CAA reference to the Competition Commission for Stansted
Airport
April 2008
Supporting paper IV
Advice to the CAA on the Calculation of Incremental Costs
Advice to the CAA on the
Calculation of Incremental Costs
Final Report
by Europe Economics
Europe Economics
Chancery House
53-64 Chancery Lane
London WC2A 1QU
Tel: (+44) (0) 20 7831 4717
Fax: (+44) (0) 20 7831 4515
www.europe-economics.com
29 April 2008
Introduction
TABLE OF CONTENTS
1
INTRODUCTION............................................................................................1
2
STANSTED AIRPORT AND REGULATION ................................................3
Features of Stansted Airport and the market for airport capacity in the South East..............3
Regulatory Issues.............................................................................................................................5
Interpretation and Implications of Options 4 & 5 .........................................................................7
3
LONG RUN AVERAGE INCREMENTAL COST CONCEPT ......................9
Introduction to LRAIC ......................................................................................................................9
Key Estimation Issues .................................................................................................................. 10
a) Definition of Increment ............................................................................................................. 10
b) Time Period of Estimation........................................................................................................ 15
c) Basis of Forecasts and Assumptions .................................................................................... 16
4
COMPETITION LAW ISSUES AND LRAIC...............................................19
Economic Analysis Regarding “Excessive Price”.................................................................... 19
Competition Cases Reviewed...................................................................................................... 21
Interpretation of “Excessive Price”............................................................................................. 25
5
RECOMMENDATIONS ...............................................................................26
Summary of Desired Properties .................................................................................................. 26
Recommendations on LRAIC Methodology .............................................................................. 26
Application of the LRAIC estimate in Options 4 and 5............................................................. 30
APPENDIX 1: LRAIC — REGULATORY PRECEDENTS...................................34
Use of LRAIC in Other Sectors .................................................................................................... 34
Regulatory Precedent on Increment........................................................................................... 35
Regulatory Precedent on Time Period........................................................................................ 36
Regulatory Precedent on Basis of Costs ................................................................................... 37
APPENDIX 2: REVIEWED COMPETITION CASES............................................38
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Introduction
1
INTRODUCTION
1.1
The CAA is required to set a price limit at Stansted for the period 2009 – 2014 (referred to
as Q5). Two of the options set out in the CAA’s consultation paper would be informed by
long run average incremental cost (LRAIC), and the objective of this report is to discuss
alternative methods by which such an estimate might be made. The numbers required in
undertaking the calculations would be calculated or estimated at a later stage, but the
methodology chosen would influence the type of information required for the purpose of
setting a price control.
1.2
The CAA explains in the consultation paper that it wishes to adopt a form of price control
that would:
(a) Prevent over-charging if Stansted were in the future to acquire sufficient market power
to make this possible; and
(b) Avoid distorting competition between Stansted and other airports and investment
decisions at Stansted or elsewhere.
1.3
The CAA’s January consultation paper outlines five possible forms of price control.
LRAIC estimates would be particularly relevant for Option 4 (a Market Led Price Cap) and
Option 5 (a Precautionary Price Cap).
1.4
These two options for price control are described as follows:
(a) Option 4 — Market Led Price Cap (MLPC) — sets the price at the lowest level
consistent with not distorting investment incentives or competition between airports.
(b) Option 5 — Precautionary Price Cap (PPC) — sets the price at a level just below that
which would be likely to be deemed excessive under competition legislation.
1.5
The difference between the two options is explored in Section 2 below. The CAA has
advised that either case of the price control could be applied in a way that would limit
charges over a regulatory period as a whole rather than annual price caps.
1.6
Advice on the issues identified in the terms of reference requires an understanding in
some detail of:
(a) The relevant features of the market for airports in the South East of England and the
particular situation of Stansted, and the CAA’s statutory duties (discussed in Section 2
of this report).
(b) Issues involved in an estimation of LRAIC and what experience of the use of LRAIC in
other sectors and different circumstances may have to offer (Section 3 and Appendix
1).
1
Introduction
(c) Whether Competition Act principles might inform price setting and how price levels
consistent with these principles might compare with LRAIC (Section 4).
1.7
This report works through these issues, finally developing a range of possibilities for the
CAA to consider for the application of LRAIC to inform its decisions about the form of price
control to implement, and in particular to Options 4 & 5 (Section 5). It discusses:
(a) The options for the methodology for estimating LRAIC, together with their advantages
and disadvantages.
(b) The input assumptions required for the calculation of LRAIC under these
methodologies.
2
Stansted Airport and Regulation
2
STANSTED AIRPORT AND REGULATION
2.1
This section briefly notes the particular features of Stansted Airport in the market for
airport services in the South East of England and the issues involved in its regulation that
are particularly relevant for this study.
Features of Stansted Airport and the market for airport capacity in the
South East
2.2
A common view, shared by the CAA, is that a significant increase in airport capacity in the
South East of England in the reasonably near future would probably be desirable. Views
differ on the degree to which the details of such expansion should be decided by
Government planners or be the result of market forces.
2.3
It is likely that such a substantial increase in capacity would have to come from one or two
new runways and associated terminal capacity rather than entirely from small increases in
a number of different airports.
2.4
However, it is not certain that the South East airport expansion should take place at
Stansted, and there is also an issue of the appropriate timing and specification of
expansion, relative to other potential sources of capacity. There is controversy over
environmental and other planning aspects at all the possible places for airport expansion.
The CAA has noted its concern that investment decisions might be distorted by the form
of economic regulation of Stansted.
2.5
The Secretary of State for Transport found in her decision that together the airports owned
by BAA, comprising Heathrow, Gatwick and Stansted, possess substantial market but that
viewed as a separate entity Stansted is not currently in that position Prices at Stansted
are below the maximum permitted under the present cap, there is some spare capacity at
both Stansted and Luton airports and there is potential for some airline services to switch
away from the airport, although many of these issues are the subject to ongoing debate.
There is uncertainty about likely market power of Stansted in the long run; a key issue is
whether and if so how quickly such market power may arise.
2.6
The Department for Transport found that potential competitive constraints on Stansted
come from a number of other airports as well as limits on airlines’ and passengers’
willingness to pay. The most important competitor airport to Stansted is probably Luton,
whilst the evidence concerning the competitive constraint posed by airports outside the
South East was found to be mixed. Indeed, the Secretary of State’s finding of a likelihood
of substantial market power in the future was finely balanced and depends to a
considerable extent on whether or not there is investment in capacity expansion in the
South East.
2.7
The extent of market power at Stansted remains a contentious issue. However, this
paper considers the application of LRAIC in the context of Options 4 and 5. As the CAA
has noted that these options would be pursued based on a view that the airport’s market
3
Stansted Airport and Regulation
power was limited, this paper takes as its basis that Stansted does not currently,
considered alone, possess significant market power.
2.8
Other features of the situation that will be important in the analysis include:
(a) The ‘product’ delivered by an airport is a bundle of services supplied jointly, whose
quality may be hard to measure.
(b) The CAA has advised us to consider the LRAIC in the context of a single till.1
(c) The business is capital intensive, and investment to increase capacity will at some
point become very ‘lumpy’ (meaning that the most efficient means of expansion will
involve large expenditure on new runways and terminal facilities).
(d) With lumpy investment, efficient pricing such as would be expected in a competitive
context is likely to involve higher (or above-average) prices when capacity is short, so
that its use is efficiently allocated, then lower (or below-average) prices following the
assumed investment, to make best and most profitable use of the new capacity. In
Chart 2.1 below the date that new capacity comes available to use shown with the
dashed vertical lines.2
1
2
Under the single-till approach, forecast non-aeronautical revenues are subtracted from total revenue requirement to arrive at a
forecast of the revenue required from aeronautical operations, which is then divided by passenger numbers to achieve a perpassenger price cap.
Long term contracts and other inertia effects mean that in reality the price drop probably is not as dramatic or fast as illustrated here.
4
Stansted Airport and Regulation
Chart 2.1: Stylised path of short-term competitive market price with lumpy investment
Price
Stylised path of
competitive market price
Time
(e) For this and other reasons prices would at some point have to be significantly above
the long term average level at which investment would be justified by expected
revenues over the whole life of the asset.
(f) In unregulated airports markets, this pattern of pricing would provide an incentive for
airports and airlines to agree long term contracts. However, the policy of “constructive
engagement” – designed to mimic the commercial interaction of airports and airlines –
between the parties that has contributed to planning at Heathrow and Gatwick has
been less successful at Stansted, and such contracts cannot be assumed in this
context.
(g) CAA has since 2003 (for Q4) set price limits for Heathrow, Gatwick and Stansted
airports on an individual basis, and will do the same for Q5. We were asked by the
CAA to prepare this report against an assumption of BAA’s continued ownership
structure and not to make any assumptions in respect of the findings of the
Competition Commission’s market inquiry into BAA. We were asked to assume that
stand-alone regulation continued to apply.
