Why NAT’s debt was doubled

When the National Air Traffic Services (NATS) was partially privatised in July last year, its debt burden was more than doubled. Prior to privatisation, it owed £330m to the National Loan Fund; after privatisation it owed £733m to a consortium of banks (Abbey National, Barclays, HBOS and Bank of America). Needless to say, the latter is at a significantly higher rate of interest than the former.

This is clear from the National Audit Office (NAO) report on the transaction published on 24 July 2002:

“NATS’ initial financial structure saw NATS’ debt rise from £330 million to £733 million to cover the sale proceeds paid to the Government.” (Summary, paragraph 16)

So a transformation that was supposed to provide NATS with access to bucket loads of private finance for investment, not to mention untold benefits from private sector management and private sector economic disciplines, began by saddling it with an extra £403m of debt. To put this figure into perspective, its annual revenue was around £600m in 2000/1, so this extra debt amounts to around eight months revenue, which it is having to pay back with interest to the banks over the next 20 years.

This extraordinary state of affairs came about because the partner chosen by the Government for the NATS Public Private Partnership (PPP) – the Airline Group – paid a mere £50m for its “partnership” and a 46% share in NATS. The Government ended up getting £758m as a result of the transaction, but the bulk of that came from a £733m loan taken out, not by the Airline Group, but by NATS and repayable by NATS. Of the £758m received by the Government, £330m was required to repay NATS’ outstanding loans to the National Loans Fund, so the Treasury got around £428m net for the transaction.

Thus, the Government’s reorganisation of NATS as a PPP was accompanied by an increase in its debt from £330m to £733m.

Airline Group

As its name implies, the Airline Group is a consortium of airlines: British Airways, British Midland, Virgin, Britannia, Monarch, EasyJet and Airtours, all of which are customers of NATS. A 5% share was reserved for employees, leaving the Government with 49%.

Why was this bizarre arrangement made, whereby a private partner was brought in for a nominal sum, but the partnership thereby created had to dramatically increase its bank debt in order pay for the new partner’s stake? The answer is the Treasury was adamant that the proceeds from the sale should conform, as far as possible, to its original estimate. As the NAO report put it:

“The Department and the Treasury attached importance to the potential proceeds from a sale. Some £500 million in receipts had been assumed in the Department's expenditure totals inherited from the previous administration.” (Paragraph 1.9)

The eventual outcome was the product of the Treasury insisting on its pound of flesh despite the serious consequences for the new part-privatised NATS. That is how in July last year, NATS had its debt more than doubled.

NATS’ business

NATS provides air traffic control services in UK airspace, and jointly with Ireland in the Oceanic Control Area over the North-Eastern Atlantic Ocean. In the year 2000, it handled more than two million flights carrying around 200 million passengers.

Control of aircraft in UK airspace flying between airports, or en route to overseas destinations, is known as “en route” air traffic control, and this is NATS’ major activity, accounting for about 82 per cent of its revenue (around £486 million in 2000/1). NATS is the sole provider of en route air traffic control in UK airspace. Charges for en route services are collected on its behalf by a division of the European organisation for the safety of air navigation, Eurocontrol.

A second source of income for NATS (around 13 per cent of turnover, or £81 million in 2000/1) is through control of aircraft arriving at and departing from UK airports. NATS provides air traffic services at 14 major airports, including Heathrow, Gatwick and Stansted. At airports, NATS recovers its costs either directly from aircraft operators or through charges paid by the operator of the airport. Provision for airport air traffic control is a competitive market. Some airports provide their own air traffic control services, while others use private companies, such as Serco.

NATS also receives revenue for services to the Ministry of Defence, for services to helicopters operating in the North Sea, and for various training, engineering support and consultancy contracts in the UK and overseas.

Prior to part-privatisation, NATS was a wholly owned subsidiary of the Civil Aviation Authority (CAA), which has a broad remit in the regulation of air transport. Crucially, it was relatively free to set its charges for en route services for which it was a monopoly provider. Unsurprisingly, therefore it was not a loss making enterprise, and turned in a modest operating surplus of around £50m a year in the 1990s.

Its safety record was (and is) second to none – there has never been a fatal incident in UK airspace attributable to NATS. In terms of flight delays, it performed better than most air traffic control bodies in Europe, despite managing some of the most heavily used airspace over southeast England.

