Benefits and Costs
9.118 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 WIAL to aircraft operators.
9.119 The Commission's analysis of the potential benefits of control involves a number of distinct parts: calculation of returns from vesting to date (1991-2001); forecasting of returns into the future (through to 2003); assessing any allocative inefficiencies associated with current landing charges; assessing any productive inefficiency; and assessing any dynamic inefficiency. Each are now discussed.
9.120 All the results presented in this Chapter are based on the Commission's assessed airfield asset base and the WACC range for WIAL estimated by the Commission. Appendix 15 contains full workings of the analysis, as well as results and sensitivity analysis based on alternative asset base assumptions.
Historic Analysis of Returns
Introduction
9.121 From an economic perspective, WIAL 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 WIAL'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 that WIAL was earning an excessive return, unless those returns reflected efficiency gains and superior performance.
The Calculations
9.122 The Commission has conducted an analysis of the historical returns of the airfield activities of WIAL 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)
9.123 The first part of the equation, net earnings, represents WIAL'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.
9.124 The returns are computed annually for each financial year from vesting (1991-2001) 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 in years where there are substantial revaluations, revaluations are spread back to vesting, or the last revaluation.395
9.125 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 WIAL (unavailable when the Draft Report was released). Inputs and assumptions have also been modified where appropriate (as discussed in this Report).
Assumptions and Inputs
9.126 As noted above, for full details of the data used and of the analysis of WIAL, readers are referred to Appendix 15. These include an analysis of the sensitivity of the results to different assumptions or scenarios regarding the appropriate asset base reported below.396 The key assumptions and inputs in the Commission's analysis of historical returns are detailed below.
9.127 Revenue figures for WIAL's airfield activities are sourced from a combination of WIAL'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 1991-1993, where an estimate of $200,000 is included each year.
9.128 Expense figures are less precise. Expense data for WIAL's airfield activities for the last two years (2000 and 2001) are sourced from information disclosures. For 1994-1999, the data is sourced from estimates provided by WIAL during the Inquiry. No such information was provided for 1991-1993. As with the analysis included in the Draft Report, the Commission derived estimates of the airfield expenses for 1991-1993. In the Draft Report, the Commission computed these estimates by extrapolating back from 2000 (working out the airfield portion of expenses for a given year based on the proportion of that expense type in 2000). In computing its revised figures for this Report, the Commission has accepted WIAL's suggestion that expenses be further adjusted to account for the change in focus of WIAL's business over time. Also, in conducting the extrapolations, the Commission now uses 1994 as the base.
9.129 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.
9.130 The Commission's assessment of the appropriate airfield asset base for WIAL as at 31 March 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. As with expenses, WIAL has provided the Commission with estimates of its airfield asset base for 1994-1999, and has disclosed figures for 2000 and 2001. In addition, WIAL has provided breakdowns of land and civil works values since vesting, as well as details of revaluations by asset type (on an entire airport basis). As part of the information provided to the airlines as part of the current consultation, WIAL has provided other estimates of airfield assets and revaluations, and a detailed breakdown of WIAL's land values since vesting. Using this information and WIAL's 2000 valuation report, the Commission has formulated a picture of WIAL's asset base (whole airport and airfield) since vesting.
9.131 Adjustments to the asset base (and revaluations included as earnings) are made over the period. Adjustments to the asset base mainly relate to the Commission's chosen method of valuing assets over this period, and are due to the reduction or removal of spread revaluations.
The Results
9.132 The Commission's assessment of the returns earned historically on airfield activities by WIAL are summarised in Table 46. Table 46 provides three different representations of the results: average returns from vesting to date (1991-2001), average returns over the last five years (1997-2001), and the present value of returns from vesting to date as at the end of WIAL's 2001 financial year (31 March 2001). For results for individual years, refer to the detailed results provided in Appendix 15.
Table 46: Returns on Airfield Activities Supplied by WIAL Since Vesting ($000s)
| | Over WACC Range | At Point Estimate of WACC |
|---|
| Average 1991-2001 | -2,123 to -941 | -1,486 |
| Average 1997-2001 | 632 to 1,891 | 1,310 |
| Present Value 1991-2001 | -42,895 to -24,641 | -33,066 |
9.133 The Commission also notes that the average figures for 1997-2001 estimate results for WIAL's current pricing Deed (which covers the period 1 July 1997 to 30 June 2001).
9.134 The figures in Table 46 suggest varying results. In the last five years, WIAL has earned positive returns, but this was not the case in the early years post-vesting. The figures per year from 1991-2001 (detailed in Appendix 15) indicate a trend of increasing returns, moving from negative returns just after vesting to positive returns per annum currently. The average of returns since vesting shown in Table 46 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.
9.135 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.
