CAA reference to the Competition Commission for Stansted Airport. Advice to the CAA on the Calculation of Incremental Costs

Transcription

1 CAA reference to the Competition Commission for Stansted Airport April 2008 Supporting paper IV Advice to the CAA on the Calculation of Incremental Costs

2 Advice to the CAA on the Calculation of Incremental Costs Final Report by Europe Economics Europe Economics Chancery House Chancery Lane London WC2A 1QU Tel: (+44) (0) Fax: (+44) (0) April 2008

3 Introduction TABLE OF CONTENTS 1 INTRODUCTION STANSTED AIRPORT AND REGULATION...3 Features of Stansted Airport and the market for airport capacity in the South East...3 Regulatory Issues...5 Interpretation and Implications of Options 4 & LONG RUN AVERAGE INCREMENTAL COST CONCEPT...9 Introduction to LRAIC...9 Key Estimation Issues a) Definition of Increment b) Time Period of Estimation c) Basis of Forecasts and Assumptions COMPETITION LAW ISSUES AND LRAIC...19 Economic Analysis Regarding Excessive Price Competition Cases Reviewed...21 Interpretation of Excessive Price RECOMMENDATIONS...26 Summary of Desired Properties Recommendations on LRAIC Methodology Application of the LRAIC estimate in Options 4 and APPENDIX 1: LRAIC REGULATORY PRECEDENTS...34 Use of LRAIC in Other Sectors Regulatory Precedent on Increment Regulatory Precedent on Time Period Regulatory Precedent on Basis of Costs APPENDIX 2: REVIEWED COMPETITION CASES

4 Introduction 1 INTRODUCTION 1.1 The CAA is required to set a price limit at Stansted for the period (referred to as Q5). Two of the options set out in the CAA s consultation paper would be informed by long run average incremental cost (LRAIC), and the objective of this report is to discuss alternative methods by which such an estimate might be made. The numbers required in undertaking the calculations would be calculated or estimated at a later stage, but the methodology chosen would influence the type of information required for the purpose of setting a price control. 1.2 The CAA explains in the consultation paper that it wishes to adopt a form of price control that would: (a) Prevent over-charging if Stansted were in the future to acquire sufficient market power to make this possible; and (b) Avoid distorting competition between Stansted and other airports and investment decisions at Stansted or elsewhere. 1.3 The CAA s January consultation paper outlines five possible forms of price control. LRAIC estimates would be particularly relevant for Option 4 (a Market Led Price Cap) and Option 5 (a Precautionary Price Cap). 1.4 These two options for price control are described as follows: (a) Option 4 Market Led Price Cap (MLPC) sets the price at the lowest level consistent with not distorting investment incentives or competition between airports. (b) Option 5 Precautionary Price Cap (PPC) sets the price at a level just below that which would be likely to be deemed excessive under competition legislation. 1.5 The difference between the two options is explored in Section 2 below. The CAA has advised that either case of the price control could be applied in a way that would limit charges over a regulatory period as a whole rather than annual price caps. 1.6 Advice on the issues identified in the terms of reference requires an understanding in some detail of: (a) The relevant features of the market for airports in the South East of England and the particular situation of Stansted, and the CAA s statutory duties (discussed in Section 2 of this report). (b) Issues involved in an estimation of LRAIC and what experience of the use of LRAIC in other sectors and different circumstances may have to offer (Section 3 and Appendix 1). 1

5 Introduction (c) Whether Competition Act principles might inform price setting and how price levels consistent with these principles might compare with LRAIC (Section 4). 1.7 This report works through these issues, finally developing a range of possibilities for the CAA to consider for the application of LRAIC to inform its decisions about the form of price control to implement, and in particular to Options 4 & 5 (Section 5). It discusses: (a) The options for the methodology for estimating LRAIC, together with their advantages and disadvantages. (b) The input assumptions required for the calculation of LRAIC under these methodologies. 2

