerincreases. Whether such horizontal integration is desirable from a broader social
perspective is far from clear, however19.
In summary, hub functions may generate market power, and this more likely accrues toairlines than to airports. In particular, airlines charge hub premiums to passengers for the
airport’s local market. This market power can partly be limited, e.g. through competition via
secondary airports and maintaining competition between hub‐and‐spoke networks20.
2.4.

Summary

The degree of competition an airport faces depends strongly on the specific market
environment it operates in. Some of the key market characteristics are scarcity of capacity,
vertical relations with airlines and the importance of hub traffic.
Congestion at airports generates pricing power. A congestion charge is one way to attainefficient use of scarce capacity. A charge that is optimal for an airport is liable to differ fromthe efficient charge, but plausibly generates more welfare than where there are nocongestion‐related charges. Since regulation is costly, allowing airports to charge forcongestion can be satisfactory. However, care needs to be taken with incentives to invest.
While full vertical separation between airlines and airports is not required to maintainsufficient competition, exclusive access for the integrating airlines should be avoided.
Vertical integration may also generate considerable market power in some market
segments, possibly justifying some form of policy intervention.
Hub functions may generate market power, mainly for airlines. Maintaining airport
competition via secondary airports and between hub‐and‐spoke networks are ways to curb
such market power.

19

The recent decision in the UK to separate ownership of the three main London airports reflects theview that the benefits from competition outweigh any gains from co‐operation on investment
decisions and operations.

20

These remedies do not fully erode market power, because secondary airports do not offer entirely
similar services to main airports, and because hub carriers limit substitution through frequent flierprogrammes. Whether better mechanisms to curb market power exist is not clear. Furthermore,some would argue that allowing some market power is one way to allow companies to survive where
there are network economies.

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Lastly, some experts doubt the extent to which the concepts outlined up to now can beapplied empirically, because of a lack of suitable data (e.g. on prices at the origin‐destinationlevel, but also on the measurement of capacity) to settle the issue.

3. WHETHER AND HOW TO REGULATE

The previous section discussed several potential sources of market power in aviationand concerning airports in particular. Abuse of market power is a form of market failure,leading to a lower surplus than in a fully efficient market. If suitable policy interventions to
restore efficiency are available and they are costless, they should be used. But policies areimperfect and costly, so the presence of market failures does not justify intervention in
itself. Before turning to explicit policy interventions, including regulation, opportunities forcompetition should be played out as much as possible. Some examples of such conditions inaviation, including stimulating airport competition, avoiding exclusive arrangements
between airlines and airports, and competition authorities’ oversight of mergers andalliances, were mentioned in the previous section. Starkie (2008) provides evidence thatcreating competition is feasible in a substantial subset of aviation markets, including somelarge airports serving large urban markets (e.g. Manchester, Birmingham).
The governance priority should be to implement ownership structures that maximise
competition, with further regulation only introduced when that solution is not satisfactory.
The scope for competition among airports is broader than is often assumed by policy‐
makers, prompting the question of whether the application of competition law may beenough to handle problems in airport competition. Minimising ex ante regulation reduces
the risk of discouraging the adoption of innovative business models21.
Even when the policy priority is to maximise competition, airport regulation is still likely
to be required in some situations. In deciding if and how to regulate an airport, the totalityof constraints facing the airport operator need to be considered, on a case by case basis. No
single type of regulation can address all shortcomings of the market in a satisfactory anduniversal manner. The type of regulation used for Gatwick and Heathrow exemplifies someshortcomings of commonly proposed regulatory systems. The regulation is based on
average accounting costs, which are below economic (forward‐looking) costs. The
consequence is that capacity expansion incentives for these airports are muted, despite
severe congestion problems. Furthermore, even with capacity being scarce, the airport
operator is rewarded for boosting passenger volumes, leading to more crowding, lower
21

However, ex post oversight requires access to data to monitor performance, and such information islacking in some countries.

