Memorandum by National Air Traffic Services
(NAT 6)
1. INTRODUCTION
1.1 The Committee has announced its intention
to undertake an inquiry into the financial situation of NATS and
the implications of that situation on air traffic control in the
United Kingdom and the development of the Two Centre Strategy.
This memorandum is a contribution to the inquiry and explains
the current financial position of the Company, following the downturn
in air traffic after 11 September, and the steps NATS is taking
to address the situation.
2. THE PUBLIC
PRIVATE PARTNERSHIP
(PPP)
2.1 There has been a good deal of media
speculation, as well as interest in the House, about the NATS
PPP. The PPP was established on 26 July last year and it was only
a matter of weeks before the Company was facing the most serious
financial challenge in its history. The Company's response needs
to be set in the context of the objectives set by Government for
the PPP:
— maintaining high safety standards
as the overriding priority;
— separating safety, airspace and economic
regulation from air traffic service provision;
— introducing a structure of incentives
and disciplines to maximise NATS' efficiency;
— injecting commercial and management
skills into the company;
— establishing the basis for access
to investment finance; and
— achieving an acceptable level of
proceeds for the taxpayer.
2.2 The rationale for establishing the Company
as a PPP remains sound, with a clear alignment between the public
interest and the interests of the airline community in maintaining
a safe, effective and efficient air traffic control service. NATS
remains committed to delivering to its customers and stakeholders
the benefits which the PPP was designed to achieve, while at the
same time maintaining the Company's status as a world leader in
the safe operation of ATC systems by:
— introducing increasingly competitive
charges;
— improving the procurement and delivery
of new technology;
— bringing private sector business
skills and experience to the areas of procurement, planning and
delivery of major capital investment projects;
— developing a sustainable, long term
investment programme for the introduction of advanced systems;
and
— establishing a leading position for
the United Kingdom as we move towards European integration under
the Single European Sky initiative.
2.3 The establishment of the PPP has given
NATS the commercial freedom and structural incentives required
to improve the efficiency of the business. However, the scale
of the present downturn in the air transport industry since 11
September has been unprecedented. The company has addressed the
impact in the same way as any other commercial business by adjusting
its costs and financial commitments to take account of the new
conditions.
2.4 The PPP continues to be supported by
the key stakeholders, who have a shared interest in ensuring that
the Company succeeds.
3. IMPACT OF
THE TRAFFIC
DOWNTURN
3.1 At the time of writing, the outlook
for the airline industry remains uncertain and it is still not
possible to predict with confidence the future level of demand
for NATS' services. The initial response from the industry to
the events of 11 September was to put in place a significant reduction
in capacity, with reductions in frequencies and aircraft sizes,
and some shedding of routes. The introduction of Winter schedules
saw scheduled services reduced by up to 20 per cent on the North
Atlantic and by up to ten per cent on some European routes, though
the market for services provided by the low cost carriers on European
and domestic routes remained quite strong.
3.2 NATS financial performance is driven
by numbers of flights, aircraft weight and distance flown. Between
October 2001 and March 2002, total UK flights have dropped nearly
five per cent compared to the same period a year ago. The fall
in North Atlantic traffic has been even greater—down 16
per cent. This is significant because, although the North Atlantic
segment comprises only 14 per cent of NATS total UK flights, it
accounts for 44 per cent of NATS income. Each North Atlantic flight
is worth roughly four times a non-North Atlantic flight in terms
of Chargeable Service Units (CSUs), since the formula used to
calculate CSUs depends on both aircraft weight and distance flown
through UK airspace and both these factors are increased for North
Atlantic flights. As a consequence, NATS income in terms of CSUs
has fallen ten per cent between October and February. Even more
significantly, when compared to the six per cent CSU growth forecast
which formed the basis for setting the Price Cap, the total decline
in revenues since October against budget has amounted to 16 per
cent.
3.3 Whilst the indications are that the
worst may now be over, recovery is expected to be slow and initially
limited to returning to pre-11 September traffic levels. Passenger
confidence is returning but airlines are not necessarily responding
by increasing capacity. There are increasing pressures on yields
due to high oil prices, low fares and high labour costs. The continuing
troubles in the Middle East also add to the uncertainty. Year
on year growths in either flights or CSUs are unlikely to become
positive until the start of the Winter schedules in October 2002
and this will largely be due to comparisons with the severely
depressed period following 11 September. Real growth is not expected
until the financial year beginning March 2003.
3.4 NATS has prepared revised forecasts
following 11 September and the revised base case is illustrated
in the chart below. To provide an appreciation of the scale and
duration of the downturn, the chart compares the current position
and the forecast with the equivalent period before and after the
Gulf War.