6 Stansted Airport and Regulation 2 STANSTED AIRPORT AND REGULATION 2.1 This section briefly notes the particular features of Stansted Airport in the market for airport services in the South East of England and the issues involved in its regulation that are particularly relevant for this study. Features of Stansted Airport and the market for airport capacity in the South East 2.2 A common view, shared by the CAA, is that a significant increase in airport capacity in the South East of England in the reasonably near future would probably be desirable. Views differ on the degree to which the details of such expansion should be decided by Government planners or be the result of market forces. 2.3 It is likely that such a substantial increase in capacity would have to come from one or two new runways and associated terminal capacity rather than entirely from small increases in a number of different airports. 2.4 However, it is not certain that the South East airport expansion should take place at Stansted, and there is also an issue of the appropriate timing and specification of expansion, relative to other potential sources of capacity. There is controversy over environmental and other planning aspects at all the possible places for airport expansion. The CAA has noted its concern that investment decisions might be distorted by the form of economic regulation of Stansted. 2.5 The Secretary of State for Transport found in her decision that together the airports owned by BAA, comprising Heathrow, Gatwick and Stansted, possess substantial market but that viewed as a separate entity Stansted is not currently in that position Prices at Stansted are below the maximum permitted under the present cap, there is some spare capacity at both Stansted and Luton airports and there is potential for some airline services to switch away from the airport, although many of these issues are the subject to ongoing debate. There is uncertainty about likely market power of Stansted in the long run; a key issue is whether and if so how quickly such market power may arise. 2.6 The Department for Transport found that potential competitive constraints on Stansted come from a number of other airports as well as limits on airlines and passengers willingness to pay. The most important competitor airport to Stansted is probably Luton, whilst the evidence concerning the competitive constraint posed by airports outside the South East was found to be mixed. Indeed, the Secretary of State s finding of a likelihood of substantial market power in the future was finely balanced and depends to a considerable extent on whether or not there is investment in capacity expansion in the South East. 2.7 The extent of market power at Stansted remains a contentious issue. However, this paper considers the application of LRAIC in the context of Options 4 and 5. As the CAA has noted that these options would be pursued based on a view that the airport s market 3

7 Stansted Airport and Regulation power was limited, this paper takes as its basis that Stansted does not currently, considered alone, possess significant market power. 2.8 Other features of the situation that will be important in the analysis include: (a) The product delivered by an airport is a bundle of services supplied jointly, whose quality may be hard to measure. (b) The CAA has advised us to consider the LRAIC in the context of a single till. 1 (c) The business is capital intensive, and investment to increase capacity will at some point become very lumpy (meaning that the most efficient means of expansion will involve large expenditure on new runways and terminal facilities). (d) With lumpy investment, efficient pricing such as would be expected in a competitive context is likely to involve higher (or above-average) prices when capacity is short, so that its use is efficiently allocated, then lower (or below-average) prices following the assumed investment, to make best and most profitable use of the new capacity. In Chart 2.1 below the date that new capacity comes available to use shown with the dashed vertical lines Under the single-till approach, forecast non-aeronautical revenues are subtracted from total revenue requirement to arrive at a forecast of the revenue required from aeronautical operations, which is then divided by passenger numbers to achieve a perpassenger price cap. Long term contracts and other inertia effects mean that in reality the price drop probably is not as dramatic or fast as illustrated here. 4

8 Stansted Airport and Regulation Chart 2.1: Stylised path of short-term competitive market price with lumpy investment Price Stylised path of competitive market price Time (e) For this and other reasons prices would at some point have to be significantly above the long term average level at which investment would be justified by expected revenues over the whole life of the asset. (f) In unregulated airports markets, this pattern of pricing would provide an incentive for airports and airlines to agree long term contracts. However, the policy of constructive engagement designed to mimic the commercial interaction of airports and airlines between the parties that has contributed to planning at Heathrow and Gatwick has been less successful at Stansted, and such contracts cannot be assumed in this context. (g) CAA has since 2003 (for Q4) set price limits for Heathrow, Gatwick and Stansted airports on an individual basis, and will do the same for Q5. We were asked by the CAA to prepare this report against an assumption of BAA s continued ownership structure and not to make any assumptions in respect of the findings of the Competition Commission s market inquiry into BAA. We were asked to assume that stand-alone regulation continued to apply. Regulatory Issues Section The CAA has some powers to regulate airport conduct through Section 41 of the Airports Act However, these powers relate to similar forms of conduct that are prohibited 5

9 Stansted Airport and Regulation under competition law and do not appear to have a significant influence for the present analysis. Potential distortions of investment incentives 2.10 The CAA is aiming to avoid distortions to investment incentives in either direction: it wishes to avoid giving incentives to invest where, in a competitive market, the airport would not invest, or to deter investment that would occur in a competitive market either at Stansted or elsewhere. The CAA is also concerned not to distort decisions about the specification for possible investment (size, quality of facilities, etc.). The risk of discouraging efficient investment would clearly arise if the price limits were too low, i.e. below the competitive market level (which would give efficient investment incentives). The concern not to artificially encourage excessive capital expenditure relates to a specific effect that the existing regulatory approach could have at Stansted, as explained in the consultation document and summarised below A significant distortion to investment incentives could result from using the RAB based price cap in Q5. The issue is as follows: (a) Stansted has in the past not been able to charge up to the regulatory price limits. The actual level of airport charges has been determined through commercial arrangements between the airport and its users, at significantly less than the regulatory ceiling. (b) Possible cross - subsidies from Heathrow and Gatwick to Stansted (before price controls were set on the basis of the financial projections for the individual airports in 2003), combined with depreciation schedules that might not reflect the actual useful economic lives of these assets, have led to a situation in which a traditional RABbased price cap might come into effect at an artificially low level, and require charges to be limited even when Stansted does not possess significant market power. (c) As a result, the CAA has argued that if the regulatory system is not changed Stansted might have an incentive to incur capital expenditure that would not otherwise be commercially justified simply in order to increase the value of the RAB and to allow it to increase charges to reach the competitive level Either Option 4 or Option 5 would deal with this problem because they would not make use of the current concept of a RAB and neither should lead to a price cap below the market level regardless of whether Stansted undertakes investment or not In setting price limits for Stansted, a major objective is that price limits should neither be set too low and thus discourage otherwise efficient investment at Stansted (or induce inefficient investment elsewhere), nor set too high so that if Stansted were to acquire significant market power it would then be able to charge excessive prices to its users. 6

