Right for size?

Airport Economics Consulting Inc’s principal and founder, Patrick Lucas, considers whether there is a business case for small scale airport Public-Private Partnership projects.

The multiplier effect and positive externalities that airports generate in terms of employment and contribution to local economies is significant.

Commerce, tourism, and an intricate supply chain of businesses thrive and depend on passenger and cargo traffic within the aviation ecosystem and beyond.

However, the many benefits of airports do not come without their costs. Airports are capital-intensive investments – irrespective of their ownership and financing model, the large capital outlay and the complexities involved in airport planning, approvals, and constructing new infrastructure means that there is risk associated with the long-time horizon of these investments.

That is, capital investments tend to be lumpy over the short-term whereas cash flows and an expected return on invested capital are only sufficiently realised over the longer term. Moreover, a critical mass of traffic throughput is required before airport operators or other stakeholders can start recovering costs – the CAPEX incurred, the associated operating expenses and a reasonable return on investments.

In the era of high government debt following the pandemic, where drawing on the public purse is not always feasible, questions are raised as to whether there are any other policy options to finance airport infrastructure and manage airport operations over the long-term?

Historically, the private sector has always been attracted or incentivised to invest in larger airports with high traffic volumes.

However, can different forms of private sector participation be extended to smaller airports even though they have low traffic throughput? Is there a sufficient business case?

Economies of scale, scope and airport size

On a distributional basis, the majority of airports across the globe are small in that they have low passenger and cargo traffic throughput in any given year. During pre-pandemic times, based on analyses from ACI World (ACI Airport Economics Report) more than 90% of the world’s airports had fewer than five million passengers on a per airport basis.

When the world’s airports are analysed through the lens of profit and loss, as much as 68% are estimated to be operating at a net loss. Interestingly, of that 68% operating at a net financial loss, the vast majority are small – 97% of these airports have fewer than one million passengers (See Chart 1).

Airports that serve the smallest markets tend to have higher overall costs on a per-passenger basis by virtue of the fact that they do not have sufficient scale.

Average total costs decline with an increase in market size. Fixed costs, such as depreciation, interest expenses and other capital costs, are spread over an expanding airport’s traffic throughput.

The inverse relationship between average total costs and throughput as seen in the data is an indicator of economies of scale. Because certain markets continue to recover from the pandemic, data during stable times is presented for the period 2017-2019.

Chart 2 shows average unit costs across various size categories of airports. Although the chart is not an actual cost curve, the significant decrease in unit costs beyond those airports with fewer than one million passengers is indicative of economies of scale.

While this may vary, at some point airports achieve a level of minimum efficiency. Moreover, there may even be diseconomies of scale in the traffic development continuum when airports need to invest more in capital (CAPEX) to meet current and future demand.

The extra costs and potential excess capacity in the near-term results in what economists refer to as diseconomies of scale.

Policy levers and financing mechanisms to support smaller airports

If the majority of small airports are loss making, why are they kept open for business? The reason smaller regional airports remain

in operation hinges on the fact that they contribute to the local, social, and economic development of their surrounding communities.

Depending on the context, there are several financing and funding tools that could be considered for smaller airports. Because of the positive externalities that they generate, in multiple jurisdictions, government intervention in the form of subsidies or grants helps to cover the shortfall or deficits. In the case of major airport networks, which consists of a portfolio of airports under a single operator in a given jurisdiction, profitable airports in the network tend to cross-subsidise or compensate for the net losses of smaller airports.

While there are always exceptions, when it comes to overall financial performance, size does matter. The probability of making a loss increases with lower traffic volumes because the overall market becomes smaller as analysed in Chart 4. Again, if net profit margins are analysed and different forms and grants and subsidies are excluded, the smallest airports have either negative margins or very thin margins.

Governments continue to find alternatives to the financing conundrum. Recognising the important role these smaller airports play in terms of socio-economic development and connectivity, in order to cover the operating deficits, the European Commission’s Aviation State Aid Guidelines have historically recognised those airports with fewer than three million passengers per annum as eligible for State aid.