So, at the time when New Labour decided to partially privatise it, NATS was doing a reasonably good job. The one blot on its copybook was the delay in opening its new en route air traffic control centre at Swanwick in Hampshire. This was originally due to open in late 1996, but eventually opened only in January this year, some £150m over the original £475m budget. This was seized upon by New Labour as yet another example of the inability of public bodies to get major projects completed on time and on budget, for which the only cure is private sector involvement. Never mind that it was the private sector, in this case, the US supplier of air traffic control equipment, Lockheed-Martin, which had failed to deliver a functional system on time.

Private investment

But the main reason given by the Government for the part-privatisation was that NATS needed to be free to have access to private capital for investment, and not have to compete with the NHS and other good causes for funds from the Treasury. The public-private partnership would, it was said, deliver vast sums of private funds to the business in the manner of a fairy godmother. Investment of £1bn over ten years was promised.

What has happened in practice is somewhat different: in addition to the £733m loan to pay the Treasury for its share of the partnership, the Airline Group negotiated further bank facilities of £690m for NATS to fund future capital expenditure. Needless to say, the cost of this borrowing is significantly dearer than public sector borrowing. However, because of its present financial difficulties, NATS is in breach of the terms of these banking facilities and the banks are no longer allowing it to draw on them. To quote from the NAO report:

“The impact of the events of September 11th on NATS’ revenue base were such that the company may have been construed as being in breach of certain of the provisions within its banking facilities. As a result, NATS agreed that it would not seek to make further drawings under the loan facilities over and above the £24 million already drawn and would fund capital expenditure from operating cash flow.” (Summary, paragraph 17)

So, far from there being vast sums of private funds for investment as envisaged by the Government prior to part-privatisation, at the moment NATS is having to rely on its operating surplus, which has been depleted not just by the downturn in revenues post September 11, but also by having to pay off a £730m loan to pay the Government for the Airline Group’s stake.

Decreased charges

In principle, any investment funds NATS required could have been generated, without recourse to the Treasury, or to these bizarre PPP arrangements. A modest increase in en route charges would have done the trick, since NATS was (and is) a monopoly supplier of these services – air traffic control charges represent only a few per cent of airline costs, so a modest increase would have little or no impact on flight volume.

(Though NATS en route charges have declined in real terms in the 1990s, at the time of privatisation they were amongst the highest in Europe. There is a standard method of charging in Europe, based on the weight of an aircraft and the distance flown, so comparisons can be easily made. In 2001, a 50 tonne aircraft, for example, a Boeing 737, was charged around 87 Euros per 100 kilometres in UK airspace controlled by NATS, compared with 52 Euros in French airspace and 49 Euros in Spanish airspace (see NAO report, Figure 2). Eurocontrol collects the charge for a flight from the aircraft operator and divides it up amongst the various air traffic control bodies through whose airspace the aircraft has flown.

Whether these comparisons are valid is a matter of dispute. NATS claims that meaningful comparisons with Europe are impossible, because the nature of the traffic differs from one provider to another. For example, in UK airspace there is a smaller proportion of overflights, which yield the most revenue for the least work, than most other European providers (see House of Commons Transport Select Committee report on NATS finances, published on 17 July 2002, paragraph 31).)

The Government chose not to go down that route of allowing NATS to raise its en route charges in order to generate investment funds. Quite the reverse: the establishment of the PPP was to be accompanied by significant decreases in these charges in real terms over the first five years of its life. That decision, coupled with the Government’s insistence on a return of around £500m for the Treasury, is the root cause of the financial mess in which NATS finds itself today.

With the establishment of the PPP in July last year, NATS became an independent corporation separate from its parent body, the CAA. The latter was given responsibility for licencing NATS to provide en route services and for setting the charge for these services. The CAA was to be its economic (as well as its safety) regulator and it cannot increase its charge for en route services (which generate around 80% of its revenue) without the permission of the CAA. Charges for other NATS services are not regulated.

What is more, the Government laid down in advance of the PPP being established that in the five years 2001 to 2005, the charge would decrease in real terms (that is, after allowing for an increase in line with the RPI) by 2.2%, 3%, 4%, 5% and 5% respectively. Because of this, at the beginning of 2002, NATS was forced to decrease its en route charge by almost 1%, even though its revenues were lower than expected because of the events of September 11, at a time when other air traffic bodies in Europe were increasing their charges by about 13% on average to cope with the fallout from September 11.

(In February NATS applied to the CAA for permission to increase its en route charge in real terms over the next three years. The CAA turned down its initial proposal but at the time of writing, consultations are ongoing.)

