Benefits and Costs
Introduction
8.166 Chapter 7 outlined the Commission's approach to deriving estimates of the potential benefits and costs of controlling airfield activities. The models developed in Chapter 7 are now applied to the airfield services supplied by AIAL to aircraft operators.
8.167 The Commission's analysis of the potential benefits of control involves a number of distinct parts: calculation of returns from vesting to date (1989-2001); forecasting of returns into the future (through to the end of the period for which landing charges are presently set, i.e., 30 June 2007); assessing any allocative inefficiencies associated with current landing charges; assessing any productive inefficiency; and assessing any dynamic inefficiency. Each are now discussed.
8.168 All the results presented in this Chapter are based on the Commission's assessed airfield asset base and the WACC range for AIAL estimated by the Commission. Appendix 13 contains full workings of the analysis, as well as results and sensitivity analysis based on alternative asset base assumptions.
Historic Analysis of Returns
Introduction
8.169 From an economic perspective, AIAL should be able, on average over time, to earn a normal return on the optimised assets used in providing the services of airfield activities. WACC is used to determine the normal or target return on AIAL's assets used for airfield activities, on the grounds that a return equal to the WACC for an entity is a return commensurate with the opportunity cost of capital for that entity. A return in excess of that would suggest AIAL was earning an excessive return, unless those returns reflected efficiency gains and superior performance.
The Calculations
8.170 The Commission has conducted an analysis of the historical returns of the airfield activities of AIAL over the period since vesting, comparing actual returns with target returns (based on the Commission's views on asset base and WACC). The returns have been calculated based on the formula provided in Chapter 7:
Excess Returns ($) = Net Earnings - (Asset Base x WACC)
8.171 The first part of the equation, net earnings, represents AIAL's actual earnings from airfield activities. As noted in Chapter 7, net earnings is computed as earnings before interest, but after tax, depreciation and operating expenses, plus revaluations. In accordance with the principles on asset base determined by the Commission, the revaluations included are those relating only to any revaluations of land to opportunity cost. The second element of the equation (asset base x WACC) represents the target returns.
8.172 The returns are computed annually for each financial year from vesting (1989-2001) separately for the lower bound, upper bound and point estimates of WACC (relevant to that financial year, based on the last price reset). In order to look at trends over time, and not create an outlier in the returns derived for the year ended 30 June 1999, the revaluation of land undertaken by AIAL as at 30 June 1999 is spread back to vesting.337
8.173 The framework for the analysis is largely the same as that in the Draft Report. However, the spreadsheets used for the analysis have been revised and simplified, and the analysis has been updated to include the 2001 financial year results for AIAL (unavailable when the Draft Report was released). Inputs and assumptions have also been modified where appropriate (as discussed in this Report).
Assumptions and Inputs
8.174 As noted above, for full details of the data used and of the analysis of AIAL, readers are referred to Appendix 13. These include an analysis of the sensitivity of the results to different assumptions or scenarios regarding the appropriate asset base reported below.338 The key assumptions and inputs in the Commission's analysis of historical returns are detailed below.
8.175 Revenue figures for AIAL's airfield activities are sourced from a combination of AIAL's financial accounts, information disclosures and breakdowns of airfield income provided to the Commission during the Inquiry. The only figures that have been estimated are those of "other revenue" for 1989-1993, where an estimate of $500,000 is included each year.
8.176 Expense figures are less precise. The Commission has only obtained actual expense data for AIAL's airfield activities for the last two years (2000 and 2001), when AIAL released the information as part of information disclosure. As with the analysis included in the Draft Report, the Commission derived estimates of the airfield expenses for 1989-1999. In the Draft Report, the Commission computed estimates for 1989-1999 by extrapolating back from 2000 (working out the airfield portion of expenses for a given year based on the proportion of that expense in 2000 when figures were available). In computing its revised figures for this Report, the Commission has accepted AIAL's suggestion that expenses be further adjusted to account for the change in focus of AIAL's business over time (based on the proportion of total income that airfield income was in 2000 compared to the year for which expenses are being computed).
8.177 In terms of taxation - as noted in Chapter 7 - the Commission now uses an effective tax rate in its analysis. The effective tax rate is unlevered to fit with the way returns are computed (i.e., before interest). In recent years, the unlevered effective tax rate and the statutory corporate tax rate are the same. The statutory tax rate continues to be applied in the forecast return analysis beyond 2001.
