Excess profits in airport's pocket emerge strangely

Spot the odd one out: theology; the grammar and pronunciation of Klingon; the calculation of appropriate returns for monopoly businesses.

Aha, trick question. There isn't an odd one out.

All three involve the painstaking analysis of imaginary figments. And all three provoke furious debate with no hope of objective conclusion.

There can no more be certainty about the nature of God than how to say "I laugh in the face of your puny starship Enterprise" in the tongue of the Federation's oldest enemy.

As for how much Wellington Airport should be allowed to make from April 2012 to March 2017, go figure. To read the transcript of the Commerce Commission's regulatory conference on the matter last August is to be reminded of a bevy of bishops arguing over how many angels can dance on a pinhead.

In the end, Archbishop Sue Begg of the commission announced this month that Wellington Airport would make $38 million to $69m in "excessive profits" during the next five years.

This amount is basically how much extra the commission thinks is being sucked out of customers by the airport because of its monopoly position.

Extracting excess profits is of course what monopolies do if they can get away with it, just as cats will catch birds - it's in their nature.

The tricky bit for the commission is not figuring out whether we're being screwed, but how much we're being screwed. Chalkie reckons the regulator has given this a good go, but looking at the fiendish complexity of the calculations it's obvious they are open to challenge.

In its press statement, the commission said a reasonable return for the airport was 7.1-8 per cent, whereas the airport was making 12.3 per cent to 15.2 per cent.

Per cent of what? The reference here is to internal rate of return, which is the percentage rate required to produce a net present value of project cashflows equal to the investment at the outset required to earn them.

Standard procedure it may be, but it immediately starts an argument about how to value the investment already made. This is one of the fundamental areas of disagreement between the commission and the airport, and it has no objective answer.

The other involves the cost of investment capital - how much the airport has to pay to satisfy the people lending it money and buying its shares. The airport says it's 9.5 per cent, the commission says it's 7.1 per cent.

Again, there is no objective measure of the cost of equity capital for a private company, so the argument can never be resolved. The overall effect, says the commission, is that the airport has set prices to earn more than it should on an inflated view of what its assets are worth.

The airport counters by saying if it couldn't charge those prices, it wouldn't invest in better facilities. Airport director Tim Brown, an executive with its 66 per cent owner Infratil, told Chalkie the issues were directly related.

"The airport at the moment is working out a position around investing $100m in the domestic terminal expansion. So a lot of the price rise in the next couple of years is related to a very big investment in the domestic terminal.

"If it turns out the commission says ‘nix on the price rise' we obviously have to look at the package deal." Price control would therefore amount to investment control, he said.

"We could say, ‘OK, look back at our past investment decisions' and we would believe a smart regulator would have endorsed it all. But the reality is we're a bit sceptical we're dealing with a smart regulator here.

"Do we want the Commerce Commission deciding whether we should be extending the runway or extending the terminal? No we don't."

Brown implied the airport would rather back down on prices than get the big stick.

"What we're trying to second guess is what pricing is acceptable to the regulator, because we don't want to be price regulated, so we want to be below the parapet." Chalkie shouldn't place too much emphasis on one remark, but Brown's comment does support the view that the airport aims to set prices as high as it can get away with.

No doubt Brown is sincere in saying the airport won't invest as much if it can't raise prices, but only a monopolist could make that case. Businesses in competitive markets have to invest first and raise prices later.

It remains to be seen whether any price change will follow from the commission's conclusion - under the light-handed "information disclosure" regulatory regime for airports the commission's view that excessive profits are being made does not mean anything will happen. The decision to do something rests with the ministers of commerce and transport - Craig Foss and Gerry Brownlee.

Given the uncertainty over the calculations they may want to review how the commission got its numbers, but if their ministries agree, Chalkie reckons the price rise imposed by the airport last year cannot stand.

In a mitigating factor, some of the apparent monopoly rents get recycled to Wellington customers through the local council, which owns 34 per cent of the airport company.

However, Chalkie reckons the council might want to look again at its share of the spoils.

The airport's shareholders take profits out in different ways. The council gets a dividend and Infratil gets a "subvention payment".

Last year, for example, Infratil got a subvention payment of $30.1m and the council got an ordinary dividend of $9.1m.

Of the total payment, 77 per cent went to Infratil and 23 per cent went to the council, which is obviously not pro rata with their shareholdings. The split has been roughly the same for several years (although a special dividend last year was split pro rata 66:34).

So why does Infratil appear to get a disproportionate share of the profits each year?

It comes down to tax - Wellington International Airport doesn't pay any. Chalkie has gone through several years of cashflow statements and found not a cent paid out since at least 2007.

The reason it doesn't pay tax relates to the subvention payment to Infratil. A subvention payment is a legitimate method of balancing the tax liabilities in a group of commonly owned companies - the threshold for common ownership is 66 per cent.

If company A owns companies B and C, where B makes a profit of $100 and C makes a loss of $100, A has made a balance of zero. To avoid the unfairness of B having to pay tax even though the group has made no money, B can make a subvention payment of $100 to C, so both make zero and no tax is payable.

Infratil does this with Wellington Airport, using a subvention payment to reduce the airport's profitability to negligible levels and offset losses elsewhere in its New Zealand portfolio. Since 2007 the payments have averaged $23.7m.

According to IRD tax rules, a subvention payment cannot exceed the amount of the loss-company's loss, so the $30.1m payment last year means another New Zealand company within Infratil had a loss of at least $30.1m.

Leaving aside the oddity of an Infratil subsidiary apparently losing tens of millions year after year, Chalkie reckons there's something odd about how the subvention payment is calculated.

According to Brown "the airport calculates what the net profit after tax would have been, and then the city council gets 34 per cent of that, and then the remaining share of net profit after tax, and the amount of tax would have been paid, is taken by Infratil as a subvention payment". But if the loss-making Infratil subsidiary pays no tax, and the airport pays no tax, why does Infratil get paid extra to cover tax?

Not only that, but the Commerce Commission calculates the airport's allowable returns as net of tax, even though no tax is being paid.

Admittedly, Chalkie is no sophisticate in tax matters, but he reckons Infratil is. If the airport's prices take a hit, perhaps tax benefits will be a consolation.

Chalkie is written by Fairfax Business Bureau deputy editor Tim Hunter.

The Dominion Post