APPENDIX
GOVERNMENT RESPONSE TO THE EIGHTEENTH
REPORT OF THE SELECT COMMITTEE ON TRANSPORT, LOCAL GOVERNMENT
AND THE REGIONS
NATIONAL AIR TRAFFIC SERVICES' FINANCES
The Select Committee's eighteenth report for the
2001-02 Parliamentary Session, concerning the finances of National
Air Traffic Services (NATS), was published on 30 July 2002.
The Committee draws attention to the financial difficulties
faced by NATS since the terrorist attacks in New York and Washington
on 11 September 2001, and the need for an early solution to enable
NATS to deliver its services effectively and develop them for
the future. The Government agrees with the Committee that an early
solution is needed, and welcomes the consultation paper published
by the Civil Aviation Authority (CAA) on 17 October 2002, which
sets out a blueprint for such a solution. NATS, its shareholders
(including the Government) and its lending banks are committed
to continuing to work to deliver the solution.
One element of the solution is an application by
NATS to the CAA for changes in the economic regulation regime
applicable to NATS, including a relaxation in the cap on its charges
for air traffic services. In its consultation paper, the CAA proposes
to agree to make changes provided that the other elements of a
robust solution are also put in place.
There are three other key elements to the solution.
First, BAA plc, which has a strong strategic interest in the continued
effectiveness of NATS' operations, is prepared to invest £65
million in NATS, partly in equity and partly through lending (subject
to any clearances required under competition law). Second, the
Government has said that as a responsible shareholder it is willing
to match an appropriate level of new private sector investment
on suitable terms. Third, NATS' lending banks would also contribute
to the solution by amendments to the terms and conditions of their
loan. All parties see the solution as a composite package in which
each element is contingent upon the others also being present.
The CAA's consultation process closes on 14 November
2002. All parties are committed to continuing to develop the composite
solution so that the completed deal can be put in place shortly
thereafter if it is confirmed by the CAA in the light of the responses
to the consultation. The intention is also that discussions between
NATS and its lending banks would continue after that so that NATS'
financing can be restructured on a more advantageous basis no
later than 30 September 2003.
The Committee's detailed conclusions and recommendations
are reproduced below, together with the Government's response.
(a) The seriousness of NATS' financial situation
is due to the reduction in air traffic that followed the 11 September
terrorist attacks and the company's dependence on north Atlantic
traffic. The financial structure created by the PPP inflated the
company's difficulties. The Government failed to give due weight
to the concerns expressed by both NATS and the CAA about the high
debt levels imposed on the company. The Government failed to heed
the warnings about the impact the financial structure would have
on the viability of the company in the event of a downside demand
shock. The weaknesses of the financial structure suggest a failure
of due diligence at the time of the sale of NATS, when traffic
was already declining and there were already moves towards the
use of smaller aircraft (paragraph 11).
(c) The air transport industry has a history
of cyclical levels of demand and sensitivity to external events.
The terrorist attacks of 11 September were unprecedented, and
the consequential downturn in air traffic was more severe than
those following previous downside demand shocks. The reduction
in demand was not outside the bounds that NATS should have been
able to withstand and should have been considered within its contingency
planning. The impact of a 'downside demand shock' should have
been assessed as part of the due diligence during the PPP sale
process (paragraph 26).
In evaluating the terms offered by the preferred
strategic partner, the Government did consider the views expressed
by NATS itself and more particularly the CAA, the prospective
economic regulator of NATS. On the evidence available, Ministers
judged the terms on offer to be acceptable. They saw three factors
as mitigating the concerns expressed. First, they had already
set the charge cap at a less demanding level than the CAA had
proposed, in order to guard against undue pressure on the company's
finances in the early years. Second, initial senior debt in the
final deal was almost £100 million lower than was envisaged
when the CAA first expressed its concerns, reflecting the less
buoyant demand to which the Committee refers. Third, the Airline
Group's strategy offered a more balanced, lower risk approach
to investment than the NATS programme which the CAA had seen,
and a much higher level of operating efficiencies than the CAA
had envisaged.
