JOINT TRANSPORT RESEARCH CENTRE

Discussion Paper No. 2009-10
May 2009

Regulation of Large
Airports: Status Quo andOptions for Reform
Hans-Martin NIEMEIER
University of Applied Sciences
BremenREGULATION OF LARGE AIRPORTS – STATUS QUO AND OPTIONS FOR REFORM

Hans-Martin NIEMEIER,
University of Applied Sciences, Bremen∗“Practice, which is evolving rapidly, continues to outstrip theory, providing challenges to theprofession in modelling, testing, and proposing superior and workable alternatives.”(Newberry, 2003)

Executive Summary
Over the last 25 years the governance structure of airports has changed in many parts of theworld. Privatisation and commercialisation of airports together with the intense airline competition
have put the airline/airport relationship under stress. The OECD has invited all stake holders toengage in a rational dialogue on airport regulation. Economics can provide criteria for such a
dialogue. Regulation should be designed to increase economic welfare in a fair anddemocratic process.
•Airport users should be protected from prices above competitive levels.

•

Airports should produce technical and cost efficiencies.

•

Airports should ration demand efficiently.

•

Airports should invest an optimal amount.

•

Regulation should be based on a legislative democratic mandate and should not be
dependent on special interests.

•

The regulation should be a fair, accessible and open process without high bureaucraticcots.

Currently airports do not perform well in terms of cost efficiency, allocative efficiency andinvestment behaviour.

∗

2

•

There is evidence of poor cost control, particularly at partially privatised airports. The
cost reducing potential of outsourcing terminal operation and ground handling has notbeen fully exploited, particularly at many European airports.

•

Allocative efficiency requires different
characteristics and capacity utilization.

pricing

regimesdepending

on

cost

School of International Business, Werderstr. 73, 28199 Bremen, Germany,
Email: Hans−Martin.Niemeier@hs-bremen.deNiemeier – Discussion Paper 2009-10 - © OECD/ITF, 2009

•−For airports with ample capacity, weight based landing fees are not correlated to
runway damaging costs. The weight based structure is an imperfect Ramsey pricing
scheme. Both imperfections lead to an inefficient traffic mix.

−

At capacity constrained airports capacity is rationed inefficiently. While the IATA
system does not rely on queuing like the US system, it does not confer slots to usersthat could make the highest productive use of them. Market based slot allocation
could result in double-digit billion welfare gains in Europe. Currently the slot limit is
not set at a level where the marginal congestion costs equal the value of anadditional slot. Most busy airports have kept their traditional weight based charges.
This discriminates against large aircraft resulting in an inefficient traffic mix. A
uniform charge per movement would be appropriate.

Over-investment occurs in areas with lack of demand and under-investment at places
with excess demand. This may be due to the non existence of price signals for excess
demand as well as a lack of cost benefit approach at airport expansions.

Market power can arise from a locational monopoly, as it is often not possible to build
airports next to a gateway airport due to planning restrictions. Another reason might be that
airports are natural monopolies with sunk costs. Empirical evidence suggests that economies
of scale might range from 3 to 12 perhaps even 90 million pax. It seems that market power is notheld by the airport industry, but by some airports. Regulation must be complementary to a slow
developing process of competition and not restrictive.
However, the intensity of competition even in Europe is not strong to make regulation
completely redundant. The intensity of hub competition is limited by the high switching costs forairlines due to specialised investment and non-tradable slots. Competition between hub andsecondary depends on traffic rights, aircraft technology and hub congestion. If catchment areas
overlap, as in London or Bratislava/Vienna, competition might work well. The strength of airport
competition has to be assessed on a case-by-case basis. It could be intensified by horizontal
disaggregation of BAA, ADP and preventing airport alliances (ADP/Schiphol) and open skies.
If competition is often not strong enough, regulation is an important tool to increase
economic welfare and needs to be assessed.
•

Regulatory institutions need independence and democratic control like in the UK. The
vast majority of European countries lack independent regulatory institutions, anindication of high internal rents as a dependent regulator undermines the position incase of conflicts with airlines.

•

The scope of regulation is both too narrow and too large. It is too narrow in that thecentral infrastructure for ground handling is not covered. It is too large in that potential
competitive activities are indirectly regulated by the single till principle. At busy airports,
single till results in too low a level of airport charges and rents for slot owners.

•

Cost-based regulation is dominant in Europe and elsewhere. It results in incentives forgold plating, high costs and inefficient price structures leading to allocative inefficiency. It
is a major cause for the poor performance of airports.

•

Although price caps are used only in hybrid forms, which set the cap on the cost baseat the beginning of the regulatory period, they have substantially lowered price levels inAustralia, UK and at some European airports. Price caps leave the structure of charges
unregulated, setting incentives to balance price structure in the direction of efficiently

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rationing peak and excess demand. Hybrid caps could be improved by benchmarking,with better data adjusted for the heterogeneity of airports.
•

Monitoring is practised with mixed results in Australia and New Zealand. A major
weakness is that the objectives are not clearly defined, with the risk of being practised
as a loosely defined cost plus regulation. It needs an independent regulator with
sufficient power to provide a credible threat to re-regulate.

•Investment regulation is of growing importance as major airports face persistentexcess demand. The regulation of airport investment becomes more complex as prices
do not carry information on the strength of excess demand. Slot rents are theconsequence of scarce capacity and accrue to airlines under current slot allocation
rules. Airports and regulators are ignorant of slot prices. Additional capacity often comesat a higher cost. Price caps must allow for higher charges and can lead to optimal
investment but do not necessarily achieve it. A price cap might lead to underinvestment
if when regulators fail to provide credible guarantees against opportunistic behaviour.

•

Regulation must be designed to be compatible with airport competition. Therefore itis necessary to establish independent regulators in order to avoid regulatory capture andcreate a fair playing field. Cost regulation as well as cost-based monitoring and revenue
sharing agreements are not compatible with competition. These should be reformed as
pure price caps which allow firms to react to competition by changing the price structure.
Price caps set upper limits but firms can also lower price levels in order to compete.

In a nutshell, airport regulation is in need of reform. Regulate less, but more effectively, withfair and democratic processes and institutions. Use a credible threat of regulation. Second,
regulate and increase competitive forces. Implement simple price caps with strong incentives forcost savings and efficient pricing and investment. Design a competitive landscape with open
skies, less horizontal integration and slot markets.

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Introduction
Over the last 25 years, the governance structure of airports has changed in many parts of
the world. Today airports are no longer a homogenous group of public utilities, but aheterogeneous group with ownership structures ranging from state-owned to partial and even fullprivatisation, with regulatory systems ranging from cost regulation to price cap and even tocomplete deregulation and with different degrees of competition, ranging from pure monopolistic
to oligopolistic markets. Airports, even publicly owned airports, have become morecommercialized and more profit oriented. Thus, the upstream markets within the vertical airtransport supply chain followed the trend set by the downstream markets, as the airline industry
underwent these changes earlier and many (“downstream”) air transport markets are now
characterized by fierce competition between airlines (Winston and de Rus, 2008).
These changes have put the airline/airport relationship under stress. The vertical relationshipof the aviation industry does not resemble the smoothly operating supply chains of otherindustries, but more like the opposite of a perfect supply that chain managers learn to operate intheir MBA courses. It has lead to a heated debate over airport regulation and the rules that
determine the quality, quantity and price of airport services for airlines. IATA claims that airports
are natural monopolies which are ineffectively regulated and which “are exploiting, in manycases, their natural monopoly position” (IATA, 2007, p. 2.). The ACI response to this is that
airports are a competitive industry which should not be regulated at all. The Association ofGerman Airports argues for example that today, in Germany, “airports are in tough competition
and therefore the level of airport charges is determined by market mechanisms” (translation byauthor) (ADV, 2007, p 2).
The OECD has taken up this issue and asked for some scientific guidance. The objective of
this paper is to provide criteria, information and concepts for an objective discussion anddialogue between airports, airlines, regulator, governments and the general public but withspecific reference to gateway airports. The focus is on gateway, airports which provide access toa country for international passengers and/or cargo. Therefore the analysis confines itself to theregulation of hubs and secondary airports. The latter are included because they provide somecompetition to hubs, although they are not gateways in the strict sense. On the contrary, no small
airports, nor those that serve only regions with a small population density, nor secondary ones
within metropolitan regions, will be considered.
In the first section the paper develops the criteria to evaluate regulation. It then provides an
overview on the performance of airports. In the third section rationale for airport regulation are
discussed. Thereafter the alternative to regulation will be analysed. Can competition among
airports substitute regulation, or is the competition between gateway airports not sufficiently
intense? In the fifth section, the strength and weaknesses of different regulatory regimes areevaluated and options for a reform are discussed. The paper closes with a summary.
1.