10 Stansted Airport and Regulation Interpretation and Implications of Options 4 & The CAA consultation document explains the difference between the two options as: (a) Option 4 Market Led Price Cap (MLPC) sets the price at the lowest level consistent with not distorting investment incentives or competition between airports. (b) Option 5 Precautionary Price Cap (PPC) sets the price at a level just below what would be likely to be deemed excessive under competition legislation, i.e. just before users of the airports might have to resort to (costly) litigation By definition, investment incentives and competition are not distorted if prices are set at the competitive level. The major attraction of LRAIC is that, when implemented appropriately, it can mimic the expected outcomes for Stansted in a competitive market. It is therefore directly relevant to both options. A regulator setting charges based on LRAIC would allow a normally efficient supplier to recover its costs, including normal profit margins reflecting the riskiness of investment. This implies that suppliers have an incentive to invest in upgrading or adding to their service infrastructure that is in principle neither stronger nor weaker than it would be in a competitive sector not subject to economic regulation It may be asked why should Option 4 (MLPC) not equal Option 5 (PPC) and both be measured by LRAIC? It has been necessary to develop a further understanding of Options 4 & 5, to identify differences between the two options There are two key defining differences one about the expectations of degree of market power and the other, linked to the first, about the time period over which the regulation is defined. MLPC is taken to be the lowest average price level over the long term that would be consistent with the competitive level, and the PPC is the level above which prices would not rise at any point in time except as a result of exploitation of a position of substantial market power. Chart 2.2 below illustrates the conceptual difference between the two options 2.18 The precautionary price cap (PPC) is drawn slightly above where the highest level of the competitive market price could be expected to be at any point in time (i.e. the short-term competitive price level). The market led price cap (MLPC) might be drawn slightly above the level of the competitive market price on average over time (i.e. above the long-term competitive price level). The maximum prices might be set slightly above the LRAIC estimate due to: the degree of market power being uncertain; the uncertainties of LRAIC estimation; and, the need to maintain investment incentives under a price cap that prevents prices rising to the full extent implied by the path of competitive prices. 7

11 Stansted Airport and Regulation Chart 2.2: Drawing the difference between Options 4 (MLPC) and Option 5 (PPC) Price PPC LRAIC MLPC competitive price path Time 2.19 Under this interpretation the MLPC would be applied over a long time period, very probably stretching beyond a single price control period. The PPC, on the other hand, would provide a check on the price level at any one point in time (e.g. in any one year) A key factor for the CAA to consider in choosing between the PPC and MLPC approaches is the expected likelihood and degree of market power Stansted has or might attain. The stronger the expectation of significant market power, the more assurance with regard to possible over-charging the CAA could obtain from MLPC relative to PPC. This is because MLPC would make the company accountable for the average level of charges over time, while the PPC would limit only the highest price over the cycle Both approaches, however, could make use of the LRAIC estimate. The next section considers alternative LRAIC concepts and estimation methods. 8

12 Long Run Average Incremental Cost Concept 3 LONG RUN AVERAGE INCREMENTAL COST CONCEPT Introduction to LRAIC 3.1 The long run average incremental cost (LRAIC) of a service or product is equal to the change in total cost in the long run resulting from a specified variation in output, averaged over the units of output supplied. The components of the acronym can be defined as follows: (a) Long run the estimation is done with a long enough time span to be relevant to planning and investment decisions. 3 (b) Average the incremental cost could be averaged in several ways. Usually, this is done by dividing the cost of the increment by the units of output it provides. (c) Incremental refers to the defined change in either services or in volume of services, the cost of which is the object of investigation. (d) Cost self-explanatory at one level, but there are important differences in the way estimates may be made. 3.2 Different approaches to the above elements determine the properties of the resulting estimates, their applicability to different settings, and their suitability with respect to different regulatory goals. 3.3 Implemented appropriately, LRAIC can estimate the maximum prices Stansted would be able to charge on average over time in a competitive market, assuming normal levels of efficiency. Another benefit of basing price controls on LRAIC is that it can reduce the reliance on information supplied by the incumbent. This occurs when the LRAIC is calculated on the basis of an efficient benchmark rather than on the basis of incumbent costs and investment plans. 3.4 One drawback of LRAIC is that its implementation can be quite complex, requiring a number of assumptions that may be open for discussion. This also introduces significant regulatory discretion in the determination. 3.5 A summary of regulatory precedents for the use of LRAIC in other sectors is set out in Appendix 1. 3 This is different from a textbook definition of the long run as the period in which all inputs are variable. 9

