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.
23 May 2001
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
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 thatunlikely and undesirable
prospectever 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
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
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
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
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 ratealready
the highest in Europewould 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