Summary & Conclusions — Discussion Paper 2009-7 — © OECD/ITF, 200915

service quality and limited reliability (“sweating the assets”)22. In light of the discussion in
Section 2, regulation removes a congestion‐prone facility’s incentive to allocate scarce
capacity well. In addition, it does not provide good incentives for capacity expansion in thelong run.
One approach to avoiding regulatory failure is “light‐handed regulation”, used inAustralia and New Zealand for major airports that are far apart and hence enjoy location‐
generated market power. This regulatory approach may be appropriate in cases where theairports’ objectives do not lead them to abuse market power, and where there is a legacy ofexcess capacity. However, the approach meets with criticism (and litigation) from airlines
and passengers because of high charges. Service quality and investment are “satisfactory”.
This outcome is in line with what the discussion in Section 2 suggests for the case of acongestion‐prone facility with a considerable degree of market power (and in a sense is the
opposite of the Heathrow–Gatwick case), with the proviso that theory predicts high quality
and high prices, but not necessarily socially optimal levels of capacity (abstracting fromlumpiness).
Oum and Fu (2008) argue for more forceful airport regulation, particularly in the case ofmajor airports and where airports co‐operate closely with airlines in order to exploit better
complementarities between aeronautical and non‐aeronautical services. Single till and dual
till systems are both forms of price‐cap regulation. Under a single till, charges to airlines foraeronautical services are determined taking (expected) non‐aeronautical revenues into
account23. Under a dual till, aeronautical activities are treated separately from non‐aeronautical ones. Oum and Fu (2008) argue that single till regulation outperforms dual tillregulation, as it allows the airport to optimise complementarities between both types ofservice, subject only to the limits included in the regulation. Dual till regulation makes
exploitation of the complementarities difficult, and poses the problem of how to allocate
costs in a multi‐product environment. However, single till regulation may be problematicwhen there is congestion, since it produces charges lower than marginal social costs. Thisboosts traffic, whereas the charge should actually reduce it. More traffic also means more
non‐aeronautical revenue, implying further reductions of aeronautical charges when theprice‐cap is reviewed (see, e.g., Starkie and Yarrow, 2000). It appears then, that if a choicemust be made between single and dual till, dual till regulation is better suited for congested
airports, while the single till may be preferable where there is excess capacity (cf. Czerny,
2006, for the latter case)24. However, congestion charges may outperform dual tillregulation, even if they are not regulated (sub‐section 2.1).

22

It was noted that the particularly low capacity‐to‐volume ratio at Heathrow, and the resulting poor
quality of service, is sustainable only because of particularly strong local demand. Similar conditions
prevail in New York, but probably nowhere else.

23

The single till approach is supported by ICAO and is widely used in Europe.

24

The choice criterion here is efficiency. Since single‐till regulation implies lower aeronautical charges,
it is clear that the choice of regulatory approach also implies a different distribution of scarcity rents,

16

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Price‐cap regulation is often thought to discourage investment (see the argumentationin sub‐section 2.1; Starkie and Yarrow, 2008; and Oum et al., 2004, for some empiricalevidence). While true in an abstract setting, the practical impact of price‐caps depends onthe estimated cost of capital. If the regulator overestimates the cost of capital, thenoverinvestment can result under a price‐cap. Furthermore, the UK single and dual tillregulations are not pure price caps and contain elements of rate‐of‐return regulation. This
too affects investment incentives in the direction of overinvestment.
Summing up, there is a fairly broad consensus that aviation policy should first focus onestablishing governance arrangements that allow competition to emerge as much as
possible, given the technology and cost structures prevailing in the industry. Doing so will
not omit the need for regulation in all cases, but may limit it compared to current practice.
Regulation is likely to be required for major airports serving large local markets and where
capacity is scarce (at the level of the airport or at the level of the airports in multi‐airport
regions). It is noteworthy that regulation in these cases tends to have considerable effects
on the distribution of scarcity rents. Since scarcity of capacity is the main source of market
power here, dual‐till regulation is likely to out‐perform single‐till regulation. However,allowing airports to charge for congestion may be a better approach.

4. CLIMATE CHANGE POLICY AND AIRLINE COMPETITION

Sections 2 and 3 focussed on market failures caused by market structure, i.e. by the cost
structures and demand patterns prevailing in aviation. Aviation also produces externalcosts, including noise, polluting emissions and greenhouse gas emissions. External costs area form of market failure (including the absence of markets), justifying a policy intervention inprinciple (possibly including the creation of markets).
This section focuses on greenhouse gas emissions, in particular CO2. Climate change is
an important policy concern, and aviation is widely expected to contribute to the abatementof greenhouse gas emissions. The principle that aviation should be included in overall
efforts in order to arrive at cost‐effective abatement, is disputed by few. In addition, many
think that inclusion of aviation in emissions trading systems is an appropriate way of
approaching cost effectiveness. Aviation would bear the costs of its emissions on the same
basis as other sectors included in trading systems, so that overall abatement costs areminimised, and carbon prices provide a clear incentive for investing in less carbon‐intensivewith airlines being better off under the single till. Distribution obviously matters in the policy
debate.
Summary & Conclusions — Discussion Paper 2009-7 — © OECD/ITF, 200917