Regulatory Issues
Section 41
2.9
The CAA has some powers to regulate airport conduct through Section 41 of the Airports
Act 1986. However, these powers relate to similar forms of conduct that are prohibited
5
Stansted Airport and Regulation
under competition law and do not appear to have a significant influence for the present
analysis.
Potential distortions of investment incentives
2.10
The CAA is aiming to avoid distortions to investment incentives in either direction: it
wishes to avoid giving incentives to invest where, in a competitive market, the airport
would not invest, or to deter investment that would occur in a competitive market either at
Stansted or elsewhere. The CAA is also concerned not to distort decisions about the
specification for possible investment (size, quality of facilities, etc.). The risk of
discouraging efficient investment would clearly arise if the price limits were too low, i.e.
below the competitive market level (which would give efficient investment incentives).
The concern not to artificially encourage excessive capital expenditure relates to a
specific effect that the existing regulatory approach could have at Stansted, as explained
in the consultation document and summarised below.
2.11
A significant distortion to investment incentives could result from using the RAB based
price cap in Q5. The issue is as follows:
(a) Stansted has in the past not been able to charge up to the regulatory price limits. The
actual level of airport charges has been determined through commercial
arrangements between the airport and its users, at significantly less than the
regulatory ceiling.
(b) Possible cross - subsidies from Heathrow and Gatwick to Stansted (before price
controls were set on the basis of the financial projections for the individual airports in
2003), combined with depreciation schedules that might not reflect the actual useful
economic lives of these assets, have led to a situation in which a traditional RABbased price cap might come into effect at an artificially low level, and require charges
to be limited even when Stansted does not possess significant market power.
(c) As a result, the CAA has argued that if the regulatory system is not changed Stansted
might have an incentive to incur capital expenditure that would not otherwise be
commercially justified simply in order to increase the value of the RAB and to allow it
to increase charges to reach the competitive level.
2.12
Either Option 4 or Option 5 would deal with this problem — because they would not make
use of the current concept of a RAB and neither should lead to a price cap below the
market level regardless of whether Stansted undertakes investment or not.
2.13
In setting price limits for Stansted, a major objective is that price limits should neither be
set too low and thus discourage otherwise efficient investment at Stansted (or induce
inefficient investment elsewhere), nor set too high so that if Stansted were to acquire
significant market power it would then be able to charge excessive prices to its users.
6
Stansted Airport and Regulation
Interpretation and Implications of Options 4 & 5
2.14
The CAA consultation document explains the difference between the two options as:
(a) Option 4 — Market Led Price Cap (MLPC) — sets the price at the lowest level
consistent with not distorting investment incentives or competition between airports.
(b) Option 5 — Precautionary Price Cap (PPC) — sets the price at a level just below
what would be likely to be deemed excessive under competition legislation, i.e. just
before users of the airports might have to resort to (costly) litigation.
2.15
By definition, investment incentives and competition are not distorted if prices are set at
the competitive level. The major attraction of LRAIC is that, when implemented
appropriately, it can mimic the expected outcomes for Stansted in a competitive market. It
is therefore directly relevant to both options. A regulator setting charges based on LRAIC
would allow a normally efficient supplier to recover its costs, including normal profit
margins reflecting the riskiness of investment. This implies that suppliers have an
incentive to invest in upgrading or adding to their service infrastructure that is in principle
neither stronger nor weaker than it would be in a competitive sector not subject to
economic regulation.
2.16
It may be asked why should Option 4 (MLPC) not equal Option 5 (PPC) and both be
measured by LRAIC? It has been necessary to develop a further understanding of
Options 4 & 5, to identify differences between the two options.
2.17
There are two key defining differences — one about the expectations of degree of market
power and the other, linked to the first, about the time period over which the regulation is
defined. MLPC is taken to be the lowest average price level over the long term that would
be consistent with the competitive level, and the PPC is the level above which prices
would not rise at any point in time except as a result of exploitation of a position of
substantial market power. Chart 2.2 below illustrates the conceptual difference between
the two options
2.18
The precautionary price cap (PPC) is drawn slightly above where the highest level of the
competitive market price could be expected to be at any point in time (i.e. the short-term
competitive price level). The market led price cap (MLPC) might be drawn slightly above
the level of the competitive market price on average over time (i.e. above the long-term
competitive price level). The maximum prices might be set slightly above the LRAIC
estimate due to: the degree of market power being uncertain; the uncertainties of LRAIC
estimation; and, the need to maintain investment incentives under a price cap that
prevents prices rising to the full extent implied by the path of competitive prices.
7
Stansted Airport and Regulation
Chart 2.2: Drawing the difference between Options 4 (MLPC) and Option 5 (PPC)
Price
PPC
MLPC
LRAIC
competitive price path
Time
2.19
Under this interpretation the MLPC would be applied over a long time period, very
probably stretching beyond a single price control period. The PPC, on the other hand,
would provide a check on the price level at any one point in time (e.g. in any one year).
2.20
A key factor for the CAA to consider in choosing between the PPC and MLPC
approaches is the expected likelihood and degree of market power Stansted has or might
attain. The stronger the expectation of significant market power, the more assurance with
regard to possible over-charging the CAA could obtain from MLPC relative to PPC. This
is because MLPC would make the company accountable for the average level of charges
over time, while the PPC would limit only the highest price over the cycle.
2.21
Both approaches, however, could make use of the LRAIC estimate. The next section
considers alternative LRAIC concepts and estimation methods.
8
Long Run Average Incremental Cost Concept
3
LONG RUN AVERAGE INCREMENTAL COST CONCEPT
Introduction to LRAIC
3.1
The long run average incremental cost (LRAIC) of a service or product is equal to the
change in total cost in the long run resulting from a specified variation in output, averaged
over the units of output supplied. The components of the acronym can be defined as
follows:
(a) Long run — the estimation is done with a long enough time span to be relevant to
planning and investment decisions.3
(b) Average — the incremental cost could be averaged in several ways. Usually, this is
done by dividing the cost of the increment by the units of output it provides.
(c) Incremental — refers to the defined change in either services or in volume of services,
the cost of which is the object of investigation.
(d) Cost — self-explanatory at one level, but there are important differences in the way
estimates may be made.
3.2
Different approaches to the above elements determine the properties of the resulting
estimates, their applicability to different settings, and their suitability with respect to
different regulatory goals.
3.3
Implemented appropriately, LRAIC can estimate the maximum prices Stansted would be
able to charge on average over time in a competitive market, assuming normal levels of
efficiency. Another benefit of basing price controls on LRAIC is that it can reduce the
reliance on information supplied by the incumbent. This occurs when the LRAIC is
calculated on the basis of an efficient benchmark rather than on the basis of incumbent
costs and investment plans.
3.4
One drawback of LRAIC is that its implementation can be quite complex, requiring a
number of assumptions that may be open for discussion. This also introduces significant
regulatory discretion in the determination.
3.5
A summary of regulatory precedents for the use of LRAIC in other sectors is set out in
Appendix 1.
3
This is different from a textbook definition of the long run as the period in which all inputs are variable.
9
Long Run Average Incremental Cost Concept
Key Estimation Issues
3.6
The differences in the objectives of LRAIC estimation in the different sectors have
contributed to alternative implementations of the various building blocks in LRAIC
estimation. The main choices, which define the characteristics of the LRAIC estimate,
relate to:
(a) Definition and measurement of the increment.
(b) Time period (definition of the long run).
(c) Basis of forecasts (whose, on what assumptions) to inform the required input
assumptions on:
–
Demand for the increment over the relevant time period.
–
Design and costs of the capital assets within the increment.
–
Operating costs relevant for the increment and time scale.
–
Cost of capital used as the basis of the allowed return (and the discounting
method used to set annual prices, if applicable).
3.7
In addition to the above, different implementations of LRAIC could be accompanied by
differing approaches to remuneration of existing assets, and the new assets over time
(e.g. when they have become part of the existing asset base). If the principle of LRAICbased charging were applied across the whole airport this might imply a revaluation of
existing RAB.
3.8
We briefly discuss each of the above key determinants in turn.
a) Definition of Increment
3.9
Defining the increment is the first step in the LRAIC estimation. It defines the service and
the capacity of the service whose costs the LRAIC method estimates. It is likely to have
the largest impact on the final result, as well as the fundamental characteristics of the final
result.
3.10
In principle, there are many different sized increments that could be measured, as well as
different dimensions over which to measure the increments. However, these might be
grouped into four different categories under two subheadings:
(a) Increments based on (hypothetical or expected) variations in capacity to supply an
existing service or set of services:
–
a small change in the volume of or demand for a particular service; or
–
a large change in the volume of or demand for a particular service.