13 Long Run Average Incremental Cost Concept Key Estimation Issues 3.6 The differences in the objectives of LRAIC estimation in the different sectors have contributed to alternative implementations of the various building blocks in LRAIC estimation. The main choices, which define the characteristics of the LRAIC estimate, relate to: (a) Definition and measurement of the increment. (b) Time period (definition of the long run). (c) Basis of forecasts (whose, on what assumptions) to inform the required input assumptions on: Demand for the increment over the relevant time period. Design and costs of the capital assets within the increment. Operating costs relevant for the increment and time scale. Cost of capital used as the basis of the allowed return (and the discounting method used to set annual prices, if applicable). 3.7 In addition to the above, different implementations of LRAIC could be accompanied by differing approaches to remuneration of existing assets, and the new assets over time (e.g. when they have become part of the existing asset base). If the principle of LRAICbased charging were applied across the whole airport this might imply a revaluation of existing RAB. 3.8 We briefly discuss each of the above key determinants in turn. a) Definition of Increment 3.9 Defining the increment is the first step in the LRAIC estimation. It defines the service and the capacity of the service whose costs the LRAIC method estimates. It is likely to have the largest impact on the final result, as well as the fundamental characteristics of the final result In principle, there are many different sized increments that could be measured, as well as different dimensions over which to measure the increments. However, these might be grouped into four different categories under two subheadings: (a) Increments based on (hypothetical or expected) variations in capacity to supply an existing service or set of services: a small change in the volume of or demand for a particular service; or a large change in the volume of or demand for a particular service. 10

14 Long Run Average Incremental Cost Concept (b) Increments based on (hypothetical or expected) variations in services: the addition of a specific service; or of a group of services The first definition of the increment involves measuring the cost associated with providing a small change in output. The second definition is usually taken to be large enough to trigger capital investment, so that LRAIC might be estimated for a particular investment program. The third definition may apply to services of very different sizes and is often referred to as service-based LRAIC. The last category is the broadest definition of an increment and one variant of that definition of the increment has been used extensively in telecommunications to set interconnection charges. Possible increments for Stansted 3.12 In the case of airports, service-based increments might be imagined, for example drawing a distinction between baggage handling and passenger handling services within the aeronautical services group. It may also be noted that, under easyjet s proposed terminal tendering approach, a service-based increment could be used, defining runway access service as the increment However, the use of a service-based increment would seem problematic in the case of Stansted. Indeed, the CAA has consulted extensively in the past on a move to a dual-till system which might be more suited to a service-based approach but decided to retain the single-till approach for the previous price control period. The reasons for the single-till approach remain valid; the services provided by an airport are to a large degree mutually dependent Viewing the whole airport as a single increment would be consistent with the single till approach, and might have some desirable properties relative to volume based increments However CAA s concern not to distort competition or investment decisions relates most closely to costing new projects and the associated operating costs e.g. new runway capacity and associated terminal infrastructure. Increment based on variations in capacity 3.16 With regard to volume-based definitions, long run cost can be calculated using either: (a) The average incremental cost (AIC) approach. This involves calculating the forwardlooking unit cost of meeting a projected growth in demand, i.e. the cost per unit of the planned investment program and associated net operating expenditure. (b) The marginal incremental cost (MIC) approach, also sometimes known as the Turvey approach, after Professor Ralph Turvey. This involves calculating the implications for 11

15 Long Run Average Incremental Cost Concept unit cost of a small change to projected demand, i.e. the forecast unit cost increase or reduction resulting from the implied change in the planned investment program and associated operating expenditure The two approaches can produce different results depending on the nature of investment program. Both can be relevant in different circumstances The AIC approach would help to ensure that prices charged for additional units of consumption cover the avoidable costs of supplying those units, including any required investments. It would therefore provide an answer to the question of what price would have to be charged such that, over the life time of the assets, investments in additional capacity recover their costs The MIC approach provides estimates of the cost of small changes in volume and in some circumstances may provide more efficient price signals These approaches are therefore aimed at different questions that can both be relevant in different circumstances Figures 3.1 and 3.2 illustrate the two methods. Figure 3.1 shows a situation in which there is a capacity surplus at the start of the period, but due to projected growth in demand additional investment will be required at T 1. The LRAIC according to the AIC method would be calculated as follows: (a) Present value (PV) of operating cost of delivering the shaded volume of service; plus (b) PV of investment triggered at time T 1 ; all divided by (c) PV of the shaded volume of service (the additional number of passengers using the airport) That is, the AIC is calculated as the net present value cost of supplying the additional passenger throughput, divided by the net present value of incremental passengers, where the present values are calculated for the full asset life of the investment. 12