9.136 Although 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).
9.137 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). As with AIAL, the analysis revealed that returns were not materially affected by the depreciating of the asset base. The trend of increasing returns was still apparent, although the magnitude of returns was slightly less).
9.138 The returns identified for WIAL are nowhere near as large as those found for AIAL. In addition, results vary markedly over the WACC range. The slight excess returns identified at the upper bound of the WACC range may be justified given that this is where the Commission's and WIAL's WACC estimates overlap. The extent of any productive efficiency gains are also yet to be examined, and these may be sufficient to negate the suggestion that WIAL has earned excess returns historically.
9.139 The extent of any productive efficiency gains is considered later when WIAL'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.
Current and Forecast Analysis
9.140 As discussed in Chapter 7, the counterfactual in WIAL's case will be the status quo.
9.141 While analysis of historical returns is useful for evaluating behaviour of WIAL 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 WIAL behaviour, assuming that behaviour in the past continues.
9.142 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.397 The analysis for WIAL projects future returns and inefficiencies out to 2003. 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
9.143 The Commission has calculated an average price per tonne (Pm) for WIAL's 2001 year based on the landing charge revenues and tonnes landed (Qm) in the 2001 financial year for WIAL. Pm is used to compute Pc. WIAL'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 47.
Table 47: Average Prices Relative to Competitive Benchmark Prices for WIAL for its 2001 Financial Year
| | Over WACC Range | At Point Estimate of WACC |
|---|
| Actual Price (PM) | $10.89 | |
| Efficient Price (PC) | $9.76 to $10.88 | $10.28 |
| Difference, PM-PC | 0.01 to 1.13 | 0.61 |
| Actual Output (QM) | 1,299,611 | |
| Efficient Output (QC) | [...] | [...] |
| Difference, QC-QM | [...] | [...] |
9.144 WIAL's actual price for 2001 exceeds the Commission's range of efficient prices shown in Table 47. WIAL's actual output for 2001 falls below the range for efficient output. Allocative inefficiencies exist and represent losses of consumer surplus.
9.145 The Commission has computed the same figures for each of the forecast years (2002-2003). These figures are not detailed here, but can be found in Appendix 15. [...], actual price is less than efficient price in 2002. For 2003, as a result of the 10% interim price increase from 1 July 2002, actual price generally exceeds efficient price. Where the actual price is below the efficient level, then allocative inefficiencies are losses of producer surplus, and negative excess returns will also be apparent (representing less than normal returns).398
Estimates of Allocative Inefficiency and Excess Returns
9.146 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 WIAL'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 WIAL.
9.147 Forecast returns are computed using the same formula as that used in the historical analysis. WIAL's actual results for 2001 are used as the base, modified as appropriate based on WIAL's forecasts and growth estimates. In computing forecast returns under scenario 1 for 2002-2003, the Commission has adopted WIAL'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).
9.148 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 48 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 48 are an average of the three years 2001-2003. Results for individual years are shown in Appendix 15.
Table 48: Estimated Allocative Inefficiencies and Excess Returns for WIAL ($000s)
| | Over WACC Range | At Point Estimate of WACC |
|---|
| Consumer Surplus | 0.4 to 6 | 2 |
| Producer Surplus | -7 to 96 | 50 |
| Excess Returns | -88 to 1,346 | 684 |
9.149 Table 48 shows that the positive returns found in recent years historically are forecast to continue. At the higher end of the WACC range, negative returns are forecast, which suggests that less than normal returns may be being earned. The level of allocative inefficiency is immaterial.
9.150 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
9.151 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.
9.152 WIAL 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. The key drivers of WIAL's cost allocations model are summarised in Table 49.
Table 49: Basis of Cost Allocation
| | WIAL |
|---|
| Return on the capital cost of land | Landings and m² runway area used |
| Return on the capital cost of runways and taxiways | Equivalent landings of design aircraft399 and m² runway area used |
| Return on the capital cost of aprons | Tonnes landed (MCTOW x number of landings)400 |
| Runway damage (operating costs of sealed surfaces) | Equivalent landings and m² runway area used |
| Rescue fire service costs | Landings |
9.153 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. Unlike AIAL, the cost of rescue fire is allocated based on the number of landings (not 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.
9.154 WIAL 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, WIAL 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.
9.155 BARNZ argue that airlines have not received sufficient information from WIAL 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.401
9.156 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.
9.157 Given the information available, the Commission considers the scope for cross-subsidisation is minimised by WIAL'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
9.158 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.
9.159 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. In the Draft Report, the Commission suggested that productive inefficiencies may be 1% of operating costs (excluding depreciation) at WIAL. The Commission has considered the submissions on WIAL'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
9.160 The major operating expenses of WIAL are depreciation, employee remuneration, repairs and maintenance, fire rescue, motor vehicles and insurance. Of the operating expenses, all but depreciation would appear to be potentially 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.