Criteria for a dialogue on airport regulation

In a dialogue on airport regulation airlines, airports and other partners of the aviation industry
argue from their own perspective and self-interest. This is not to be criticized or evencondemned, as market economies rely on self-interest and managers rent seeking as a normal
process of maximizing shareholder value. However, entering a dialogue on public policy implies
that it is not sufficient to argue only in one’s own interest, as a particular proposal might bebeneficial to one party but more costly for another. Therefore it is necessary to define criteria for
a rational dialogue on airport regulation which are acceptable to all parties and to which not only
lip service is paid.
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Regulatory economics provides here a widely shared set of criteria (see Baldwin and Cave,
1999; Brunekreeft and Neuscheler, 2003; Forsyth, 1997; Kunz, 2000). The basic idea is that
regulation should lead to the same results as perfect competitive markets. It will later become
obvious that regulation can only achieve such results if regulators are perfectly informed, which
they are typically not. Although only second best solutions are feasible this does not make thecriteria useless as they define what a perfect system might achieve. Similar competition is not
perfect in most industries, but competition policy tries to correct these imperfections to achieve
outcomes for competitive markets.
The criteria of airport regulation consist of a set of economic welfare and institutional criteria.
Economic welfare
Airports maximize economic welfare under the following conditions:
A. Airport users should be protected from prices above competitive levels. Charges should
be set at marginal cost or, if marginal costs are below average costs, at prices
minimising the welfare loss.
B. Airports should produce technical and cost efficiencies; that is, they should use only theminimum of resources to produce a given level of output, and should select from thesetechnical efficient combinations those which minimize the cost of producing this output
level.
C. Airports should ration demand efficiently. If demand exceeds capacity, output should be
distributed to those with the greatest willingness to pay.
D. Airports should invest an optimal amount; that is, the marginal benefit of additional
capacity should equal its marginal costs.
In order to maximize economic welfare, it is necessary to price environmental externalities
correctly. As this paper confines itself to economic regulation it does not deal with this issue andleaves it to environmental regulation. But it should be noted that at many large airports
environmental externalities are ineffectively priced, leading to the problem of political acceptancefor urgently needed new capacity (Gillen, 2000 and Niemeier, 2000).
Fairness and democratic acceptance
Regulation is a process in which the involved parties interact with each other and with theregulator. This process presupposes some notion of fairness and democratic acceptance1.
Regulation should fulfil the following criteria (Baldwin and Cave, 1999, Vass, 2005):
A. Legislative mandate from elected legislature. Parliament should define objectives ofregulation, such as above economic criteria.
B. Independency and accountability to democratic bodies. The regulator should not be
dependent on special interests. The function of regulator and ownership should be
separated. Parliament should control the regulator if he fulfils his statutory obligations. It
should not intervene directly in day-to-day business.
1.

6

In this context fairness is not defined by the outcome. The outcome should be efficient, as defined
above.

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C. The regulation should be a fair, accessible and open process. It should be carried out
with expertise and aim at appropriate non-biased decisions.
D. The legislative mandate is efficiently implemented without high bureaucratic costs.
These criteria are widely shared2. The European Union and many other jurisdictions haveaccepted the criteria of efficient pricing in their principal concept of transport policy in general,and their airport policy in particular (European Commission, Transport Directorate, 1995).
2.

How have airports performed?

Given the above criteria for economic efficiency, the question arises as to how well or poorly
airports perform. This is a question which has only recently been studied by economists becauseof the changes in government regimes. These changes which make the airport industry sointeresting for economists also make performance analysis so difficult.
2.1.

Evidence on Cost inefficiencies

Obviously airports differ from one another depending on the economic characteristics of themarkets they serve (and the markets which serve the airports) and the institutional framework
within which they have to provide their services. Cost inefficient production might not always be
due to bad performance by airport management; it may also result from imperfect markets andgovernment regulation. For example inefficiency may result from:•

Legal and structural barriers to market entry that prevent competition (see section 3).

•

Inadequate ownership structures that create inefficient incentives for management.

•

Inadequate regulatory rules (e.g. how to provide security) that force management toproduce inefficiently.

•

Low-density hinterland that the airport serves which prevents management from fully
exploiting potential economies of scale and density.

•

Operational and environmental factors such as unattractive location, scarcity of land,
bad weather and inefficient, but costly, environmental constraints.

Some of these factors are beyond the control of management and politics either in the short,or long, run. For example, the takeoff and landing system is beyond managerial control in the
short run, but in the long run it can be changed. Noise problems might be mitigated in the shortrun by noise surcharges, and in the long run by land use planning. Measuring efficiency requires
a lot of data, particularly in order to establish the causes of inefficiency. Data problems are noteasy to overcome; the measurement of capital and the degree of vertical integration being
particularly difficult.
A number of studies attempted to measure airport performance using different methods3 to
try to control the differences between airports that may have an effect on airport performance but
2.

It should be noted that objectives such as fair sharing of revenues, strengthening international
competitiveness and creation of new jobs are not appropriate criteria for a dialogue on airport
regulation, as they create unintended consequences which result not only in less efficiency andwelfare, but sometimes even in higher unemployment and loss of competitiveness.

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which are outside the control of management (for an overview see Kamp et al., Francis, et al.
2002). Of particular interest here are studies that take into account governance structures thatvary between airports•

While Parker (1999) found no impact on the technical efficiency of BAA airports prior to,
and following, privatization, Hooper and Hensher (1997) for Australian airports, andBarros and Dieke (2007) for Italian airports, show that commercialisation andprivatization improves performance.

•

Oum et al. (2006, 2008) compared worldwide airports with different ownership structuresand concluded that public and fully privatised airports operate more efficiently than otherownership forms. Interestingly, the Continental European model of partially privatised
airports failed.

•

The Air Transport Research Society (ATRS 2008) investigated the impact of different
management strategies. By outsourcing of services such as the operation of terminals
airports achieve higher efficiency scores. Substantially different degrees of vertical
integration can be observed between Europe and North America. Whereas the terminal
operation and often ground handling is provided by the airport operator (e.g. Germany),
both activities were contracted out in North America leading to higher performance
ratings. Of course, there are large differences among European airports: German
airports have so far achieved only low ranking (for a discussion see Kamp, et al. 2007).

Studies on the effects of privatisation on performance have not isolated the effects ofdifferent forms of economic regulation supporting or rejecting the hypothesis that incentive
regulation tends to improve the airport’s efficiency rather than cost-plus regulation. Here, further
research needs to be done.
2.2.

Allocative inefficiency

Allocative efficiency requires that airport services are correctly priced. This requires different
pricing regimes for airports depending on their cost characteristics and their capacity utilization.
Two broad cases can be distinguished. Airports might have ample capacity and have to cover
fixed costs. Alternatively airports might have scarce capacity, either at peak times or all day long.
Efficient pricing requires different price structures and levels (see below for the leading two
regulatory cases). The evidence is that airports are inefficiently priced, in particular because
airports have a weight-based landing fee and do not change the price structure should demandand cost conditions change.
Because of lumpy investment the demand curve might cut the average long-run costfunction in the range of falling average costs (see below). Such airports have ample capacity and3.

The underlying quantitative methodology varies with some studies using parametric approaches
such as Stochastic Frontier Analysis (SFA) to estimate a production or cost function. For simplicity, agreater number included the non-parametric Data Envelopment Analysis (DEA), which constructs
the efficient frontier with linear programming. A limited number of studies focused on Total Factor
Productivity (TFP) using index numbers because input prices, in particular capital of, are rarely
available for airports. The selection of inputs and outputs is different according to the data availability
and research focus. Some studies include only physical data, such as the number of gates as an
input and the number of passengers as an output, whereas other studies prefer to incorporate
financial measures, such as operating costs and revenues.

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no rivalry exists for the users. For such airports first best marginal pricing is not feasible as
marginal costs are below average costs. Airports must adopt second best pricing; that is, setting
price and quantity at a level that maximize economic welfare subject to the airport at least
breaking even. For simplifying the case of independent demand, the Ramsey rule is that the
airport should mark up the price above marginal cost inversely to the price elasticity of demand.
The traditional weight-based system can be interpreted as an attempt to find such a second bestsolution, because larger aircrafts with lower price elasticity pay more than small ones. However,two inefficiencies arise:•

Hogan and Starkie (2004) show convincingly that weight is not correlated to thedamaging cost of the runway, taxiway and apron pavement and hence does not reflectmarginal damage costs.

