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Implications of the Choice of Rate-setting Methodology for Airport Performance

In the 33 years since the deregulation of the airline industry, many airports have moved from the residual rate-setting methodology to the compensatory or hybrid methodology. Under the residual method, all nonairline revenues at the airport are applied to costs, and airlines are charged the residual amount (or given a credit in case of an excess in nonairline revenues). Under the compensatory method, the airport sets airline rates and charges based on the percentage of costs corresponding to the airlines' use of facilities, without consideration for the amount of nonairline revenues. Excess revenues are generally retained by the airport. Hybrid methods are typically compensatory for terminal facilities and residual for airfield facilities. However, there are many possible hybrid variations, including methodologies that involve compensatory calculations, combined with a sharing of nonairline revenues with the airlines. The choice of a rate-setting methodology is perceived to involve a trade-off between risk and return. Under a pure residual method, airports effectively face no financial risk. The airlines collectively bear all the risk by ensuring payment of all airport costs not covered by nonairline revenues. The airport, however, has limited or no ability to generate or retain any excess revenue. Airline rates and charges are set so that they are just enough to cover operating expenses and debt service costs. In addition, airline use and lease agreements based on the residual method typically include a majority-in-interest (MII) provision that requires the airport to obtain the approval of a majority of the airlines operating at the airport with majority defined based on share of landed weight or enplanements, or both  before proceeding with any capital outlay. Under the compensatory method, airports have the ability to retain any excess nonairline revenues and have greater control over airport capital investment decisions, but their financial position also becomes more heavily dependent on nonairline revenues and therefore more vulnerable to traffic fluctuations. Most compensatory agreements, however, have risk mitigating features such as a mechanism to recover shortfalls over time through annual rate adjustments and an extraordinary coverage provision that allows for end-of year settlement should net revenues fall short of meeting a bond rate covenant. In summary, airports that move to a compensatory method take on greater risk in the short-term in exchange for the ability to realize and retain excess non-airline revenues and to exercise greater control over capital outlays. Against this background, the proposed research project will examine whether differences in rate-setting methodologies across the airports translate into systematic differences among airports in their financial operating performance.

The objectives of this research project are as follows: (1) To document cases of US airports switching from residual to compensatory or hybrid rate-setting methodology. (2) To evaluate, taking account of the institutional framework airports are operating under, the rationales for and expected outcomes of different rate-setting methodologies. (3) To examine systematic differences among airports with different rate-setting methods in: (a) Financial operating performance; (b) Optimization of non-airline revenue potential; (c) Operational efficiency.

Key Words

Residual versus compensatory rate-setting methodology; airport-airline relationships

Related Work Academic literature on the implications of rate-setting methodology for airport performance and social welfare is rather slim and not very conclusive. The most relevant study to the proposed research project is Oum, Zhang, and Zhang (2004) . That study finds that airports using compensatory (also known as dual till) rate-setting method appear to be more efficient (in terms of higher total factor productivity) than those operating under the residual regime. At the same time, Czerny (2006) argues that residual rate-setting methodology will be associated with higher total market welfare at regulated non-congested airports most US airports fall under this category. Yang and Zhang (2011) demonstrate that Czerny's result may not hold for congested airports. The literature on determinants of airport revenues, including the potential impact of rate-setting method, is also sparse. Bilotkach, Clougherty, Mueller, and Zhang (forthcoming) demonstrate that European airports operating under residual rate-setting exhibit lower average take-off and landing charges as compared to the airports using compensatory method. While Van Dender (2006) examines determinants of a series of airport performance indicators, including aeronautical and non-aeronautical revenue, in a sample of US airports; possible impact of rate-setting methodology is not considered. At the same time, previous studies (e.g., Czerny, 2006) suggested that residual methodology can be more conducive to non-aeronautical revenue optimization, as airports will have an incentive to lower aeronautical charges to boost their non-aeronautical revenue. Overall, the implications of rate-setting methodology for airports financial operating performance and optimization of non-airline revenue potential have not been systematically discussed. This research will provide the first comprehensive investigation of this issue. Urgency/Priority We believe this project is of high priority for two reasons. First, a brief look into the existing body of literature suggests that the currently observed trend among the US airports for moving to compensatory or hybrid rate-setting methodology could result in lower total welfare, despite potentially making the airports more efficient. This is a classic example of the efficiency-quality trade-off: airports that are the most congested and least liked by the public are oftentimes declared the most efficient by the relevant benchmarking studies. It is therefore crucial to promptly assess the mechanisms via which changes in rate-setting methodology can impact on the airports efficiency and market welfare. Second, the perilous budget situation most local authorities (which own and oftentimes operate airports in the US) find themselves in increases the value of studies that investigate measures which can be undertaken to optimize cost and revenue related to property owned by local authorities. This research will produce knowledge that can be used by decision-makers at the local level to understand the implications of different rate-setting methods available to airports. Cost The estimated cost associated with this project is $300,000 (three hundred thousand US dollars).

User Community

This proposal should be sent to ACRP and FAA (specifically, division responsible for managing the Airport Improvement Program). Implementation Findings of this research project will be implemented through a comprehensive research report. More technical aspects considered within the project’s framework can be implemented through several research papers, to be submitted for publication in peer-reviewed outlets. Effectiveness Research to be undertaken within this project will inform airports and corresponding local authorities on ways to optimize their revenue. Policy-makers will receive new information about the implications of an important and wide-spread trend in price-setting for the airport services, which will help them optimize regulation of airports. It is our hope that recommendations stemming from our research will contribute to increased operating efficiency of airports, which can in turn contribute to creating a better travel experience for the general public.

Sponsoring Committee:AJE50, Economics, Revenue, and Finance
Source Info:Original research statement written by Dr. Volodymyr Bilotkach, reviewed by the committee, and revised by the author. Approved by the committee January, 2013.
Date Posted:01/25/2013
Date Modified:01/29/2013
Index Terms:Airlines, Airport operations, Rates, User charges, Operating costs, Operating revenues, Airport choice,
Cosponsoring Committees: 
Administration and Management

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