10
Long Run Average Incremental Cost Concept
(b) Increments based on (hypothetical or expected) variations in services:
3.11
–
the addition of a specific service; or
–
of a group of services.
The first definition of the increment involves measuring the cost associated with providing
a small change in output. The second definition is usually taken to be large enough to
trigger capital investment, so that LRAIC might be estimated for a particular investment
program. The third definition may apply to services of very different sizes and is often
referred to as service-based LRAIC. The last category is the broadest definition of an
increment and one variant of that definition of the increment has been used extensively in
telecommunications to set interconnection charges.
Possible increments for Stansted
3.12
In the case of airports, service-based increments might be imagined, for example drawing
a distinction between baggage handling and passenger handling services within the
aeronautical services group. It may also be noted that, under easyJet’s proposed
“terminal tendering approach”, a service-based increment could be used, defining
“runway access service” as the increment.
3.13
However, the use of a service-based increment would seem problematic in the case of
Stansted. Indeed, the CAA has consulted extensively in the past on a move to a dual-till
system – which might be more suited to a service-based approach – but decided to retain
the single-till approach for the previous price control period. The reasons for the single-till
approach remain valid; the services provided by an airport are to a large degree mutually
dependent.
3.14
Viewing the whole airport as a single increment would be consistent with the single till
approach, and might have some desirable properties relative to volume based
increments.
3.15
However CAA’s concern not to distort competition or investment decisions relates most
closely to costing new projects and the associated operating costs e.g. new runway
capacity and associated terminal infrastructure.
Increment based on variations in capacity
3.16
With regard to volume-based definitions, long run cost can be calculated using either:
(a) The average incremental cost (AIC) approach. This involves calculating the forwardlooking unit cost of meeting a projected growth in demand, i.e. the cost per unit of the
planned investment program and associated net operating expenditure.
(b) The marginal incremental cost (MIC) approach, also sometimes known as the Turvey
approach, after Professor Ralph Turvey. This involves calculating the implications for
11
Long Run Average Incremental Cost Concept
unit cost of a small change to projected demand, i.e. the forecast unit cost increase or
reduction resulting from the implied change in the planned investment program and
associated operating expenditure.
3.17
The two approaches can produce different results depending on the nature of investment
program. Both can be relevant in different circumstances.
3.18
The AIC approach would help to ensure that prices charged for additional units of
consumption cover the avoidable costs of supplying those units, including any required
investments. It would therefore provide an answer to the question of what price would
have to be charged such that, over the life time of the assets, investments in additional
capacity recover their costs.
3.19
The MIC approach provides estimates of the cost of small changes in volume and in
some circumstances may provide more efficient price signals.
3.20
These approaches are therefore aimed at different questions that can both be relevant in
different circumstances.
3.21
Figures 3.1 and 3.2 illustrate the two methods. Figure 3.1 shows a situation in which
there is a capacity surplus at the start of the period, but due to projected growth in
demand additional investment will be required at T1. The LRAIC according to the AIC
method would be calculated as follows:
(a) Present value (PV) of operating cost of delivering the shaded volume of service; plus
(b) PV of investment triggered at time T1; all divided by
(c) PV of the shaded volume of service (the additional number of passengers using the
airport).
3.22
That is, the AIC is calculated as the net present value cost of supplying the additional
passenger throughput, divided by the net present value of incremental passengers, where
the present values are calculated for the full asset life of the investment.
12
Long Run Average Incremental Cost Concept
Figure 3.1: Illustration of AIC approach to LRIC
Volume
Investment
planning horizon
Life of new assets
Available
capacity
Existing
consumption
Additional
demand
T1
3.23
Time
The LRAIC according to the MIC method, on the other hand, considers the forwardlooking cost per unit of a hypothetical permanent incremental change to the existing
investment plan, as illustrated by Figure 3.2.4 This increment would be additional to the
forecast increase in demand, and in this example would require the company to bring
forward investment in new capacity. (It would also be possible to construct an example in
which the size of the required investment increased.) The LRAIC according to the MIC
method would be calculated using the information presented in Figure 3.2 as follows:
(a) PV of operating cost of delivering the shaded capacity (the increment); plus
(b) PV cost of bringing forward the planned investment from T1 to T2; all divided by
(c) PV of the shaded capacity (PV of the increment of passengers).
3.24
That is, the marginal incremental LRAIC is calculated as the net present value of the
additional costs of the hypothetical increment on the original investment program and
associated operating costs, divided by the numbers of passengers served.
13
Long Run Average Incremental Cost Concept
Figure 3.2: Illustration of MIC approach to LRIC
Volume
Investment
brought
forward
Increment to
projected demand
T2 T1
3.25
Time
Given the above, there are several potential ways to calculate LRAIC, including:
(a) AIC approach based on delivering the forward-looking investment program.
(b) MIC approach based on an increment of demand specified by the CAA.
(c) MIC or “perturbation” approach using different increments and decrements and
averaging the results.
3.26
4
However, the relevance and applicability of the MIC approach in the current case is
doubtful.
The investments involved in increasing capacity at airports are not
homogenous, and can vary widely between investment in say, security infrastructure,
additional baggage handling capacity and marginal runway capacity. Further, it is likely
that to increase a planned new runway capacity by X per cent at the design stage would
add less than proportionately to its cost (due to economies of scale within the project), so
that the investment might not be justified by charges based on MIC even if overall it would
cover its total costs.
The increment of demand is assumed to be permanent here for clarity of exposition. The approach can in principle be applied to
any postulated size of increment lasting any postulated amount of time. It can also be applied to a decrement in demand.
14
Long Run Average Incremental Cost Concept
3.27
The AIC approach seems more aligned with CAA’s objectives of avoiding distortions to
the decisions about possible significant expansion at Stansted. This still leaves open the
question of exactly what the increment is, what service levels are to be specified (a
contentious issue) and against what baseline it is measured. The alternative to an AIC
type approach would seem to be to define the increment as the whole airport or the whole
system of runways. This could also be consistent with the CAA’s underlying objective of
not distorting investment incentives or competition between the airports.
3.28
The two approaches do, however, have different strengths and weaknesses, discussed
further below and in Section 5.
b) Time Period of Estimation
3.29
Two issues arise regarding the time period of the estimation.
3.30
First is the definition of the long run that should be used. Here a relatively straightforward
interpretation is available. The length of the time period considered for LRAIC should be
the longest term relevant for planning and decision making in the industry. It also should
be coherent with the definition of the increment used.
3.31
A second group of questions arises in the context of Stansted. LRAIC estimation under
the AIC view of the increment considers only the forward looking costs of the increment.
When investment is lumpy and so not undertaken continuously, as spare capacity comes
into use and the time of the next investment becomes nearer the prices estimated by
LRAIC would rise. However, in the period after the investment, the forward looking
LRAIC estimate would be relatively low due to the (new) spare capacity in the system.
Indeed, this reflects one of the desirable qualities of LRAIC — it mimics the behaviour of
prices in a competitive market. The result is the “saw tooth” pattern of LRAIC estimates
done at different points in time relative to dates of investment, similar to that in a
competitive market (see Chart 2.1 in paragraph 2.8).
3.32
In the case of Stansted the effect would be as follows: in the run up to a time when
investment is most likely to be needed the price cap based on LRAIC would rise. Once
the investment is complete, recalculation of a price cap based on LRAIC would fall, as
one would expect to happen in a competitive market. However, if the company were to
fear that the regulatory limit imposed would be lower than it would expect to be able to
charge in a competitive market this would act as a disincentive to invest, and it would be
appropriate for the regulator to explain clearly how the methodology would be intended to
be applied in successive periods.
3.33
The issue would not arise under the “whole service” definitions of the increment, typical to
telecommunications implementations of LRAIC, as they involve the forward-looking
valuation of the full asset base (or equivalent, see below). That would be beneficial from
a regulatory consistency point of view. However, it would also mean that the resulting
price controls less accurately reflect competitive market outcomes in the case of Stansted.
The use of LRAIC based on the unit costs of a forward looking investment plan (the AIC
15
Long Run Average Incremental Cost Concept
approach) has been used as an input towards structuring charges (energy sector), or as
signals towards efficient long term investment and use (water sector).
3.34
In other regulatory contexts the LRAIC methodology has been applied in a situation of
confirmed significant market power. In such a setting, the price cap is expected to bind
more or less continuously, so the regulators can focus on ensuring that the incumbents
earn only normal returns and recover only efficient costs over time, recalculated every five
years. Indeed, there is little discussion in the regulatory precedent about the length of the
price control period not matching the length of the investment horizon used for the LRAIC
estimates.