8.178 The Commission's assessment of the appropriate airfield asset base for AIAL as at 30 June 2001 was detailed earlier in this Chapter. In analysing historical returns, the Commission also needed to determine the asset base in each year from vesting through to 2001. For recent years (1998-2001), data was able to be sourced from a combination of the 1999 valuation report, information disclosures and AIAL's pricing model from the recent consultation round.
8.179 For 1988-1997, the Commission has endeavoured to derive estimates of the airfield asset values. Except for sealed surfaces (the runways, taxiways and aprons), assets have been extrapolated in a similar manner as expenses. The sealed surfaces (the runways, taxiways and aprons) are included at the full amount as per AIAL's financial accounts (as they all relate to airfield activities).
8.180 Adjustments to the asset base (and revaluations included as earnings) are made over the period 1988-1997. One adjustment for optimisation over this period relates to the second runway land, for which the historic cost values (as advised by AIAL) are removed. Other adjustments to the asset base due to optimisation and the Commission's chosen method of valuing assets over this period are due to reduction or removal of spread revaluations.
The Results
8.181 The Commission's assessment of the returns earned historically on airfield activities by AIAL are summarised in Table 21. Table 21 provides three different representations of the results: average returns from vesting to date (1989-2001), average returns over the last five years (1997-2001), and the present value of returns from vesting to date as at the end of AIAL's 2001 financial year (30 June 2001). For results for individual years, refer to the detailed results provided in Appendix 13.
Table 21: Returns on Airfield Activities Supplied by AIAL
| | Over WACC Range | At Point Estimate |
|---|
| Average 1989-2001 | -1,926 to 1,208 | -239 |
| Average 1997-2001 | 2,707 to 6,101 | 4,534 |
| Present Value 1989-2001 | -74,365 to -8,887 | -39,107 |
8.182 The figures in Table 21 suggest varying results. In the last five years, despite the presence of this Inquiry, AIAL has earned significant returns annually. However, this was not the case in the early years post-vesting. The figures per year from 1989-2001 (detailed in Appendix 13) indicate a trend of increasing returns, moving from negative returns just after vesting to large positive returns per annum currently. The average of returns since vesting shown in Table 21 indicates the presence of positive returns only at the margin, but the average is distorted by the significant negative returns in early years. The same applies to the present value of returns since vesting. In all cases, returns are greater at the lower bound of the WACC range.
8.183 The Commission considers that the results of recent years (and forecast returns ahead), and the trend that is shown, are more relevant than an average or present value of returns since vesting, which (due to compounding) can have the effect of over-emphasising the negative returns earned over a decade ago. As such, the Commission places more weight on the results in recent years, and those expected in future years, than those at or soon after vesting.
8.184 Although significant positive returns have been identified, a finding of excess returns cannot be made without eliminating, as possible causes, certain reasons for the returns. As noted above, what might otherwise be considered excess returns (and evidence of the exercise of market power), may just reflect efficiency gains and/or superior performance. In addition, a trend towards increasing returns may be (partially) explained by a declining asset base (as assets are depreciated annually).
8.185 To test the influence of a depreciating asset base on the trend of increasing returns, the Commission recalculated returns without depreciating the asset base (depreciation was still included as an expense in the calculation of net earnings). This analysis revealed that less than 10% of the returns were due to the effect of a depreciating asset base. The trend of increasing returns was still apparent, although the magnitude of returns was slightly less).
8.186 Whether the returns might reflect productive efficiency gains is considered later when AIAL's productive efficiency is examined. However, the Commission notes, at this point, that the high proportion of fixed costs associated with airfield activities mean that it is unlikely that there could be sufficient productive efficiency gains to explain all the returns identified.
8.187 To a large extent, returns are likely to have been driven by increasing revenues, which have increased as the result of increases in landing charges and increasing aircraft movements. There is no evidence to suggest that they are reflective of superior performance. Rather than reducing landing charges as movements have increased, AIAL has reaped the benefits itself, as revealed by the increasing returns.