However, such subsidies are deemed as time bound and temporary based up to the year 2027. Thereafter, smaller airports are expected to achieve financial viability by raising airport charges, incentivising traffic development and achieving certain cost efficiencies.

While there is no doubt that some of these tools may slightly improve traffic and the bottom line, there is no denying the underlying economics. A recent report by ACI EUROPE, in collaboration with Oxera, revealed that that those airports with fewer than one million passengers have a high likelihood of operating at a loss irrespectively. That is, the underlying economics linked to economies of scale remain the same.

Thus, there are strong arguments recognising that State aid is still a critical safeguard in covering the financial shortfall beyond 2027.

Risky business?

Given that many small airports operate at a loss, it begs the question, can a case be made for private sector participation? What possible factors are at play to incentivise such an investment?

Small scale airport Public-Private Partnership projects are generally complex to implement, due to difficult operational considerations, high project development costs with minimal payout, and weak profitability metrics.

So how do we make it happen? Many governments across the globe have recognised the complexity of covering the high costs that small airports face due to their low throughput. In these instances, such smaller airports are included in a cluster or network that encompasses profitable airports with higher throughput levels.

From a policy standpoint, several objectives could be met under this model – government financing is reduced by capitalising on the cross-subsidisation model of a network thereby ensuring that the economic and social benefits that small airports offer to their communities are maintained.

The PPP model remains applicable to small-scale airports, albeit in varying forms:

• Mexico and Brazil, or even more recently the Cape Verde Islands, have adopted airport cluster or network schemes, where one or more larger profitable airport tend to cross-subsidise or compensate the net losses of smaller airports.
• On some continents, such as in Africa, small-scale airport PPP schemes are introduced through a combination of measures via grants and higher passenger charges. This solution presupposes that vital and costly infrastructure such as the runways and aircraft aprons are already in place, or that a government and/or multilateral institution offer appropriate grants as a source of finance.
• In North America and Europe, many regional airports or small-size secondary airports are developed and managed within the framework of Operate and Maintain (O&M) management contracts, where the private party assumes full management of the airport’s operation and maintenance. However, the more substantive investment in infrastructure is ensured through subsidies either by regional or national institutions.

Creating fertile grounds for small scale airport Public-Private Partnership projects (SSPPPs)

Whatever the model, we are reminded by the timeless adage that ‘there’s no such thing as a free lunch’. That is, private operators have a bottom line and expect a return on their business for a given level of risk.

A successful PPP typically allocates risk appropriately between the public and private entities with the appropriate contractual instruments depending on the objectives.

The models of private sector participation are differentiated by the degree of risk transfer. For instance, shorter-term management contracts (~5 years) typically follow a classic O&M model with no or minimal requirements linked to financing the infrastructure.

In cases where capital investments are required, and a government is not able to finance or construct the capital asset such as a new terminal or runway, a build-operate-transfer (BOT) model is used.

The BOT concession contract is longer lived than a short-term management contract, and its lifespan is dependent on the cost-recovery time (~35 years), as revealed in ACI World’s 2018 Policy Brief: Creating fertile grounds for private investment in airports.

The longer the time horizon, the higher the risk transfer to the private sector. However, successful SSPPPs, usually require a combination of public sector financing or other economic incentives coupled with the appropriate model of private sector participation. This is often known as hybrid PPP financing schemes that may also consider evolving models of private sector participation.

Based on government objectives and needs, matching the PPP model with the right contract lifespan and recognising the underlying economics are foundational elements.

In addition to having clear and consistent economic regulatory frameworks set up prior to privatisations, it is critical that governments make the appropriate preparations and due diligence ahead of time of the tendering and bid process. This instils confidence in private investors and other related stakeholders.

