Setting airport regulated charges: the choice between ... · July 2014 | Frontier Economics 3...

July 2014 | Frontier Economics 1

Setting airport regulated charges: the

choice between single-till and dual-till

A NOTE PREPARED FOR EASYJET

Over the last twenty years, a recurring theme in the field of airport price

regulation has been whether aeronautical charges, if regulated at all, should be set

on a “single-till” or a “dual-till” basis.

Under a single-till approach, profits from an airport’s non-aeronautical activities

(for example, from the provision of retail space or car parking) are deducted

from the revenue requirement for aeronautical services before determining the

level of aeronautical charges (typically covering aircraft take-off, landing, parking

and use of air bridges, provision of terminal services to passengers and airlines,

including processing and screening of passengers and their baggage). Under a

dual-till approach, instead, the regulator excludes non-aeronautical activities from

its calculation and focusses solely on aeronautical functions.

The UK airports regulator most recently considered this issue in 2000/011, and

ultimately determined to continue with single-till regulation. This decision was

influenced by the UK Competition Commission, which at the time questioned

whether dual-till arrangements would lead to improved efficiency and stated that

a switch to dual-till would lead to “a substantial transfer of income to airports

from airlines and/or their passengers, potentially undermining regulatory

credibility and creating regulatory uncertainty”2.

Recently the Irish airports regulator has also consulted on the same topic and

come to the same conclusion.

In contrast, in recent years we have seen a move away from single-till regulation

in both Spain and France3. At the same time, the European Directive on Airport

Charging is open-minded on the issue, leaving the matter to Member States4. On

the other hand, single-till approaches are generally supported by ICAO5.

Furthermore, the recently adopted new EU Guidelines on State Aid to airports6

1 CAA (December 2000) “The ‘Single-till’ and the ‘Dual-till’ Approach to the Price Regulation of

Airports - Consultation Paper”

2 Competition Commission (2002) report on price caps for BAA airports, Appendix 2.3.

3 Commission for Aviation Regulation CP4/2010 and CP1/2012.

4 Directive 2009/12/EC of the European Parliament and of the Council of 11 March 2009 on

Airport Charges. See preamble, para. 2.

5 ICAO Doc 9082/7 – paragraph 22(i)

6 Commission Communication C(2014) 963, “Guidelines on State aid to airports and airlines”.

2 Frontier Economics | July 2014

Setting airport regulated charges: the choice

between single-till and dual-till

implicitly recognise single-till principles by stating that “[in] order to assess

whether an arrangement concluded by an airport with an airline complies with

the [state aid] test, expected non-aeronautical revenues stemming from the

airline's activity should be taken into consideration …”.7

It is clear that opinion remains divided on this topic.

In this paper we try and bring some clarity to the economic issues surrounding

single-till and dual-till regulation. We start by considering the matter from a

theoretical perspective, asking: which approach is likely to most closely replicate

the outcome of a competitive market, promoting efficient operating and

investment decisions? We then go on to consider the practical issues of

implementing price regulation. We provide guidance as to how the regulatory till

should be defined and single- or dual-till regulation could be applied to result in

efficient prices to airlines, and effective incentives and rewards for airport

operators.

We note that support for single-till or dual-till usually divides along clear lines:

airlines and IATA in favour of single-till, airports in favour of dual-till. This says

a lot about stakeholder perceptions of the issue and who are thought to be the

winners and losers from the alternative approaches. Opponents tend to observe

that single-till regulation reduces airport charges, discouraging investment in

airport capacity. This may be perverse at a time when capacity at many major

European airports is becoming increasingly stretched.

Summary of conclusions

The issue of regulating airport charges arises only when an airport has substantial

market power (SMP). In these circumstances we conclude that regulation based

on a single-till model is generally superior to solutions based on the dual-till

approach.

Airports that do not have SMP will respond to competitive pressures by

offsetting non-aeronautical profits against aeronautical charges, when the non-

aeronautical profits are a by-product of aeronautical activities.

In a regulatory setting, the single-till approach mimics this dynamic more

accurately than dual-till and therefore leads to more economically efficient

outcomes. Specifically, even when single-till regulation reduces aeronautical

charges, the airport should have efficient incentives to expand aeronautical

capacity, provided regulation has been properly applied.

7 Ibid., para. 64.




We note that where an airport is subject to single-till regulation, the airport entity

should expect to earn a competitive rate of return on its activities, provided it is

operating efficiently.

Against this benchmark, a switch to dual-till has the prospect of transferring

profits into an unregulated entity while at the same time increasing aeronautical

charges. The net result is dual- allows the airport to generate returns above

competitive level.

A move to dual-till is sometimes justified by arguing that a “cross-subsidy” is

being removed. But we demonstrate that there is no cross subsidy in the first

place. The commercial activities that properly belong within the single-till are by-

products of the main activity of the airport. And insofar as these by-products

generate locational rents, these rents would be fully reflected in aeronautical

charges set by an airport in a competitive market.

We also consider the argument that has been advanced in some places that dual-

till regulation is more appropriate for congested airports. We show that this is not

correct, being based on an incorrect interpretation of theoretical models whose

properties bear little relation to the reality of congested airports.