3.35
In the case of Stansted, the price cap may not bind - at least in the near term, or following
a significant increment in capacity. Further, the incremental capacity increasing
investment at Stansted is likely to be lumpy compared to some other sectors, which would
lead to higher variations in the before and after investment LRAIC estimates. This will
need to be taken into account in the application of LRAIC in setting price limits for
Stansted.
Relevant time frame for Stansted
3.36
Economic logic and regulatory precedent both point towards interpreting the “long run” as
the longest term relevant for planning and decision making in the industry.
c) Basis of Forecasts and Assumptions
3.37
Any implementation of LRAIC requires the following input estimates or assumptions:
(a) Demand over the relevant time period.
(b) Design and costs of capital assets within the increment.
(c) Operating costs relevant for the increment and time scale.
(d) Cost of capital used as the basis of the allowed return.
3.38
There are two broad approaches to establishing the above estimates or assumptions.
Using the convention of naming from the telecoms sector, these can be broadly defined to
be:
(a) A “top-down” approach, which is based on the actual costs of the regulated operator
as posted in the financial statements, allocated to product groups, and the incumbent
company’s forecasts of demand and costs in the context of a planned expansion.
(b) A “bottom-up” approach, a forward looking approach which considers modern
equivalent assets, efficient design of the capital assets (e.g. network structure), and
efficient (if hypothetical) net operating costs consistent with the efficient layout and
utilisation of modern assets.
16
Long Run Average Incremental Cost Concept
3.39
The cost of capital could be established using the approach developed elsewhere for the
price controls of Heathrow and Gatwick.
Top down approach — pros and cons
3.40
In a top-down application of LRAIC the starting source of information for estimating the
costs of services is normally the costs actually incurred, or envisaged, by the regulated
company. The recorded costs are allocated, through a number of intermediate steps, to
final services. The resulting charges have a direct link with the company’s actual
accounts. A top-down approach can also be applied with a current cost adjustment to the
asset values — the historic cost figures need to be “adjusted” into current cost figures. In
some cases this may lead to certain costs incurred by the modelled company being
excluded.
3.41
The benefits of the approach are generally taken to be that the resulting costs can be
traced back to the formal accounts of an existing company, helping to ensure that all
relevant costs are accounted for.
3.42
However, there are several drawbacks to this approach. Depending on the definition of
the increment, the development of estimates can be more resource intensive and time
consuming than a bottom-up approach, and the resulting estimates could incorporate the
incumbent’s inefficiencies in the layout, type or design of the assets, or in their use.
Further, if the estimates are based on proprietary data, it might not be possible for third
parties to examine the estimates and provide expert views on them.
Bottom-up approach — pros and cons
3.43
The bottom-up approach uses demand projections as a starting point and determines, by
using economic, engineering and accounting principles, an efficient structure capable of
serving that demand, independently from the incumbent’s actual or planned structure. In
principle, bottom-up models give the model developer more flexibility regarding efficiency
considerations and reduce dependence on the company for data. All of these are
desirable qualities in terms of implementation of LRAIC with the object of obtaining an
estimate of the maximum price Stansted would be able to charge in a competitive market
on average over the long term (assuming normal levels of efficiency).
3.44
The bottom-up approach is more appropriate in cases where a hypothetical efficient
company is assumed. Accounting for efficiencies (technical and operational) is much
easier in a bottom-up context as legacy asset issues are less of a problem than in a topdown approach. The bottom-up approach also does not need to refer to a specific
company — the thought experiment is that of a hypothetical efficient entrant, or
hypothetical efficient investment to satisfy capacity demand — effectively reducing the
dependence on the incumbent, and increasing effectiveness of consultation in
determining the cost and demand assumptions.
3.45
However, there is a danger that bottom-up models may understate the costs of efficient
companies particularly where technologies are rapidly changing. In practical terms,
17
Long Run Average Incremental Cost Concept
particularly forecasts of operating expenditure can be difficult to model in a bottom-up
setting.
3.46
In principle, both methods should lead to the same result. In practice though, this can
only happen if the same assumptions are made (e.g. regarding asset types, layout and
operational efficiency). Consequently in telecommunications it is often observed that
bottom-up and top-down models are used in parallel with a view to reconciling the results
of the two models and developing a hybrid model, so as to minimise the weaknesses of
the two models and take better advantage of their strengths.
Basis of forecasts
3.47
If a top-down approach is chosen, the main data source typically used is the modelled
company’s accounts (or investment plans). On the other hand, bottom-up models also
use data gathered from market participants, equipment suppliers and other publicly
available information. In both cases, though, the required information for proper LRAIC
estimation is extensive and requires the exercise of discretion. In the case of top-down
models it is sometimes very difficult to audit or review the results since the necessary data
are confidential. The information gathering powers provided to the CAA would reduce this
latter concern.
3.48
In LRAIC methods there may arise some problems related to the knowledge of the cost of
the assets. For instance, some elements may be customized and may not have a welldefined market price, or the future usage of different assets may affect the choice of what
constitutes efficient equipment. For technology dependent increments, forecasts of
technological progress are needed both for proper determination of LRIC technology and
for determining demand forecasts. However, the weight of this factor depends on the
sector. For instance, it is more important to better predict technological changes
regarding a core telecommunications network than a water network.
Possibilities for Stansted
3.49
It seems that a forward looking, bottom-up approach would be preferable in the case of
Stansted. It would not be overly reliant on information from BAA, and allow for direct
consultation of and input from independent experts. It would be more consistent with the
view of utilising LRAIC as an estimate of maximum Stansted would be able to charge in a
competitive market in the long term, and avoiding distorting incentives for investment.
3.50
Indeed, if the relevant increment is taken to be an increase in existing capacity, the likely
absence of forward looking information held by Stansted would necessitate a bottom-up
type approach. Even then, more emphasis could be placed on independent forecasts,
estimates and designs, rather than relying on information from the incumbent.
18
Competition Law Issues and LRAIC
4
COMPETITION LAW ISSUES AND LRAIC
4.1
Option 5 requires a view on what might be judged to be an excessive price level from the
view of the competition authorities.
Article 82
4.2
The Article 82 prohibition of the consolidated EC treaty is the basis of the competition law
on abuse of dominance as it may affect trade between Member States. The Competition
Act 1998 extends Article 82 to apply also in cases where the dominance only affects trade
within the UK. The full Article 82 text is as follows:
“Any abuse by one or more undertakings of a dominant position within the common
market or in a substantial part of it shall be prohibited as incompatible with the common
market insofar as it may affect trade between Member States.
Such abuse may, in particular, consist in:
(a) directly or indirectly imposing unfair purchase or selling prices or other unfair trading
conditions;
(b) limiting production, markets or technical development to the prejudice of consumers;
(c) applying dissimilar conditions to equivalent transactions with other trading parties,
thereby placing them at a competitive disadvantage;
(d) making the conclusion of contracts subject to acceptance by the other parties of
supplementary obligations which, by their nature or according to commercial usage, have
no connection with the subject of such contracts."
4.3
The interpretation of Article 82 is a subject of much debate and some case law. The
charging of excessive prices is only one of several ways in which a dominant position
might be judged to have been abused within the legislation — “unfair prices” is only a part
of one of the four distinct abuses of dominant position, and case law on the point is
relatively limited.
Economic Analysis Regarding “Excessive Price”
4.4
Economic interpretation of an excessive price has to start with the characteristics of a
“normal” competitive market price.
4.5
Normally, in a competitive market, prices would at all times be at a level that covers the
short run marginal costs of production. In the long term, in order for production to be
sustainable, prices would cover, on average, the long term costs of production, including a
return on investment (i.e. normal profit). The required return on investment, or the normal
profit, is determined by the cost of capital to the industry. There is, therefore, a difference
between the prevailing competitive price level in any given period (the short-term
19
Competition Law Issues and LRAIC
competitive price level) and the average level of prices in a competitive market over the
longer-term.
4.6
If prices do not achieve this level on average over the long term, there would be exit from
the market, followed by a reduction in supply and, other things being equal, an increase in
the price (for a given level of demand). If prices exceed the competitive level, the
resulting excess profits would be eroded away through entry into the market. As
discussed above, LRAIC can be used to estimate such a long term average price level.
4.7
However, such a cost-based definition of a “normal” long term price level is not directly
useful for determining what might be an excessive price at any point in time. This is
because, in the short run, the market price could fluctuate substantially (and nonsystematically) around the long term average that would deliver cost recovery and normal
profit. A major source of such short term movements in the price is likely to be changes in
demand, possibly amplified by real-options effects given irreversible investment in the
presence of uncertainty.5
4.8
Indeed, such price fluctuations are necessary for the long term cost recovery price to be
achieved. Without market power, companies are fully exposed to the effect of demand
fluctuations in the market. Therefore, to achieve long term viability, companies must be
able to take advantage of favourable market circumstances (e.g. increase their price) to
compensate for periods of bad market outcomes (e.g. times of low demand leading to
lower than the long term average prices).
