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8. MED has undertaken a review of the regulatory control provisions in Parts 4, 4A and 5 (sections 70-73) of the Commerce Act 1986. An accompanying paper details the review and seeks approval of recommended changes to the Act.

9. The objectives of the review are to provide a credible regulatory regime to address markets where competition is not possible, improve certainty, timeliness and predictability for businesses, and provide for incentives for efficient investment in infrastructure.

10. The primary changes include:

• providing for a wider range of regulation (including information disclosure, negotiate/arbitrate, and a default/customised price-quality path) in addition to conventional price control;
• a more conventional, qualitative test, with quantification where possible, for when regulation may be imposed;
• a requirement that the Commerce Commission set "input methodologies" (how to determine the weighted average cost of capital, value assets, allocate common costs etc) as an upfront and stand-alone process, to improve certainty and predictability for businesses; and
• providing for limited merits review of Commission decisions on input methodologies.

11. The three major international airports and the airline sector were active in making submissions on the review. Submissions were received from Air New Zealand, Auckland International Airport Limited (AIAL), the Board of Airline Representatives in New Zealand (BARNZ), Christchurch International Airport Limited (CIAL), the International Air Transport Association (IATA), Peet Aviation, Virgin Blue and Wellington International Airport Limited (WIAL). There were no submissions from airports other than Auckland, Wellington and Christchurch or from those small domestic airlines, which are not represented by BARNZ. Sector participants have also been active in the media on these issues.

Structure of the paper

12. The following sections of this paper:

1. consider the purpose of economic regulation of airports;
2. consider the problems with the current regime; and
3. consider the options for introducing a more robust regulatory regime for airports.

Objectives of economic regulation of airports

13. The over-arching objectives of economic regulation of airports are to:

• provide a credible regulatory regime to address markets where competition is not possible;
• constrain the scope for exercise of substantial market power by airports;
• protect consumers from prices that would not be consistent with those in a workably competitive market;
• improve certainty, timeliness and predictability for businesses, and
• provide for appropriate incentives for efficient investment in infrastructure, taking into account the benefits to end-users.

Current regulatory regime

14. Many airports, particularly the larger and international airports, have strong natural monopoly characteristics. This potentially enables them to set prices above those that would prevail in a workably competitive market and/or to provide inferior service. Accordingly, most OECD countries subject larger airports to a regulatory regime aimed at preventing monopoly pricing.

15. The current regulatory regime in New Zealand comprises:

• an information disclosure regime under the Airport Authorities Act (AAA) which requires airports to disclose specified financial and performance information, and for specified airports to disclose specific financial information relating to aeronautical related activities. The disclosure requirements do not specify input methodologies or pricing principles for the preparation of this information
• consultation with substantial customers:¹ Airports are required to consult with every substantial customer before fixing or altering charges. Those with revenues over $10 million per year are also required to consult with substantial customers on capital expenditure plans at least every five years;
• the power for airports "to set charges as they see fit" under the Airport Authorities Act 1966 (the AAA); and
• the threat of price control under the Commerce Act 1986.

Previous reviews

16. Between 1999 and 2002 the Commerce Commission undertook an inquiry into AIAL, WIAL and CIAL. It recommended control of AIAL (and WIAL, if charges were raised significantly²). The Commission estimated that Auckland Airport was earning excessive returns of $4.5 million in 2001, with excess returns of $27 million expected over the next six years if the regulatory regime remained unchanged. Notably, for the purposes of the Commission's forecasts, revaluation gains were not considered, thus these figures would likely have underestimated excess returns.

17. In the event the Minister decided not to impose control because net public benefits (overall efficiency) were negative (the benefits of regulation in terms of efficiency gains did not outweigh the costs) and benefits to consumers were relatively low (at only about 40 cents per passenger). At that time the only regulatory option available under the Commerce Act was full price control.

18. A review in 2001 by Arthur Andersen, for the Ministry of Transport found that the lack of clarity and specificity under the current information disclosure regime meant that none of the disclosures would allow an interested party to understand the price setting process to such an extent as to make a meaningful assessment of the appropriateness of cost allocations.

Problems with Current Regime

19. After considering information from previous reviews, and submissions from the three major airports and airline interests on the Commerce Act review, we have identified the following problems with the current regulatory regime:

• the information disclosure regime is ineffective. The absence of guidelines or methodologies limits transparency about regulatory issues and disclosed information tends to be largely of the nature of general purpose financial statements. They do not provide a robust basis for assessing whether there is monopoly pricing. In addition even if there were meaningful disclosure, no government agency actively monitors the information;
• the statutory requirement is to consult, not to negotiate. Because airports have the right to make investment decisions and set charges unilaterally (after consultations) it is inevitable, absent an independent dispute resolution mechanism, or credible and timely threat of heavier handed regulation, that airports will tend to make decisions in their own interests. Again the lack of pricing principles and binding input methodologies mean that these are a major source of contention between larger airports and airlines, along with the outcomes of consultation; and
• the current threat of regulation is weak. The Commission is not funded to undertake an inquiry on its own initiative, it does not undertake price monitoring of airports, and there is likely to be Government reluctance to undertake a new inquiry within a few years of the last one. Furthermore, inquiries and decision-making (and appeals) take many years, and even if price control is eventually imposed it is not able to recover past excess profits.

20. In sum, the current regulatory regime is not a credible or robust regime for constraining the scope for exercise of airports market power.

21. The recent interest by overseas investors in Auckland airport means there is some urgency for clarity as to the nature of the regulatory regime going forward. In the absence of a robust regulatory regime there is a risk that either:

1. Overseas investors will pay a discounted price for ownership based on the expectation that a robust regime will be put in place for New Zealand's major international airport. If such a regime does not eventuate, and high returns continue, there will be a transfer of monopoly rent out of New Zealand, which is a loss to New Zealand, or:
2. Overseas investors will expect that the regulatory regime will remain as it is. Any subsequent Government action to introduce a tougher regime might be perceived as aimed at foreign owners, with a consequent reputational risk for New Zealand. Furthermore, if they initially over-pay for assets (in the light of their unrealised expectations about continuation of the current regime), it may be difficult to subsequently reduce the asset base to a reasonable level.

Options for action

22. This section considers the main options available to Ministers. In summary they are:

• One: Take no further action at this stage, but let the proposed amendments to the Commerce Act take effect;
• Two: Do further work (either an independent consultancy study or a Commerce Commission inquiry) to identify whether there is a problem and the best solution;
• Three: make a decision to improve the information disclosure regime and undertake price monitoring for major international airports, with further work undertaken in 2008/09 on whether further regulation is warranted;
• Four: make a decision to impose a robust information disclosure regime and a negotiate/arbitrate regime under the revised Commerce Act;
• Five: make a decision to impose price control under the current Commerce Act on major international airports;