However, we conclude that the application of single-till regulation does not

always imply lower airport charges than dual-till. In many cases, especially at

smaller airports, it is possible that charges should be the same under either

approach.

In the final section of this paper we also consider a range of practical issues that

should be addressed to ensure that single-till regulation works effectively and as

intended. This includes the need for arrangements that encourage and reward the

airport for developing non-aeronautical profits, but also discourage regulatory

gaming over the anticipated levels of those profits.

Models of regulation

Before we start our analysis, we need to describe in more details the two models

of airport charges regulation which we consider in this paper.

As noted above, in practice the regulation of an airport’s aeronautical charges can

be done in a variety of ways. For the purpose of this discussion, though, we only

need a high-level definition of single-till and dual-till. This is because the key

conclusions of our assessment do not depend on the specific implementation of

the regulatory framework.

The regulatory till represents the total of the airport revenues that need to be

recovered via regulated aeronautical charges.

Depending on the regulatory model chosen, a regulator might wish to focus only

the provision of aeronautical services or may also take into account all or a share




of the profits from non-aeronautical services. A regulator is generally faced by a

continuum of options along this spectrum. In practice, however, the regulatory

models can be divided into two groups: single-till and dual-till. We consider each

in turn.

Figure 1 below shows in a stylised way how the regulatory till is defined under a

single-till approach.

Figure 1. Simple schematic for deriving the regulatory till under a single-till approach

This contrasts with Figure 2, which shows how the till is derived under a dual-till

approach.

Figure 2. Simple schematic for deriving the regulatory till under a dual-till approach

On the face of it, it appears that the two approaches are very similar. In both

cases non-aeronautical activities are excluded in some way to derive the regulated

till. In the single-till approach, the regulatory till is determined by deducted non-

Total Airport Costs

Non-Aeronautical Revenues

Less

Regulatory Till

Total Airport Costs

Non-Aeronautical Costs

Less

Regulatory Till




aeronautical revenues from total airport costs, leaving the remainder to be

recovered from aeronautical charges. In the dual-till approach it is non-

aeronautical costs which are deducted. Considered at this conceptual level

therefore, the difference between the two approaches is what happens to the

profit from non-aeronautical services. In the case of single-till regulation this

profit is deducted from the regulatory till and so reduces aeronautical charges,

while in the case of dual-till regulation these profits (if there are any) are retained

by the airport.

We note that the above descriptions provide only a stylised view of the actual

issues that a regulator would have when setting regulated charges. A key issue is

that the definition of “profit” in the previous paragraph needs clarification, as the

economist’s definition of profit differs from the commonly-used accounting

sense of the word.

Furthermore there are many practical issues that a regulator would need to

address. For example, with regards to single-till, there is an obvious issue

associated with deciding which non-aeronautical services should be included in

the regulatory till. On the other hand, dual-till solutions require a thorough cost-

allocation to be carried out so that shared and common costs can be split

between aeronautical and non-aeronautical activities. Failing to allocate costs

properly could result in hidden cross subsidies between aeronautical and non-

aeronautical activities. In turn this may lead to providing the regulated airport

with misleading incentives.

The regulator must address these practical issues when defining the regulatory

framework. We believe that the high-level descriptions we have provided above

are sufficient for the purpose of the discussion presented in this paper. We will,

however, explore some practical issues with the application of airport charges

regulation later on in the paper.

Our approach

The general aim of price regulation is to counter the effects of market power,

preventing the generation of excess profits and promoting efficiency of operation

and investment in sectors where the forces of competition are too weak to

achieve these ends by themselves.

While a purely competitive equilibrium is unattainable, it is a useful conceptual

tool as it acts as a natural benchmark for assessing alternative regulatory options.

Generally, regulatory frameworks that more closely induces a regulated company

to behave as if they were subject to competitive pressures are superior to those

that do not.

Therefore, our approach involves defining two reference scenarios against which

the stylised regulatory options listed above, single-till and dual-till, can be

assessed. We first consider how an airport operating in a competitive market




would take non-aeronautical activities into account in setting aeronautical

charges.

In practice, of course, airport cost structures tend to involve high fixed costs, or

rather costs that are fixed relative to the volume of traffic over the very long run

(the runway and terminal capacity), and relatively low variable costs.

With this cost structure it is inevitable that airport markets cannot correspond to

a textbook model of perfect competition. As a result airports need to price above

short run marginal cost to recover their capital costs. In order to achieve this,

airports need to be differentiated in some way. The obvious differentiation is

spatial: airports are spread out geographically to give each its own catchment. But

other forms of differentiation exist, including serving different segments of the

passenger market, such as low cost carriers or network carriers.

Differentiation lends airports some degree of market power, but it does not

follow that airports automatically need price regulation. Given the high fixed cost

nature of the business, differentiation does not necessarily imply excess profits

for the airport. For simplicity, however, we consider as our second reference

scenario the case of an unregulated airport with a monopoly over passengers, and

again ask the question, how would the monopoly airport take non-aeronautical

activities into account in setting aeronautical charges?

