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1. Introduction

Project MC-ICAM investigates the implementation of marginal cost pricing (MCP)

in transport. Its goal is to provide clear policy conclusions on this topic, based onstrong theoretical analysis, in-depth case studies and analyses of current situationsin transport markets in different modes and countries with a large number ofmodelling case studies covering many different situations. The project covers intra-modal, inter-modal and inter-sectoral aspects. It focuses on a phased approach toimplementation of pricing measures.

The purpose of this report is to provide MC-based policy packages and transition paths or steps of the phased approach for rail, air and water transport. This summaryreport is based on a number of background reports listed at the end of this section.Each mode is described in detail, including the geographical properties and industry

profile. The market structure and stakeholders involved are identified in general andspecifically with respect to the case studies analysed. Institutional, organizational,technological, legal, political, financial and competitive issues are discussed indetail and barriers and constraints to MCP are identified. For each mode, types anddrivers of externalities are identified. Current pricing mechanism characteristics aredescribed and classified followed by the proposed second-best pricing measuresmodelled or developed through case studies. Finally for each mode, we discuss barriers to implementation of the proposed pricing schemes and potential paths ofimplementation with respect to constraint removal and acceptability issues over theshort, medium and long term. More specifically, this report is organised as follows:

Section 2 analyses the requirements and prospects for institutional change, definingand discussing future directions in rail transport pricing. We discuss an overall package of measures to implement MCP for rail transport and tentatively suggestthe necessary or second-best optimal implementation steps from the rail transport perspective. Different instruments are considered and selected case studies look indepth at systems implemented in a selection of member states and accessioncountries to understand how they came about, the issues involved in implementingthem and the lessons for future implementation that can be learned. The sectionreports on four case studies, including Britain, Germany, Sweden and Hungary.They include a review of the existing rail infrastructure charging regimes anddevelopment of alternatives. It explores how the existing pattern of charges came

into existence in each country, what alternatives were considered, why they wererejected and how the objections to MCP could be overcome. It leads torecommendations on how to move closer to MCP and on the phasing and packagingof such moves.

Section 3 analyses the need for institutional change, defines future directions inairport pricing and discusses barriers to the implementation of MCP in air transport.It develops an overall package of measures to implement MCP at airports andtentatively suggests the necessary or second-best optimal implementation steps fromthe air transport perspective. Schiphol Amsterdam airport is examined in detail. Thecase study concerns airport charges for passenger airline carriers. Inter-sectoralissues include employment, residence, government, passengers and airlines. It

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considers first-best versus second-best implementation and phasing issues, EU policy harmonisation and the barriers to MCP that are likely to arise from airlines,labour unions and state governments. MCP will impact both airfares and specificairport usage whilst the revenues can be used to mitigate congestion and adverseexternalities.

Section 4 analyses the needs and prospects for institutional change and futuredirections in water transport pricing. It develops an overall package of measures toimplement MCP for both short sea shipping and inland waterways and tentativelysuggests the necessary or second-best optimal implementation steps from watertransport perspectives. It reports on two case studies, namely short sea shipping inGreece and inland waterway transport on the river Rhine. The case studies look atcosts, prices, market imperfections, ways in which external costs can be priced andimplementation barriers for pricing policy.

Section 5 assesses the packages of measures and the necessary and second-bestoptimal implementation steps suggested in sections 2 to 4 for rail, air and watertransport, from the viewpoint of acceptability constraints and issues. Assessment ofthe measures and implementation steps will be made considering public, politicaland business acceptability using both SWOT (strengths, weaknesses, opportunities,threats) and compatibility analyses. The section explores ways of overcoming theidentified barriers. Finally, section 6 concludes, drawing comparisons between thedifferent modes and the identified paths towards implementation of marginal cost pricing.

This report is based the background documents listed below. At the end of eachchapter, references are given to these documents. The background documents areavailable from the MC-ICAM web site.

Matthews B., Nash C., Nilsson J-E. and Farkas G. (2002). Institutional andTechnological Barriers to Implementation - Rail Transport, MC-ICAM Task 5.2 part1.

Matthews B. and Nash C., (2002). Railway Infrastructure Charging in Britain - theProcess of Re-organisation and Reform, MC-ICAM Task 5.2 part 2 .

Adler N. and Berechman Y. (2002). Marginal Cost Pricing Approach to Setting

Airport Charges, MC-ICAM Task 5.3 . Nilsson E. (2002). The Case for Using a Market Mechanism for Slot Pricing, MC- ICAM Task 5.3 Part 2 .

Zografos K. (2002). Institutional and Technological Barriers to Implementation -Water Transport, MC-ICAM Task 5.4 part 1 .

Henstra D. (2002). Institutional and Technological Barriers to Implementation inInland Waterways a case study of the river Rhine, MC-ICAM Task 5.4 part 2 .

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Zografos K. (2002). Acceptability Barriers of Pricing Strategies for Rail, Air &Water, MC-ICAM Task 5.5 .

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2. Rail

There has been much interest at the EU level in reforming the railway industry,stemming from a strong desire to limit subsidies to the industry and enhance itsmarket share. The aim of this section is to review the current situation in railtransport with respect to pricing mechanisms, identify the important barriers to pricing reform and provide tentative suggestions for implementation paths. Rail is by far the most advanced of the three modes studied in this report, with varioustypes of MCP schemes applied at different levels in the diverse EU countries overthe past decade. Hence, case studies with historical analysis are the most appropriateform of analysis for rail infrastructure and can provide a rich picture of potentialimplementation paths from which the other modes can learn.

This section is a summary of case studies that review experiences of railwayinfrastructure charging reforms in four European countries: Britain, Germany,

Hungary and Sweden. The case studies are used to provide an analysis of the keyissues in relation to implementing pricing reform in rail transport. The four analysesdraw on detailed literature reviews, supplemented where appropriate by expertinterviews with those who have been, or are, closely involved in the reforms. Thecase studies provide information as to appropriate implementation paths withrespect to MCP schemes, taking the successes and failures of the past into account.

The first subsection will discuss the types and drivers of externalities specific to railthat cause the pricing issue to be of specific interest. A broad discussion of the casestudies is then presented, followed by sections on the current pricing regime andappropriate new pricing mechanisms. The next section discusses barriers to the

suggested pricing schemes, followed by a final section discussing possibleimplementation paths.

2.1 Types and Drivers of ExternalitiesThe additional costs generated when an additional train uses the infrastructure can be divided into five main types: use-related infrastructure wear and tear costs,congestion costs, scarcity costs, external accident costs and environmental costs.Each type of externality will be discussed individually below.

Wear and tear of railway track is caused by a combination of usage-related andenvironmental-related damage. This results in the need to inspect, maintain and

renew the track which gives rise to costs. Use-related wear and tear costs are that proportion of these inspection, maintenance and renewal costs which result fromtrains using, and hence causing damage to, the track.

Congestion represents the expected delays resulting from the transmission of delaysfrom one train to another. The introduction of an additional rail service onto thenetwork reduces the infrastructure managers ability to recover from an incident andincreases the probability of delays. This becomes worse at high levels of capacityutilisation, since there is a lack of spare capacity to recover from any delays.Congestion costs are the costs associated with these expected delays. In this way,the consumption of additional capacity and the resulting congestion on the network

imposes delay costs on train operators and, ultimately, rail customers.

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Scarcity represents the inability for an operator to obtain the path they want, interms of departure time, stopping pattern or speed. Therefore, in the presence of acapacity constraint, the value of any train that could not run due to insufficientcapacity would be added to the costs of track damage and of expected delays. TheHigh Level Group on Transport Infrastructure Pricing identified scarcity, rather thancongestion, as the dominant consequence of existing capacity constraints on theexisting rail network (European Commission, 1999).

When travellers use a rail service, they expose themselves to accident risk on thatservice. At the same time, their use of that service may affect the accident risk forall other rail users and for users of other transport modes. Moreover, part of thecosts of accidents may be imposed on third parties (such as the National HealthService) and not recovered from the rail company or its insurers. The economicvalue of these consequences of additional rail use form the marginal accident cost.Whilst the users internalise their valuation of the risk to which they are exposed, themarginal external cost consists of the expected accident cost to the rest of society(e.g., medical and hospital costs) and the willingness-to-pay of the household,relatives and friends and the rest of society with respect to the change in accidentrisk for other transport users. However, the exact nature of the relationship betweenthe use of rail infrastructure and the number and severity of accidents is not clearlyunderstood.