8.188 In the absence of any other explanation, the Commission finds evidence that AIAL has earned excess returns. On face value, these findings suggest the conclusion that AIAL has used its market power in airfield activities by raising prices above the efficient level. It would also appear difficult to argue that the period for review biased the findings by, for example, being too short a time in which to assess performance. This reinforces the Commission's findings earlier that there are insufficient constraints on the exercise of market power by AIAL.
Current and Forecast Analysis
8.189 As discussed in Chapter 7, the counterfactual in AIAL's case will be the status quo, which includes the November 2001 agreements reached between AIAL and its substantial airline customers (including Air New Zealand and Qantas). The terms of the agreements are open to all airlines and are, therefore, used as the basis for projecting earnings through to 30 June 2007.
8.190 While analysis of historical returns is useful for evaluating behaviour of AIAL in the past, an analysis of the forecast returns helps to determine whether such results are an indication of the future. The future analysis also presents an evaluation of the efficiency effects of AIAL behaviour, assuming that behaviour in the past continues.
8.191 The Commission uses the year 2001 as a base year for introducing the forward-looking models, as this is the most recent year from which projections can be made.339 The analysis for AIAL projects future returns and inefficiencies out to 30 June 2007. The approach is designed to be consistent with the historical analysis, in particular, it takes into account any unrealised capital gains or losses.
Allocative Inefficiency and Excessive Returns
Determining PC, PM and QC
8.192 The Commission has calculated an average price per tonne (Pm) for AIAL's 2001 year based on the landing charge revenues and tonnes landed (Qm) in the 2001 financial year for AIAL. Pm is used to compute Pc. AIAL's price elasticity of demand of [...] (calculated in Chapter 3) is used in calculating Qc, per the model in Chapter 7 (Figure 2). The results of these calculations are presented in Table 22.
Table 22: Average Prices Relative to Competitive Benchmark Prices
| | Over WACC Range | At Point Estimate |
|---|
| Actual Price (PM) | $15.09 | |
| Efficient Price (PC) | $13.14 to $14.39 | $13.72 |
| Difference, PM-PC | 0.70 to 1.96 | 1.38 |
| Actual Output (QM) | 3,290,392 | |
| Efficient Output (QC) | [...] | [...] |
| Difference, QC-QM | [...] | [...] |
8.193 AIAL's actual price for 2001 exceeds the Commission's range of efficient prices shown in Table 22. AIAL's actual output for 2001 falls below the range for efficient output. Allocative inefficiencies exist and represent losses of consumer surplus.
8.194 The Commission has computed the same figures for each of the forecast years (2002-2007). These figures are not detailed here, but can be found in Appendix 13. The figures for 2002-2007 reveal similar results. In the few isolated instances where the actual price is below the efficient level, then allocative inefficiencies represent losses of producer surplus, and negative excess returns represent less than normal returns).340
Estimates of Allocative Inefficiency and Excess Returns
8.195 The figures above have provided the information to calibrate the model in Figure 2 of Chapter 7. The model can now be used to estimate the potential allocative inefficiencies and excess returns associated with AIAL's 2001 price levels. Because the precise values of marginal cost are not available, although they are known to be very low, it is assumed that marginal cost is 50 cents. It is also assumed, for the purpose of analysing allocative inefficiencies, that there are no productive inefficiencies or cost misallocations, and that levels of service quality demanded by the airlines are being provided (to be discussed below). On this basis, the Commission has estimated that the likely size of the allocative inefficiencies associated with pricing of airfield activities in the 2001 financial year of AIAL.
8.196 Forecast returns are computed using the same formula as that used in the historical analysis. AIAL's actual results for 2001 are used as the base, modified as appropriate based on AIAL's forecasts and growth estimates. In computing forecast returns under scenario 1 for 2002-2007, the Commission has adopted AIAL's forecasts of MCTOW (tonnes landed), expenses and changes in the asset base (i.e., capital expenditure and depreciation). Those figures are then adjusted as appropriate to be consistent with the Commission's view on how to calculate the appropriate asset base (e.g., adjustments to depreciation in respect of the move from ODRC to DHC).
8.197 The Commission's projections to 2007 assume, as did AIAL's own projections, that the value per hectare attributed to the airfield land remains unchanged at the 1999 level. However, the Commission is aware that since 1999 land values in Auckland have increased substantially. This increase has occurred over a relatively short period of time, and it is unclear whether it is a cyclical phenomenon or a move to a new higher level of value. Should those higher values be maintained, however, then an adjustment to the company's asset valuation is likely to be required in the future, with the consequent revaluation being reflected in landing charges. The Commission has not factored these prospective adjustments into its projections to 2007.