The financial structure envisaged for the PPP was
tested - by its proponent, the Airline Group, by the Group's lending
banks and by the Government - against a range of reasonably foreseeable
shocks. The tested range of shocks did not include anything as
severe as that caused by the events of 11 September 2001. Those
events were, as the Committee states, unprecedented and the consequent
effects on traffic levels, in terms of their combination of depth
and length, have gone beyond anything previously experienced or
which could reasonably have been foreseen. Because of the UK's
geographical position, NATS is more heavily dependent on revenue
from transatlantic traffic than any other national air traffic
service provider. Prior to 11 September, such traffic accounted
for 14% of the flights handled by NATS but 44% of its income.
This would have affected NATS in the same way regardless of ownership.
(b) We repeat our predecessor Committee's
recommendations to the Government to consider alternative funding
models for NATS, contained in their Reports into the Future
of National Air Traffic Services and the Proposed
Public-Private Partnership for National Air Traffic Services Limited
(paragraph 15).
The Government considered a range of options for
NATS before deciding on a PPP. The merits of alternative models
were discussed at length in both Houses during the passage of
the Transport Act 2000. In those discussions, the Government acknowledged
that other models could deliver some of the benefits foreseen
for the PPP. But it argued that only the PPP would achieve separation
of service delivery from regulation, freedom from the need to
compete for public sector capital, private sector expertise in
project management, effective efficiency drivers and freedom for
the company to extend its operations into developing markets overseas.
Those arguments still hold.
There is no evidence that NATS would have weathered
the effects of 11 September 2001 any better under any other model.
Publicly owned service providers elsewhere in Europe have coped
only by hiking charges, in some cases very steeply, thereby increasing
the burden on airlines who are themselves affected by the downturn
in traffic. The UK's five nearest neighbours (France, Germany,
Belgium, Netherlands and Ireland) all increased prices by more
than 10%. So did the not for profit trust in Canada. NATS on the
other hand, subject to economic regulation under the PPP, marginally
reduced its prices for 2002.
The Government notes the favourable views on the
PPP expressed by the National Audit Office (NAO) in its report
The Public Private Partnership for National Air Traffic Services
Ltd (HC1096) published on 24 July 2002. The NAO finds that
the PPP provides for continuing high standards of safety and national
security, and for public accountability. It notes that since the
Airline Group assumed control NATS has produced a business plan
which proposes additional capacity over the next ten years to
meet a high rate of traffic growth and limit delays. The NAO adds
that the plan has withstood the scrutiny of airspace users within
and outside the Airline Group, and of the regulator.
There is no reason to re-open the issue of NATS'
ownership structure. The Government continues to believe that
the PPP will be a success once the current financial problems
have been addressed. The Government wishes to allow the PPP to
prove itself, not to add an unjustifiable degree of uncertainty
and disruption for the company, its staff and its users at an
already difficult time.
(d) NATS charges were supposed to reduce,
not increase, under the PPP. The arguments advanced so far will
probably do little to persuade the CAA that an increase in charges
is warranted (paragraph 30).
NATS' charges are reducing in real terms under
the PPP, and will continue to do so if, after consultation, the
CAA confirms its agreement to the revised price cap which the
company is seeking. NATS has asked the CAA to adjust the X factor
in the RPI-X formula for year-on-year changes in NATS' charges
for its UK en route services. Under NATS' proposals, the value
of X would be 2 each year for 2003 to 2005. This means that NATS'
charges would continue to fall in real terms, as they have for
the past two years.
As indicated above, NATS continues to compare very
favourably in this respect with the performance of its European
counterparts. This demonstrates one of the advantages of the PPP
to airlines, who pay NATS' charges, and ultimately to their customers.
The PPP has moved away from cost-plus charging, where all risk
was passed on to the airline users through uncontrolled charge
increases. But the PPP is not just about reducing charges. It
is also about safety and service, security and accountability.
