Select Committee on Transport, Local Government and the Regions Appendices to the Minutes of Evidence

Annex 1

  The CAA has profound reservations about the proposed high debt financing of NERL, its subsequent ability to meet its obligations under the loan facilities and its ability to fund its development programme if it is buffeted by plausible adverse shocks. In addition the financial structure raises doubts whether it would be feasible to continue to apply normal incentive regulation (RPI-X) to NERL.

  In its advice to the DETR on the charge control, ERG expressed reservations about a debt-equity ratio of 50 per cent. Under the proposed financing this ratio is well over 100 per cent with an initial debt of £829 million compared to the regulatory asset base in our advice of £643 million. This is considerably higher than those contemplated recently in the water industry.

  It would clearly call the whole PPP and regulatory regime into disrepute if the price cap needed to be opened up soon after it had been completed and we support work on measures that address this risk over at least the next five years.

  There is however a more long-term aspect, which will become apparent at future price reviews. NERL's capacity to service such a high level of debt only arises because charges have been and are expected to be set based on the relatively high cost of capital predicated on a standard financial structure. In this situation, airlines would be both bearing the risk and paying for it to be borne by others. This might be sustainable if it could be demonstrated to be to the benefit of customers but it is by no means obvious. At future price reviews there is likely to be pressure for lower charges that reflect the low cost of capital implied by the cost of financing NERL. The regulatory policy will come under considerable undesirable pressure diverting its focus from ensuring the delivery of needed capacity.

  The lenders may assume that the regulator's objective to ensure that the licensee does not find it unduly difficult to finance its business puts the risk onto users. We will of course deliver our role in terms of the statutory duties under the Transport Act, but this is just one of the duties. However future regulation could be driven towards a US-style cost of service regulation including capital expenditure and efficiency reviews rather than UK style incentive regulation.

  There are solutions to manage the downside risk to maximise the prospect that the PPP achieves its policy objectives. The critical point is that the initial set-up of NERL should be consistent with the overall policy objectives of the PPP, the statutory objectives in the Transport Act and the generally accepted principles of economic regulation in the UK. It is not clear, at this stage, that these objectives are likely to be achieved.

  We would be happy to discuss this with you or your advisers further if you wished.

  Kind regards.

Doug Andrew

23 May 2001

Dear Malcolm


  Doug Andrew wrote to me on 23 May about reservations which the CAA had about the proposed debt financing of NATS En Route Limited (NERL) and the implications of that financing. We have, of course, discussed this issue with you and with Doug, who has had meetings with our advisers; he has also now had the advantage of a face-to-face meeting with the Airline Group's (AG's) lending banks. I have, however, held off providing you with a substantive reply, as I hoped the final details of a reworked financing package would be available more quickly. In the event, it may be the beginning of next week before an acceptable package is finalised. The shape is, however, sufficiently clear for me to give you the following information.

  As you now know, the initial level of bank debt that is proposed for NERL has been reduced to £730 million (£100 million lower than before) and the Government has been invited to accept significantly lower day one proceeds. However, AG's offer preserves much of the value of the transaction to Government, at a level broadly in line with the indication which Lord Macdonald gave to Parliament. AG's offer achieves this by creating a £50 million debenture at the NATS level (essentially deferred proceeds), £15 million of which is purchased by AG from the Government at completion, with the Government continuing to hold the remaining £35 million. In this way, the two key shareholders act to resolve the key difficulties that faced the company and prevented the completion of the deal in May. Further, the debt financing is now predicated on more conservative traffic forecasts and refined operating costs assumptions, thus providing NERL with greater comfort on the downside in the first control period.

  Doug raised a number of wider issues in this letter. We accept that the capital structure being proposed for NATS is different to other regulated utilities; and we accept that this means that any regulatory actions will need to be assessed carefully since they might have a quicker and more profound impact that they would on a company with significantly more equity. The flip side of that coin is that the company will give even minor regulatory signals their immediate attention. As regulator, Doug will of course have the freedom to ensure the regulatory framework remains effective.

  We certainly refute any suggestion that the NATS capital structure, as revised, is inconsistent with PPP policy; that it unduly limits the CAA's freedom as regulator; or sets unwanted precedents for other regulated utilities. Each PPP will have to be assessed for what it is designed to achieve. Unlike most other utilities (except perhaps airports), NATS' customer base has the leverage, knowledge and resources to discipline NATS' approach. And, of course, AG is committed to a more open and co-operative approach to pricing. Although it is true that not all airlines are in AG, the group does enjoy the support of the airline community (as expressed by IATA) and AG must be mindful of reciprocity in future ATM policy. There can therefore be no doubt that the identity of this particular strategic partner for NATS brings additional disciplines to bear on the performance of the business. The wider business interests of the Airline Group's constituent members are to ensure that NATS operates efficiently and delivers a robust and effective investment programme.