8.198 Allocative inefficiency consists of consumer surplus (area BFE in Figure 2, Chapter 7) and producer surplus (area EFHG in Figure 2, Chapter 7). In addition, the excess returns stemming from prices being above the efficient levels cause a redistribution of wealth from acquirers to suppliers (as measured by area PCPMBE in Figure 2). Estimates of these distribution effects are given in Table 23. These transfers are proportionally much larger than the associated allocative inefficiencies, as would be expected, given the highly inelastic demand for airport services. It should be noted, however, that transfers are distributional in nature, not losses to economic efficiency. The figures shown in Table 23 are an average of the seven years 2001-2007. Results for individual years are shown in Appendix 13.
Table 23: Estimated Allocative Inefficiencies and Excess Returns for AIAL ($000s)
| | Over WACC Range | At Point Estimate |
|---|
| Consumer Surplus | 1 to 24 | 9 |
| Producer Surplus | 45 to 335 | 210 |
| Excess Returns | 816 to 6,494 | 3,873 |
8.199 Table 23 reveals that the excess returns found historically are also forecast to continue into the future. Some allocative inefficiency also exists; however, it is very small in comparison to the excess returns forecast.
8.200 Table 24 presents forecast excess returns for individual years:
Table 24: Estimated Excess Returns for AIAL for Individual Years ($000s)
| | Over WACC Range | At Point Estimate |
|---|
| 2001 | 2,316 to 6,446 | 4,540 |
| 2002 | 1,943 to 6,883 | 4,603 |
| 2003 | -160 to 5,509 | 2,892 |
| 2004 | -844 to 5,217 | 2,419 |
| 2005 | -1,316 to 5,208 | 2,196 |
| 2006 | 804 to 7,119 | 4,204 |
| 2007 | 2,973 to 9,075 | 6,259 |
8.201 Results for individual forecast years show that returns are expected to decrease slightly over 2003-2005, but increase in 2006 and 2007 to levels greater than at present. The increase in returns between now and 2007 is primarily due to [...] The forecast decrease in returns for 2003-2005 is due to the impact of increases in the asset base in coming years as the costs of rehabilitating the current runway are capitalised. Actual returns will be higher to the extent that AIAL has overstated forecasts of capital expenditure required in respect of the runway rehabilitation. The Commission has not assessed whether the forecasts are overstated.
8.202 It should be noted that for the purpose of the forecast analysis, no expected revaluation gains are estimated for and, although the Commission considers that there may be revaluation gains over the forecast period. If this were the case, this would be likely to suggest that the figures above understate forecast allocative inefficiencies and excess returns.
Cross-Subsidisation
8.203 In Chapter 4, the Commission presented the way it would assess whether there was any cross subsidisation associated with airfield activities by considering:
- Prices charged by aircraft type per landing, with prices per landing dependent on weight bands.
- Cost allocation between airfield activities and other airport activities
8.204 AIAL determines the price charged by aircraft type per landing by first using a cost allocation model and then establishing weight bands and prices into which different aircraft fall. For airlines, the landing charge they pay for a given aircraft landing is calculated by multiplying a dollar charge per MCTOW by the MCTOW of that aircraft. Key drivers of AIAL's cost allocations model are summarised in Table 25.
Table 25: Basis of Cost Allocation
| | AIAL |
|---|
| Return on the capital cost of land | Landings and m² runway area used (width x length) |
| Return on the capital cost of runways and taxiways | Landings and m³ runway used (width x length x depth) |
| Return on the capital cost of aprons | Landings and m³ runway used |
| Runway damage (operating costs of sealed surfaces) | Equivalent landings341 |
| Rescue fire service costs | Seats landed342 |
8.205 The cost allocation model attempts to identify the causes of costs, and to allocate costs accordingly. The cost of runway damage aims to take account of the wear-and-tear on the runway, and associated taxiway and aprons, caused by aircraft movements, with heavier aircraft causing greater damage. The cost of rescue fire is related to the seat capacity of aircraft, with international standards requiring more services available the greater the aircraft's seat capacity. The returns on the various capital costs are related to the size of the aircraft and, therefore, the likely number of potential passengers, reflecting demand conditions. This seems to be a reasonable attempt to recover the costs involved.