Environmental costs arise out of the impacts of local and regional air pollution,global warming and noise emitted by railways. Several methods have beendeveloped for valuing these impacts and extensive national and internationalresearch has been conducted over the past decade to derive actual values (Friedrichet al, 1998).

Table 2.1: Types and drivers of externalities over rail infrastructure

Type of Externality Externality Driver

Operational Wear and tear costs.Congestion and delays.Scarcity.

Usage related damage.High level of capacityutilization.Capacity constraints.

Safety Accidents.

Congestion and delays.

Exact connection between railinfrastructure use and

number & severity ofaccidents is unknown.

Environmental Noise and air pollution.Train fuel use.Population living near tracks.Demand profile & volume.

2.2 Recent Reforms in Railway IndustryThe European Commissions policy of separating railway infrastructure fromoperations and opening up operations to new entry has given rise to the need forexplicit methods of charging for the use of rail infrastructure. The Commission seesthis as an important way of improving the efficiency and marketing of rail transportand, hence, of increasing the role of the railways in the European Common

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Transport Policy (CEC, 1996). They are keen to see comparable approaches toinfrastructure charging being used in all member states, to avoid the distortions thatexist when neighbouring countries charge for the use of infrastructure on a verydifferent basis, and to base these charges on marginal social cost as the mostefficient approach to transport pricing (CEC, 1998).

However, deriving and implementing an appropriate pricing system poses extremedifficulties. These difficulties are reflected in the amount of progress theCommission and the member states have made to date, both on implementation of pricing proposals and on reform and liberalisation of the rail industry. Very fewcountries have seen radical change. However, the most radical changes have taken place in Germany, Sweden and Britain. In addition, Hungary has made considerable progress with implementing railway reform and a system of railway infrastructurecharges, as part of its preparation for accession to the European Union.

The case study countries generally span the extremes of the current situation inEurope. Other countries either follow the pure marginal cost approach of Sweden,with most infrastructure costs paid by the state (the Netherlands being an extremecase with zero infrastructure charges until recently), or some form of cost allocationwith budgetary contributions from the state, more like that of Germany (France is agood example as the relative charges for different parts of the network reflect bothdiffering levels of congestion and abilities to pay). Britain is unique so far in havingattempted to operate a system with a privately owned infrastructure companyreceiving no government finance other than from access charges, but that attempthas now been abandoned as noted below.

In Britain, during the mid-1990s, the rail system was broken up into around ahundred different companies and privatised. The industrial structure that emerged isunique to Europe and comprised a privately owned infrastructure authority,Railtrack Plc; privately owned passenger franchises, whereby all passenger servicesare operated on contracts for a fixed number of years; privately owned freightoperations; extensive sub-contracting; an independent regulator, responsible fordetermining the rules for rail infrastructure charges, licensing all rail companies andapproving all access agreements; and a strategic rail authority, responsible for thelong term planning of the passenger network. However, in September 2001,Railtrack was declared bankrupt and placed in the hands of administrators. It is proposed that its functions will be taken over by a not-for-profit company, NetworkRail. In the meantime, substantial direct government funding is being paid toRailtrack to supplement funding via track access charges.

During the mid 1990s, Germany embarked on a programme of railway reforms, anumber of elements of which are relevant here. The previously separate DeutscheBundesbahn (DB) in the former German Federal Republic and Deutsche Reichsbahn(DR) in the former German Democratic Republic were merged into DBAG, a publiclimited company with share capital, owned wholly by the Federal Government.DBAG was established as a holding company, with a number of separatesubsidiaries responsible for infrastructure, stations, long distance passenger services,regional passenger services and freight. At the same time, a Federal Railway Office

was created as a government body and responsibility for funding regional services

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was transferred from the federal Government to the States, enabling them tocontract with DBAG to run the services, to provide them themselves or to contractwith a third party. Thus an element of contracting out for the provision of serviceswas provided for, and open access to the German rail network was provided for both passenger and freight operators.

Throughout the 1990s, Hungarys railway industry underwent a series of reformsand restructurings. Some of these reforms were driven by a desire to revitalise theHungarian railway sector following substantial changes in the market demand forrail services in the wake of the political and economic changes. In addition, thedesire to move towards compliance with EU regulations and policies, as a precursorto accession to the European Union, was also a driver for change. The first reforms,in the early 1990s, involved breaking up the former Hungarian State Railwaysorganisation into approximately 100 separate companies, including Hungarian StateRailways Plc. (MAV) and a series of infrastructure maintenance and constructioncompanies. In the mid 1990s, the Hungarian government and MAV formalisedarrangements for financing MAVs public service obligations and agreed on theseparation of infrastructure organisation and accounting from commercial railoperations. In 1999, it was decided to separate the state owned infrastructurecompany from the commercial railway company. The infrastructure company will be responsible for the development, maintenance and operation of the track and belongings, whilst the railway company will be responsible for passenger andfreight services, will own the rolling stock and will pay track user fee to theinfrastructure company. The track user fee is designed to cover the cost ofmaintenance and operation, but funding for the development of the infrastructurewill be provided by the state. At time of writing, two companies specialized in passenger transport and two companies specialized in freight transport operate trainservices on the Hungarian railway network and there is no open access to railwayinfrastructure.

In 1988, Sweden was the first country in the world to vertically separate its railwaysector.1 The government was seeking a radical transformation of the industry,following two decades of escalating state subsidies and the failure of a majorfinancial reconstruction package in 1985. The state owned monopolist was brokenup into two parts; Banverket the Swedish National Rail Administration withresponsibility for infrastructure, and Statens Jrnvgar (SJ) running railwayservices, under a monopoly franchise.

By organisationally separating infrastructure from service operations, the 1988reform put railways on an equal footing with roads. The reforms also involvedcontinued financial support to rail, in recognition of its safety and environmental benefits and transferred the responsibility for commercially unviable traffic oversecondary, low-density lines to regional transport authorities, enabling rail supportto form part of regional policy (Nilsson, 1995).

1 Strictly speaking, this may not be so; there is reason to believe that the joint use by several operators ofcommon infrastructure was familiar during the first decades of the industry, but evidence and possibleexperiences are scant.

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The first move towards market entry came in 1989, when the first competitive procurement of regional train services resulted in a four-year contract beingawarded to a private operator, BK Tg (at that time an operator of coach services),who began operations in 1990. The first years of the 1990s also saw theestablishment of several small-scale freight operators. Most of these are sub-contractors to SJ on peripheral parts of the network. From July 1996, anyone fit,willing and able can run freight services over the network, competing with SJ forcontracts with consignors. At time of writing, only long-distance passenger servicesrun by SJ on a commercial basis, operate on a monopoly franchise.

From 1988 to 2001 SJ was run as a public sector state business administration,administering assets on behalf of the government, but doing so based on commercial principles. From 2001, three independent limited liability corporations have beenformed, one running passenger services (SJ AB), one in charge of freight transport(SJ Green Cargo AB) and the third AB Swedecarrier a holding company for realestate assets, heavy maintenance, etc. All stock is still owned by the government, but the new organisation can now be sold to other investors, wholly or partially. Thenew organisational format inter alia means that the previous monopolist has beenturned into two separate claimants for track capacity that in 2001/02 has to competefor track access with another 20 firms.

2.3 Initial Pricing ReformsIn Britain, the initial pricing reform resulted in a system of infrastructure chargesimplemented for passenger franchises, which relied on a two-part tariff:

(i) allocated access rights, a MC based solely on wear and tear and whereappropriate electric traction costs(ii) a large fixed element based on avoidable costs and an allocation of jointcosts (Office of the Rail Regulator, 1995).

In addition, the franchise agreements contain 'performance regimes' which specify penalty payments or bonuses according to specified performance criteria, such as punctuality and cancellations.

Given the arbitrariness of the allocation of joint costs, the pricing system does notnecessarily provide good information on the relative profitability of differentservices. Moreover, the system has been criticised for the very low variable elementin the charges, which give too great an incentive to fill scarce track capacity withlightly loaded trains. The variable charges include no element either to allow forcongestion or the opportunity cost of slots or for externalities such as air pollution.Moreover, Railtrack has little incentive to enhance capacity to provide for extraservices, indeed they argue that the variable element does not even cover wear andtear cost, resulting in a disincentive to expand capacity. From the point of view ofefficiency, the result is that the system has no mechanism to ensure efficient use ofscarce capacity. Adjustments in capacity or quality may be made by negotiation between Railtrack and the operators beyond the access rights held by operators, butthese negotiations are complex, involving often several operators as well as theStrategic Rail Authority and the Regulator, and there is an obvious incentive foroperators other than the main one affected to seek to 'free ride'.