4.9
The implication is that the price at any one point in time could be substantially above the
long term average level as estimated by LRAIC, and yet not be considered “excessive”.
This is why it is appropriate that competition law would not contemplate the possibility of
prices being excessive except in circumstances in which the supplier has significant
market power.
4.10
In the case of airports, a major cause of short term price fluctuations could be movements
in demand while capacity remains relatively fixed. The demand at airports can vary
annually, according to the season, as well as according to the time of day with substantial
potential differences in peak and off-peak demand. The daily peak price to average price
variation provides one indication of how much prices may move, in the absence of market
power, between periods of high demand and low demand.
5
If there are irreversible costs to investment and there is an option to wait and there are not other countervailing factors (such as the
possibility to pilot scalable investment), following a positive demand shock, causing prices to rise and firms to make positive profits,
firms will wait before investing just in case prices fall back down again and the irreversible costs of investment are lost. Similarly,
negative demand shocks will not instantly stimulate exit, for the market may pick up in the future. Prices may rise above average
total cost for a period without stimulating entry or investment, and may be sustained for some time below average total cost without
stimulating exit or disinvestment. There is thus greater/more sustained variance in the path of prices under irreversibility and
uncertainty than in the standard competitive model. This analysis is set in the Dixit-Pindyck framework, which is also referred to by
the CAA in paragraph 4.13 of the consultation paper.
20
Competition Law Issues and LRAIC
4.11
Economic intuition, then, would indicate that an excessive price might be defined as a
price higher than that which could reasonably be expected to result from short term
demand or other fluctuations, above a long term average price that would ensure efficient
cost recovery (including normal profit). Real-options analysis could also be relevant to
reflect the full potential for variation in competitive prices.6
Competition Cases Reviewed
4.12
The published decision documents of the some relevant cases have been reviewed with
particular reference to the definitions of excessive prices, and any comments on the tests
and data used to determine whether a price is excessive or not. The list of cases
reviewed is in Appendix 1.
4.13
The cases that seemed to establish the most relevant and directly useful precedent were
the United Brands (1978), Sacem (1987), Port of Helsingborg (2004), AttheRaces (2005),
Deutsche Telekom (1997), and the Napp Pharmaceuticals (2001) cases. The Albion
Water case might also be particularly relevant. However, the Competition Appeals
Tribunal has not yet given its final decision on the case.
4.14
As might be expected, the competition authorities responsible for the decisions have been
reluctant to specify precisely what is meant by an excessive price and how exactly to
judge whether a price is excessive. The courts have seemed particularly loath to
prescribe any particular price level as the threshold over which prices should not rise, lest
they appear to be price regulators. Nevertheless, some useful lessons can be learned
from the past cases.
United Brands (1978)
4.15
In United Brands case, the European Court of Justice (ECJ) set out a definition of what
may constitute an excessive or unfair pricing abuse under Article 82. The judgment set
out what is essentially a two part test, which defines a price as excessive “because it has
no reasonable relation to the economic value of the product supplied”. The ECJ did not
explain how it supposed that the “economic value” of a product should be determined,
although the decision (paragraph 251) implied that the profit margin could be determined
objectively if it were possible to objectively calculate the cost of production and compare
that to the selling price. This would disclose the amount of the profit margin, though the
judgment did not say how it would be determined whether the profit margin was
excessive or not.
4.16
However, the ECJ further stated, in paragraph 252, that “[t]he questions therefore to be
determined are whether the difference between the costs actually incurred and the price
actually charged is excessive, and, if the answer to this question is in the affirmative,
6
This is also referred to in paragraph 4.13 in the CAA consultation paper.
21
Competition Law Issues and LRAIC
whether a price has been imposed which is either unfair in itself or when compared to
competing products”. The two part test inferred from the judgment is:
(a) First, a comparison of price to costs of production, and if the price is found to be
excessive in this sense;
(b) Second, a consideration whether the price is unfair in itself or when compared to
competing products.
4.17
This leaves many questions open — most importantly the amount by which price should
be above the costs for the second stage to become relevant (profits to be excessive), and
what constitutes a price that is unfair in itself (question about the definition of the
economic value). The comparison to prices of other competing products could however,
be useful in the case of Stansted. Also, an indirect implication of the test is that the ECJ
seems to consider at least some level of profit over “costs actually incurred” to be
acceptable.
SACEM (1987)
4.18
In the SACEM case, the ECJ considered that the production costs to be taken into
account are those of an efficient firm, and not necessarily those of the investigated firm.
This recognises the fact that prices may be excessive even if profits are not high, as the
investigated firm may have inflated production costs because of its dominant position (Xinefficiency).
4.19
The excessive price test actually employed in the SACEM case was a comparison to
prices in other geographic markets. However, the notion of using an efficient firm as the
basis of comparison would be consistent with the way in which LRAIC is implemented in
some settings, or to put it another way, LRAIC could be used to calculate the costs of the
efficient firm.
4.20
The notion of the efficient costs was also employed in the KLM (2000) case by the Dutch
competition authority.
Deutsche Telekom (1997) and Napp Pharmaceuticals (2001)
4.21
The Deutsche Telekom (1997) and the Napp Pharmaceuticals (2001) cases are the only
two cases of those reviewed that provide any direct indication of what was and what was
not regarded as an excessive margin on costs of production.
4.22
In the Deutsche Telekom (DT) case, following a complaint made in 1996 against the
conditions imposed on third parties for access to DT’s infrastructures the European
Commission initiated proceedings against the company. An independent price survey
carried out on behalf of the Commission demonstrated DT’s inability to prove that its
prices were cost-orientated, and found the DT price level to be 100 per cent higher than
on comparable competitive markets.
22
Competition Law Issues and LRAIC
4.23
DT was invited to adjust the tariffs “to real economic conditions”, so that they in the
Commission’s opinion cannot constitute an abuse of a dominant position. DT lowered its
tariffs by 38 per cent for access to the local network and 78 per cent for access to the
long-distance network, and the Commission decided to terminate the investigation.
Depending on the exact margin on the services provided before the new prices
suggested by the incumbent, the new lower prices still could retain substantial headroom
above efficient costs (as defined by prices in comparable but competitive markets).
4.24
In the Napp Pharmaceuticals case, the OFT applied a similar test to the United Brands
test by benchmarking price-cost margins, and by benchmarking prices themselves. The
OFT found both to be significantly higher than those of relevant competitors. In an appeal
to the CCAT (now the CAT), Napp argued that brand value and premium to compensate
for ex-ante uncertainty was not taken into account in OFT’s analysis. Both the OFT and
the CCAT argued that a brand value premium could not be as high as 40 per cent. (The
CCAT also rejected the arguments that ex ante uncertainty justified high ex post prices.)
However, the judgment on excessive prices was given in a context of another abuse of
dominant position — exclusion of access. It is not clear whether the 40 per cent
difference between Napp and competitor prices would have been judged excessive on its
own.
4.25
The implication from these two cases is that the headroom above a LRAIC estimate that
competition authorities might allow could be quite large before prices are deemed as
excessive.
Port of Helsingborg (2004)
4.26
The judgment in the case against Port of Helsingborg (HHAB) explicitly followed the
methodology set out by the ECJ in the United Brands judgment. The judgement:
(a) Compared the costs actually incurred by HHAB in providing the products/services in
question, and made a comparison to the prices charged.
(b) Investigated whether the prices were unfair when compared to prices charged to
other users or by other ports.
(c) Investigated whether the prices were unfair in themselves.
4.27
The first test differs somewhat from the interpretation in the SACEM case in two respects.
First, in considering stage 1 of the test the Commission used the costs actually incurred
by HHAB, including explicitly rejecting the use of a forward looking costing method
(replacement value of assets) in favour of the historical book value of the existing assets
as part of the stage 1 analysis of costs actually incurred. Second, the allocation of costs
to the services was also based on audited financial results of HHAB, rather than, say, an
allocation that was considered somehow explicitly efficient.
4.28
However, in determining whether the prices were unfair in themselves, the Commission
emphasised the importance of demand factors above the simple costs of production, and
23
Competition Law Issues and LRAIC
in a competitive context the demand factors would incorporate forward-looking cost
expectations. The clear implication is that the “economic value” cannot be determined by
adding a pre-determined percentage profit margin on the production costs. Therefore,
according to this precedent, finding a positive difference between production costs
(including a normal profit) and price would not necessarily lead to the conclusion that the
price is excessive, provided that the price has a reasonable relation to the economic value
of the service supplied.
4.29
Apart from referencing the importance of demand factors, the judgement does not give a
specific opinion on how the effect of the demand factors might be taken into account.