•

The current weight based structure is an imperfect Ramsey pricing structure (Morrison,1982) as “current fees increase too rapidly with aircraft size” and “do not increase with
distance flown by the aircraft.” (ibid., p. 158, see also Martin-Cejas, 1997).

Both imperfections lead to an inefficient traffic mix and use of capacity with repercussions in
the airline and aircraft manufacturing market. However, these welfare losses are smaller4 than
the welfare losses at busy airports.
There are growing numbers of busy airports which face excess demand for a small part ofthe day, and very busy airports which face excess demand all day long. In both cases, rivalry
exists for the users and the problem arises as to how to ration demand for a given capacity.
Allocative efficiency requires that scarce capacity should be given to those airlines with thehighest willingness to pay and that, assuming intense airline competition,5 will make the bestproductive use of it. Excess demand can be either efficiently rationed by price or by quantity.
Another option is to ration inefficiently through queues and administrative measures. So far,airports have implemented only inefficient options.
At most US airports charges are weight based and, unlike in Europe and elsewhere, scarce
capacity is given on a “first come, first served” basis. At high density airports, national (notinternational) slots are allocated through a secondary trading system in combination withadministrative measures. Overall, this system has performed inefficiently. Morrison and Winston(2005) estimate an annual welfare loss of $ 6 billion for US-airports. While there is debate overthe correct level of congestion charges, economists agree that peak and congestion pricing is
one option to increase efficiency (Brueckner and Van Dender, 2008; Czerny et al. 2008).
In other parts of the world, airports have adopted the IATA slot allocation system. It has theadvantage that congestion is not inefficiently rationed by queuing. This leads to less welfare
decreasing congestion than the US system, as it coordinates ex-ante flights, but generally theslots are not given to users with the highest willingness to pay. In a study for the EU Commission,
Mott Mac Donald (2006) estimated that secondary trading would lead to 7,2 % more passengers,
17.1 % more revenue passenger kilometers and 51.6 Mio more passengers, resulting in a gain in
consumer surplus of + € 31bn and producer surplus + € 1.2 bn at current rates in 2025. It istherefore necessary to reform the distribution mechanism through such methods as welldesigned auctions and secondary trading. While this aspect has been intensively discussed two
perhaps equally important factors of efficient rationing have been overlooked. An efficient
4.

The welfare loss due to imperfect Ramsey pricing is small relative to the loss due to costinefficiencies if demand is inelastic in countries with a low density of airports, such as New Zealand.

5.

See Gillen and Morrison (2008) and Starkie (2008c)

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allocation of given capacity requires, besides an efficient slot allocation mechanism, the correct
choice of slot capacity and an efficient structure of airport charges. Currently, the slot limit at
airports is set by some administrative process involving airline and airports. The authorities willseek to provide enough capacity at an acceptable level of delay. Most likely it will not be set at an
efficient level, where the marginal congestion costs equal the value of an additional slot (Forsythand Niemeier, 2008). Most busy airports have kept their traditional weight-based charges. This
discriminates against those airlines which can use scare slots efficiently. In particular, large
aircraft pay relatively more than small aircraft, causing an inefficient mix at busy European hubs.
A uniform charge per movement in the case of excess demand would be efficient. Unfortunately,
few airports have adopted such a charge (Forsyth and Niemeier, 2008).
2.3.

Suboptimal investment

The inefficient allocation of given capacity has important implications for the long-term
adjustment from building new airports and expanding existent ones. In both respects the airport
industry has not performed well. There is abundant capacity in areas with lack of demand andunderinvestment in those with excess demand. This is a situation which has persisted overdecades, has become more severe, and has created a bottleneck for the rapid expansion of airtransport (Button and Reynolds-Feighan, 1999; Eurocontrol (2006); Morrison and Winston 2008).
In competitive markets, excess demand drives prices up, makes these activities profitable
and signals the level and timing of adjustment. This has obviously not happened in the airport
industry, and relates very much to short term inefficiencies. There are no prices reflecting shorttime excess demand. Peak and congestion pricing is generally not practised by airports. Slots
are traded at no European airport with the exception of London. While trading there seems towork well, prices might be still inefficient due to arbitrary slot constraints and an inefficient
structure for charges.
The current IATA system has another negative implication. It breaks the linkages between
short- and long-term adjustment. It has created rents which do not fall to the airport, but to theairline companies. Some of these rents must have been dissipated and used forcross-subsidizing unprofitable routes or higher wages, as the major slot holders are not very
profitable (Forsyth, 2008). The system has also created a quite stable coalition of slot creating
airports and rent seeking airlines which, so far, has stopped any effective reform of airport
pricing. Busy slot creating airports have abstained from efficiently pricing their assets and instead
engaged in a political process of capacity expansion. The question of airport expansion is apolitical question, as it involves the assessment of environmental externalities such as noise andother local emissions. In this political process many airports have developed a “predict andprovide” strategy based on the logic of “jobs versus the environment” (ACI, 1998). Airports hopethat high growth promises, based on optimistic forecasts and employment effects generated by
input output models, will lead to an acceptance of the negative effects of growth − namely noiseand pollution − in the neighbourhood. However, such a strategy is logically flawed because
expansion is a question of social net return on investment, which cannot be answered by input
output analysis, but only by Benefit-Cost-Analysis. The strategy of airports, therefore, is veryrisky as not only the economics of airport extension but also the politics of airport extension
become irrational. It is doubtful whether a political consensus on airport expansion will evercreate an optimal amount of capacity for airports (Niemeier, 2001).

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Why regulate airports?
There are basically two6 rationales: a theoretical and a more pragmatic one.

The pragmatic one argues that for most airports there are no close substitutes, as attractive
locations are limited (Forsyth, 1997). It seems next to impossible to build a competing airport next
to hubs like Frankfurt or Paris airports. Such airports have a de facto monopoly reflecting
planning and environmental restrictions, and they have market power in the provision of aviation
services which should be regulated.
The theoretical rationales are rooted in the general theory of market failure applied to public
utilities and to airports (for an early treatment see Bator, 1958; for a recent textbook treatment
see Church and Ware, 2000). Airports might have such production and cost characteristics thatcompetition cannot work because they are natural monopolies that is an industry “whose costfunction is such that no combination of several firms can produce an industry output vector as
cheaply as it can be provided by a single supplier” (Baumol et al. 1977, p. 350). For the simple
case of a single product (see Figure 1) this is the case if the demand curve D intersects the longrun average cost curve LRAC in its decreasing part and because a portion of the fixed costs of
airports are sunk.7 In such a case, the airport which could attract more traffic realizes economies
of scale due to density, and would have such a cost advantage that it would drive out the otherairport and have a monopoly. As a new airport requires specialized investment while the capitalcosts of the incumbent monopolists are sunk, this airport cannot be challenged by a new entrant.
Such a natural monopoly is efficient as two or more airports would lead to higher average costs,
but the efficiency gains might be lost due to market power. A profit maximizing airport would
charge prices well above average costs. Therefore the market power of the natural monopolist
has to be reduced either by public ownership or, in the case of a private operator, by a regulator.

6.

Positive network effects are another factor which has been discussed, but which is not very wellresearched. There are benefits to airlines and passengers to concentrate their operation at one
airport, thereby creating economies of density due to higher frequencies, larger aircrafts and joint
usage of common facilities such as lounges. As part of these costs are sunk costs e.g. costs ofbuilding up hub operations for the airlines, lock-in effects might occur and switching costs might besubstantial. Although there are no estimates on this entry barrier they should not be overlooked. It
may be that such positive network effects “create a more significant barrier to entry than do airport
supply characteristics” (Australian Productivity Commission, 2001, p. 105)

7.