Strategic partner

The severe price cap imposed by the Government severely reduced the value of NATS, and made it much more difficult for the Government to achieve its target of £500m proceeds from the sale.

The Government chose not to sell shares in NATS to the general public, the route followed in most of the privatisations of the 1980s. Instead, a private corporate body was to be selected as a so-called Strategic Partner by means of a competitive bidding process. In this way, the Government had the ability to veto undesirable ownership.

Opponents of privatisation had made an excellent case for retaining NATS in the public sector on safety and national security grounds. That was why the Government chose to retain control over who owned NATS, while privatising 46% of it. It wouldn’t look good if the monopoly provider of air traffic control services in the UK developed into an enterprise that obviously put profit over safety, or if Saddam Hussein Enterprises bought a stake in the body that provided air traffic control for the RAF (and the USAF).

To guard against this, the Government went down the route of selecting a respectable private Strategic Partner and keeping that partner in a straitjacket by means of a Strategic Partnership Agreement, which gives the Government a veto over a whole range of issues, including the disposal of equity and assets (see NAO report, Part 4). In extremis, the Government has powers under the Transport Act 2000 to place it in administration, as it did with Railtrack. All of which goes to show how unsuitable NATS was for privatisation in the first place.

Four consortia eventually bid to be a Strategic Partner: the Airline Group, Nimbus (in reality Serco), Novares and Raytheon. All of them had potential conflicts of interest. The Airline Group had an interest in getting preferential treatment for its own members from NATS (and in low charges for air traffic control services); Novares and Raytheon, as air traffic equipment providers, had an interest in getting preferential treatment for the supply of their equipment to NATS; and Nimbus, as the UK’s largest private air traffic control provider, had an interest in creating an effective monopoly out of which it could profit.

On 27 March 2001, the Government announced that the Airline Group had been chosen as its partner in NATS, “subject to completion later this year” (to quote from John Prescott’s press statement at the time). The Government was due to get £845m proceeds from the deal, mainly paid for by a bank loan of £796m repayable by NATS. Had this deal gone through, the Government would have received £515m from the sale, after paying off NATS’ outstanding £330m debt to the National Loans Fund, a figure very close to the £500m Treasury target.

But the deal could not be concluded – because the Airline Group could not get the necessary backing from their lending banks unless the Government was prepared to settle for less. The main reason for this was that by that time (May 2001) air traffic was declining, particularly, across the North Atlantic, due the slowing of the US economy and the effect on tourism of the outbreak of foot and mouth disease in Britain. The Government had to settle for £87m less up front, that is, £758m, plus around £21m to be paid over the next 30 years. The final deal was signed on 26 July 2001.

Conflict of interest

Why did the Airline Group buy a stake in NATS? The members of the Airline Group have a direct conflict of interest with NATS. In their core business, they have a financial interest in low air traffic control charges, while NATS has an interest in pushing them up in order to maximise revenue. So why buy a stake in NATS? It cannot have been to get a commercial return on their £50m investment, since that might cost them much more in their core business through higher charges.

The NAO report says of their motives in bidding:

“The Airline Group was reluctant to see NATS controlled by any organisation which they felt might have a greater interest in maximising shareholder value, rather than in investing in expanded capacity for air traffic control.” (Paragraph 1.17)

In other words, their investment in NATS was a defensive measure – to prevent any other body gaining an interest in NATS, and being in a position to push up charges for air traffic control services – and they do not expect to get a commercial return on their investment. (This is borne out by the fact that one member of the Group – EasyJet – has already written off its £7m investment.)

The Government must have been very happy with its partner’s lack of expectation for profit. The last thing the Government wanted was a private sector partner appearing to make excessive profits at the expense of public inconvenience from air traffic delays, or even at the expense public safety. The Airline Group, not only had an obvious interest in safety in the air, but also didn’t expect to make a commercial return from its investment. With the Airline Group as a partner, NATS would not turn out to be a Railtrack of the skies.

NATS objects

Prior to the deal being signed, NATS itself and the CAA, its regulator to be, objected strenuously to the proposed financial structure.

The then Chairman of NATS, Sir Roy McNulty, who was an enthusiast for the PPP (not surprisingly, since he had been appointed by the Government in order to be enthusiastic), wrote to the Department of Transport on 11 June 2001, and again on 15 June, describing the proposed financial structure as unworkable. These letters do not appear to be in the public domain, but Gwyneth Dunwoody quoted liberally from them in questioning witnesses before the Transport Select Committee (see the Minutes of Evidence accompanying the Committee’s report on NATS finances, published on 17 July). She quoted him as writing:

“It seems clear the financial structure as currently envisaged will not work and that significant changes are required.”

