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• Estimated Excess Returns by Auckland International Airport
• Net Benefits to Acquirers and Net Public Benefits
• Net Benefits as a Proportion of Total Landing Charges and Net Profit
• Other Forms of Control
• Preliminary Conclusions
• Wellington International Airport
• Christchurch International Airport
• Other Matters

Commission's Analysis

22. The Commerce Commission has concluded that "market conditions" are such that you should recommend control in the case of Auckland International Airport in the interests of acquirers. As part of these market conditions the Commerce Commission has concluded that the existing regulatory framework under the Commerce Act, the Airports Authority Act and disclosure regulations designed to enhance the countervailing market power of airlines have not been effective in constraining the ability of airports to earn excess returns.

23. In reaching its conclusions the Commission necessarily made certain assumptions and adopted certain methodologies after taking into account both in-house and external expert advice, and the views of interested parties. One of the more hotly contested issues raised in submissions was the Commission's choice of valuation methodology used in calculating the appropriate asset base. The Commission determined that assets should generally be valued at opportunity cost and specialised assets should be valued at depreciated historical cost. The major opponents of this view support an optimised depreciated replacement cost valuation methodology for specialised assets, which if accepted would reduce the net benefits to acquirers of control closer to zero. Some of the submitters request you form a view on the valuation methodology to remove uncertainty.

24. The approach we are taking is that the Commerce Commission is an expert in these matters. The Commission gives sound reasons, some of them airports specific, for adopting the valuation methodology that it has in this case. We do not think it is necessary for you to form a view on this matter, as the adoption of an alternative valuation methodology that would result in lower net benefits to acquirers of control would not change our preliminary conclusion.

Submissions

25. We have requested submissions on the Commission's report. Submissions in favour of control argue that the Commission was generous towards the airports in its assumptions and that in fact there were much higher benefits to acquirers. Submissions against control argue that greater weight should be given to efficiency and the net public benefits of control. They also argue that the Commission has a bias in its assumptions in favour of acquirers. We will provide you with a summary of the submissions in our final advice.

Further Information from the Commission

26. We have asked the Commission to correct any factual errors identified in submissions. In the letter to you of 31 October, the Commission corrected two factual errors that have the effect of further reducing the net benefits to acquirers of control for both Auckland and Wellington International Airports.

27. The Commission has also identified four other matters that are not errors but are issues of judgement that could be reconsidered. These four matters relate to treatment of inflation, future capital expenditure, cost of capital, and future land revaluation gains for particular airports. If all the points were accepted, the net benefits to acquirers of control for Auckland International Airport would be within a range of $2.0 - $3.9 million per annum (up from $1.6 - $1.8 million in the final report) depending on assumptions about land valuation, but the net public benefits of control would still be negative. The net benefits to acquirers of control for Wellington International Airport would be further reduced.

28. The Commission states in its letter to you that, in light of it having considered these four matters in its final report, it is not advocating that you incorporate them into your decision on whether to recommend control. The judgements made at the time the Commission prepared its final report took into account a range of factors, including the absence of available information and the difficulty of making forecasts. With the benefit of these further submissions, the Commission considers that there may have been a case for incorporating the impact of these matters, although its notes that all forecasts have a degree of uncertainty.

29. The Commission considers, however, that further consultation would be required with interested parties before it could recommend that the possible revisions (and therefore their aggregate impact) should be accepted, particularly given the sensitivity of the issues and the strongly held contrary views on their appropriate treatment. The Commission estimates that this consultation and revision of the report would likely take two to three months. In the absence of consultation, the Commission considers that you should be cognisant that the analysis in its final report is sensitive to the assumptions made for these matters.

30. We do not think it is appropriate to ask the Commission to second-guess its own judgement in respect of these other matters. Submissions will have a natural bias and it is not possible to amend some matters without fully revising the report. The matters raised by the Commission are not sufficiently material in our view to the overall analysis to warrant the further costs to the parties and the consequential cost of revising the report. We will, however, be assessing the sensitivity of the analysis and recommendations to these matters. We do not think that further consultation is necessary.