Nevertheless, it is compatible with the view that the price estimated by LRAIC would not
give a ceiling of excessive price, and the CAA should provide some head room above it.
AtTheRaces versus British Horseracing Board (2007)
4.30
The ATR case provides further insight to the importance of demand factors in determining
the economic value of the product under the United Brands test. ATR argued that the
prices charged include an excessive margin over any reasonable costs of the data
provided by BHB. BHB, on the other hand, argued that it added value to British racing
through its governance role, the cost base should reflect all costs in organising British
horse racing, and the pre-race data had distinct value to bookmakers.
4.31
The High Court and the Court of Appeal both accepted that “competitive price” could
reflect the economic value of the product to the user. The Court of Appeal found also that
the wider cost base of the BHB than that relating strictly to the data should be taken into
account, in line with BHB’s claim. The Court explicitly stated that if consumers and
competition were unaffected competition law should be silent on the proportion of the
value that each supplier should earn.
4.32
Albion Water (ongoing)
4.33
Although this case is still ongoing, it is relevant as it provides the most recent example of
a case that is clearly about excessive prices. The case relates to an appeal by Albion
Water to the CAT about Ofwat’s conclusion that Dŵr Cymru did not abuse its dominant
position by engaging in excessive pricing. The test applied by Ofwat was whether the
access price offered by Dŵr Cymru could be said to “bear no reasonable relation to the
economic value of the service provided, when judged by reference to the difference
between the costs actually incurred by Dŵr Cymru and the price charged”.
4.34
The initial judgment by the CAT (November 2006) found that evidence strongly suggested
that the access price was excessive, but was careful to leave room for further
submissions to be made. A further judgment in December 2006 set out the CAT’s views
on excessive pricing in more detail. The Tribunal is clear that the test it is applying is that
set out in United Brands and moves a step closer to a final judgment. In particular, the
CAT’s December 2006 judgment emphasised the importance of further investigation of
costs when assessing whether the price is “unfair”.
24
Competition Law Issues and LRAIC
4.35
The CAT has received further submissions covering a variety of cost estimates, including
LRAIC estimates, and has yet to deliver a final judgment. An important issue in this case
is whether or the extent to which cost estimates or a specific service may be derived from
wider average cost estimates (e.g. of supplies all industrial users of Dŵr Cymru’s
services).
Interpretation of “Excessive Price”
4.36
The framework set out in the United Brands case seems to have been established as the
way in which competition authorities would consider whether a price charged by a
supplier with substantial market power is excessive. As discussed, the test would seem
at least not inconsistent with intuition about how an excessive price might be defined.
4.37
It would be preferable to view the relevant cost base in the way it has been interpreted in
the SACEM case, rather than the interpretation in the HHAB case. This interpretation
allows for efficient forward looking costs to be considered, and would seem to avoid the
possibility of abuse of dominance through inflation of costs as well as inefficiency of the
incumbent operator. The interpretation in the HHAB case would rule out the use of
forward looking LRAIC estimates in a way that can approximate a long term average
outcome in a competitive setting. The forthcoming CAT judgement on Albion’s appeal will
provide a further important indication on the treatment of costs.
4.38
The relationship between the LRAIC estimate and the “excessive price” would be
determined by some mark up on the LRAIC estimate to allow for the effect of fluctuations
in demand and other factors. The competition case review indicates that this mark up
over efficient costs (including normal profit) could be quite substantial while remaining
acceptable from the competition authorities’ point of view.
25
Recommendations
5
RECOMMENDATIONS
Summary of Desired Properties
5.1
The LRAIC approach adopted for Stansted should be:
(a) Theoretically robust.
(b) Consistent with CAA’s statutory powers and responsibilities.
(c) Avoid distortions to investment incentives and to competition between the airports.
(d) Consistent with viewing Stansted as an independent economic entity (free of effects of
cross subsidy).
(e) Practical and understandable to implement.
Recommendations on LRAIC Methodology
Appropriateness of LRAIC with view to overall objectives
5.2
LRAIC is an appropriate methodology to use to establish the cost base for price control
under either Options 4 or 5. This is because:
(a) LRAIC is a forward looking methodology that can estimate the maximum level that
Stansted would be able to charge, on average over time, in a competitive market. As
such, it has a robust theoretical basis and can ensure that investment incentives and
competition between airports are not distorted by regulation applied to Stansted.
(b) It is consistent with the viewing Stansted as an independent economic entity, avoiding
issues about past or future cross-subsidies.
(c) It is consistent with a reasonable interpretation of the precedent in competition law
cases. Its use would be consistent with CAA’s statutory duties.
5.3
LRAIC estimation and use in setting price limits involves three main steps: defining the
increment7; measuring its cost and translating that cost to a price (or revenue) limit.
5.4
It will need to be applied in a way that is appropriate to Stansted’s particular
circumstances.
7
Or decrement; this complication does not change the analysis in a way that is relevant here and is ignored for simplicity of
exposition.
26
Recommendations
Definition of the Increment
5.5
Service based increments (e.g. in terms of aeronautical and non-aeronautical services)
seem tenuous, and indeed divisions of that type have been investigated and rejected in
the past by the CAA. The use of a capacity based increment would be consistent with
single-till regulation, which has been judged preferable.
5.6
There are three main options for defining the increment:
(a) A small increment
(b) A new runway and associated terminal expansion
(c) Stansted as a whole.
5.7
There would be serious disadvantages of estimating LRAIC with regard to a small
increment. The nature of airports is such that expansion may involve lumpy investment,
an aspect that sits uncomfortably with measuring the costs of small changes. It is unlikely
that this approach would be credible.
5.8
If the increment is defined as a new runway and associated terminal costs, this would
probably seem a realistic basis to many. It leaves major issues to be settled (as
discussed in Section 3 and below), but in principle, provided that prices charged at
Stansted for the use of the new runway etc. bore a reasonable relation to prices charged
for the use of the existing assets, it would allow price limits to be set for Stansted as a
whole.
5.9
The third option for the definition of the increment would be the services provided by
Stansted as a whole, including any new runway etc. regarded as necessary. This would
involve estimating the cost of providing the existing services through the use of modern
equivalent assets. It would have the advantage of explicitly treating the costs of any
proposed new runway in the same way as those of existing assets, and like the previous
option would avoid the need to use the historical RAB. In some respects, this approach
would echo that used in many telecommunication applications of LRAIC. However, it
would involve a major additional estimation exercise, the uncertainties in which would
probably reduce the credibility of the result.
5.10
The provisional view is that CAA should concentrate on the application of the second of
these options for the definition of the increment, and turn to the third only if problems with
the second appear insurmountable.
5.11
Within the increment of a very large increase in capacity at the existing airport, there
remain various possibilities of how exactly the increment should be specified. The
increment could be defined as a runway, or a run way and increased terminal capacity
(with associated infrastructure). These relate to assumptions to be used in cost and
demand forecasting, as well as design of the investment which we return to below.
27
Recommendations
Timescale of LRAIC estimation
5.12
The definition of “long run” in this context does not mean an infinitely long period.
Practical estimations need to be made; and there is a point beyond which future
uncertainties would be irrelevant. The practical requirements include avoiding distorting
investment decisions, including in a possible new runway etc. that would have a long but
it may be assumed finite life. This suggests a timeframe of 40 to 50 years.
5.13
If such a timeframe is used, the assumptions made about long- run economic trends in
matters such as technological advance, and relative input prices, will have a large
influence and will need careful thought.
5.14
The LRAIC estimate would be applied in a regulatory setting in which price limits are set
for five years at a time, and within Q5 the price control may not be binding. The
implications of this are also discussed below, in considering the application of LRAIC
estimates in price controls on Stansted.
Basis of engineering and other input assumptions
5.15
The absence of any consensus between BAA and the airlines using Stansted means that
difficult issues are involved in deciding the basis for engineering and other cost
assumptions. Several questions arise, and a number of options may be considered.
5.16
First, it will be necessary to make a reasonably clearly specified and practical definition of
the runway and associated facilities whose costs are to be estimated, including quality as
well as capacity. In order to do this, BAA could be asked for its view of the type and size
of facilities most likely to be a successful investment. Alternatively, CAA could make its
own estimates, informed by consultation with both the airlines and with BAA. Thirdly, in
theory the task could be sub-contracted to expert advisers. The guiding principle is the
investment plan that would be adopted by an efficient supplier, expecting to be able to
charge competitive prices but not expecting to be able to abuse any position of
dominance or substantial market power.
5.17
Secondly, the basis for the cost estimates will need to be decided. Again, the possible
sources include BAA estimates, and independent (but inevitably in some respects
probably less well-informed) assessments from outside the company.
