Wednesday, April 25, 2012

Regulated cost of capital for airports

Many elements of infrastructure have natural monopoly characteristics. Under these conditions, if the owner of the infrastructure is profit-maximising, he is likely to impose high user charges and extract a monopoly rent. As a consequence, in many infrastructure services in most countries, independent regulators are established which control the user charge.

The critical building block that goes into this is assessing the `fair' rate of return on equity capital. By and large, infrastructure projects have low betas; whether business cycle conditions are good or bad, they tend to generate stable cashflows. By this logic, the rate of return obtained by the developer should be relatively low.

India requires a trillion dollars of infrastructure investment in coming years. For this to come about properly, sound thinking on the appropriate rate of return is required. If this rate of return is set too low, then the required investments will not be forthcoming. If the rate of return is set too high, then developers will earn monopoly rents, and the economy will be hobbled with expensive infrastructure.

The regulated industry has strong incentive to lobby with the regulatory agency. Almost nobody else in the country has detailed technical knowledge about the activities within the regulated industry. This field is thus fraught with problems of governance, the capabilities of regulatory agencies, etc. High quality public discussion, and criticism of the activities of regulatory agencies, is thus critical to ensuring that the outcomes are sensible. Our puzzle in India is that of getting to an ecosystem comprised of well drafted laws that create independent regulators, high quality staff in regulators, high quality independent experts outside government, well educated journalists, freedom of press, etc.

In this setting, an important order has been released by the Airports Economic Regulatory Agency (AERA): tariff setting for the Delhi airport. This will be of great interest to people interested in the fields of infrastructure financing and corporate finance in India. In my knowledge, this is the first episode in the field of Indian infrastructure where high quality corporate finance knowledge has gone into tariff setting. The arguments and methods here will be relevant for other airports, and for other areas of infrastructure.


  1. As a nation we are indeed entering newer territories now...a few weeks back the Controller General of Patents Design & Trademarks issued the first Compulsory License in India to Natco Pharma for a patented drug by Bayer.

    This also makes for an interesting read.

  2. The tariff orders for DIAL and MIAL appear to be classic symptoms of regulatory capture by the regulated, regardless of the AERB being touted as a progressive regulator with a great process.

    A weighted average percentage hike of a few hundred percent suggests that either the earlier tariff was way off the mark, or the current one is mindless. References in the tariff order about how Chambers of Commerce that supported the hike have those who opposed them as members, suggest that utterly irrelevant issues have weighed with the regulator in taking this decision.

    Worldwide, regulators work on lowering the tariff. Telecom and mutual fund loads are cases in point even in India - not that that should be the sole objective. The model of a regulator ruling on a "fair return" is another form of administering subsidies, of course at the expense of the consumer, rather than the State.

    Airports have to deal with a wider householder and retail community unlike seaports, which is regulated by the TAMP, another tariff regulator constantly at war with and in vigil over terminal operators. The quality of the debate there is a bit higher since it is only between industry (shipping) and industry (operators) while with airports there ought to have been a more political debate - akin to telecom and mutual funds.

    These AERB tariff orders only go to show how it is not enough to have in place great law and regulations on due process. How they are administered will determine how well a regulatory system functions.

    (These views are personal. Disclosure: I understand, some of my colleagues at JSA are involved in challenging this order.)

    1. It seems that the tariff being charged was indeed much lower than what is required to provide a reasonable return on capital to the investors in the airport company. The process adopted by AERA for calculating the cost of capital is based on the best practices in this field internationally. This is a commercial investment, and the calculation of cost of equity is based on the risk investing in this enterprise would add to a well-diversified portfolio of assets. The return on equity sought by the airport company (24%) was much higher than what has been finally decided by AERA(16%). So, it is not clear how this is regulatory capture.

      The reason why this hike in tariff seems so steep is also because the decision has come after a long time, and if there had been hikes periodically, to ensure reasonable return on capital, this wouldn't have happened. Probably there were constraints that led to this delay. In fact, the regulator was set up after some of these airports had been commissioned.

      As the order show, AERA did receive submissions from various stakeholders (including consumer advocacy groups, airline associations, and airports). Comparable to the example of seaports, here also representations were made by the airlines and the airports, both of which are businesses capable of informing the debate and have almost opposing views on the matter. What seems interesting from the process point of view is that all the submissions have been responded to carefully in the order, and a reliable method has been used for estimation.

      This is not to say that there will be consensus on decisions regarding certain variables going into the estimation, but it does seem that due process was followed.

  3. what about the huge LAND BANK which DIAL has got. They have got tons and tons of money from that. Their own equity contribution is very low.

  4. Why did they create only one PPP based new airport at each of the metros like DIAL, BIAL or MIAL ? At least two are required to keep up the competition rather to succumb to manoeuvring through regulation after allotment through due process of techno-commercial bids.

    Pitting two against each other, across cities creates healthy rivalry and wider scale for future needs. Mumbai is overloaded and underequipped in the absence of planned alternatives while policy paralysis upsizes the price that citizen pays at Bangalore, Delhi, et al.

    Land bank abuse, policy misuse and town planning norms' disuse is the hallmark of these vested interests plying as opinion makers and policy advisors, and later overmanaging on underinformed basis as regulators.

    To take a detour, imposition of road tax (for pro-rata moving surface area portion of public transport bus) for every new private car is plausible but distanced from policy due to car manufacturers' lobbies; additionally congestion tax to ply these cars is not extracted for trips; entry tax for business districts are also done in many developed nations. All of these, increases the quality and quantity of public transport while drawing a balance between new cars on the road with ample buses plying for those who can't afford it.

    The industry will earn and the citizenry will learn from the mistakes of such regulators, govt policy makers and market observers.

    I rest my case.



Please note: Comments are moderated. Only civilised conversation is permitted on this blog. Criticising me is perfectly okay; uncivilised language is not. I delete any comment which is spam, has personal attacks against anyone, or uses foul language. I delete any comment which does not contribute to the intellectual discussion about the blog article in question.

Please note: LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.