16 Long Run Average Incremental Cost Concept Figure 3.1: Illustration of AIC approach to LRIC Volume Investment planning horizon Life of new assets Available capacity Existing consumption Additional demand T 1 Time 3.23 The LRAIC according to the MIC method, on the other hand, considers the forwardlooking cost per unit of a hypothetical permanent incremental change to the existing investment plan, as illustrated by Figure This increment would be additional to the forecast increase in demand, and in this example would require the company to bring forward investment in new capacity. (It would also be possible to construct an example in which the size of the required investment increased.) The LRAIC according to the MIC method would be calculated using the information presented in Figure 3.2 as follows: (a) PV of operating cost of delivering the shaded capacity (the increment); plus (b) PV cost of bringing forward the planned investment from T 1 to T 2 ; all divided by (c) PV of the shaded capacity (PV of the increment of passengers) That is, the marginal incremental LRAIC is calculated as the net present value of the additional costs of the hypothetical increment on the original investment program and associated operating costs, divided by the numbers of passengers served. 13

17 Long Run Average Incremental Cost Concept Volume Figure 3.2: Illustration of MIC approach to LRIC Investment brought forward Increment to projected demand T 2 T 1 Time 3.25 Given the above, there are several potential ways to calculate LRAIC, including: (a) AIC approach based on delivering the forward-looking investment program. (b) MIC approach based on an increment of demand specified by the CAA. (c) MIC or perturbation approach using different increments and decrements and averaging the results However, the relevance and applicability of the MIC approach in the current case is doubtful. The investments involved in increasing capacity at airports are not homogenous, and can vary widely between investment in say, security infrastructure, additional baggage handling capacity and marginal runway capacity. Further, it is likely that to increase a planned new runway capacity by X per cent at the design stage would add less than proportionately to its cost (due to economies of scale within the project), so that the investment might not be justified by charges based on MIC even if overall it would cover its total costs. 4 The increment of demand is assumed to be permanent here for clarity of exposition. The approach can in principle be applied to any postulated size of increment lasting any postulated amount of time. It can also be applied to a decrement in demand. 14

18 Long Run Average Incremental Cost Concept 3.27 The AIC approach seems more aligned with CAA s objectives of avoiding distortions to the decisions about possible significant expansion at Stansted. This still leaves open the question of exactly what the increment is, what service levels are to be specified (a contentious issue) and against what baseline it is measured. The alternative to an AIC type approach would seem to be to define the increment as the whole airport or the whole system of runways. This could also be consistent with the CAA s underlying objective of not distorting investment incentives or competition between the airports The two approaches do, however, have different strengths and weaknesses, discussed further below and in Section 5. b) Time Period of Estimation 3.29 Two issues arise regarding the time period of the estimation First is the definition of the long run that should be used. Here a relatively straightforward interpretation is available. The length of the time period considered for LRAIC should be the longest term relevant for planning and decision making in the industry. It also should be coherent with the definition of the increment used A second group of questions arises in the context of Stansted. LRAIC estimation under the AIC view of the increment considers only the forward looking costs of the increment. When investment is lumpy and so not undertaken continuously, as spare capacity comes into use and the time of the next investment becomes nearer the prices estimated by LRAIC would rise. However, in the period after the investment, the forward looking LRAIC estimate would be relatively low due to the (new) spare capacity in the system. Indeed, this reflects one of the desirable qualities of LRAIC it mimics the behaviour of prices in a competitive market. The result is the saw tooth pattern of LRAIC estimates done at different points in time relative to dates of investment, similar to that in a competitive market (see Chart 2.1 in paragraph 2.8) In the case of Stansted the effect would be as follows: in the run up to a time when investment is most likely to be needed the price cap based on LRAIC would rise. Once the investment is complete, recalculation of a price cap based on LRAIC would fall, as one would expect to happen in a competitive market. However, if the company were to fear that the regulatory limit imposed would be lower than it would expect to be able to charge in a competitive market this would act as a disincentive to invest, and it would be appropriate for the regulator to explain clearly how the methodology would be intended to be applied in successive periods The issue would not arise under the whole service definitions of the increment, typical to telecommunications implementations of LRAIC, as they involve the forward-looking valuation of the full asset base (or equivalent, see below). That would be beneficial from a regulatory consistency point of view. However, it would also mean that the resulting price controls less accurately reflect competitive market outcomes in the case of Stansted. The use of LRAIC based on the unit costs of a forward looking investment plan (the AIC 15