The ‘diamond in the rough’ – managerial levers to grow traffic

The cautionary story that has been told up to now is that small airports with fewer than one million passengers per annum are loss making due to insufficient scale. Thus, when private sector participation is considered, appropriate government incentives need to be bundled into the right P3 model based on those circumstances.

On the other hand, truth be told that the smallest airports across the globe are also the fastest growing in the world. When airports are analysed through the lens of the year 2006, before the Global Financial Crisis, and based on the airport size categories in that year, the smallest airports have had the greatest gains in passenger traffic.

From 2006 to 2023, airports with fewer that one million passengers (<1m), between 1 and 5 million (1-5m) and between 5 and 15 million (5-15m) experienced absolute growth of 130%, 102% and 94% respectively.

Indeed, it is true that the smaller airports start from a lower passenger traffic base, but many of those airports classified as small in 2006 (<1m) have graduated into other size categories over the years. This means with the increased scale, profitability follows.

There is no doubt that these small and emerging airports play an essential role in feeding traffic into hub airports for onward journeys to other major national and international destinations.

This results in important feedback loops for airports in a given aviation market.

In other instances, existing major airports may already be congested and have reached a point of saturation. This is when smaller airports stand to strategically benefit from traffic leakage and grow as a result of this burgeoning demand.

Centerline Airport Partners, an aviation company focused on identifying and enhancing the value of airports through strategic investment, development and operational excellence, recently acquired a 51% stake in Parma International Airport (PMF) in Italy.

While PMF has modest passenger traffic of 125,000 per annum, the airport is located in between the populous cities of Milan and Bologna. Talking to Canadian newspaper The Globe and Mail about the deal, Centerline’s CEO, Andrew O’Brian, described Parma as “a diamond in the rough”. He explained that, in consideration of the airport’s strategic location, saturation at other airports and expansive catchment area, Parma International Airport is ripe for the right business model that aims to attract airlines. PMF is poised for significant growth in the years to come.

Smaller airports that are commercially driven or have a policy objective to support the economic development of the communities they serve have various managerial levers at their disposal.

The strategic development of traffic and resultant revenue growth involves several managerial levers and the engagement of multiple stakeholders to ensure success.

1. Market analyses and forecasts to determine and promote the viability of new routes or increased air service;
2. Ensuring that an airport has the necessary infrastructure to support the desired level of air service;
3. Effective marketing and promotional strategies alongside the local tourism authorities and hospitality industries;
   a) Passenger traffic development (Leisure and business)
   b) Air cargo development
4. Airport-airline relations – Provision of incentive packages such as landing fee or passenger fee discounts, marketing support, and streamlined customs and immigration processes
5. Enhancing the overall customer experience (for passengers) goes hand in hand with air traffic development.

Public-private partnerships remain an important development tool and viable financing mechanism for small scale airport projects, provided that they are structured properly, balancing government objectives with investor expectations.

Making use of proven schemes and hybrid financing models are definite ingredients in propelling SSPPPs in the airport sector. Unless loss-making airports are clustered within a network alongside profitable airports, they usually require some public subsidies or grants. This ensures that any financial shortfall is covered, and that infrastructure is financed in a sustained manner.

Finally, blending in the right entrepreneurial talents for a longer-term strategy aimed at developing traffic growth and revenue streams are also critical levers.

About the author and some acknowledgments

ACI World’s former vice president and chief economist, Patrick Lucas, is principal and founder of Airport Economics Consulting Inc (www.airport-economics.com/).

The author would like to recognise that this article was inspired by earlier work and contributions from the Leadership Committee of the Airport Chapter of the World Association of PPP Units (WAPPP). They include Jacques Foullain, Curtis Grad and Rodolfo Echevaria.

Special thanks to ACI for the useful data and reports and to Andrew O’Brian (Centerline Airport Partners); Pierre-Hugues Schmidt (VINCI Airports); Jorge Roberts (AvPorts); Alexandre Leigh (IFC PPP Transaction Advisory) and Rogerio Prado (Pax Aeroportos) for their insight and contributions.