Aviation Policy and Research Center Airport Privatization and Deregulation Theory and Some Empirical Evidence 14 th December, 2004

Airport Privatization and Deregulation: Theory and Some Empirical Evidence Anming Zhang Sauder School of Business

Background Airports traditionally owned by governments: national or local governments Rationale: Natural monopoly Private airports pursue profit maximization Government ownership pursues social welfare maximization … is also an alternative to regulation In addition, it creates right incentive for airport s capacity investment

Problems of government department: Inefficient management Lack of clear objective: May serve employee interest rather than public Lack of freedom for finance: difficult to raise fund from capital market

Set up public corporation (Crown Corporation) : Separate management from ownership Commercialization: - Experience of YVR: - A recently (1992) commercialized public enterprise - Local airports authority - Not-for-profit, private corporation - Self-regulating Board of Directors - Long-term lease

The trend of privatization Started in 1970s in Europe and North America Privatize national railroad, airlines, oil companies, and public utilities

Government returns public enterprise to the private sector sells shares to highest bidder or to highest bidder with ownership limits government gives public shares Mixed ownership: Minor private stake in equity Majority private

Airport privatization has become a growing trend: BAA of the UK, 1987 Private airports pursue profit maximization Airports monopoly power Most privatized airports are regulated Predominantly, regulation of airport charges Landing fees (69%), aircraft parking (6%), terminal building charges (25%; passenger based)

Form of price regulation varies from country to country: Predominantly, Rate-of-return regulation, Price-cap regulation Recent studies on country-specific options and experiences: e.g. Forsyth (1997), Beesley (1999), Starkie and Yarrow (2000), Starkie (2001), Tretheway (2001), Gillen and Morrison (2001) Specific form of regulation may be inappropriate Critical to regulations: complex, unresponsive and expensive to administer costs of regulation Regulatory failure and deregulation

Starkie (2001) further concluded price regulation might be unnecessary: Existence of a complementarity between demand for air-side and demand for concession activities This puts downward pressure on airport charges A private airport sets charges close to social optimum The concession effect Indeed, some countries are moving towards no formal price regulation: e.g. NZ, Australia

Airport as a multi-product firm: air-side and concession activities Higher proportion of airport revenue from concessions: 75-80% in US; 40-80% for 50 major airports in the world (ATRS, 2002) Concession operation has grown faster … and more profitable

Objectives 1.Examine airport charges of a private airport and a public airport (with break-even constraint) - Nature of concession effects? - Price regulation unnecessary? 2.Investigate impacts of different forms of price regulation on capital and productive efficiencies 3.Empirical examination of privatization and regulation using major airports around the world

Basic Model = P + D(Q,K) + x: full price perceived by passengers P = airport charge for a flight x = portion of ticket price excluding P; exogenous to the model Q( ) = demand for airport facilities (# of flights) K = airport capacity D(Q,K) = flight delay costs C(Q)= airport operating costs r = cost of capital of the airport

Social welfare: where u = price of concession services X(u) = demand for concession services per flight c(X) = costs of providing concession services -The objective of a public airport: - Decision variables P, u, and K

Price comparison -For a public airport, FOCs lead to: where V = the consumer surplus from concession purchases, plus concession profits

-For a private airport, the objective is: (9) -FOCs lead to: - Result: P π > P w Price regulation might be necessary

Alternative Forms of Price Regulation Rate-of-return regulation (ROR) - Firms prices are regulated in such a way that the firm can not make more than the allowed (fair) rate-of-return Price-cap regulation

ROR and investment decision: Consider the bus companies that are subject to the ROR regulation that bus fare should give the companies a return not exceeding 10% Averch-Johnson (A-J) Effect: - Increase the rate base - this leads to overcapitalization (use too much capital input and too little non-capital inputs notably labour) - i.e., inefficient use of capital input

In addition, 1.regulatory proceedings costly - need regulatory oversight of costs (to ensure firm is efficient) - allowable ROR on the rate base (investment) is debatable - long history of regulatory battles over fair ROR 2. lack of incentives for the firm to minimize its costs: - gold plating and other cost inefficiency - concern about inefficiency being induced - call for new type of regulation

Price-cap regulation In 1980s, economists designed a new form of regulation, the price-cap regulation The regulated firm can set its price freely as long as it does not exceed a ceiling (the price cap) The cap is subject to periodic review (e.g. every 5 years)

- Limit the maximum allowable average price increase to: (RPI - X) % RPI: retail price index, like our CPI X: expected decrease in cost due to productivity improvement - Usually fix X at a given level for a period; so that firms have incentive to improve their productivity further than X% and keep the profit for several years; i.e., Price-Cap rewards firms who outperform the expected productivity growth This is the reason, some times called as incentive regulation

Manchester Airport The price cap is set as RPI – X In October 1997, CAA made its ruling on the price cap for the third 5-year period ( ): Based on expected efficiency gain, the X was estimated to be 11.5% per year However, with the integration of European Union, there was an estimated loss in duty-free sales, so the airport got a 6.5% rebate Overall, airport charges are limited to RPI – 5% in each of the next 5 years

Main results: ROR tends to induce over-investment in capacity, whereas price-cap regulation under- investment Dual-till price-cap has less severe distortional effects on investment than single-till price-cap

Empirical Work Analytical results imply: 1) Capital input productivity would be highest under single-till price cap, followed by dual-till price cap and ROR 2) TFP would be highest under the dual-till price cap, followed by the single-till price cap and then by the ROR

Table 1: Sample Airports

Regression variables SINGLE: Single-till price-cap regulation or residual cost-plus regulation DUAL: Dual-till price-cap regulation or compensatory cost-plus regulation OTHER: Other than price-cap regulation and ROR regulation PAX: Volume of annual passenger traffic (in million) RATIO_CON: Percentage of concession revenue in total airport revenue PUBP: Dummy, equal to 1 for mixed ownership with majority public ownership PRIP: Dummy, equal to 1 for mixed ownership with majority private ownership PRI: Dummy, equal to 1 if airport is 100% private owned EUROPE: Dummy, equal to 1 if airport is in Europe NA: Dummy, equal to 1 if airport is in North America CONGSTON: Dummy, equal to 1 if airport is congested HUB: Dummy, equal to 1 if airport is used as a hub by airlines

Table 2: Descriptive statistics

Table 3:Capital productivity and TFP regressions

Conclusion Airport charge of an unregulated profit- maximizing airport is higher than that of a public airport (subject to break-even constraint) even after taking into account concession effects Under a price-cap regulation, the airport tends to under-invest in capacity, and the problem is more severe for the single-till than for the dual-till Analytical results appear to be supported empirically

Privatization and productivity: -No clear evidence on the positive link -UK airports -US airports: participation from the airlines -Experience of YVR Commercial freedom given to management important; Not necessarily ownership type

Q & A