“Under current proposals, NATS' debt would be £350m higher and it would be very thinly capitalised.”

“The financial plan should not require cuts in staff numbers on a scale which could put at risk the delivery of a safe and effective service.”

“The structure must afford adequate financial headroom to cope with the uncertainties.”

“The success of the PPP will be judged against whether these things happened in practice, not against the specific level of proceeds [to the Treasury] achieved in the short run.”

Obviously, what was at issue was the massive loan that NATS was going to be forced to take out in order to pay the Treasury.

CAA objects

The CAA objected in similar terms in correspondence with the Department (which is available as an appendix to the Transport Select Committee report). A letter dated 23 May 2001 began:

“The CAA has profound reservations about the proposed high debt financing of NERL [NATS en-route service], 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.”

The CAA had advised the Government, at the latter’s request, on the price cap for NATS’ en route charge in the first 5 years of the PPP from 2001 to 2005. The CAA proposed a decrease of 5% every year in real terms (which the Government had eased in the first three years – see above). The CAA made this proposal on the assumption that the debt-equity ratio of NATS as a PPP would be around 50%, though they expressed reservations about that level of debt.

What was being proposed in May 2001 was an initial debt-equity ratio of 129% for the PPP (which would increase when the investment loan was drawn upon). This ratio was subsequently reduced to 110% when the banks insisted that the Government settle for less (see above). Obviously, the CAA had no idea that NATS was going to be saddled with an enormous debt in order to pay the Treasury, which meant that the price cap they proposed originally was not appropriate.

Another letter on 20 July 2001, a few days before the deal was finalised, said:

“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.”

Department ignores objections

The Department, then under the stewardship of Stephen Byers, ignored the warnings from NATS itself and the CAA, and the deal was signed on 26 July 2001. To be fair to him, it is clear that the Treasury was in the driving seat – the correspondence between his Department and the CAA was copied to the Treasury and the Department’s replies were agreed with the Treasury.

(It was not coincidental that Roy McNulty resigned as Chairman of NATS on 25 July 2001, the day before the deal was signed. At first glance it might be thought that his resignation was a consequence of his stated objections to the financial structure of NATS under the PPP. In fact, it was because he was going to become the head of NATS’ regulator to be: in early September he was appointed Chairman of the CAA. )

It cannot be said that the Department did not seek expert advice on putting together the PPP. The total cost of the project to the Department was around £44m (see NAO report, Table 12), some of it incurred by NATS and the CAA and chargeable to the Department. Their lead advisers were the investment bank, Credit Suisse First Boston (CSFB) which was retained in September 1998 initially for 18 months at £222,000 a month, later extended to 33 months. (Apparently, it is not their practice to provide records to enable payment on the basis of actual time spent, so they had to be employed on a fixed retainer, whether they had any work to do or not). They received almost £9m in all for advice about the PPP. (Legal advice cost £13.7m).

Within months, CFFB got further work from the Government, this time to advise on the financial status of the new NATS. It was effectively bankrupt. According to the NAO report:

“In March 2002 the Department and Treasury were advised by CSFB that NATS was in a serious financial position and was at risk of defaulting on the terms of its loan agreement with the banks. Without short-term support, the NATS Board would have to consider whether the company should apply to be taken into administration.” (Paragraph 3.39)

9/11

Of course, the events of 11 September had happened in the interim, causing a severe downturn in air traffic. Throughout last winter, flights were down about 5% compared with the previous year, and revenue was down about 10%. The decline in traffic was most serious on trans-Atlantic routes from which NATS derives around 45% of its revenue. Since 11 September, not only has the number of air traffic movements declined, but also airlines have introduced smaller aircraft, which bring in less revenue (since the en route charge is based on weight as well as distance flown) but costs NATS as much to handle. NATS revenue in 2001/2 was around £55m less than projected, but significantly £15m of this was before 11 September.

The Government, and others responsible for the financial structure of the PPP, assert that the events of 11 September, and the impact on air traffic, were unprecedented and could not have been foreseen, and therefore it was nobody’s fault that six months after NATS was established in its new form it was close to bankruptcy. This attempt to avoid blame might wash if the Department hadn’t ignored warnings from NATS itself and from the CAA that the proposed financial structure would not withstand “adverse shocks” or if the Department had considered the possibility of a drop in air traffic occurring at any time.