The NAO's remarks on the strength of the institutional arrangements
under the PPP are referred to above.
(e) The Government must provide greater detail
about the implications of BAA becoming an investor in NATS alongside
the Airline Group. None of our witnesses was able to offer an
informative opinion on those implications. It was not clear whether
the additional investment would significantly improve NATS' financial
position (paragraph 34).
There was an extensive search for additional private
sector investment to offset the downturn in revenues after 11
September 2001. BAA has provided the best available financial
offer, as well as a high degree of complementary expertise to
that already injected by the Airline Group.
The new investment will be used to pay down some
of the existing senior debt and will thus significantly strengthen
NATS' future financial position. The composite solution, of which
BAA's strategic investment constitutes a central feature, offers
NATS a more robust basis for withstanding future shocks.
(f) The Government must ensure that BAA's
involvement in NATS is, and is seen to be, transparent, especially
if charges of a quid pro quo for BAA's capacity expansion plans
in return for investing in NATS are to be avoided (paragraph 35).
The Government accepts this recommendation. The Committee
was assured that there was no link between BAA's willingness to
invest in NATS and any particular outcome from the consultation
on future airport capacity currently being conducted by the Government.
The Government now repeats that assurance. Moreover, as in the
case of the Airline Group when the PPP was first set up, steps
will be taken to ensure that there is no conflict of interest
between BAA's two future roles as shareholder and customer of
NATS.
(g) At the time of the PPP, the Airline Group
was acceptable as a bidder for NATS ownership only because of
its inherent aviation interests. The Government should ensure
that any further attempts to secure capital do not dilute the
aviation expertise and stake in NATS (paragraph 36).
The NAO report comments on the highly competitive
and well managed process which led to the establishment of the
PPP. The Airline Group's offer was assessed as being the best
available against a series of prescribed evaluation criteria.
As the NAO note, the choice of the Airline Group was popular with
stakeholders in the industry, but that was not one of the Government's
evaluation criteria.
The Government agrees, however, that there is merit
in the involvement of aviation interests in the running of NATS.
It welcomed the Airline Group's bid, and it welcomes BAA's interest.
The composite solution is structured in such a way that BAA will
acquire the right to appoint directors and influence strategic
decisions while the Airline Group will retain the controlling
interest. The solution will strengthen, not dilute, the aviation
expertise and stake in NATS.
(h) The reduction in engineering staff seems
misplaced given the probability of teething problems with the
new systems at Swanwick. Engineering skills will be essential
for NATS to develop and expand. Experience has shown that loss
of engineering expertise is not easy to recover (paragraph 42).
(i) We are not convinced that NATS' systems
are sufficiently robust to enable it to reduce the numbers of
safety-critical staff. Air traffic control assistants are vital
to the safe operation of air traffic control, and it is incredible
that NATS intends to reduce their number so soon after moving
into a new, highly complex operating environment. It is essential
that NATS and the CAA clearly demonstrate a substantially greater
level of robustness in computer equipment at Swanwick before embarking
on the planned reductions (paragraph 44).
The Government shares the Committee's underlying
concern to ensure that NATS is adequately staffed for safe and
effective service delivery, and recognises NATS' continuing need
for adequate levels of staff with the appropriate technical and
operational skills.
NATS' plans are of long standing, and the reductions
will now be spread over a longer period than originally planned.
NATS is not reducing the numbers of safety critical staff. It
must continue to roster levels of staffing which meet with the
approval of the CAA.
On the engineering side, the reductions are primarily
in maintenance engineers, not systems and programming engineers.
The reduction is a direct consequence of being able to eliminate
in part the older technology at the West Drayton centre. The Government
welcomes the fact that NATS is moving to a modern platform, with
a fully integrated system capable of providing a service for decades
to come.