19 Long Run Average Incremental Cost Concept approach) has been used as an input towards structuring charges (energy sector), or as signals towards efficient long term investment and use (water sector) In other regulatory contexts the LRAIC methodology has been applied in a situation of confirmed significant market power. In such a setting, the price cap is expected to bind more or less continuously, so the regulators can focus on ensuring that the incumbents earn only normal returns and recover only efficient costs over time, recalculated every five years. Indeed, there is little discussion in the regulatory precedent about the length of the price control period not matching the length of the investment horizon used for the LRAIC estimates In the case of Stansted, the price cap may not bind - at least in the near term, or following a significant increment in capacity. Further, the incremental capacity increasing investment at Stansted is likely to be lumpy compared to some other sectors, which would lead to higher variations in the before and after investment LRAIC estimates. This will need to be taken into account in the application of LRAIC in setting price limits for Stansted. Relevant time frame for Stansted 3.36 Economic logic and regulatory precedent both point towards interpreting the long run as the longest term relevant for planning and decision making in the industry. c) Basis of Forecasts and Assumptions 3.37 Any implementation of LRAIC requires the following input estimates or assumptions: (a) Demand over the relevant time period. (b) Design and costs of capital assets within the increment. (c) Operating costs relevant for the increment and time scale. (d) Cost of capital used as the basis of the allowed return There are two broad approaches to establishing the above estimates or assumptions. Using the convention of naming from the telecoms sector, these can be broadly defined to be: (a) A top-down approach, which is based on the actual costs of the regulated operator as posted in the financial statements, allocated to product groups, and the incumbent company s forecasts of demand and costs in the context of a planned expansion. (b) A bottom-up approach, a forward looking approach which considers modern equivalent assets, efficient design of the capital assets (e.g. network structure), and efficient (if hypothetical) net operating costs consistent with the efficient layout and utilisation of modern assets. 16

20 Long Run Average Incremental Cost Concept 3.39 The cost of capital could be established using the approach developed elsewhere for the price controls of Heathrow and Gatwick. Top down approach pros and cons 3.40 In a top-down application of LRAIC the starting source of information for estimating the costs of services is normally the costs actually incurred, or envisaged, by the regulated company. The recorded costs are allocated, through a number of intermediate steps, to final services. The resulting charges have a direct link with the company s actual accounts. A top-down approach can also be applied with a current cost adjustment to the asset values the historic cost figures need to be adjusted into current cost figures. In some cases this may lead to certain costs incurred by the modelled company being excluded The benefits of the approach are generally taken to be that the resulting costs can be traced back to the formal accounts of an existing company, helping to ensure that all relevant costs are accounted for However, there are several drawbacks to this approach. Depending on the definition of the increment, the development of estimates can be more resource intensive and time consuming than a bottom-up approach, and the resulting estimates could incorporate the incumbent s inefficiencies in the layout, type or design of the assets, or in their use. Further, if the estimates are based on proprietary data, it might not be possible for third parties to examine the estimates and provide expert views on them. Bottom-up approach pros and cons 3.43 The bottom-up approach uses demand projections as a starting point and determines, by using economic, engineering and accounting principles, an efficient structure capable of serving that demand, independently from the incumbent s actual or planned structure. In principle, bottom-up models give the model developer more flexibility regarding efficiency considerations and reduce dependence on the company for data. All of these are desirable qualities in terms of implementation of LRAIC with the object of obtaining an estimate of the maximum price Stansted would be able to charge in a competitive market on average over the long term (assuming normal levels of efficiency) The bottom-up approach is more appropriate in cases where a hypothetical efficient company is assumed. Accounting for efficiencies (technical and operational) is much easier in a bottom-up context as legacy asset issues are less of a problem than in a topdown approach. The bottom-up approach also does not need to refer to a specific company the thought experiment is that of a hypothetical efficient entrant, or hypothetical efficient investment to satisfy capacity demand effectively reducing the dependence on the incumbent, and increasing effectiveness of consultation in determining the cost and demand assumptions However, there is a danger that bottom-up models may understate the costs of efficient companies particularly where technologies are rapidly changing. In practical terms, 17

