The UK Civil Aviation Authority has published, for consultation, its initial regulatory proposals for the three BAA airports designated for price control, Heathrow, Gatwick and Stansted.This is a key stage in the CAA’s periodic review of price controls for these airports, which started in December 2005 and culminates in new price controls set in early 2008 for the five-year period from April 2008. In today’s publication the CAA puts forward proposals for the separate regulation of each airport, grounded in the market circumstances of each:

á a continuation of the current price cap framework for Heathrow and Gatwick; and
á for Stansted, a recommendation to Government that it consider removing the requirement on the CAA to set price controls.

Heathrow and Gatwick Airports

Indicative Price Caps

For Heathrow and Gatwick airports, the CAA is putting forward indicative ranges for caps on airport charges in the five years 2008 to 2013 of:

á Heathrow: RPI plus 4 to 8% each year, compared to the current rate of growth in price caps of RPI +6.5%;
á Gatwick: RPI minus 2 to plus 2% each year, compared to the current rate of growth of RPI +0%.

Regulatory Framework

The CAA has confirmed its preference for retaining key elements of the existing regulatory framework at Heathrow and Gatwick including:

á Regulatory Asset Base regulation, through which the airports are rewarded for investment;
á the single till, through which commercial revenues effectively offset airport costs; and
á separate price caps for each of these airports.

Investment

Rising demand and the need to upgrade existing infrastructure and services is evident in the scale of BAA’s investment programme, focused currently at Heathrow on the new Terminal 5 which will open in 2008. Significant further investments are planned in airfield and terminal infrastructure, to enable better use of the existing runway capacity and to give an improved passenger experience. Capital expenditure at Heathrow and Gatwick is projected by BAA to be some £3.3 billion (2006/07 prices) in the five years from 2008 compared to £6.0 billion (2006/07 prices) in the current price control period.

The CAA has therefore focused particular attention in its initial proposals on encouraging efficient investment whilst protecting the reasonable interest of users. In particular:

á the CAA has assessed BAA’s performance against best practice project management and consultation (the two tests set in 2003) and is proposing, on current evidence, that all of the capital investment, of some £6.0 billion (2006/07 prices), undertaken at Heathrow and Gatwick from 2003 to 2008 should be passed into the RAB and remunerated;
á pending further discussions between the airports and their airline users, the CAA’s indicative price cap ranges are based on BAA’s full proposed capital expenditure programme to 2013; and
á the proposed cost of capital allowed, 6.2% (pre-tax, real) for Heathrow and 6.7% (pre-tax, real) for Gatwick (while reduced markedly from the 7.75% (pre-tax, real) allowed in 2003):
- will provide real terms equity returns of 11% (pre-tax, real) at Heathrow and 12.4% (pre-tax, real) at Gatwick on a 60% gearing (debt to RAB) assumption;
- retains, consistent with CAA’s past practice, allowance for tax at the statutory rate.

Operating Costs and Commercial Revenues

The CAA has commissioned detailed studies into various elements of BAA’s operating costs and commercial revenues which suggest that while there is some evidence of good performance, including against external benchmarks, there is scope for the company to improve both its operating cost and commercial revenue performance. The CAA’s assessment is that this points to further incremental improvement rather than a step change. As a result, the CAA is provisionally proposing operating cost allowances, at both Heathrow and Gatwick, that are based on an assumption that BAA can achieve real operating cost efficiencies of 1% a year from 2005/06 until 2012/13. In relation to commercial revenues, it is proposing revenues per passenger at Heathrow and Gatwick some 4% higher on average over Q5 than BAA’s own projections.

Service Quality

Service quality issues covering a range of airport services continue to be discussed between Heathrow and Gatwick airports and airlines. The CAA intends to take the results of these discussions into account later in the review.