After defining how the competitive and monopoly airport would reflect non-

aeronautical activities in its aeronautical charges, we consider the implication for

airport regulation. Specifically, we compare the single-till and dual-till approaches

with the competitive and monopoly scenarios and draw conclusions about which

approach is likely to generate the most efficient outcome.

The reference scenarios

In this section we set out the reference scenarios, which we will use to assess the

single-till and dual-till approaches to regulation. First, we set out a competitive

scenario.

We then consider how a monopoly airport will set aeronautical charges.

Finally we move on to consider single-till and dual-till regulation and compare

these approaches to the reference scenarios.




Competitive market

We start from considering the hypothetical case of an airport that only provides

aeronautical services. If we assume that an airport is operating in a perfectly

competitive market, and do not concern ourselves with the issues of cost

recovery for fixed investment, competition will drive down airport charges to

equate aeronautical charges with the marginal cost of providing aeronautical

services c. At this level of price economic profit equals zero. In this scenario, all

costs are variable with output/passenger numbers, including any capital costs;

marginal costs are assumed to include a competitive return on any capital

employed.

We now consider whether this conclusion would change if airports started

offering non-aeronautical services too. Clearly the airport would experience costs

in providing non-aeronautical services and would likewise expect to generate

revenues which at a minimum cover those costs. How then would this new

factor affect aeronautical charges?

There are a number of possibilities that must be considered.

Is the non-aeronautical activity expected to cover its costs (i.e. are its

economic profits greater than or equal to zero)?

If this is not the case then the airport would be better off not performing the

non-aeronautical activities in the first place. The airport cannot raise its

aeronautical charges to recover non-aeronautical losses, because it is in a

competitive market and could simply be undercut by rivals that did not

attempt to provide non-aeronautical services.

Provided economic profits from non-aeronautical services are positive,

are these profits related to the throughput of passengers at the airport?

If the airport expects to generate increasing non-aeronautical profits as a

result of increasing passenger numbers (for instance because the fixed assets

costs embodied in in-terminal retain space are used more intensively) then

for any additional cost per passenger the airport expects to incur, it will

perceive an offsetting non-aeronautical profit per passenger, reducing its

perceived marginal costs

In more formal terms, if the airport has a marginal cost c of accommodating

additional passengers and generates non-aeronautical profits of per

passenger, then its perceived marginal cost, of providing aeronautical

services is reduced from to . Hence the airport would equate its

airport charges at equal to its perceived marginal costs:




So we see in this very simple case that the completive airport would pass on all

economic profits from non-aeronautical services in full to passengers in lower

aeronautical charges.

This situation is illustrated in Figure 3 below. Without non-aeronautical profits

output is set at , where the downward-sloping (red) demand curve cuts the

horizontal supply curve at price equal to . With non-aeronautical profits,

output is set higher, at , where the demand curve cuts the horizontal supply

curve at the lower price, reflecting non-aeronautical profits.

Figure 3. Impact of non-aeronautical profits on aeronautical charges – competitive

case

There are a number of important observations to make about this result:

Competitive aeronautical charges can only be reduced by non-aeronautical;

activities. Non aeronautical losses cannot be recovered because of

undercutting from competitors.

Competitive aeronautical charges will only be adjusted if the non-aeronautical

activity is a complement to the aeronautical that is if non-aeronautical

revenues increase as passenger numbers increase. Commercial activities

undertaken by the airport but unrelated to passenger numbers should not be

expected to impact on aeronautical charges.

Aeronautical charges will only be reduced if the airport generates economic

profits from, non-aeronautical activities. If the non-aeronautical activities

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only generate a normal (accounting) profit, hence economic profit is zero,

aeronautical charges will be unaffected by the non-aeronautical activity.

This last point raises an important question. Does this conclusion imply that an

airport will only set lower airport charges if it has market power over its non-

aeronautical activities? The answer to this is no.

First, if the market for the non-aeronautical activities is corresponds to textbook

perfect competition, then the retail prices for the non-aeronautical services will

be determined by the market outside the airport and will equal the marginal cost

of the service. In this limiting case there will be no economic profits from non-

aeronautical services and the issue does not apply. However, in reality some

services could generate economic profits without market power, because of the

presence of fixed costs. Take retail as an example. Assuming that the retail prices

of goods in the airport shops are competitively determined – i.e. determined by

the cost of those goods in shops outside the airport. It is still possible that

economic profits could be generated because the density of customers created in

the terminal building means that sales per m2 of floor space exceed anything that

could reasonably be expected from a high street shop. In this case the retail space

generates locational profits as a result of the concentration of potential customers

created by the terminal building.

Hence we might expect to see larger airports, which are more likely to achieve

these locational profits, setting lower aeronautical charges, other things being

equal.

One final observation is required on this scenario. It is sometimes said that the

outcome described here is “inefficient” because the price of aeronautical services

is set below their marginal cost. But this outcome is not inefficient. The only

non-aeronautical services captured in this system are those that are a by-product

of the aeronautical activity – a complement in economic terms. As such the

airport is behaving as an efficient profit-maximiser in discounting aeronautical

charges. Overall the airport is generating normal profits consistent with the

economic risks of the activity as a whole, and the total marginal revenue from

expanding the airport is equal to the total marginal cost of doing so.

