Economic regulation of Heathrow and Gatwick airports 2008-2013

311 Pages·2008·1.01 MB·English

UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

Economic Regulation of Heathrow and Gatwick Airports
2008-2013

CAA decision

11 March 2008

Civil Aviation Authority
CAA House, 45-59 Kingsway, London, WC2B 6TE
i
UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

(page left intentionally blank)

ii
UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

Table of contents
Summary ...............................................................................................................................v
1. Introduction..............................................................................................................1
2. Regulatory approach for Q5 and beyond.................................................................7
3. Approach to setting price caps...............................................................................27
4. Traffic forecasts.....................................................................................................35
5. Operating expenditure...........................................................................................51
6. Non-regulated aeronautical revenues....................................................................69
7. Commercial revenues............................................................................................79
8. Capital expenditure................................................................................................87
9. Regulatory asset bases.......................................................................................107
10. Cost of capital......................................................................................................121
11. Price control design.............................................................................................135
12. Service Quality.....................................................................................................139
13. Capital investment triggers..................................................................................163
14. Public Interest Conditions....................................................................................179
15. Price cap financial modelling...............................................................................183
16. CAA decision.......................................................................................................195
A. Competition Commission recommendations.......................................................199
B. Respondents to the CAA’s November 2007 proposals........................................201
C. Conditions as to airport charges..........................................................................203
D. Public interest conditions.....................................................................................223
E. Regulatory Policy Statement................................................................................237
F. Rolling forward the Regulatory Asset Bases........................................................263
G. BAA’s agreement on enhanced information disclosure and consultation at
Heathrow and Gatwick Airports - update for Q5................................................................271
H. Statement of Standards and Rebates at Heathrow and Gatwick Airports...........279

iii
UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

(page left intentionally blank)

iv
UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

Summary
1. The CAA’s purpose in its economic regulation of price-controlled airports is to
further the reasonable interests of airport users, to promote the development of
efficient and profitable airports in the UK, and to encourage timely investment in
capacity to meet demand. It does this through setting price controls and other
conditions every five years on the operation of airports designated by the
Government for such economic regulation, according to the statutory functions and
duties set out in Part IV of the Airports Act 1986. These conditions limit the amount
of revenue which each airport can raise from airport charges and create incentives
on the airport operator to operate efficiently, to invest in response to users’ needs,
and to deliver a high standard of service to passengers and airlines.
2. This document sets out the CAA’s price control decisions in respect of Heathrow
and Gatwick Airports for the five-year period commencing 1 April 2008 (the fifth
quinquennium, or Q5). It represents the culmination of over two and half years’
work by the CAA, by the airports’ operator BAA and by airlines themselves,
including through the process of constructive engagement which the CAA
established in 2005. The CAA considers that, as a result of such engagement, its
price control decisions are significantly better informed by a broader and deeper
understanding of airlines’ views, along with BAA’s own responses to its users’
requirements. The CAA is grateful for the valuable inputs which airlines, passenger
groups, and BAA have provided during the price control review, which together
have enabled the CAA to reach its decisions on airport regulation.
3. Building on the evidence from constructive engagement and other consultations,
the CAA has conducted its own analysis of the regulatory framework appropriate to
each airport; the projections of airport traffic, service standards, costs and
offsetting commercial revenues which together produce a projection of maximum
allowed airport charge revenues; and the financial incentives to encourage
investment and service performance to meet users’ needs. In doing so, the CAA
has had regard to the recommendations set out in the report of the Competition
Commission1 in respect of the price control reference which the CAA made to the
Commission in March 2007. The CAA has also given careful attention to the
evidence advanced by all interested parties in consultation at all stages in the price
control review.
4. The CAA considers that the price control decisions which it is setting out in this
document are best calculated to meet its statutory duties. Airport users’ reasonable
interests are furthered by setting charges based on the CAA’s assessment of an
efficient level of costs, while strengthening the array of financial incentives on each
airport to improve further its service performance across a broader suite of
activities, and to invest in a timely fashion. Each airport is separately regulated,
with price controls closely linked to the specific circumstances of the airport and

1 BAA Ltd - A report on the economic regulation of the London airports companies (Heathrow Airport Ltd and
Gatwick Airport Ltd), presented to the CAA 28 September 2007
Summary v
UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