5.18
The provisional view taken here, with regard both to the specification of the new runway
etc and with regard to its likely costs, is that CAA will have to be responsible for settling
the assumptions to be used. In both cases, BAA’s views should be fully considered, but
weight should also be given to independent assessments. However, these assumptions
should be put in context. Whilst they determine the level of the price cap they do not
define what must be built by the airport operator.
5.19
CAA would also need to take responsibility for economic assumptions such as the rate of
improvement to be assumed in operating cost efficiency, any important relative price
28
Recommendations
assumptions, and the cost of capital, again taking account of the views of BAA and others
concerned.
Demand assumptions and LRAIC calculation
5.20
A similar approach will be needed to the demand assumptions to be used. Long term
forecasts from the Department for Transport and others can be used up to a point, but ad
hoc analysis would also be needed. Again, it should be envisaged that the regulator
would ultimately decide on the forecasts to be used, having consulted with interested
parties.
5.21
When the costs of the increment have been estimated, and divided by the forecast
numbers of passengers, the LRAIC per passenger will have been estimated. Allowing for
expected commercial revenues it would be of the form of the average charge per
passenger that, over the very long term, would be required to justify the investment in a
competitive context. In the context of an increment based on a forward looking
investment plan over some time horizon (AIC approach), at a very high level the
calculation would be of the form:
LRAIC =
5.22
Sum of the present value of net costs forecast over the investment horizon
Sum of the present value of number of passengers over the investment horizon
Calculation of the present value of net costs requires:
(a) Estimate of expected costs to be incurred in each year of the estimation period
(capital and operating expenditure, and financing costs), in constant prices.
(b) Estimate of expected net commercial and freight revenues in each year of the
estimation period, in constant prices.
(c) Subtracting (b) from (a) to gain the net expected cost in each year of the estimation
period.
(d) Estimate of the cost of capital, used as the discount rate to express the result in (c) in
present value terms.
5.23
Calculation of the present value of the number of passengers requires the expected
passenger numbers for each year of the estimation period, discounted using the cost of
capital to express the volume in present value terms.
5.24
The overall result, therefore, is the long run incremental cost, averaged over the expected
number of passengers. It need hardly be said, but should be underlined, that a large
margin of uncertainty will attach to the estimate, and due allowance would need to be
made for this in the light of sensitivity analyses.
29
Recommendations
Application of the LRAIC estimate in Options 4 and 5
5.25
It remains to consider the application of the LRAIC estimate for both the PPC and MLPC
options.
5.26
The essential difference between the two options was set out in Section 2, above. Chart
2.2 is reproduced here for convenience.
Chart 2.2 [copied from above]: Drawing the difference between Options 4 & 5
Price
PPC
MLPC
LRAIC
competitive price path
Time
5.27
To recapitulate briefly, the difference between the two approaches is taken to be that the
long run MLPC would be somewhat above the LRAIC estimate, to reflect: uncertainties in
estimation; uncertainties about the likelihood that Stansted will experience a period in
which it has significant market power; and the need to maintain investment incentives
under a price cap that prevents prices rising to the full extent implied by the path of
competitive prices.
5.28
The stronger the expectation that Stansted would have substantial market power, the
more assurance the regulator would have in preventing excessive charges through
applying MLPC rather than PPC limits.
5.29
The regulatory argument for using PPC limits is that, for suppliers without market power,
periods of strong demand and high returns are likely to be balanced by weaker periods. A
regulatory intervention that prevented prices from rising to these peak levels would have a
serious adverse effect on the overall returns that would be expected from investment.
30
Recommendations
Application of LRAIC estimate in setting MLPC
5.30
An allowance will be needed for expected commercial revenues in setting either MLPC or
PPC, since a single till approach is assumed.
5.31
The MLPC could be based on the LRAIC, as an approximation to the long term average
of the maximum that Stansted would be able to charge in a competitive market. Due
allowance for uncertainties would need to be made. Provisions for rolling forward underor over- charging in relation to the long run average would be employed within and
between price control periods.
5.32
CAA has to set price limits for each five year period, whereas the LRAIC estimate would
be relevant to, say, a 40 year period. If in some periods Stansted were not able to charge
up to the limit, but in others it would have been able to charge more, then the application
of the LRAIC as a limit in each period would risk preventing the investment being justified.
As discussed in Section 3, this would be particularly pertinent if the LRAIC is calculated
on the basis of new runway and associated terminal investment in a truly forward looking
manner.
5.33
This problem might be resolved or alleviated if CAA were to make credible commitments
relating to the whole period. The consultation document discusses some ways in which
this might be done. The CAA is limited in its ability to commit its successors, but use
might be made of regulatory policy statements.
5.34
It would in any case not seem desirable to consider annual application of the MLPC price
cap set at a level that was close to LRAIC, due to the fact that the short term movements
in the market price should be permitted within the cap. Within any five year period, there
should be maximum flexibility with clear provision for carry forward of pricing allowances
unused in any year.
Application of LRAIC estimate in setting PPC
5.35
Considering the PPC option, the question arises; how much above the long term average
market price should the precautionary price cap be set? The competition case review in
Section 4 indicates that the competition authorities would be likely to allow significant
margins over the long term cost level, before a price is deemed excessive. They would
also be likely to take into account the charges being levied at other airports.
5.36
In the case of the airports, relatively short term movements in price could arise due to
demand fluctuations with capacity being fixed; either longer term fluctuations from one
year to the next, seasonal fluctuations, or, in the very short term, daily peak and off-peak
variance. The ratios between charges over time, and between peak and average
charges, may provide an indication of the ratio between the LRAIC and the price that
might be regarded as excessive by the competition authorities.
5.37
As such ratios will vary, the approach would be to tabulate a set of such ratios and review
how and why they vary (over time, between airports, between time frames – daily,
31
Recommendations
seasonal, etc) in order to draw from them a ratio that could be applied to the LRAIC
average to derive the PPC.
Process at successive periodic reviews
5.38
There could be an issue about revisions to the input assumptions used in the LRAIC
estimates over time and between different price control periods (if a five year price control
period remains in place). The basic input assumptions about design and costs might be
reviewed every five years, as usual in price reviews. This would have the effect of
increasing the LRAIC until the point of investment, and would be desirable in terms of
efficiency of the signal to competitors and the incumbent operator. However, as the CAA’s
discussion document suggests, this would need to be done in a way that avoided reopening the basis on which the LRAIC had been estimated in a way that would amount to
a disincentive to investment.
5.39
It will also be necessary to explain the relation between the LRAIC-based price limits and
accounting returns. If market conditions improve so that charges at Stansted can be
increased in the course of Q5, this will result in improved returns to the existing assets.
An increase in returns in the period before an investment is what would be expected in a
competitive situation.
5.40
The following table summarises the main information requirements of the alternative
approaches to the estimation of LRAIC as the basis for the legally-required price control
at Stansted.
32
Recommendations
Table 5.1: Comparison of information requirements
MLPC
PPC
Traditional RAB-based
building block method
Demand forecasts
Yes
Yes
Yes
Capex plans (design and costs)
Yes
Yes
Yes
Opex projections
Yes
Yes
Yes
LRAIC estimation
(a) Increment defined by new investment
MEA of existing assets
No
No
No (but RAB estimation)
Cost of capital
Yes
Yes
Yes
Yes
Yes
No
Relationship between average and maximum
likely competitive price
No
Yes
No
Consideration of carry-forward of regulatory
commitments between price control periods
Yes
(important)
Yes
Yes
(b) Increment is airport as a whole including
new investment
As above, except:
MEA of existing assets
Application to price control
33
Appendix 1: LRAIC — Regulatory Precedents
APPENDIX 1: LRAIC — REGULATORY PRECEDENTS
Use of LRAIC in Other Sectors
Telecoms
A1.1
The telecommunications sector provides many examples of LRAIC use in setting price
controls — it has been used to set access prices in both Europe and the USA, and has
become the dominant cost standard approach used in telecoms regulation. The
European Commission has recommended the use of ‘forward looking’ LRAIC for the
assessment of cost oriented interconnection tariffs, as it “is most compatible with
competitive market”. This recommendation has been confirmed in a subsequent study
carried out by Europe Economics. The concept has also been used in estimation of limits
to be applied to charges for call termination.
A1.2
The use of forward-looking LRAIC in the telecoms regulation has been predicated on the
desire to send efficient ‘build-or-buy’ signals to potential entrants (i.e. to send efficient
signals on whether an entrant should buy access to the incumbent‘s network, or build its
own alternative networks). These signals are particularly important in the telecoms
industry due to potential for new network technologies to emerge that might challenge the
essential facility status of incumbent networks. They are also clearly important in the case
of airports in the South East of England.