NATS is currently experiencing a shortage of controllers,
which has particularly affected its ability to handle the summer
peak of traffic at Swanwick. The position has been exacerbated
by unusually high levels of sickness. Steps are being taken to
address the problem in the short term by more efficient deployment
of the existing workforce. For the longer term, by contrast with
the position on engineers and assistants, the number of air traffic
controllers is planned to increase. The NAO report notes that
the number of en route controllers is due to rise from 1421 in
2001 to 1617 in 2011. This too is part of NATS' business plan,
and is reflected in an active programme of recruitment and training.
(j) NATS must balance its need to reduce costs
with its future development. The opportunities for NATS to sell
its expertise to others and develop new sources of income should
not be missed for short-term financial savings (paragraph 45).
The Government notes the Committee's views. NATS'
paramount objective for the immediate future is to implement its
investment programme to support the UK aviation network. It is
right that this should be the focus of NATS' financial and human
resources. If a profitable growth opportunity arises, NATS' unregulated
subsidiary, backed by the international expertise of the Airline
Group and BAA, will still have the opportunity to pursue it.
(k) We welcome the statements of commitment
to the Prestwick centre, but, given the financial considerations
and the inauspicious precedent set at Swanwick, we find it highly
unlikely that it will be operational until well after the new
intended completion date in 2009 (paragraph 48).
(l) NATS' capital investment programme is
critical. A failure to deliver the improvements in capacity will
have dire consequences for the aviation industry and the United
Kingdom economy. The capital programme is an essential plank in
the company's business plan that would allow a rationalisation
of operations into fewer sites (paragraph 49).
The Government shares the Committee's regret about
the extent of the overruns of both cost and time in the development
of the new control centre at Swanwick. One of the prime objectives
of the PPP was to enhance NATS' project management capability,
in order to ensure that future projects would proceed more smoothly
and without similar delay. For the new Scottish centre at Prestwick,
piling has been completed and design work is being taken forward.
NATS is currently engaged with suppliers in evaluating systems.
Changes in forecast future demand are being carefully monitored.
These steps will enable the centre to be taken forward as soon
as the work can be justified.
(m) If NATS' business plan is to succeed,
the company must demonstrate that its computer systems are robust
and will increase the productivity of its controllers. The Committee
is not convinced that the systems at Swanwick have shown either
the necessary robustness or the productivity required (paragraph
51).
In technical terms there have been few teething troubles
at Swanwick. The service has been interrupted only once (on 17
May 2002) since its inception on 27 January 2002. The fault which
led to the interruption has been identified and addressed, and
steps are in hand to improve resilience for the future. The problems
with the system at West Drayton, which also led to service interruptions
last spring, have also been addressed.
Swanwick is primarily about delivering increased
capacity over time, to meet future demand safely, at least as
much as about increased productivity. There will be substantial
productivity gains, but the opportunity to achieve such gains
in the short term has been limited both by the reduction in traffic
and by a shortage of controllers. NATS is addressing the staffing
issue as quickly as practicable, in the short term through a new
voluntary overtime scheme and in the longer term through additional
recruitment.
(n) The Committee recommends that the Government
reconsider the exemption from compensation. NATS is supposed to
benefit from the private sector pressures introduced by the PPP.
It should be subject to the pressures of financial penalties in
situations where it has failed to deliver its services to its
customers (paragraph 52).
The Government understands the reason for this recommendation,
but cannot accept it. As the Committee rightly notes, NATS enjoys
a measure of protection under the Transport Act 2000. This is
a safety issue. When an operational problem occurs - whether it
is caused by technical failure, staff shortage or any other cause
- NATS' first concern is always to maintain safety. Many of the
delays attributable to NATS occur because safety is put ahead
of throughput. The formula by which NATS' charge cap is set includes
a modest penalty on future prices for the overall level of NATS-attributable
delays in a given year. This is intended to provide an incentive
to invest adequately in effective service delivery. But a regime
which imposed a more direct penalty for particular delays would
provide an incentive to put safety at risk.