21 Long Run Average Incremental Cost Concept particularly forecasts of operating expenditure can be difficult to model in a bottom-up setting In principle, both methods should lead to the same result. In practice though, this can only happen if the same assumptions are made (e.g. regarding asset types, layout and operational efficiency). Consequently in telecommunications it is often observed that bottom-up and top-down models are used in parallel with a view to reconciling the results of the two models and developing a hybrid model, so as to minimise the weaknesses of the two models and take better advantage of their strengths. Basis of forecasts 3.47 If a top-down approach is chosen, the main data source typically used is the modelled company s accounts (or investment plans). On the other hand, bottom-up models also use data gathered from market participants, equipment suppliers and other publicly available information. In both cases, though, the required information for proper LRAIC estimation is extensive and requires the exercise of discretion. In the case of top-down models it is sometimes very difficult to audit or review the results since the necessary data are confidential. The information gathering powers provided to the CAA would reduce this latter concern In LRAIC methods there may arise some problems related to the knowledge of the cost of the assets. For instance, some elements may be customized and may not have a welldefined market price, or the future usage of different assets may affect the choice of what constitutes efficient equipment. For technology dependent increments, forecasts of technological progress are needed both for proper determination of LRIC technology and for determining demand forecasts. However, the weight of this factor depends on the sector. For instance, it is more important to better predict technological changes regarding a core telecommunications network than a water network. Possibilities for Stansted 3.49 It seems that a forward looking, bottom-up approach would be preferable in the case of Stansted. It would not be overly reliant on information from BAA, and allow for direct consultation of and input from independent experts. It would be more consistent with the view of utilising LRAIC as an estimate of maximum Stansted would be able to charge in a competitive market in the long term, and avoiding distorting incentives for investment Indeed, if the relevant increment is taken to be an increase in existing capacity, the likely absence of forward looking information held by Stansted would necessitate a bottom-up type approach. Even then, more emphasis could be placed on independent forecasts, estimates and designs, rather than relying on information from the incumbent. 18

22 Competition Law Issues and LRAIC 4 COMPETITION LAW ISSUES AND LRAIC 4.1 Option 5 requires a view on what might be judged to be an excessive price level from the view of the competition authorities. Article The Article 82 prohibition of the consolidated EC treaty is the basis of the competition law on abuse of dominance as it may affect trade between Member States. The Competition Act 1998 extends Article 82 to apply also in cases where the dominance only affects trade within the UK. The full Article 82 text is as follows: Any abuse by one or more undertakings of a dominant position within the common market or in a substantial part of it shall be prohibited as incompatible with the common market insofar as it may affect trade between Member States. Such abuse may, in particular, consist in: (a) directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions; (b) limiting production, markets or technical development to the prejudice of consumers; (c) applying dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage; (d) making the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts." 4.3 The interpretation of Article 82 is a subject of much debate and some case law. The charging of excessive prices is only one of several ways in which a dominant position might be judged to have been abused within the legislation unfair prices is only a part of one of the four distinct abuses of dominant position, and case law on the point is relatively limited. Economic Analysis Regarding Excessive Price 4.4 Economic interpretation of an excessive price has to start with the characteristics of a normal competitive market price. 4.5 Normally, in a competitive market, prices would at all times be at a level that covers the short run marginal costs of production. In the long term, in order for production to be sustainable, prices would cover, on average, the long term costs of production, including a return on investment (i.e. normal profit). The required return on investment, or the normal profit, is determined by the cost of capital to the industry. There is, therefore, a difference between the prevailing competitive price level in any given period (the short-term 19

23 Competition Law Issues and LRAIC competitive price level) and the average level of prices in a competitive market over the longer-term. 4.6 If prices do not achieve this level on average over the long term, there would be exit from the market, followed by a reduction in supply and, other things being equal, an increase in the price (for a given level of demand). If prices exceed the competitive level, the resulting excess profits would be eroded away through entry into the market. As discussed above, LRAIC can be used to estimate such a long term average price level. 4.7 However, such a cost-based definition of a normal long term price level is not directly useful for determining what might be an excessive price at any point in time. This is because, in the short run, the market price could fluctuate substantially (and nonsystematically) around the long term average that would deliver cost recovery and normal profit. A major source of such short term movements in the price is likely to be changes in demand, possibly amplified by real-options effects given irreversible investment in the presence of uncertainty Indeed, such price fluctuations are necessary for the long term cost recovery price to be achieved. Without market power, companies are fully exposed to the effect of demand fluctuations in the market. Therefore, to achieve long term viability, companies must be able to take advantage of favourable market circumstances (e.g. increase their price) to compensate for periods of bad market outcomes (e.g. times of low demand leading to lower than the long term average prices). 4.9 The implication is that the price at any one point in time could be substantially above the long term average level as estimated by LRAIC, and yet not be considered excessive. This is why it is appropriate that competition law would not contemplate the possibility of prices being excessive except in circumstances in which the supplier has significant market power In the case of airports, a major cause of short term price fluctuations could be movements in demand while capacity remains relatively fixed. The demand at airports can vary annually, according to the season, as well as according to the time of day with substantial potential differences in peak and off-peak demand. The daily peak price to average price variation provides one indication of how much prices may move, in the absence of market power, between periods of high demand and low demand. 5 If there are irreversible costs to investment and there is an option to wait and there are not other countervailing factors (such as the possibility to pilot scalable investment), following a positive demand shock, causing prices to rise and firms to make positive profits, firms will wait before investing just in case prices fall back down again and the irreversible costs of investment are lost. Similarly, negative demand shocks will not instantly stimulate exit, for the market may pick up in the future. Prices may rise above average total cost for a period without stimulating entry or investment, and may be sustained for some time below average total cost without stimulating exit or disinvestment. There is thus greater/more sustained variance in the path of prices under irreversibility and uncertainty than in the standard competitive model. This analysis is set in the Dixit-Pindyck framework, which is also referred to by the CAA in paragraph 4.13 of the consultation paper. 20