Estimated Excess Returns by Auckland International Airport

31. The Commission's analysis is sensitive to the weighted average cost of capital (WACC) for each airport for which there is some uncertainty in the calculation. The WACC estimates what is a reasonable rate of return on investment and is airport specific. Given the uncertainty, the Commission has provided all its estimates over a WACC range for Auckland International Airport of approximately 7.21% to 9.81%, with a point estimate of 8.41%.

32. Incorporating the two factual error corrections, the Commission has revised its estimates of excess returns and net benefits to acquirers of control. Excess returns are calculated according to the following formula:

Excess returns ($) = Net earnings - (Appropriate asset base x WACC)

33. Table one outlines the excess returns over the WACC range and at the point estimate. The forecasts use Auckland International Airport's actual returns for 2001 as a base and Auckland International Airport's forecasts and growth estimates, modified as appropriate to be consistent with the Commission's methodology and assumptions.

Table One: Estimated Excess Returns for AIAL ($000s)

34. We note that in four out of the seven years considered, Auckland International Airport's estimated rate of return falls within the upper bound of the WACC range and excess returns are negative at this upper bound.

Net Benefits to Acquirers and Net Public Benefits

35. Net benefits to acquirers and net public benefits¹ are calculated taking into account the direct and indirect costs of control (see table two). The Commission assumes that the full costs of control are passed on to acquirers (i.e. that portion of the costs payable by the airports would be passed on to the airlines in the landing charges).

36. The Commission has concluded that the net benefits to acquirers are approximately ($1.6 - $1.8 million per annum) from the imposition of control of airfield activities at Auckland International Airport. The range given at the WACC point estimate considers two different scenarios about the direct and indirect costs of control,² with the lower bound reflecting the higher costs of control.

Table Two: Net Benefits to Acquirers of Control (000s)

37. We calculate that the net benefits to the public will continue to be negative (approximately -$0.6 million per annum) as shown in table three.

Table Three: Net Public Benefits of Control (000s)

Net Benefits as a Proportion of Total Landing Charges and Net Profit

38. We calculate the net benefits to acquirers of price cap control (at the point estimate) as a proportion of total landing charges paid to Auckland International Airport, and as a proportion of Auckland International Airport's net profit from airfield activities. These calculations are outlined in table four.

Table Four: Net Benefits to Acquirers of Control as % of Total Landing Charges Paid and Net Profit of Auckland International Airport

39. Given the two factual corrections to the report, these proportions are less than the averages of 4% and 10% respectively, which the Commission considered to be significant. Table four shows that landing charges paid by airlines to Auckland International Airport will reduce by 3.1% on average. The Commission assumed that these savings would be passed on to passengers through reductions in ticket prices, however it noted that the average proportion of total landing charges to the price of passenger tickets was small (see table five). As such, the net benefits to indirect acquirers (i.e. passengers) of control would be minimal.

Table Five: Average % of Landing Charges to Ticket Prices for Air NZ at the Three Airports

Other Forms of Control

40. The Commission has assumed price cap control regulation is imposed on the airports as a basis for estimating the costs of control and the subsequent benefits. It has also assumed that these costs are incurred in addition to the current costs associated with the information disclosure and consultation regimes, given that these legislative requirements will continue to apply under control.

41. As the Commission notes in its report, the costs of control are not easy to estimate. While we agree there are other less costly forms of control that the Commission could consider under Part V of the Commerce Act, these other forms of control may be less effective in reducing excess returns and inefficiencies. The Commission has estimated that price cap regulation would likely result in a 75% reduction in the difference between the unregulated and the efficient price, and limited productive or dynamic efficiency gains from control. Other less costly forms of control are likely to result in lower benefits of control³.

42. Given this uncertainty, we consider that the net benefits of control may not be highly sensitive to the alternative forms of control that the Commission could impose.

Preliminary Conclusions

43. Based on these conclusions and all other relevant factors, our preliminary conclusion is that a recommendation of control is not appropriate. We consider that the negative net public benefits of control are a matter that you should give significant weight. The estimated net benefits to acquirers of control are relatively small in our view, particularly given some uncertainty in the calculations.