The concept of a natural monopoly can be extended for the case of multiproduct firms (see Baumolet.al. 1997). Economies of scope occur when it is less costly to produce different services jointly
than separately. However there are few estimates on the strength of economies of scope in the
airport industry. It is plausible that economies of scope might arise from the use of runways forscheduled, charter and freight traffic as well as from jointly offering aeronautical services (Australian
Productivity Commission, 2001, p. 102) Furthermore, rising average costs are consistent withnatural monopoly (see, the discussion on weak natural monopoly in Church and Ware, 2000, p. 759)

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Figure 1. Natural Monopoly

Cost(Dollar per cent)D
LRAC of
Smaller Firm

LRAC ofMonopoly

LRAC
D
Output smaller Industry
Firm
OutputOutputBoth rationales have to be carefully applied and thereby face major challenges. The
pragmatic one faces the problem that it might misinterpret the performance of an airport. The
profits of an airport might not reflect monopoly, but locational rents. It is not easy to disentangle
location and monopoly rents, as planning restrictions might result from successful rent seeking of
public or private airport operators. Nearby public airports are very often kept in one hand, whichmight reflect a preference for less competition. Private investors demand that the public should
not allow new airports to be operated within the catchment area. As economists have traditionallytaken planning decisions as given, these questions have not been well studied.
The theoretical rationale must acknowledge that there is no clear evidence on the shape ofthe long run cost function. Therefore estimates differ substantially at what level economies ofscale are exhausted (see below table 1). Average costs might fall up to a level between 3 and12.5, or even up to 90 million passengers, and hubs might experience diseconomies of scale.
Furthermore, it is unclear if the cost curve is very flat so that the cost disadvantages of small
airports may not be so large.

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Table. 1. Economies of Scale at Airports
Study
DoganisandThompson(1973)
Tolofari etal. (1990)
Doganis etal. (1995)

Salazar dela Cruz(1999)
Main, Leverand Crook(2003)

Observed
period1969-70

Sample of
Airports
18 UK airports

WLU

Parametric

L-shape cost curve withdecreasing average costs up to
three million.

1979-1987

7 BAA airports

WLU

Parametric1993

25 airports
thereof 12
European
airports
16 Spanish
airports

WLU

Parametric

Economies of Scale until 20.3
million WLU
L-shape cost curve withdecreasing average costs up to
five million

Passenger

NonParametric1988 –2001

27 UK airports

WLU andpassengers

Parametric

1993-95

Output

MethodMain, Leverand Crook(2003)
Pels (2000)

1998- 2001

44 airports of
TRL data set

WLU

Parametric

1997

35
European
airports

NonParametric

Vogel(2005)

1990
1999

Air traffic
movements(ATM) and Air
Passenger
Movements(APM)
Passenger

Jeong(2005)

2003

94 US airports

WLU andpassengers

Parametric

Martin andVoltesDorta(2007)

1991-2005

41 worldwide
airports

ATM and WLUParametricto47
European
airports

NonParametric

Results

Decreasing average costs up to
3.5 million passengers,
increasing from 12.5 million
Sharp decreasing costs up to
4 million passengers and5 million WLU and weakdecreasing costs up to
64 million and 80 million
passengers.
L-shape cost curve withdecreasing average costs up to
90 million WLU
Average airport with 12.5 Mio.
APM passengers and 150 000
APM operates under constantreturns to scale for ATM andincreasing returns for PTM.
Increasing economies of scaleof up to 4 million terminal
passengers
Economies of Scale present
until 2.5 million pax or 3 million
WLU
Economies of scale do not
exhaust at any output level

It may also be the case that airport policy may change and new planning regimes mightallow entry. ‘Natural’ does not mean that circumstances never change. Many former public
utilities, especially within the aviation sector, have been transformed into competitive firms. The
production technology can change and, in particular, the demand curve might shift to such a levelthat two or even more airports can be sustainable. Liberalization may be possible and could leadto substantial welfare gains (Winston, 1993)
These problems have important implications for the design of regulation. First of all, it isimportant that the airport industry as a whole has market power, but only some airports havemarket power. Second, regulation should carefully assess the industry structure with their
particular circumstances. If, for historical reasons as in the UK, there are many former military
airports in one region and the public gives them for free to private investors, economies of scale
are not an issue and airport competition might work so that regulation is only temporarily
required, if at all (Starkie, 2008). However, this might be not the case in many regions of the
Niemeier – Discussion Paper 2009-10 - © OECD/ITF, 200913

world. Therefore, in the third place, regulation must be complementary to a slowly developing
process of competition. A form of regulation should be designed which can be combined withcompetition. Finally, the rationale for regulation must be revisited in time: is it necessary at all?
Which airports should be designated and which airports should be subject to the threat ofregulation?
4.

How strong is airport competition?

With liberalization of the airline market and the commercialisation and privatisation of
airports, competition between airports has certainly begun to develop in many parts of the world.
It has taken many forms (Air Transport Group Cranfield, 2002, Forsyth, 2006). In particular, lowcost carriers are now serving many airports which did not play any role at all. Today, many small
airports are competing for this type of traffic (Lei et al., 2009). For some regions, such as the
Manchester/Liverpool region or the Düsseldorf/Cologne region, airport competition has become(or at least could be) so intense that regulation is not necessary (Starkie 2008, Malina, 2009). In
Australia, New Zealand (Forsyth, 2009c) and Greece (Papatheodorou, 2009) the distance
between airports is too large. For gateway airports four forms of competition8 are relevant.
a) Hub competition: Passengers and shippers can choose between different airlines to fly
through different hubs to their long haul destination. Airports compete through theairlines to win this traffic. The intensity of hub competition has with a few exceptions(Schiphol versus ADP, Heathrow versus Gatwick) not been intensively studied(Burghouwt, G. and Veldhuis, J. (2006). If hubs were close substitutes, hub airports
could easily win new hub carriers. While in the US some airlines have switched hubs,
Europe has relatively stable hub and spoke networks (Burghouwt and de Wit, 2005).
Hub competition is limited by a relatively high switching cost for airlines because hub
operation is a specialised investment. In some cases air service agreements restrict
traffic rights, making switching unattractive. Most relevant, as many hubs are slot
coordinated, slot trading is not possible so that airlines are locked in (Wolf, 1999).
Nevertheless, the alliance of Schiphol and ADP is an indication that airlines might shifttraffic and airport managers try to reduce this competition (De Wit 2009, Forsyth et al.,2009) Overall, hub competition is currently rather limited − partly because regulation of
air service agreements prevents it from realizing its potential.
b) Hub and secondary hub: The intensity of competition (for example Heathrow versus
Manchester, Fraport versus Munich versus Stuttgart versus Düsseldorf versus
Hamburg) depends in particular on traffic rights, aircraft technology and hub congestion.
Traffic rights may play an important, but very often underestimated, role. In many
countries, particularly in Europe, only certain airports were designated as landing points
in air service agreements. They gained economies of scale and scope in the past andare today offering high connectivity. Although today open sky agreements are not asimportant, as landing points are no longer specified (with the notable exception of
Stuttgart airport in the bilateral with the United Arab Emirates) secondary airports are ata disadvantage (Gillen et al., 2000). So far, no secondary airport in Europe has becomea major hub − which might have happened if competition were intense.

8.

Airports are competing in other markets with other firms. The shopping mall of an airport competes
with a the local shopping mall How this affects competition among airports and how it might restrain
monopoly power are questions demanding further research. See Starkie 2001 and 2002, Gillen,
2009

14

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c)

Primary and secondary airport: There are few regions where a relatively large airport
competes against a mid-sized secondary airport. For example, most recently Luton won
traffic from Stansted (Starkie, 2009c). Vienna and Bratislava are competitors, indicatedby the attempt of Vienna to buy Bratislava which was blocked by the Slovak Competition
Authority (Forsyth et al. 2009). Overall, this type of competition is currently not strong
enough as airport products differ and access costs might be high (Forsyth et al. 2009).

d) Potential competition: In competitive markets with strong growth and persistent excess
demand, entry would occur and competition would be intense. In Europe, only a few
market entries were observed but not in areas with strong demand − with the exceptionof Manchester (Müller-Rostin et al., 2009). Unlike the airline industry, potential
competition has no disciplinary force.
In summary, Forsyth (2009) is certainly correct in his review on European airport competition
that “there does not seem to be much evidence of strong competition between the airports of
medium to large cities”. The intensity of competition even in Europe is not strong enough to makeregulation completely redundant. However, it is necessary to assess the forces of competition ona case-by-case basis. Such an analysis should include the different types of traffic, for example
cargo versus passengers and intermodal competition from high speed trains (see Mandel, 1999
and Kouwenhoven, 2008). It should also include the potentials of competition by horizontal
disintegration in cases like BAA and ADP (see Starkie and Thompson, 1985), abstaining fromalliances such as ADP/Schiphol Alliances, further liberalisation of air service agreements and byslot trading.
5.

How to regulate airports?