the needs of the airlines and passengers at that airport. Through maintaining the
‘single till’ approach to regulation, users benefit from the co-funding of the airport’s
costs from (unregulated) commercial income generated at each airport, which
reduces the level of the regulated airport charge. The CAA considers that the
allowed revenues at each airport would promote the efficient, economic and
profitable operation of the airport. They would also provide adequate revenues,
given the risks entailed in operating and developing Heathrow and Gatwick
Airports respectively, to enable each airport operator to invest in airport
infrastructure and service quality. The CAA judges that the specific risks affecting
each component of each airport’s costs and revenues has been adequately
allowed for in setting the allowance for each of these regulatory ‘building blocks’,
and that non-diversifiable risk is adequately funded through the cost of capital
allowance in the price caps. As such, and combined with other financial
incentives, the CAA considers that the price controls will encourage investment in
time to meet users’ demands. Finally, the CAA has set only those conditions which
it considers necessary to meet its statutory functions.
5. In November 2007, the CAA put forward proposals for price caps to rise to £11.97
per passenger in 2008/09 at Heathrow and £6.07 at Gatwick (2007/08 prices), and
to increase thereafter in real terms at 7.5 per cent and 2 per cent per annum
respectively to reach £15.90 and £6.57 respectively by 2012/13. In light of its
assessment of new information since November, including responses to its
consultation, the CAA has decided that the maximum allowed airport charge
revenues per passenger at each airport for Q5 shall be as summarised in Table 1
below.
Table 1 Maximum levels of airport charges per passenger
£, 2007/08 prices
Price cap
% real increase % real annual
Adjusted 2008/09 increase 2012/13
Reclassification in airport charge increase in
2007/08 price 2007/08 price cap 2007/08 price
of costs into price cap from airport charge
cap price cap to cap
airport charges* adj. 2007/08 to price cap from
2008/09
2008/09 price 2008/09 to

cap 2012/13

Heathrow
9.28 1.08 10.36 23.5% 12.80 2.44 7.5% 16.99
Gatwick
4.91 0.70 5.61 21.0% 6.79 1.18 2% 7.34
* offset by reductions in air navigation service direct charges and in other BAA service charges
6. These maximum airport charge levels are somewhat above those for Heathrow
which the CAA proposed in its November 2007 final consultation document, and
significantly so for Gatwick, equivalent to £0.83 per passenger more at Heathrow
and £0.72 per passenger more at Gatwick in 2008/09. This implies maximum
airport charges revenues at Heathrow of £5.5 billion over the whole of the Q5
period, some 7 per cent higher than the £5.2 billion proposed in November 2007,
and for Gatwick maximum revenues over the five year period of £1.3 billion, some
11 per cent higher than the £1.2 billion previously proposed. The main reasons for
these differences are additional investment, primarily at Heathrow, which has
Summary vi
UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

largely been endorsed by the airlines operating at each airport; and additional
security costs at both airports, but with greater impact at Gatwick, which (in the
CAA’s view) are required to meet Department for Transport security requirements
and its drive to restore more normal arrangements across the UK for passengers’
hand baggage.
7. Continuing investment is vital at both airports to meet the legitimate expectations
and anticipated demands of passengers and airlines for safe, well-functioning
terminals and efficient airfield infrastructure, which should provide the platform for
better service delivery in the coming years.
8. Prior to T5, Heathrow has not had a new terminal building for some 22 years2 and
Gatwick has not had one for 20 years3. At both airports, terminal buildings have
become tired, over-crowded and out-of-date. With T5 and the new Heathrow East
Terminal, by the start of the next quinquennium in 2013, nearly two thirds of all
passengers travelling through Heathrow should pass through new terminals built to
the best international standards. The other terminals will also benefit from reduced
passenger numbers and substantial expenditure to bring them also up to
standards comparable with other major hub airports. As a result it is inevitable that
the relatively low charges enjoyed for many years by airlines using Heathrow will
rise to levels more comparable with those at many other major airports.
9. Gatwick has also seen relatively low investment, accompanied by low charges to
airlines using it. Substantial expenditure is now needed to improve conditions for
passengers, notably in security processing and through the expansion or
refurbishment of terminals and piers. In doing so, Gatwick’s leading performance
as the world’s busiest single-runway airports can be better matched with the
service offered to passengers. Making these improvements also puts upward
pressure on charges.
10. Building on the consensus emerging from constructive engagement at each
airport, the CAA has incorporated BAA’s latest capital investment plans for each
airport into its price cap calculation. The broader scope of these plans, notably at
Heathrow where projected investment in the coming five years has risen 9 per cent
to £3.9 billion since November 2007, has contributed to the increase in maximum
airport charges since then. In addition at Heathrow, the CAA has built into the price
caps contingent funding for the costs of developing further during Q5 the option to
expand the capacity of the airport, which is currently subject to a Government
policy decision expected later in 2008. The CAA has also broadened the financial
incentives at both airports, most notably Gatwick, for the timely delivery by BAA of
those investment projects which are of particularly high priority to airline users.
11. Much airline and CAA attention has focused since November 2007 on the issue of
security costs, which have been subject to upward pressures through the price