8.206 AIAL is a multi-product business, and serves a variety of customers. This suggests there is potential for cross-subsidisation to occur across its different activities. Because of the throughput of passengers generated by airfield activities, AIAL can undertake other integrated aeronautical activities (such as the provision of both airfield and terminal facilities) together with significant complementary commercial activities (such as the provision of retail and commercial premises). There are incremental and common costs associated with these activities.
8.207 BARNZ argue that airlines have not received sufficient information from AIAL on the apportionment of common costs to commercial activities and airfield activities to judge whether cross-subsidisation is occurring. It considers disclosures could be enhanced to assist in assessments of such allocations.343
8.208 The Commission considers there is no economically appropriate way to allocate costs, except indirectly via Ramsey Pricing. MCTOW based pricing approximates Ramsey Pricing. The Commission also notes that an analysis of the adequacy of information disclosure regulations is outside the scope of this Inquiry.
8.209 Given the information available, the Commission considers the scope for cross-subsidisation is minimised by AIAL's use of a multiple till approach, which where possible does try to associate costs with their cause and, to some degree, the demands of the various user groups.
Productive Inefficiency
Introduction
8.210 Airports are predominantly fixed-costs businesses characterised by economies of scale. As traffic builds up, the runway facilities are better utilised and the fixed costs are spread over a larger number of landings or passengers. In general, therefore, unit costs would go down with increased use, unless an airport invests too much or too soon in new facilities. However, despite the importance of fixed costs for efficiency, the operating costs at airports are also significant.
8.211 The pricing principles in Chapter 4 suggest a productively efficient operation is one that, over the medium-term, meets demand at the lowest possible cost, commensurate with the level of service quality demanded. The Commission has considered the submissions on AIAL's productive efficiency from interested parties. It presents below some of the evidence that has informed its decision on this matter.
Measures of Operating Costs and Their Trends
8.212 The major operating expenses of AIAL are depreciation, employee remuneration, repairs and maintenance, and rescue fire services. Of the operating expenses, all but depreciation could be susceptible to productive inefficiency over the medium-term. These might arise, for example, because of overly lavish maintenance expenditure, over-staffing, or excessive levels of staff remuneration.
8.213 In the Draft Report, the Commission suggested that productive inefficiencies may be 1% of operating costs (excluding depreciation) for AIAL. AIAL argued that the 1% figure used by the Commission was in effect a 4% figure on variable costs. To determine this 4% figure, AIAL assumed 75% of operating expenses (including employee costs, which is the greatest expense) were fixed.344 However, the Commission applied the 1% figure only to operating costs. Depreciation expenses were considered fixed and were deducted from operating costs before the 1% figure was applied. It is arguable, however, that some costs classified by AIAL as being fixed are also variable to some extent, particularly if a longer-term perspective were taken, but the Commission conservatively assumed that these were all fixed.
8.214 AIAL's operating expenses (excluding depreciation) have increased since vesting. However, aggregate operating costs on their own do not provide sufficient information for evaluating productive efficiency. Relative (per unit) measures of operating costs are needed. Since vesting, Auckland International Airport has experienced significant growth in passenger, aircraft movements, cargo and tonnes landed. Passenger and landing data for Auckland provide a complete record since vesting. The Commission has, therefore evaluated AIAL's productive efficiency in relation to costs per landing and per passengers.345
8.215 On a per passenger and per landing basis, the operating costs (excluding depreciation) of AIAL have fallen on average by 2.1% pa and 3.5% pa respectively, when comparing the operating costs in 2000 to those in 1989. [...].346 Despite the reduction in flights from Air New Zealand and the fallout of the 11 September 2001 terrorist attacks in the United States, [...].