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A similar difficulty in ensuring fair and efficient charges exists in the case of freightoperators, which are the subject of individual negotiations but again subject to theapproval of the Regulator. The major operator here has also negotiated a two-parttariff, which it may be argued favours it above rival operators.

From the start, charges for use of the infrastructure in Germany were a highlycontentious issue (Link (1997)). The initial structure of charges provided a detaileddifferentiated tariff, which recovered the total cost of the infrastructure, excludingcapital charges, from users on essentially a fully allocated cost basis as a charge pertrain kilometre. However, there were major quantity discounts, which of course benefited the train operating divisions of DBAG relative to any entrant. Moreover,the relatively high charge per train kilometre also made new entry relativelyunattractive; for instance, rail freight operators through the Channel Tunnel had previously expected through traffic to Germany to be a major market, but in theevent they ran no through services to Germany, which was served by road fromrailheads in neighbouring countries. The United States, in particular, objected to thelevel of charges they would have to pay if any operator other than DBAG providedthem services. The first reform in the face of this protest was to provide a discountfor regional services, but soon the entire tariff structure was changed (see below).

In Sweden, the first version of the pricing regime was constructed as a multi-parttariff. A fixed annual charge was levied per vehicle, different for different vehicles,and in addition, several variable components of the tariff generated revenue relativeto gross ton km or train km run, etc. An accident charge was included within thisoriginal charging regime, based on a cost allocation principle, that the total(external) accident cost2 being averaged over total number of train kilometresdriven. In addition, diesel trains which account for about 10% of total trainkilometres driven were required to pay SKr 0.31 per litre of fuel used, as a meansto internalise otherwise external environmental costs; cf. Hansson & Nilsson (1991)for more detail. The projection was that revenue and infrastructure costs would addup to SKR 890 and 1,854 million, respectively, the difference being the projectedneed for subsidies. In addition, a promise was made to invest massively ininfrastructure, and to finance these costs over the public budget. Thus, the chargingand investment regimes were initially set to mirror those for the use of roads.

Cost recovery was of secondary importance in the 1988 organisational separation.Policy-makers realised that substantial parts of the network would have to beabandoned if the industry was forced to cover its own cost. This sentiment, althoughimplicit, still permeates the political attitude towards charges for railway use. In thiscontext, a simplistic version of the short-run, MCP paradigm, whereby efficiencyenhancing charges for using existing infrastructure are set below average costs inrecognition of increasing returns to scale (assuming no shortage of capacity and noneed to levy Pigouvian charges to handle externalities), legitimises financial deficitsas a means to ascertain efficient use of existing infrastructure.

2 Total cost is computed by multiplying the social cost per average accident, including a willingness-to-paycomponent for reducing accident risks, with the number of injuries and casualties over a year.

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2.4 Subsequent Reforms and Propositions for Alternative Pricing MeasuresThe first regulatory review of access charges in Britain concluded that the initialstructure was in need of substantial revision to improve the incentives to Railtrack.As part of this review, Railtrack has brought forward evidence for a higher variableelement in the charges. This is based on a number of factors: engineering evidence thatthe wear and tear element of the charges does not fully recover these costs, evidenceon the impact on delays to other trains of adding additional services to the system. anargument that Railtrack needs an incentive payment to encourage increased use of thesystem, and that such an incentive payment will give it reason to undertake smallcapacity enhancing investments without costly negotiations over who will pay forthem.

The regulator accepted the broad arguments put forward by Railtrack, whilst differingwith them on many specific points regarding how the new system would beimplemented. The eventual conclusion of the Regulatory Review was published inOctober 2000 and the new charging regime took effect as of May 2002.

The new system retains the two-part tariff, but with the variable element increasedto some 20% of total charges. Rather strangely, the new variable element includesthe revised marginal wear and tear cost but only 50% of the estimated congestioncost. In other words, it is being deliberately held below marginal social cost to givean incentive to expand services. There is also a new incentive payment to Railtrack based on increases in traffic, but this is recovered through the fixed element of thetwo-part tariff rather than the variable element. (Office of the Rail Regulator, 2000). New entrants in the passenger sector will be treated relatively favourably, in thatthey must be offered the chance to operate paying only the variable element of thecharge. However, the extent to which entrants are permitted to challenge franchiseeshead on is very limited.

Thus, Britain will move to a system where the charge for using the infrastructure willconsist broadly of a variable element reflecting wear and tear (and electric tractionwhere relevant), a capacity charge reflecting the likely delays imposed on otherservices, and a fixed charge in the case of the franchisees based essentially on trainkilometres. These charges will apply to most modest changes in services, althoughindividual negotiation will still be needed for major projects affecting capacity orquality.

In Germany, a move was made to a two-part tariff, with a fixed charge for using a particular stretch of track plus a charge per train kilometre run. This gave a greaterincentive to expand services, and did not greatly disadvantage anyone running at areasonably high frequency over that track, but it did of course mean that a newentrant running just once or twice a day would be at a disadvantage. However, suchentrants were offered the choice of a single charge per train kilometre similar to theaverage paid by DBAG taking account of the fixed element in their charge. In otherwords, a new entrant would be required to make the same average contribution tofixed costs as that made by DBAG. This may seem a reasonable approximation tothe efficient component pricing principle (Baumol, 1983) given the impossibility ofa tariff taking account of the contribution made by each individual train. Yet again,

the structure has had to be changed because of a ruling by the German competition

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authorities that the two-part tariff was anti-competitive and reversion to a singledifferentiated charge per train kilometre is now being made.

In Hungary, the proposed charges are based on infrastructure expenditure excludinginvestments. That is, the amount of charges to be paid equals the sum ofexpenditures on track maintenance and renewal, signalling maintenance andrenewal, train circulation (traffic control), depreciation, overhead, wear and tear andstructures maintenance and renewal. The infrastructure charge to be paid applyinga global method is calculated using Operation and Traction Statistics (OTS) data.This method of calculation is adequate at the moment since only the nationaltransport company has to be taken into account. (The charges exclude charges fortraction energy).

Within the prime cost calculating system of MV Inc., infrastructure charges belong to domicilated costs costs are to be stated per statistical sections andstations. Therefore, according to the variable costs of specific lines, an ITaccounting database is to be created. To achieve this, a new method should beimplemented. The charging system makes it clear that the infrastructure charge isthe offset of the maintenance costs of track and structures, telecommunication andsignalling and depreciation, but bears no other content (neither performance, nor the parameters describing service quality are taken into consideration). That is, it doesnot provide information about the utilization or profitability of the lines.

The drafted model is applicable to calculate the lump-sum charge of a single user, but is not applicable to:

1. Assessing the costs utilising market value and technical service quality ofeach line section (at MV Inc. satisfying prime-cost calculation needs).2. Calculating a reasonable infrastructure charge on a given part of the network(line(s) sections).3. The calculation of the infrastructure charge on a definite train path.

In recognition of these limitations of the proposed system, the Ministry of Transport prescribes the introduction of a charging scheme that takes into account the qualityof infrastructure and harmonizes with the EU Directives. A decree on the aboveissue is planned to be passed during 2002.

In Sweden, the charging system was revised in February 1999. One part of thetransformation was to abandon the fixed charges per vehicle. Table 2.2 provides anoverview of the current structure of infrastructure charges.

Table 2.2: Charges for using Swedish tracks, January 2000. 3

Type of charge SKrTrackage fee, passenger 0,0086 per gross ton kmTrackage fee, freight 0,0028 per gross ton kmInformation fee, passenger 0,002 per gross ton km

Accident charge, passenger 1,10 per train km Accident charge, freight 0,55 per train kmDiesel charge 0,31 per litre diesel

3 SFS 1998:1827 1 corresponds to about SKr 9.

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Type of charge SKrShunting charge 4 per shunted carCharge for using resund bridge, freight 2 325 per passage

A trackage fee ( spravgift ) of 0.28 re per gross ton km is paid by freight trains.The charging level is based on detailed econometric analyses of the variability oftrack maintenance costs with respect to traffic, measured as gross ton, and a numberof technical parameters (track length, number of switches, tunnels and bridges, etc).The data set does not include costs that are reported to be common for several trackunits; the district, region or main office costs are not expected to vary with trackusage. Since it is not obvious how to measure traffic load in station areas, costsrelated to usage of this part of the network are not part of the analysis. Usage-relatedre-investment (or renewals) costs are also not included.