24 Competition Law Issues and LRAIC 4.11 Economic intuition, then, would indicate that an excessive price might be defined as a price higher than that which could reasonably be expected to result from short term demand or other fluctuations, above a long term average price that would ensure efficient cost recovery (including normal profit). Real-options analysis could also be relevant to reflect the full potential for variation in competitive prices. 6 Competition Cases Reviewed 4.12 The published decision documents of the some relevant cases have been reviewed with particular reference to the definitions of excessive prices, and any comments on the tests and data used to determine whether a price is excessive or not. The list of cases reviewed is in Appendix The cases that seemed to establish the most relevant and directly useful precedent were the United Brands (1978), Sacem (1987), Port of Helsingborg (2004), AttheRaces (2005), Deutsche Telekom (1997), and the Napp Pharmaceuticals (2001) cases. The Albion Water case might also be particularly relevant. However, the Competition Appeals Tribunal has not yet given its final decision on the case As might be expected, the competition authorities responsible for the decisions have been reluctant to specify precisely what is meant by an excessive price and how exactly to judge whether a price is excessive. The courts have seemed particularly loath to prescribe any particular price level as the threshold over which prices should not rise, lest they appear to be price regulators. Nevertheless, some useful lessons can be learned from the past cases. United Brands (1978) 4.15 In United Brands case, the European Court of Justice (ECJ) set out a definition of what may constitute an excessive or unfair pricing abuse under Article 82. The judgment set out what is essentially a two part test, which defines a price as excessive because it has no reasonable relation to the economic value of the product supplied. The ECJ did not explain how it supposed that the economic value of a product should be determined, although the decision (paragraph 251) implied that the profit margin could be determined objectively if it were possible to objectively calculate the cost of production and compare that to the selling price. This would disclose the amount of the profit margin, though the judgment did not say how it would be determined whether the profit margin was excessive or not However, the ECJ further stated, in paragraph 252, that [t]he questions therefore to be determined are whether the difference between the costs actually incurred and the price actually charged is excessive, and, if the answer to this question is in the affirmative, 6 This is also referred to in paragraph 4.13 in the CAA consultation paper. 21

25 Competition Law Issues and LRAIC whether a price has been imposed which is either unfair in itself or when compared to competing products. The two part test inferred from the judgment is: (a) First, a comparison of price to costs of production, and if the price is found to be excessive in this sense; (b) Second, a consideration whether the price is unfair in itself or when compared to competing products This leaves many questions open most importantly the amount by which price should be above the costs for the second stage to become relevant (profits to be excessive), and what constitutes a price that is unfair in itself (question about the definition of the economic value). The comparison to prices of other competing products could however, be useful in the case of Stansted. Also, an indirect implication of the test is that the ECJ seems to consider at least some level of profit over costs actually incurred to be acceptable. SACEM (1987) 4.18 In the SACEM case, the ECJ considered that the production costs to be taken into account are those of an efficient firm, and not necessarily those of the investigated firm. This recognises the fact that prices may be excessive even if profits are not high, as the investigated firm may have inflated production costs because of its dominant position (Xinefficiency) The excessive price test actually employed in the SACEM case was a comparison to prices in other geographic markets. However, the notion of using an efficient firm as the basis of comparison would be consistent with the way in which LRAIC is implemented in some settings, or to put it another way, LRAIC could be used to calculate the costs of the efficient firm The notion of the efficient costs was also employed in the KLM (2000) case by the Dutch competition authority. Deutsche Telekom (1997) and Napp Pharmaceuticals (2001) 4.21 The Deutsche Telekom (1997) and the Napp Pharmaceuticals (2001) cases are the only two cases of those reviewed that provide any direct indication of what was and what was not regarded as an excessive margin on costs of production In the Deutsche Telekom (DT) case, following a complaint made in 1996 against the conditions imposed on third parties for access to DT s infrastructures the European Commission initiated proceedings against the company. An independent price survey carried out on behalf of the Commission demonstrated DT s inability to prove that its prices were cost-orientated, and found the DT price level to be 100 per cent higher than on comparable competitive markets. 22