Market power

In this section we consider the case of an airport with unregulated monopoly

power. This is the most extreme case of market power, but the conclusions we

reach apply also in situations where the market is not perfectly competitive, such

as oligopolistic markets.

Again, first we consider the case of an airport that only offers aeronautical

services. Having monopoly power, the airport will set aeronautical charges at the

level at which its marginal revenue for aeronautical activities (that is, the

increment in revenues from serving an additional passenger) equals its marginal




cost (that is, the increment in cost from serving an additional passenger). This is

the condition for the monopolistic equilibrium. If the marginal revenue were

higher than the marginal cost, the airport would have an incentive to generate

more demand by reducing its price. If the marginal revenue were lower than the

marginal cost, the airport would increase the unit price to cover its cost.

We now think about the introduction non-aeronautical services as in the previous

case. The same two questions apply, but the conclusions are somewhat different.

Is the non-aeronautical activity expected to cover its costs (i.e. are its

economic profits greater than or equal to zero)?

In this case, because the airport has no competitors, it is able to pass on

losses from non-aeronautical services in higher aeronautical charges. As we

shall see later, this has important implications for the application of single-till

regulation.

Are these profits related to the throughput of passengers at the

airport?

If the airport expects to generate increasing non-aeronautical profits as a

result of increasing passenger numbers, then for any additional cost per

passenger the airport expects to incur, it will perceive an offsetting non-

aeronautical profit per passenger, reducing its perceived marginal costs

In more formal terms, if the airport expects to generate non-aeronautical

profits per passenger, then in effect its perceived marginal cost, , of

providing aeronautical services is altered from to , where

could be positive or negative, and so could be higher or lower than .

The profit maximising monopolist without non-aeronautical services will set

aeronautical charges at a level , which is higher than the equivalent

competitive level . How much higher depends on how sensitive demand is to

price – the less sensitive the higher will be the monopoly price.

If profits from non-aeronautical services are introduced, it is straightforward to

show that the profit maximising monopoly airport will set aeronautical charges at

, where:

That is, the monopolist will reduce (assuming is positive, increase if

negative) by half the economic profits from non-aeronautical activities. Moreover,

this level of unregulated charges will always be higher than the charge that would

be set by a competitive airport taking non-aeronautical activities into account.




This is illustrated in Figure 4 below. A monopolist will maximise profit by

choosing a level of output that makes marginal revenue equal to marginal cost.

Marginal revenue is the red-dotted line on the figure below. Because marginal

revenue has a steeper slope than the demand curve, output is set at a lower level

and prices are set higher. The monopolist with no non-aeronautical profits sets

aeronautical prices at , which is higher the equivalent competitive level, and

output at , which is lower than in the competitive scenario. Introducing non-

aeronautical profits reduces the monopolist’s aeronautical charges to and

output rises to .

Figure 4. Impact of non-aeronautical profits on aeronautical charges – monopoly

case

Overall we see that the case of unregulated monopoly has some similarities to the

competitive outcome. In particular the profit maximising airport will offset non-

aeronautical economic profits against aeronautical charges. However, market

power allows the airport to retain some of that profit, which would not be

possible in a competitive market. Furthermore, market power allows the airport

to recover losses from non-aeronautical services, at least partially, which is not

possible in the competitive scenario.

It is sometimes observed8 that the presence of non-aeronautical profits may

remove the need for the regulation of aeronautical charges, even if the airport has

8 For instance, see Starkie & Yarrow (2001)

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market power. The logic of this argument is that the profit maximising

aeronautical price is lower than the full monopoly aeronautical price for

in the absence of non-aeronautical activities. Indeed one can go further and

observe that in certain circumstances it is possible that the unregulated

monopolist sets an aeronautical charge that is lower than , the marginal cost

of aeronautical services.

These observations are true but the conclusion about the need for regulation of

an airport monopolist is incorrect.

First, note that the efficient competitive price for aeronautical services in this

situation is , which is always lower than . So an unregulated monopolist will

price above the efficient competitive level, which suggests price regulation would

continue to improve efficiency in this case.

Secondly, it cannot be taken for granted that for an unregulated monopoly the

economic profit from non-aeronautical activities, , is always positive. If it is

negative and the monopoly is unregulated, the airport will set aeronautical

charges even higher than the stand-alone monopoly price, . It would be sound

to argue that no airport would plan on being negative, as this reduces overall

profits. But there is an important difference between what is planned and what

occurs in practice, and this is an important distinction when considering

regulation.

A competitive airport will invest in non-aeronautical activities if it sees the

opportunity to gain competitive advantage9. However, if that investment turns

out badly, the airport will not be able to recover losses from its aeronautical

customers. This is exactly the same as if it were to invest unwisely in aeronautical

facilities. An unregulated monopolist, on the other hand can recover some of the

costs of its inefficiency or misjudgements from its customers. This reduces the

incentive to act efficiently in the first place. The fact that the unregulated

monopolist can recover some part of non-aeronautical losses from passengers

reduces its incentives to be efficient in its commercial developments as well as its

aeronautical activities. Economic regulation can protect passengers from this risk

and promote efficiency on the non-aeronautical as well as the aeronautical side.