9.161 In its response to the Critical Issues Paper, WIAL suggested that "[b]ecause of the difficulties in drawing valid conclusions from cross-airport comparisons WIAL focuses on changes in its own efficiency over time."402 WIAL refers to different phases in its history, namely: establishment 1990-1993; consolidation 1994-1995; terminal area development 1996-1999; and consolidation (2000-). By the measures WIAL presents, most significant cost savings measures were first felt during the consolidation phase of 1994-1995, "in particular relating to airport fire services".403 Since vesting, some airfield activities have been brought in-house (such as fire services), while other airfield activities have been contracted out (such as repairs and maintenance).
9.162 WIAL's operating expenses (excluding depreciation) have decreased 43.5% 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, Wellington International Airport has also experienced growth in passenger, aircraft movements, cargo and tonnes landed. Passenger and landing data for Wellington provide a complete record since vesting. The Commission has, therefore, evaluated WIAL's productive efficiency in relation to costs per landing and per passenger.404
9.163 On a per passenger and per landing basis the operating costs (excluding depreciation) of WIAL have fallen on average by 6.8% pa and 3.8% pa respectively, when comparing the operating costs in 2000 to those in 1991. [...]
9.164 BARNZ argued in submissions that 1% productive inefficiency, as indicated in the Draft Report, was appropriate for WIAL. BARNZ recognised that WIAL had made cost savings of 7.2% per annum over the period 1998 to 2000.405 In general terms, however, BARNZ noted that airports should benefit from economies of scale.406
Benchmarking
9.165 The Commission considers that benchmarking of WIAL's productive efficiency has merit. However, it is also difficult to do. There were no benchmarking exercises presented on WIAL's productive efficiency, although WIAL was used as a comparator in the NECG response on LEK's study of AIAL's productive efficiency.407 In this study WIAL's productive efficiency compares favourably with that of AIAL.
9.166 WIAL has a trend of falling operating costs (excluding depreciation) on a per passenger and landing basis, and also had the lowest operating costs (excluding depreciation) per passenger and per landing of either AIAL (23% and 61% respectively) or CIAL (15% and 10% respectively) for 2000.
Summary
9.167 As noted above, WIAL's operating costs (excluding depreciation) have fallen on a per passenger and landings basis since vesting. In 2000, WIAL had the lowest operating costs (excluding depreciation) on a per landing and passenger basis compared to AIAL and CIAL. However, while WIAL has achieved cost savings in the past, the Commission considers there is likely to be scope for further improvement in the productive efficiency of the airfield activities at Wellington in the future. The Commission notes that operating costs (excluding depreciation) per passenger and landing are [...] at the Airport.
9.168 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). The Commission considers there to be productive inefficiency of the order of 0-1% of operating costs (excluding depreciation) at WIAL.
9.169 Table 50 presents the levels of potential productive efficiency benefits based on the 0-1% range. The figures shown in Table 50 include an average of the three years 2001-2003.
Table 50: Potential Productive Inefficiency at Wellington International Airport ($000s)
| | 0-1% Range |
|---|
| 2001 | 0 to 55 |
| 2002 | [...] |
| 2003 | [...] |
| Average 2001-2003 | 0 to 54 |
9.170 The 7.2% per annum productive efficiency gains achieved by WIAL from 1998 to 2000 (the period of the Deed), may account for the bulk of the positive returns earned by WIAL over that period (as identified earlier). This being the case, the Commission does not find evidence that WIAL had earned excess returns historically.
Dynamic Inefficiency
9.171 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.
9.172 As noted earlier, there appears to be no over-investment by WIAL in airfield activities and no misuse of assets. The Commission considers there are no dynamic inefficiencies at Wellington International Airport.
Costs of Control
9.173 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.
9.174 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. Where excess returns are zero or negative, the indirect costs cannot be measured in the same way, and are, therefore, recorded as zero. However, the Commission notes that, in principle, indirect costs would exist were control to be imposed in such circumstances.
- 43.75% of any consumer surplus and 25% of any producer surplus.
- From 50% to 100% of any dynamic inefficiencies.
9.175 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.
9.176 Table 51 summarises the likely indirect costs, per annum, of controlling the airfield services supplied by WIAL to aircraft operators. The figures shown in Table 51 are an average of the three years 2001-2003. Results for individual years are shown in Appendix 15.
Table 51: Likely Indirect Costs of Controlling WIAL ($000s)
| | Over WACC Range | At Point Estimate |
|---|
| Consumer Surplus | -0.1 to 2 | 1 |
| Producer Surplus | -1.9 to 24 | 12 |
| Excess Returns | 47 to 336 | 176 |
| Productive Inefficiency | 0 to 108 | 54 |
| Dynamic Inefficiency | 0 | 0 |
Back to Top