(o) The Committee doubts that a financially
vulnerable NATS would be able to play an appropriately significant
role in a more centralised European air traffic control service
(paragraph 53).
(p) At present, NATS is far from capable of
meeting the challenges of the long term future of air traffic
control services in the United Kingdom. The cost-cutting and penny-pinching
mentality foisted on NATS merely to survive will leave it ill-equipped
to compete with the new satellite-based air traffic control service
provision being developed in Europe and North America (paragraph
54).
The Government notes the Committee's views. It agrees
that the financial position which NATS has faced since 11 September
2001 is not conducive to meeting long-term challenges. That is
why the Government has been working closely with all parties involved
to secure an effective long-term solution for NATS' finances,
and why it welcomes the proposals in the CAA's consultation paper.
The composite solution described above will provide the firm foundation
which NATS needs on which to build its future operations.
In addition, the productivity measures proposed will
all improve efficiency, to the benefit of users in the short and
longer term. This improved efficiency, along with NATS' strengthening
capability in assessing technological developments and managing
projects, will be crucial in meeting the future challenges facing
NATS.
The benefits will be felt both in this country and
in Europe. NATS' status as the first PPP among European air traffic
services providers, will place NATS in a powerful position to
play a pivotal role in the reform of air traffic management in
Europe. The UK constitutes the largest aviation market in the
European Union. It is inconceivable that NATS' expertise, network
capability and technology should not form an integral part of
any long-term plan for service provision across Europe.
(q) We expect the Department to publish details
of its full contingency recovery plan in the event of a complete
failure of NATS finances (paragraph 55).
The proposed composite solution addressing NATS'
future financial structure is described above. Further details
are in the CAA's consultation document. With this solution in
place, there should be no reason to expect a failure of NATS'
finances.
The Transport Act 2000 contains provisions for handling
the financial or other failure of a company which holds a licence
to provide air traffic services. The measures include a special
form of administration regime. There are also contractual provisions
under the PPP which enable the Government and the banks to step
in and take necessary measures to maintain the performance and
safety of NATS' business while the company's problems are resolved.
The Government is committed to ensuring continuity of service,
for the benefit of airlines and their passengers and in discharge
of its international obligations under the Chicago Convention.
(r) We were told that the PPP and the introduction
of private sector management would deliver a more efficient air
traffic control service. We have seen little evidence of those
efficiencies or the improvements in NATS' management. NATS' business
plan is crucial to its survival. We are not convinced that it
will deliver improvements (paragraph 56).
Greater efficiency and productivity will take time
to deliver. This is true for new management entering any organisation.
It is all the more true at NATS at present, where the effects
of 11 September 2001 have been felt throughout the business. The
period since the attacks has been a very difficult one for the
company, increasing the challenges faced by management. The successful
launch of Swanwick in such difficult circumstances - and, despite
the Committee's comments, it has been a success - is a credit
to the management of the company.
The Government does, however, agree with the Committee
about the importance of high quality management and of the delivery
of improvements through the business plan. Strengthening NATS'
management capabilities to the required world-class standard will
take time. Since the PPP, new appointments have been made to the
posts of Chairman, Chief Executive, Chief Technology and Programmes
Officer and Commercial Director.
There is clearly more which needs to be done. As
a condition of its further investment in the company, the Government
has required NATS to produce an updated management plan within
three months of completion of the deal.
(s) The Committee's previous conclusions about
long term funding and alternative ownership models remain valid.
NATS provides an essential service that must be run safely and
efficiently. The PPP was not appropriate and should be reviewed
before it does terminal damage to United Kingdom's aviation industry
and vital national interests (paragraph 57).
The Government endorses the Committee's emphasis
on the importance of a safe and efficient service. The PPP remains
the right solution to deliver the objectives originally set for
it. A review at this stage would be disruptive and unhelpful.
The Government notes that the NAO does not challenge that. Once
the company's finances are re-established on a firm footing, NATS
will be able to move forward with confidence to meet those objectives.
Department for Transport
30 October 2002
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