technology25. But since climate change is a global problem and policy is regional, piecemeal
and imperfect, overall cost effectiveness is hard to reach, and concerns about the impacts ofeconomic instruments on countries’, sectors’ and companies’ competitive positions, as well
as distributional concerns, dominate policy discussions. Forsyth (2008) discusses theseissues, focusing on the potential consequences of including aviation in emissions trading
systems. Such inclusion is under serious consideration in the EU, Australia and New Zealand.
A particular feature of the intended EU system is that it includes all flights departing or
arriving outside the EU, not just intra‐EU traffic. New policy views on climate change issues
in the US may lead to similar initiatives.
At a price of 20€ per ton of CO2‐equivalent, and when carbon costs are fully passed
through to consumers, fares can be expected to increase by 1‐5% when no cheap abatement
options are available (Forsyth, 2008, Table 3). If the demand for aviation increases, as
generally expected, given that the aggregate elasticity of demand for air travel is rather low
and given that the technological scope for emissions reductions is limited, including aviationin trading systems will probably force the sector to acquire permits in excess of its historicalemissions level. Even if permits are given away for free on the basis of historical emissions,aviation hence will be a net buyer of permits26.
Whether pass‐through is complete depends on market structure (which differs between
routes), on the time‐frame (allowing sufficient time for firms to exit or not) and on whether
airport capacity is scarce or not. We consider non‐constrained situations first. In
competitive markets there is no pass‐through in the short run but full pass‐through after
profitability has been restored through exit. In monopoly markets, pass‐through is
incomplete and depends on the elasticity of demand and of marginal costs. Oligopoly
markets are usually in between those extremes, but it is noteworthy that pass‐through canbe more than 100% in the long run because exit reduces the intensity of competition in themarket. Overall, when capacity is abundant, this suggests that putting a price on carbon
causes a short‐run profitability problem for the industry, but that long‐run profitability is notjeopardised.
In the polar case, where an airport capacity is strictly binding, fares are determined by
the capacity constraint and in many cases will not increase with the introduction of a carbon
price. Instead, scarcity rents will fall by the amount of tax revenue, and flight volumes
remain unchanged. The general lesson is that capacity constraints, whatever their source,
25

Pricing carbon, through trading or taxes, tackles the carbon externality. However, there may beother market failures that affect emissions and require their own solutions. For example, research
into and take‐up of technological innovations may be slower than would be expected in an efficient
market. Such arguments have been made for car transport (cf. Van Dender, 2009, for somediscussion) and may apply in aviation as well.

26

This situation, where airlines buy permits but do not reduce emissions, may generate a problem ofpolitical acceptability in itself (i.e. the least‐cost principle is not necessarily deemed fair by policy‐
makers).

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Summary & Conclusions — Discussion Paper 2009-7 — © OECD/ITF, 2009

tend to limit the extent of pass‐through of carbon costs into fares. Given that such
constraints prevail at many major airports and on some international routes, on average,
fares are likely to increase by less than the cost of carbon. This implies a transfer of rents
from airlines to holders of permits, but the effect on air travel demand and emissions fromaviation is limited. Distributing permits for free potentially reduces the impact of pricing
carbon as well, because it may weaken incentives for airlines to exit certain markets (thelock‐in effect).
The impact of putting a price on carbon on the sector as a whole is expected to be fairly
limited: see, e.g., Forsyth (2008) and Adler et al. (2008) for some estimates. Anger et al.
(2008) use a macroeconomic model to estimate the impact of including aviation in the EU
ETS, and find limited effects: aviation is a net buyer of permits, requiring about 2.5% of thetotal supply of permits; at a permit price of 40€, demand for airline services is estimated to
be 1% lower than the baseline in 2020, while emissions drop by 7.5%. The authors point out
that if permits are auctioned, the revenues should not be recycled to non‐ETS sectors, as thispotentially undoes carbon savings.
Including aviation in the EU ETS affects airlines differentially. The EU plans to include all
flights bound for or departing from the EU in the trading system. This may allow someairlines to improve their competitive position by intensifying the use of hubs close tojurisdiction of the EU ETS, thus limiting the emissions accounted for within the trading
system. More generally, carriers that are mostly active within the EU may see a worseningof their competitive position compared with carriers with a large share of non‐EU operations
in markets where they compete directly, as the latter can cross‐subsidize from markets
where there is no price for carbon.