However, the heightened security requirements since 10 August have thrown the issue of service quality at BAA airports into sharp relief, particularly as it affects passengers. The CAA has therefore asked airports and airlines (including those at Stansted) to consider:

á how best to ensure greater resilience in airport operations at a time when security standards are subject to change, sometimes at short notice;
á the appropriateness of the current passenger queuing standard (passengers processed within 10 minutes 95% of the time), and whether staffing up for faster processing in normal circumstances would provide a more secure base against which to cope with security changes to the benefit of passengers. Any cost implications will be considered in the review alongside other operating cost issues; and
á whether, given the importance of airline as well as airport processes to the passenger experience, there should be more transparency of targets for, and performance against, both airport and airline service standards at each airport and terminal.

Stansted Airport

At Stansted, BAA has yet to charge up to the price cap set by the CAA; and there is substantial investment in prospect to meet generally rising demand. In the circumstances, the CAA’s objective is to provide the best framework for encouraging the right amount of investment at the right time, protecting the reasonable interests of users.

To understand the circumstances of Stansted better and to tailor regulation accordingly, the CAA has assessed the market forces at play now - and prospectively - which will influence the way in which this airport interacts with its airline and passenger users and with other airports. The CAA finds only a limited possibility that Stansted can be expected to enjoy a position of market power that justifies price regulation. This suggests that competition and competition law is likely to prove a sufficient discipline. The CAA also finds that the current regulatory system may itself be distorting incentives on - and, consequently, the commercial interests (and behaviours) of - the airport and airlines. This arises from the size of prospective new investment relative to the much smaller existing asset base. These considerations suggest that Stansted presents a different regulatory challenge to that of Heathrow or Gatwick, going to the heart of the rationale for price cap regulation.

The result is that the CAA is regulating an airport which does not appear to require price controls, and where regulation itself may be imposing unnecessary costs and distortions.

The CAA is therefore proposing to Government that it consider de-designating Stansted Airport for the purposes of economic regulation, so removing it from price controls. Pending consideration by the Government of this proposal, the CAA’s current preference is to move away from setting price caps based on the regulated asset base, capital expenditure and other cost ‘building blocks’, and towards a ‘market led’ price cap designed to give the airport more latitude to respond to market signals, including for investment. This would shift the balance away from regulation and towards competition and commercial interaction between the airport and its airline customers.

In the CAA’s view, the more deregulatory approach proposed for Stansted is likely to provide a better framework for bringing forward investment, that is efficient and economic and that therefore furthers the reasonable interest of users.

The CAA is consulting in this document on its proposed approach. It is not, therefore, at this stage proposing price caps for Stansted. It will do so, in due course, should they be necessary. In the meantime, the analysis and direction identified by the CAA should provide a clearer context for commercial discussions between the airlines and Stansted Airport.

Manchester Airport

Control of airport charges at Manchester Airport is not dealt with in today’s document. The CAA is planning to issue a policy consultation on this in late January. It will take that opportunity to consider whether there remains a need to regulate prices at Manchester Airport.

Commenting on this, Dr Harry Bush, CAA Group Director, Economic Regulation, said:
“The CAA’s initial proposals are put forward for consultation. They will be refined in the light of that, as well as further work by the CAA, before the reference to the Competition Commission. However, they provide a significant body of evidence and analysis for all parties to consider.

“The picture emerging on efficiency is a mixed one. BAA often demonstrates very good performance; elsewhere, particularly in airport processes, there is room for improvement. The CAA’s proposals represent a material - if still moderate - challenge to the company’s plans.

“Efficient and economic investment at BAA’s airports is critical to airlines and passengers. The CAA is alive to the need to continue incentivising BAA through a reasonable return on equity. However, lower borrowing costs and a higher - if still cautious - gearing assumption suggest a marked reduction in the cost of financing Heathrow and Gatwick airports. Nevertheless, at Heathrow substantial levels of investment in the 2003-2013 period, and higher levels of operating expenditure and lower traffic growth than previously anticipated, will continue to put upward pressure on prices.

“The CAA’s proposal for de-regulation of Stansted reflects careful analysis of the airport’s circumstances. Traditional price cap regulation seems both unnecessary given the market constraints, and potentially damaging as it distorts the commercial interests and behaviours of both parties, with possible implications for competing airports. In these circumstances, de-regulation is likely to provide a better framework for both incentivising and disciplining investment at Stansted.”
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