Economic Regulation - IATA

There are alternative versions of a rate-of-return system
that can partially address some of these problems. For
example, in the United States a form of earnings sharing
or profit sharing regulation is common, especially in cases
where airlines have direct investment stakes in airport
terminals and other facilities.
Such a system sets allowable costs in reference to
actual costs, but not entirely. It creates some incentive
for improved efficiency but still faces the fundamental
problem of little control on an over-expansion of capacity
and insufficient progress towards the optimal levels of
costs and service quality.
PRICE-CAP REGULATION (CPI-X)
Price cap regulation sets an allowable level of revenues
for a regulated company – based on projected efficient
cost levels and a cost-of-capital rate of return – along
with a CPI-X profile 15 for user charges to reflect a sharing
of efficiency gains (or of additional investment costs).
Price-cap regulation has been adopted in the UK and
Ireland and some parts of Continental Europe. It was also
adopted initially in Australia, though the regime has since
been changed to light-handed price monitoring.
The key objective of price-cap regulation is to give the
regulated firm a strong incentive to deliver cost efficiency
improvements and to eliminate its ability to exploit its
market power to raise both user charges and profits. The
regulated firm is incentivised to improve cost-efficiency
because if actual costs are less than that projected by
the regulator the firm can keep them as profits, but if
they are higher than projected the extra cost will not be
remunerated. The CPI-X price-cap is only for an average
price. Airports and ANSPs can adopt different pricing
structures within the overall price cap with regard to the
type and weight of different aircraft and, in theory if not
in practice, can also adjust costs according to peak times
for capacity use.
Determining an appropriate X within the CPI-X price-cap
is central to the viability and success of regulation. If too
small an X is imposed (or too high an X value in a CPI+X
determination) the regulated firm can earn excess profit
and undermine the credibility of regulation. If too high
an X is imposed the financial viability of the firm could
be threatened and, as in the case of smaller airports in
Australia, it could reduce the support of governments
and investors for regulation. Therefore, the objective is
to find an X value that provides a challenging, but not
unachievable, target for firms and which promises to
provide clear efficiency and productivity improvements 16 .
Setting a price-cap is intended to replicate the effect of
competitive market forces. X should be zero if the firm is
expected to increase its productivity and face the same
rate of input cost inflation as other sectors in the economy.
However, if it has the capability to improve productivity
faster or limit its cost increases, these benefits should
be passed on to users through an appropriate value for
X. Therefore, X is determined after taking account of the
regulator’s view of demand growth, expenditure plans and
efficiency potential. However, in some cases – such as
London Heathrow airport since 2003 – an RPI+X profile
15
CPI-X is the Consumer Price Index (i.e. the rate of inflation) adjusted for and efficiency component (i.e. X). It sets the level by which total nominal
charges change each year within a regulatory period.
16
See Bernstein and Sappington, “How to determine the X in RPI-X regulation: A User’s Guide”.