8.216 BARNZ argued in submissions that AIAL should have been able to achieve the same cost reductions as WIAL. BARNZ claimed WIAL achieved 7.2% per annum reduction in airfield expenses over the period 1998 to 2000, "while operating under a Deed which specified prices".347 BARNZ argued the 1% figure suggested by the Commission was, therefore, too low for AIAL, and it suggested a 3% figure instead. BARNZ also noted that airports should benefit from economies of scale, and that AIAL should be able "to achieve efficiencies above the level of total factor productivity improvement experienced by the economy as a whole."348 AIAL argued that offsetting any economies of scale is the increasing complexity associated with handling more intensive traffic flows.349
8.217 AIAL suggested that the airlines participate in a variety of AIAL's operating committees and claimed that the airlines have never advised AIAL on where it could improve its efficiency of airfield operations.350 Airlines in response have suggested that, in some instances, even though they have been involved in the various operational committees, they have disagreed with AIAL over the level of necessary costs to be incurred. One example, mentioned by BARNZ, was the maintenance expenditure on the main runway. It is also noted that there are areas, such as staffing and remuneration, where the airlines do not have a say in AIAL's operation.351
Benchmarking
8.218 Monopolies may be less productively efficient, implying that there may be "X inefficiencies" associated with the lack of competitive constraints. AIAL in its submission argued that both competitive and monopoly sectors face incentives to be "normally efficient". AIAL advocates, and uses, benchmarking to assess its operational efficiency.352
8.219 The Commission considers that benchmarking of AIAL's productive efficiency has merit. However, it is also difficult to do, because appropriate indicators of productivity and comparator airports are difficult to find. For example, output can be defined in terms of the number of aircraft movements, passengers and cargo volumes. Each of these output measures is related to only part of the Airport's infrastructure. For this reason, operational indicators tend to be only partial efficiency indicators. Appropriate indicators can vary between airports, reflecting differences in operating conditions, traffic mix and other factors. AIAL notes such difficulties in its submissions on benchmarking in response to the Critical Issues Paper and reports it has commissioned.353
8.220 AIAL referred to reports prepared by Transport Research Laboratory (TRL) and LEK Consulting, the latter being commissioned by AIAL.354 The airport-wide focus of these reports makes it difficult to determine their implications for airfield activities alone. These reports also had difficulties of finding appropriate benchmark airports. For example, London's Heathrow was used as one benchmark airport despite being many times the size of AIAL.355 Some of the indicators used were also questionable. For example, one of the variables used to benchmark AIAL against other international airports, and on which it scored well, was a measure of profitability. The profitability indicator is of limited relevance given the nature of this Inquiry, which in part must assess whether AIAL is misusing its market power. Nonetheless, these reports do present AIAL in a favourable light when comparing the airport's total costs on a per passenger and per landing basis against the vast majority of the international airports included in the survey.
8.221 BARNZ commissioned a report by NECG that challenged the findings of the LEK Consulting report obtained by AIAL.356 NECG argues in its report that "AIAL compares unfavourably with all Australian airports on the basis of operating costs per passenger", when the graphs used by LEK are recast to show costs and revenue per passenger.357 NECG also argue that AIAL is less efficient than WIAL and CIAL.358 They are critical of LEK's arguments that the different functional characteristics of the airports (such are the length of the runways and number of terminals), and other factors (such as having a higher proportion of international traffic compared to WIAL and CIAL), means AIAL's operations are of greater "complexity", and that this "complexity" should explain AIAL's greater operating costs per passenger compared to WIAL and CIAL.359
8.222 On the question of future productivity gains, the NECG report suggests that "[LEK] stretches credulity somewhat to suppose that...AIAL is so different from Australian airports that its scope for efficiency gains is a very modest 1.1% per annum [for total costs per passenger]".360 The LEK estimate was for the period 1996 to 2005. In cross submissions, BARNZ also noted that the ACCC, in its May 2001 decision regarding aeronautical charges at Sydney Airport, had imposed cost savings of 4% per annum (Sydney Airport itself had suggested 3%).361
8.223 Despite the trend in falling operating costs (excluding depreciation) on a per passenger and landing basis, AIAL still has the highest operating costs (excluding depreciation) per passenger and per landing of the three airports subject to this Inquiry. In 2000, on a per landing basis, its operating costs (excluding depreciation) were over twice those of WIAL and CIAL, and on a per passenger basis, AIAL's operating costs (excluding depreciation) were 30% greater than WIAL's and 11% greater than CIAL's. AIAL explains its higher per unit operating costs by the higher complexity of its operations.362 The Commission is sceptical of AIAL's explanation. Even if AIAL's operations were significantly more complex (which is by no means clear), such complexity would likely be more than offset by economies of scale.