3.5 NATS is forecasting revenues for its
financial year ended 31 March 2002 of £552 million against
a budget of £607 million, a reduction of £55 million.
Most of this fall is a direct result of the traffic downturn described
above. Despite this revenue shortfall and the higher interest
costs of the PPP financing arrangements (net debt was £727
million at 31 March 2002), the Company is forecasting a small
profit before tax and exceptional items.
3.6 There is continuing uncertainty about
the financial consequences for the Company, and about the overall
scale and duration of the downturn and the longer term recovery
profile. Based on NATS' base case forecast, agreed with shareholders
and lenders, the effect of 11 September will be to reduce income
by around £230 million over the course of the next four years
compared with the CAA's original demand forecast against which
the Price Cap was set. Faced with this revenue shortfall NATS
management has responded in the following ways to restore the
financial position.
4. RESPONSE
Short term liquidity
4.1 In the aftermath of 11 September, the
Company maintained its process of regular meeting with lenders
and shareholders, but focused on quantifying the revenue loss
and determining appropriate next steps. The level of co-operation
between the stakeholders has been excellent.
4.2 In order to manage the short term cash
shortfall, a number of actions were initiated, including savings
in operating costs, suspension of non-essential capital expenditure,
a re-assessment of the capital programme and reductions in working
capital. These actions improved the cash position at the end of
February by £42 million. In addition, the Government and
lenders have provided up to £60 million of additional loan
facilities to meet operating cash flow requirements to the end
of September 2002. This is a commercial loan on commercial terms
and is intended to provide bridging finance while the steps outlined
below are implemented. In a written answer on 20 March the Secretary
of State reported that "A short-term loan facility for National
Air Traffic Services has now been agreed. It is for a maximum
of £60 million over the period to 30 September 2002, £30
million of which is to be provided by the Government and the other
£30 million by a group of four lending banks. Each party
will lend on the same commercial terms. Its purpose is to relieve
NATS' cash-flow position until arrangements are put in place to
secure the long-term financial stability of the company following
the unprecedented events of 11 September 2001." In addition,
further options for strengthening the balance sheet are under
review.
Business Plan
4.3 An accelerated programme of cost savings
has been identified through the Company's business planning process.
This is expected to realise additional savings in excess of £200
million in the remaining years of the current Control Period and
is designed to strengthen the Company's financial position and
protect against further demand risk. The Company will not make
any changes that could compromise either the safety of operations
or the integrity of NATS systems.
4.4 The NATS (En Route) Ltd element of the
Business Plan was submitted to the CAA at the end of March as
required by the Licence. Work is continuing on the NATS (Services)
Ltd element of the Plan, to establish the full scope of the business
development opportunities open to the Company.
4.5 The main strands of the Business Plan
are as follows:
— a Long Term Investment Plan that
provides capacity ahead of demand yet maintains flexibility to
adjust project timings to match traffic growth.
— a competitive sourcing approach for
Commercial Off The Shelf (COTS) based systems.
— targeted cost savings in engineering
and R&D, through staff reductions arising from efficiency
measures, reductions in requirements and collocation, as well
as through optimisation of maintenance contracts. In addition,
the number of support staff is being reduced.
— a continuing increase in the number
of air traffic controllers—140 are being recruited this
year.
— Overall staff numbers are planned
to decline from 5,700 to around 4,500 (21 per cent) by 2005-2006
as a result of modernising and standardising NATS equipment systems,
bringing in greater automation, rationalising NATS accommodation
arrangements and other good housekeeping measures. There is a
firm commitment to ensuring the staff issues are managed properly,
for example maintaining the commitment to the current Staff Surplus
Agreement.
— a Human Resources and Change Plan
to drive up management capability, introduce new performance management
processes and improve employee relations.
— business efficiency measures to reduce
overhead and support costs through organisational change, improved
business systems, a shared services approach for Human Resources,
Procurement and Facilities Management, and a new accommodation
strategy.
— validating the safety implications
of each aspect of the business plan.
4.6 The Plan has been approved by the NATS
Board, which comprises both Government and Airline Group directors,
and has been the subject of extensive consultation with customers.
There were a series of staff open meetings in December and the
Plan was discussed at the first meeting of the Stakeholders Council
held on 24 January. The Plan will have a major bearing on the
application currently with the CAA for an increase in prices.
Prices and the CAA Application
4.7 When the PPP was established, the regulatory
regime was set at RPI—three per cent for 2002, RPI—four
per cent for 2003 and RPI—five per cent for 2004 and 2005.
The Company has implemented the RPI—three per cent reduction
in en route charges for 2002, unlike our European counterparts
where prices have increased by an average of 12 per cent and by
up to 40 per cent following 11 September.