9 In this simplified example that advantage comes entirely through the ability to undercut rivals on

aeronautical charges, but in practice this advantage could also result from improved quality of

passenger experience.




Implications for regulation

Dual-till regulation leads to prices set above the competitive level

We have shown that an airport operating in a competitive market will fully offset

expected profits from non-aeronautical activities against aeronautical charges

when those profits are a by-product of aeronautical activities, i.e. when those

profits increase in line with increasing passenger numbers.

We have shown that a competitive airport would set aeronautical prices equal to

its perceived marginal cost, net of those non-aeronautical profits). This outcome

(a price of ) is equivalent to the expected outcome of single-till regulation. This

also holds when the airport has market power as shown in Figure 4.

By contrast, dual-till regulation would be equivalent to capping aeronautical

charges at the marginal cost of aeronautical services, allowing the airport to retain

the profits of non-aeronautical activities. In this case the regulated airport may

charge below the regulated cap, because it is still in its interest to share some of the

non-aeronautical profits with customers, so it will in practice charge the lower of

or . Profit maximising prices will only be lower than the dual-till

regulated price if demand is very elastic and/or if economic profits from non-

aeronautical activities are large relative to aeronautical marginal costs .

In any case, the aeronautical prices that the airport sets will definitely be higher

than the competitive level. This also means that the profit generated by the

airport as a whole will be higher than the competitive level, implying excess

profits to the airport operator. It is unclear why the retention of these excess

profits could be justified. If they are, as described here, created by locational rents

on activities that are by-products of the main airport activity then it is clearly

appropriate for a regulatory authority to consider (and where necessary limit) the

profits of the whole aeronautical activity, which by definition includes the profits

of any by-products.

Single till regulation corresponds more closely to the competitive

outcome

From these observations we conclude that single-till regulation corresponds, in

principle, to the competitive paradigm. It will lead to lower aeronautical charges

than dual-till regulation and charges that correspond more closely to the efficient

level.

We note that, in the presence of SMP, single-till regulation can always be

expected to improve welfare and pricing efficiency relative to the unregulated

situation. In most cases it is likely that dual-till regulation would also improve

efficiency, but to a lesser extent than single-till. In the specific circumstance that

the monopoly price after allowing for non-aeronautical profits (that is, as

explained above, with the monopolist returning half of any non-aeronautical




profits to customers) is lower than the marginal cost of aeronautical services (i.e.

> ) then dual-till regulation would actually be redundant as the airport can

be expected to set charges below the cap set by the regulator anyway. But the

outcome would still be worse for passengers than the single-till outcome as the

price set by the airport would still be higher than the single-till (or the

competitive) outcome.

In the following section we address some of the practical issues of setting single-

till or dual-till regulation. Before moving on, however, we cover two additional

complications. These are:

What happens if the airport has market power in non-aeronautical

services; and

The case of congested airports.

Market power in non-aeronautical services

In the preceding analysis we have assumed that the airport does not have market

power over non-aeronautical services. This means that passengers are paying an

efficient competitive price for retail services, car parking, etc.. Nevertheless, it is

possible that the airport generates economic profits from these activities, because

of fixed costs and the high density of use that these services achieve.

If, however the airport has unregulated market power over non-aeronautical

services then passengers will be being over-charged for these services (meaning

there is a welfare loss) and economic profits from these services will be increased.

In these circumstances, considering Figure 3 and Figure 4, the behaviour of the

airport will remain the same, but aeronautical charges will be set lower, reflecting

the market power in non-aeronautical services.

This outcome is not ideal. In this case aeronautical are in efficiently low – the

airport is leveraging its market power in non-aeronautical into the aeronautical

market. As passengers will not all consume non-aeronautical equally, this also

involves a cross subsidy from the users on the non-aeronautical services to all

other passengers.

Given that in these circumstances the single-till regulated charge will be too

low, while the dual-till charge will be too high it is not possible to say

definitively which leads to the greater welfare loss.

The correct solution from a regulatory point of view, however, should be to

address the issue of market power in the non-aeronautical activities as a separate

issue, and having done so, set airport charges on single-till principles. This

approach offers the prospect of achieving the best possible solution for all

passengers.




Congested airports

There is a limited literature which purports to address the relative merits of

single-till and dual-till regulation by solving theoretical mathematical models.

These papers tend to quote a result that single-till regulation is more efficient for

uncongested airports while dual-till regulation may be more efficient at congested

airports.

We have reviewed this literature and find that these results depend on a specific

stylised formulation of “congestion” that bears little relation to how congestion

actually impacts on airports. Importantly in this literature “congested” should not

be confused with “full”. In this literature airports always have spare capacity.

For this reason alone little or nothing can be inferred from this literature.

In reality congestion delays at major airports tend to be synonymous with the

airport being almost full and slots being in short supply. Under these conditions

ticket prices rise to choke off demand which is reflected in slot values if

aeronautical charges are prevented from rising by regulation.

In these circumstances passenger welfare is largely unaffected by the level of

aeronautical charges or the method by which they are set. In this case the level of

aeronautical charges primarily determines the share of congestion rents between

airlines and the airport.