The trackage fee for passenger trains is three times higher than for freight trains.The difference goes back to the Swedish-Danish deal over the resund Bridge. Itwas stipulated that train traffic was to pay an annual lump sum of 50 million SKr forusing the bridge. When it was to be opened in 1999, SJ declared that its passengerservices could not bear this cost and the incumbent refused to run commuter orlong-distance services over the bridge. The government however, did not agree tofoot the bill for passenger services. The solution was to charge freight services2,325 SKr per train and passage over the bridge but to include the cost for passengerservices within the trackage fee. Consequently, all passenger services in the countrynow contribute to the revenue generation required by the agreement.

In addition, all passenger operations pay an information charge

(trafikantinformationsavgift). This has nothing to do with MCs but is a way torecover costs for information services to passengers, an activity that was transferredfrom SJ to Banverket in 1999. Infrastructure charges also include a fee per carshunted at the major shunting yards. The logic behind this fee is MCs but theempirical substance behind the charging level is thought to be poor (Nilsson, 2002).

The accident charge was substantially reduced in the late 1990s. This resulted from Banverket arguing that the costs for road/rail accidents were irrelevant for charging because a road vehicle is legally culpable in any incidents with railway vehicles andthat accidents occurring because of people (illegally) walking on the tracks werealso irrelevant to pricing accident externalities. The differentiation between freight

and passenger vehicles is based on the argument that freight services conduct alarger proportion of their transports on those parts of the network that are moreexposed to accidents. There are two problems related to the current level of theaccident charge. The first is that the rate is based on average rather than MCs. Thereare indications that additional train traffic, controlling for the extent of safetyinstallations, reduces accident risk (Lindberg (2002)). If this is correct, ceteris paribus, the current charge is too high. Secondly, and as described above, thecurrent charge does not include certain classes of accidents. The legalistic motivesgiven for this have poor relevance for calculating social MCs; irrespective ofwhether people have been culpable in a legal meaning, the presence of railwaytraffic does per se give rise to an accident. This would then motivate a charge

increase, ceteris paribus. The net consequences of these offsetting aspects are not

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yet clear, but it is not probable that the optimal charge would be considerably higherthan today.

Despite arguments that it should be increased substantially, the current diesel chargehas not been adjusted since it was first introduced in 1988. The main reason for this being regional policy concerns; much diesel traffic is operated in remote parts of thecountry and upward adjustments of the charging level might impact negatively onthe possibility of retaining these services.

2.5 Barriers to ImplementationBased on the discussions in the previous sections, the key barriers to theimplementation of marginal social cost pricing in the rail sector appear to be:

1. Problems of measurement : estimation methods and, in most cases, estimatedvalues exist for most cost components of marginal external costs, though the needfor further research is especially acute for congestion and scarcity (see Nilsson(2002) for one method of treating scarcity).2. Governments are unwilling or unable to provide necessary subsidies : underMCP with scale (and/or density and/or scope) economies, there is a need tosubsidise (in the static perspective), but this may be unacceptable politically. It may be considered equitable to charge according to MCP but governments may fear X-inefficiency resulting from subsidization.3. Anti-trust legal problems : currently there are legal problems with theimplementation of two-part tariffs, which either require changes to the law or adifferent mechanism design achieving an uncommon tariff.3. Failure to provide correct incentives for investment : There is a fear that theincorrect or diluted application of MCP may provide poor incentives for capacityexpansion where needed, as well as causing X-inefficiency. The EC Directive oninfrastructure charges (2001/14) recognises these issues by permitting non-discriminatory mark-ups above MC for financial reasons and to recover the costs ofspecific investments.4. Failure to encourage competition within the rail sector and across modes : themost likely second best policy involves two part tariffs and/or Ramsey pricing, butthis may not be possible to do in a way that preserves terms of competition betweenoperators. Furthermore, if other modes of transport charge less than MCP, forexample road, this may cause rail to lose competitiveness.

Only Sweden of our case studies, and as far as is known - more generally,explicitly includes environmental costs within its tariffs. No country other thanBritain includes congestion costs in its tariffs, and no country includes pure scarcitycosts. Scarcity costs remain a priority for further research. A summary of the barriers discussed can be found in table 2.3 alongside potential solutions.

Table 2.3: Barriers and solutions in marginal cost pricing of rail infrastructure

Categories Barrier SolutionsInstitutional:OrganizationalPoliticalLegal

1. The individual governments lack thepower to implement MCP.2. Governments are unwilling or unableto provide necessary subsidies.

1. Separate track authority withregulator charged with achievingMCP.2. Open access for freight.

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Categories Barrier Solutions3. Anti-trust concerns with 2-part tariffs. 3. Fare regulation for passengers

as part of franchising.4. 2-part tariff for infrastructure(by legislation) and Ramseypricing by operators.5. Appropriate treatment of costof public funds and equityweighting.6. Change of political philosophye.g. change of government

Acceptability 1. Inappropriate pricing in competingmodes2. No charging of environmental costs inother modes

1. Second best subsidies to railuntil pricing in other modes arereformed.2. Charge other modes.

Technological Problems with measuring congestion andscarcity.

1. Further research

The modelling constraints that draw on the barriers described in table 2.3 could bedefined as follows:

1. No change in current prices in short term. Then separate track authoritywith regulator charged to achieve MCP.2. Cap passenger fares as part of franchising in short to medium term.3. No 2-part tariffs until anti-trust legislation changed.4. Set budget constraints in form of total revenue greater than or equal tosome proportion of costs, with proportion differing among countries.5. No pricing of scarcity until measurement agreed upon through furtherresearch.

2.6 Implementation of Pricing MeasuresCurrently, there is a diversity of approaches in terms of charging, institutionalarrangements and competitive structures in the European rail industry. MCP isclearly much easier to implement where the infrastructure manager is a public body,funded largely from general taxation, as in Sweden. In both Britain and Germanythere were strongly held fears that such a solution would lead to X-inefficiency andexcessive investment at the time when the reform was discussed and designed.Therefore, in both countries, the infrastructure manager was to be a commercial body funded largely by payments from train operating companies. Moreover, inBritain the infrastructure manager was privatised.

Even with a commercial infrastructure manager, there is a variety of ways ofcovering costs. In particular, direct funding from the state remains possible; inGermany, the state funds DB Netzs investment, whilst in Britain because of thecrisis in Railtracks finances that led to its bankruptcy, the state now funds asubstantial part of Railtracks maintenance and renewal costs directly. To the extentthat train operating companies do pay the total costs of rail infrastructure, two parttariffs are a popular solution. The benefit of this approach is that it means that trainoperating companies make decisions, such as frequency of service, on the basis oftrue marginal costs and are free to exercise their power to implement Ramsey pricing in final markets in order to raise the revenues needed to pay the fixed part of

the tariff. In general, train operating companies have much greater ability to

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discriminate between different types of traffic according to their price elasticity ofdemand than do infrastructure managers, as they are closer to the end consumer, andcan differentiate between different types of customer using the same train, oridentical trains. The principal objection to them is in terms of their potential impacton competition, and (as stated above) this has led to their abandonment in Germany.

No country, except perhaps to a limited degree France, has attempted to implementRamsey pricing for rail infrastructure. Ramsey pricing for infrastructure, which is anintermediate good, is problematic because the degree of differentiation that would be practicable is very limited and because it distorts train operating companieschoice of frequency of service, although this is a solution that is often favoured inreports (NERA (1998)). Pricing rail services to the final consumer is generally seenas a matter for commercial train operating companies, though with a degree ofregulation particularly of commuter fares. Thus, no country has attempted a policyof MC pricing for rail services, as opposed to rail infrastructure. Commuter fares areoften held below MC, perhaps on justifiable second-best grounds; inter city faresshow an increasing degree of differentiation perhaps on Ramsey pricing principles.Something approaching perfect price discrimination is practiced in freight markets,where negotiations with each individual customer are the norm.