Unprecedented?

The latter was not an entirely unknown scenario. Air traffic suffered a decline on three occasions in the last 30 years, in 1973 and 1979 when oil prices rose sharply and in 1990 as a consequence of the Gulf War. But according to the NAO report, although the Department considered 19 adverse scenarios, all assumed a consistent growth in air traffic. The NAO remarked:

“We consider that other scenarios could usefully have been tested, such as a lower traffic case, given the risks of growing economic recession in the USA and uncertainty as to whether airports could cope with four to six per cent annual growth in perpetuity. The economic regulator can adjust for such factors every five years when capping NATS’ prices, but in the meantime NATS may encounter financial difficulties.” (Paragraph 3.25)

When the NAO analysed the effect of adverse shocks on the lines of the two oil price hikes and the Gulf War, they concluded:

“During the Gulf War, the increase in military activity across the North Atlantic counterbalanced NATS’ downturn in civil aviation, and we found that NATS finances may have dealt with such pressure. Conversely, given a reduction in traffic on the scale experienced in both of the oil shocks, each of which lasted several years, we found that NATS would have been unable to meet its debt service obligations.” (Paragraph 3.27)

The Government didn’t want to know about “adverse shocks” leading to a downturn in air traffic, which would inevitably translate into a downturn in NATS’ revenue. It didn’t want to know because that meant that the PPP would not be able to carry the level of debt necessary to give the Treasury the proceeds it wanted from the sale. So a blind eye was turned to the possibility of a downturn in air traffic.

When the downturn came after 11 September, NATS was in an impossible position. Unlike other air traffic control bodies it couldn’t raise its prices in order to restore its revenue, and it still had the £733m halter imposed by the Government around its neck. It would have gone bust if the Government hadn’t in March agreed to lend it £30 million on a temporary basis, a figure matched by its bankers. This facility ends on 30 September 2002. By then a permanent solution has to be worked out.

Permanent solution

The solution can only lie in three areas: raising revenues, cutting costs and raising additional finance.

NATS can do very little to raise revenues. Nothing can be done about traffic volumes and charges for its core en route business is subject to the approval of the CAA, which has turned down its application for an increase. There may be some scope for raising extra revenue from the other parts of its business but much of this is subject to competition.

NATS has proposed a programme of cost cutting, including staff cuts (though not amongst air traffic controllers whose numbers are scheduled to rise from 1946 to 2033 over the next four years). But many of the staff cuts are subject to new technology working (and to CAA certifying that safety will not be impaired by doing so). Cost cutting will not yield much in the short term. Ironically, making staff redundant has been delayed because the company hasn’t got the cash to make redundancy payments.

As for raising extra finance, NATS banks are not willing to cough up any more, so it is up to the main shareholders – the Airline Group and the Government – to come up with some by way of additional equity or loans to get their business out of trouble. But, the Airline Group isn’t interested. Understandably so, since it has got what it wants out of its partnership in NATS: it has prevented any other group getting it and pushing up charges for air traffic control services to the disadvantage of airlines. It got this blocking mechanism for £50m, on which it doesn’t expect to earn a commercial return. Any further investment would be in the nature of a donation to NATS.

The Airline Group can sit on its hands in the certain knowledge that there will always be air traffic control services to enable it to fly its planes. The Government has international legal obligations to provide air traffic control in UK airspace. But, more importantly, the economic and social consequences of failing to do so could not be contemplated. Air traffic control is an essential public service, and at the end of the day the Government will have to stump up what it takes to maintain it, if no other source of funds is available.

However, at the moment the Government doesn’t wish to be seen to be baling out NATS so soon after putting together the PPP, which was supposed to solve all its problems. So for the moment at least the Government is not prepared to cough up on its own. A new private sector investor is being sought. The Government has said that it will match anything the new investor comes up with. The CAA may be prepared to ease the price cap in order in order to oil the wheels.

Negotiations are going on with BAA, which owns and operates the major UK airports, including Heathrow, Gatwick and Stansted. Like the Airline Group, it is a customer of NATS, with an interest in keeping the cost of NATS’ services to it at a minimum. Is BAA going to put in money like the Airline Group without expecting a commercial return? And if so, what does it hope to get instead? Sympathetic consideration from the Government for extra runways at Heathrow and Stansted?

Labour & Trade Union Review

October 2002