As competition is currently not strong enough to limit the market power of airports in such a
way that airports become cost and allocative efficient, the question arises if effective regulation
can achieve this. Given the cost, but more important the allocative inefficiencies of airports (seesection 2), regulation of airports might be more complex than regulation of other public utilities.
Regulation is very often thought of as reducing the level of prices and thereby forcing the firm tobecome more efficient. This is certainly also an issue with airport regulation as airports show
signs of gold plating and too high costs. But regulation of airports faces another problem.
Reducing the level of charges at busy airports will increase the excess demand. Therefore
regulation of airports faces the additional problem of rationing demand efficiently and setting
incentives for investment. Hence the structure of charges, the allocation mechanism and the
incentives for investment become a major issue for airport regulation.
This section analyses the strengths and weaknesses of airport regulation by analysing theinstitutional design of regulation, its scope, the different types of regulation, and specific problems
such as incentives for optimal investment. Finally, the relationship between competition andregulation will be discussed.
5.1.

Institutional design of regulation

The issue of good governance has been a major economic issue in developing countries
but, surprisingly, when it comes to airport regulation in industrialized countries it remains an issue(for US airports see Morrison and Winston, 2008). The regulator and also the monitoring agency9
should be independent but accountable to democratic bodies and regulation should be a fair,
9.

Independency is important for all types of regulation, in particular for monitoring. See 5.3. below.

Niemeier – Discussion Paper 2009-10 - © OECD/ITF, 200915

accessible and open process. These self evident principles have not been widely practised inEurope (see below) and are therefore part of the new directive on airport charges.
Table 2. Regulation of large European Airports, 2007
Rank

City

Code

PAX
Mio

RegulationFormsingle/dual till

Regulator

Private
share
%
100

1

LONDON

LHR

68,1

Incentive

single till

independent

2

PARIS

CDG

60,0

Incentive

single till

dependent

32.5

3

FRANKFURT

FRA

54,2

cost based

dual till

dependent

47.2

4

MADRIDMAD

52,1

Cost-based

single till

dependent

0

5

AMSTERDAM

AMS

47,8

cost based

dual till

independent

0

6

LONDON

LGW

35,2

Incentive

single till

independent

100

7

MUNICH

MUC

34,0

Cost-based

single till

dependent

0

8

ROME

FCO

32,9

Cost-based

dual till

dependent

97

9

BARCELONA

BCN

32,8

Cost-based

single till

dependent

0

10

PARIS

ORY

26,4

Incentive

single till

dependent

32.5

11

ISTANBUL

IST

25,6

Cost absed

n.adependen

14

12

MILAN

MXP

23,9

Cost-based

dual till

dependent

0.88

13

LONDONSTN

23,8

Incentive

single till

independent

100

14

DUBLIN

DUB

23,3

Incentive

single till

independent

0

15

PALMA DEMALLORCA

PMI

23,2

Cost-based

single till

dependent

0

16

MANCHESTER

MAN

22,7

Incentive

single till

independent

0

17

COPENHAGEN

CPH

21,4

Incentive

dual till

dependent

77.3

18

ZURICHZRH

20,7

no regulation

19

OSLO

OSL

19,0

Incentive

single till

dependent

0

20

VIENNA

VIE

18,8

Incentive

dual till

independent

50

42

Source: 2007 ACI-EUROPE, GAP data base.

So far, independent regulators have been established only in Austria, Ireland, theNetherlands, and the United Kingdom. Interestingly, very often countries are privatise their
airports without addressing clashes of interest. In Austria, Vienna airport was privatised in threesteps in 1992, 1995 and 2001. Up to the last step the central government held a major share andregulated the airport charges (for further discussion see Wolf, 2003). German airports are
regulated by the federal states that have a minority or majority share in the partial privatised
airports of Frankfurt, Hamburg and Hannover (Müller et al., 2008).
A fair, accessible and open process requires at minimum a consultation process. In thepast 15 years, an increasing number of European states have implemented a consultation on
airport charges, and today it has become standard (ACI, 2003). There is still room for
improvement, as often the airports fail to provide the necessary information to make a decision
on airport charges transparent and plausible to the airlines. The standards of transparency in UK

16

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regulation, with parliamentary control and openness for the general public, are rarely met incontinental Europe. One example is the recent price cap regulation of Aereports de Paris, inwhich key figurers such as the value of the regulated asset base were not made public (Morgan
Stanley, 2006, p. 4). It is also reflected in the minority share Lufthansa holds in their main hub
Frankfurt in order to be better informed.
Given the likelihood of more intense conflicts between both parties, a dependent regulator
undermines the position of (in particular privatised) airports. Therefore, the lack of support frommany European airports for independent regulators is surprising and can be explained as byshort sighted behaviour, a lack of incentives or as an indication of high rents. All these
explanations are clearly signs of inefficiencies and show how important it is to avoid regulatory
capture (Stigler, 1971).
5.2.

Scope of regulation

Regulation should be confined to those activities in which the airport has persistentmonopoly power. This is the case where the airport services are essential for downstream users
and cannot be duplicated without substantial costs. Traditionally, the starting and landing systemwith the apron and the passenger and freight handling terminals are regarded as such services.
Non aviation activities and ground handling are seen as activities in which the airport might havesome market power, but at least potential competition could discipline the airport (Kunz 1999b,
Templin, 2009). Liberalization of ground handling allowed self handling and third party providers
to enter the market. Ground handling services should not be regulated, but central infrastructureservices, such as baggage handling systems, should be part of the regulated activities. This is
not an issue in countries like the UK, where airports do not offer ground handling, but in others
like Austria, Germany, Italy, Spain and France. In Germany, the regulation of charges does not −with some notable exceptions like Düsseldorf − cover the central infrastructure fee, so that some
airports which were not able to raise their charges found an easy way out by shifting costs totheir users. At Amsterdam and Rome Flumicino the central infrastructure fee is regulated, while
in Paris Charles De Gaulle and Madrid Barajas this is not the case (Templin, 2009).
Besides the direct regulation of certain activities of an airport, all activities can be regulated
indirectly through the single till principle under a price cap as well as under a cost-based
regulation. It is one of the most debated issues among airports and airlines and the pro and consin this debate are summarized in the table below (for an excellent overview see Starkie andYarrow, 2001).
Table 3. Single Till
Pro

Con

Shifts monopoly rents to the users

No increase in efficiency

Non aviation revenues are created by airline
passengers

Tax on non aviation

Windfall profits

No direct regulation of profits

Simple to control

Less information, but allocation of common costs
is difficult

Improves Ramsey pricing

Decreases level of charges at busy airports

Niemeier – Discussion Paper 2009-10 - © OECD/ITF, 200917

The single till passes potential monopoly rents from non aviation activities to the users
through lower charges, but thereby it does not prevent the creation of market power. As mostprobably monopoly rents are lower than locational rents, the single till shifts rents without
increasing efficiency. Airlines argue that non aviation revenues and passenger throughput areclosely correlated and that therefore the revenues should be shared. However, this argument
neglects the fact that the decision is taken by the consumer and the airport is the supplier of theservices. The single till principle acts like a tax on the supply of airport services, as the airport
has to pass parts of its revenues to the users. Therefore it reduces the incentives to develop the
non-aviation business. The airlines fear that a shift from the dual to the single till principle raises
charges and creates windfall profits for the airport. This is most probably the case, but regulation
should not try to regulate profits directly as this reduces incentives for cost savings from which
the airlines also gain. The single till is by no means easier to implement and control than the dual
till. However, the dual till has the disadvantage of separating the regulated from the nonregulated activities, which implies the need to allocate common costs in a pragmatic way.
Subsequently it needs less information. At airports with ample capacity the single till might bepart of Ramsey pricing to cover fixed costs. However at airports with excess demand at peaktimes it reduces the level of charges, thereby lowering the scope for the airport to ration efficiently
by price differentiation. In these circumstances rationing can only be achieved by slot allocation.
Relying on the inefficient IATA slot allocation schemes does not make much sense. Overall thearguments for a dual till carry more weight and seem to prove the principal that regulation should
not intervene in workable competitive markets and to restrict itself to the monopolistic bottleneck.
The single till principle was recommended by ICAO and has been widely used in Europe, but
this long tradition is slowly breaking up. The UK was obliged to regulate UK airports by a bilateral
air service agreement, but this is not the case. The CAA recommended a dual till in 2001, but
surprisingly the Competition Commission rejected the proposal with dubious arguments (Starkie,2008). Australian airports were price capped on a dual till principle (Forsyth, 2004). In Europe theprice cap for Hamburg Airport was one of the first to be set on a dual till (Niemeier, 2002). Since
then, more German airports have adopted the dual till − however on a cost plus basis resulting inhigher charges without any efficiency gains.
The distortions due to the single till are only obvious at some airports. At ADP the retail andreal estate business is, relative to other European Hubs, underdeveloped and ADP has roughly
the size of London Heathrow to develop this business. The regulatory framework is a single till,with a vaguely defined option to take part of real estate and retail income out of the till in the next
regulation period from 2011 to 2015. Morgan Stanley (2006) values the ADP in different
scenarios between € 38.1 and € 127.1 per share. The differences are mainly due to different
degrees of non-aviation business left out in the till. These differences give a rough idea of themagnitude of the distortions caused by the single till principle.
5.3.

