Select Committee on Transport Third Special Report




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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