Where, either for budgetary reasons or because of fears of X inefficiency,governments are unwilling to provide the funding necessary to achieve full marginalsocial cost pricing for rail, we recommend that implementation paths concentrate ontwo part tariffs for rail infrastructure and on Ramsey pricing in final output markets,with the major unresolved issues being the treatment of small new entrants andcharging for scarcity. Probably the best that can be done in terms of new entrants isto ensure that they can buy access to small parts of the network at a fixed chargethat reflects their desired route coverage and to offer them a choice of the two parttariff or a single price, per train kilometre, reflecting the average charge paid by theincumbent. For scarcity, more research is certainly needed into auctioning systems, but until these can be shown to work an attempt to calculate the opportunity cost inthe light of knowledge of competing demands may be made. However, precise pathstowards implementation of marginal social cost pricing for infrastructure use will bedependent on national governments attitudes towards cost recovery and subsidywithin their national rail industry and on their existing infrastructure chargingframework. In addition, appropriate charges for both rail infrastructure and endusage will hang on the far more politically difficult issue of implementingcorresponding charges for road users, most of whom fall a long way short ofcovering their external costs.

The degree to which such an approach will actually cover fixed costs will varyaccording to the perceived constraints at the level of the individual countries. Untilrecently there was a constraint in Britain that, as a commercial organization,Railtrack had to cover all its costs from charges, although that constraint has now been breached. In Germany, the government is willing to provide DB Netz withassistance with capital but not operating cost. In both cases, the governmentoffsets part of the inefficiency caused by charges that exceed marginal cost forinfrastructure by the provision of subsidies for some or all services. What is

important is that, in such a structure of charges, the fixed element of the

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infrastructure charge should be set so as have as little effect as possible on thedecisions of train operating companies. Likewise in final consumer markets, if puremarginal social cost pricing is impossible, prices should be as differentiated as possible in order to minimize the extent to which users who are willing to paymarginal social cost are dissuaded from using rail.

The solutions to potential barriers for implementation of MCP in rail, assummarised in table 2.3, implies that the main implementation path might be asfollows. Existing EU proposals should remove the organizational constraints overthe next few years, whilst further research will remove the technological barriers.The remaining key issues then are the relationships between prices on the differentmodes and the willingness of governments to provide subsidies. The currentsituation is very variable with many countries (such as Sweden and the Netherlands)charging below MC for infrastructure and some considerably above (such asGermany). After 5 years, it is envisioned that every country charges marginal costof wear and tear including renewals as part of a two-part tariff where necessary.Second best subsidies to train operators should be in place to allow for incorrect pricing of competing modes and no environmental costs should be charged unlessthis is true in other modes. Open access for freight and franchising of passengerservices should lead to efficient pricing of operations, with Ramsey pricing wherenecessary for financial reasons. After 10 years the problems of measuringcongestion and scarcity should be overcome, hence full MCP still as part of a two- part tariff where needed, should be applied to infrastructure pricing. End usersshould be paying Ramsey priced tariffs and second best subsidies will bemaintained only if other transport modes are not efficiently priced. Table 2.4summarises the discussion on implementation paths in rail transport for the short,medium and long term. The paths are split according to a basic timeframe: shortterm (up to 5 years), medium term (5 to 10 years) and long term (10 years and beyond).

Table 2.4: Potential implementation paths to pricing rail infrastructure

Short Term Medium Term Long TermRailinfrastructurecharging

No changescurrently.

All countries implementMCP of wear and tear.Introduce environmentalcharges, if charged onother modes.

Full MCP includingcongestion, scarcity andenvironmental costs.Introduce accidentcharges, if charged on

other modes.Charges to endusers

No changes. Introduce Ramsey pricingwith second bestadjustments for pricing ofother modes.

Continue with Ramseypricing, reflectingrevised infrastructurecharges too.

Technology Establish agreedprocedures forestimating orincorporatingcongestion andscarcity costs.

Establish agreedprocedures for estimatingor incorporating accidentand environmental costs.

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Short Term Medium Term Long TermInfrastructure Use cost-benefit

analysis to evaluatetargeted investments

to alleviate currentcapacity constraints.

Implement value for money investment to alleviatecapacity constraints and assess the need for anytargeted line closures in the face of over capacity.

Marketcharacteristics

Complete the move towards separation ofinfrastructure from operations and establishindependent regulator.

Determine appropriatemix of open accessversus franchisedoperations.

We do not expect to see further significant changes in general to rail infrastructurecharges in the short term, but within 5 years we expect all countries to implement a pattern based on a variable charge reflecting marginal wear and tear. Environmentalcharges at this stage will only be seen as acceptable if already imposed on othermodes. Charges to end-users will by this stage be more explicitly based on Ramsey pricing principles. Within 10 years it should be possible to modify the variableelement of the charge to reflect all the elements of marginal social cost, althoughagain acceptability of this will depend on progress on other modes.

This section is based on the background reports:

Matthews B., Nash C., Nilsson J-E. and Farkas G. (2002). Institutional andTechnological Barriers to Implementation - Rail Transport, MC-ICAM Task 5.2 part1.

Matthews B. and Nash C., (2002). Railway Infrastructure Charging in Britain - theProcess of Re-organisation and Reform, MC-ICAM Task 5.2 part 2 .

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3. Air Transport

The air transport industry consists of many players, including airlines, airports,ground transport authorities, local, state and EU governments, the travelling public,cargo and the general public. In general terms, airlines are the users of airports, with passengers and cargo representing derived demand. The airlines within Europe areowned by a variety of institutions. Some are fully privatised, such as BritishAirways, others are entirely government owned, such as Olympic, and some are a public-private partnership, such as Air France. In general, airlines aim to maximize profits and consequently desire to minimize charges paid to airports andEUROCONTROL (for en-route sector usage). Airports within Europe are generally publicly owned with one or two notable exceptions, for example the British AirportAuthority (BAA) owns and runs the four London airports. Government interest alsolies in the employment opportunities provided by the air transport industry, throughwhich they collect both labour and transport taxes. The general public is affected byairports directly, through noise and congestion issues both from the air and on theground and indirectly through house values.

The aims of this section are to evaluate second best MCP mechanisms through asimple modelling approach and derive empirical results for Schiphol Amsterdamairport. Unlike rail, where MCP has been analysed and in some countriesimplemented, airport pricing is largely a secret, except for the London airportswhere the Civil Aviation Authority (CAA) publishes price caps for the privatisedairports in an open manner. The current tariffs are known for all airports in Europe, but the economic rationale lying behind the prices is unclear, hence the aim of thisexercise was to evaluate the appropriate levels of MCP and then compare them tocurrent prices for the case study. Subsequently, the aim is to discuss barriers to thesetting of MC-based tariffs and suggest implementation paths to move from current pricing to the proposed pricing at all airports in Europe. To this end, section 3.1examines externalities of the airport system and sections 3.2 and 3.3 discusses thecurrent and proposed MCP measures that could be applied at all airports. Section3.4 presents a modelling approach in order to compute second-best MCP andspecifically compute such a pricing scheme for Schiphol Amsterdam airport. Thescheme suggested includes peak and off-peak pricing with charges for delays andnoise pollution and is substantially different to the current pricing mechanism,which is weight rather than time based. Finally, section 3.6 discusses barriers andconstraints to implementation of MCP and suggests potential implementation paths,describing how to reach the proposed solutions from the current situation inincremental steps over time.

3.1 Types and Drivers of Externalities at AirportsAirport capacity that limits demand is a major driver of all the externalities, asdescribed in table 3.1. In general, the capacity of an airport is defined as the volumeof passengers and cargo that can be accommodated within a given time period (e.g.,an hour). This capacity consists of several distinct components, as described in thefollowing list.

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Runway capacity (maximum number of take offs and landings per hour thatcan be performed safely);

Terminal capacity (number of passengers that can move about the terminalat an acceptable pace in a given time unit);

Apron capacity (maximum number of aircraft per area that can be served per time unit)

Air traffic control (ATC) capacity (maximum number of aircraftapproaching or departing the airport in a given time frame)

Gates (number of gates available in a time frame)

If capacity is insufficient to accommodate demand then delays will develop.However, runway capacity changes as a function of operational conditions such asaircraft spacing, proximity of runways one to the other, runway characteristics andairframe technology. It has been argued that head-up displays on aircraft, grooved,cement runways and a reduction in distance between aircraft movements togethercould expand existing capacity by at least one-third. This should be considered inconjunction with the pricing mechanisms proposed in the current study.