Summary
8.224 The Commission considers that it cannot fully rely on the benchmarking exercises commissioned by AIAL, or the response by NECG, to determine the level of productive inefficiencies. The benchmarking exercises are, however, relevant to informing the Commission's decision on the appropriate level it has adopted. The Commission has adopted a pragmatic approach to an issue that involves significant uncertainty by presenting productive inefficiencies as a percentage range of operating costs (excluding depreciation).
8.225 AIAL has significantly higher operating costs (excluding depreciation) on a per landing and passenger basis compared to some airports overseas and to WIAL and CIAL. The Commission considers this cannot be explained by claims of its greater complexity, particularly given that economies of scale could be expected with increasing size, and that some of the Australian Airports of comparable size are less costly, albeit on a total cost basis. It may also be significant that the comparable Australian airports have been price-capped for the last five years.
8.226 The Commission considers there is likely to be some room for improvement in the productive efficiency of the airfield activities at Auckland. Although operating costs (excluding depreciation) have fallen (and are expected to continue to fall) on a per passenger and landing basis, the Commission considers there was scope for these reductions (and future reductions) to be greater than what was achieved, and for future reductions to be greater than expected to be achieved. The Commission notes that the LEK report (commissioned by AIAL) suggests that there is scope for a 1% productive efficiency gain per annum. BARNZ, on the other hand, submitted that a productive efficiency gain of 3% per annum was more appropriate. The Commission considers there to be productive inefficiency of the order of 1-3% of operating costs (excluding depreciation) at Auckland.
8.227 Table 26 presents the levels of potential productive efficiency benefits based on the 1-3% range. The figures shown in Table 26 include an average of the seven years 2001-2007.
Table 26: Potential Productive Inefficiency at Auckland International Airport ($000s)
| | 1-3% Range |
|---|
| 2001 | 161 to 485 |
| 2002 | [...] |
| 2003 | [...] |
| 2004-2007 per annum | [...] |
| Average 2001-2007 | 141 to 425 |
8.228 The Commission notes that the slight productive efficiency gains that AIAL has achieved to date account for some for some of the excess returns that AIAL has earned historically (as identified earlier). However, they are insufficient to explain all the excess returns identified.
Dynamic Inefficiency
8.229 Dynamic efficiency relates to minimising costs over time through investment, and to the quantity and quality of assets used by an entity. Inefficiencies can arise where investments that would be optimal are not made (or made at the wrong time), or investment has led to too many assets being acquired - meaning that some assets are not "used or useful" in meeting demand - or because some assets are "gold plated". Given the nature of airfield activities, the acquisition of too many assets (most likely land) is more likely to be a potential source of dynamic inefficiency than "gold plating". The issue then becomes one of whether the optimal amount of assets is being used to provide the service.
8.230 As noted earlier, there appears to be some over-investment by AIAL in airfield activities in the form of land held for future development of the second runway and in respect of the eastern approaches land. This land has been optimised out of AIAL's asset base. However, there may also be dynamic efficiency implications regarding the optimised land, particularly if the land is not put to its best alternative use until it is used for airfield activities.
8.231 AIAL argued in its submission to the Draft Report that optimising out the land from the asset base for charging purposes, and evaluating the efficiency of the investment itself, constituted double counting. AIAL also argued that it was impractical for the airports to be expected to use the land in best alternative uses until the time it is used. AIAL advised that it has endeavoured in the past to find more productive uses for the second runway land in revenue terms, but in each case, they were not viable nor practical at the time.363 For example:
- AIAL worked with Fletcher Forests to assess the possibility of planting the land in pine trees. The plan was ruled out as the forest would need to stand for some 25-30 years before being felled, and the second runway would be needed before then.
- Large scale dairying was considered but the configuration and access points of the various land holdings did not permit the scale of operation that would be required. Short-term leases were subsequently entered into, principally involving grazing.
- Low cost housing - this was considered undesirable from a social perspective by AIAL's Board and possibly fraught with problems in the longer term when tenants needed to be moved on to make way for the second runway.
8.232 having considered AIAL's submission, the Commission considers that, if the optimised land will form part of the airfield activities markets in the medium-term, and was a prudent investment, then consideration of any inefficiencies in the interim may constitute double counting. Double counting would be inconsistent with the Commission's principles in Chapter 4, in particular it would compromise prices being dynamically efficient over the medium-term.