It is sometimes argued that higher airport charges would act as a signal to expand

the airport when the airport is full. We note that higher capacity prices when an

asset is congested can act as a signal for market entry, but it is by no means clear

that higher prices would give an incumbent airport the incentive to expand that it

is facing no prospect of competitive entry.

In our view this literature cannot be used to draw any useful conclusion about

the merits of different forms of regulation in reality. It does not contradict the

fact that single-till principles remain the benchmark for price-setting in a

competitive market, while decisions over airport expansion, in reality are complex

and balanced policy decisions in which congestion costs form one part of a

complex agenda.

A further explanation of the significance of these issues is given in an annexe.




Practical issues associated with single-till and

dual-till regulation

We recognise, of course, that there is a big difference between a theoretical

model of pricing and a real regulatory mechanism. The method by which a rule is

applied in practice can have a significant bearing on the effectiveness of the

solution.

We have argued that an airport in a competitive market will apply single-till

principles. But this is not the same as saying any form of single-till regulation must

be superior in practice to dual-till regulation.

The application of regulation raises a number of important practical issues, which

include:

The scope of the regulatory till and the definition of included and excluded

non-aeronautical services.

Cost allocation issues.

Incentive mechanisms.

Non-aeronautical revenue yardsticks.

Timing issues.

The scope of the regulatory till

As previously explained, regulation of airport charges, whether single-till or dual-

till should not cover all activities simply because they belong to the airport or its

owners. There is a clear rationale for deciding what should or should not be

included in the regulatory till.

All services that are ring-fenced and offered to airlines under competitive

conditions (whether by the airport or third parties) should be excluded from

any calculation of regulated charges. This primarily relates to ground

handling services.

All activities relating to the handling of aircraft on the runway and apron,

and the processing of passengers through the terminal, which typically are

covered by aeronautical charges should be included in the till.

All non-regulated activities which are clearly a by-product of the aeronautical

function of the airport should be included in the till. A by-product is a

service which can be expected to increase in value as the number of

passengers passing through the airport increases.




Any service that does not fall within these categories should have its costs and

revenues excluded from any regulatory calculation, whether the approach taken is

one of single- or dual-till. However, the separation of the costs of different

services creates specific issues.

Cost allocation

In the discussion above we have talked about economic profits from non-

aeronautical activities being offset against aeronautical costs. In practice single-till

regulation does not work in this way. Instead non-aeronautical revenues are netted

off against total airport cost (after excluding ground handling and the unrelated

services identified above.) to arrive at a residual that makes up the aeronautical

charge.

This represents a significant simplification of the regulatory process, compared to

dual-till regulation.

In the latter case it is necessary to exclude not only the revenues of the non-

aeronautical activity from the regulatory till, but also its costs, but also its costs.

This latter step if fraught with difficult and provides huge opportunities for

regulatory gaming on the part of the airport.

This is because a significant proportion of the costs associated with non-

aeronautical services will in fact be incurred as costs in common with

aeronautical services. Most obviously, separating the costs of retail space in the

terminal building from space used for aeronautical services involve judgement

and calculation. Does the regulator allocate costs pro-rata on the basis of floor

space? If so, on currently used floor space, or future projected space, or the

maximum space that could be allocated to retail? How are airport central

overheads dealt with, including, but not restricted to the negotiation and

management of contracts with franchise operators?

Under a dual-till approach there is a clear incentive for the airport to attempt to

allocate as large a proportion of costs as possible to the regulatory till, while

excluding the revenues from these activities.

Incentive mechanisms

While we believe single-till principles most closely match the appropriate

competitive outcome, we recognise that the incentive properties of any specific

regulatory scheme will not be identical to those of a competitive market.

As already described a profit maximising airport will reflect non-aeronautical

economic profits in its aeronautical charges to some extent. But in the real world

it will not simply pass through its actual non-aeronautical economic profits.

Rather it will seek to pass through a “competitive” level, based on the equivalent

profits that its rival airports can generate from similar activities. So, if an airport

is exceptionally good at generating no-aeronautical profits, it will get to retain a




proportion of that profit, reflecting the extent to which it is able to out-perform

its rivals.

This is a healthy process as it provides the airport with an incentive to improve

efficiency. To the extent that this gives the airport a commercial, advantage over

its rivals, they will be induced to try harder and, in a dynamic market, may be

expected to catch up their rival eventually. As the airport’s lead over its rivals in

the non-aeronautical arena is eroded, that airport will be forced to pass on the

benefits of its performance in lower aeronautical charges.

This means that in a competitive market we would expect to see a lag between

the generation of any specific economic profits on non-aeronautical activities and

the passing-back of these profits in in lower aeronautical charges.

By contrast the process by which non-commercial profits are passed back in

single-till regulation tends to be somewhat different. Typically a forecast of actual

airport-specific revenues is made for the next regulatory period and that is

deducted from total costs to arrive at the regulatory till.

This process has the benefit that once the regulatory till is fixed the airport keeps

the benefit of any out-performance until the next review of charges. However,

the airport also has an incentive to understate its forecast of revenues in the first

place, to minimise the reduction in the till and maximise the scope for out-

performance. Furthermore, as the next regulatory review approaches, the airport

may have a reduced incentive to further improve non-aeronautical revenues,

because it will rapidly see any benefits taken away in lower aeronautical charges.