4.8 As noted above, NATS has assessed the
size of the revenue loss from the reduction in traffic at £230
million. The application to the CAA therefore includes a proposal
to increase prices by RPI + 4 per cent, + 3 per cent and + 2 per
cent respectively in each of the remaining years of the current
Control Period to repair the shortfall caused by 11 September.
The CAA is now assessing the application and has indicated that
it will include a statement of regulatory principles in its decision.
The CAA's consultation document is expected to be issued in May.
5. THE TWO
CENTRE STRATEGY
5.1 The Company's capital expenditure programme
was one of the key areas for review during the development of
the Business Plan. A series of review principles were adopted
when considering priorities for investment, as follows:
— complete the Swanwick Centre. This
was the top priority and Swanwick was successfully introduced
into operational service on 27 January;
— complete essential system replacements;
— continue with planning for sectorisation
capacity developments, which allow relatively inexpensive increases
in capacity;
— contine research studies into future
capacity productivity tools;
— continue with evaluation of new centre
systems for Scotland and elsewhere;
— contine feasibility studies into
the best programme for Flight Data Processing (FDP) system replacement;
— delay major projects where feasible
in the light of the reduced traffic demand situation;
— assess the feasibility of bringing
forward necessary projects to allow the closure of the West Drayton
site to realise operating cost savings.
5.2 The major projects considered suitable
for delay included the programme for replacement of NATS' radar
network and the New Scottish Centre (NSC) project. This view was
accepted by the Airline Group and Government after careful consideration,
on the basis that all stakeholders remain committed to the NSC
project and to the Two Centre Strategy.
5.3 Against the background of reductions
in North Atlantic traffic, and depending on the final extent of
the downturn, the Company took the view that the start of the
main work on the NSC building could be delayed by around eighteen
months to two years. The precise timing for the resumption of
building work will depend on future traffic levels, however the
delay is temporary. The requirement to construct the NSC is a
contractual obligation on the Airline Group, agreed as part of
the PPP transaction, and this obligation remains in place.
5.4 Work has continued on the building design
and piling contracts. Work has also continued on the evaluation
of air traffic equipment systems for deployment in the new Centre.
The ATC system contract with Lockheed Martin has been terminated
in order to implement the Airline Group's strategy of establishing
an open competition for the system using COTS based products.
The cost of work under the former contract has been written off
and will be charged to the Profit and Loss account as an exceptional
item.
5.5 NATS is using the additional time to
produce a high quality product and is currently engaged with suppliers
in evaluating systems proposals. We expect to commence the competitive
selection process in the course of this year. This should enable
the Company to complete the project in an accelerated timescale
when the traffic situation becomes clearer. In the meantime, the
recent refurbishment of the Scottish domestic Operations Room
has provided a number of potential extra sector positions, which
allows for some further growth in capacity ahead of the transfer
to NSC. The Company believes this should provide sufficient capacity
potential to cover the additional time needed to complete NSC
once the project re-commences. In addition, the recent interim
facilities upgrade has provided a new radar processing system,
which addressed the most immediate systems issue.
5.6 In recent discussions with the Secretary
of State for Scotland, NATS' Chief Executive Officer re-affirmed
the Company's commitment to the Two Centre Strategy, including
the completion of a new air traffic control centre at Prestwick
in the 2008-09 timetable.
6. CONCLUSIONS
6.1 The PPP structure has been the subject
of an unprecedentedly severe financial test. The financial problems
have demonstrated that, as an institutional structure, the PPP
is working well even in the most difficult circumstances. There
is a clear alignment of interests between the key stakeholders
and this underlying strength of purpose will serve the Company
well in the future. The Partnership gives the company a commercial
cutting edge, but it also preserves the best of the old NATS in
terms of high safety standards and commitment to public service.
6.2 The PPP provides the structural incentives
to ensure that the company looks to its customers first, rather
than simply passing on its costs. Unlike its European counterparts,
the Company has reduced its charges in 2002, which is clearly
critical to airlines as they trade through the current difficulties.
The Company is seeking modest increases in charges for the three
years to 2005.
6.3 NATS has responded in a commercial and
responsible manner following the traffic downturn, with the continuing
safety of air travellers as the clear priority. Rapid action was
taken to contain costs, whilst maintaining safety and service
standards. The Company has delivered the new Swanwick Centre into
operational service and developed a Business Plan, which meets
customer requirements. Through the Business Plan, it has committed
to delivering additional savings of more than £200 million,
through a wide variety of good housekeeping measures, without
damaging the business in any way.
6.4 The measures summarised in this memorandum
will be sufficient to address the revenue shortfall and restore
NATS' financial position. On this basis, NATS is confident that
it will continue to be able to discharge its obligations to provide
air traffic services while maintaining safety and service standards.
National Air Traffic Services Ltd
11 April 2002
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