The second major driver of externalities is the market structure and specifically thedemand for air transportation, which is characterized by two main elements:

1. Traffic pattern (passengers origin-destination demand matrix), which in partreflects the configuration of airlines networks (e.g., hub-andspoke, multi hub,alliances linked networks, linear networks)2. Peak and off-peak daily and seasonal demand patterns

Demand fluctuations over a 24-hour period at major hub airports can be extreme.For example, daily demand at Schiphol airport has three major peak times: 9 a.m.,12-1 p.m., and 3 p.m., see graph 3.1 for details. Shoulder or off-peak periods show asubstantial drop in demand.

Graph 3.1: Annual passenger volume in 2001 by time of day at Schiphol airport

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0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Arrivals Departures

Clearly the market structure and demand patterns affect other externalities, namelynoise and air pollution and cause ground transportation congestion in the process.

Table 3.1: Types and drivers of externalities at airports

Type ofExternality

Externality Driver

OperationalCongestion anddelays

Demand profile & volume

Airport capacity (airside, grooved runways etc.)Technological infrastructure Airport operational characteristics (hub) Airframe characteristics & operating conditions(head-up displays etc.)

Safety

Accidents,congestion anddelays

Demand profile & volume Air traffic control behaviour (safe distancebetween ACM)

Airport capacity (runways etc.)Technological infrastructure

Airframe operating conditions

Environmental

Noise, air andwater pollution

Demand profile & volumePopulation area and density

Aircraft characteristics (older, noisier etc.)Traffic patterns (ground transport access)

Airport operational characteristics (hub)Technological infrastructure

3.2 Current Pricing Mechanisms at AirportsCurrently, airport activity related charges consist mainly of the following twoservices:

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i) Airport tariffs (landing and take-off charges, aircraft parking charges, passenger boarding charges, freight loading and unloading charges, securityand control charges for passengers and freight);ii) Handling (administrative assistance and supervision, baggage assistance,freight and mail, runway operations assistance, cleaning and ramp services,fuel assistance, aircraft maintenance assistance, air operations and crewassistance, ground transport and catering).

The price determination mechanisms differ substantially from one service to anotherand we will now discuss each in detail. The European Union is interested in uniformcharging principles in the long run, based on the following criterion:

airport differentiation according to traffic dimension e.g. size of market; differentiation within airports according to traffic intensity during a day; correlation with the quality and quantity of the supplied services; cost recovery considerations, including development and improvement; environmental protection goals.

These criteria are often not applied to date, and frequently the update of the level oftariffs would appear to be made by the local and state governments, mainlyadjusting the level to the forecasted inflation rate given regional competition. Thestructure of the tariffs is mainly linked to the technical features of the aircraft suchas weight, and the duration of infrastructure use. In particular, landing and take-offcharges are determined as follows:

Landing charges The charge applied to the aircraft is proportional to the maximum take-offweight (a price per tonne is fixed forthe first 25 tonnes and a higher pricefor the following tonnes).

Parking fees for aircraft(Apron)

The charge applied to the aircraft is proportional to the maximum take-offweight and is equal for internal andinternational flights

The result is a price structure that does not reflect management and operating costs,and does not differentiate according to changes in demand during the day.Moreover, the level of landing charges and parking charges increases for nightflights (a 50% increase is applied to night flights to cover lighting expenses in Italy).In this case, a cost based logic drives the increase, but results in a furtherdisincentive to flying during less congested periods such as night, at least at thoseairports where night flying is permitted. Clearly some airports have begun peak andoff-peak pricing, such as BAA and Brussels, however the number of cases isdiminutive and the additional peak charge is relatively small.

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The airport handling services market is in general privatised, consequentlyspecialized companies handle both baggage and cargo. Within this market, tariffsare generally determined through contracts between the handling services operatorand the customer, based on a multiplicity of factors such as cost, market power andmedium and long-term objectives of the operators. The level of the tariffs istherefore extremely uneven, and generally negotiated on a one-to-one basis with thespecific customer.

A tax on aircraft noise emissions, if it exists, is normally added on top of landingcharges paid by the airlines, and is proportional to noise emissions. The incomefrom this tax, collected from airlines by the airport operators, is currently transferreddirectly to city, county or federal governments. The revenues are earmarked tofinance schemes to reduce noise emissions from aircraft, complete and improveacoustic pollution monitoring systems, reduce noise pollution and pay compensationto residents living near the airport area. This charge is already in existence at certainairports, such as Schiphol Amsterdam and yet to be legalized in other countries,such as Italy. Fees to account for NOx and CO2 emissions are not yet considered inany form.

Non-aeronautical fees collected from concessions amount to between 40 and 60% ofall airport revenues. The question then arises as to whether these additional revenuesshould be used to expand existing infrastructure or whether airside operations aloneshould cover these costs. If an airport is government owned, it is also unclear as towhat yield level could be considered acceptable with respect to airside operationsand whether airport profitability ought to include non-aeronautical revenue. Clearly,if airport managers were to receive bonuses based on revenue achieved, all aspectsof airport revenue would be promoted. However, landside concessions are entirelydependent on derived airside demand in general. Zhang and Zhang (2002) wouldappear to argue that consideration of both sets of revenue is important, dependent onwhether the airport is privatised or not, whilst the CAA would appear to be movingtowards a single till system for the three privatised airports in London.

3.3 Proposed New Pricing Mechanism for AirportsThe proposed pricing measures aim to correct inefficiencies including:

(i) peak and off-peak charges , needed as a result of airline network choice andaimed at ensuring efficient use of current capacity limitations;(ii) congestion charges , in the face of limited and indivisible runway capacity,demand may exceed available capacity generating congestion and delay whichmay not be internalised in its entirety by all airlines (Brueckner (2002) arguesthat airlines at hub airports internalise their own congestion costs which suggeststhat such charges would consequently be relatively low. On the other hand,congestion can be substantially high at hub airports, suggesting perhaps theopposite, a subject for debate in the current literature e.g. Daniel (1995));(iii)noise charges , due to environmental externalities, which if unpriced, willresult in social costs exceeding users costs.

Other externalities, including air pollution, accidents and ground traffic congestion,are not considered within the proposed, short-term pricing mechanism modelled in

section 3.4. Air pollution has been modelled very little in the air transport industry

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(see for example Perl et al. (1997), Lu and Morrell (2001), Schipper (2001) andOum and Tretheway (1988)) necessary data will need to be collected in the short tomedium term, in order to lead to potential pricing schemes in the longer term. Air pollution needs to be considered both at airports, where the majority of fuel is spent(approximately 60%) and along flight paths, through EUROCONTROL inter-sectoral charges. Perl et al. (1997) suggest using economic calculations drawn fromresearch in other ground transportation fields and multiplying these figures with theestimated yearly emission inventories emanating at airports. Using Lyon-Satolas asan example, they do not provide a single value, but rather a range of potential costlevels based on the following data: total number of aircraft movements, type ofaircraft and engines employed and the average time that aircraft spend in taxi-idle-queue mode. The probability of accidents is very small, and much greater researchneeds to be undertaken in order to find valid methods for charging. Finally, groundtraffic congestion needs to be considered in a multi-modal analysis.

3.4 Schiphol Case StudyThe aim of this section is to discuss the modelling approach subsequently applied toSchiphol airport in order to compute second-best MC prices. In order to undertakethe analysis, the following information was collected (however, it should be notedthat it has proven extremely difficult to attain useful information and as part of theMCP introduction, data collection will need to be improved and made publiclyavailable):

(i) airport charges including landing, passenger, noise-related and emission-related, parking, security, terminal navaid, lighting and cargo charges and taxesfor various airports as well as fuel costs and ground handling charges(ii) airport operating costs and revenues from airside and landside operations(iii) capacity data including runway, terminal, apron and air-traffic controlmaximum capacities on an hourly, daily and weekly basis as well as number ofgates and baggage handling capabilities(iv) origin-destination passenger and cargo matrix(v) delay data as an average number of minutes per peak and off-peak periods

Having chosen a social welfare maximisation model with congestion and noiseexternalities and an airport minimum net revenue constraint, the following notationand assumptions are required to solve the model.