5. AIR‐RAIL COMPETITION AND THE SOCIAL DESIRABILITY OF HIGH‐SPEED RAIL

Some policy‐makers in the US and especially in the EU are concerned about thesustainability of prevailing interurban and interregional transport patterns. Road and airtransport are perceived to generate excessive emissions of conventional pollutants andgreenhouse gases, and the networks are excessively congested at some times and places.
Given imperfections in road and air pricing to handle external costs, the provision of rail
services is seen as a second‐best policy to increase the net benefits from interurban andinterregional transport. For passenger transport, high‐speed rail is seen as sufficiently
attractive to change the modal split in these markets.
De Rus (2008) questions the general social desirability of high‐speed rail, pointing outthat for a generic high‐speed rail connection the benefits are well below the costs, unless
Summary & Conclusions — Discussion Paper 2009-7 — © OECD/ITF, 200919

rather favourable assumptions are made on demand and costs. The construction of newlines requires a high volume of demand, with enough economic value to compensate thehigh cost involved in providing capacity. It is not only that the number of passengers must belarge, but a high willingness‐to‐pay for the new facility is required as well, i.e. one needs
many users who obtain high benefits when switching mode or travelling more. This suggeststhat careful evaluations of projects are required on a case‐by‐case basis. The benefits fromhigh‐speed rail mainly take the form of time savings compared to other modes, and possiblyof congestion relief in competing modes. Environmental benefits are minor27. In fact, thebenefits are outweighed by the costs (in particular the high fixed costs), except in cases
where there is a high density of demand and there are pressing capacity problems in air androad alternatives28.
The French situation was mentioned as one where capacity in aviation was a crucial
factor in the assessment of high‐speed rail projects. Some French TGV connections brought
about a substantial shift from air to rail29, freeing up scarce capacity (valuable slots) inaviation30. This effect occurs irrespective of whether low‐cost or other carriers mightprovide service between the cities linked by the high‐speed rail connection. Furthermore,since high‐speed rail uses separate facilities, it can also free up capacity for rail freight andfor regional passenger transport. It was noted, however, that in many cases the main
(expected) modal shift in response to a high‐speed rail connection is from road to rail, notfrom air to rail.
Low‐cost carriers might respond to the emergence of a high‐speed rail alternative by
increasing the frequency of service. A similar improvement on the rail side would be very
expensive given the cost of trains, and this would reduce rail’s market share and profitability.
In addition, low‐cost carriers can provide services between regions instead of cities (soavoiding the need to acquire expensive slots at centrally located airports). This is effectively
what happened after the high‐speed rail service between Paris and London opened. The
potential strategic responses from low‐cost carriers reinforce the view that high‐speed rail
may be justified where densely populated origin‐destination pairs exist, but is not a generalmodel for interurban and interregional transport.

27

French studies find that net reductions of CO2 emissions represent 2‐3% of total benefits.

28

With very high densities of demand, costly technologies like Maglev may be justified, as is possibly
the case in the main Japanese corridors.

29

Domestic air traffic in France declined by 7% between 2000 and 2007, and this is mostly (not only)
attributable to the increased availability of TGV connections. Domestic CO2 emissions declined by
23%.

30

The costs of congestion in aviation in most of Europe are difficult to measure because there is active
slot management, so that measurable delays are small. This of course does not imply there is nocongestion.

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Summary & Conclusions — Discussion Paper 2009-7 — © OECD/ITF, 2009

De Rus’ (2008) analysis considers high‐speed rail projects at the level of individual links.
In contrast, Adler et al. (2008) analyse a European network of high‐speed rail connections (a300km/h TEN network and a 160km/h conventional network), where the shape of the
network is determined within the analysis. They find that the TEN network produces net
benefits (and higher benefits than an all‐air network), at least when access charges are
based on short‐run marginal costs (and the train operator maximises profits in a deregulated
environment). If rail is required to break even, the network is not worthwhile. Instead, if
deficits resulting from short‐run marginal cost pricing are financed from costly public funds,
the network passes the cost‐benefit test. The difference between the outcomes of bothstudies is attributable to network effects and to assumptions on pricing rules and budgetary
constraints, and not so much to different assumptions on costs, demand and discounting.

6. CONCLUSIONS

The first part of the paper focused on the question: what are the circumstances in which
airports might have market power and what should be the policy responses? The preferred
policies will be shaped by the underlying economic conditions. For example, when an
airport is congested and competition with other airports is limited, regulation may bejustified, and the dual‐till approach likely works best. In other cases, however, policy should
establish conditions for competition to emerge as much as possible, instead of attempting todesign a general regulatory framework. Since ex‐ante rules and principles cannot reflect thediversity of market conditions, good, evidence‐based analysis is a prerequisite for good
policy‐making.
The second part of the paper discussed elements of climate change policy in aviation.
Including aviation in emissions trading schemes is a sensible idea, but should not be
expected to produce major cuts in CO2 emissions from aviation; containing its growth bydiktat may be more easily realised, but potentially at substantial economic cost. High‐speed
rail is justified in a number of situations, but is not a general alternative for air travel or asecond‐best way to reduce greenhouse gas emissions from aviation.

Summary & Conclusions — Discussion Paper 2009-7 — © OECD/ITF, 200921

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