Types of airport regulation

The central problem for regulation is that the regulator has asymmetric information about thedemand and cost functions and that the regulator must design a contract to set incentives for the
regulated firm10. While high powered regulation sets incentives for cost reductions and productive
efficiency and an efficient price structure, low powered regulation does not. Given the information
asymmetry, the regulated firm will provide the regulator with the information only if it can keepsome of its informational rents. Therefore all types of regulation will not achieve first best10.

18

In addition, the airport also has asymmetry information about the regulator. The airport does notknow how the regulator will regulate prices in the future on which the profitability of investment
depends. See below 5.4.

Niemeier – Discussion Paper 2009-10 - © OECD/ITF, 2009

outcomes. Also, so-called “light handed regulation”, a term used for monitoring, faces thisasymmetry and should be evaluated as to whether it can set strong incentives for efficiency.11
Traditionally, in Europe and elsewhere,12 airport charges have been regulated on a rate of
return or cost plus basis. This is a rather low powered type of regulation as it sets no incentive forcost reduction. Littlechild (1983) tried to overcome these deficiencies with price cap regulation.
While the following discussion showed that many of the original claims of superiority were
exaggerated and that there might be better regulatory systems, there remain importantdifferences among the practical regulatory regimes for airports. The paper differentiates between
cost based regulation, pure price caps, hybrid price caps, revenue sharing agreements andmonitoring.
Cost based regulation
The vast majority of authorities in Europe regulate airport charges according to principles ofcost relatedness. The charges should create just enough revenues to cover total costs including
the depreciation of capital and a normal rate of return on capital. The structure of charges should
also be cost related, namely each charge should reflect its costs. Charges are supposed to be
set to ICAO principles of cost relatedness.
The problems with cost based regulation are well known (see for example Sherman, 1989).
Firstly, the incentives are set for inefficient choice of inputs. If the allowed rate of return on capitalis above the cost of capital the airport has an incentive to expand the capital base to increase
profits (Averch Johnson effect). Furthermore, there are high incentives for cost-padding leading
to productive inefficiency. Secondly, cost based leads to an inefficient price structure. Under costbased regulation the airport has no incentive to adopt peak pricing, but instead may overprice offpeak demand and under-price peak demand in order to justify capacity expansion. The
incentives at cost based regulated airports are leading to uniform pricing without peak andcongestion pricing. Cost based regulation sets prices in such a way that relative prices will lose
the function to give guidance to the question at what time and to what extent airports should be
extended. When excess demand exists, it is not rationed away efficiently, but rather, expensive
additional capacity is provided which raises environmental and political concerns. The question of
airport expansion becomes more and more a political question. In short, cost based allocation isa cause of cost and allocative inefficiencies and not the solution.
Pure and hybrid Price caps
Price cap regulation sets charges over a certain period in accordance with the rate of
inflation (PRI) minus productivity gains (X). Unlike cost based regulation, price caps do not
regulate profits, but set incentives to cost reduction. The gains from cost reduction can be kept by
the regulated airport within the regulation period and might be then passed to the users via lower
charges. Quality might be monitored or regulated as cost reductions might be achieved bylowering quality13.
11.

In the following, the term “light handed” is not used because it is a rather misleading category.
“Light-handed regulation” is a trendy expression, but also an empty one. However, price caps arelight-handed constraints because they mimic competitive pricing ceilings and identify a wide range ofpricing sets which are ex ante permissible” (Kunz, 1999 b, p 46)

12.

The US system has some similarities with price cap, but does not set any incentives for cost
efficiency. See Graham (2004), Gillen (2009).

13.

See CAA, 2006, and Niemeier, 2002.

Niemeier – Discussion Paper 2009-10 - © OECD/ITF, 200919

Pure and hybrid price caps differ in the way that the X is set in the price cap formula. The X
should reflect the productivity growth of the regulated industry in excess of the rest of thecompetitive industry. Pure price caps set the X without reference to the costs of the regulated
firm by benchmarking while hybrid set the X with reference to the regulated cost base. Hybrid
price caps provide less incentives for cost reductions as for e.g. the regulated could be a highcost firm at the regulated period in order to raise prices and profits. Hybrid price caps have beenused for UK airports, temporary for Australian airports and for some European airports. Overall
the experience in terms of efficiency is positive, certainly better than cost based regulation(Graham, 2008, Forsyth, 2008). Price cap regulation is superior to cost based regulation because
it is forward looking, while cost plus regulation relies on historic costs. The regulatory lag oftypically 5 years is sufficient to set at least some incentives towards cost reduction. In addition,
price cap regulation does not regulate the charges structure according to some arbitrary costallocations based on historic costs. A well defined price cap sets incentives for Ramsey prices aswell as for a reform of weight related charges at airports with excess demand.
The current practised systems of price cap regulation are certainly not perfect and could bereformed in many ways (see Forsyth 1997; Niemeier, 2002). One option is to set the X bybenchmarking. This type of yardstick regulation has been successfully practised in the electricity(Netherlands, Norway, UK) and water industry (UK). The Irish regulator conducted abenchmarking but found, during the consultation process, that the results were not robust. Also,
the CAA reached this conclusion and is using benchmarking only for specific processes to obtain
information on productivity potentials, thereby trying to increase incentives for cost reductions. As
there are no systematic reasons, preventing regulators from robust comparison benchmarking
remains an interesting option (Bouf, and Léveque, 2004, Reinhold et al., 2009).
Revenue sharing arrangements
Revenue sharing arrangements in the European airport industry take the form that the levelof charges is inversely related to the passenger growth over a certain period. These so-called
sliding scales can be combined with price cap regulation, as in the case of Hamburg, Vienna andregional Austrian airports, but do not have to be. At the German airports Fraport and Düsseldorf,
they are the result of a Memorandum of Understanding between Fraport and airlines on the levelof airport charges for the period 2002 to 2006. Thereafter a public contract between Fraport andthe regulator, in the case of Frankfurt the Ministry of Economic Affairs and Transport of Hessen,
in case of the Düsseldorf the Ministry of transport of North Rhine Westfalia, was signed.
(Klenk, 2004). In case of disagreement the charges would be fixed according to cost based
regulation. Most interestingly this contract has to date not been renewed for Frankfurt airport,
indicating that major investments might lead to hold-up problems and high transaction costs noteasily reduced by long term contracts (see below).
The core of these contracts is a revenue sharing agreement. The average charge perpassenger will be determined by the future passenger growth rate. Both parties agreed that witha projected growth rate, for example 4 per cent, average charges could be raised by 2 per cent.
Note that these are nominal prices as the agreement is not related to the price level. In the caseof a higher growth rate airlines participate with a 33% share in additional revenues. With lower
growth rates the airport cannot fully compensate revenue losses through higher charges. Only
33% of the loss can be compensated.
Such agreements have the important advantage that they break with the tradition of low
powered cost plus regulation. Within the contract period, the airport may behave as though it issubject to a price cap, though not of the CPI-X form. Furthermore, they seem to offer somestability if demand fluctuates, as in the current economic crisis. A demand shock leads to higher
charges so that the airport can cover average costs and that the airport will not face bankruptcy,