Notation Decision Variables: P 1 airport charge in peak period P 2 airport charge off-peak

Data:t ={1,2} index for peak/off-peak periods t percentage of time airport operates under peak/off-peak demand

D t (P t ) demand in the peak/off-peak perioda t intersection of demand function in peak/off-peak periodbt elasticity of price to demand in peak/off-peak periodc(D t (P t ) average/marginal cost per ACM in peak/off-peak period

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FC fixed cost of providing capacityC congestion costs per ACM

N noise costs per ACM level of profit that the airport must attain

Assumption (A1) specifies that the demand is linear in price. We also assume thatthere are no cross-elasticities between the two periods, mostly for reasons of datacollection. Assumption (A2) specifies that the MC of maintaining the infrastructureof the airport increases linearly in aircraft movements (ACM). The assumption oflinearity in turn means that we are assuming that average cost equals MC. This issubject to debate and needs to be analysed more accurately when relevant data can be collected. Morrison and Winston (1989) evaluate the marginal cost of airportmaintenance at $40 (in 1989 terms) per landing, however both Pels et al. (2000) andAdler et al. (2002) find constant returns to scale to exist at airports. Assumption(A3) specifies that we are assuming an additional fixed cost with respect to the costof providing current capacity. If we wish to consider the addition of new capacity, astep function is required, in order to consider the indivisibility of runway expansion.

The model, taking account of assumptions A1 to A3, can be defined as in equations(1) and (2).

( ) ( ) ( )( )

( ) ( ) ( )( )

( ) ( )( )2222111111

22222222

11111111

2

2

2

1

1

121

max

P ba P ba N DC FC

P bac P xd xba

P bac P xd xba f

ba

P

ba

P ,P P

+++

++++

+++=

(1)

subject to:

( )( )[ ] ( )( )[ ] FC c P P bac P P ba +++ 222222111111 (2)

The objective function aims to maximize social welfare, as defined by consumer(airlines) and producer (airport) surplus less the cost of providing capacity,congestion and noise externalities. It is assumed that congestion charges only occuronce full capacity has been utilized and noise charges are paid by all flights equally.

Constraint (2) sets a minimum level of profitability for an airport at , where = 0is a break-even constraint. Consequently, the model will compute the drop in socialwelfare corresponding to one additional unit of airport profitability ( 1).

Solution to model for Schiphol airport: The current situation at Schiphol airport isthat all landings pay the same fixed price, on average 3,170, and demand at the peak period is on average 42 landings and at off-peak 25. The maximum capacityfor aircraft landings is approximately 35 per hour. One set of results is presented intable 3.2.

Table 3.2: Results of Schiphol case study

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SocialWelfare in

s perhour

Airportprofit in s per

hour

Peaktariffs in s perlanding

Off-peaktariffs

in s perlanding

Numberof Peaklandings

Numberof Off- peak

landings

Numberof

aircraftDelayed

1

0 35,168 17,954 3,350 2,900 39.7 29.4 4.7 0 20,000 35,095 20,000 3,433 3,006 38.2 27.9 3.2 0.077 25,000 33,373 25,000 3,644 3,450 34.4 21.7 0 1.147

Under the requirement that the airport breaks-even, constraint (2) is redundant andthe airport achieves 17,954 per hour profit, as compared to the approximately 60,000 profit it is achieving today. On the other hand, we are only consideringairside revenue, whereas 50% of Schiphols revenue is drawn from landsideconcessions (The Civil Aviation Authority of Great Britain is discussing this issuetoday and planning to move to a dual till system, as presented here). The results ofthe model show that peak period prices should increase to 3,350 in order to reduce

congestion slightly. Currently, demand in the peak period is 7 landings above theairport capacity of approximately 35 landings per hour. Under this pricing regime,delay would drop to just under 5 landings. Off-peak prices should be reduced to 2,900, in order to increase social welfare. This would enable the airport to be usedmore efficiently, encouraging a more uniform demand pattern and reducing delaysdue to congestion. As the net profit requirement increases, social welfare decreases,tariffs increase in both peak and off-peak periods and delays drop. However, giventhe fact that slot allocation is already limited so we are evaluating an already stunteddemand curve, there is obvious room for expansion if the political issues can beresolved.

The results of this model demonstrate the need to move towards MCP in order toimprove the efficient use of monopolistic airports. It has also become clear indeveloping the model and collecting the data required that several barriers exist tocomputing MCP tariffs today and in resolving some of the disagreements that existin the literature as to the most appropriate path over time. The barriers andimplementation paths are discussed in the following sections.

3.5 Barriers and Constraints to Implementation of Proposed Pricing MechanismsThe barriers fall into three broad categories, namely institutional, acceptability and,to a smaller extent, technological. The biggest barrier today to changing the pricingformula would appear to be the lack of transparency involved in the entire charge-setting approach making suggestions for appropriate tariff setting very difficult. It iscurrently very difficult to ascertain the formula that lies behind the setting of airportcharges, though the levels of charges themselves are fairly well known. It may infact be true that no formulas are used to set charge levels, rather simple accountingrules may be followed in which last year's tariffs are increased by at least the levelof inflation, considering also the competitors levels, namely other airports aroundEurope. Consequently, it could be argued that the first institutional and legalrequirement necessary to begin the policy of first or second best MCP is to clearlyspecify the current formula, often set by local or state government. A clear and openexplanation of the computation will aid in reducing lobby power that always prefersthe status quo and improve acceptability of the entire scheme amongst politiciansand the public alike.

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A second barrier is the lack of harmonization between the countries within the EU.An agreed pricing formula needs to be defined at EU level, ensuring minimumdistortion amongst airports. Clearly, levels can be different across countries but themethods by which they are computed should be similar to ensure that allexternalities are internalised and not simply passed from one country or region toanother. There would also need to be an agreed upon administrative body, such asEUROCONTROL, that could ensure that if peak demand indeed changes withadjustment in tariffs, the airports are able to respond. Certainly newer aircraft withlower noise levels, for example, ought to be continually encouraged throughappropriate tariffs. In this respect, technology is constantly in flux and needs to bemanaged.

Another consideration is the natural tendency of airlines to push towards monopolyusing hub airport market power. The trade off is airline profitability from the hub-spoke network, through aggregation of demand hence lower costs versuscompetition, which ensures lower airfares in the long run. Thus, whilst it is notworthwhile preventing airlines from developing hub-spoke networks, a balancemust be attained through some form of regulation. One alternative is to authorizelower airport fees for new entrants, thus warding off excess airline profits. Thequestion here is whether international carriers should pay the same as regional,smaller airlines and whether discriminatory charges would break EU and state law.

Another barrier to the introduction of MCP will likely come from the airportsthemselves, who have little interest in either annoying their customers, the airlines,or collecting additional data that will be required to accurately charge the newtariffs. Hence, the local and state governments will probably need to pass newlegislation in order to implement the new pricing regime. It is clear that somelegislation has already been passed, but this is not true in all countries and tends to be partial at best.

Within the air transport industry today, charges are already levied and substantialdata collected, consequently, technology is not a barrier to pricing. However, delaydata is currently very difficult to compute and scarcity is not considered at all.Improvements in technology, based on research, should aid in the computation of both scarcity and delay on an on-line basis. Furthermore, expansion of airportinfrastructure, namely the building of additional runways and terminals, assuggested in the results of the Schiphol case study presents political, acceptabilityand legal problems that will need to be overcome. The political problems lie in landuse and environmental issues. Table 3.3 describes the key barriers to MCP thatcurrently exist and have been identified, based on the discussion above.

Table 3.3: Barriers and solutions to marginal cost pricing at airports

Categories Barrier SolutionsInstitutional:OrganizationalPoliticalLegal

1. Monopolistic hub airport power.2. Monopolistic flag carrier power.3. Lack of harmonisation acrossEU countries and across smallerand hub airports.

1. Privatise airports with price capregulation or regulate airport pricingusing transparent mechanisms that areunderstandable.2. Privatise all airlines and encourage

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Categories Barrier Solutionscompetition.3. Artificially restrict aircraft movements,saving some slots for new entrants

and/or introduce market mechanisms forslot allocation. Acceptability 1. Status quo strongly preferred

by powerful airline lobby groups.2. Not acceptable to chargeenvironmental costs until othermodes charged.

1. Through international negotiations andaction at EU level, slowly introduce fueltaxes, thus ensuring refuelling at zero-taxcountries is not possible.2. Encourage all EU countries tointroduce environmental charges both ofnoise and air pollution at all airports (not

just hubs) and then across all modes oftransport.

Technological 1. Data collection of delays andtheir causes.2. Current questions as to noisemeasurement and data collection.3. Lack of information on scarcityand its estimation.