2 Terminal 4 opened in 1986
3 North Terminal opened in 1988
Summary vii
UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

control review from two sources: changing Government security directions, and the
desire of all parties (passengers, airlines, BAA, and the CAA) to achieve a
significantly better passenger experience through smoother and more reliable
passenger security search. The CAA has had careful regard to all the evidence
presented, and to the inevitable uncertainties in modelling future costs in a rapidly
changing operational environment. It has decided to include a material increase in
security costs at Heathrow and (more significantly) at Gatwick (though both lower
than requested by BAA), up 12 per cent (£67 million) and 51 per cent (£111
million) respectively over Q5 on the CAA’s November proposals. The CAA
considers that this should provide adequate funding for higher service standards,
provided throughout the day, meeting more stringent Government-imposed
security requirements, and delivered by an increasingly efficient security function
at each airport over Q5. Combined with other less significant adjustments, notably
at Heathrow, this has led the CAA to increase the operating costs on which the
price caps are based by 3 per cent to £4.2 billion over Q5 at Heathrow, and by 8
per cent to £1.4 billion over Q5 at Gatwick.
12. The CAA has reassessed its own previous estimate of the costs of capital for each
airport which underpinned its price control proposals in November 2007, and the
prior recommendations and analysis of the Competition Commission in this area. It
has also, as previously indicated, reviewed the emerging evidence from the
financial markets to update its judgement on the cost of capital which should be
allowed within each airport’s price cap for the coming five-year period. Finally, it
has reassessed the likely access to debt and equity capital markets in the coming
five years for an efficiently operated and financed airport, given the proposed
maximum allowed revenues and investment plans for each airport.
13. The CAA concludes that the maximum allowed airport charge revenue should be
calculated using a pre-tax real weighted average cost of capital of 6.2 per cent for
Heathrow and 6.5 per cent at Gatwick. The CAA’s view of the cost of debt remains
unchanged at 3.55 per cent real (6.45 per cent nominal), which includes allowance
for the (currently higher) costs of new issuance required to finance growing asset
bases over Q5 and, beyond that, some headroom above current market rates. The
CAA, having had close regard to the latest evidence presented in its final
consultation period and to its own analysis of financial market turbulence on the
cost of equity over the medium term, has also retained its previous estimates of
the real pre-tax cost of equity for Heathrow at 10.2 per cent and for Gatwick at 10.9
per cent. The CAA has also maintained its assumption of a notional gearing level
of 60 per cent, which it considers represents a reasonable balance for users
between the lower costs of debt financing, on the one hand, and the risks to
investment and service from more highly geared structures, on the other.
14. In terms of financing, the CAA has assessed, on the basis of prudent assumptions
about future debt market conditions and over a range of scenarios for airport
financial performance, the likelihood of each airport being able to access sufficient
debt finance on reasonable terms through Q5. In doing so, the CAA has continued
to adopt its own notional financial structure, with 60 per cent gearing assumed,
Summary viii
UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

rather than the current or prospective actual financial structure which BAA may put
in place. Having undertaken this assessment, the CAA concludes that there is no
basis on which to adjust the proposed price controls at either Heathrow or Gatwick
airports in Q5 for reasons of financeability. The CAA is clear that the risks and
rewards of the specific financing which the airports put in place lie with the airports’
owners and investors, and will not be underwritten by users.
15. This price control decision embeds and extends further the current framework of
financial incentives on each airport to deliver good standards of service to
passengers and airlines. Building on the most recent evidence from constructive
engagement, the CAA has broadened the suite of service measures against which
BAA’s performance will be measured and subject to financial penalties if not up to
standard, with all such measures to be introduced from April 2008 or, by exception,
no more than one year later. It has also increased the performance standards
(below which rebates are paid to airlines) for existing measures, notably passenger
security processing, and it confirms its previous proposal to raise the total amount
of potential rebates to 7 per cent of each airport’s annual airport charge revenue.
Finally, the CAA has decided to implement positive financial incentives for
improving service to passengers (throughout the airport) above the performance
thresholds, in the form of the ability to increase maximum airport charges by a
defined amount. The scope of this ‘bonus’ scheme has been narrowed to exclude
passenger security processing, for which the CAA considers each airport has been
adequately funded to meet passengers’ and airlines’ service requirements. The
maximum amount of bonus revenue achievable over Q5 has thereby been
reduced to 2¼ per cent of total airport charge revenue from 3 per cent proposed in
November 2007.
16. Finally, the CAA’s price control decision envisages a continuing and strengthened
role for airline users in influencing the evolution of each airport’s capital investment
programme and its service performance metrics over the coming five years. This
will be complemented by mid-term reviews by CAA of capital investment efficiency
and service quality measurement. To complete the oversight, the CAA is also
mandating much greater transparency by BAA to passengers and the public at
large of its service performance. It remains the CAA’s goal to improve the
passengers’ overall appreciation of services directly relevant to them provided at
Heathrow and Gatwick, through publication in time of complementary measures of
airline and other agencies’ service performance.
Summary ix
UK Civil Aviation Authority Economic Regulation of Heathrow and Gatwick Airports 2008 -2013
– CAA Decision

(page left intentionally blank)

Summary x