These are problems which have similarities with the promotion of cost-efficiency

under price cap regulation. There are potential solutions to the problem that

could be considered, including benchmarking of non-aeronautical revenues

against other airports to avoid gaming, and rolling adjustments that allow the

airport to retain the benefit of any out performance for a fixed period regardless

of when the outperformance is achieved.

Yardsticks for non-aeronautical activities

The previous section mentioned the possible use of benchmarking as a method

of countering the potential gaming by an airport when assessing non-aeronautical

revenues.

The use of yardsticks, as opposed to benchmarking, is when a regulator actively

substitutes estimates calculated from other firms (in this case airports) in place of

the airport’s own estimates of costs or revenues.

Such an approach has its uses in the application of either dual-till or single-till

regulation.

Starting with single-till, we have discussed the fact that competitive airport

charges reflect single-till principles, and that the effect of non-aeronautical




activities should be one-way, that is they can reduce airport charges but not

increase them.

In contrast there are scenarios in single-till regulation where the charges could

actually be increased by taking a single-till approach. In other words, aeronautical

charges calculated on a single-till basis could exceed those calculated using a dual-

till.

By way of an example, consider an airport with a new, and largely empty

terminal. This fact by itself may not suggest inefficiency: merely that the airport

has built to accommodate expected future growth.

Now, consider that, for simplicity, half the new terminal space was built to

accommodate retail outlets, but at present these are largely empty.

Consider then one possible outcome under a single-till regulatory approach: the

regulator takes all retail costs into account (including half the empty terminal) and

deducts forecast retail revenues, which even if they are normal on a per-

passenger basis, are low absolutely because there are few passengers at present.

Contrast this with a dual-till approach where the regulator identifies that half the

terminal building is for the purpose of retail and excludes all these costs, along

with forecast revenues.

As the airport almost certainly making a loss on its retail space, aeronautical

charges set on a single-till basis will almost certainly be higher than those set on a

dual-till.

Of course this result has occurred because in the dual-till case the regulator has

made a sensible judgement on cost allocation, while in the single-till case the

regulator has failed to benchmark adequately terminal costs. If it had done so it

would probably have concluded that the terminal was excessively large and

prevented the airport from recovering these terminal costs, at least until

passenger numbers have risen sufficiently to justify the new space.

It is equally possible however for a regulator using dual-till to make a similar

mistake. In this case suppose half the terminal is intended for retail space but

only 10% of the space is actually in use. If the dual-till regulator deducts 10% of

the terminal costs (as well as the retail revenues) from the regulatory till then

passengers will equally end up subsidising the excessive retail space.

For the single-till regulator the use of yardsticks presents one potential solution

to this problem. The key is not to allow a loss incurred by the airport on non-

aeronautical activities to be cross-subsidised from aeronautical charges. In the

above case the regulator could either disallow a proportion of terminal costs

from the regulatory till (on grounds of inefficiency) or it could substitute actual

retail revenues with a yardstick of revenues, based on what would be reasonable

to expect from a terminal building g of the relevant size.




One approach or the other is needed to avoid aeronautical charges subsidising a

loss on non-aeronautical activities.

Timing issues

Continuing the theme from the previous section, there are further complications

that should be considered. The example given may represent an example of

inefficiently scaled terminal expansion or simply a timing issue.

As is often the case with commercial investment, costs may be front-end loaded

and revenues may be back-end loaded.

In this case the relevant benchmark for the single-till adjustment we would

expect to see in a competitive market is not the actual in year profit (we have

already noted that it is really the profit that rivals can make, rather than the

airport’s own profit that determines the adjustment), but rather the average rate

of profit that a typically efficient operator can achieve.

Given this observation, regulators faced with the problem described above might

think about a method of averaging of costs and revenues over time, possibly on a

per-passenger basis, to smooth out the variations caused by the inevitable fact

that capacity and demand are unlikely to rise smoothly in line with one another at

an airport.

This applies to the issue of adjustments for non-aeronautical activities, but also

more generally to the evolution of aeronautical costs and demand.




Annexe – the treatment of congestion costs

There is a limited literature which purports to address the relative merits of

single-till and dual-till regulation by solving theoretical mathematical models. A

number of these articles are listed in the references to this paper.

These articles tend to quote a result that single-till regulation is more efficient for

uncongested airports while dual-till regulation may be more efficient at congested

airports.

We have reviewed this literature and find that this result depends on a specific

stylised formulation of “congestion” that bears little relation to how congestion

actually impacts on airports. Importantly in this literature “congested” should not

be confused with “full”. In this literature airports always have spare capacity.

For this reason alone little or nothing can be inferred from this literature.

Interpretation of “congestion”

It is worth starting with the observation that in these models the level of

aeronautical charges that maximises welfare in the absence of congestion clearly

reflects single-till principles, so surplus (or profit, depending on the exact

objective function) from non-aeronautical activities is passed back in full in lower

aeronautical charges. So the literature confirms our observations in this paper,

that other things being equal aeronautical charges should follow single-till

principles.

However, the literature adapts this picture by adding the effects of “congestion”.