1. Invest in research on the question ofscarcity estimation.2. Legislate reporting of all delayinformation on a standardised EU-widebasis.3. Based on noise mapping data (EUdatabase expected by 2005), evaluatemethods to translate data into noisecharges.

Modelling constraints drawing on the barriers described in table 3.3 would includethe following:

1. Restrict size of change from current tariff in short term, weakenconstraints over medium term with no restrictions over long term.2. Cap tariffs below MC at small airports in short term, relaxing regulationover medium term with no restrictions over long term. At large hub airports,tariffs equal to MC (i.e. not higher) in short, medium and long term.3. Introduce slot charges to reflect issue of scarcity. Requires research inshort term to analyse appropriate market mechanism. Introduce at large, hubairports in medium term and apply to all airports in long term.4. Offer tariff reduction to airlines investing in technology to improvecapacity usage in short-term.5. Permit two tariffs (peak/off-peak), introducing continually changingcharges (based on delay data) in longer-term.6. Add additional charge to cover research and IT costs for data collectionissues in short to medium term.7. Permit price discrimination (different tariff levels) between internationalcarriers and smaller, regional airlines, if not illegal.8. Constrain size of changes until all airports around Europe are using MCP principles.9. Include budget constraint, such that airports are not subsidized beyond a pre-specified level.

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3.6 Implementation Paths to Marginal Cost Pricing at Airports

Having discussed the barriers to achieving MCP schemes, we will now attempt toaddress the issue of implementation. One of the important elements toimplementation of MCP is the necessity to ensure that the schemes are implementedat all airports within the European Union. Clearly some airports have begun toimplement peak and night charges. However, the additional peak charges arecurrently very low and are implemented only by BAA London and SchipholAmsterdam and nominally by Dublin, Hamburg, Athens and Madrid. Furthermore,some airports charge additional night tariffs whilst others are cheaper over night andyet others shut down entirely over night. Schiphol Amsterdam has initiated noisecharges to fund a noise abatement scheme but the rest of the airports in Europe haveyet to initiate such charges. No congestion or delay charges have yet beenimplemented.

In the short-term, the implementation path could consider the introduction of peak/off-peak, congestion and noise charges, first at all major, hub airports. Themedium or long term should lead to a harmonisation amongst all airports. There isthe question of whether small, spoke airports might be exempted from such pricingsystems and this may in fact be preferable in order to encourage traffic to usesecondary airports.

Another question arises as to whether privatisation of airports and subsequentmarket driven pricing could in fact overcome some of the political barriersdiscussed in the previous section. Nilsson (2002) discusses the development of amarket mechanism such as an auction to decide on issues of slot allocation, whichare currently chosen according to grandfather principles. This principle specifiesthat an airline using its slots more than 80% of the time in the previous year haveautomatic rights to the same slot allocation in the coming year. Whilst open marketmechanisms would probably encourage higher prices, drawing profits from airlinesto airports, ensuring the availability and use of slots by new entrants needs to beconsidered too. These are thorny issues, which are a long way from being settled,and the monopoly powers of both hub based flag carriers and airports, in thisinstance, are likely to cause serious political barriers to implementation. In theshorter term, legislation is more likely to successfully implement social welfaremaximization to the extent possible. Following the EU liberalization policies andopen skies practices, both airlines and airports should eventually be privatised,encouraging market mechanisms to eventually solve the pricing issues, with somesafeguards preventing extensive monopoly power. Alternatively, airports couldremain government-owned and regulated, in which case it would appear to beimportant to regulate both airside and landside revenues together. Zhang and Zhang(2002) show that a profit-maximizing monopolist that controls both airsideoperations and concessions will discount the price charged for operations in order to boost travel through the airport and increase its revenue from concession profits.This is consistent with Starkies (2001) contention that allowing airports to retainmonopoly profits from concessions encourages them to set lower prices foroperations. Zhang and Zhang (2002) also compare the timing of airport capacityexpansions under three administration regimes; (1) profit-maximizing, (2) welfare-

maximizing subject to a long-run self-financing constraint, and (3) unconstrained

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welfare maximizing. They establish two results; expansion is delayed underconstrained welfare maximisation compared to the unconstrained regime, anddelayed under profit maximisation compared to constrained welfare maximisation.Furthermore, permitting a private airport to retain concession profits encourages itto expand sooner than it would otherwise.

Clearly, high-speed trains are a serious competitor within Europe to the air transportindustry, as well as autobahns to a lesser extent. Average air trip lengths withinEurope are 750 kilometres, a distance over which high speed trains in countries suchas France and Italy compete. If prices at airports increase dramatically and even ifsome of the increase is not rolled over to the end-consumer, clearly a modal changefrom air to rail is a possibility. Given that rail is subsidized and air is to a muchlesser extent, this too should be a consideration.

Airlines have developed hub-and-spoke networks, up until 1997 due to the bi-lateralagreements between each country. Since liberalization and the introduction ofcabotage rights, the European airlines are now freer to develop their most preferablenetworks. Based on academic research (Adler and Berechman (2001), Button(2002)) and current practice in both the U.S. and Europe, it would appear that thehub-spoke system is efficient due in part to the aggregation of demand along fewer paths and the reduction in costs due to centralization. However, major congestionoccurs at hub airports and is a direct result of demand patterns. Travellers flying viaa hub prefer to minimize layover time and airlines therefore choose to fly in over anhour or two and then fly out over an hour or two in approximately two or threewaves over a 24 hour period. Capacity needs to be sufficient to meet this peak needand slot allocations need to be organized to enable such network patterns. Withoutthe ability to fly in waves, a more fully connected network will be developed withthe resultant loss of efficiency and higher prices for passengers. Consequently a balance needs to be found, in which congestion and delays are minimized throughsufficient infrastructure, namely runways, air traffic control, terminals and groundtransport capabilities on the demand side with pricing measures used to balancesupply.

The problem of acceptability is a direct result of the market structure. In themajority of cases, airlines are still flag carriers in their respective countries,although this is slowly changing and the airlines are being privatised. The vastmajority of airports in Europe are not yet privatised and in the case of major, hubairports, may behave as monopolists. Consequently, if the aim is to maximize socialwelfare, the results of the models are rather different to the existing situation.Furthermore, lobby power on the part of the directly interested parties and the political organization is such that it will not be simple to change the pricingmechanisms. Moving forward in stages may be more manageable and several pathsare indeed available. The simpler and more immediate path will lead to peak/off- peak pricing and noise charges, which in some cases are slowly beginning to beadopted, such as the Netherlands, and in others are on the legislative agenda, such asItaly. The medium term measures call for pricing delays so as to ensure that airlinesinternalise all congestion, not just that which affects them alone. Charging policiesat airports in the medium term also need to ensure that new entrants are given the

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chance to use all airports. Finally, privatisation issues will probably be decided inthe middle to longer term, as will mechanisms for slot allocation.

Table 3.4 suggests potential implementation paths, which are based on the previousdiscussion. The paths are split according to a basic timeframe: short term (up to 5years), medium term (5 to 10 years) and long term (10 years and beyond). In theshort term, the aim is to gain political acceptability and understanding by allstakeholders in the system. In the medium term, the aim is to achieve welfare gainsfrom reduced externalities and in the long term, the aim is to achieve first bestoptimal pricing under sustainable growth.

Table 3.4: Potential implementation paths to pricing airports

Short Term Medium Term Long Term Airport pricing Harmonise state

legislation accordingto EU legislation,define delay legallyand set-up EU-widedatabase for allairports.

Initiate use of peak-off

peak, congestion and noisepricing mechanism at allairports, such that totalcost is not substantiallydifferent to current, totalairport charges.

Use MCP mechanism

without constraints.Introduce fuel taxes toaccount for NOx andCO2 emissions.

Technology Encourage airlines to adopt head-up technology incockpit to improve productivity through tariffbreaks.Set up EU-wide noise, air and congestion database.

Continue to invest intechnological researchto reduce noise and airpollution in new aircraft.

Infrastructure Improve runwaysand air traffic controlcapabilities toincrease runwayproductivity.

Increase runway capacity and remaining infrastructureto meet demand patterns, if necessary and possible.

Use of revenues Financeinfrastructureimprovements atairport and datacollation.

Cross-subsidise lowerdemand airports with hubairports, thus ensuringservice for all and somediversion to secondaryairport usage.

Finance increasedinfrastructure, includingground transportaccess.

Marketcharacteristics

Privatise airlines as p