20

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which would also undermine the political stability of regulation. However, there are
disadvantages, too. Firstly, in cases of Frankfurt and Düsseldorf the incentives for cost reduction
and for traffic increase are rather mild as the level of charges is stabilized at a high levelreflecting more the limited countervailing power of airlines. Secondly, a flat linear sliding scaleguarantees the airport nearly the same revenue irrespective of output. This reduces the
incentives to change the historically grown price structure and to manage efficiently capacity
problems. Thirdly, it most likely creates inefficiencies and non market clearing prices. Prices
move in the opposite direction of demand shifts. This can only be efficient if short run marginal
costs are decreasing. This might be the case for airports with ample capacity, but most gateway
airports are highly utilized so that marginal operating costs are constant or rising and opportunity
costs of delays are created. Sliding scales reflect more the behaviour of a sleepy monopolist
preferring a stable revenue basis at whatever cost. They lead to inefficient price structures and to
the unintended consequence that a macroeconomic recession is prolonged as charges do not fall
and airlines cannot adjust to a new market clearing equilibrium.
Monitoring
Monitoring is a system of oversight with the threat of sanctions for poor behaviour.
Monitoring differs from abolishing ex-ante regulation insofar as the behaviour of airports is closely
followed. The most interesting examples are Australia and New Zealand (Forsyth, 2008).
On 13 May 2002 the Australian transport minister decided to phase out price cap regulation andto adopt a more light handed regulation − namely monitoring of the main airports for a period offive years − with an independent review and the right to reverse powers of price control in case ofabusive pricing. In New Zealand the approach is more general and looser, as the relevant
minister can undertake a review of pricing behaviour in any industry. In 1998 the airports of
Auckland, Christchurch and Wellington were subject to a review of pricing. The CommerceCommission recommended price regulation of Auckland in 2001, but the ministry did not follow
up and left airports unregulated.
The strength and weaknesses depend on three aspects. Firstly, monitoring needs a credible
threat (Kunz, 1999). This is first of all an institutional question. Is there an independent regulator
with sufficient information and democratic support? This might be the case in Australia and, to alesser extent, in New Zealand (Australian Productivity Commission, 2001), but it is not in thosecases in which an independent regulator has never been established. Secondly, the guidelines
have to be clearly and precisely stated. This has been not the case and is criticised by Forsyth(2008). Thirdly, the incentives towards efficiency depend on whether the guidelines demand costbased pricing or are incentive based. Forsyth shows that both systems are vague in this respect,
but nevertheless “generally perform well in promoting efficiency” (ibid, p. 96).
Adopting monitoring might be an attractive option for other countries but, as Forsyth points
out, the situation in both countries is very special in many respects. Airports are not busy due tooverinvestment in the past and neither do they compete for geographical reasons. Airline
competition is not as intense as in Europe or the US. Under these circumstances, traditional
weight based charges are fairly efficient and have not to be reformed to manage capacity.
Therefore it remains to be seen if monitoring can set incentives towards efficient pricing if
capacity is scare and airlines oppose such changes as they cannot pass higher charges topassengers as easily as with ample airport capacity.
5.4.

Regulation of investment

The assessment of regulatory options focused so far on the short run cost and allocative
problems with given capacity. Given the expected strong demand regulation of investment
Niemeier – Discussion Paper 2009-10 - © OECD/ITF, 200921

becomes more and more important and creates a number of challenging problems (Forsyth,2008, Guthrie, 2006):•

Risk of too low or too high demand. Uncertainty and risks of future demand is common
to all industries, but airports and regulators face the additional problem that prices do notsignal the strength of demand, scarcity rents are created for airlines but not for airports
and that the inefficiencies of airlines usage of slots might be substantial. False prices
affect the level and the structure of demand in terms of share of LCC versus FSA,
choice of destination, aircraft size and so on. A vertically integrated air service provider
would know these prices but, unlike in other network industries, these services arevertically unbundled in air transport. Regarding this problem, price caps and incentive
based monitoring are superior to cost based regulation and revenue sharing agreements
because of their incentives for efficient pricing especially if combined with slot markets(Niemeier, 2006).

•

Cost of new capacity. The costs of adding new capacity are not known to the regulator
but fairly well to the airport. Very often new capacity is costly. If the regulator triggers the
new price level to the costs of new capacity, like for BAA and ADP, there are incentives
for a price capped airport to invest. If the regulator underestimates these costs the
airport will not invest14. If the regulator overestimates the costs and sets the regulated
charges too high overinvestment might occur (Forsyth, 2008).

•

Hold up problem. Building new terminals or a new runway are long-term projects withsunk costs characteristics. The costs of adding new capacity are not known to theregulator but fairly well to the airport. Very often new capacity is costly. Price caps havea shorter period than the revenues stream of the investment. After the investment
decision of the airport the regulator might opportunistically lower prices to short run
marginal costs. Anticipating this risk the airport might under invest (Helm and Thompson
1991). Therefore the investment decision depends on the credibility of regulation(Vickers and Yarrow, 1988). Cost-based regulation guarantees a safe return on theassets, but leads to overinvestment and gold plating. Hence it is hardly superior. The
hybrid price cap regulation of the CAA established a clear framework that clearly signals
to the airports that the regulator will leave the airport a fair return on investment for costeffective investments (Andrew and Hendricks, 2004).

Overall, there is little conclusive evidence on the empirical question if price cap leads tounderinvestment. The Competition Commission has argued that BAA has not pursued
investment in new capacity at Heathrow aggressively enough. This could be interpreted as an
example of underinvestment. Starkie also acknowledged the incentives for underinvestment, butargues that these effects were outweighed by three factors, namely the preference of the
management to avoid congestion and quality problems with users, the preference of managers to
be mangers of large firms and the strategy to deter entry (Starkie, 2006). Starkie provides
evidence for overinvestment at regulated UK airports. One reason why it is difficult to provide adefinite answer is that capacity enhancing investments create a number of externalities. The
investment is ultimately decided by politics, typically basing their decision not on cost benefit
rationale, but on dubious impact analysis.

14.

An interesting example is the different approaches of the CAA and the CC in the UK. Yarrow (2009)
defends the CAA and criticizes the CC for price capping at lower long run incremental costs.

22

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5.5.

Regulation and competition

It was argued above that regulation should be compatible with slow developing competition
among airports and this raises some interesting problems.
In general competition creates positive effects, but it does not have to. The notion ofcompetition defined as “the racing of one person against another, with special reference tobidding for the sale or purchase of anything” (Marshall, 1920, p. 5) does not imply good results,
and competition has to prove its beneficial effects. Forsyth (2009) has argued convincingly thatcompetition from new entrants might decrease welfare because economies of scale and scope
are lost at the main airport. Competition might also result in tight oligopolistic markets with tacit
collusion and constrained capacity due to planning restrictions. The hopes that a break up of
BAA is the magic bullet are certainly unrealistic (Forsyth and Niemeier, 2009). However, airport
competition can certainly increase welfare in many cases. Littlechild (1983) developed price cap
regulation as an instrument to protect consumers, for a short time, from the monopolistic powerof a privatised public utility. As it turned out regulation has had to play a longer role in theorganization of infrastructure of network industry. Nevertheless it seems reasonable to think ofregulation as a temporary device to transform a natural monopoly into a more or less competitive
industry. Starkie (2008) argues that the UK airport industry has been transformed into acompetitive industry with the exception of Heathrow. Regulation was part of this transformationand can play an important role as it safeguards private investors from opportunistic behaviour ofthe state (Wolf, 2003) and reduces transactions cost in the form of conflicts and litigations among
the partners of the aviation supply chain (Niemeier, 2004). This is certainly relevant for European
countries with a relatively high density of airports, but not for Australia or New Zealand.
Firstly, price regulation and other forms of regulation have to be independent, democratic
and fair. This is important in two respects.
A. If airports are exposed for the first time to some form of mild competition they have the
incentive to engage in rent seeking. Airports might influence regulation to receive
subsidies, erect barriers to entry, or increase costs of rivals in order to keep the quiet lifeof a monopolist or to avoid reductions in revenues and profits. Rent seeking is notconfined to private airports. Also public airports are quite successful. Competition needs
a fair playing field and regulatory capture distorts it.
B. The regulation of investment showed that the system must be credible in order to avoid
underinvestment. Competition increases these risks. Generally competition creates risks
that airports fail as traffic shifts from one airport to another and risk that airports become
very profitable. In such cases regulators might come under strong pressure to interveneand regulate profits which sets negative incentives for efficiencies.
Secondly, increasing competition implies that regulators have to decide carefully over time
which airports should be subject to regulation and which are left unregulated with the credible
threat to reregulate. This decision is not a matter of size and not something to be determineduniformly over markets and across countries like in the EU. Furthermore, the decision on
designation should not be taken by the regulator as he might have an interest in prolonging
regulation unnecessarily. In a study for the Federal government of Germany, Wolf (1997)
developed a simple system of checks and balances as early as 1997. Unfortunately this wasnever taken up or seriously discussed - a clear failure of policy. It would also have reduced direct
regulatory costs (Niemeier, 2002).
Thirdly, the currently dominant form of airport regulation is not compatible with competition(Vogelsang 1998, Niemeier, 2003). Cost regulation does not set any incentives to compete for
Niemeier – Discussion Paper 2009-10 - © OECD/ITF, 200923