44. We have considered the precedent effect that this decision may have on the behaviour of airports given the importance of the threat of control as a restraint on earning excess returns. It is difficult to judge if a decision against recommending control will significantly weaken constraints, given that a decision now does not preclude you recommending control at a later date and much of the analysis towards your making such a recommendation has already been completed.

45. In addition, the government does have available other regulatory options, if necessary, which the Commission was unable to consider. The Ministry of Transport has put on hold reviews of the information disclosure regulations and consultation requirements pending the outcome of your decision on control, and these reviews may be reinstated in 2003. These reviews are not currently directed at addressing the issues of excess returns, but if desired, Ministers could request further work on these issues. Our initial view is that a decision on whether or not to recommend control should be made on its merits and any further work on other policy options should proceed independently.

46. Before reaching any final conclusions on how we advise you, we need to look carefully at the submissions and identify if there are any new matters that the Commission did not consider which if it had considered them would have increased the net benefits to acquirers. Assuming these arguments to be correct, we need to assess how big the benefits to acquirers would have been. If they would have been substantially larger then we will need to look more closely at the arguments on the other side as well. If they would not have been much larger then the analysis is complete.

Wellington International Airport

47. Wellington International Airport is currently consulting on possible increases on landing charges with a decision pending in the near future. The Commerce Commission noted in its final report that its recommendation against control was based on a price increase of 10%. This resulted in net benefits to acquirers of control of -($0.488 million) per annum. However, the Commission noted that if the proposed price increase of [...] were adopted, then it would likely recommend control be imposed, with net benefits to acquirers of up to [...] million per annum. That is, the thresholds in section 52 of the Commerce Act providing that control may be imposed would likely be met.

48. In its letter to you of 31 October 2002, the Commission corrected its calculation on net benefits to acquirers based on a 10% price increase, such that the net benefits to acquirers of control reduced to -($1.9 million) per annum. We calculate that this will mean a [...] price increase would result in net benefits to acquirers of approximately [...] million per annum, which is unlikely to be sufficient to recommend control for Wellington International Airport. The net public benefits continue to be negative.

49. Wellington International Airport recently [...]. We have been advised that the increase includes a 27.6% increase in charges for airfield activities, which are the subject of the Commission's inquiry. This 27.6% includes the interim increase of 10% taken into account in the Commission's final report. Wellington International Airport is continuing to consult with airlines on these increases and may finalise the charges in the New Year.

50. Our current view is that a decision on whether or not to impose control should not be delayed pending the final announcement of Wellington's new landing charges. The consultation that Wellington International Airport has already carried out, and the relative ease with which you could revise your decision given the Commission's analysis, should act as a discipline on the final prices set in this round. Based on the information available at this time, we would recommend that you do not impose control on airfield activities at Wellington International Airport.

Christchurch International Airport

51. The Commerce Commission recommended that control should not be imposed on airfield activities for Christchurch International Airport, as the thresholds in section 52 of the Commerce Act were not met. We recommend that you accept that advice.

Other Matters

52. We also think that this inquiry has identified some problems with applying the provisions of Part IV of the Commerce Act. The criteria for when control may be declared are poorly targetted. Our preliminary view is that the test of "limited competition" is too low, as this could apply to many markets in New Zealand. The relationship between the net benefits to acquirers and net public benefits could also be considered.

53. In addition, the inability of the Commerce Commission to consider what form of control it may impose constrains its analysis and means that if control were declared a further inquiry of potentially similar size would need to be undertaken to implement control. This seems inefficient. We consider that it may be worthwhile reviewing these provisions, although the timing of this would need to take into account the pending inquiry into the gas pipeline sector.

¹In Appendix Two we outline the difference between net benefits to acquirers and a net public benefit test.

²Based on two scenarios of costs of control. One being indirect costs of control of 50% of dynamic inefficiencies and a lower bound for direct costs of control and the other being indirect costs of control of 100% of dynamic inefficiencies and the upper bounds for direct costs of control.

³Or in the Commission's methodology - lower direct costs of control are likely to result in higher indirect costs of control, as indirect costs of control are assessed as the ineffectiveness of control in removing the excess returns and inefficiencies.