8.233 The Commission has attempted to quantify the extent of dynamic inefficiencies at Auckland International Airport by first determining that proportion of land that may have resulted in dynamic inefficiency (either through the purchase or subsequent use). Determining whether the optimised land, even if it is not presently used or useful, is prudently held over the medium-term provided a basis on which the decision could be made. That land which is not prudently held over the medium-term is subject to dynamic inefficiencies and should be used elsewhere (or not acquired in the first place) as it will not earn its opportunity cost in the medium-term. Land that is prudently held is expected to enter the asset base on which charges are based over the medium-term, and will, therefore, earn its opportunity cost in the future.
8.234 The portion of land subject to dynamic inefficiency at Auckland is that proportion of land which will not be needed for the shorter second runway now proposed. This is about 18% of the total land held for the second runway. The extended runway is not expect to be needed for at least 40 years. The presence of this excess land holding implies sub-optimal use of this land. The size of dynamic inefficiencies for this land depends on its best alternative use. Two scenarios are possible:
- If the optimal use for this land is rural land uses, and because it is currently used for these purposes, there are unlikely to be dynamic inefficiencies associated with the use of this land. No dynamic inefficiencies could therefore be attached to this excess land holding at Auckland.
- If the best alternative use were residential or commercial (reflected by the $140,000 per ha opportunity cost value), then the dynamic inefficiencies attached to this land can be measured using the approach described in Chapter 7. By way of example, some of the key figures of this calculation for 2001 were:
- The Commission has estimated the annual returns on the land at $100,000. With a discount rate of 10.28% to 7.68% and treating these returns as a perpetuity (as land does not depreciate) and adding expected revaluation gains of 2%, the excess land (in its current use) was valued at $1-$1.3m in 2001.
- AIAL's valuation of the excess land was $6.7 million in 2001.
- The difference between the two valuations indicates the extent to which the land is being misallocated. This difference was converted into an annual equivalent value of $0.2-$0.4 million in 2001, and represents the dynamic inefficiency AIAL would experience with the higher opportunity cost value.
8.235 The eastern approaches land was also optimised out. No dynamic inefficiency exists for the eastern approaches land as the land is employed in its best alternative rural use and is earning its opportunity cost.
8.236 The estimate of dynamic inefficiency in airfield activities per annum at Auckland, for all years, is presented in Table 27.
Table 27: Potential Dynamic Inefficiency at Auckland International Airport ($000s)
| | Over WACC Range | At Point Estimate |
|---|
| 2001 | 0 to 378 | 0 to 283 |
| 2002-2007 per annum | 0 to 346 | 0 to 251 |
| Average 2001-2007 | 0 to 350 | 0 to 256 |
Costs of Control
8.237 Costs of control are forward looking by the very nature of this Inquiry. The Commission considers that the direct costs of control (including both the regulators' and market participants' costs) for a single airport might be $1-$2 million in a review year, and $0.5-$1 million in other years. Over a five year period, with one review, this suggested an annual average of between $0.6-$1.2 million per year at each airport.
8.238 The total costs of control are not easy to estimate. In Chapter 7, the Commission considered that, in the absence of any superior alternatives, the indirect costs of control could be measured by considering what extent of the potential benefits of control could be realised by control. The Commission determined that the indirect costs of control as a proportion of potential benefits would be 25% of any excess returns and producer surplus, 43.75% of any consumer surplus, and from 50% to 100% of any dynamic inefficiencies. The productive efficiency costs of control are estimated at 0 to 2% of operating costs (less depreciation), and are offset against the range of possible benefits of control regarding productive inefficiencies.
8.239 Table 28 summarises the likely indirect costs, per annum, of controlling the airfield services supplied by AIAL to aircraft operators. The figures shown in Table 28 are an average of the seven years 2001-2007. Results for individual years are shown in Appendix 13.
Table 28: Likely Indirect Costs of Controlling AIAL ($000s)
| | Over WACC Range | At Point Estimate |
|---|
| Consumer Surplus | 0.5 to 10 | 4 |
| Producer Surplus | 11 to 83 | 52 |
| Excess Returns | 287 to 1,623 | 968 |
| Productive Inefficiency | 0 to 283 | 141 |
| Dynamic Inefficiency | 0 to 350 | 0 to 256 |
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