  Doug also raised questions about lenders' assumptions about future regulatory policy and decisions on charges in relation to the high cost of borrowing that NATS will face. I hope that discussions with the lending banks will have met these concerns. It is not for this Department or the Treasury to second-guess what decisions the regulator will take on pricing or how best to incentivise the company to provide needed capacity. As noted earlier, we believe that the very composition of AG is evidence enough of their motivation to provide needed capacity. We also believe that the arrangements which we have inserted for selecting a replacement to AG, should that—unlikely and undesirable prospect—ever prove necessary, can similarly secure a partner committed to invest in the future.

  I hope that you, your Board and Doug Andrew (to whom I am sending a copy of this letter) find these comments helpful. I shall ensure that you are kept in touch with the progress of the PPP. For our part, we expect to have final details of the proposals over the coming weekend, thus enabling Ministers to take a final decision next week on the way forward, which I shall immediately communicate to you.

  Meanwhile, I trust that this letter gives sufficient information and assurance for your Authority to continue its crucial collaboration with us in finalising the PPP. If you would like a further word either on substance or process, please telephone me.

  We have agreed the contents of this reply with the Treasury; and a copy of this letter goes to Harry Bush there.

R J Griffins

17 July 2001

Dear Roy

  Thank you for your letter of 17 July 2001 concerning the revisions to the proposed financing structure for the NATS PPP. We found this a helpful exposition of the Government's position.

  As you indicate we have discussed the revised proposals with your and the Airline Group's advisers and with the lending banks. Following your letter and these more detailed discussions the CAA Board has reviewed its position against the concerns set out in our letter to you of 23 May. As I indicated by phone, in spite of our continuing concerns, the CAA has agreed to comply with the Direction given to it by the Secretary of State on 17 July and make the Transfer Schemes in the same form and content as the draft Schemes attached to the Direction. We consider it important that the PPP is finalised as soon as possible so that NATS' management has certainty and can proceed to manage the business.

  We recognise that there has been a change in the financial structure for NERL. However, NERL would still have an initial debt-RAB ratio of around 110 per cent, rising over the medium term to finance NERL's investment. This goes well beyond any precedent we have seen in regulated utilities in the UK. The strong likelihood is that under the proposed arrangements NERL's financial resources would still be severely constrained on a continuing basis, unless traffic volumes are much stronger than expected or NERL is able to make more efficiency gains than expected.

  A financial structure such as this is usually considered beneficial where the key objective is to maintain the pressure on management to be rigorous in pursuit of cost efficiencies or additional sources of revenue within its price cap. The downside is the risk of NERL management being excessively cautious in respect of NERL's capital investment programme and innovation more generally, in spite of signals from AG and customers, and the existence of the capital loan facility. We continue to consider that this would run counter to one of the key objectives of the Government's PPP policy.

  There seems to be broad agreement that it is desirable that NERL operates under incentive-based economic regulation built around multi-year price caps. This is in contrast to more frequent price adjustments to ensure that the regulated firm has sufficient funds to cover its costs. I have mentioned that the CAA would be publishing a statement of regulatory policy late this year. This would obviously start from the statutory objectives, NERL's licence obligations and resourcing position. It would outline options for ensuring that NERL is resourced to achieve the statutory objectives and has maximum certainty within an incentive regulation regime. These options could range from confirming the status quo through to signalling an adjustment to the regulatory asset base to deliver a more conventional financial structure. An interim price adjustment could also be considered. The statement would indicate, for consultation, the CAA's view on the option that would best achieve the statutory objectives.

  A consequence of the proposed financial structure is that there is a much higher probability that NERL and the CAA may be faced with the need to re-open the price cap in the short term, within the first five years to ensure that NERL is able to carry out the investment programme which would meet users' preferences. This was never the policy intention.

  A price increase means that the UK unit rate—already the highest in Europe—would stand out further still. In such circumstances the general support which IATA has expressed for the Airline Group becoming the strategic partner may not translate automatically into general unconditional acceptance by non-Airline Group airlines for price increases by NERL. We note that non-AG airlines account for around three quarters of NERL's revenues from UK en route air traffic services. A consequence may be more intrusive on-going regulatory involvement than normal under the standard incentive-based model with adverse affects on NERL's autonomy and accountability.

  To conclude, in our letter of 23 May we emphasised that the critical point was that the initial financial structure of NERL should be consistent with the overall policy objectives of the PPP, the statutory objectives in the Transport Act and the generally accepted principles of economic regulation in the UK. CAA continues to have concerns that this has been compromised. However, as it is critical that PPP is established as soon as possible to end the uncertainty for NATS, and that there are other less desirable options available to NERL and the CAA to achieve those objectives, the CAA will work closely with the Government to complete its part of the transaction.

  The CAA would not wish the Government to be taken by surprise when the regulatory statement is published. Accordingly I would request that Ministers are made aware of CAA's concerns at this stage.

  I am sending a copy of this letter to Harry Bush at HM Treasury.

Sir Malcolm Field


20 July 2001

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