The economic definition of “congestion” being applied is passenger delays,

measure in terms of time and multiplied by an assumed value of time. It is

assumed that delays increase as a linear function of the number of passengers.

One should start by noting that this has nothing to do with an airport being

“full”, as in having no spare runway slots. Indeed in these models there are no

capacity constraints at all. Any level of demand can be accommodated, just with

delays increasing in a linear fashion.

This has huge implications for the results.

Any increase in demand increases delays, which is a negative externality

experienced by all passengers. Demand for air travel is assumed to depend on the

total cost of travel which is the sum of the ticket price and the value of time lost

through delays.

Having set up this system, the authors make the observation that, in the presence

of an externality of this kind, profit maximising behaviour by firms will not

maximise social welfare. This is a well-known general result and not special to

this literature. Typically profit-maximising prices will be lower than the social

welfare maximising level and congestion will be too high.




This would be true under all forms of price regulation, but in this case, observing

that dual-till prices are higher than single-till prices and social welfare maximising

tariffs are also higher than single-till prices, then if the costs of congestion are

high enough (although high enough cannot be quantified) re is a window it is

possible that dual-till prices are closer to the social welfare maximum than single-

till prices. It should be emphasised that this fact, while true in this model, is by

coincidence, not by design.

There are a number of problems with drawing policy conclusions from this

result. The first is that as a matter of fact a linear function linking passengers to

delays bears no relation to the reality of delays at a busy airport. In reality delays

at an airport tend to be low until the airport has nearly run out of runway slots,

when delays rise sharply. But even then delays do not rise exponentially: even

when an airport is “full” it cannot gridlock like an over-used road, because the

number of ATMs is rationed to the available slots. Delays rise to a higher level

because the fullness of the airport reduces the ability of the system to recover

from shocks, but that effect is always likely to be limited.

This is illustrated in Figure 5 below.

Figure 5. Typical airport delay curve – stylised example

0

2

4

6

8

10

12

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Ave

rage

De

lay

Pe

r Fl

igh

t

Demand/Capacity Ratio




This figure shows that in practice delays occur in one of two states: low or high.

High corresponds to the airport running out of slots.

But if this is the pattern of delays then the marginal relationship between price

and welfare identified in the papers is wrong. The result of these papers relies

crucially on there being a marginal relationship between congestion and

passenger numbers.

Furthermore, if congestion really is a binary state synonymous with full or not

full, then one needs to think about pricing at an airport when it is full. In that

case, when slots are in short supply, ticket prices need to rise to choke off

demand, which is reflected in slot values if aeronautical charges are prevented

from rising by regulation.

In these circumstances passenger welfare is largely unaffected by the level of

aeronautical charges or the method by which they are set. In this case the level of

aeronautical charges primarily determines the share of congestion rents between

airlines and the airport.

It is sometimes argued that higher airport charges would act as a signal to expand

the airport when the airport is full. We note that higher capacity prices when an

asset is congested can act as a signal for market entry, but it is by no means clear

that higher prices would give an incumbent airport the incentive to expand that it

is facing no prospect of competitive entry.

Given these reservations we conclude that this literature cannot be used to infer

the superiority of dual-till over single-till regulation for real airports. The single-

till approach remains a sound basis for avoiding excessive pricing. Decisions over

capacity expansion, as should be apparent from the on-going debate in the UK,

are not made on the basis of price signals alone, but rather are complex policy

decisions involving a wide assessment of the impact of decisions on passengers,

businesses, local populations and the environment.




References

CAA (December 2000) “The ‘Single-till’ and the ‘Dual-till’ Approach to the Price

Regulation of Airports - Consultation Paper”

Commission for Aviation Regulation (2010 & 2012), Defining The Regulatory

Till, Commission Paper 4/2010, Future Investments and the Regulatory Till,

Commission Paper 1/2012

Czerny, A. I. (2006). Price-cap regulation of airports: Single-till versus dual-till.

Journal of Regulatory Economics, 30, 85-97

European Commission (2009), Directive 2009/12/EC of the European

Parliament and of the Council of 11 March 2009 on Airport Charges

ICAO (2004), ICAO’s Policies on Charges for Airports and Air Navigation

Services, Seventh Edition 2004, Doc 9082/7

Lu, C-C. & Pagliari, R. (2004), Evaluating the potential impact of alternative

airport pricing approaches on social welfare. Transportation Research Part E, (40):1–

17

Oum, T. H., Zhang, A., & Zhang, Y. (2004). Alternative forms of economic

regulation and their efficiency implications for airports. Journal of Transport

Economics and Policy, 28, 217-246

Starkie, D. & Yarrow, G. (2000), “The single-till approach to the price regulation

of airports”, CAA Paper

Yang, H. & Zhang, A. (2011), Price-cap regulation of congested airports. Journal

of Regulatory Economics

Frontier Economics Limited in Europe is a member of the Frontier Economics network, which

consists of separate companies based in Europe (Brussels, Cologne, London & Madrid) and

Australia (Melbourne & Sydney). The companies are independently owned, and legal

commitments entered into by any one company do not impose any obligations on other

companies in the network. All views expressed in this document are the views of Frontier

Economics Limited.

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