Energy
A1.3
Unlike in telecoms, in the energy sector LRAIC estimates have been used mostly to
structure charges calculated on standard building block approach, rather than to set the
actual level of charges. For example, according to the National Grid’s most recent
Statement of the Use of System Charging Methodology, charges are calculated on an
incremental cost basis rather than on average costs so as to promote the optimal use of
and investment in the transmission system. 8
A1.4
The reason given is that efficient economic signals are provided to users when services
are priced to reflect the incremental costs of supplying them. Therefore, charges should
reflect the impact that users of the transmission system at different locations would have
on the Transmission Owner's costs, if they were to increase or decrease their use of the
respective systems.
Water9
A1.5
8
9
Ofwat has considered that use of long run marginal cost (LRMC) can help to achieve:
National Grid (April 2008): “The statement of the use of system charging methodology”
http://www.nationalgrid.com/NR/rdonlyres/BC5D87D0-4682-4C56-9375-7B932A1BD726/24475/UoSCMI4R0FINAL.pdf
MD 159 and MD 170. Note that the examples from the water industry quoted here all use the concept of forward looking average
incremental costs (unit costs of a future investment program) to calculate what is referred to by them as LRMC.
34
Appendix 1: LRAIC — Regulatory Precedents
(a) more cost-effective use of existing assets;
(b) least cost investment in new assets to balance supply and demand; and
(c) conditions to ensure that entry into the market for water services is beneficial to
customers.
A1.6
Ofwat considers that volumetric rates should reflect LRMC as closely as possible to
provide appropriate incentives to promote economy in the use of water. Ofwat has further
considered the role of LRMC estimates to include:
(a) To signal about opportunities for bulk supplies for cross-border trading of water.
(b) Forming a basis of assessment of avoidable costs in charging access to incumbent
networks for common carriage, as LRMC should approximate the (long term) savings
made by an incumbent as a result of not having to supply water or sewerage services.
(c) Guiding long term water resource planning.
(d) Providing a benchmark to assess company leakage targets.
A1.7
Ofwat has also used LRMC in its evidence to the Competition Appeals Tribunal (CAT) in
the Albion case, where demand was expected to rise so that the relevant part of the
network was close to capacity; it was argued that LRMC would give appropriate signals of
the opportunity cost of providing third party access.
A1.8
The Canadian Water and Wastewater Authority uses LRMC not to set the overall price
control, but as a basis of the volumetric charge that has the objective to encourage
efficient use of water and financial resources (there is a fixed charge also to ensure total
cost recovery).
A1.9
In Australia the Queensland Competition Authority considers that the volumetric charges
in two part tariffs should be set using LRMC.
Regulatory Precedent on Increment
A1.10 The CAA preferred the ‘perturbations’ approach in 2001, using a comparison of capacity
expansion to a modified “do-minimum” case. The increment was large enough that it
might be considered an application of the AIC rather than the MIC method. The CAA
chose its preferred increment as the one it considered provided the best measure of
incremental costs and incremental outputs — a forward looking investment program to
deliver a substantial capacity increase.
A1.11 In telecommunications the norm has been to measure the costs of large service - based
increments (namely the core and access networks) where part of the common interincrement costs are also allocated to the regulated services.
35
Appendix 1: LRAIC — Regulatory Precedents
A1.12 In the water sector, following responses to MD 170, Ofwat required LRMC estimates of
the water companies to be based on the AIC method only. Ofwat did, however, note that
the MIC approach could be relevant if companies are anticipating significant changes due
to competition, bulk supplies, or changes to levels of service.
A1.13 In the energy sector at least three different variations of the increment have been used:
(e) The direct current load flow (DCLF) investment cost related pricing (ICRP) transport
model in the UK electricity sector calculates the marginal costs of investment in the
transmission system that would be required as a consequence of an increase in
demand or generation at each connection point or node on the transmission system.
This is based on a study of peak conditions on the transmission system.10 The
increment is measured as a variation in demand of 1MW. The methodology is closest
to the MIC approach.
(f) In the New South Wales electricity sector, the increment is based on new generation
capacity (as opposed to the inclusion of existing installed capacity). The increment
considered was a substantial factor of the existing load. This is closer to the AIC
approach. 11
(g) In the setting of the UK gas transmission network, incremental entry capacity means
capacity in excess of the volume of obligated entry capacity determined in accordance
with paragraph 14(5)(g) of part 2 of Special Condition 28B of Transco’s gas
transmission license. Increments of varying sizes have been used, but in general the
methodology seems most in line with the AIC approach above.12
A1.14 In relation to the water sector in Australia, the QCA defines the increment as the next
most economically efficient discrete augmentation possible. This also seems to be in line
with the AIC approach.
Regulatory Precedent on Time Period
A1.15 In the water sector, Ofwat specified in Report C of MD170 that the time period over which
LRMC should be conducted to be the lifetime of an investment plan. The reason given by
Ofwat for this was the saw tooth effect described in Section 3. The consideration of the
whole lifetime of the investment plan alleviates the saw-tooth effect in the sector, as the
horizon includes several equal investments (the investment is “indivisible”, rather than
“lumpy” in the sense of an airport investment). Indeed, Ofwat noted that the planning
horizon used by companies varies between 10 and 50 years and recommended that, in
10
11
12
See “The Statement of the Use of System Charging Methodology, April 2008”
See “The long run Marginal cost of Electricity Generation in New South Wales A Report to the Independent Pricing and Regulatory
Tribunal February – 2004”
See “Incremental Entry Capacity Release Statement”, October 2002.
36
Appendix 1: LRAIC — Regulatory Precedents
their LRMC calculations, companies used a horizon of at least 25 years as this time
period is consistent with the water resource plans.
A1.16 In the energy sector, the definition of the long run ranges between 10 and 30 years.
A1.17 In telecoms regulation, as the definition of the increment used in the sector includes all
assets used in providing the service, recalculated periodically, the time period considered
is the assumed asset life of the service increments.
Regulatory Precedent on Basis of Costs
A1.18 In the telecommunications sector, Oftel (now Ofcom) considered two principal methods of
estimating forward-looking costs: a bottom-up approach which used an engineering
economic model reflecting best practice, and a top-down approach using BT’s
management and financial data as the starting point. Oftel then reconciled the results of
the two models and produced a hybrid figure. The models considered two increments;
core and access.
A1.19 Regarding mobile termination, Oftel began in 2000 a review of competition in the market.
During the review, Oftel also met mobile and fixed operators to discuss the calculation of
mobile charges based on LRIC. Oftel concluded that the target charges for 2005/2006
should be based on LRIC figures on which equal proportionate mark-up is applied to
allocate common costs and an estimate of the value of network externalities is added on
the resulting figure.
A1.20 In the energy sector, users who are Generators or Interconnector Asset Owners provide
to National Grid a forecast for the following Financial Year of the highest Transmission
Entry Capacity (TEC) applicable to each Power Station or Interconnector for that Financial
Year. For the Financial Year 2008/9 Scottish Generators or Interconnector Asset Owners
provide to National Grid a forecast of the equivalent highest ‘export’ capacity figure.
A1.21 Users who are owners or operators of a User System (e.g. distribution companies)
provide a forecast for the following Financial Year of the Natural Demand attributable to
each Grid Supply Point equal to the forecasts of Natural Demand under both Annual
Average Cold Spell (ACS) Conditions and a forecast of the average metered Demand
attributable to such Grid Supply Point for the National Grid Triad.
A1.22 If no data are received from the User, then National Grid will use the best information
available for the purposes of calculation of the TNUoS tariffs. This will normally be the
forecasts provided for the previous Financial Year.
A1.23 In the water sector, the LRMC estimates are based on companies’ forecasts of demand
and estimates of the investment costs required to maintain supply-demand balance.
37
Appendix 2: Reviewed Competition Cases
APPENDIX 2: REVIEWED COMPETITION CASES
A2.1
We reviewed the final decision documents of the following cases with the view of
extracting out the definitions of excessive prices, and any comments on the tests and data
used to determine whether a price is excessive or not.
(h) General Motors Continental NV (1976)
(i) United Brands (1978)
(j) Sacem (1987)
(k) Scandlines v Port of Helsingborg (2004)
(l) Deutsche Telekom (1997)
(m) Deutsche Post AG – Interception of Cross border Mail (2002)
(n) Alpha Flight Services/Aéroports de Paris (1998)
(o) Deutsche Grammophon v. Metro (1971)
(p) Aeroportos e Navegacao Aerea (1999)
(q) Frankfurt Case (1998)
(r) Ilmailulaitos/Luftfartsverket (1999)
(s) AtTheRaces Vs British Horseracing Board (2007)
(t) Napp Pharmaceuticals (2001)
(u) Albion Water v. Water Services Regulatory Authority (2006)
(v) Veraldi-Alitalia (2000)
(w) Verengingg Vrije Vogel v. KLM and Stweart v. KLM (2000)
38