traffic through the price structure. This is also the case for cost orientated monitoring and forrevenue sharing agreements. The latter tends to neutralize revenue losses from decreasing
market shares due to competition. Price caps leave the structure unregulated and allows airports
to react to competition by lowering prices for competing services. This form of competition isparticularly relevant for competition among capacity constrained airports in London (Forsyth andNiemeier, 2009). Furthermore, price caps set only upper limits, and firms can lower price levels inorder to compete, as Stansted has done in the past to win low cost carrier traffic from Luton(ibid.).
Fourthly, competition among airports in the long run relies on the ability to provide enoughcapacity for traffic from other airports. Therefore the regulation of investment, environmental
management and planning restrictions become important. It might be necessary to provide more
flexibility for negotiations between airlines and airports on investment and quality and to pricenoise and other externalities efficiently. However, it certainly is not necessary to give theregulator, as the Competition Commission (2008a and b) suggests, more powers to intervene in
the regulatory period for the reform of regulating London’s airports, as this contradicts incentive
regulation and might cause gaming (Forsyth and Niemeier, 2009).
6.

Summary

Given the changes in governance of airports and the stress in the supply chain of aviation, it
is time to engage in a rational dialogue on regulation of airports. Economics can provide criteria
for such a dialogue. Regulation should be designed to increase economic welfare in a fair anddemocratic process. It is argued that airports have a large potential to increase welfare. Currently
airports do not perform well in terms of cost efficiency, allocative efficiency and investment
behaviour. There is evidence on X-inefficiency and poor cost control. At capacity constrained
airports capacity is rationed inefficiently due to IATA slot distribution rules, inefficient pricestructures and suboptimal slot constrains. Over investment occurs in areas with lack of demand
and underinvestment at places with excess demand, indicating a wrong timing due to the nonexistence of price signals for excess demand and a lack of cost benefit approach at airport
expansions.
These welfare losses might be at least partially due to unregulated market power. Market
power can arise from a locational monopoly, as it is often not possible to build airports next to a
gateway airport due to planning restrictions. Another reason might be that airports are natural
monopolies with sunk costs. There is some evidence that even airports are natural monopolies,
as economies of scale might range from 3 to 12, perhaps even 90 million, pax. Some Hubs aremost likely constrained by scarce land leading to rising marginal and average costs. This issue
requires more research as the shape and form of the long run average is not known. This lack ofknowledge leads to the conclusion that the airport industry as a whole does not have market
power, but some airports do have market power. Regulation must be complementary to a slow
developing process of competition and not restrict competition. The rationale for regulation must
be revisited periodically to assess whether it is necessary at all, which airports should be
regulatated and which airports should be subject to the threat of regulation.
Regulation might be substituted by competition for certain types of market structure. In thispaper, the strength of airport competition was assessed for large airports. While in the US some
switching of hubs occurred, hub and spoke networks have been relatively stable in Europe. The
intensity of hub competition is limited by high switching cost for airlines, as hub operation
involves specialised investment and scarce slots cannot be traded. Competition between hub
and secondary depends on traffic rights, aircraft technology and hub congestion. It appears to be
increasing, albeit from a a low level. If catchment areas between large primary and secondary
airports overlap, like Luton and Stansted or Bratislava and Vienna, competition might work

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depending on access costs and product differentiation. Unlike with airlines, potential competition
has hardly any force as only few market entries occurred, generally not in areas with strong
demand. The strength of airport competition has to be assessed on a case-by-case basis. Thereis potential to increase competition by horizontal disaggregation of BAA and ADP, by preventing
airport alliances such as ADP/Schiphol, through further liberalisation of air service agreements
and through slot trading.
When competition is not strong enough, regulation is an important tool for increasing
economic welfare. The need for regulation should be assessed on this basis. Regulation needs
well-designed institutions. It needs independency and democratic control and backing. Only a
few countries have followed the UK regulatory model. The vast majority of European countries
lacks independent regulatory institutions, an indication of high internal rent as a dependent
regulator undermines position in case of conflict with airlines.
The scope of regulation is too narrow as, for example, central infrastructure for groundhandling is not covered and, at the same time, too large − as potential competitive activities areindirectly regulated by the single till principle. The rationale for dual till is a case of second bestpricing to cover fixed costs in case of decreasing average costs. This is irrelevant if economies ofscale are exhausted or marginal costs are rising due to factor scarcity. Hence the single till ismost probably not relevant for large airports in metropolitan areas like London or Frankfurt. The
dual till forces airports with ample capacity to Ramsey pricing by weight-based as well as moresophisticated charging schemes. Therefore the welfare gain of including non aviation revenues islimited and should be balanced against the risk of distorting other markets by taxing non aviation
revenues. At busy airports, single till results in a too low level of airport charges and rents for slot
owners.
Regulation has to address the problem that the regulator never has as much information on
costs and demand as the airport. Successful regulation sets incentives for the airport to provide
this information, allowing the airport to keep part of the information rent. The various types of
airport regulation address this problem very differently.
Cost based regulation, which is the dominant form in Europe and elsewhere, sets incentives
for gold plating, high costs and inefficient price structure leading to allocative inefficiency. It is amajor cause of the poor performance of airports.
Although price caps are only used in hybrid forms, which set the cap on the cost base at the
beginning of the regulatory period, they have substantially lowered price levels in Australia, UK
and at some European airports. Price caps leave the structure of charges unregulated, setting
incentives to balance price structure in the direction of efficiently rationing peak and excess
demand. Hybrid could be improved by benchmarking with better data adjusted for theheterogeneity of airports. Unlike with other public utilities this is currently not possible, but thismight change in the future.
Monitoring is practised with mixed results in Australia and New Zealand. A major weakness
is that the objectives are not clearly defined, with the risk of being practised as a loosely definedcost plus regulation. It needs an independent regulator with credible threat to reregulate.
Revenue sharing agreements in the form of sliding scales try to cope with demand shocks
by allowing higher prices with lower demand and vice versa. This is efficient only if short run
marginal costs are declining, which is hardly the case at busy gateway airports. It stabilizes
revenues, thereby reducing incentives to manage capacity efficiently. Revenue sharing
agreements seem difficult to achieve if airports invest in major new runways and terminals.
Investment regulation is of growing importance as major airports face persistent excess
demand. The regulation of airport investment faces the major problem that prices do not carry
Niemeier – Discussion Paper 2009-10 - © OECD/ITF, 200925

information on the strength and magnitude of excess demand. Slot rents are the consequence of
scarce capacity and accrue to airlines under current slot allocation rules. Unlike in other public
utilities, air transport is not vertically integrated so that airports and regulators do not know slot
prices. Additional capacity often comes at a higher cost. Price cap must allow for higher charges
and can but not necessarily lead to optimal investment. Price cap might lead to underinvestment
if the regulator cannot credibly commit to not behaving opportunistically. So far there is hardly
any evidence for this type of regulatory failure in the airport sector.
Regulation must be designed to be compatible with airport competition. Therefore it isnecessary to establish independent regulators in order to avoid regulatory capture and create afair playing field. Cost regulation as well as cost based monitoring and revenue sharing
agreements are not compatible with competition. These should be reformed to pure price caps,
which allow firms to react to competition by changing the price structure. Price caps set upper
limits and firms can also lower price levels in order to compete.
To sum up, reform of airport regulation is needed. Regulate less, but more effectively, withfair and democratic processes and institutions. Use a credible threat of regulation. Second,
regulate and increase competitive forces. Implement simple price caps with strong incentives forcost savings and efficient pricing and investment. Design a competitive landscape byliberalization of air service agreements, less horizontal integration and slot markets.
Acknowledgement
I am grateful to Peter Forsyth, David Gillen, Vanessa Kamp, Nicole Adler, Jürgen Müller,
David Starkie and Hartmut Wolf for extensive comments on earlier drafts of the paper. I am
indebted for excellent research assistance to Xuan Hoa Bui and Christoph Prühn. Mark Winzler
has carefully revised the English style. The research builds on data and analysis of the research
project GAP (German Airport Performance) supported by the Federal Ministry of Education andResearch. The responsibility for any remaining shortcomings remains the author’s.

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